Corporate lawyers and software developers have been watching eagerly as the State of Delaware takes steps to enable Delaware corporations to issue shares of their stock as digital tokens. Instead of recording shares on paper ledgers, corporations will record ownership using “Blockchains”: ledgers that are secured by cryptographic keys that can be distributed around the world without fear of tampering.
Why all the excitement? What’s so wrong about how corporations have been issuing shares and keeping track of shareholders? What’s aspects of Delaware corporate law, used reliably since Delaware first enacted its corporate laws in 1899, now need a fix?
On March 27, 2017, the Corporation Law Section of the Delaware State Bar Association approved proposed amendments to the Delaware General Corporation Law (DGCL) that had been proposed by the DSBA Corporation Law Council. These amendments address changes that are needed for Delaware corporations to issue and manage their shares using Blockchains. The proposed amendments were drafted to welcome in a certain future, not a hypothetical possibility. NASDAQ and other prominent companies are building Blockchain-based platforms for issuing, transferring, managing and trading corporate stock. Why?
Blockchains, often referred to as distributed ledgers, valuable provided qualities compared to legacy information systems:
These qualities can solve many issues that corporations and their attorneys (and their paralegals) grapple with frequently.
1. Whose shares are these?
A deep concern of corporate officers and their lawyers is that two people will claim the same shares. This can happen, to give only a few examples, when the corporate secretary accidently issues the same certificate numbers to different people, when a nefarious shareholder purports to transfer the same shares to two (or more) buyers, or where the chain of ownership over the shares gets muddied by corporate transactions or intestate succession.
Blockchains record the issuance of each new digital asset, and each transfer of that digital asset. Unlike a traditional databases or excel spreadsheets, the digital ledger is stored on a multitude of computers anywhere in the world (referred to as nodes). The owner of the asset can only transfer it once, and must use digital cryptographic keys to sign the transaction. If the owner attempts to transfer the same digital asset again, the nodes will check their records, see that the owner has already transferred the digital asset, and refuse to confirm the transfer. Therefore, once a share of stock is encoded into a digital asset on a Blockchain, no one should be able to successfully claim that they have ownership and control over the share unless they actually do as evidenced by the Blockchain.
But what if the Blockchain record is tampered with, deleted, forged or somehow altered? What if the Company or nefarious paralegal tampers with the ledger? Properly configured, Blockchain records are immutable. They cannot be deleted or altered. The way to correct an error is to record a new transaction. For example, if Ms. Smith accidently transferred her stock to Mr. Jones, Mr. Jones would need to transfer it back. If he refused, Ms. Jones would need to rely on claims she may have in law or equity to get the shares back.
2. Where did that certificate go?
As long as corporations have issued stock certificates, people have found new and interesting ways to lose them. Nonetheless, investors and others enjoy the security of receiving and holding their stock certificates, and a considerable amount of law has been developed to govern the claims and rights of shareholders holding certificates versus those who do not.
With Blockchains, the digital asset simply cannot be lost, it can only be transferred. If anyone needs to find it, it will be right where they left it – on the Blockchain. The digital asset cannot be transferred off the Blockchain unless it is connected to another Blockchain. However, we note that anyone can lose their access to the digital asset simply by losing their cryptographic keys. Today, there are solutions that utilize back-up keys to avoid this loss.
3. Thou Shall Nots: Protective Provisions and Restrictive Covenants
Every day, often including weekends, corporate law associates relish the opportunity to draft rights of first refusal, rights to “tag-along” offerings, vesting provisions, obligations to be dragged-along in acquisitions, and other restriction and obligations governing the transfer of shares. The only thing more enjoyable, of course, is reviewing bylaws, certificates of incorporation, stock purchase agreements, and checking the backs of stock certificates to discover if there is some language to be found restricting or obligating the transfer of shares that might apply to the transaction the associate is tasked to close tomorrow.
These associates may need to find something else to do on weekends once shares are encoded on Blockchain as digital assets, with the Blockchain protocol governing how and when the assets can be transferred. Restrictions will be encoded into the Blockchain protocol and into the assets themselves. No one will need to check the back of a printed certificate for restrictive legends, and no transfer agent of the company need guard against unpermitted transfers. Does the underwriter need a need “lock-up” shareholders before an IPO? That should be achievable electronically as easily as we now distribute Docusign contracts for signature, and thereafter enforced by the code in the digital share certificate themselves.
Some restrictions, such as a right of first offer, may get waived for a particular transfer but should still apply to the transferee. If the restrictions are encoded into the digital share of stock itself, it will put any buyer on notice and continue to apply the restriction.
4. Due Diligence? Done.
Using a Blockchain to manage stock, any investor or acquirer will be able to see not just the capitalization of the corporation, but the full history of each share with accurate time stamps and the cryptographic signatures for each transfer of shares.
Not many relish the difficulty of obtaining shareholder votes at an annual meeting, on the eve of a corporate acquisition, or in a heated proxy fight. With Blockchains for corporate securities, voting functionality will be integrated into the protocol just as scheduling a meeting is part of what your Google calendar or Microsoft Outlook can do. NASDAQ has demonstrated this functionality in at least one “proof of concept” in Estonia.
If all this sounds too good to be true, it is. It will take a while before platforms for Blockchain-based stock issuances and management become commonplace, full-functional, and affordable. NASDAQ announced its platform Linq in December, 2015, but it is not yet in general release. The full promise of the technology depends on corporate adoption, and the depends in turn on Delaware and other states amending corporate laws for uncertificated. The end result, however, is enticing: more accurate and auditable ledgers, easily implemented restrictions on transfer, and swift voting, and a new generation of paralegals as amused by paper certificates as they were by carbon paper.
Adam Ettinger is co-chair of the Blockchain Technology and Digital Currency Team.