Delaware Blockchain Initiative: Transforming the Foundational Infrastructure of Corporate Finance
or much of American corporate finance is Delaware corporate law. Later this year, a small change to Delaware corporate law, if enacted, could facilitate a major simplification of the plumbing of the financial system built on top of that foundation. The change is part of the Delaware Blockchain Initiative (DBI), which then-Governor Jack Markell introduced in May 2016. The initiative will allow for the application of distributed ledger technology to many of the private sector’s most basic and critical legal documents, which companies currently file with the Delaware Division of Corporations.
What Is Blockchain Technology?
Blockchain technology, also known as distributed ledger technology, is a new type of information technology that combines two components: distributed ledgers and smart contracts.
Distributed ledgers are mutual, shared ledgers. They create a single record of transactions among multiple parties, providing one immutable, “golden copy” of data that all parties see at the same time and can trust as valid. Consequently, parties do not need to maintain their own copies and reconcile with each other. Distributed ledgers are append-only databases that maintain a perfect, immutable audit trail of who did what and when they did it.
Smart contracts are automated “if/then” software programs that self-execute when a specific trigger occurs. Online bill payment is a widely-used example of a smart contract. On the due date of your bill, the software springs into life and automatically pays your bill by executing the instructions you previously provided. Smart contracts automate workflow.
When smart contracts run on top of distributed ledgers, the combination is so powerful that it can automate wide swathes of financial services. Software can fulfill the functions of clearing and settlement intermediaries, thereby streamlining today’s labyrinthine workflows and eliminating today’s unnecessary counterparty risk and latency in transaction settlement. The transition may take 20 years to complete, but it has already begun.
The Delaware Blockchain Initiative
The first milestone on DBI’s roadmap has been reached. It is the rollout of distributed ledger technology at the Delaware Public Archives, which has been the “beta” test for the technology within State government. New “smart records” technology automates compliance with laws pertaining to retention and destruction of archival documents, among other features.
The second milestone will be “smart UCC” filings, which will be rolled out later this year. Many attorneys are familiar with the UCC filing process, which is still surprisingly paper-based, slow and error-prone. UCC filings on a distributed ledger will (1) automate the release or renewal of UCC filings and related collateral, (2) increase the speed of searching UCC records, (3) reduce mistakes and fraud and (4) cut cost. Banks have already told us they welcome this upgraded technology for UCCs, and we believe lawyers will as well. We anticipate banks will ultimately link their “smart UCCs” into software that values their collateral, so that the “smart UCC” can automatically call for additional collateral from a borrower when the value of collateral covered by a UCC financing statement drops below a threshold loan value. The new technology will permit UCC filings to become critical tools through which lenders actively manage credit risk, rather than mere “check the box” documents.
The third milestone—distributed ledger shares—will be next on the roadmap.
Why Distributed Ledger Shares Would Transform the Foundational Infrastructure
If shares are registered on a distributed ledger, investors and issuers would be able to interact directly. Property rights would be crystal clear. Capitalization table management would become easy. Proxy voting would be transparent and always accurate. Dividends and other corporate actions (such as stock splits) would be automated and always accurate. Certificates of good standing would never again require a prerequisite forensic audit. Securities lending records would always be accurate, so accidental over-issue of securities would never happen.
None of the above is necessarily true of the status quo.
Delaware’s move to authorize distributed ledger shares would be much more significant than simply an upgrade to shareholder recordkeeping tools. When a company chooses to incorporate in Delaware using distributed ledger shares, the Division of Corporations could validate and file the incorporation plus transfer the authorized shares to the new company. Only shares that are cryptographically “signed” and transferred by the Division of Corporations, in that genesis transaction for the new company, would be considered validly-authorized distributed ledger shares (and a similar procedure would apply to converted corporations). By doing this, the Division of Corporations establishes a perfect record of authorized shares, and the distributed ledger can then track shares that are issued and outstanding.
