In a new paper, we analyze the major disconnect between the theory of corporate governance, its legal expression, and the reality of corporate ownership structures, based on an “indirect holding system” (IHS), which has evolved from complex existing technological limitations. We argue that distributed ledger technology (DLT) offers the potential to redesign the company registry and securities clearing and settlement systems for public companies and realign them with theory. While doing so, we also seek to transcend the hype around DLT. While carefully considering the current financial market’s path dependence, we assess the actual and substantial potential of DLT to increase transparency where the IHS has failed: around shareholder ownership.
Our paper evaluates increased transparency in shareholder ownership as the first step towards realizing more efficient and effective proxy-voting systems that can bring the reality of corporate governance back into line with the theory of corporate ownership and control. We suggest that the significant benefits offered by share registration and proxy-voting organized on DLT include a reduction in voting process errors, which reduces agency problems and fosters higher market liquidity and greater legitimacy of decisions, and an increase in participation among corporate stakeholders before meetings, for the betterment of corporate governance and performance. In addition to analyzing these benefits, we also highlight that such transparency can improve share settlement and support financial supervisors in monitoring practices like securities collateral and rehypothecation and prevent the actualization of their risks.
The history leading to the IHS begins in the early 1950s, when factors such as the increased prosperity of the American middle class, new investments from institutional investors such as insurance companies and pension funds, and the rise of mutual funds combined to send the trading volumes of shares of listed public companies skyrocketing. However, securities firms were not equipped to keep up with these new volumes of trading, and fell behind egregiously in settling trades following contract sales.
Indeed, as our paper investigates, back then the settlement of share transactions involved the physical delivery of both the transfer forms (the contracts) and the share certificates to buyers. The entry of their names on the registers of companies followed upon the production of share certificates. It was an analog paper-based process that created a direct relationship between listed corporations and their shareholders, as reflected in the underlying principles of corporate law and finance theory. Corporations could follow any change in shareholdings directly from the share register, and shareholders could exercise a degree of control by directly voting at meetings. This paper-based analog system of physical settlement, however, buried securities firms in “back-office” paperwork. Combined with frequent lack of clear and straight-forward record-keeping, defaults were just a matter of time.
When the number of defaults increased, the U.S. government enacted the Securities Acts Amendments in 1975. This legislation mandated listed public companies to “immobilize” their shares at specific intermediaries – what we now know as Central Securities Depositories (CSDs) – adopting a solution similar to that established in Europe some decades earlier. From that moment onwards, the establishment of IHS evolved worldwide, thanks also to the concurrent evolution of digitization and computerization, which dramatically enhanced the efficiency of transfers over that of paper-based approaches. With a few exceptions, major financial markets today rely on the IHS, supporting a very high degree of cross-border financial integration but also raising a range of issues which have been a long-time focus of study.
The main feature of the IHS is that companies issue their shares in the name of CSDs or similar entities, and shareholders transfer their shares through intermediaries (their securities broker-dealers), which settle transactions on an aggregated basis as book entries on their databases. On the one hand, the IHS greatly benefits market liquidity. On the other hand, however, it causes two main problems. First, it builds opacity into the relationship between companies and their shareholders so that the former barely know who their “beneficial shareholders” are – the ones with the real economic interest in the shares of the company. Second, the IHS makes the corporate governance of listed companies much more difficult, because it distances shareholders from their companies, to the detriment of the underlying theory of the corporation and its legal expression: that the shareholders are the owners and controllers of the corporation. For this reason, proxy-voting systems have developed concurrently with the establishment of the IHS to counteract its challenge to the effective exercise of shareholders’ rights and their control over their shares.
The presence of intermediaries (financial institutions and information service providers) within current proxy-voting systems leads to “pass-it-along” architectures that burden the corporate governance of listed public companies with several inefficiencies that fall into three main categories. First are the inefficiencies directly linked to the complexity embedded in proxy-voting chains (for instance, uncounted and miscounted votes). Second are the inefficiencies arising from the lack of transparency in share ownership, which can lead to over-voted ballots that undermine the ultimate reliability of decisions. Third, the current architectures favor the abuse of practices based on the separation of voting rights from the economic interest of shares.
Although new regulation can undoubtedly help to address these issues, most of the problems of corporate governance of listed public companies are rooted in the existing IHS infrastructure, and a mere legal discussion can be “futile unless it is accompanied by a discussion about structural reform”. The rise of blockchain and DLT has fostered such a discussion in the most recent years. DLT is widely and enthusiastically viewed as a potential solution to the issues driven by the IHS because it is capable of fixing the most salient cause of these problems: the discrepancy between “recorded” and “beneficial” shareholders. Therefore, re-establishing a direct relationship between companies and their shareholders is no longer a pipedream.
Of course, the transition from intermediated systems of proxy-voting to ones arranged on DLT is not costless. In our paper, we also consider that more shareholder ownership transparency drives new risks, to which regulation must respond. These include risks related to the privacy of shareholders’ identity. On the one hand, DLT responds well to the calls of international organizations advocating for more ownership transparency, but on the other hand, it makes privacy protections even more critical. Likewise, regulation must deal with both technological limitations and the risks associated with identity theft when confronted with proxy-voting systems organized on DLT. Our paper concludes, therefore, with a call for regulation to establish a legal framework for digital identity management of shares so that proxy-voting systems based on DLT can benefit the corporate governance and shareholder democracy of public companies.
 Eva Micheler, Transfer of Intermediated Securities and Legal Certainty, in Transnational Securities Law edited by Thomas Keijser, 143.
This post comes to us from Federico Panisi, a PhD candidate at the University of Brescia; Professor Ross P. Buckley at the University of New South Wales – Faculty of Law; and Professor Douglas W. Arner at the University of Hong Kong – Faculty of Law. It is based on their recent paper, “Blockchain and Public Companies: A Revolution in Share Ownership Transparency, Proxy-Voting and Corporate Governance?” available here.