Blockchain could transform securities transfer systems

Author: | Published: 29 May 2018
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Change is coming to the way stock transfers are recorded as blockchain technology allows stockholder lists to be managed electronically

1 minute read
It appears inevitable that within a few years, stock transfers will be electronically recorded on corporations’ stockholder records as they take place, whether using blockchain technology or some other form of electronic transaction recording.

The current securities transfer system, which once seemed highly sophisticated and efficient, now seems bulky and outmoded. It will be very surprising if in the next five to 10 years, there isn’t a new convention for carrying out stock transactions that uses the corporate stock ledger, not accounts with securities intermediaries, as the place stock transfers occur.

Effective August 1 2017, the Delaware General Corporation Law was amended to accommodate the possibility that stockholder lists would be maintained, and stock transactions would be recorded, electronically, probably on electronic distributed ledgers, frequently referred to as blockchains. This was the culmination of an initiative that had been underway in Delaware for several years.

As is discussed below, it will probably be a number of years before stock transfers are electronically recorded on corporations' stockholder records as they take place. On the other hand, it appears inevitable that this is going to happen, whether using the current blockchain technology or using some other form of electronic transaction recording. The current securities transfer system, which once seemed highly sophisticated and very efficient, now seems bulky and outmoded. It is hard to imagine it won't be replaced.

How would electronic securities ownership ledgers work?

Although the amendments to the Delaware General Corporation Law were publicised as enabling use of electronic distributed ledgers (the current blockchain technology) to record stock ownership, what they really do is to permit a corporation to maintain an electronic list of the owners of record of its stock that will reflect all issuances and transfers of stock as they occur. Based on today's technology, that would be done using electronic distributed ledgers, but that is not essential to what Delaware has authorised.

The concept of electronic distributed ledgers is fairly simple. Instead of a transaction's being recorded in various parties' records, the transaction is recorded simultaneously on a number of unrelated computers and all the parties have access to the information. Revisions to information about a transaction have to be made using procedures that will simultaneously reflect them on all the computers on which the information had been recorded and will affect all transactions in each chain of transactions that followed the transaction that is being changed. This makes it prohibitively expensive to make an unauthorized change in recorded information about a transaction. In other words, distributed ledgers make it possible to record all the information about a transaction as a single block of information that can be accessed by all the parties to the transaction.

Recording of changes of ownership of securities as they take place will be a significant improvement over the current system

As an example of how this would work, currently, if person A wants to make a payment to person B, person A will use a check or electronic communication to instruct his or her bank to transfer a specified sum of money to person B. The bank will then check to make sure person A has enough money in his or her account to cover the payment. If there is enough money in person A's account, person A's bank will instruct the Federal Reserve system or another clearing system to transfer money from person A's bank to person B's bank for the account of person B, and person B's bank will increase the balance in person B's account by the amount received from person A's bank. Using a distributed ledger system, person A would issue an electronic instruction to transfer a specified sum to person B, and the electronic system would reduce the amount of money in person A's electronic wallet, and increase the amount of money in person B's electronic wallet, by the specified amount (unless Person A did not have adequate funds, in which case the transfer would not take place). That transaction would simultaneously be recorded on a number of dispersed computers, and after that, either person A or person B could access the record of the transaction.

In the context of securities transfers, the way electronic distributed ledgers would work probably would be something like: if Y corporation wants to issue 100 shares of stock to person A, it would record on its electronic stock ledger that person A owns 100 shares (or 100 shares more than person A previously owned). Then, if person A wants to transfer 50 shares to person B, person A will electronically cause the Y corporation stock ledger to reduce the number of shares person A owns by 50 shares and to increase the number of shares person B owns by 50 shares.

Of course, what will really happen will not be as simple as what is described above. In the first place, the technology necessary to make electronic stock records reflect transactions as they take place, whether using distributed ledgers or otherwise, will be extremely complicated. Also, when a person for the first time receives stock or other securities issued by an entity, the person is going to have to give the entity information about the person's address and taxpayer identification number, and perhaps some other information (unless, as probably will be the case, there is some sort of universal security holder information system that will provide required information to each issuer of securities acquired by a person). However, recording of changes of ownership of securities as they take place will be a significant improvement over the current system, and it is difficult to imagine that it will not be implemented, probably fairly soon.

