On May 2, 2016, during a keynote address at Consensus 2016, Jack Markell – Governor of Delaware from 2009 to 2017 – announced a comprehensive program to provide an enabling regulatory and legal environment for the development of blockchain technology in Delaware.
As part of this initiative, Delaware implemented distributed ledger technology for the Delaware Public Archives, as the beta test for the technology within State government. This smart records technology automates compliance with laws pertaining to retention and destruction of archival documents, among other features.
On June 30, 2017, the Delaware legislature approved various amendments to the Delaware General Corporation Law (the “DGCL”). The blockchain-related changes include amendments to Sections 151(f), 202(a), 219(a), 219(c), 224, 232(c) and 364 of the DGCL. Amendments to Sections 219, 224 and 232 and related provisions are intended to provide specific statutory authority for Delaware corporations to use networks of electronic databases (examples of which are described as “distributed ledgers” or a “blockchain”) for the creation and maintenance of corporate records, including a corporation’s stock ledger. Section 219(c), as amended, now includes a definition of “stock ledger.” Section 224, as amended, requires that the stock ledger serve three functions contemplated by the DGCL: it must enable the corporation to prepare the list of stockholders specified in Sections 219 and 220; it must record the information specified in Sections 156, 159, 217(a) and 218; and, as required by Section 159, it must record transfers of stock as governed by Article 8 of subtitle I of Title 6. Sections 151, 202 and 364 have also been amended to clarify that the notices given to holders of uncertificated shares pursuant to those sections may be given by electronic transmission.
On August 1, 2017, the Governor of Delaware signed the proposed DGCL amendments into law, marking a historic milestone for the state. This development will help position Delaware at the forefront of corporate law, making it the leading US state in terms of enabling the use of ”distributed ledger shares” in a world where distributed ledger technology is rapidly becoming a worldwide trend.
The future roadmap for the initiative includes the issuance of legally-enforceable smart UCC filings, which are expected to be rolled out later in 2017, followed by the possible offering of new registry services not presently offered by Delaware.
Our Take on the DGCL Amendments and Digital Securities:
The changes to Delaware law enacted today will not affect existing shares of stock but will permit issuers to begin to issue new shares in a new way, as digital securities. Its effective adoption will depend on the perceived value of this new paradigm compared to the challenges it poses.
The basic idea behind digital securities is to “tokenize” shares of stock, debentures , warrants or any other type of security, by representing each unit of a given security as a unique cryptographic public-private key pair that is stored and transferred on a blockchain. The current changes to the DCGL are merely clarifications of what was already possible based on the truly fundamental changes to the DGCL in 2005 that permitted the issuance of “uncertificated” shares of stock. Perkins Coie, in fact, gave the very first “duly authorized and validly issued” legal opinion with respect to digital securities; it was filed as the Exhibit 5 opinion to Overstock’s S-3 Registration Statement, which registered the first digital securities in 2015. Historically, our entire system of delayed T+3 (trade date plus three more days) settlement of securities trades was necessary because Delaware law used to require physical stock certificates for every share. In the 1970s, the Depository Trust Company (“DTC”) was created as a “work-around” to reduce the number of days for settlement. Since then, every public company basically issues a single stock certificate made out to Cede & Co., as nominee for DTC, in the amount of the entire public float of shares. DTC then has its own proprietary ledger of member banks that own portions of that global share certificate, and each member bank keeps its own proprietary ledger of beneficial owners who have a right to a portion of that bank’s stock “in street name.” This system is still pretty clunky and it takes three days to settle securities trades because of all the back office settlement going on with all the proprietary ledgers involved. The promise of using a distributed ledger or blockchain technology is that all the back office settlement goes away, DTC is no longer needed (at least for its historical function) and securities can settle T+0, or effectively instantaneously. Digital currency trades instantaneously and irrevocably. When shares of stock are tokenized, they take on this feature too.
Among other things, T+0 settlement makes it impossible to “naked short” a stock because you must deliver the securities at the moment of sale. You can still borrow stock from a broker to sell it short, but you have to actually take delivery of the borrowed shares in order to sell the shares, which means that every sale, even a short sale, must have been associated with a preceding purchase of the shares. Naked shorting happens when someone simply decides to sell shares and because there is a delay in delivery, they do not need to have the shares at the point of sale and never wind up purchasing shares to cover unless there is a short squeeze. In theory, this leads to more selling pressure than there is buying support because more shares can be sold than are outstanding at a given moment. Naked shorting is technically not legal and experts differ on how much it actually happens, but many CEOs of public companies suspect it to be a problem. If nothing else, eliminating the possibility of naked shorting makes the system more trustworthy.
Adopting this new paradigm also means that the stockholders are no longer holding shares “in street name” through their broker-dealers. There will no longer be a distinction between beneficial owners and record owners and issuers will no longer have to wait several days and pay a bunch of money to get a NOBO (non-objecting beneficial owner) list by querying all the broker-dealers to run reports. They will know exactly who their true stockholders are at all times. Voting is direct instead of through brokers and dividends are paid direct instead of through brokers. Broker-dealers will still play a significant role and stockholders will need to have brokerage accounts to hold shares of public companies, but those brokerage accounts will just be reading the blockchain and displaying the customer’s share accounts held directly with issuers instead of reporting the customer’s beneficial rights to shares held by the broker. Similarly, transfer agents will still play a role, but it will be much easier since they too will just be reading off the blockchain and not keeping any proprietary ledger of their own.
The adoption challenge, however, is that none of the existing Stock Exchanges are currently set up to trade digital securities. Overstock set up its own Alternative Trading System (“ATS”) as a Securities and Exchange Commission (“SEC”) regulated broker-dealer trading system that can trade digital securities. Other issuers could use that same ATS and other similar ATS’ could be created if there is demand. Demand among public companies will be limited, however, as there are challenges associated with having the same share class trade both in a T+3 system (traditional exchange using DTC) and on a T+0 blockchain-based system, so Overstock, for example, is starting out by issuing an entirely new class of preferred stock as digital securities. It’s possible that some companies might choose to go public with an IPO using digital securities and never issue common stock on a traditional exchange, but liquidity concerns will limit this as a practical matter.
Private companies, on the other hand, are more likely to be the early adopters of this new paradigm. NASDAQ Link is a “blockchain-in-a-box” tool for issuing digital securities aimed at the private company market. Ironically, NASDAQ and other Wall Street players are very interested in building tools for private companies right now since IPOs have become so rare and unicorns are staying private longer. Coincidentally, Silicon Valley startups were already beginning to use “uncertificated” shares as of a few years ago. There are a number of competing cap table management solutions being tried and most of the big Silicon Valley law firms are in a state of flux today with respect to cap table management solutions. This is a huge opportunity for NASDAQ Link and other blockchain-based solutions to step in. If private companies do begin using blockchain-based cap table management solutions to issue digital securities, it will only be a matter of time for public companies to adopt.
Bottom line, this will take a few years to unfold. Other states will likely follow suit if it takes off.