Jim Verdonik

JFV@Wardandsmith.com 

(919)  277-9188

One of the best applications for Blockchain technology is automating the tedious process of maintaining stock ownership records.

Delaware requires corporations to be able to produce a list of stockholders entitled to vote and in some circumstances to share that list with the stockholders of the corporation.

For many businesses, this is a fairly simple task, because their stockholders rarely change. If your stockholder base is more active, however, automating the stock transfer record keeping process through blockchain software may be useful to you.

Obviously, publicly-traded corporations have a changing stock ownership base. But some types of private corporations do as well.  The reasons private companies have large numbers of changing owners (and that many more are likely to in the future) include:

  • COINS and Tokens offerings (some of which may be equity securities) are being marketed to retail investors in the U. S. and foreign jurisdictions. In many cases, these investors are reselling without restrictions.
  • Several years ago, the number of record owners that triggers public company reporting requirements under Section 12 (g) of the Securities Exchange Act of 1934 was increased 2,000 as long as no more that 500 are not Accredited Investors. So, some private companies have a lot of shareholders.
  • Crowdfunding is increasing the number of private businesses that have hundreds of stockholders.
  • Certain Crowdfunding exemptions (Regulation CF and Tier 2 of Regulation A) provide that owners who purchase shares in these offerings are not counted toward the number of stockholders that trigger Section 12 (g) registration.
  • Regulation A permits stockholders to resell their shares in the same offering the issuer uses to raises capital. This facilitates a few large stockholders reselling to many other investors while the company is still private.
  • Early angel investors are becoming more proactive in seeking to be able to exit their investments before the corporation is sold or becomes public.
  • Brokers-dealers are operating secondary trading markets for mature private companies.
  • Corporations are choosing to stay private much longer than several decades ago. Private Unicorns have market caps that exceed $1 Billion.
  • Public reporting requirements under Sarbanes-Oxley and other “reforms” make it more expensive to be a public company, which has caused many businesses to choose to stay private. There has been a substantial decrease in the number of public companies.
  • Large private tech and science based businesses have granted stock options and restricted stock to many employees.
  • Private equity funds provide the capital for private businesses to grow much larger than without becoming public. Many of these businesses reward employees with equity grants.
  • Families use trusts and LLCs for estate tax planning purposes. So, shares are distributed to many family members.Several states have already changed their corporate statutes to permit the use of blockchain and other technology to record corporate records, including stock ownership ledgers.

All these factors are increasing the demand for cheaper more efficient securities transfer systems.

In other article, I discuss how to design your blockchain transfer system to comply with SEC rules or transferring “restricted securities” and why SEC transfer restrictions are the Achilles of the ICO world.

https://gatewaycapitalx.com/2018/03/02/designing-blockchain-smart-contract-securities-transfer-systems-that-comply-with-securities-law-re-sale-restrictions/

https://gatewaycapitalx.com/2018/03/01/securities-re-sale-restrictions-the-achilles-heel-of-icos/

In this article, however, we will  focus on how state law applies to automated securities transfer systems.

 Several states have already changed their corporate statutes to permit the use of blockchain and other technology to record corporate records, including stock ownership ledgers.

Let’s look at how Delaware is treating blockchain and other record keeping technologies.

The Delaware General Corporation Law (“Delaware GCL“) was amended in 2017 to authorize using “electronic networks and databases” for records that state law requires corporations to maintain.

Section 224 of the Delaware GCL says that corporate records may be kept on “one or more electronic networks or databases (including one or more distributed electronic networks or databases).” This authorization is broader than either stock transfer records or blockchain.  It applies to any type of corporate records and to any type of “electronic records of databases.”

Section 219 of the Delaware GCL specifically covers stockholder lists. Section 219 (c) defines what a stock ledger is, but Section 219 does not \use the term “stock ledger.”

(c) For purposes of this chapter, “stock ledger” means 1 or more records administered by or on behalf of the corporation in which the names of all of the corporation’s stockholders of record, the address and number of shares registered in the name of each such stockholder, and all issuances and transfers of stock of the corporation are recorded in accordance with § 224 of this title.  The stock ledger shall be the only evidence as to who are the stockholders entitled by this section to examine the list required by this section or to vote in person or by proxy at any meeting of stockholders.

