The First Block in the Chain: Proposed Amendments to the DGCL Pave the Way for Distributed Ledgers and Beyond
This article was originally published on March 16, 2017 and is part of The Harvard Law School Forum on Corporate Governance and Financial Regulation's Delaware law series. Additional posts related to the blockchain initiative are available here.
On May 2, 2016, Delaware’s Governor announced the official public launch of the “Delaware Blockchain Initiative.”1 The primary goal of the initiative is to encourage the adoption of blockchain technology in the private and public sectors for the benefit of both private enterprises and the public.2 As part of the initiative, the Governor requested that the Council of the Corporation Law Section of the Delaware State Bar Association (which we refer to herein as the Council) begin to explore whether any changes or clarifications should be made to the General Corporation Law of the State of Delaware (commonly referred to as the DGCL) to enable Delaware corporations to utilize blockchain technology for the registration and transfer of record ownership of shares of stock.3
In his speech, the Governor enthusiastically described his support for “distributed ledger shares.”4 The phrase “distributed ledger shares” generally refers to shares of stock that can be recorded and transferred on decentralized electronic networks using blockchain technology.5 Although the “hows” of blockchain technology are quite complicated, the “what” is simple. Blockchain technology enables the validation and recordation of transfers of assets between parties over peer-to-peer networks.6
Advocates of blockchain technology “have praised its potential to clear and settle nearly any transaction imaginable.”7 Blockchain technology enables parties to transfer assets directly to one another without the costs and delays inherently resulting from the involvement of intermediaries. Blockchains can be used to record ownership transfers of a variety of assets, including shares of stock.8 While transfers of assets typically require a trusted third party intermediary to verify each transaction, blockchains instead rely on “proof” achieved by mathematical computation to determine if a transaction is authentic. The network participants collectively validate and record transfers on the blockchain through a computational process that enables real-time, secure, traceable, and authenticated transfers. The blockchain is updated and replicated in real-time on each electronic database in the network.
On March 13, 2017, the Council announced certain proposed amendments to the DGCL that would provide specific statutory authority for Delaware corporations to use networks of electronic databases (such as distributed ledgers) to create and administer corporate records. The proposed amendments, if enacted, would enable Delaware corporations to use a distributed ledger, in lieu of a traditional stock ledger, to record and transfer record ownership of shares of stock.9
The Current State of Delaware Law
Delaware corporations are required to maintain a stock ledger and register the issuance of shares and any transfers of record ownership on that ledger. The stock ledger is the definitive source for the names and addresses of record owners of the corporation’s stock.10 Stock ledgers are typically maintained by the corporate secretary or the corporation’s transfer agent in hard copy form, on a computer program like Microsoft Excel, or in some similar fashion.11 Regardless of the form, stock ledgers are maintained and updated by individuals who must actively manage and record any issuances and transfers of stock. Under this system, the corporation (or its transfer agent) must be notified of any transfer of record ownership, and that transfer must be recorded on the corporation’s stock ledger in order for the transferee to become the record owner of the transferred shares.12 The need for an intermediary to record transfers means that the mechanical process of recording a transfer of record ownership takes time and is susceptible to human error.
The Proposed Amendments
Although the DGCL currently contemplates that a corporation may maintain its corporate records (including its stock ledger) by means of, or in the form of, any information storage device or method,13 it does not expressly provide that such information storage device or method may include the use of a network of electronic databases (e.g., a distributed ledger). The proposed amendments are designed to expressly provide such statutory authority and thus to enable Delaware corporations to use networks of electronic databases (including distributed ledgers) to create and administer corporate records, including the corporation’s stock ledger. To effectuate that goal, the Council has proposed amendments to Sections 151(f), 202(a), 219, 224, 232(c), and 364 of the DGCL.
