Security"tokens"blockchain Technology and Article 8 of the Ucc
| Publication year | 2023 |
| Pages | 34 |
FEATURE | BUSINESS LAW
BY STEPHEN KEEN
This article explains the application of Article 8 to securities registered and transferred using distributed ledger (blockchain) technology and identifies issues attorneys should consider when representing issuers of such security "tokens."
For some years now, there has been interest in using distributed ledger technology (DLT, also known as blockchain technology) to record and transfer securities. People sometimes talk of creating DLT "tokens" that represent securities in the same manner as a security certificate. This metaphorical "security token" can lead to confusion if taken literally, particularly if the token is regarded as something separate from the security. As this article will explain, DLT is just a new means of recording ownership of an uncertificated security or security entitlement in compliance with the Uniform Commercial Code (UCC).[1] Properly understood, "token" signifies the technology employed for a security rather than a separate asset linked to a security.
DLT can be applied to various functions relating to securities, such as conducting shareholder meetings or distributing dividends. But the terms "security tokens" or "tokenizing securities" typically refer to using DLT to record the issuance and transfer of securities to their holders. This article considers this particular application of DLT. It does not address collateral legal concerns, such as compliance with anti-money-laundering and sanctions regulations, tax reporting, or registration as a clearing agency, transfer agent,[2] or broker-dealer under the Securities Exchange Act of 1934 or similar state blue sky laws.[3]
Classifications of Securities
Our analysis begins with considering what forms of securities may be tokenized. All 50 states have adopted Article 8 of the UCC (Article 8),[4]which governs the ownership and transfer of "securities."[5] Article 8 provides three ways of obtaining a property interest in a security:
■ if the security is represented by a certificate (a "certificated security"[6]), by a person acquiring possession of the certificate and, if the security is in registered form, having the issuer or its agent register the person as the owner;[7]
■ by having the issuer or its agent register the person as the owner of an uncertificated security;[8] or
■ by having a securities intermediary (such as a clearing corporation, broker-dealer, or bank) credit the security to the person's securities account, thereby creating a "security entitlement" to the security.[9]
Because ownership of a certificated security requires a transfer of possession, the certificate must be in a tangible form. DLT operates on data in electronic rather than paper form, so it cannot be used to transfer ownership of certificated securities. This means that only uncertificated securities and security entitlements can be tokenized.
Uncertificated Securities and Security Entitlements
Having established that tokenization must involve uncertificated securities or security entitlements, we next consider how ownership of these forms of securities is established and transferred in compliance with Article 8. This will define the minimum functions that DLT must perform to successfully tokenize these securities.
Uncertificated Securities
Ownership of an uncertificated security requires only that the issuer or the issuer's agent register the owner (or another person who acknowledges holding the security on behalf of the owner, like a nominee).[10] Article 8 does not specify how ownership should be "registered." In the context of certificated securities, however, "registered form" means "a form in which . . . a transfer of the security may be registered upon books maintained for that purpose by or on behalf of the issuer." This definition has been extended to uncertificated securities[11] and implies that an issuer of uncertificated securities must maintain "books" for the purpose of registering ownership. Such books can be maintained using DLT.
Subject to several conditions discussed below, an issuer must comply with "a request to register [the] transfer of an uncertificated security" upon delivery of an "instruction" made by the currently registered owner or authorized agent.[12] An "instruction" is "a notification communicated to the issuer of an uncertificated security that directs that the transfer of the security be registered or that the security be redeemed."[13]
Security Entitlements
Security entitlements provide an indirect means of owning a security by giving the entitlement holder "a pro rata property interest in all interests in that [security] held by [a] securities intermediary."[14] Generally, "a person acquires a security entitlement if a securities intermediary . . . indicates by book entry that a [security] has been credited to the person's securities account."[15] Article 8
does not attempt to specify exactly what accounting, record-keeping, or information transmission steps suffice to indicate that the intermediary has credited the account. That is left to agreement, trade practice, or rule in order to provide the flexibility necessary to accommodate varying or changing accounting and information processing systems.[16]
Article 8 therefore gives a securities intermediary and its entitlement holders latitude to agree on the method of crediting securities to their securities accounts, including a method using DLT.
A securities intermediary must comply with an entitlement order originated by the entitlement holder.[17] An "entitlement order" is "a notification communicated to a securities intermediary directing transfer or redemption of a [security] to which the entitlement holder has a security entitlement."[18] An agreement between the securities intermediary and its entitlement holder may govern how the securities intermediary will comply with entitlement orders.[19]
Execution of an entitlement order results in a transfer of the property interest in the security rather than a transfer of the security entitlement. The securities intermediary may execute an entitlement order by delivering the security (in certificated or uncertificated form, as applicable) to the transferee or by causing the transferee to acquire a new security entitlement to the security. Coincident with this delivery, the securities intermediary will make book entries that terminate or reduce the transferor's security entitlement to the security. Transfers of publicly traded securities are typically settled entirely through book entries by the transferor's and transferee's respective securities intermediaries operating through a clearing corporation, as illustrated in the accompanying chart.
Summary
A person acquires a property interest in an uncertificated security by being registered as the owner in the issuer's "books" and can transfer the security by sending an instruction to the issuer. A person may also acquire an indirect property interest in a security (either uncertificated or certificated) through a security entitlement created by the person's securities intermediary. Someone acquires the security entitlement when their securities intermediary credits the security to their securities account, and they can transfer the security by sending an entitlement order to the securities intermediary.
Distributed Ledger Technology
Fortunately, our analysis of security tokens requires only a basic understanding of DLT. "All blockchain technologies should allow connected computers to reach agreement over shared data."[20] In the case of a security token, the shared data are the amount of the security registered to each holder (a "register"). The connected computers (a "network") processing this data may be limited (a "permissioned" network) or open to anyone who downloads and runs the required software (an "open-source" or "public" network). Using a public network to register security holders presents significant challenges that are beyond the scope of this article,[21] which focuses on the legal effects of using either form of network to maintain a securities register.
“A network uses a consensus mechanism to bring the data on the connected computers into agreement. There are various protocols for synchronizing the data maintained by a network, which may include blockchains.”
A network uses a consensus mechanism to bring the data on the connected computers into agreement. There are various protocols for synchronizing the data...
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