The Delaware GCL requires four types of information to be in a stock ledger:

  • Stockholder name
  • Stockholder address
  • Number of shares registered under each name
  • All issuances and transfers

In assessing whether blockchain is suitable for use as a “stock ledger,” it should be noted that the Delaware DCL does not specifically require a physical mailing address and does not require the corporation to record only legal names in birth certificates. Corporations rarely inquire as to the legal status of names and often use email and other types of addresses that stockholders give them.

Corporations should, however, consider the impact of anti-money laundering, anti-terrorist and anti-privacy laws on the information they collect about stockholders in original issuances and stock transfers.

So, what does a corporation do if a record owner only provides a blockchain address?

No law requires any person to have a physical mailing address. Therefore, people can choose their addresses, which can be electronic or not.  Likewise, people change addresses and are not required it inform corporations in which they own stock of address changes.  Many stockholders are unreachable.

Tax and other laws may require businesses to report information to the IRS and other agencies. Names are associated with social security and other tax ID numbers for reporting tax information, but the Delaware GCL does not require such tax ID information to be in the “stock ledger.”

Securities laws (such as those relating to bad actors, accredited investors and beneficial ownership) may affect decisions about what information corporations should require stockholders to provide, but such information is not required to be included in the stock transfer ledger.

Note that the requirements for a stockholder ledger are different from a stockholder list (the stockholder list is not required to include all issuances and transfers. Section 219 (a) of the Delaware GCL provides that:

The corporation shall prepare, at least 10 days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting; provided, however, if the record date for determining the stockholders entitled to vote is less than 10 days before the meeting date, the list shall reflect the stockholders entitled to vote as of the tenth day before the meeting date, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. Nothing contained in this section shall require the corporation to include electronic mail addresses or other electronic contact information on such list.

“Stock ledgers” are part of the “books and records” of a corporation. Section 220 of the Delaware GCL gives stockholders limited rights to inspect corporate books and records and specifically includes “the corporation’s stock ledger, a list of stockholders and other books and records.”

Section 224 of the Delaware GCL that governs the form of corporate records does not require corporations to maintain paper records, but it does require that records kept in electronic form be kept so that they “can be converted into clearly legible paper form within a reasonable time.”[1]

What other information is required by the Delaware GCL to be in the corporate records?

Section 224 of the Delaware GCL provides that records kept in electronic form must be kept so that they:

“(i) can be used to prepare the list of stockholders specified in §§ 219 and 220 of this title, (ii) record the information specified in §§ 156,[2] 159,[3] 217(a)[4] and 218 of this title, and (iii) record transfers of stock as governed by Article 8 of subtitle I of Title 6.[5]

Other provisions of the Delaware GCL that permit notices to be delivered in electronic form will enable corporations to communicate with their stockholders through blockchain addresses. These include: notices of preferences and special rights for stock certificates,[6] stock transfer restriction notices,[7] electronic notices,[8] and notices regarding “public benefit” status.[9]

The bottom line is that blockchain stock transfer records can, if thoughtfully implemented, satisfy the requirements of the Delaware General Corporation Law.

Blockchain is a relatively new technology. Corporations may find that they need to customize blockchain software to make it suitable for stock transfer ledger purposes. For example, corporations may want to make it easier to locate and convert into paper form the information required to satisfy the paper and inspection requirements of Delaware General Corporation Law.

This raises the question of what type of blockchain should corporations use for stock transfer ledger purposes. Other blockchain solutions may emerge over time, but the Ethereum Network is a good candidate, because the Ethereum Network accommodates “Smart Contracts” that permit corporations to decide what data to collect and who has access to the information.

Of course, there are several important differences between traditional stock transfer records and using the blockchain:

  • Blockchain enables sellers to make it known that they want to sell, how many shares they want to sell and the price they are willing to sell at and buyers to make it known that they want to buy, the number of shares they want to buy and the price they want to pay.
  • Blockchain facilitates direct communications between potential sellers and buyers.
  • Blockchain actually powers the transaction between buyers and sellers instead of passively recording it after the fact.

