We hear about tokenisation of shares regularly. But what does it actually mean? To answer the question we must confront the fact that English company law did not anticipate developments in technology.
Considering tokenisation in practice requires an analysis of how the characteristics of ‘tokenised’ shares relate to the particular requirements of English company law. The explanation below is much simplified but illustrates the type of analysis required and where changes in the law will follow to make tokenisation administratively easier.
Let’s start with the issuance of shares. An English private limited company may issue shares with or without share certificates. So we would think that in the case of tokenised shares these would be of the “uncertificated” (digital) variety and all is well. Not so fast. English law does not contemplate the issue and registration of shares by a company via an electronic system of its own making, for example one based on blockchain technology or smart contracts. Uncertiﬁcated shares have to be managed through CREST. That means that tokenisation currently takes place in relation to certiﬁcated shares (shares that are evidenced by share certificates).
This brings us to the register of members. In the case of certiﬁcated shares, a company must keep a register of members and issue share certiﬁcates reflecting the register. The requirement to keep a register of members is generally understood to mean that the company must have control over a register containing details of the holders of its shares. If the register were to consist of blocks on a blockchain updated in accordance with instructions from smart contracts that identiﬁed each transferor and transferee and other details of the transaction, the board of the company would need to have the practical ability to add a block and to prevent a block from being added to the blockchain. The system would also need to have functionality to enable at any time the extraction of all the information required by law (names and dates, share details and payments for shares etc). But that is not technically difficult.
A court can order changes to a company’s share register so a register maintained on a blockchain must be capable of being rectiﬁed pursuant to a court order. In principle a court can make an order to rectify a register by adding a block or blocks to the blockchain or by ordering that the information on the blockchain or instructions given by a smart contract is updated. We know from this that that a permissionless blockchain would not be suitable for a register of members. A permissioned blockchain that is controlled by the company could satisfy these requirements, however.
Next, let’s look at the transfer of shares. A company may not register a transfer of shares in its register of members unless an “instrument of transfer” has been delivered to it. More than that, according to the laws that require the payment of stamp duty on transfers of shares, a register of members must not be updated to record the transferee as the holder of the shares unless that instrument has had duty paid on it and been stamped. Payment of stamp duty and stamping takes place outside the company’s offices and there is no plug-in to HMRC that allows receipt and confirmation of duty paid and then stamping in real time. So it seems from this that we’ve hit a roadblock and transfers cannot take place on a blockchain-enabled platform.
However, the English law rules of property come to our aid here. Once a buyer pays for shares, they become the beneficial (i.e. economic) owner of those shares. Once the instrument is stamped and the register is written up at that point the buyer becomes the legal owner. Therefore, a blockchain receiving instructions from a smart contract can be updated to reflect the new beneficial owner of shares simultaneously with a transfer. But the company’s own books cannot. The legal title will follow once the register of members is updated i.e only after duty is paid.
As an aside, there have been proposals over the years to digitalise the stamping process and currently HMRC has changed its stamp duty policy and accepts electronic copy documents, electronic signatures and electronic payment during the coronavirus (COVID-19) pandemic. If these or similarly adapted measures become permanent, we would be a step closer to a system permitting tokenised legal ownership of shares in an English private company.
So how is tokenisation actually done? The answer is a work around that combines familiar things. The first is the concept of beneficial title explained above and the second is the nominee company. Although a holder of beneficial title has economic ownership in a broad sense they do not have all the rights of an owner under English law. A nominee company fills the gap by ensuring that within a tokenisation platform legal title does not need to pass. The nominee company is used to hold legal title to tokenised shares so that legal title can be retained by the same entity incorporated specifically for this purpose regardless of transfers of beneficial interests as shown on the platform. Beneﬁcial interests in shares in a company can be recorded and transferred via any system and a nominee holding legal title to shares in an English company can decide to record the beneﬁcial owners of the interests on a blockchain and transfer interests using smart contracts that add a block to the blockchain. The user interface of a tokenisation platform can choose to show the beneficial ownership of the underlying shares. The tokenised asset is a digital representation of the shares rather than the shares themselves. The rules of the platform, a contract between participants, work alongside the relevant mandatory laws to create a trading environment for digital assets. So, there you have the technology (in the legal sense) underlying tokenisation.
Is that it? Of course not. The rules I’ve skirted over above are complicated and detailed and we also have to deal with rules relating to the requirement for transfers of beneficial interests to be in writing, rules relating to signatures and electronic signatures, rules relating to data security and document retention and rules relating to AML and KYC, among others. However, it is likely that the end results of the Law Commission’s current consultation to support the digital economy will tidy up the laws that we’re working with in ways that are helpful. For now, we have found a way despite them. And next time you hear someone tell you about tokenised shares or digital assets you will know that underlying this is the flexibility of the English legal system and the ingenuity of its practitioners.