The crux of the proposed amendments lies in the changes to Section 224 of the DGCL. This is the provision that sets forth the statutory requirements for the form of corporate records under Delaware law. The Council proposes that Section 224 of the DGCL be amended to: (i) provide that corporate records may be “administered by or on behalf of the corporation” (rather than “maintained by the corporation,” as currently required by the statute), and (ii) include specific language recognizing the use of electronic networks or databases (including one or more distributed electronic networks or databases) as permissible forms for administering a stock ledger.
Importantly, the proposed amendments to Section 224 of the DGCL would establish certain minimum requirements with respect to the form of the stock ledger (whether administered on a distributed ledger or otherwise). In particular, Section 224 of the DGCL, as amended, would require that the records so kept must: (i) be convertible into clearly legible paper form (as currently required by the statute); (ii) enable the corporation to prepare the list of stockholders specified in Sections 219 (stockholder meetings) and 220 (inspection of books and records) of the DGCL; (iii) be capable of recording the information specified in Sections 156 (partly paid shares), 159 (collateral transfer), 217(a) (voting rights of fiduciaries, pledgors and joint owners of stock), and 218 (voting trusts and other voting agreements) of the DGCL; and (iv) record transfers of stock as governed by Article 8 of the Delaware Uniform Commercial Code.
The proposed amendments to Section 219 of the DGCL would add a definition of “stock ledger” to Section 219(c). A “stock ledger” would be defined as “one 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” Section 224 of the DGCL. As amended, Section 219(a) also would remove the requirement that the list of stockholders entitled to vote at a meeting be prepared and made by an officer who has “charge of the stock ledger” and instead would require more generally that the corporation prepare a list of such stockholders. The foregoing proposed amendments to Section 219 recognize that a stock ledger does not need to be administered directly under the charge of a corporate officer and therefore enable the use of a distributed ledger to record and transfer shares so long as the stock ledger is administered “by or on behalf of the corporation.”
Finally, additional amendments have been proposed to other sections of the DGCL to accommodate the possibility that notices may be given through the use of blockchain technology. In particular, Section 232 of the DGCL would be amended to clarify that the definition of “electronic transmission” for purposes of the DGCL includes the use of, or participation in, one or more electronic networks or databases (including one or more distributed electronic networks or databases). As a result, notices by electronic transmission under Delaware law could be given by means of a distributed ledger. Moreover, Sections 151(f), 202(a) and 364 of the DGCL would be amended to explicitly permit delivery of certain notices by electronic transmission (including via a distributed ledger) to a holder of uncertificated shares.
Implications of the Blockchain for Share Transfers
Set forth below are certain considerations regarding the practical implementation and potential implications of the proposed amendments.
Administration of the Stock Ledger.
The proposed amendments require a stock ledger to be administered “by or on behalf of the corporation.” Blockchain technology offers the possibility of transfers without the participation of any intermediary, including the corporation. The proposed amendments, however, do not go so far as to authorize the use of blockchain technology without some involvement by the corporation. Although not specified in the statute, the reference to the stock ledger being administered “by or on behalf of the corporation” indicates that the corporation must remain involved in some capacity.
There are a number of ways for a corporation to satisfy this requirement. For example, a corporation could enter into some form of contractual relationship to ensure the proper administration of the stock ledger (through a distributed ledger) in accordance with the requirements of Delaware law. This arrangement likely would not differ much from arrangements corporations make today with transfer agents. Although the corporation must remain part of the process, the proposed amendments would permit the corporation (or its transfer agent) to move from a direct gatekeeper function, greenlighting every transfer of record ownership, to an overseer role in which the corporation establishes parameters for the inclusion of the corporation’s securities on the distributed ledger and otherwise sets rules as provided pursuant to the contractual relationship.
It may be likely, at least during its infancy, that a distributed ledger used for recording and transferring record ownership of stock will be administered by a service provider (like a transfer agent) that enters into a contractual relationship with various participants that adopt the technology. This contractual relationship would set out the framework for participation and any applicable rules governing the transfer of securities on the distributed ledger.14 Ultimately, the blockchain construct utilized and its compliance with Delaware law probably will (at least in the near term) depend on contractual relationships between and among the participants.15
Legacy Certificate Issue.
