With Blockchain, The Early Lawyer Gets The Worm
Written by Andrea Tinianow and Caitlin Long
The Delaware Blockchain Initiative has prompted a burst of activity by corporate lawyers in Delaware, New York and other jurisdictions around the world who are considering how blockchain technology can benefit their Delaware-based clients. Many have already identified new and specific corporate and commercial services they will be able to offer clients as a result of Delaware’s decisive entry into the blockchain ecosystem.
These services promise greater efficiencies, reduced risk, automated administrative functions and enhanced security for entities incorporated in Delaware. Significantly, these services will also generate new revenue streams for the Office of the Secretary of State, as well as for Delaware’s service companies and legal community. For example, the Delaware Division of Corporations anticipates substantial income from fees charged for new, premium blockchain services.
Registered agents and other service companies are likely to create the new services, ranging from automated capitalization (“cap”) table management to Uniform Commercial Code (“UCC”) financing statement notification services. However, the market is competitive, and other providers may emerge to provide similar blockchain services. To date, no particular set of market players has established a dominant role.
Similarly, the legal community is uniquely positioned to become trusted advisors to clients on all things blockchain, counseling them on how best to structure their corporate affairs to maximize the benefits of utilizing the Division of Corporations’ distributed ledger. Possibilities include automating the work of share issuances and transfers, corporate governance and commercial transactions. Additional opportunities include providing legal advice on smart contracts and, for the most innovative law firms, providing their own firm-branded blockchain services.
With the potential benefits and substantial revenue opportunity for state governments, it is likely only a matter of time before other states deploy similar blockchain innovations. As more states connect to the same distributed ledger, benefits multiply exponentially. For example, a corporation could qualify to do business in multiple states (perhaps, at some point, even all 50) using a single “Smart Qualification” filing, and renewals could be automated so that the corporation never misses a deadline and always has an accurate record of qualification.
The services envisioned comprise high-value offerings that could not exist without a secure distributed ledger platform that is integrated with the Delaware Division of Corporations. Initial services fall into two categories, corporate and UCC, due to the high value and efficiencies to be gained from being on a blockchain, not to mention the huge demand.
Corporate Services
Prospective corporate services include automated document filing and storage; cap table management; automated voting; investor communication; automated state filings; certificates of good standing; and board services.
Document filing and storage
Automated document filing and storage will provide an immutable record and repository of certificates of incorporation, bylaws and stockholder agreements. With regard to certificates of incorporation, when Delaware’s Division of Corporations integrates with Symbiont, the Division’s exclusive distributed ledger provider, smart contract functionality embedded on the blockchain will ensure that the certificate is well-formed in accordance with statutory requirements, and will enable amendments to be filed without the need for human intervention. The distributed ledger will record the number of shares issued at the time of incorporation, and track share activity to prevent the company from issuing more than the authorized number of shares.
Similarly, recordation of bylaw amendments to a blockchain ledger establishes a clear chronology of amendments, regardless of whether effected by the board of directors or stockholders, and potentially forestalls or resolves disputes about which set of amendments are controlling.
All relevant shareholders can be permissioned to have access to the current version of the stockholder agreement at all times. Stockholders who acquire their shares via the distributed ledger can be required to digitally sign a joinder to the corporation’s stockholder agreements as a condition to the effectiveness of the transfer.
Capital table management
Distributed ledger technology offers the potential to maintain ownership records that are 100 percent accurate in real time. Privately-held, complex entities in particular stand to benefit because of the current difficulties associated with cap table management of preferred stock or common stock with special rights, multiple series of preferred stock, or other securities with conversion or voting rights, such as convertible debt. Managing the tables on a distributed ledger will reduce the risk of error, streamline the process and create an immutable record.
