If you have a Canadian place of business, safeguard client assets, and perform one or more of the following functions, be sure you’re in full compliance:

• Foreign exchange dealing
• Remitting or transmitting funds
• Issuing or redeeming money orders, traveler’s checks, or anything similar
• Dealing with cryptocurrency exchange or transfer services 
• Crowdfunding platform services

The Growth of Canadian MSBs

Several types of MSBs are growing exponentially in Canada.

For instance, Canada’s number of new immigrants has doubled yearly since 2000, and the growth of its foreign currency exchange and remittance markets are directly correlated. Its foreign currency exchange services industry is expected to increase by 29.2% in 2022, while its digital remittance transaction value is expected to grow at a 5.71% CAGR between 2022-2027 and exceed $2.33 billion.

Additionally, Canada’s digital payments are projected to grow at a 15.20% CAGR between 2022-2027 and reach a market volume of $243.1 billion.

The Role of Crypto as an MSB 

One aspect of MSBs gaining significant traction globally and within Canada, is crypto.

Canada began regulating cryptocurrency activity in August 2017 after the CSA passed the CSA Staff Notice 46-307 Cryptocurrency Offerings Act.

Canada further cracked down in March 2021 and is again looking to reign in the industry following crypto’s multiple collapses and inefficiencies in 2022, most notably the unwinding FTX bankruptcy. 

“This is an area that is still small, but it’s growing really rapidly. And it is largely unregulated,” Bank of Canada Senior Deputy Governor Carolyn Rogers told Reuters. “We don’t want to wait until it gets a lot larger before we bring regulatory controls in place.”

If you are a crypto entrepreneur or business owner attempting to handle or safeguard client assets, you must register with FINTRAC. 

Furthermore, securities legislation must also apply to cryptocurrency transactions. Some cryptocurrencies can be considered a security under securities law depending on how they are structured, marketed and designed.

Additionally, crypto is not considered legal tender in Canada. Transactions with crypto are allowed, but you cannot use it to pay state fees, taxes and charges. Crypto is also defined as a commodity (e.g., tokens are considered “utility” or non security tokens), which acts as a barter transaction in exchange for other goods.

Operating in a country without regulations may seem more appealing to an entrepreneur. After all, the world’s largest and most liquid crypto exchange, Binance, recently left Ontario because of the OSC (Ontario Securities Commission) regulatory regime.

However, history tends to repeat itself in business. Outcomes rarely end favorably without a sound and credible regulatory framework cultivating strong controls and accountability.  

Conclusion: Do I Need to Get Registered?

Crypto custodians, fintech companies, and payment processors like PayPal are conduits in the payment cycle and hold or safeguard client assets- even for a short  period.

All else being equal, if a financial conduit does not safekeep client assets or money, the business is not required to be registered with FINTRAC as an MSB. However, this does not imply that KYC (Know-Your-Customer) rules can be ignored, but simply that formal registration is not needed.

The financial conduit has regulatory compliance obligations for which other third parties (e.g., custodians, payment processors that hold client assets for any given period) that it deals with is relying upon to ensure their risk exposures are mitigated.  

If you think your firm is safekeeping client assets and fall into one of Canada’s categories as an MSB, speak to us at Black Swan Diagnostics. We can guide you in the right direction.

Failing to register with FINTRAC if your business model triggers the MSB requirements violates the PCMLTFA regime and can result in fines of up to $2,000,000 and/or up to five years of imprisonment.

Reputations take years to develop but seconds to destroy.

Black Swan can help you navigate the regulatory compliance requirements, first and foremost, with compliance manuals. As an MSB, you will need all compliance manuals specific to your business model.

Additionally, MSBs also need an Independent Risk Assessment to identify and evaluate their key risk exposures and how to best mitigate them.

Lastly, the registration process includes other specific tasks like setting up a legitimate Canadian bank account and completing several KYC forms, risk acknowledgment disclaimers, terms of use, privacy policy, policies and procedures. 

Our experience at Black Swan comes with a unique understanding that different responsibilities and obligations come once you’re a regulated entity. We can help guide you every step of the way and help you complete the registration process with all Manuals within three months.

We welcome the opportunity to speak with you and answer any inquiries.   

The post Registering Your Money Services Business (MSB) in Canada appeared first on Black Swan Diagnostics.

Blockchain is easing the burden of simple repetitive tasks, how we interact and verify data, and improvements to the capital lifecycle. These improvements require us to understand what Blockchain technology accomplishes and some of its limitations. Industry knowledge among boards of the implications of blockchain in corporate governance is lacking. A 2016 Gartner report found that 91 percent of board directors have at least heard of blockchain technology, while only 36 percent see blockchain as an opportunity and 21 percent as a threat. We will discuss and address such knowledge gaps and how blockchain can improve governance effectiveness for boards. 

One of the newest improvements is through Security Token Offerings, or STO’s, otherwise referred to as Smart Security Offerings (SSOs). These are becoming increasingly popular for companies to issue as an alternative means to raise either debt or equity capital. Security Token Offerings (STOs) or Smart Security Offerings (SSOs) are security tokens that are not utility tokens. A utility token is a token that is not considered a security token and fails to satisfy all four components of the SEC Howey test. The Howey test is a long-established test used in securities law by the SEC based on the precedent of SEC v. Howey. The test helps to determine whether a digital currency is considered a utility or security token under US securities statutes. The Canadian equivalent of the Howey test is the Pacific Coast Coin test.

STOs  are considered securities by securities regulators and are regulated and treated as such. They are often accompanied with exemption filings with the SEC before public distribution, trading, and liquidity events. STOs are also referred to as Digital Asset Security Issuances (DASIs) by the SEC (Securities & Exchange Commission).  DASIs are digital securities based on the blockchain using DLT. Blockchain powers all digital currencies.

Companies vary regarding the capital structure of their security issuance and raise capital at different stages of development. STO’s can be used as a bridge funding source instead of pursuing the traditional IPO (Initial Public Offering) method. Also, there are companies that issue security tokens to represent assets that have historically been linked to bonds. STOs are regulated offerings that must comply with existing regulatory frameworks including SEC Regulation D, Regulation A, Regulation S, Regulation CF, and the usual KYC/AML Accreditation that applies.