Gone would be the days of discovering that a company’s capitalization table is wrong before a material corporate transaction, which today requires a scramble to perfect the capitalization table through a Section 204 filing that, in turn, requires a forensic audit and payment of overdue franchise taxes. Furthermore, even after a capitalization table has been perfected, errors still occur today that would simply not be possible with distributed ledger shares. Examples include cases in which a company’s SEC filings report that more shares are issued and outstanding than were actually authorized in Delaware filings, or in which the securities industry counts more shares in omnibus accounts than are authorized in Delaware filings. Distributed ledger technology solves all of these problems, and more, automatically.
Importantly, distributed ledger shares would also solve an inconsistency between corporate and securities laws that has created real-world consequences. Delaware corporate law generally confers rights on the direct, record owners of shares. By contrast, certain federal securities laws pertaining to listed securities require that securities be “depository eligible,” which, in practice, means investors own them indirectly. When investors own securities indirectly, what they own is not legally a security but instead is a pro rata share of fungible “security entitlements” under UCC Article 8—which are IOUs issued by a broker/dealer (a “securities intermediary”), which in turn holds a pro rata share of security entitlements from other securities intermediaries, which in turn hold a pro rata share of the actual securities that are legally owned by a nominee called Cede & Co. (itself a nominee of The Depository Trust Company). At each of these layers above the broker/dealer, intermediaries account for security entitlements on an omnibus basis. This means they track owners only on an aggregate basis, not by tracking the true beneficial owner.
This ownership inconsistency between corporate and securities laws, direct vs. indirect, sometimes creates bizarre and unintended outcomes.
For example, the Bank Holding Company Act restricts a single shareholder’s ownership of a bank holding company to 24.99% of any voting class of shares. Consequently, is it consistent with the Bank Holding Company Act that the DTC’s Cede & Co. owns nearly 100% of the shares of every U.S. bank holding company whose shares are publicly-traded? Other ownership restriction laws, including those restricting foreign ownership of airlines, nuclear facilities, mining interests, communications companies and other critical infrastructure, similarly were drafted to restrict ownership without acknowledging that beneficial owners are frequently not the same as record owners. Another example is the SEC’s Regulation AB, which requires trustees of asset-backed securities to facilitate communications between investors. Yet, how can trustees comply when the simple fact is trustees have no right to access the list of beneficial owners and therefore cannot verify ownership?
The system is also a recipe for mistakes. While it works fairly well, mistakes happen surprisingly frequently. And they can be costly.
Delaware Chancery Court Vice Chancellor J. Travis Laster, in a speech to the Council of Institutional Investors in September 2016, provides several examples. He encouraged investors to adopt blockchain technology as the plunger that can unclog the plumbing of capital markets for the benefit of investors. Pointing to conflicts with federal securities law, he said: “Delaware corporate law is not built to accommodate the nominee system. It assumes that stockholders own shares directly…”
Prominent judges do not often call their own legal opinions “absurd,” but Vice Chancellor Laster did just that in a case involving T. Rowe Price (In re Appraisal of Dell Inc. (Dell Continuous Ownership), 2015 WL 4313206 (Del. Ch. July 30, 2015)). This is one of many examples he shared in which Delaware corporate law conflicts with federal securities law regarding direct vs. indirect ownership. T. Rowe Price paid $194 million to compensate its clients for actions for loss of appraisal rights and a proxy voting mistake that were, at root, caused by the indirect system of share ownership. Vice Chancellor Laster said, “Personally, I think that [decision] is absurd. This was an example of people doing what they should do and then getting caught up by the system…The upshot for present purposes is that the complexities of the nominee system harmed stockholders.”
Another recent example is the Dole Food Company class action litigation, in which Vice Chancellor Laster revealed a curious fact in his decision of February 15, 2017. Investors filed claims to 49.2 million Dole shares that were “facially eligible,” but only 36.8 million Dole shares were outstanding.
Most of the difference was caused by unsettled trades during the final three trading days (“T+3”) before Dole’s buyout closed, because “DTC’s centralized ledger did not reflect all of the trades in Dole common stock on the day of the merger or during the two days preceding it.” The rest of the difference resulted from uncovered short sales of Dole stock. As Vice Chancellor Laster wrote,
The shorting resulted in additional beneficial owners who received the merger consideration, who fell within the technical language of the class definition, and who could claim the settlement consideration. Meanwhile, the lenders of the shares, not knowing that the shares were lent, also could claim the settlement consideration. This is another means by which two different claimants could submit facially valid claims for the same underlying shares.