All of these blockchain capabilities raise securities law issues for corporations intending to use blockchain for their stock transfer ledgers, including compliance with:

  • Offering rules for original issuances by issuers
  • Stock transfer restrictions following issuances of unregistered securities
  • Section 12 (g) of the Securities Exchange Act of 1934
  • Broker-dealer issues and
  • Rules related to securities trading exchanges.

Unless corporations understand rules for stock transfers and include in their software functions that assure compliance, they risk violating numerous securities laws. Smart Contracts are a vehicle for establishing these rules.

We deal with these issues in other articles.

[1] Section 224 of the Delaware DCL:  “Any records administered by or on behalf of the corporation in the regular course of its business, including its stock ledger, books of account, and minute books, may be kept on, or by means of, or be in the form of, any information storage device, method, or 1 or more electronic networks or databases (including 1 or more distributed electronic networks or databases), provided that the records so kept can be converted into clearly legible paper form within a reasonable time, and, with respect to the stock ledger, that the records so kept (i) can be used to prepare the list of stockholders specified in §§ 219 and 220 of this title, (ii) record the information specified in §§ 156, 159, 217(a) and 218 of this title, and (iii) record transfers of stock as governed by Article 8 of subtitle I of Title 6. Any corporation shall convert any records so kept into clearly legible paper form upon the request of any person entitled to inspect such records pursuant to any provision of this chapter.  When records are kept in such manner, a clearly legible paper form prepared from or by means of the information storage device, method, or 1 or more electronic networks or databases (including 1 or more distributed electronic networks or databases) shall be valid and admissible in evidence, and accepted for all other purposes, to the same extent as an original paper record of the same information would have been, provided the paper form accurately portrays the record.”

[2] Section 156 of the Delaware DCL governs partly paid shares.

[3] Section 159 of the Delaware DCL governs transfer rules for when shares are transferred as collateral security.

[4] Section 217(a) of the Delaware GCL governs stock held by fiduciaries

[5] Article 8 of subtitle I of Title 6 of the Delaware Code governs security interests in stock and other financial assets.

[6] Section 151 (f): “Within a reasonable time after the issuance or transfer of uncertificated stock, the registered owner thereof shall be given a notice, in writing or by electronic transmission, containing the information required to be set forth or stated on certificates pursuant to this section or § 156, § 202(a), § 218(a) or § 364 of this title or with respect to this section a statement that the corporation will furnish without charge to each stockholder who so requests the powers, designations, preferences and relative participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights.”

[7] Section 202 (a) of the Delaware GCL states : “A written restriction or restrictions on the transfer or registration of transfer of a security of a corporation, or on the amount of the corporation’s securities that may be owned by any person or group of persons, if permitted by this section and noted conspicuously on the certificate or certificates representing the security or securities so restricted or, in the case of uncertificated shares, contained in the notice or notices given pursuant to § 151(f) of this title, may be enforced against the holder of the restricted security or securities or any successor or transferee of the holder including an executor, administrator, trustee, guardian or other fiduciary entrusted with like responsibility for the person or estate of the holder. Unless noted conspicuously on the certificate or certificates representing the security or securities so restricted or, in the case of uncertificated shares, contained in the notice or notices given pursuant to § 151(f) of this title, a restriction, even though permitted by this section, is ineffective except against a person with actual knowledge of the restriction.”

[8] Section232 (c) of the Delaware GCL states: “For purposes of this chapter, “electronic transmission” means any form of communication, not directly involving the physical transmission of paper, including the use of, or participation in, 1 or more electronic networks or databases (including 1 or more distributed electronic networks or databases), that creates a record that may be retained, retrieved and reviewed by a recipient thereof, and that may be directly reproduced in paper form by such a recipient through an automated process.”

[9] Section 364 of the Delaware GLC provides: “Any stock certificate issued by a public benefit corporation shall note conspicuously that the corporation is a public benefit corporation formed pursuant to this subchapter.  Any notice given by a public benefit corporation pursuant to § 151(f) of this title shall state conspicuously that the corporation is a public benefit corporation formed pursuant to this subchapter.”

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