DASIs carry many advantages and their ascent has seen a steady uptick in popularity. Recent data from Pitchbook suggests that 2018 was likely the biggest year on record in total value for Venture Capital fundraising. While this includes all Venture Capital deals, more than 20 percent of all capital raised went to digital asset issuers including both ICO’s and STO’s. Initial Coin Offerings (ICOs) are a low-cost and efficient means of raising capital for mainly privately-owned technology companies that offer an amount of their company’s digital currency instead of a given number of shares. The secondary market for trading ICOs is usually on decentralised digital asset exchanges (e.g., Binance, Huobi, Kraken, Coinbase), while the market for trading these digital currencies on centralised exchanges is limited to non-existent. We will discuss the emergence of Smart Contracts, DLT, and Digital Asset Enhancements.

Smart Contracts

A smart contract is programmable computer code that automates functions but is not immutable. Smart contracts can be transferred automatically from one party to another provided certain conditions are met. A smart contract is just a program that is based on an agreement from multiple parties. The smart contract is created to ensure automated compliance to the agreement by the parties by hardcoding compliance. They can be based on any number of variables just as a traditional paper contract can. They are a  simple concept and are gradually working their way into mainstream business governance as an improvement to any formal agreement. This reduces the effort of staff, legal assistance and executives to ensure contractual obligations are met by outside parties, and for managers to ensure internal compliance. 

Distributed Ledger Technology (DLT)

Another very simple concept Blockchain technology has created is Distributed Ledger Technology, or DLT. This improves the process of verifying large amounts of data and their transactional value quickly and efficiently. It also can use a decentralized and encrypted system to ensure greater privacy and security. Decentralized exchanges are mainly unregulated exchanges that provide for trading of key functional digital currencies that involve utility tokens (e.g., BTC, BCH, ETH, LTC, XRP). Information is the most valued asset for corporations. DLT allows that information to be sent and managed more efficiently and with greater security, thereby improving another area of corporate governance.

Digital Asset Enhancements

Digital assets are electronic currency powered by the blockchain that are backed by an asset (e.g., real-estate, bonds, intellectual property, revenue or royalty income streams, etc.). Digital assets are significantly more versatile for managing the capital lifecycle. Digital Assets allow companies to issue fractional shares in their company, automatically payout dividends, ensure reporting to investors, manage multiple jurisdictions and their regulations automatically, verify ownership without the need for a transfer agent, and improve consensus mechanisms for shareholder voting. Digital assets are greatly improving the process of managing all those levels of corporate governance. 

Digital assets are also improving the way directors of boards interact with a company in a similar way. Boards are often scrutinized for their lack of transparency to shareholders. The use of digital assets can manage the entire process of transparency more efficiently. This reduces the cost of capital, friction costs, informational asymmetry, and the cost of management while improving profitability.

Governance relates to voting rights in this context. Voting rights are typically accorded on a share basis and are like tokens. An investor owning an equity token would have a vote in key corporate decisions made by the issuer. Security tokens allow an investor to participate in company decisions with more efficiency and greater transparency. 

Like voting shareholders in publicly traded companies or preferred shareholders in VC-backed companies, security token holders would be given rights to participate in certain governance decisions related to their assets. Some of the guiding questions that drive governance decision-making are centred around the following inquiries: How will rules be established? Will the founders set the rules, or will there be an independent board of directors? Do contributors get voting rights? If yes, what are the limits of such voting rights? Can contributors elect the board? What structures and processes exist to oversee the direction of the company to ensure it stays on course?

Institutional Imperatives in Digital Currency

Digital currency is electronic currency used for commercial transactions powered by blockchain technology. The relevance of these underlying currents is that institutional investors such as venture capital is starting to affix itself to these digital issuers and increasing the capital output. Institutional investors see a greater opportunity for liquidity on multiple channels through an STO. There is a defined process for the transfer of ownership and custody. The ability to hardcode and define governance for token holders also enables a more efficient process in terms of managing and codifying “shareholder” rights. The efficient and effective execution of shareholder rights and more broadly, stakeholders including customers, governments, regulators, suppliers, vendors and the like, are cornerstones of sound corporate governance

STO’s are enabling a more efficient and effective implementation of governance protocols. Security Tokens can accelerate investor liquidity while maintaining compliance with securities statutes. The STO achieves that without changing the current capitalization table to account for the transfer of ownership. Liquidity can be materialized in some jurisdictions within just a few months to a year. This is an attractive proposition for new age venture capitalists. Most companies don’t succeed and typically have a two-year runway. This serves as a hedge for institutional and sophisticated investors.

Digital currency is not only favorable for VC firms and Family Offices. The benefits extend to founders, and key team members – indeed, even the company itself can benefit from additional liquidity through digital issuance. These parties take some comfort in knowing that they can continue their innovation without having to compromise everything immediately. This may include the cost of capital, share dilution, divesting assets, or reallocating resources towards suboptimal use.  They can also generate partial liquidity to utilize for their own financial needs to continue their work. The universe of viable options is broadened.

Even if an STO includes an equity component, it can be spread over multiple investors. This can be a more collaborative approach without stifling decision-making. This is favorable for founders because while they still have investors to account to, they can imbue potential innovation at a greater pace. Liquidity is king in the new age of digital issuers, but governance will also play a key role in the accessibility, efficiency, and portability of new age security offerings.

What Role Will DAOs (Decentralized Autonomous Organizations) Serve In Corporate Governance?

A DAO is an organization of people who communicate with each other via a “network protocol,” communicating with one another through an online set of rules but reaching governance consensus with offline diplomacy. DAOs are the end-points of the ‘gig economy’, which so far has been championed by platforms like Uber and Airbnb, for example. However, they are likely to be truly global cooperatives and their value distributed to stakeholders – not just shareholders and executives.

Decentralized Autonomous Organizations (DAOs) will be superior to that of today’s corporate firm structure. For investors, DAOs will eventually become a less risky investment class compared to shares in a regular company that is centralized by control. This will be achieved by offering more predictable and stable ROI (Return-on-Investment) and favorable passive returns than most stock dividends – while also minimizing two of the greatest risks in corporate operations – human error and executive self-interest. According to the World Economic Forum, “The potential for blockchain lies in its architectural ability to shift, and potentially upend, traditional economic systems – potentially transferring value from shareholders to stakeholders as distributed solutions increasingly take hold.”

