In our new Series “Walk me through the Process” we will learn and understand more about the cost-saving effects & efficiency improvements blockchain technology / Security Tokens can bring to the financial industry.
This week we are welcoming Marc Borion from FisherBroyles. Marc represents leaders in blockchain and other distributed ledger technologies in a broad number of industries, has a strong expertise in Delaware law and helped multiple companies using exemptions like Reg D, Reg A+, and Reg CF.
Marc will educate us on the concept of Fractional Shares, showing us how the traditional approach works, how Security Tokens can represent fractional ownership in Offchain Securities and what potential Digitally Native Onchain Security Tokens can offer in the future.
Enjoy the Insight.
The Path to Fractional Ownership of Securities Through Security Tokens
One of the most touted benefits of security tokens (also known as “digital securities” and “smart securities”) is the ease with which fractional ownership in assets can be created, transferred, and further fractionalized. If the fractional ownership is created for holders of the asset to benefit from the potential increase in value of the underlying asset, then the asset, regardless of its status before being fractionalized, will very likely be deemed to be a security.
This article explores the process that traditionally has existed to create and transfer fractional ownership in securities and how that process changes with security tokens. This article also will discuss how digitally native, onchain security tokens provide even greater simplicity in the creation and transfer of securities than security tokens representing offchain securities. For simplicity, shares of a Delaware corporation’s stock will be used as an example of the expected evolution in the creation and transfer of fractional ownership in securities.
Fractional Shares: Traditional Approach
Contrary to many people’s beliefs, corporations have always been able to issue a fractional share but generally have chosen to prohibit it. The current process for creating a fractional share is as follows:
- the board of directors and stockholders approve a certificate of incorporation and/or bylaws of the corporation that does not prohibit the issuance of fractional shares;
- the board of directors approves the issuance of a fractional share; and
- the corporation issues the fractional share in return for payment and enters the fractional share amount issued on the company’s stock ledger and, if the corporation’s stock is certificated, issues a stock certificate evidencing ownership of the fractional share.
After the fractional share has been issued, the transfer of all or part of the share must happen as follows:
- the buyer and seller agree on a price, likely offline, though some companies allow for the parties to reach agreement on price online through an alternative trading system (ATS);
- the seller requests that the corporation transfers all or part of the fractional share to the buyer, which will involve, if requested by the corporation, the seller giving an opinion of counsel stating that the transfer does not violate securities laws and, if the fractional share is certificated, then signing the stock certificate and presenting it to the corporation; and
- the corporation will record the transfer on the stock ledger, including the portion of a share continued to be owned by the seller and the amount of the fractional share owned by the buyer, and, if the shares are certificated, issue a new stock certificate to each of the buyer and the seller of the fractional share reflecting each of their current share ownerships.
The issuance of a fractional share has been permitted under Delaware law for a long time, but it has been difficult to administer fractional shares. Carta, which is the largest cap table management software provider for private securities, only recently began permitting fractional shares in its software. However, soon after, it again stopped permitting corporations to track fractional shares using its software. Therefore, most private companies cannot use the most popular software to administer fractional shares, requiring them to use lesser known providers that support them or not using any such provider. Neither option is great.
There are other implications to not having fractional shares. First, the corporation likely will need to pay more franchise taxes to the Delaware Secretary of State. If fractional shares are issued, then it is possible to have very few shares of stock authorized in the corporation’s certificate of incorporation, which allows a corporation to pay the minimum franchise tax in Delaware of $175. Instead, corporations usually authorize 10,000,000 shares upon incorporation and increase the number of shares authorized with each round of financing, which, especially as the value of a corporation’s assets grows, causes franchise taxes to increase to the high hundreds or thousands of dollars, and the minimum franchise tax in those circumstances is $400.
Second, if a corporate transaction takes place in which fractional shares would have been issued had they been permitted, then the corporation needs to pay the “fair value” of the fractional shares that are not issued to the stockholder. Corporations and stockholders have incurred millions of dollars of costs litigating the meaning of “fair value” in Delaware courts.
These reasons, along with the simplicity of administering security tokens, make security tokens so appealing for issuing fractional ownership in securities, including fractional shares.
Fractional Shares: Security Tokens for Offchain Securities
Security tokens representing an offchain security, such as a fraction share of a Delaware corporation, are created in the same way as without security tokens, except that, rather than the corporation entering the original issuance of the fractional share in its stock ledger, it creates and transfers a security token to the stockholder. That transfer automatically acts as the recordation of the transfer and ownership of the fractional share on the blockchain.