Blockchain technology offers potential benefits, as discussed, but uncertainty still exists as to certain logistical aspects of adoption. For example, the proposed DGCL amendments do not address certain practical challenges that may arise for existing Delaware corporations seeking to adopt blockchain technology. One such issue is not new and has existed since the DGCL was amended to permit the use of uncertificated shares. To the extent a Delaware corporation adopts blockchain technology while it has stock certificates outstanding, which would be the case for the vast majority of publicly traded corporations, there remains a potential impediment to achieving the benefits afforded by the new technology.
Section 158 of the DGCL provides that the board of directors may provide by resolution that some or all of the corporation’s capital stock shall be uncertificated shares (this necessarily would be the case for shares on a distributed ledger). Section 158 also provides, however, that any such resolution shall not apply to shares represented by a certificate until such certificate is surrendered to the corporation.16 Consequently, any Delaware corporation that has certificates outstanding may not be able to easily transition to a distributed ledger, which by definition is a system that would operate to transfer only uncertificated shares. Any Delaware corporation seeking to transition to a distributed ledger should carefully consider these and any other potential practical impediments.
Secondary Securities Market.
The proposed amendments address only the transfer of record ownership. Virtually nothing happens to a public corporation’s stock ledger each day, however, to reflect the great bulk of the changes in beneficial ownership of shares that occur on the secondary securities market.
Although the amendments do not address the workings of the secondary securities market, the potential benefits of blockchain technology for that market are potentially far-reaching.17 Blockchain technology has the potential to allow every stockholder of a publicly traded corporation to own its stock of record while still maintaining the simplicity, speed, and other benefits proffered by the secondary securities market. For now, however, it is unclear whether or when such a drastic change to the system will occur. What is more plausible in the short-term (and what is in fact occurring in practice) is that intermediaries and stock exchanges will begin to utilize blockchain technology to improve upon (as opposed to replace) the current system.18
The proposed amendments to the DGCL pave the way for the use of blockchain technology and distributed ledgers at the corporate level and beyond. Regardless of the ceiling for this technology, Delaware has taken a vital first step in welcoming and accommodating blockchain technology and will continue to remain at the forefront of innovation as the use of this technology grows throughout the market.
* Matthew J. O’Toole and Michael K. Reilly are partners, and David B. DiDonato is an associate, in the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP. Mr. O’Toole currently chairs the Council of the Corporation Law Section of the Delaware State Bar Association, and both he and Mr. Reilly served as members of the Council committee charged with exploring whether any changes or clarifications should be made to Delaware’s corporate statute to enable Delaware corporations to utilize blockchain technology for the issuance and transfer of stock. The views expressed herein are solely those of the authors and do not necessarily represent the views of the firm or its clients.
1 Jack Markell, former Governor, State of Delaware, Consensus 2016 Keynote Presentation: Introducing the Delaware Blockchain Initiative (May 2, 2016).
2 Id. at 3-4.
3 Id. at 13-14.
4 Id. at 11.
5 The term “distributed” signifies that each party on the network maintains a complete, accurate, and up-to-date copy of the same ledger.
6 For those seeking a more in-depth comprehension of how the technology operates, several articles have been written describing the details of blockchain technology in a relatively easy to understand format. See, e.g., David Yermack, Corporate Governance and Blockchains, NYU Stern School of Business and National Bureau of Economic Research (Nov. 28, 2016) (discussed on the Forum here); Vice Chancellor J. Travis Laster, The Block Chain Plunger: Using Technology to Clean Up Proxy Plumbing and Take Back the Vote, Keynote Speech to Council of Institutional Investors (Sept. 29, 2016); Larissa Lee, New Kids on the Blockchain: How Bitcoin’s Technology Could Reinvent the Stock Market, Hastings Business Law Journal (2016).
