Blockchain Will Not Solve the Proxy Voting Problem

The U.S. proxy voting process is widely viewed as inefficient, opaque, and frequently inaccurate. The conventional wisdom is that voting inaccuracy has arisen largely as a result of decisions made in the 1960s to transition to a system of share immobilization[1] pursuant to which most shares are held in “street name”[2],[3] by securities intermediaries as a fungible mass of shares that is not directly traceable to any individual.[4] In particular, although the street name system facilitates securities trading, holding shares in fungible bulk makes it difficult, if not impossible, for street name investors to confirm that their shares are voted in accordance with their wishes since there is purportedly no way to provide end-to-end voting confirmations.

Consequently, a number of academics[5] and practitioners, including several SEC commissioners,[6] expressed an interest in exploring whether blockchain technology could provide end-to-end vote confirmations by enabling market participants to trace share ownership to the ultimate beneficial owner and bypass the layers of intermediaries. But while blockchain technology may work in certain cases, it probably will not be the panacea that its proponents expect.

Reliance on blockchain technology presumes that the aforementioned problems are primarily a function of existing technology. But several  securities industry pilot projects have demonstrated that end-to-end vote confirmations are already possible under the existing proxy voting system, and in any event, the Depository Trust Corporation’s (“DTC”) Direct Registration System (“DRS”) Service has enabled investors to avoid holding their securities in street name since 1996. In addition, while blockchain technology could facilitate end-to-end voting, investors would have to hold custody of their own tokens[7]  and, for a number or reasons, many investors will not.[8]  More to the point, blockchains use public key cryptography, and the loss of private keys associated with a particular token would result in the loss of that token.  Due to the complexities of safeguarding private keys, and the severe consequences for failing to do so, many token holders have relied on centralized exchanges or third-party custodians to hold their tokens and, absent better key management technology, there is little reason to think that this trend will change.  While this would seem to contradict one of the primary rationales for adopting blockchain technology –  eliminating intermediaries – the logic is clear; how many times have you used the login reset function on a financial website because you have forgotten your username or password?[9]

There may be other problems with migrating the existing trading and clearance system to a blockchain.[10]  In particular, putting equity securities on a blockchain may increase the risk of a cyber attack on a holder of those securities. That’s because  trades involving equity securities on a blockchain are cleared and settled nearly instantaneously,[11] and the asset used in clearing and settling and such a trade is likely to be another blockchain token that is either a bearer instrument or easily converted into another token that is a bearer instrument.[12] The proceeds of such an attack can, therefore, be easily laundered.  Securities holders might avoid the problem by not disclosing that they own securities tokens, but most state laws require issuers to maintain records on the identity and holdings of their security holders and to give that information to security holders under certain circumstances.[13]  Federal securities laws also require security holders that meet certain ownership criteria to file beneficial ownership reports under Sections 13[14] and 16[15] of the Securities Exchange Act of 1934.[16]

Finally, if equity securities are converted into tokens, there will presumably be an incentive to implement some form of blockchain voting.  Yet a number of researchers have pointed out that using blockchains may exacerbate the problems inherent in internet voting.[17] Moreover, unless the voting procedures are carefully thought out and implemented, migrating to a blockchain-based voting system could also facilitate vote buying.[18]

ENDNOTES

[1] See Transfer Agent Regulations, Exchange Act Release No. 34-76743, Dec. 22, 2015, at pages 11 – 36, available at https://www.sec.gov/rules/concept/2015/34-76743.pdf (“Transfer Agent Release”).  See also Kenneth Levine, Was Trade Settlement Always on T+3? A History of Clearing and Settlement Changes, Friends of Financial History, Issue 56, Summer 1996, at 20 – 26, available at https://archive.org/stream/friendsoffinanci00muse_12#page/20/mode/2up.

[2]Street Name,” which stands for “Wall Street name,” refers to the practice of registering securities into the name of a nominee rather than the name of the investor. See Transfer Agent Release at page 20, FN 45.

[3] See Transfer Agent Release at page 38. Beneficial share ownership now comprises over 85% of share ownership in U.S. corporations. See Written Statement of the Independent Steering Committee of Broadridge, Nov. 14, 2018, at page 2, available at https://www.sec.gov/comments/4-725/4725-4649189-176471.pdf, and SEC, Roundtable on Proxy Voting Mechanics,” May 23, 2007, available at https://www.sec.gov/spotlight/proxyprocess/proxyvotingbrief.htm (“Proxy Voting Mechanics Roundtable”).