How the current securities transfer system evolved

Until the late 1970s, all shares and debt securities were represented or evidenced by pieces of paper. Initially, these pieces of paper had to be signed by the officers of the company that issued the securities. However, as ownership became more widespread, signing stock certificates or debt instruments became an unacceptable use of executive time, so the practice arose (with the help of corporate statutes) of having stock certificates or debt instruments contain printed facsimiles of officers' signatures together with the actual signatures of representatives of organisations acting as stock registrars, indenture trustees or in similar capacities.

Even that, however, was cumbersome. When stock or debt was in the form of certificates registered in the names of the actual security holders, in order to transfer the stock or debt, the security holders would have to deliver endorsed stock certificates or debt instruments to the security holders' brokers, who would then arrange with the buyers' brokers to have new certificates or instruments issued in the names of the buyers. Therefore, the practice developed of having most stock or debt registered in the names of the holders' brokers or other financial institutions (so-called street name), with the individual holders' beneficial ownership of the securities shown on the account records maintained by the brokers or other institutions. That simplified clearances, because brokerage firms and other financial institutions could settle with one another periodically the net balances transferred by all their respective customers. However, at some time pieces of paper still had to be delivered. As trading volumes increased in the 1960s, brokerage firms and transfer agents were unable to keep up with the required paper work, creating a serious paperflow crisis.

The SEC has said that each DTC participant that holds stock of a company will be treated as a holder of record

In 1977, the Uniform Commercial Code (UCC), which governs commercial transactions in almost all US states, was amended to accommodate the concept of uncertificated securities. It was further amended in 1994 to make possible a new indirect holding system, in which most securities would be held by central depositaries and transfers would be made by entries on the books of the depositaries.

In 1997, the Securities and Exchange Commission urged all broker-dealers to transfer their securities (including securities they were holding for the accounts of their customers) to central depositaries and to trade securities through transfers on the records of those depositaries. As a result of this urging, all major US securities firms, and many other firms that are engaged in securities transfers, became participants in a central clearing system called The Depositary Trust Company (DTC) and transferred record ownership of all the securities they were holding to DTC. Since then, the vast majority of trading in stock of publicly held US corporations has been in the form of book entries showing changes in what is held in participants' accounts with DTC. The stock records of publicly traded US corporations reflect only a small portion of actual transfers of ownership of the corporations' stock. They show on average approximately 70% of the outstanding shares as being owned by Cede & Co., which is the nominee for DTC. The number of shares of a corporation's stock owned by Cede & Co. rarely changes much, unless the corporation issues additional shares or redeems shares.

The indirect holding system also required changes in things beyond securities transactions themselves. For example, the UCC had provided that the only way a lien on investment securities could be perfected was by possession of the certificates representing or evidencing the securities. When the securities that people own stopped being represented or evidenced by certificates, a new method of perfecting liens on investment securities had to be developed. Accordingly, at the same time the UCC was amended to enable the indirect holding system, it was amended to enable liens on investment securities to be perfected by agreements in which brokers and other securities intermediaries give lienholders control over dispositions of the securities that are subject to their liens.

The indirect holding system created in the mid-1990s is the securities transfer system in effect today.

What's wrong with the current system?

When the current system was developed, it appeared to be the height of efficiency, eliminating the need for movement of thousands or millions of pieces of paper. Now that system looks cumbersome and out of date. In order for person A to transfer shares to person B, person A has to tell his or her broker to instruct DTC to transfer shares to person B's broker, DTC has to transfer the shares to the account of person B's broker, and person B's broker has to record the fact that person B has become the beneficial owner of the shares. And the payment for the shares has to be handled in the same multi-step process going the other direction. There would be no need for all those steps if transactions could be directly recorded electronically by the actual parties involved.

Under the current system, it is not even clear who should be treated as the holder of record of shares. For corporate law purposes, since the holder shown on the corporation's stock records is DTC (through its nominee Cede & Co), DTC is the holder of record. The corporation pays dividends to DTC, which pays them to its participants, who, in turn, allocate them to the accounts of their customers who are the true beneficial owners of the shares. In order for shares to be voted, DTC has to issue proxies to its participants, and the participants have to ask the beneficial owners how the shares should be voted and cause the proxies to be voted as the beneficial owners instruct. However, the Securities and Exchange Commission (SEC) uses a different definition of holders of record. A number of rules under the Securities Exchange Act of 1934 depend on how many holders of record there are of a company's stock. Those rules don't make much sense if DTC is treated as a single stockholder. On the other hand, although a company can find out how many DTC participants hold its shares, a company has no way of knowing how many beneficial owners there may be of shares held by particular DTC participants. Therefore, the SEC has said that for the purposes of rules under the Securities Exchange Act, each DTC participant that holds stock of a company will be treated as a holder of record.

