Stock-Option Warrants: Critiques, Mechanics, and Historical Performance

Key Insight

Stock-option warrants are strongly criticized as a 'near fraud, an existing menace, and a potential disaster' for creating huge aggregate dollar 'values' out of thin air and misleading investors. An ominous historical precedent is the American and Foreign Power Co. warrants, which in 1929 held a market value over $1 billion, only to shrink to $8 million by 1932 and be wiped out by 1952, despite the company remaining solvent. These instruments, analogous to Goethe's description of paper money in 'Faust,' have resurfaced since 1967 as familiar 'instruments of finance,' often in real-estate ventures where units of common shares and warrants are sold together.

The fundamental issue with warrants is that they take away value inherent in ordinary common shares, specifically the preemptive right to buy additional common shares, and transfer it to a separate certificate. This occurs because many investors are inexpert and do not realize that common stock is worth less with warrants outstanding. Consequently, the combined package of stock and warrants often commands a better market price than the stock alone, and standard company reports frequently overstate true earnings per share by failing to properly account for the dilutive effect of outstanding warrants.

Companies typically derive no direct advantage from warrants, as they cannot compel warrant holders to exercise their rights and provide new capital. If additional funds are needed, the company must offer shares to existing shareholders, often below market price, further complicating the situation. While older warrants, such as Tri-Continental Corp. warrants from 1929, demonstrated astronomical advances (e.g., from 0.03125 to 75.75 by 1969, a 242000% gain), the main objection is the 'wanton creation of huge 'paper-money' monstrosities' rather than their use in moderate-sized bond issues, where they might offer a valid alternative to convertible issues.