The technology will also allow for the automation of other services that are currently labor-intensive and error-prone, such as option accounting; compliance with transfer restrictions (no-sale or limited-sale requirements, lock-up restrictions, ROFO/ROFR restrictions, “white list/black list” sale restrictions); automated conversions from one security to another, whether based on exercise of investor rights (with blockchain confirming availability of right) or external data sources; real-time voting power calculations in the aggregate, for a particular class or series, or for a particular holder; and real-time fully-diluted ownership calculations.
Blockchain will enable companies to model “what if” scenarios of how voting rights, conversion rights, or other rights will be affected by a dilutive issuance or other transaction. It will also provide easier due diligence for investment or M&A. Follow-on rounds will be easier and therefore cheaper because of certainty as to rights of existing investors—the seller will have confidence when giving a rep regarding the accuracy of its cap table, minimizing the need for rep, enabling a shorter survival period, and/or avoiding the need for transaction insurance.
Automated voting
Distributed ledger technology will ensure timely compliance with annual meeting requirements. It will facilitate action at real-world or virtual meetings, and will automatically determine whether a quorum is present, which securities and which holders can vote, and whether the correct numerator and denominator are met for approval. It will also facilitate action by written consent without a meeting by providing automatic determination of whether shares could vote at a meeting as well as end-to-end confirmation of consent delivery.
Investor communication
When a corporation’s stock ledger is on the Division of Corporations’ distributed ledger, voluntary communications to investors about the business can be streamlined and tracked. These communications could include proxy statement delivery, tender/exchange offers, or other communications pertaining to registered securities. The technology could also be used to expedite required communications, such as prompt notice of action by written consent as required by Section 228 of the DGCL.
Automated state filings and certificates of good standing
Filings with the Office of the Secretary of State such as the annual report and franchise tax payments could be automated using smart contracts, ensuring that companies meet deadlines. Smart contracts could also be used to accurately calculate amounts owed, thereby avoiding penalties and audits.
Certificates of Good Standing requests for blockchain-registered companies could be expedited quickly and easily, given that all relevant information needed to issue the certificate would be dynamically tracked and available.
Board services
Board services realized on the blockchain would provide a secure and confidential platform for maintaining records of board actions. The service would ensure that corporate actions (such as authorizing new shares) happen only after board approval, and provide automated verification of quorum requirements and satisfaction of any special approval requirements, such as affirmative vote of designated directors. Users could also create automated alerts for special veto rights held by particular investors or equity holders.
Such services could be expanded to create a platform for managing all board information that would serve as a secure and confidential repository for sensitive board materials and provide secure communication channels for the Board.
UCC Services
The use of distributed ledger technology together with smart contracts has the potential to revolutionize UCC filings due to its ability to address critical pain points associated with such filings.
Smart UCCs would reduce or even prevent errors in and with respect to financing statements that cause security interests to become unperfected and, thus, unenforceable, as well as mistakes that may prevent security interests from becoming perfected in the first place. Smart UCCs could also prevent the inadvertent or incorrect filing of termination statements or missed continuation statements.
With smart UCCs, a UCC-1 filer could receive immediate notification at the time of filing if the applicable financing statement contains any variation from the debtor’s name as it appears in the state’s official records (i.e., the certificate of incorporation, in the case of a Delaware corporation), ideally with the differences highlighted.
As soon as the UCC-1 is filed by or on behalf of a secured party, the debtor and all other secured parties of record with filings against such debtor could be notified with full information from the newly filed UCC-1, such as the name and address of secured party, a description of the collateral, and the nature of filing. Secured parties of record could also receive notice of the continuation date of their respective UCC-1s at a predesignated time (for example, six months in advance of lapse date).
Any post-filing changes to the financing statement could be automatically and immediately communicated to all interested parties, with the change highlighted. Examples include: a debtor name change; a secured party name change; the addition of a debtor or secured party to a UCC-1; a change in the collateral description, preferably with a redline against former description; the removal of a debtor or secured party; the assignment of a UCC-1, identifying the old and the new secured parties; an address change of debtor or secured party, etc. Smart UCC technology could also recognize UCC-1 lapses and provide immediate and automatic notice to the debtor and all secured parties of record with filings against the debtor.