The nature and origins of ‘the firm’ is rapidly changing in the digital age where intangible assets such as intellectual property and the corporate brand are now regarded as the most important driver of corporate value compared to tangibles accumulated in the industrial model. This poses challenges for firms still operating in the ‘old model’ including:

• Difficulty in valuing intangible assets in digitally native organizations;
• A gradual and continuing decline in corporate accounting and auditing standards; 
• New forms of fundraising, such as Security Token Offerings (STOs) – less costly than traditional and often overpriced and expensive IPOs;
• STOs which can blend equity rights and debt with governance; 
• Growing social responsibility for corporations to account for ‘external costs’, such as ESG and CSR;
• Mounting social costs for corporations such as climate change value-at-risk; and
• The concentration of share value and corporate earnings in growth and tech stocks invested through passive strategies, thereby increasing systemic risk in the capital markets.

Facebook’s Proposed Libra Coin: The DAO in Practice

In June 2019, Facebook announced their intention to launch their own proprietary stablecoin, Libra coin, to serve as a payment gateway on their platform of 2.4 billion monthly active users. The Libra coin would be operated under the umbrella of Calibra, a Swiss registered non-profit organization consisting of a consortium of one-hundred private organizations that have equal voting rights. Libra is mainly targeting the over $600 USD billion annual market for cross-border remittances. This space has been mainly dominated by major banks and may pose a threat to the existing competitive landscape. The US Federal Reserve and major US banks have expressed concerns over Facebook’s initiative and view it as a threat to the US dollar and its functional stability in FX markets.

The goal of Libra coin is to send money instantaneously across borders securely and at low-cost. Libra would be presumably asset-backed by financial assets to include bank deposits in various currencies and short-term government securities (e.g., US Treasuries) which will likely reduce the coins’ short-term volatility while engendering trust and stability. Facebook intends to turn its crypto project ‘Libra’, into a DAO utilizing a native governance token (the Libra Investment Token). This is a significant development for a company notorious for its centralized control. Facebook’s fundamental business model is to harvest and monetize data – reams of data with over 2.4 billion users and targeting the over 1 billion unbanked in Africa. In China and India respectively, for example, there are nearly 200 million and 100 million people with a mobile phone but without a bank account. This represents a significant opportunity for a digital currency to serve as a payment gateway at costs much lower than traditional money service businesses such as Western Union. 

The Libra coin could serve as a leading payment gateway among its 90 million small business customers spanning not just consumer products and brands already advertising on Facebook, but potentially including financial services. This includes banking, savings and deposits, investments, insurance, and other financial products. In effect, the Facebook payment gateway would require registration and license as a de facto shadow bank, a regulated CFTC (Commodity and Futures Trading Commission) entity, or money transmitter license.  Going into the details of the cost-benefit analysis of the Libra coin is beyond the scope of this chapter. However, in the final analysis, instead of Libra usurping the central banks authority or undermining sovereign currency legitimacy, Libra is likely to be a vehicle for Facebook to achieve its wider goal of becoming the industry benchmark for digital identity. If Facebook can achieve this milestone, it would have access to all personal data. In a digital age of data monetization and artificial intelligence, data is the currency that begets power and sustainable competitive advantage. 

The implications of Facebook becoming the industry proxy for digital identity through its Libra stablecoin for the governance of boards are numerous. First, with nearly unfettered access to sensitive personal data of users, this gives Facebook the ability to better optimize and monetize personal financial data that may have otherwise been protected or limited. Second, although it is initially a “permissioned” blockchain with the goal of converging towards a “permissionless” blockchain, the decentralized nature will make it like Bitcoin and Ethereum in which anyone with technical capabilities can operate.  This will expose the coin to certain risks. Although permissionless blockchains can reduce infrastructure costs, they are also slow, open, and are constrained by scalability and privacy issues. This especially applies to financial services organizations, a space Facebook is clearly aiming towards penetrating on a large scale. The recent exit in October 2019 of key members of the Libra Association, including Visa, PayPal, Mastercard and Stripe, indicate that the strength of increased government regulatory scrutiny may present material obstacles to Facebook’s initial coalition of 28 corporate backers. The spate of exits by large players, including the absence of a major US payment processor, is evidence that without regulatory clarity in this emerging space, more companies are likely to exit. The recent congressional testimony of Facebook’s CEO, Mark Zuckerberg, in testifying before various members of Congress further demonstrates the delayed pace of this significant initiative and its potential impact on the US dollar. This will also likely delay Facebook’s strategic program implementation in its quest to compete directly against banks. Third, Calibra has developed specific governance protocols for its association members. Although in theory each corporate member has equal voting rights, this has yet to be demonstrated given Facebook’s dominant market power and ownership of the Libra coin. In summary, Facebook’s proposed launch of Libra through the Calibra entity is fraught with challenges and risks, let alone Facebook’s checkered history of extensive privacy violations. 

What Role Does Board Governance Serve in a Digital Currency Environment?

Governance has more to do with voting rights in this context. Voting rights are typically imparted on a share basis similar with tokens. An investor that owns an equity token would have a vote in key company decisions. Currently, most publicly traded companies or reporting issuers send out a quarterly newsletter or “alert” to investors. That alert announces upcoming meetings at which investors could exercise their votes. With security tokens, an investor could be part of company decisions with more efficiency and greater transparency. Governance is not discussed much when it comes to digital issuance, but it plays a key role in the benefits for both the digital currency issuing organization and the investor.

The definition of a security can be broad and unnecessarily overreaching. It can mean an equity position in a company, or a dividend payout/revenue sharing, convertible debt, an asset-backed security like a REIT (Real Estate Investment Trust), intellectual property rights, and even royalty components. Security tokens make it viable to have a multi-layered security that has hardcoded protocols that ensure both the investor payouts and the issuing organization remain compliant down to the individual investor digital wallet. That makes jurisdictional compliance far less costly for the issuer. Smart contracts have enabled this. 

