Recent Cases Demonstrate Need for Blockchain

by Goodwin

A recent Delaware bill is poised to allow private Delaware corporations “use networks of electronic databases (examples of which are described currently as “distributed ledgers” or a “blockchain”) for the creation and maintenance of corporate records, including the corporation’s stock ledger.”  The bill is a significant step towards the mainstream adoption of blockchain technology, which has the potential to solve problems that legacy technologies could not previously solve.

For example, one practical reason for using blockchain technology to track the transfer of corporate securities stems from a long-standing uncertainty surrounding the property rights of investors who “ultimately have no identifiable relationship with the corporate issuers of investment securities” that they purportedly hold. A majority of investors today only hold shares in “street name,” while intermediaries, the actual shareholder of record, “assign interests [to investors] from among the fungible bundles of stock certificates it holds in its vaults.” A 1994 UCC amendment established the rights of holders of these indirectly-owned securities, which are essentially contractual IOUs, by providing holders with “security entitlement rights.” One of the largest direct holders in the United States is Depository Trust Company, or DTC, who has over 800 participants that sell beneficial rights to investors. Further, participants typically turn around and sell beneficial rights to individual stock holders. Although the 1994 amendment helped clarify certain legal rights to such securities, it did nothing to address issues related to clerical errors by intermediaries and did little to clarify certain rights associated with direct ownership, such as voting rights and collateralization.

One recent instance demonstrating the fallibility of the current system occurred in June of 2016 when T. Rowe Price Group, Inc. agreed to a $194 million settlement to “compensate certain clients for a proxy voting error the firm made in connection with the 2013 leveraged buyout of Dell, Inc.” Specifically, the error occurred when at least 14 portfolio managers holding Dell stock beneficially—with T. Rowe Price acting as a client of the DTC participant, State Street—had made clear to T. Rowe Price that they wished to vote in opposition to the buyout. T. Rowe Price had enlisted Institutional Shareholder Services, or ISS, to both give recommendations on the merger questions and to actually vote the shares as a proxy. Instead of voting against the merger, however, the shares of the individual portfolio managers were voted in favor of the merger when T. Rowe Price forgot to change its default vote setting before sending voting instructions to ISS. While the lost “AGAINST” votes would not have altered the outcome of the merger vote, they stripped the portfolio managers of appraisal rights. Under Delaware General Corporate Laws Section 262(a)(4), any shareholder who votes in favor of a merger is not able to seek a court appraisal. The court ordered T. Rowe Price to compensate the additional value that the portfolio managers would have received from the company had they not lost their appraisal rights. T. Rowe Price was unable to seek indemnification from ISS or DTC, because the risk of incorrect votes was inherent in the relationships that T. Rowe Price had established.

A second instance occurred in March of 2017 when Dole Food Co. reached a $74 million settlement with common stock holders following a take-private deal in 2013. A settlement based on a 2015 shareholder suit alleging fraud under federal securities law against Dole’s fiduciaries left the company’s Chairman and CEO liable for compensation of an additional $2.74 per share in addition to the merger consideration. Upon the completion of the claims process, 49.2 million shareholders made “facially eligible” claims for merger consideration when only 36.8 million shares of the stock class were outstanding. The discrepancy resulted primarily from two sources. First, more than 32 million trades occurred in the three days leading up to and including the day of the merger. The largest direct security holder of Dole, DTC, had a centralized ledger that did not clear trades for three days. Consequently, “multiple owners could submit claims for shares involved in trades that had not cleared. A DTC participant who continued to hold the shares as reflected on DTC’s records could submit a claim, but so could the beneficial owner who was a client of the DTC participant that acquired the shares and therefore owned them as of closing.” Second, an increase in open short positions, led to an increase in borrowed shares. At the time of merger, both the short investor with borrowed shares and the beneficial owner lending the shares had facially valid claims for merger consideration. The extremely high volume of trading and short selling in the three days leading up to the merger were responsible for the resulting imbalance in facially valid claims. The Chancery Court ruled that the additional merger considerations should be distributed to DTC, who would issue it to its over 800 participants, who would then issue it to the individual beneficial owners. The Court warned that this process would likely result in incremental costs for beneficial owners, but noted that “these are [the] risks inherent in choosing to hold [equities] in street name.”

The Delaware law allowing private companies to transmit stock ownership via blockchain, raises the possibility of cutting out intermediaries who were once necessary to make transmitting stocks quick and easy. Instead, investors would be able to directly own shares, vote or elect a proxy of their own choosing and transfer shares directly to other investors. It will clear up ownership issues and cap tables, because only one individual will be able to hold a security at any one time, even in the case of short sales.

All three branches of Delaware’s government seem to be on board for further experimentation in blockchain applications. In 2016, Delaware’s former Governor, Jack Markell, announced the formation of the Delaware Blockchain initiative, intended to “to embrace the emerging blockchain and smart contract technology industry.”  The legislature voted nearly unanimously to adopt the blockchain law. Finally, following his decisions in both cases noted above, Vice Chancellor J. Travis Laster, spoke out strongly in favor the adoption of  blockchain technology, saying:

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 issues with the current system of record-keeping are real and substantial. In addition, blockchain is a technology specifically designed to streamline issues related to inefficient intermediaries, like DTC. Delaware’s new law will be an early indicator as to whether the technology is ready to change substantial portions of our economy.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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