The use of digital securities or security tokens has coincided with the explosion of crypto-currencies and efforts to establish Internet-traded coins or tokens with utility as a form of currency. Lost amidst the enthusiasm over the revolutionary implications of crypto-currencies is the simple fact that security tokens which use block-chain technology and smart contracts have significant advantages over traditional platforms for issuing, holding and trading securities.
Version 0.0: Stock Certificates
Historically, companies provided their equity owners with a physical stock certificate to evidence their share ownership. The owner’s name and number of shares are printed on the stock certificate. The stock certificate is authenticated by using a customized form and logo, impressing the company seal, and requiring the signatures of two authorized officers.
Any trading restrictions associated with the shares—whether because of (1) regulatory restrictions imposed in the absence of registration under the Securities Act of 1933, as amended, (2) buy-sell or drag-along provisions under a shareholders or similar agreement, (3) contractual lock-ups, (4) security interests or otherwise—are noted by printing a legend on the certificate alerting prospective purchasers of the restriction. A prospective buyer bears the burden of investigating the nature of the restriction and the risk that the company will not process a transfer of the shares into the buyer’s name if the transaction violates statutory, regulatory or contractual restrictions.
The company records the issuance of each new stock certificate in a stock ledger, generally maintained by the company secretary, which reflects all of the transactions involving the company’s outstanding shares.
To transfer shares represented by a physical stock certificate, the owner signs a stock power to evidence the transfer. The form of stock certificate will generally have a pre-printed stock power on the back of the certificate, or an owner can sign a stock power separate from the certificate. The stock power confirms the name of the buyer and the number of shares transferred and is signed by the registered owner of the stock certificate. In making the purchase, the buyer is implicitly relying on the legitimacy of the stock certificate and the validity of the signature on the stock power.
The buyer of shares then delivers the stock certificate and the stock power to the issuing company with a request to issue a new stock certificate reflecting the buyer’s ownership of the shares. If the stock certificate contains a legend, the buyer may also need to supply a legal opinion from counsel acceptable to the issuing company, confirming that the transfer is permissible under applicable law.
When the issuing company receives a stock certificate, stock power and any legal opinion, it confirms the legitimacy of the certificate against its stock ledger, cancels the certificate, prepares a new stock certificate for the buyer, updates its stock ledger and sends the new stock certificate to the buyer.
If a company is sold, the company typically completes the transaction and deposits the proceeds from the sale into an escrow account. It then sends a form of letter of transmittal to its owners instructing them to complete the form and return it with the stock certificate back to the company. Upon receipt, the company verifies the certificate against their records, cancels the stock certificate and mails a check to the owner for the payment for the owner’s shares. If the owner has lost the stock certificate, the owner completes an affidavit of lost certificate, agreeing to indemnify the company for any damages if someone else produces the certificate and claims to be the valid owner. The company may also require that the owner that lost the certificate purchase a bond or insurance to fund the indemnification obligation.
This platform of a central stock ledger and physical stock certificates, while it has been in place for over 100 years, has three significant drawbacks. First, transactions take a long time to process because stock certificates must be signed and delivered to the issuing company, which then validates the transfer, prepares the new certificate and issues it to the buyer. Second, the system is insecure as it relies on the validity of stock certificates and signatures, which can be easily be duplicated or forged. Third, there are attendant costs stemming from the time and effort to maintain a physical stock ledger to check and verify any trading restrictions on shares that are proposed to be sold or transferred and to secure legal opinions on whether the transfer complies with applicable securities laws.
See the full article here: Security Tokens — A Superior Platform.