For example, Canadian Tire fiat currency is the equivalent of a digital currency that has the functionality of a utility token. Canadian Tire fiat currency is issued only to users within its existing ecosystem, allowing users to redeem its value for equivalent goods and services without paying – nor promising – dividends. The currency offered by Canadian Tire has an intrinsic value within its respective ecosystem, and value is not derived outside of this system. It is effectively a closed system providing a means of payment while being engaged in loyalty and other programs to incentivize users. Each of the four prongs of the US SEC Howey test are not satisfied in claiming Canadian Tire fiat currency operating as an equivalent security token under the dictates of the SEC regime. 

Canadian case-law further supports this position as illustrated in Pacific Coast Coin, where the Supreme Court of Canada (SCC) elucidated “a common enterprise” as a scenario where investors’ fortunes are interwoven with and depend upon the efforts and successes of those seeking the investment of third parties. The Pacific Coast Coin test is the Canadian equivalent of the US Howey test. The only difference between Canadian Tire fiat currency and a digital currency via a utility token is that Canadian Tire fiat currency is paper-based; digital currency, in contrast, is electronically built and powered on the blockchain.

By comparison, an established US company, Ripple, has its own native digital currency with ticker symbol, XRP. XRP is widely classified as a utility token and is considered one of five functional currencies. XRP is broadly traded and is liquid on major digital asset exchanges. Ripple is aiming to replace and compete with the archaic and slow SWIFT banking network for international, cross-border fiat currency remittances.   

Smart contracts are really “dumb” programs that act as a written script of agreement between two or more parties. These contracts can be affixed to a security token. Security token compliance platforms like Polymath, Harbour Capital, Securrency, or Securitize, for example, have designed the technical pieces using these smart contracts to issue various types of tokens easily and to manage the process effortlessly. These firms have a series of “off-chain” processes including anti-money laundering and “know-your-customer” checks to identify customers, match investors to blockchain wallet addresses, and confirm an investor’s eligibility to participate in trading. Blockchain wallet addresses allow funds from a wallet, a user requires the recipient’s “receive” address or QR code. To receive funds from a wallet, a user can share his or her address or QR code with the sender.  Interestingly, and for technical reasons, a Bitcoin (“BTC”) or Bitcoin Cash (“BCH”) address will change each time a user requires it, but an Ether (“ETH”) address will always stay the same.  

The Role of DASIs and Their Potential Impact in Corporate Governance

DASIs will revolutionize the way we invest in organizations at any stage. Each party, including regulators, will benefit broadly. The digital age is moving with incredible speed and ferocity throughout the world. Digital currency can solve some issues, but it is not as ground-breaking as the possibility of hybrid security offerings that can eventually be linked to these digital currencies. For anyone doubting how a security can eventually become an openly traded currency, just look to the case of Ethereum – an open-sourced platform. Ethereum had components of a security offering during its ICO but has become so useful as a digital currency and so decentralized, that it is no longer considered a security by the SEC and other leading securities regulators around the world. It has been widely viewed as a commodity that is open-sourced where its value is not derived by any of the four properties of the Howey test.

Jurisdictional Considerations for STO Launch

When launching an STO, a global strategy and framework must be developed. Blockchain is global and borderless, and the same applies to your STO. Domestic biases will likely impair your ability to complete the STO funding cycle. The reality is that, for now, digital currency trading activity is heavily concentrated in Asia. For example, reports show as of 2018, that 60 percent of all digital currency buyers and sellers are in Japan, while nearly 8 percent are in the US and less than half of a percent in Canada. When marketing an STO, demographics matter and should form part of your strategy to determine which countries to focus on and which ones to outright avoid.

Generally, companies conducting STOs should block countries that are, at a minimum, considered high-risk STO jurisdictions. These are countries that are not friendly to digital currencies and/or hostile to digital assets in any form via regulation or other punitive measures. High-risk countries that STOSs should avoid include Indonesia, Bangladesh, and Nepal. Lower-risk countries that STOs should avoid include Macedonia, Algeria, Bolivia, Ecuador, and Libya. Recent FATF (Financial Action Task Force) reports in June 2019 have demonstrated these countries are considered high-risk from a KYC/AML perspective. 

Incidentally and not surprisingly, none of these countries form part of the G-20, which is where the majority of STO buyers are likely to be identified with serious interest. It’s the G-20 countries in combination with FATF guidance and recommendations that are material. The G-20 countries have had delayed digital currency regulation recommendations since mid 2018.. The biggest challenge to succeeding with this initiative will be regulatory coordination among the G-20 due to countries varying capital market structures, maturity, political risks, and liquidity preferences. Luckily, blocking the jurisdictions above shouldn’t materially affect the universe of token solicitations nor the efficacy of the STO funding campaign.

The post Blockchain Enhancements In Corporate Governance appeared first on Black Swan Diagnostics.

The Canadian takeover bid (TOB) regime under MI 62-104 (“62-104”) regulates the bidder while the U.S. TOB regime mainly oversees board conduct. The Canadian and U.S. takeover systems differ mainly with the primacy of shareholders and boards, respectively. Canadian securities law statutes emphasize shareholder democracy. Delaware jurisprudence shows a board-centric model in takeovers at the expense of short-term shareholder profits. The Canadian TOB system has more shareholder protections than its U.S. counterpart. This gives shareholders voting ability on takeover bids, thereby enhancing value.

II    DIFFERENCES IN SHAREHOLDER TAKEOVER PROTECTIONS

Canadian securities regulators have relied on a modified version of the Revlon duty. The Revlon principle was established by the Delaware courts and suggests that target boards have a duty to seek the best price available for shareholders. The goal of NP 62-202 (“62-202”) is to protect the interests of target shareholders by creating shareholder equality, identical consideration, and continuous disclosure. In its simple form, 62-202 requires regulators to intervene when defensive tactics prevent shareholders from responding to TOBs. This protects shareholders through a vote, fairness hearing, or board determination. 