The time to eliminate the cumbersome multi-party processing of stock transactions (and other securities transactions) is near

One problem that surfaces in several contexts is that, at least with regard to transactions over securities exchanges, it is not possible to determine the specific seller whose shares are acquired in a purchase. One of the provisions of the Securities Act of 1933 makes a person who sells securities by means of a misleading prospectus or oral communication liable for damages or rescission to the person who purchased the securities. But this provision is rarely used because it is usually not possible to tell which purchases of securities were from the person who used the misleading prospectus or made the misleading statement.

Similarly, the Delaware General Corporation Law gives a stockholder whose shares are not voted in favour of a merger or similar transaction the right in many instances to seek what a court determines in an appraisal proceeding to be the fair value of the shares, rather than accepting the agreed upon transaction consideration. Recently, in two cases in the Delaware courts, the question arose how a company could know whether shares held by a person who acquired them after the record date for determining stockholders entitled to vote on a transaction had or had not been voted by the prior owners in favor of the transaction. In most instances, it is not possible to determine who the prior owners were. The courts said that unless the company could prove that particular shares had been voted in favour of the transaction, it would be presumed that they had not been voted in favor of the transaction and the post-record date purchaser would be permitted to bring an appraisal proceeding.

In short, the current system is expensive, requiring multiple instructions and account entries to effect even a simple securities transfer. And there are gaps in the information available under the current system. Undoubtedly there would be a charge for having each stock issuance or transfer recorded on the issuing company's stockholder records as it takes place, but that charge should be much less than the cost of the current multiple party processing. And instead of having only limited information about the parties to securities trades, companies would have exact information about the real parties to trades (as they did when all stock transfers involved the cancellation and issuance of certificates registered in the names of the true owners).

Possible problems with direct recording of securities transactions

No significant change takes place without problems. That would be true with moving to a system that records transfers of securities on stock ledgers as they take place. Problems might include:

  • Much of the current stock transfer system would become unnecessary. Among other things, there might be little or no reason for DTC to continue.
  • The role of brokers as stock transfer facilitators, and their ability to earn compensation for acting in that capacity, would be reduced. A stock sale would be effected by an electronic transfer of funds from the buyer to the seller and a direction from the seller to the corporation's electronic stock ledger to move shares from the seller's name to the buyer's name. Brokers would still function as financial advisers. However, there would be little need for discount brokers or others who primarily process trades. And there would probably be a significant reduction in the need for brokerage firm back office personnel.
  • There would be a loss of privacy. Direct recording of securities transfers would almost surely make it possible to trace even small securities holders' purchases and sales – information that currently is kept confidential by brokers and other custodians. While stock could still be held in the names of nominees, it is hard to imagine that the government would not insist on access to the names of the true beneficial owners.
  • A new legal structure would have to be created to make up for the fact that securities would no longer be held in accounts with firms that act as securities intermediaries.

However, problems of this type, which would result primarily from the increased efficiency of a system of directly recording stock transfers and other securities transactions on electronic ledgers, are the price of progress. They are not a reason to keep in place a system that has become outmoded.

What will happen

Delaware's initiative will not by itself result in direct recording of issuances and transfers of securities on electronic ownership ledgers. While a majority of large US corporations are incorporated in Delaware, there cannot be one securities transfer system for Delaware entities and a different system for entities formed in other states. On the other hand, corporations formed in many states other than Delaware probably could implement direct recording of stock transactions on electronic ledgers without the need to amend the states' corporation laws. And where statutory amendments are required, they should not be controversial. What would be needed would be efforts by the SEC, and possibly by Congress, to cause all companies to accommodate direct electronic recording of securities transfers.

The ubiquity and power of computers makes it easy now to do things that only recently were impossible. The blockchain approach to dispersed information recording seems to create a safe way of preserving information. It may or may not be the technology that is used in the future to facilitate direct recording of changes of stock ownership. However, as Delaware has recognised, the time to eliminate the cumbersome multi-party processing of stock transactions (and other securities transactions) is near. It will be very surprising if, within the next five to 10 years, there isn't a new convention for carrying out stock transactions that uses the corporate stock ledger, not accounts with securities intermediaries, as the place stock transfers occur.

David Bernstein
Goodwin Procter (New York)