The transfer of a security token on a blockchain is insufficient to comply with Delaware law, unless details regarding ownership of the security token, including the name, address and number of shares of each stockholder, are recorded on the ledger. The requirement is no different with when issuing security tokens. Given that the Ethereum blockchain and many other blockchains allow for 18 decimal places, there are no practical limitations in that respect for recording a fractional share on the Ethereum blockchain or most other blockchains (unless corporations choose to include fewer decimals).
Currently, no onchain solutions are used to store that stockholder information privately. Thus, the data is stored by the issuer offchain. Eventually, all information required to be kept on the stock ledger of a Delaware corporation may be securely and privately stored onchain, even for security tokens representing offchain securities.
Wyoming corporations do not face the same issue because the only information required for a stockholder is a digital wallet address. The practical distinction is small, though, because other U.S. laws will require knowing information about stockholders to ensure those laws are not being violated.
The transfer of a security token representing a fractional share of a Delaware corporation occurs somewhat differently than has traditionally occurred with a fractional share:
- the buyer and seller agree on a price, which likely occurs on an ATS or national securities exchange (NSE); and
- the seller sends the security token to the buyer, which will result in any restrictive legend (i.e., a legend stating that the securities cannot be transferred until certain events occur) being deemed to be removed and the transfer and ownership being recorded on a blockchain reflecting the fractional share ownership of the buyer and seller.
The process outlined above assumes that the corporation will not require the seller to give it an opinion of counsel stating that the transfer does not violate securities laws and that the shares will be uncertificated. If either of those assumptions are not true, then the corporation needs to be in the middle of the transaction and the benefits of security tokens for transferring fractional shares are immaterial.
Issuers take some risk when they do not require an opinion of counsel because the transfer may violate securities laws, but issuers likely will choose to trust that the process they put in place to ensure compliant token transfers is satisfactory. If issuers are not willing to take that step, then using a security token to represent a fractional share likely does not add much value because the process for creating and transferring the fractional share will be extremely similar to that process without security tokens.
The assumption that the fractional share is uncertificated is not necessary for Wyoming corporations, which are permitted to issue security tokens that constitute stock certificates of that corporation.
Fractional Shares: Digitally Native Onchain Security Tokens
Although the definition of a digitally native, onchain asset can be debated, in my view, the security is digitally native and onchain if all terms of that security exist and are enforced from the beginning of time onchain and only onchain (other than enforceability of court and regulatory orders, which will for the foreseeable future exist offchain for all assets). In addition, all the disclosures and other information regarding that security needs to forever exist onchain.
Digitally native, onchain shares will not exist for many years. For shares to ever possibly be considered digitally native and onchain, the corporation’s certificate of incorporation and bylaws would need to exist and be enforced onchain, all funds of the corporation must be held onchain, all other securities of the corporation must be digitally native and onchain, all disclosures of the corporation must exist onchain and all governance (including board and stockholder votes) must occur onchain.
Until digitally native, onchain shares exist, the closest thing to those shares is a smart contract that contractually replicates all rights that would exist in a share of a corporation. For example, security token holders would have a right to their pro rata share of profits and any other contractual rights agreed upon that mirror the rights of a stockholder in a corporation. However, the impact of those rights and the results of enforcing them will not perfectly mirror those of stockholders of the corporation because of limitations under Delaware corporate law.
To avoid the limitations that exist with a corporation, instead of using a corporation in this structure, a limited liability company would be the entity used in the structure. Limited liability companies provide significant flexibility with virtually no statutory requirements that cannot be altered.
The process for creating the fractional limited liability company interest would be as follows:
- the certificate of formation, which gets filed with the Delaware Secretary of State, would never have more terms than the minimum required by law;
- the limited liability company agreement would exist onchain and, only to the extent any rights of the board of managers and the members of the limited liability company could not be coded in a smart contract, would be in natural language; and
- security tokens representing the fractional ownership of the company are created and transferred to the members, and that transfer automatically acts as the recordation of the transfer and ownership on the blockchain.
After a security token described above has been issued, the transfer of that token must happen as follows:
- the buyer and seller agree on a price through an ATS or NSE; and
- the seller sends the security token to the buyer, which automatically records the transfer of the security token on the blockchain, with any fractional ownership reflected on the blockchain.
As with securities tokens for offchain assets, the process outlined above assumes that the limited liability company will not require the seller to give it an opinion of counsel stating that the transfer does not violate securities laws, which creates some risk for the company.
The transfer of fractional ownership in securities has historically been slow and inefficient. The current form of security tokens helps solve some of that slowness and inefficiency. It is, however, not until securities are digitally native and onchain that the full benefits of fractional ownership in securities will be realized. Much of that can be achieved with a limited liability company, but several limitations to achieving digitally native, onchain equity exist.
Thank you for the Insight!
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