Although it seems archaic to us now, it used to be the case that forming a corporation involved going door-to-door across the state searching for potential investors that would provide the cash that would fund the start-up operations of the corporation. If you were investing in an old timey IPO, one of your primary concerns was that someone else might get more advantageous terms for the IPO than you.
Imagine if a company was seeking $100,000 to start its business, and a farmer commits to paying $10,000 for 10% of the issued common stock for the business. As the initial promoters of the business searched throughout the state, they end up securing an additional $70,000 in exchange for selling the common stock ownership rights to 70% of this forming corporation.
As the search for an initial investor base goes on, the stock promoters find themselves stuck–there is a textile manufacturer who will put forward $10,000…but in his negotiation, he insists upon acquiring 20% ownership of this forming corporation.
The promoters of the business, wanting as much initial capital as possible, might be tempted to take that additional $10,000 because it’s better to start out with $90,000 than $80,000. And since the people seeking the capital to run the business are going to be officer management (i.e. contract employees), they don’t have an interest protecting the rights of those other eight initial investors.
This created a problem: How can the formation of capital be facilitated to grow a young nation if no one invests in new businesses out of a fear that the initial stock promoters might act arbitrarily in their treatment of the initial capital providers?
To combat this, New York, Delaware, and other eastern states like Pennsylvania began to issue “par value” stock that was part of the initial public offering process. In the above scenario, the capital formers would state that they are creating one hundred shares of stock with a par value of $1,000 each. When a farmer invests $10,000, he would collect ten share certificates with a par value of $1,000 each.
The par value was a guarantee of fair treatment–your certificate would entitle you to collect damages. Your remedy would be against anyone associated with the stock promotion that knew about the sale of 20% of the business for $10,000 to the last investor. When you paid for your 10%, you had to pay $10,000. The last investor only had to pay $5,000 for each ten percent interest in the forming corporation that he acquired.
The amount of damage, then, was calculated according to the difference between the $1,000 par value listed on the stock certificate and the price under par that an IPO investor was able to pay. In this case, the last investor only paid $500 for each share. The damages would be substantial–it would be $500 per share for the 80 shares that paid a par value price of $1,000. The damages would total $40,000–each of the eight investors that collected $10,000 in par value from the stock certificates would be entitled to $5,000 in damages from the stock promoters’ action of selling the stock at half the par value.
You can see how this multiplies fast–the share count multiplied by the discount to par can give you a very large number, and this acted as a strong deterrent against stock promoters creating disadvantageous terms for some investors compared to others.
Two notes on this early 1800s construction:
First, your remedy would allow you to collect in full against any stock promoter associated with selling stock below par value. If there were 5 promoters, and only one had the cash to pay the $40,000, you had the legal right to collect the $40,000 from him, and that stock promoter had the burden of collecting $32,000 from the other four investors. This deepest pockets theory relied on the Victorian notion that the richest stock promoter would also be the most sophisticated stock promoter and was therefore in the best position to supervise the capital raising process. This theory would also be borrowed years later in the tort law concept of “joint and several liability.”
Secondly, par value acted as a ceiling on your remedy. In other words, if you paid $1,200 per share for stock with a par value of $1,000 in which another investor only paid $800, your damages were only $200 and not $400. However, if you paid $800 for stock with a par value of $1,000 that was later sold to someone for $600 as part of the capital formation process, you were only entitled to $200 per share in damages. The theory is that you knew the kind of people you were dealing with when you were agreeing to purchase stock below par value, and therefore the law shouldn’t go out of its way to protect you from the dishonesty of people you know to be dishonest.
This approach had one large flaw–state law prevented the stock from ever being sold below par value and this created a block in the construction of efficient markets. Imagine if you owned $1,000 par stock in a tobacco company, and the next year the tobacco company had some of its tobacco destroyed in a warehouse or a recession hit, you couldn’t sell your stock certificates below par value. If someone wanted to pay $500, you couldn’t do it. You as an investor wouldn’t be on the hook for damages to the other shareholders for selling below par value, but it was considered a voidable transaction–the other guy could show up in court and later have the transaction undone.
As America continued to industrialize, the wisdom of high par values became increasingly obsolete as the original regime created capital freezes when a company deteriorated in value or general business conditions changed to lower the fair price of the stock. Also, states began tying IPO fees to the amount of par value of stock under the theory that large capital corporations forming should pay a higher price to exist in a state because it would have more assets subject to legal, police, and infrastructure protections.
On the eve of the Civil War, it became a tradition to begin issuing $0.01 par value stock.
This wasn’t saying the stock was worth $0.01. Instead, it was saying the stock could never be sold for less than $0.01 per share. The market grew in efficiency as investors could better respond to natural fluctuations, fees of starting a corporation went down because $0.01 par value stock costs way less to form than $1,000 par value, and the risk of getting your hands dirty and raising capital diminished because it became a remote possibility that a share of stock would be sold for less than $0.01 (a stock would become insolvent before that point). Also, state law predecessors to what we now call fiduciary duties were beginning to emerge, and ripped-off IPO investors could use these new laws as a remedy for abuse in the capital formation markets.
Eventually, the par value tradition became ridiculous–the fees set by states for capital formation were no longer efficiently addressed when all capital formers are issuing $0.01 stock, and no meaningful protection is provided by knowing that you are guaranteed a penny for each share of stock you buy for tens, hundreds, or even thousands of dollars. Recognizing this ridiculousness, the New York legislature in 1912 permitted corporations to begin issuing “no par” stock in which the issuing corporation would make no promises about the minimum value the stock would sell for.
However, the $0.01 tradition has continued to this day because some state laws still provide additional protection for par value stock compared to no par value stock, and also, it became a cultural habit for the stock promoters of the 19th century that got passed on to their disciples in the craft.
As for an investor in a large-cap today that sees a stock certificate with a $0.01 par value, the inscription in almost nearly an anachronism. The only time it matters is if you purchase callable common stock, something that is common in companies with a complex capital structure of different shareholder classes and contains an Articles of Incorporation that permit the corporation to redeem a certain class of stock at par value (the risk for you is that the market value would appreciate but the Articles of Incorporation would permit the management team to buy you out by redeeming the callable class of common stock).
Other than those narrow circumstances, it is almost entirely irrelevant to see the $0.01 par value on a common stock because it will have no bearing on any aspect of business operations. If you have a Bank of America stock certificate that mentions the $0.01 par value, it just means that Bank of America can’t issue new stock to shareholders for anything less than $0.01 each and the New York Stock Exchange would have to shut it down if the trading every got below a penny (an irrelevant rule because the NYSE removes company that spend a certain period of time trading below $1). Par value was once an important measuring tool of fairness for the IPO investors of yesteryear, but it is no longer a metric that drives the early stages of capital formation.
Originally posted 2016-04-06 17:35:06.
