| SUBJECT: The Rule on ‘Watered Stocks’ |
I. Introduction
This memorandum provides an exhaustive analysis of the rule on watered stocks under Philippine commercial law. The doctrine addresses situations where shares of stock are issued by a corporation for a consideration less than their par or issued value, thereby potentially defrauding creditors and other shareholders. This memo will examine the legal foundations, consequences, and procedural mechanisms surrounding watered stocks, with particular attention to the provisions of the Revised Corporation Code of the Philippines (RCC).
II. Definition and Conceptual Foundation
Watered stocks refer to shares issued by a corporation as fully paid when, in fact, the consideration received for them is less than their par value or the stated issuance price. The term evokes the image of cattle being driven to market after being forced to drink water to increase their weight fraudulently. The core legal principle is that the capital stock, subscriptions, and payments thereon, as stated in the articles of incorporation, constitute a trust fund for the benefit of creditors. Issuing watered stocks impairs this trust fund.
III. Legal Basis under the Revised Corporation Code
The primary statutory prohibition is found in Section 60 of the RCC: “No corporation shall issue stock except in exchange for cash, property, or services actually rendered, or a combination thereof, duly valued at not more than their fair market value and received by the corporation.” Furthermore, Section 61 mandates that “consideration for the issuance of stock may be fixed by the board of directors, subject to limitations provided in this Code and in the articles of incorporation.” The issuance of stock for a consideration less than its par or issued value violates these provisions, as the consideration is not “actually received” at its full valuation.
IV. Forms and Methods of Creating Watered Stocks
Watered stocks can arise through several methods:
a. Issuance for Overvalued Property: Issuing shares for property or services whose fair market value is intentionally inflated beyond its true worth.
b. Bonus Shares: Issuing shares as a “bonus” to promoters or incorporators without corresponding consideration, often as part of a subscription contract.
c. Discounted Issuance: Directly issuing shares at a price below par value without lawful justification.
d. Failure to Collect the Full Subscription Price: Treating shares as fully paid despite the subscriber not having paid the full amount due.
V. Liability of Parties Involved
The RCC and jurisprudence impose liabilities on various parties:
a. Subscriber or Shareholder: The holder of watered stock remains liable to the corporation and its creditors for the difference between the par value and the actual consideration paid (the “water”). This is an original liability that attaches upon the defective issuance.
b. Directors and Officers: Directors who willfully and knowingly vote for or assent to the issuance of watered stocks become solidarily liable with the shareholder for the unpaid balance. This is a secondary liability contingent upon proof of bad faith or gross negligence.
c. Transferees: A bona fide purchaser for value of watered stocks who had no knowledge of the defect may generally be protected. However, a transferee who acquires the shares with knowledge of the watering may inherit the original subscriber’s liability.
VI. Consequences and Remedies
The issuance of watered stocks triggers several legal consequences:
a. Liability for Unpaid Subscription: The corporation, or a receiver in insolvency proceedings, may institute an action to recover the unpaid balance from the liable parties.
b. Defense in a Shareholder’s Suit: A holder of watered stock may be estopped from asserting full shareholder rights, such as voting or receiving dividends, until the deficiency is paid.
c. Criminal Liability: Under Section 161 of the RCC, willful violation of the provisions on stock issuance may result in criminal penalties.
d. Piercing the Corporate Veil: In egregious cases, the doctrine of piercing the corporate veil may be invoked to hold shareholders personally liable for corporate debts, especially if the issuance of watered stocks was used to defraud creditors.
VII. Comparative Analysis: Watered Stocks vs. Similar Doctrines
The doctrine of watered stocks is distinct from, though related to, other capital maintenance rules.
| Doctrine / Concept | Primary Legal Focus | Triggering Event | Typical Remedy |
|---|---|---|---|
| Watered Stocks | Adequacy of initial consideration received for issued shares. | Issuance of shares for less than par or issued value. | Recovery of the unpaid balance from subscriber and/or liable directors. |
| Unpaid Subscription | Enforcement of the subscription contract for shares already subscribed. | Failure of a subscriber to pay call for payment or full price. | Action for specific performance or damages against the subscriber. |
| Stockholder’s Individual Liability (Sec. 10, RCC) | Liability for corporate debts arising from misrepresentation in the articles of incorporation. | False certification of paid-up capital in the articles of incorporation. | Personal liability of incorporators for the deficiency to innocent creditors. |
| Liability for Ultra Vires Acts | Legality and authority of the corporate act itself. | Corporate action performed beyond its stated corporate purpose or powers. | Injunction, damages, or ratification of the act. |
| Doctrine of Trust Fund | Preservation of corporate capital for creditor protection. | Any act that improperly distributes or impairs stated capital. | Various, including restitution and damages. |
VIII. Defenses Against Liability
Possible defenses for a holder alleged to possess watered stocks include:
a. Full Payment: Proof that the full par or issued value was indeed paid to the corporation.
b. Estoppel of the Corporation: If the corporation itself, through its authorized officers, represented the shares as fully paid and the holder relied on this to their detriment.
c. Laches or Prescription: An action to recover the unpaid balance may be barred by the statute of limitations or unreasonable delay.
d. Bona Fide Purchaser for Value: As noted, a purchaser without notice of the defect may assert this status as a defense.
IX. Procedural Aspects and Burden of Proof
An action to recover the unpaid balance on watered stocks is typically a civil action for sum of money. The burden of proof initially lies with the party alleging the existence of watered stocks (e.g., the corporation, a receiver, or a creditor) to establish that the shares were issued for less than their par or issued value. Once this is shown, the burden may shift to the shareholder to prove a valid defense, such as being a bona fide purchaser for value. In cases against directors, the plaintiff must prove the directors’ willful or negligent assent to the unlawful issuance.
X. Conclusion
The rule on watered stocks is a fundamental doctrine of Philippine corporate law designed to ensure the integrity of a corporation’s capital structure and protect creditors from fraud. It imposes significant original liability on the recipient shareholder and potential solidary liability on complicit directors. While distinct from doctrines like unpaid subscription or individual liability under Section 10 of the RCC, it shares the overarching policy of capital maintenance. Legal practitioners must carefully scrutinize share issuances for compliance with valuation and consideration rules to avoid the severe consequences associated with watered stocks.
