Distributed ledger technology (DLT) has attracted widespread interest because of its potential as a transformative force across diverse industries. While there are a number of practical uses for DLT, (see our recent on DLT and smart contracts, and their general application to varied industries), broad adoption of this technology will take time; its transformational nature may seem daunting. However, businesses may want to explore implementing DLT-based platforms; we believe they can increase efficiency, accuracy, transparency and security in record management and finance while minimizing cost, providing significant competitive advantages to companies that adopt this technology.
"If it ain't broke, don't fix it" – unfortunately, it's broken.
Generally, substantive legal areas are quite slow to adapt to the modern world, and corporate governance is no exception. While we have slowly moved away from handwritten shareholder registries, opportunities for human error remain rampant, and repercussions can be costly and serious.
Currently, shareholder registries are commonly maintained by corporations in software spreadsheets. Maintenance of the registry is susceptible to errors because it relies on manual entry. Registries are usually updated on the issuance of new shares or options, if they are updated at all. Early-stage companies often make use of convertible notes, which convert into equity on a predetermined date or the occurrence of a particular event. Unfortunately, these notes aren't always registered correctly. Larger companies might have professional advisors to maintain a separate registry to help prevent this problem, but regardless of company's size, any time there's a discrepancy in the corporate records, it's costly and time-consuming to reconcile.
Clearly, shareholder registries can be the source of confusion for companies. Given that their primary purpose is to provide a true record of ownership, this confusion is troubling. If the information is inaccurate or out of date, it becomes difficult for the issuer to contact shareholders if they need to vote on a major acquisition, arrangement or sale process. In some instances, companies might resort to what seems like extreme measures to track down "missing shares" – using third parties like private investigators. Or the company might go forward with the transaction, but risk missing shareholders screaming oppression if they emerge later from the weeds. In either case, the process is less than desirable.
Note that the majority of public company shares are actually registered with brokers. Therefore, when issuer information is disseminated, it is the brokers that receive the information and not the beneficial owners, because they aren't necessarily known to the issuer. This streamlined dissemination isn't without its problems.
For example, following Dell's going-private transaction in 2013, beneficial shareholders sought to exercise their appraisal rights. Because of a series of legislative changes beginning in the 1970s, Dell shares were titled in the name of custodial banks, rather than their nominees' names. However, under Delaware law, to exercise a right to appraisal, the nominees had to demonstrate they had continuously held the shares for a specific period of time. The Court held that, because the record holder had technically changed during the required time, the beneficial owners no longer met the continuous ownership requirement needed to seek appraisal rights.1
Also, as a result of a 2013 going-private transaction, Dole Food Company was subjected to a class action lawsuit. When the parties settled the case in the shareholders' favour, beneficial owners filed claims for 49.2 million shares when only 36.8 million shares had been issued. The discrepancy arose because the depository, which held Dole Food Co.'s ledger, took three days to settle trades, so both buyers and sellers claimed ownership at the time of the ruling.
Results of a close shareholder vote have also been questioned, partly because of issues certifying the election. In 2017, Procter & Gamble initially claimed to have successfully fought off a challenge from Nelson Peltz, an activist investor who had been aggressively pursuing a seat on the company's board. However, preliminary recount results showed that Peltz won by a slim 0.0016 percent margin. While Peltz was eventually appointed to the Board, the vote count was an arduous, manual process. Shareholders could vote as many times as they liked, without only their last vote counting, and it is estimated that more than 200,000 paper ballots were individually reviewed.
Other problems that may plague corporate-record maintenance include:
- The administrative burden when share certificates are lost. For example, 1.3 million share certificates were jeopardized when a vault flooded following Hurricane Sandy in 2012.
- Forgotten, unclaimed or disputed share certificates when individuals pass away. Updating share registries is made more complicated when an executor cannot verify that a deceased person rightfully owned shares.
- Investors may not track their share ownership percentage. New issuances, buy-backs, conversions or splits can complicate things, potentially putting an investor offside securities regulation should they exceed certain disclosure thresholds.
How DLT could "fix it"
At the core of many of the issues described above is what is known as the "agency problem," meaning management (the agent) may not always be inclined to act in the best interests of the shareholders (the principals). The costly and inefficient solutions that have evolved to address that agency problem have resulted in associated agency costs. DLT has been proposed as a way to bring down those costs.2
Cryptocurrencies originally introduced DLT to address the "double-spend problem" inherent in virtual currencies, but DLT platforms (or blockchains) have emerged as an alternative mechanism for storing and transmitting all kinds of data by giving DLT platform users access to a decentralized, synchronized record of transactions. DLT platforms are constructed as networks of computer nodes in a way that, once a transaction is verified by the network nodes, it is combined with other transactions to create a new block of data for the ledger, which is then added to the existing blockchain in a way that is permanent and immutable. The ledger is replicated across the DLT network nodes, and is simultaneously updated as new blocks are added to the ledger, providing all DLT platform users with a single, immutable source of truth. These two attributes—decentralized trust and transparency—are vital to corporate governance and addressing the agency problem.