First, the conflict in 62-202 is finding a balance between the board’s fiduciary duties to maximize shareholder value while protecting the ability of shareholders to tender to the bid. Limiting the role of the board creates a “responsibility vacuum” where shareholders can affect a control change while owing no duties in connection with that result. Unlike Canadian boards, U.S. boards can choose a suitable framework under s. 102(b)(7) of Delaware General Corporation Law (“DGCL”). The 1985 Delaware Supreme court decision in Van Gorkom showed the depletion of director duties as director judgment trumps short-term shareholder profits. This can prevent shareholders from voting on takeover bids, affecting their ability to tender to an attractive bid. This does not protect investors and may reduce shareholder value.

Second, there are major differences in the treatment of poison pills among the two TOB regimes. Poison pills make it prohibitively expensive for acquirers through dilution in voting power and economic position in the target company. While poison pills do not change the value of the company, wealth is redistributed from the acquiring company to shareholders. A poison pill gives the target time to find competing offers to maximize selling price and increase the negotiating power of the target. In Canada, poison pills give directors limited discretion since they expire after 45-75 days from bid inception. Under s. 157 of DGCL, poison pills do not require shareholder approval, nor do they expire. This allows U.S. target directors to deny a takeover bid with a “just say no” defense under DGCL. It also allows the bidder to negotiate with the board, thereby bypassing shareholders. The Circon case illustrated the speed of U.S. board approval without a shareholder vote. This fails to protect shareholders in voting on a TOB.

The 2011 Delaware Chancery Court decision in Airgas upheld the right of the Airgas board to maintain a pill during a hostile takeover bid. In Airgas, Chancellor Chandler III concluded that “the power to defeat an inadequate hostile tender offer ultimately lies with the board of directors.” The Airgas decision is inconsistent under DGCL which allows shareholders to limit a board’s authority on poison pill issues. As Delaware courts defer to boards on the use of poison pills, investors may accept takeovers at lower prices. This can harm shareholders by failing to capture more value through competitive bidding.

Third, there are concerns with bidders making cash offers and avoiding disclosure, diluting transparency for target shareholders. Under DGCL, boards are not required to accept all cash bids despite shareholder support. Under DGCL, U.S. boards can adopt the “just say no” defence despite a premium offered to shareholders. The 2010 OSC decision in Magna required enhanced disclosures and showed the risks of insufficient investor disclosures during a hostile TOB. Additional disclosures allow target shareholders more time to review the merits of a transaction, thereby safeguarding shareholders.

Fourth, although the U.S. takeover regime gives discretionary powers to boards, Canadian minority shareholders are protected against the oppressive actions of controlling shareholders under MI 61-101 (“61-101”). 61-101 was designed to safeguard against the undue capturing of the private benefits of control at the expense of minority shareholders. The 2008 Supreme Court of Canada (SCC) decision in BCE showed the protections under the CBCA oppression remedy given to bondholders whose values would significantly decline by the leveraged takeover. The takeover was an opportunity for BCE shareholders to capture over $10.3B of lost enterprise value from weak board governance by neglecting to pursue various strategic options. The decision in BCE showed that where the interests of the corporation conflict with shareholders, under s. 122(i) of the CBCA the duty of directors is to the corporation.  

Finally, there are concerns over unequal consideration paid to target shareholders tendering to a bid at a low premium above the pre-bid price. Other discriminatory measures include controlling shareholders offered a premium, while neglecting to offer minority shareholders the same premium. This is unjust for shareholders for which no offer was previously made. The U.S. shareholder profile is more dispersed with a higher volume of large-cap issuers on NYSE/NASDAQ than any other capital market. Over 25% of all TSX companies have controlling shareholders, the highest of any developed exchange. The Canadian takeover regime aims to minimize inequities and offers takeover protections for minority shareholders.

III    VARIANCES IN SHAREHOLDER VALUE-ADDED FROM PROTECTIONS  

The Canadian and U.S. takeover regimes yield differences in shareholder value from various protections given to shareholders. Under DGCL, directors may use a variety of defensive mechanisms to prevent an inadequate takeover bid before reaching a shareholder vote. The Delaware approach is at odds with the Canadian approach where boards may not deny shareholders the ability to vote on a takeover bid. Canadian issuers have limited takeover defences as shareholder primacy prevails.  Shareholders ultimately decide whether to accept or reject a bid. Airgas reaffirmed the director primacy of U.S. boards. This gives U.S. target boards more negotiating power and control in takeovers, increasing premiums for shareholders.

Under s. 122(1)(b) of the CBCA, the duty of care obligates Canadian boards in a takeover bid to get the best price for shareholders through acting as auctioneers. This is consistent with the Revlon duty under DGCL. BCE illustrated that the fiduciary duty analysis of maximizing shareholder value applies during TOBs. BCE showed that Canadian boards have limited options to prevent a TOB. This allows shareholders to vote on TOBs that provide opportunities to unlock shareholder value.

In addition, in Canada unlike the U.S., poison pills are regulated by securities regulators who rely on their public interest jurisdiction to intervene in contested takeovers. In the 2007 decision in Pulse Data, the ASC prevented the poison pill from expiring and emphasized the duty of the target board owed to the corporation and not only to shareholders. The 2010 BCSC decision in Lions Gate showed the challenges for a target board to keep a poison pill during a hostile bid. Pulse Data and Lions Gate show shareholder approval is not a conclusive factor in allowing a poison pill to expire. Canadian boards cannot use a “just say no” defence by unilaterally denying shareholders the ability to vote on TOBs. This protects shareholders by allowing them to vote on bona fide TOBs.

Canadian securities regulators can prohibit target boards from taking inappropriate defensive measures to prevent a takeover. 62-202 gives regulators takeover protections that encourage unrestricted auctions for shareholders. The 2006 OSC decisions in Sears and the 2010 OSC decision in Magna showed regulatory interference when transactions are perceived to be abusive or coercive towards minority shareholders. The practice of U.S. issuers using staggered boards makes it difficult to gain board control by limiting the number of directors elected in any year. Empirical evidence shows that neither poison pills nor staggered boards increase shareholder value. The excessive entrenchment of U.S. boards having wide discretionary powers has prevented shareholders from voting on TOBs, thereby compromising value. U.S. shareholder protections are limited as director primacy dominates board decisions in takeovers.

IV    CONCLUSION 

Canadian takeover regulations under securities law gives shareholders more statutory protections compared to its U.S. counterpart under Delaware corporate law. The director primacy of U.S. boards can enhance value through premiums for shareholders. Canadian courts and regulators have a clear bias towards shareholder primacy in TOBs. The U.S. Dodd-Frank Act may shift the governing power from boards to shareholders through greater voting rights, transparency, and disclosure. This may strengthen U.S. investor protections in takeovers, thereby increasing value.

1. Harvard Business School (HBS) Case Study, “Circon (A) (Abridged)”, at 6.
2. Airgas, supra note 2, at 5.
3. INSEAD Case Study, The Bid for Bell Canada Enterprises (BCE), at 15.
4. Bebchuk, Cohen, and Ferrell, “What Matters in Corporate Governance?” 22 Review of Financial Studies (2009), at 792.

The post What Are Some Differences In Shareholder Protections Between The Canadian And U.S. Take-Over Bid (TOB) Regime? appeared first on Black Swan Diagnostics.

Smart contracts may be viewed as part of an evolution to automate processes with machines and self-executing code. A smart contract is a set of coded functions that incorporate the elements of a binding contract (e.g., offer, acceptance, and consideration) that execute certain terms of a contract. The smart contract allows self-executing computer code to take actions at specified times and/or based on reference to the occurrence or non-occurrence of an action or event (e.g., delivery of an asset, weather conditions, or change in reference rate).

Smart contracts can be stored and executed on a distributed ledger, an electronic record that is updated in real-time and intended to be maintained in geographically dispersed servers or nodes. Through decentralization, evidence of the smart contract is deployed to all nodes on a network, which effectively prevents modifications that are unauthorized nor agreed to by the parties. The use of blockchain technology is a continuously growing database of permanent records, “blocks”, which are linked and secured using cryptography.

What Role Will ‘Smart Contracts’ Serve in Corporate Governance?

Smart Contracts are computer programmable code that automate functions but are not immutable. They can be transferred automatically from one party to another provided certain conditions are met. Aaron Wright, associate clinical professor at Cardazo Law School and director of The Cardazo Blockchain Project, recently stated that: “The internet forced attorneys to better understand copyright law [and] similarly, blockchain will require a better understanding of securities law and an understanding of the underlying technology of smart contracts.” For reporting issuers, it is crucial that directors have at least a cursory understanding of fundamental securities law principles relating to the fiduciary obligations of directors. The automation and enforcement of smart contracts will be significant    to boards as they grapple with shareholder rights, activism, and other oversight functions such as insider trading, quarterly reporting, and proxy voting. 

Given that blockchain is both anonymous and decentralized, it is highly secure. This is critical for legal transactions since every single transaction on the blockchain is sent to and verified by every node on a very large peer-to-peer (P2P) network. P2P (Peer-to-Peer) Transactions are electronic money transfers made from one person to another through an intermediary. This is usually referred to as a P2P payment application. Each node on that network validates each blockchain event via a challenge-response system, which it then resends to all other “verifiers” on the node. In the end, independent nodes arrive at a consensus, and “declare” the transactions as valid; notably, any attempts to corrupt this data are then, in turn, made unsuccessful by being ignored.  This concept comprises the core systematic differentiator between traditional legal processes and – now with the aid of blockchain technology – are termed “decentralized” (i.e., P2P) transactions.

How Smart are ‘Smart Contracts’?

Against this background, a “smart contract” is not necessarily “smart” in   that the operation is only as ‘smart’ as the information feed it receives and the machine code that directs it. One implication of many is that a “smart contract” may not necessarily be a legally binding contract. For example, it may be a gift or some other non-contractual transfer; it may be part of a broader contract. The result of this is that to the extent that a smart contract violates the law, it may be neither binding nor enforceable.

They use digital signatures through private cryptographic keys held by each party to verify participation and assent to agreed terms. Private cryptographic keys are a sophisticated and encrypted form of cryptography that allows a user to access his or her cryptocurrency or digital currency. Smart contracts also allow access to refer to external information data to trigger action(s). In this sense, smart contracts use oracles – a mutually agreed upon, network-authenticated reference data provider which may be an independent third-party. This is a source of information to determine actions and/or contractual outcomes, such as commodity prices, interest rates, or the probability of an event occurring. In addition, smart contracts can automate execution processes through self-execution whereby a smart contract will take actions without further actions by the counterparties (e.g., disburse payments).  

What are the Main Benefits of ‘Smart Contracts’?

There are various benefits associated with smart contracts below:

1. Standardization – standardized code and execution may reduce costs for negotiations and agreements. 
2. Security – transactions are encrypted and stored on a distributed ledger that is immutable
3. Economy and Speed – automation reduces transaction times and unnecessary manual processes.
4. Certainty – Well-designed smart contracts execute automatically, thereby reducing counterparty risk and settlement risk.
5. Business innovation – automating the flow of digital assets and payments may foster new products and business models. 

The above use cases become particularly attractive for financial markets and participants. For example, in the buying and selling of derivative instruments, firms can streamline post-trade processes, real-time valuations and margin calls. For firms that have securities outstanding with shareholders, they can simplify capitalization table maintenance by automating dividends, recalibrate share issuances, and stock splits. This provides for a more seamless experience for shareholders and reduces the margin of error for board and regulatory reporting. 

What are Some Legal Limitations of Smart Contracts?

Current law and regulations apply equally regardless of what form a contract takes. Contracts or constituent parts of contracts that are written in code are subject to otherwise applicable law and regulation. Legal frameworks apply to smart contracts and may be subject to multiple legal frameworks depending on their application or product characterization. This may span various regulatory statutes, spanning federal and state securities laws and regulations, such as The Bank Secrecy Act (BSA), The USA Patriot Act, and Anti-Money Laundering (AML) rules and regulations. Smart contracts are by no means perfect and contain structural and legal limitations, some of which are outlined below.

Extending Security Token Protocols with Voting Rights While Shoring Up Efficiencies 

STOs via the DLT for voting provide a necessary level of transparency. The chief benefit of switching traditional voting systems to the blockchain is the enhanced level of transparency the blockchain provides. The blockchain would — definitively — preclude bad actors from cheating the system. It would ensure participants do not double-vote since there would be an immutable record of both their vote and identity. Deleting votes would be impossible since the blockchain is immutable. Those charged with counting votes would have a final record of every vote counted that could be verified by regulators or auditors at any time. On the blockchain, everything is both immutable and verifiable. Results can also be encrypted, which would encourage transparency while at the same time maintaining a crucial sense of privacy.

Reporting speed is essential for efficient capital markets. Results entered and stored on the blockchain are not just immutable and transparent, however — they’re also immediately available. That means conducting shareholder proxies on the blockchain is not only safer but also more efficient. Compared to the way current shareholder voting is conducted for reporting issuers, for example, the differences are stark. It currently takes hours to count votes for board elections to fill the slate — and sometimes results are muddled on account of human or machine error, which extends the process even longer. The blockchain, however, offers a reality in which that human error is stripped from the equation and results are counted immediately. Blockchain enables voting results to be available to shareholders immediately after completion of the voting process. 

Private issuers can benefit significantly from these more efficient voting processes. What becomes clear is the more you investigate the blockchain as a mechanism for governing voting processes, the more you find its application extends further than general voting mechanisms. Individual companies and organizations could reap the same benefits by utilizing the blockchain internally. For example, companies could use tokens to grant employees and stakeholders voting rights. The more tokens or STs (security tokens) an employee or voter is granted, the more weight their potential vote may carry. Granting tokens is also a way to incentivize favorable behavior, such as consistent accuracy.

In contrast, the AGM (Annual General Meeting) voting process for public companies consists of intermediaries and inefficiencies that can result in a lack of shareholder engagement. Proposals are often voted by proxies instead of by shareholders, often weeks before the meeting. Few or a limited number of shareholders attend AGMs in person. Large institutional shareholders may be granted engagement opportunities with management of the issuer that are not otherwise afforded to individual shareholders. This may give rise to preferential treatment, asymmetrical voting opportunities, and benefits select shareholders. These factors can result in a lack of transparency in the voting process and disproportionate voting power amongst shareholders. Blockchain technology has several potential applications that can remedy these inefficiencies and restore shareholder trust, confidence, and engagement. This provides more equitable distribution of voting while also democratizing shareholder voting. 

The immutable nature of a blockchain and the ability to create a specified set of rules for its use make blockchain technology an appealing option as an automated, secure method of counting shareholder votes at an AGM. For example, Broadridge Financial Solutions Inc., a corporate services company that provides a variety services for annual meetings, was recently granted a patent for proxy voting using blockchain technology. In 2018, Broadridge tested a pilot blockchain-based voting system at the annual meeting of Banco Santander, S.A. The technology was successfully used to create a digital register of the proxy voting at the meeting and was used by more than 20-percent of voting shareholders.

Voting Systems as a Blockchain Use Case

Stock exchanges around the world have been exploring the use of blockchain-based voting systems for years. Foreign stock exchanges, such as the Abu Dhabi Securities Exchange, use blockchain-based voting systems for shareholders of issuers. In 2016, Nasdaq and the Nasdaq-operated Estonia central securities depository, developed a web-based user interface for shareholders of listed companies on Nasdaq Tallin. The interface allowed shareholders to vote before or during annual meetings, transfer their rights to a voting proxy, monitor how the proxy voted, and review previous meetings and transactions. The system relied on blockchain technology to record ownership, issue voting rights, and allow shareholders to vote. This application is particularly acute as the blockchain was not only used to register votes, but also to provide a credible and immutable audit trail of previous meetings and transactions for shareholders to view. Similar applications of blockchain technology could help resolve information asymmetries in shareholder votes.

U.S. State legislation has started to address similar uses of blockchain in corporate governance. In 2017, the state of Delaware passed legislation allowing Delaware-registered corporations to use blockchain technology in order to keep any corporate records, including stock ledgers, books of account and minute books. In 2018, the state of Vermont passed legislation allowing the creation of blockchain-based limited liability companies that can legally use blockchain and smart contracts to provide their governance, including voting procedures. In addition, the SEC continues to study the “proxy plumbing” problem and scheduled a public roundtable on the issue in 2018. As blockchain technology continues to develop, so will its practical uses for issuers in both AGMs and corporate governance.

The post Voting Rights And ‘Smart Contracts’: Compliance Automation appeared first on Black Swan Diagnostics.

1. Cybersecurity Risks: Blockchain code is still in its infancy stage and might be liable to presently obscure security vulnerabilities. For example, the Ethereum (ETH) contract language is relatively new and there may be zero-day attacks that programmers could misuse. Blockchain also imposes the real risk for a double-spending attack whereby an attacker effectively generates more than one transaction while utilizing only one token and bringing about the discrediting of the “fair” exchange. Private key holders of each account are the ones on which the reliability of each entry rests. The partial reestablishment of the agent is done through private blockchains. A private blockchain is a permissioned blockchain. Establishing rules that are maintained by either the starter of the system or by the starter of the network enables nodes in a private blockchain network to be validated and thereby require invitations. The board should ensure proper and regular oversight for the management of this recurring obligation. 

2.   Insider Trading Surveillance: Smart contracts such as Ethereum can be written so that rules and regulations are enforced at the token (asset) and protocol (technology) level. This is a significant benefit for both companies wanting to interact with digital assets and regulators seeking compliance. Smart contracts can not only remove the need for continuous compliance surveillance but are able to eliminate the need for regulatory compliance monitoring to start. For example, assume a company raises capital with ‘Company Security Token’ (CST). Your legal and regulatory counsel has advised that you utilize Rule 504 of Regulation D, which provides an exemption to the normal securities registration requirements assuming certain conditions are satisfied. One of those conditions is that CST qualify as a restricted security. This means it cannot be resold for at least six months to a year without going through the traditional securities registration process with the SEC. In the current state of the digital asset market, preventing all participants of the CST offering from violating this 6 to 12-month restricted lockup rule is a difficult and labor-intensive process. Smart contracts can solve this problem. Instead of issuing CST directly to users’ personal digital asset wallets, which gives way to track or prevent assets from being transferred or sold unlawfully, CST can be distributed directly into a smart contract that locks the asset’s movement for a specified period. This ensures that your company and its employees comply with Rule 504 of Regulation D. This can prevent the excess sale or dumping of security tokens on a digital asset exchange, thereby minimizing downward pressure on token price and liquidity. 

3.   Proxy Voting: Blockchain will provide for secure and accurate proxy voting. Proxy voting is a complicated process for corporations and often result in flaws, incomplete ballot distributions, imprecise voter lists, and problematic voter tabulation. With blockchain, this cumbersome and unsecured process of proxy voting can be completely revamped. Using the issuer’s digital currency or tokens, shareholders will have tokens representing their voting power. Votes are cast and secured on the secure blockchain network and voters can observe the ongoing voting process. Blockchain will enable corporate voting to become more accurate, and strategies such as ‘empty voting’ that are designed to separate voting rights from other aspects of share ownership, may become more difficult to execute secretly. This minimizes voting fraud or corruption and adds an important layer of integrity to the voting process. The greater speed, transparency, and accuracy of blockchain voting could also motivate shareholders to participate more directly in corporate governance and demand votes on more topics and with greater frequency. This may enable wider shareholder engagement, especially among special interest groups (e.g., Socially Responsible Investing (SRI), Corporate Social Responsibility (CSR), or Environmental & Social Governance (ESG)), voting at AGMs and other meetings. 

1. Transparency: Through disintermediating transactions via the DLT, blockchain ensures a more transparent and effective audit trail. This will help to reduce or eliminate corporate corruption. The use of DLT could provide unprecedented transparency in allowing investors to identify the ownership positions of debt and equity investors and overcome corruption by insiders, boards, regulators, broker-dealers, market makers, exchanges, and listed issuers. Authenticating a shareholder’s digital identity allows the blockchain to use an embedded trust component. This means that a shareholder doesn’t need to be physically present to prove their identity. By extension, by ensuring the democratization in corporate governance, blockchain provides opportunities for companies to manage their assets directly. In a KPMG study (2016-2017) of selected blockchain projects, it was estimated that a 20-40 percent increased efficiency of data and digitisation from single source of truth was realized from the blockchain. Digitization of data can unlock efficiencies, and consequently, incremental shareholder value.  

2. Enhanced access to documents: The existence and immutability of the DLT means that access to documents by directors is quick and efficient. Directors can easily manage insider stock ownership data to guard against trading anomalies (e.g., insider trading profits evidenced through trade surveillance tools) and the real-time and equal transmission of public information to all shareholders.  

3. Smart contracts will improve transparency: Smart contracts help to mitigate the risk of fraud for organisations by providing an immutable audit trail. They will dramatically reduce the costs of identity verification and contract enforcement. 

4. AGMs will empower shareholders: Voting can be slow and fraught with human error at an AGM. Blockchain technology can deliver faster and more reliable voting results that give shareholders a higher level of trust and confidence in voting outcomes. This should empower rather than embolden shareholders to contribute to decision-making that is in the best long-term best interests of the corporation.

5. Real-time financial reporting streamlined: Consumers of financial statement information would not need to rely on the judgment of independent third-party external auditors and the integrity of managers. Instead, users of financial statements can trust with certainty the data on the blockchain and impose their own accounting judgment to make their own non-cash adjustments such as depreciation or inventory revaluation. 

6. Board dependency is reduced via permissioned access: A permissioned blockchain a network that requires permission to gain access. Only authorized users can join and start verifying. The blockchain can offer lower costs of trading and more transparent ownership records, while permitting visible real-time observation of share transfers between owners. DLT bolsters the audit trail/record keeping function by using blockchains to record stock ownership. This could solve many challenges related to issuers’ inability to keep accurate and timely records of shareholder ownership.

Board Inquiries of Management About Blockchain

Given the nascency of blockchain technology, boards must understand the risks and opportunities associated in using blockchain as part of their corporate strategy. The following are questions that boards should be asking management in using blockchain.

1. Competition: What are our direct and indirect competitors using as it relates to blockchain for their business? 

2. Cost-Benefit Analysis: Has management considered the advantages and disadvantages of using blockchain?

3. Risk Management: What are the cybersecurity and privacy risks and other mitigating factors, in using blockchain? Do we have a Business Continuity Plan (BCP) or Disaster Recovery Plan (DRP) if the blockchain goes down or is temporarily disrupted? 

4. Protocols: Would the company deploy a permissioned or permissionless blockchain protocol? Which vendor (if any) would be used and its cost?

5.  Infrastructure: Do we have the systems and technology to support the blockchain technology? What internal controls are there to manage and mitigate such infrastructure risks?

6. Strategic Integration: How does blockchain fit into our data protection strategy?

7. Auditing: How can we independently audit the technology to ensure it can be trusted? This is especially pervasive in the financial services sector and supply chain management, two leading use cases of blockchain. 

8. Regulatory Compliance: What are the regulatory compliance issues to satisfy if blockchain was deployed? 

9. Accounting: What accounting issues should we consider in using blockchain?

10. Taxation: Where a digital currency applies, what tax issues should we consider in using blockchain?

1. KPMG, “Blockchain for technology, media, and telecom (TMT) companies: What COOs, CFOS, CIOs, CISOs, and other executives should understand about blockchain”, 2019, p.1.
2. If the organization is storing transactions, that is an expense.  The method by which it stores such transactions, however, will determine the cost. PoW (Proof-of-Work) requires that the entire blockchain and history be contained on each node (server) that is responsible for transaction processing.  This means an infinite amount of storage space is required to store its history over time for each node.  PoW is expensive to store the data because the full history must reside on each node. The continual tension for companies using the blockchain is choosing between speed versus storage.  A blockchain running at 50,000 tps (transactions per second), for example, would consume 385 TB (TeraBytes) of storage annually. The solution is to have an archive node which would cost nearly $180K.  If a company is running a permissioned blockchain, then it is more advantageous and cost-effective to archive transactions off-chain to avoid the infinite growth of PoS (Proof-of-Stake). PoS can be configured so that it can be archived and the full blockchain does not have to reside on every node.  The implication for companies and management is that it is a more efficient way to operate.

The post Security Token Issuances: Board Considerations appeared first on Black Swan Diagnostics.