Fixing the stock market's 'clogged toilet' starts in Delaware
Last month, the home state for most incorporated companies in the U.S. made it legal for corporations to offer digital shares that would be recorded and tracked on a blockchain, the ledger that powers cryptocurrencies like bitcoin.
Patrick Byrne may finally get his vindication.
The chief executive officer of Overstock.com Inc. has fought for a dozen years against a market abuse called naked short selling, where investors bet a stock will drop without first taking the required step of borrowing shares. He says it was used back in 2005 to drive down his company's stock, an episode that spurred a Securities and Exchange Commission probe and set Byrne on a crusade to improve accountability in the system that underlies U.S. stock ownership.
Finally an answer is near, thanks to Delaware. Last month, the home state for most incorporated companies in the U.S. made it legal for corporations to offer digital shares that would be recorded and tracked on a blockchain, the ledger that powers cryptocurrencies like bitcoin. Delaware officials hope the move will increase ownership accountability and clarity. The new law, more than a year in the making, is also a shot across the bow for the Depository Trust & Clearing Corp. and its little-known partner Cede & Co., the legal holder of the vast majority of U.S. stocks.
"It eliminates naked short selling completely as well as other forms of mischief," Byrne said of Delaware's overhaul in an interview. "If this had come along 10 years ago, I would've recognized it as the solution." (While defendants in lawsuits filed by Byrne eventually settled, no one was ever held liable for naked short selling Overstock's shares.) Overstock lawyers are currently working to convert the company's shares to digital, he said. "If we get to a world of digital securities, then there isn't a need for DTC and Cede & Co. anymore," Byrne said. "It's a really huge step in returning to clean capital markets."
The effect digital shares could have on the $27 trillion U.S. stock market goes far beyond stopping naked shorting. What was bugging Byrne had a lot to do with the U.S. system of stock-certificate ownership that he says is toxic to corporate governance. The system dates to the late 1960s "paperwork crisis," when Wall Street brokerages were drowning in securities certificates, leading to routine shutdowns of the stock market so they could catch up.
Before the advent of electronic trading, the shares investors bought and sold had to be hand-delivered by messengers.
To modernize the system, DTCC was created as an industrywide clearinghouse to track and settle ownership. Its unit Cede & Co. became the registered owner of all U.S. shares, which dealt only with large brokerages. Investors who don't opt out of this arrangement only have a claim to stock through their brokerage, which in turn has a claim to what is held in Cede & Co.'s name. This is referred to as owning shares "in street name," while average investors are considered to be "beneficial owners."
While these changes added convenience and security to how the U.S. stock market operates, they put in place a system that can't sort out who owns which stock in real time. This can make it difficult to track ownership, especially during mergers and buyouts, when hundreds of millions of shares switch accounts in seconds, according to Lawrence Hamermesh, a Widener University law professor who specializes in Delaware corporate law issues.
"The whole idea of blockchain is to allow trades to be cleared immediately and be tagged with who the buyer and seller are," Hamermesh said. "That solves the M&A problem."
The Delaware Blockchain Initiative aims to change all that. The plan, which got its start under former Gov. Jack Markell, is designed to weave distributed ledger technology through the fabric of the state's business and legal systems. A critical point in the plan, which he detailed at a conference in May 2016, is the ability for companies to issue shares on a blockchain, making them easier to track. If companies take advantage of the new system, the state can gain tax revenue from maintaining an accurate count of how many shares are outstanding and ease the burden on its court system.
The Delaware initiative would change nothing about how shares are traded on the New York Stock Exchange, Nasdaq Stock Market, or other U.S. markets. It would allow investors to have direct ownership of their shares for the first time since the early 1970s.
The cost savings could be huge: $100 billion is spent on annual post-trade and securities servicing fees, according to estimates from Oliver Wyman and affiliates of Santander Bank.
Cede & Co. is, perhaps predictably, not the No. 1 fan of the Delaware game plan. By creating alternative systems to track stock ownership, you risk fragmenting and needlessly complicating the market, Dan Thieke, managing director of DTCC, said in a phone interview.
"We would be concerned by any development that would ultimately create a greater level of fragmentation," Thieke said.
Delaware and Overstock are working on the digital share plan with Symbiont, a blockchain start-up that created smart contracts to manage events in equity ownership such as dividends, additional share sales, and franchise tax payments. Smart contracts interact with a blockchain, in this case a version of the distributed ledger modeled on the Ethereum system.
Corporations must get permission from Delaware to issue a certain number of authorized shares, say one million, said Symbiont CEO Mark Smith. The state collects filing fees and other revenue based on the authorized number of shares, but sometimes companies issue additional shares that Delaware is unaware of, he said. A smart contract eliminates that possibility.
"The smart contract manages the authorized and issued shares," Smith said. "It's impossible to issue more than one million shares on the blockchain because the smart contract has that as a limitation." Overstock recently invested in Symbiont with this project in mind, Smith said. He expects companies to go public using the so-called distributed ledger shares or to convert to them within the next six months.
The DTCC isn't sticking its head in the sand when it comes to blockchain's potential to transform central parts of the financial world. It's a member of the Enterprise Ethereum Alliance and Hyperledger, industry groups creating standards for blockchain systems. It also offers investors the opportunity to take direct ownership of their shares through its direct registration service.
"It's an electronic way for an asset to move in and out of Cede & Co.," DTCC's Thieke said.
Still, the current system appears to have lost the confidence of important Delaware officials. As the corporate home to more than half of the nation's publicly traded companies and 63 percent of Fortune 500 firms, Delaware had more than a million legal entities incorporated in the 900,000-resident state as of 2012. That means the majority of corporate disputes wind up in the Delaware legal system and are often stymied by simple questions of stock ownership and voting rights. The 2013 take-private buyout of Dole Food Co. highlighted the difficulties in identifying who owns what shares at what time.
Investors sued company founder and CEO David Murdock in Delaware, accusing him of shortchanging shareholders in his acquisition of the portion of the fresh-food producer he didn't already own. Murdock agreed to pay $148 million plus interest to settle the suit after Delaware Chancery Court Judge Travis Laster concluded the billionaire improperly drove down the value of the company's stock to acquire it on the cheap.
When it came time to divvy up the nearly $170 million recovery in the Dole case, however, shareholders' lawyers were left scratching their heads. Dole investors proffered more than 49 million shares as qualifying for settlement payments even though the company had only 36 million authorized shares.
After reviewing the discrepancy, Laster, who declined to be interviewed for this story, said short sales and trades in the days before the Dole deal closed, along with some DTCC procedural issues, made it difficult for the DTCC system to accurately identify who held settlement-qualified shares.
The Dole case and other similarly nightmarish legal sagas apparently left Laster at the end of his tether. Speaking in September 2016 at a meeting of the Council of Institutional Investors in Chicago, Laster compared the Cede & Co.-based stock ownership system to a clogged toilet.
"You need to fix the proxy plumbing," Laster said. "The current system works poorly and harms stockholders. But the current plumbers — financial intermediaries — do not have an incentive to fix it." He said one solution would be intervention by the SEC, but said top down change is hard to accomplish and takes a lot of time.
"Someone is going to do this. If a judge can see it, the opportunity is pretty obvious," Laster said. "The good news is that you have a plunger that you can use to clean up the plumbing. That plunger is distributed ledger technologies."