7 Marco A. Santori, Governor Jack Markell announces Delaware Blockchain Initiative, The Global Delaware Blog (June 10, 2016), http://global.blogs.delaware.gov/2016/06/10/delaware-to-create-distributed-ledger-based-share-ownership-structure-as-part-of-blockchain-initiative.
8 Many people believe that blockchain technology could have a revolutionary impact on the secondary securities market. As discussed herein, the proposed amendments to the DGCL address only the use of blockchain technology in connection with the issuance and transfer of record ownership of stock at the corporate level, and do not address transfers of beneficial ownership of stock in the secondary securities market, which operate through complex contractual arrangements and are not within the purview of Delaware corporate law. Nevertheless, paving the way for the adoption of blockchain technology at the corporate level may foster more expansive uses of the technology.
9 It is anticipated that the proposed amendments will be introduced in the Delaware General Assembly during the current legislative session. If approved by the Delaware General Assembly and thereafter signed by the Governor, the amendments likely would become effective on August 1, 2017.
10 Under Delaware law, the stock ledger is used to create the list of stockholders entitled to notice of and to vote at each stockholders meeting, and any stockholder or director may demand to inspect the stock ledger. 8 Del. C. §§ 219, 220. In general, only record owners are legally entitled to exercise stockholder rights, and the corporation must recognize only such registered owners as the persons entitled to vote, to receive notices, and otherwise to exercise all the rights and powers of a stockholder.
11 Section 224 of the DGCL currently permits a stock ledger to be kept on, or by means of, or be in the form of, any information storage device, or method, provided the record so kept can be converted into clearly legible paper form within a reasonable time. 8 Del. C. § 224.
12 This is generally accomplished through delivery of endorsed stock certificates to the corporation in the case of certificated shares, or delivery of instructions to the corporation in the case of uncertificated shares.
13 8 Del. C. § 224.
14 For example, if a corporation has a cap on the amount of voting securities a stockholder may own, the blockchain could be coded to account for this limitation and restrict the transfer of securities to that stockholder above the cap. The technology has broad capabilities and allows each corporation to customize the rules for how its securities and securityholders are treated on the blockchain.
15 There are a number of potential benefits of registering issuances and transfers of shares on a distributed ledger that go beyond the mere transfer of shares. For example, the Delaware Secretary of State could participate as a node in a permissioned ledger and thus provide access to State records to, among other things, prevent an over-issuance of shares. A distributed ledger also may permit more seamless interaction between Delaware corporations and the Secretary of State in connection with such matters as the filing (and payment) of a corporation’s annual franchise taxes and perhaps, someday, the ability to make corporate filings with the Delaware Secretary of State through the blockchain (e.g., charter amendments, certificates of merger, etc.).
16 In addition to the DGCL, the existence of outstanding certificates and the legal nature of those certificates is meaningful under Delaware’s version of the Uniform Commercial Code.
17 For example, blockchain technology would provide beneficial owners the means to transfer securities peer-to-peer in real-time on a distributed ledger without the expensive and cumbersome involvement of intermediaries. Blockchain technology also creates a way to know, at any given moment, past or the present, who owned or owns the shares of any particular public company (whether of record or beneficially). That type of information is currently unavailable in the secondary securities market.
18 For example, in Australia, the Sydney-based Australian Securities Exchange announced that it intends to use blockchain technology in its clearing and settlement system. See Samburaj Das, Australian Stock Exchange Confirms Upcoming Blockchain for Settlement (Jan. 22, 2016), https://www.cryptocoinsnews.com/australian-stock-exchange-confirms-upcoming-blockchain-for-settlements/. In the U.S., Nasdaq has embraced blockchain technology. See Laura Shin, Why Nasdaq Is Even More Optimistic About Blockchain Than It Was 3 Years Ago (Feb. 21, 2017), https://www.forbes.com/sites/laurashin/2017/02/21/why-nasdaq-is-even-more-optimistic-about-blockchain-than-it-was-3-years-ago/#557b93851a26.