[4] See SEC, November 15, 2018: Roundtable on the Proxy Process Proxy Roundtable Transcript, Nov. 15, 2018, available at https://www.sec.gov/files/proxy-round-table-transcript-111518.pdf (“2018 Roundtable Transcript”)(“So the SDA statement is disturbing. We believe that the most important reasons for inaccuracies are fundamental, the current system of share immobilization with a fungible share mass, which Katie[Sevcik] referred to, with no traceable link to a specific holder.”)(statement of Ken Bertsch, Executive Director of the Council of Institutional Investors (“CII”), at page 38).

[5] See, e.g., Panisi, Federico and Buckley, Ross P. and Arner, Douglas W., Blockchain and Public Companies: A Revolution in Share Ownership Transparency, Proxy-Voting and Corporate Governance? 2 Stanford Journal of Blockchain Law & Policy 2019, May 1, 2019, available at SSRN: https://ssrn.com/abstract=3389045 (positing that “…blockchain could enable the tracking of share ownership through the complete settlement cycle, enhancing the ‘shareholder democracy’ of listed companies, and benefiting their corporate governance and the market in their shares”); and Geis, George S., Traceable Shares and Corporate Law. Northwestern University Law Review, v. 113, Forthcoming; Virginia Public Law and Legal Theory Research Paper No. 2018-13; Virginia Law and Economics Research Paper No. 2018-05, Feb. 2018, available at SSRN: https://ssrn.com/abstract=3129042 (positing that “The rise of distributed ledgers and blockchain technology is poised to allow for specific share identification and precise records of share provenance,” which in turn “…will change the structure of shareholder lawsuits, alter the allocation of corporate governance rights, and require lawmakers to rethink fundamental principles of shareholder responsibility for corporate misdeeds.”).

[6] See, e.g., Kara M. Stein, Opening Remarks at the 2018 SEC Staff Roundtable on the Proxy Process, Nov. 15, 2018, available at https://www.sec.gov/news/public-statement/stein-remarks-2018-roundtable-proxy-process (“…I am interested in hearing how technology can help proxy mechanics. For example, should companies be able to use distributed ledger or blockchain technology to identify and reach their shareholder bases more efficiently?”); and Jay Clayton, SEC Rulemaking Over the Past Year, the Road Ahead and Challenges Posed by Brexit, LIBOR Transition and Cybersecurity Risks, Dec. 06, 2018, available at https://www.sec.gov/news/speech/speech-clayton-120618 (“Another significant initiative for 2019 is improving the proxy process… There was consensus among the panelists that the proxy “plumbing” needs a major overhaul. I encourage market participants to explore what such an overhaul would entail and to consider how technology, including distributed ledger technology, could improve the proxy plumbing.”).  See also Kenneth A. Bertsch, Executive Director, and Jeffrey P. Mahoney, General Counsel, CII, Jan. 31, 2019 Letter to Brent J. Fields, Secretary, SEC, available at https://www.sec.gov/comments/4-725/4725-4864575-177347.pdf (“January 2019 CII Letter”)(“In this letter, we suggest specific regulatory relief the SEC could provide to foster the use of innovative technology by permitting issuers to elect to place their equity securities on a private, permissioned blockchain.”)

[7] Some commentators refer to “tokens” as the digital assets that are built on top of another network (such as the Ethereum blockchain), and “coins” as the digital assets that are unique to a particular blockchain (e.g., Ether is the native digital asset of the Ethereum blockchain) and therefore do not need to rely upon another coin. See Sherwin Dowlat and Michael Hodapp, Cryptoasset Initiation Report Network Creation, Satis Group, Jul. 11, 2018, at page 2, available at https://research.bloomberg.com/pub/res/d28giW28tf6G7T_Wr77aU0gDgFQ). While the economic and behavior incentives created by each differ, the Article will refer to both as Tokens.

[8] While one of the purported selling points of Tokens is that they enable the holder to become his/her/its own bank, there is little evidence that most people would voluntarily chose to do so.  See, e.g., Preethi Kasireddy and Nathaniel Whittemore, LIVE DEBATE: People don’t want to be their own bank, Twitter, Mar. 19, 2019, available at https://twitter.com/iam_preethi/status/1108065479824859136 (concluding that while many people would appreciate the option to do so, most would not choose to be their own bank); and Rocco, On Abstraction and Risk, Medium, May 28, 2019, available at https://medium.com/alpineintel/on-abstraction-and-risk-e981e06830f3 (“It’s important to know the risks with using these services, but “being your own bank” isn’t the most appealing thing to most of humanity. There’s a reason why banks are popular, even after all of the fraud they’ve engaged in.)(emphasis in original).  See also CZ on Centralization Vs. Decentralization, Binance Blog, Feb. 12, 2019, available at https://www.binance.com/en/blog/301982828007075840/CZ-on-Centralization-Vs-Decentralization?ref=tokendaily (opining that leaving Tokens on a centralized exchange is probably safer for most people than being their own bank).

