LIABILITY ON WATERED STOCKS
X Corp had financial difficulties and in the process, plaintiff MMC received a judgement
46 CAL. 2D. 484 – BING CROSBY MINUTE MAID CORP v. EATON
SHENK, J.
Plaintiff corporation (Minute Maid Corp – "MMC") is a judgement creditor of a frozen foods
corporation ("X Corp") where Eaton is a shareholder. Plaintiff seeks to recover the difference
between the par value of stock issued to it and the fair value of the consideration it paid for such
stock (total of 4,500 shares). The lower court decided in favor of the plaintiff corporation, but
unfortunately, the same court granted Eaton's motion for new trial. The general rule is that a
shareholder (i.e. Eaton) is not personally liable for the debts of the corporation (i.e. the frozen
foods corp) however, an exception to this would be: a subscriber who pays only a part of what
he agreed to pay is liable to the creditors for the balance. Unfortunately, MMC can't rely on this
basis since MMC's appeal did not include evidence that Eaton promised to pay all of the 4,500
but actually only paid a part. So MMC had to rely on the only other exception: that shareholders
are personally liable for holding watered stock.1 There are two theories supporting this
attachment of liability (see Doctrine). The SC held that in the State where the case was filed,
only the misrepresentation theory is used. Unfortunately, based on this theory, two factual
situations should be proven (see Doctrine) which justifies the lower court's order for a new trial
(to adduce more evidence and decide on these factual issues).
DOCTRINE
The liability of a holder of watered stock has been based on one of two theories: (1) the
misrepresentation theory or (2) the statutory obligation theory.
Misrepresentation Theory
The misrepresentation theory is the one accepted in most jurisdictions. The courts view the
issue of watered stock as a misrepresentation of the corporation's capital. Creditors who rely on
this misrepresentation are entitled to recover the "water" from the holders of the watered shares.
To hold a shareholder liable under this theory, one must prove: (1) that the creditor (i.e. MMC)
extended credit to the corporation after the watered stock was issued OR (2) that the creditor did
so without knowledge that such watered stock was outstanding.
Statutory Obligation Theory
Statutes expressly prohibiting watered stock are commonplace today. In some jurisdictions
where they have been enacted, the statutory obligation theory has been applied. Under this
theory, the holder of watered stock is held responsible to creditors whether or not they have
relied on an overvaluation of corporate capital.
FACTS
1. Defendant Wallazz B. Eaton ("Eaton") formed a corporation (let's call this "X Corp") to
acquire his frozen foods business which was slowly failing.
2. The Commissioner of Corporations authorized such corporation to sell and issue 4,500
shares of $10 par value stock to Eaton and other individuals in consideration of the transfer
of business.
3. The same permit provided that 1,022 shares be deposited in escrow and not be transferred
without written consent of the commissioner. Eaton successfully transferred his business to
X Corp.
4. Plaintiff Bing Crosby Minute Maid Corporation ("MMC") is a judgement creditor of the
aforementioned corporation.
5. X Corp placed 1,022 shares in escrow and issued the remaining 3,478 shares to Eaton,
and after 3 years transferred the same to other individuals.
6. It is important to note that although the 1,022 shares were listed on the corporate
records as being "held by Eaton" these shares were never released from escrow.
1 Watered stock are shares of a company that are issued at a much greater value than its underlying assets, usually as part of a
scheme to defraud investors. This term is believed to have originated from ranchers who would make their cattle drink large
amounts of water before taking them to market. The weight of the consumed water would make the cattle deceptively heavier,
enabling the ranchers to fetch higher prices for them. Holders are generally held liable to the creditors for the difference between
par value of the stock and the amount paid in.
7.
against X Corp for $21,246.42. A writ of execution on the judgement was returned
unsatisfied. The trial court found that:
a. Eaton gave $34,780.83 to X Corp (which would correspond to the 3,478 shares)
BUT Eaton was actually issued the WHOLE 4,500 shares with a par value of
$10.
b. Subsequent to this issue of shares, X Corp purchased merchandise from MMC
and has not yet paid for all of it.
c. Around $15,000 of the judgement amount remains unsatisfied.
d. X Corp is insolvent.
8. Eaton filed a petition for new trial which was granted by the same trial court on the following
grounds: (1) the finding that he owned the 4,500 shares was unsupported by evidence &
(2) the trial court failed to make a finding on a material issue raised by him.
9. Hence this appeal by MMC on the ground that it was error to grant a new trial since the trial
court's findings of fact were supported by evidence.
ISSUE with HOLDING
1. WON the granting of the motion for new trial was proper. – YES IT WAS.
a. General Rule: a shareholder is not personally liable for the debts of the
corporation – he undertakes only the risk that his shares may become worthless.
b. Exceptions: (1) a subscriber to shares who pays only in part of what he agreed
to pay is liable to the creditors for the balance; and (2) a shareholder is liable for
holding watered stock.
i. In this case: the record on appeal discloses no evidence to support
that Eaton promised to pay/ subscribe the whole 4,500 shares. It is
only the 1,022 shares in escrow which Eaton has sufficient title to since
the escrow contained provisions to protect future stockholders but
offered no protection over future creditors. Hence, it would appear that
Eaton acquired sufficient title to the 1,022 shares to permit MMC to
proceed against him for those shares.
c. Thus, for the remaining 3,478 shares, MMC has no choice but to rely on
Exception No. 2.
i. Exception 2 is based on two theories (see Doctrine).
ii. SC held that under its jurisdiction, only the first theory is used.
iii. Based on this (misrepresentation theory), either of the following factual
scenarios must be proved:
1. that the creditor (i.e. MMC) extended credit to the
corporation after the watered stock was issued; OR
2. that the creditor did so without knowledge that such watered
stock was outstanding.
iv. Since the trial court did not have any finding on any of the aforesaid
issues, its order of a new trial is justified.
d. Plaintiff contends that even under the misrepresentation theory, a creditor's
reliance on the misrepresentation arising out of the issuance of watered stock
should be conclusively presumed.
i. This contention is without merit. If this argument would be allowed, the
misrepresentation theory and the statutory obligation theory would be
essentially identical.
DISPOSITIVE PORTION
The order granting the new trial is affirmed. The appeal from the judgment is dismissed.
DIGESTER: