Blockchain technology has created new opportunities for corporations. Blockchain, or otherwise referred to as Distributed Ledger Technology (DLT), is an immutable digital ledger of commercial transactions that can be programmed to record transactions (both financial transactions and anything else of value). Distributed Ledger Technology (DLT) is a means of transferring digital information between two parties in a fully automated and safe manner. An immutable record is a permanent record of a digital transaction that cannot be erased. This is a salient feature of the DLT/blockchain. What DOS (Disk Operating System) was in powering everyday Microsoft applications, blockchain will be in powering many new applications across many industries.
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.