Further evidence that most people would not choose to hold their own Tokens can be seen in the number of applications that have been filed with the Securities and Exchange Commission (“SEC”) seeking permission to list a Bitcoin Exchange Traded Fund (“ETF”).  While ETFs can provide investors exposure to assets that would otherwise be difficult to obtain and/or diversify risk by providing exposure to a basket of assets, none of those rationales would seem to explain the perceived attractiveness of a Bitcoin ETF since investors can purchase Bitcoin directly from virtually any cryptocurrency exchange, and a Bitcoin EFT, by definition, only provides exposure to a single asset.  Moreover, since investors in EFTs pay at least some fees to the ETF’s sponsors, it is difficult to see how an investment in a Bitcoin EFT could outperform a direct investment in Bitcoin.  Taken together, this suggests that the primary appeal of Bitcoin EFT is that it would provide a way to gain exposure to Bitcoin without the need to actually own Bitcoin. See, e.g., Jay Baris and Joshua Ashley Klayman, In Pursuit of Perfection? A Primer On Digital Asset-Related ETPs, Jun. 2019, available at https://www.shearman.com/-/media/Files/Perspectives/2019/06/Primer-on-Digital-Asset-Related-ETPs.pdf?la=en&hash=009A8A7C2519F294AE1899061D884B7C0DD02A5C.

[9] To state the obvious, there is no analogue to the “forgot my password” function in private key management – i.e., once the private key is lost, it is gone.  Of course, one could attempt to “hack” the private key to recover it, but if that were a viable option, the value of the associated blockchain would plummet since its associated cryptographic security scheme would be compromised.

[10] Before going any further, it is helpful to note that there is not a proxy voting system per se, but rather a set of market practices and regulatory requirements that evolved over time to leverage the existing securities trading and clearing system to facilitate security holder voting. As such, unless the existing securities trading and clearing system is restructured entirely, only incremental changes can presumably be made to the proxy voting system. On that point, Chairman Clayton closed the Panel discussion by cautioning the participants regarding potential changes to the existing securities trading and clearing system. See 2018 Roundtable Transcript (“Third, I just want to note this for people who are maybe watching and aren’t focused on proxy but are focused on trading and other things. I do think we have to have respect for our intermediary system. It’s not just an intermediary system for ownership and voting, but it’s an intermediary system for trading, and it adds to efficiencies in trading.” (statement of Chairman Jay Clayton, at pages 112 – 113).

[11] For example, although Overstock subsidiary tZero’s newly launched alternative trading system (“ATS”) will initially operate during normal market hours between 9:30 a.m. and 4 p.m. EST, tZero’s technology platform allows it to conduct trading on a 24/7 basis, and the management team indicated that that was an eventual goal. See Anna Baydakova, Overstock’s tZERO to Trade Tokens During Wall Street Hours Only, CoinDesk, Jan. 28, 2019, available at https://www.coindesk.com/overstocks-tzero-to-trade-tokens-during-wall-street-hours-only.

[12] With the exception of so-called non-fungible Tokens such as the ERC-721 Tokens used to represent individual CryptoKitties, Tokens are intended to be completely fungible and therefore are essentially bearer instruments.  For regulatory reasons, however (e.g., compliance with securities laws), certain Tokens are designed to be only transferred between certain pre-cleared accounts for regulatory reasons, and in that sense, are not truly bearer instruments.

[13] More to the point, most state laws provide an issuer’s security holders with the right to inspect its books and records under certain circumstances, including the issuer’s securities ledger.  See, e.g., §220(b) of the General Corporation Law of the State of Delaware (the “DGCL”), available at http://delcode.delaware.gov/title8/c001/sc07/index.shtml#220 (“Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from…The corporation’s stock ledger, a list of its stockholders, and its other books and records…”).  In addition, prior to any meeting of the security holders, the issuer is typically required to prepare a complete list of the security holders entitled to vote at such meeting, and make that list available for inspection by the issuer’s security holders.  See, e.g., DGCL §219(a), available at http://delcode.delaware.gov/title8/c001/sc07/index.shtml#219 (“The corporation shall prepare, at least 10 days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting…arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder.”)

[14] See Exchange Act Rule 13d-1 [17 CFR 240.13d-1], available here https://www.ecfr.gov/cgi-bin/text-idx?amp;node=17:4.0.1.1.1&rgn=div5#se17.4.240_113d_61 (imposing a reporting requirement on the direct or indirect beneficial owner of more than five percent of any class of voting equity securities registered under Exchange Act §12, subject to certain exceptions.)

[15] See Exchange Act Rule 16a-2 [17 CFR 240.16a-2], available here https://www.ecfr.gov/cgi-bin/text-idx?amp;node=17:4.0.1.1.1&rgn=div5#se17.4.240_116a_62 (imposing a reporting requirement on the direct or indirect beneficial owner of more than ten percent of any class of equity securities registered under Exchange Act §12, and any director or officer of the issuer of such securities.)

