In 1976, two Stanford University authors published a seminal paper on cryptography discussing the concept of a mutual distributed ledger (although not using that term)—the same concept underlying today’s blockchain DLT. Historically, the notion of a smart contract is not new. In the financial and derivatives arena, smart contracts are not entirely new tools to automate complex and often technical agreements with many variable reference rates. According to ISDA (International Standards for Derivative Agreements), “A smart contract is an automatable and enforceable agreement. Automatable by computer, although some parts may require human input and control. Enforceable either by legal enforcement of rights and obligations or via tamper-proof execution of computer code.” Increasing automation has long been a function of our financial markets through automating trading orders (stop loss, market order, limit order, short-sale order, etc.) and trading algorithms with smart order routers.
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:
- Standardization – standardized code and execution may reduce costs for negotiations and agreements.
- Security – transactions are encrypted and stored on a distributed ledger that is immutable
- Economy and Speed – automation reduces transaction times and unnecessary manual processes.
- Certainty – Well-designed smart contracts execute automatically, thereby reducing counterparty risk and settlement risk.
- 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.
| Although Smart Contracts could: | Smart Contracts could also: |
| Enhance market activity and efficiency | Unlawfully circumvent rules and protections |
| Verify customer and counterparty identity | Diminish transparency and accountability |
| Facilitate trade execution and contract fulfilment | Impair market integrity, stability, and confidence |
| Ensure accurate books and recordkeeping | Introduce various risks, including operational, technical, and cybersecurity |
| Complete prompt regulatory reporting | Be subject to fraud and manipulation |
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.