Some possible benefits to implementation of a DLT-based solution:
Increased transparency: The blockchain can store all relevant corporate information (i.e., shareholder name, address, share series, quantity, percentage, options, etc.) within a digital, immutable ledger. The use of this type of technology would make it easier for shareholders to register their holdings directly with the company, rather than registering with a broker. Furthermore, DLT platforms can permit greater visibility into share ownership percentages, including that of management, allowing for more informed investor decisions.
Voting transparency and efficiency, and increased shareholder engagement: As illustrated above, voting today is an arduous, inefficient and opaque process. The current system of shareholder proxy voting has been called a "daisy-chained system of share ownership."3 DLT platforms can be leveraged to allow shareholders to more easily exercise their voting rights, transfer those rights to a proxy (if one is required), and verify that their voting instructions have been counted in the outcome. Vote tallying, in turn, is much more accurate. Additionally, making voting less complicated can increase shareholder engagement and help democratize shareholder participation.4
Compliance: The distributed ledger can address regulatory concerns, including early warning requirements and insider trading issues, because the ledger can be monitored in real time. Furthermore, the registry could be configured to provide comfort to regulators that shareholders have been through appropriate Know-Your-Customer procedures.
Efficiency: DLT eliminates the need for paper share certificates, and if there is ever a dispute in court regarding ownership or number of shares issued, the ledger provides indisputable evidence, saving courts time and money.
Capital markets: A blockchain-based solution could help streamline organizational processes, and improve the accuracy and efficiency of trades, reducing the three-day settlement time to minutes, because counterparties could potentially be eliminated altogether in some cases.
Conversions: Smart contracts are applications that run on top of a blockchain. They are designed to bring about a particular outcome every time a specific set of conditions is fulfilled, using self-executable computer codes and data permission systems. Using a smart contract, preferred shares could automatically convert into common shares upon a subsequent financing round. Employee options will automatically terminate if they haven't been executed prior to a predetermined date. The execution of each smart contract is recorded on the distributed ledger, eliminating the need for manual updates to multiple copies of share registries.
Current progress in the field
It may take time for corporate management to get comfortable with DLT and for vendors to build the right platforms to solve specific corporate governance challenges. However, Delaware is helping to pave the way. On August 1, 2017, Delaware amended its General Corporation Law legislation, allowing corporations to use distributed ledger technology for record-keeping, including the creation and maintenance of their share registers, which may eventually lead to blockchain-based share trading. The amendment is significant, given that 85 percent of initial public offerings occur in Delaware, and one million corporate entities, including 64 percent of Fortune 500 companies, are incorporated in Delaware. Should Canada follow suit, provincial and federal laws (such as the Canada Business Corporations Act and the Québec Business Corporations Act), would have to be amended to eliminate the requirement for the maintenance of a central securities register.
There have also been other significant strides towards incorporating DLT in corporate governance, as summarized in Table 1 below. One company, Overstock, an online retail company, is a pioneer in the field with its recent distribution of more than 126,000 shares through the platform tZero. Overstock is looking to license the platform to other businesses, as well as exchanges, banks and other financial institutions.
Table 1 – Platforms using DLT in corporate governance.
|Vote Room||Proxy voting service utilized by KAS BANK on April 25, 2018, at their Annual General Meeting||Scheduled to be released in 2018|
|TMX Group Ltd. in consultation with Accenture Plc||E-proxy voting system for electronic shareholder voting||Prototype released April 2017|
|The Ledger||Company share tracking on the blockchain||Prototype released November 2017|
|tZero||Distributed ledger platform for capital markets||Private offering for security token closed August 6, 2018|
1. In re Appraisal of Dell Inc. (Dell Continuous Ownership), 2015 WL 4313206 (Del. Ch. July 30, 2015)
2. For a more detailed discussion of agency costs, see for example, A. Lafarre and C. Van der Elst: Blockchain Technology for Corporate Governance and Shareholder Activism, European Corporate Governance Institute, Law Working Paper No. 390/2018.
3. Ibid. at 15, quoting Vice Chancellor Laster of the Delaware Court of Chancery.
4. See C. Van dee Elst and A. Lafarre: Blockchain Technology for Modernizing the Shareholder Dialogue, Working Paper, June 2018.
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