UCC-1 terminations could also generate immediate and automatic notification to the debtor and all secured parties of record with filings against the debtor, identifying date on which termination was filed and by whom, among other relevant information. The days of a debtor having to request a lender to file a termination statement for obligations that already had been paid, discharged and satisfied in full could be gone, as this could occur automatically using smart contracts.
Running UCC lien searches could become a quicker and easier process, and lien search results could be clearer and easier to interpret. For example, the search results would be able to provide only the current filings.
Reincorporation or removal of a debtor to another jurisdiction could trigger an immediate and automatic alert to all interested parties, as could the lapse of a debtor’s good standing, or the rejection of a UCC-1 filing.
If a particular state has a procedure for reinstatement of an erroneously terminated UCC-1, that could also be incorporated into the system, using smart contracts. Secured parties of record could also be notified of changes in the state’s search logic or filing criteria.
A smart UCC solution could include links to fixture filings of the same debtor in the same and
other states that implement “smart” UCC filing services. If equity interests can be coded on the blockchain to reflect that they have been pledged, then perhaps someday the concept of the secured party holding possessory collateral in the form of certificated shares of stock and corresponding transfer powers (which sometimes are lost by secured parties) no longer will be necessary for the secured party to be certain that it has the “best” priority perfected security interest. (This likely would require amendments to the Delaware Uniform Commercial Code.)
Finally, as distributed ledgers improve the traceability of title to personal property, it may be possible to create direct linkage between a debtor’s acquisition of title to specific items of property and the collateral description in a related UCC-1 financing statement.
It is expected (and hoped) that the reduced risk associated with trade finance due to smart UCCs will spur more lending and create new opportunities and lower pricing for lending in areas that have up until now been considered risky. Reduced risk and digitized collateral tracked on a blockchain could unlock or free up new sources of collateral that could, in turn, “turbocharge” the economy. In addition, reduced risk may permit lenders to make certain loans less expensive to borrowers – for example, by lowering the interest rate or reducing collateral management fees, etc. – as such risk may no longer need to be “priced-into” a given loan.
Cui Bono — Who Benefits?
Delaware has staked out a leadership position to bring blockchain to the rest of the United States (and the world) for the benefit of constituents across the global corporate finance ecosystem. According to Delaware’s vision, corporations and other business entities will benefit from lower costs, reduced risk, better recordkeeping and automation of administrative functions.
Lawyers will benefit from offering their clients a whole new area of expertise. This will create new business opportunities, as clients migrate to “smart” versions of existing services on a blockchain. As momentum develops, many existing corporations will likely consider whether to convert to blockchain registration, and early movers demonstrate the benefits of administrative efficiencies, reduced risk and cost-saving. Law firms can be at the forefront of that progress, and can advise clients how to get on board.
Law firms themselves may become nodes on a blockchain, offering new services, such as immutable document storage for multiple parties to a transaction. The line between services traditionally provided by lawyers and registered agent functions may also blur, as lawyers find additional ways to monetize their corporate structuring and recordkeeping advice that comply with ethics requirements. And law firms may interface with their service providers to develop new, value-added services for clients that can only be provided on a blockchain.
In short, a wide range of market participants (including business entities small and large), service providers (including lawyers), governments and others potentially may benefit from blockchain-based solutions, including in terms of cost savings, reduced risk, efficiency and new revenue streams.
The authors would like to acknowledge the following for their valuable contributions to this article: Lewis Cohen, Hogan Lovells; Doneene Damon, Richards, Layton & Finger; Russell DaSilva, Hogan Lovells; Joshua Ashley Klayman, Morrison & Foerster; Hon. J. Travis Laster, Court of Chancery; Mark Morton, Potter Anderson & Corroon, Matthew O’Toole, Potter Anderson & Corroon; Mark Smith, Symbiont