[16] While this is also a risk faced by holders of non-equity Tokens such as Bitcoin and Ethereum, the difference is that holders of these Tokens typically are not required to disclose their ownership.

[17] See, e.g., David Jefferson, The Myth of “Secure” Blockchain Voting, U.S. Vote Foundation, available at https://www.usvotefoundation.org/blockchain-voting-is-not-a-security-strategy#_ftn1; Jesse Dunietz, Are Blockchains the Answer for Secure Elections? Probably Not, Scientific American, Aug. 16, 2018, available at https://www.scientificamerican.com/article/are-blockchains-the-answer-for-secure-elections-probably-not/; Ari Juels, Ittay Eyal and Oded Naor, Blockchains won’t fix internet voting security – and could make it worse, The Conversation, Oct. 18, 2018, available at https://theconversation.com/blockchains-wont-fix-internet-voting-security-and-could-make-it-worse-104830 (“Juels, Eyal & Naor”); and Stephen Shankland, No, blockchain isn’t the answer to our voting system woes, C|Net, Nov. 05, 2018, available at https://www.cnet.com/news/blockchain-isnt-answer-to-voting-system-woes/.  Regarding the risks of internet voting in general, please see New Report Identifies Steps to Secure Americans’ Votes; All U.S. Elections Should Use Paper Ballots by 2020 Presidential Election; Internet Voting Should Not Be Used at This Time, The National Academies of Sciences, Engineering, Medicine, Sep. 06, 2018, available at http://www8.nationalacademies.org/onpinews/newsitem.aspx?RecordID=25120; Sarah Jamie Lewis, Olivier Pereira & Vanessa Teague, The use of trapdoor commitments in Bayer-Groth proofs and the implications for the verifiabilty of the Scytl-SwissPost Internet voting system, Mar. 12, 2019, available at https://people.eng.unimelb.edu.au/vjteague/UniversalVerifiabilitySwissPost.pdf and by Sarah Jamie Lewis, Olivier Pereira and Vanessa Teague, Trapdoor commitments in the SwissPost e-voting shuffle proof, available at https://people.eng.unimelb.edu.au/vjteague/SwissVote (analysis identifying a security flaw that would theoretically permit the administrators of Swiss Post’s e voting solution to alter votes without detection.  Swiss Post’s system is currently used in the Swiss cantons of Fribourg, Neuchâtel and Thurgau); J. Alex Halderman and Vanessa Teague, The New South Wales iVote System: Security Failures and Verification Flaws in a Live Online Election, Last Revised Jun 05, 2015, available at https://arxiv.org/abs/1504.05646; Scott Wolchok, Eric Wustrow, Dawn Isabel, and J. Alex Halderman, Attacking the Washington, D.C. Internet Voting System, available at http://www.ifca.ai/fc12/pre-proceedings/paper_79.pdf; Independent Report on E-voting in Estonia, Open Rights Group, available at https://estoniaevoting.org/; and Chris Culnane, Mark Eldridge, Aleksander Essex, Vanessa Teague, Trust Implications of DDoS Protection in Online Elections, submitted Aug 03, 2017, available at https://arxiv.org/abs/1708.00991.

[18] See, e.g., Juels, Eyal & Naor; Philip Daian, Tyler Kell, Ian Miers, and Ari Juels, On-Chain Vote Buying and the Rise of Dark DAOs, Hacking, Distributed, Jul. 02, 2018, available at http://hackingdistributed.com/2018/07/02/on-chain-vote-buying/ (“On-Chain Vote Buying”); and Phil Daian and Ali Yahya, a16z Podcast: Voting, Security, and Governance in Blockchains, Feb. 09, 2019), available at https://a16z.com/2019/02/09/voting-blockchains-governance-security-cryptoeconomics/?ref=tokendaily (“a16z Podcast”). See also Marty Bent and Matt Odell, Tales from the Crypt Rabbit Hole Recap: Week of 2018.11.12, beginning at 30:00, available at https://anchor.fm/tales-from-the-crypt/episodes/Rabbit-Hole-Recap-Week-of-2018-11-12-e2j942 (discussing the downsides of blockchain voting).

This post comes to us from Park Bramhall, senior counsel at the law firm of Lowenstein Sandler LLP. It is based on his recent article, “Blockchain Isn’t Always the Solution (or Why Tokenizing Equity Securities Is Not the Answer to the Proxy Voting Problem),” available here.  While Mr. Bramhall is a lawyer with Lowenstein Sandler, he has published this post independently and apart from the firm. Accordingly, the post does not reflect the views or positions of Lowenstein Sandler, its partners or employees, or any of its clients.