I. Introduction and Definition
The concept of “watered stocks” refers to shares of corporate stock issued by a corporation as fully paid when, in fact, the corporation has received consideration less than the par value or stated value of such shares. The term evokes the image of diluting the true value of an asset, akin to adding water to milk. Under Philippine law, this issuance is not merely a breach of corporate propriety but a violation of specific statutory mandates designed to protect creditors and the investing public by ensuring the integrity of the corporation’s capital structure.
II. Legal Basis: The Corporation Code and Related Doctrines
The primary legal foundation is found in the Revised Corporation Code of the Philippines (Republic Act No. 11232). Section 60 is pivotal, stating that “consideration for the issuance of stock may be paid, in whole or in part, in money, in property, or in labor or services actually rendered to the corporation.” Crucially, it mandates that such consideration must be “at least equivalent to the par or issued value of the stock.” The issuance of stock for a consideration less than this equivalent results in watered stocks. This principle is further reinforced by the trust fund doctrine, which holds that the capital stock, property, and other assets of a corporation are regarded as a trust fund for the payment of its debts.
III. Distinction from Bonus and Discounted Stocks
It is critical to distinguish watered stocks from legally issued bonus or discounted stocks. Bonus shares are those issued as stock dividends, fully paid from surplus profits or retained earnings, and involve no consideration. Discounted stocks may be issued below par only under stringent conditions: (a) with the approval of the Securities and Exchange Commission (SEC), and (b) when justified by the corporation’s financial condition. Watered stocks arise from an illegal issuance where the deficiency in consideration is not authorized.
IV. How Watering Occurs: Common Scenarios
Watering typically occurs in several ways: (1) Overvaluation of Property: Issuing shares for property or patents inflated in value beyond their fair market value; (2) Issuance for Future Services: Issuing fully-paid shares for promises of future labor or services, which are not “actually rendered” at the time of issuance as required by law; (3) Direct Underpayment: Simply accepting cash or property worth less than the par value without SEC approval for a discount; and (4) Secret Agreements: Having a side agreement between the corporation and the subscriber to refund part of the payment.
V. Liability of the Holder of Watered Stocks
A subscriber or holder of watered stock is not relieved of the obligation to pay the full consideration. Under Section 65 of the Revised Corporation Code, the original subscriber and all subsequent transferees who had knowledge of the watering are liable to the corporation and its creditors for the difference between the price paid and the par or issued value (the “water”). This liability is primarily to the corporation but can be invoked by creditors if the corporation is unable to satisfy their claims.
VI. Defenses Available to the Stockholder
A holder may avoid liability by proving: (1) Lack of Knowledge: For a subsequent transferee (not the original subscriber), a defense of being a holder in good faith and for value without knowledge of the defect; (2) Estoppel of the Corporation: If the corporation itself, with full knowledge of the facts, affirmed the transaction or accepted benefits over a prolonged period; or (3) Full Payment: Demonstrating that the full consideration was, in fact, paid to the corporation.
VII. Consequences to the Corporation and Its Directors/Officers
The corporation itself is adversely affected as its capital stock is impaired, misrepresenting its true financial health to the public. Directors or officers who willfully and knowingly consent to the issuance of watered stocks may be held jointly and severally liable with the stockholder for the unpaid balance. They may also face administrative sanctions from the SEC and potential criminal liability for violation of the Code or for estafa under the Revised Penal Code if fraud is present.
VIII. Relevance in Contemporary Practice
While the prevalence of par value shares has diminished with the Code’s allowance for no-par value shares, the concept remains vital. For no-par value shares, the entire consideration received by the corporation constitutes the capital, so “watering” in the traditional sense does not apply. However, the core principle persists: shares cannot be issued for a consideration less than what is lawfully stipulated in the articles of incorporation or the board resolution fixing the issue price. Fraudulent overvaluation of property in exchange for no-par shares can lead to similar liabilities for directors and shareholders under doctrines of fraud and misrepresentation.
IX. Practical Remedies
Upon discovery of watered stocks, the following remedies should be considered: (1) Corporate Action: The board of directors must demand payment from the liable stockholder for the unpaid balance. A formal resolution and demand letter should be issued. (2) Derivative Suit: If the corporation refuses to act, a stockholder may file a derivative suit on behalf of the corporation to recover the unpaid consideration. (3) Creditor’s Action: A creditor of an insolvent corporation may file an action directly against the holder of watered stocks to recover the unpaid balance for the benefit of corporate creditors, pursuant to the trust fund doctrine. (4) SEC Complaint: Filing an administrative complaint against the corporation and its erring directors/officers for violation of the Corporation Code, seeking sanctions, fines, or even revocation of the certificate of incorporation in grave cases. (5) Criminal Action: In cases involving clear fraud, a criminal complaint for estafa or violation of the Corporation Code may be pursued. (6) Rescission and Damages: In contracts involving overvalued property, the corporation may seek rescission of the contract and claim damages, provided the innocent stockholders ratify the action. Proactive measures include rigorous due diligence on in-kind contributions, obtaining independent appraisal reports, and ensuring strict board oversight over share issuances to prevent liability at the outset.