In a footnote to the opinion, Vice Chancellor Laster wrote,
…despite laudable and largely successful efforts by the incumbent intermediaries to keep the system working, the problems have grown…Distributed ledger technology offers a potential technological solution…
Proxy voting is yet another area in which the nominee, or indirect, ownership system can breed inaccuracy. In the 2008 proxy contest for control of the board of Yahoo, a recount demanded by a shareholder revealed that almost 20% of the vote was miscounted. As Vice Chancellor Laster explained in his September 2016 speech, the default voting option is sometimes set to vote for management’s proposals, which adds to the difficulty of success in proxy contests because quirks in the system can cause votes to default back to vote in favor of management. This happened to T. Rowe Price in the Dell case, as T. Rowe Price checked three times to ensure its vote was against Dell’s management but the system actually recorded its vote in favor of management’s proposal by default. Vice Chancellor Laster continued,
Aside from overvoting, the complexity in the voting system creates opacity and the opportunity for miscalculated votes…As the SEC has explained, ‘Because the ownership of individual shares held beneficially is not tracked in the U.S. clearance and settlement system…imbalances occur.’ When those imbalances occur, ‘broker-dealers must decide which of their customers will be permitted to vote and how many shares each customer will be permitted to vote.’
In other words, one share does not equal one vote. Vice Chancellor Laster concluded,
The plumbing needs to be fixed. A plunger exists…With distributed ledgers, a central accountant like DTC becomes unnecessary. Custodians become unnecessary. Ownership lies only with beneficial owners. A single distributed ledger would allow straight-through accounting. It is a utopian vision of a share ownership system where there is only one type of owner: record owners.
The indirect system of share ownership evolved historically around the basic fact that most corporations in existence today were incorporated on paper and issued their shares on paper. In the case of public companies, Cede & Co., holds in its custody a single piece of paper—a “global security”—representing all (or nearly all) of the company’s issued shares.
Some of these paper documents have been digitized in recent years. But doing so merely digitized the labyrinthine workflows of the status quo, which trace their origins to the Wall Street paperwork crisis of the early 1970s. The technology limitations of 40 years ago that gave rise to the status quo are long gone, but status quo business processes remain. The true benefits of digitization will only reach the securities industry when its layers of settlement processes are finally streamlined, so that securities issuers and investors can again interact directly. The DBI may spark that change.
Benefits to Delaware
Why has Delaware been so forward-thinking to enable such an important change to the foundational infrastructure of corporate finance? Two reasons: leadership and value-added services.
When distributed ledger technology hit their radar screen in 2015, State officials immediately understood the ramifications for companies that register in the State. By being the first to adopt the technology, the State will maintain its leadership in corporate registry services. In addition to the State offering the most developed body of corporate and trust law, the Delaware Court of Chancery is widely recognized as the nation’s preeminent forum for dispute resolution for corporations. The Court of Chancery also has subject matter jurisdiction for technology disputes in the amount of $1 million, which makes it an ideal forum for disputes pertaining to blockchain technology. In addition, Delaware’s Rapid Arbitration Act fits well with the ethos of blockchain technology—namely, fast settlement of transactions—by providing an ideal regime for the speedy, efficient and relatively inexpensive resolution of disputes.
And Delaware’s registry services provide true value to businesses. State officials saw the opportunity to create even more value for businesses that choose Delaware for registry services if the State were to offer registries on a distributed ledger. Such registries include not just incorporation services, but also UCCs, land titles, personal property titles, birth/death certificates, professional licenses and many other new types of registries that the State may introduce as part of the DBI (for example, diamonds and other luxury goods). A certification from Delaware that something has been properly registered carries significant value in the business world. And if companies choose to access the imprimatur of Delaware on a distributed ledger instead of a piece of paper, it will carry even more value because companies can integrate it with other upstream technologies to streamline workflows. Potential users of Delaware’s distributed ledger service have already confirmed their willingness to pay more because it will save companies costs. It is win-win.
We look forward to engaging with the corporate law bar as the DBI reaches more milestones, and to providing these new services to Delaware’s business constituents. Stay tuned for many developments!