Takeaways

A new California law will allow certain corporations to use blockchain technology for certain corporate records; privately held companies and social purpose organizations qualify.
Specific corporate records include issuances and transfers of stock and number of shares registered in the name of each stockholder.
We expect that this law will enable California corporations to issue equity securities as “security tokens” in security token offerings.

Discussion

On September 28, 2018, the Governor of California signed SB-838 into law. The legislation amends Cal. Corp. Code § 204 (General Corporation Law) and Cal. Corp. Code § 2603 (Social Purpose Corporation Act). The new law will take effect on January 1, 2019, and it has a sunset provision causing it to automatically expire on January 1, 2022.

Summary of New Legislation

The new law allows California’s privately held corporations and social purpose organizations to add to their articles of incorporation authorization to use blockchain for certain purpose. These corporations qualify because they do not have outstanding securities listed on the New York Stock Exchange, the NYSE Amex, or the NASDAQ Global Market.

The law defines “blockchain technology” as a “mathematically secured, chronological, and decentralized consensus ledger or database.” The permitted uses for blockchain now include recording and tracking the issuance and transfer of stock certificates, the names of corporation’s stockholders of record, and the address and number of shares registered in the name of each stockholder.

The law additionally requires that the companies using blockchain must meet certain requirements in its application. For example, the encrypted information in the records must be able to be decrypted and converted into a clearly readable format within a reasonable period, and the records must be able to be used to prepare the list of shareholders, record information required to be included on stock certificates, and record required transfers of stock.

The full text of the bill can be found here.

Relatedly, this week the Governor of California also signed into law legislation that requires the appointment of a “blockchain working group.” This group will evaluate the risks and legal implications associated with the use of blockchain by state government and California-based businesses. The full text of that bill is found here.

Background on Blockchain

For the purposes of this update, blockchain technology can be considered to be software running on a network of computers that allows for the creation of a digital ledger. The ledger is maintained by multiple computers on the network, and each transaction must be verified by multiple computers on the network before it is added to the ledger. A blockchain’s security derives in part from the fact that the network at large must approve any addition to the blockchain ledger. Cryptographic techniques are also used to encode and verify each transaction, and to record the transaction in the blockchain’s digital ledger. Once it is entered on to the ledger, information generally cannot be erased. 

Governments and companies are already using and testing blockchain systems for many different purposes. Ripple is perhaps the most famous example of a corporate deployment of a blockchain, but there are many others; for example, Walmart is requiring certain suppliers to join its food-tracking blockchain by early next year in order to increase the speed and accuracy of any future food recalls following E.coli outbreaks. It has also been reported that FedEx Corp. is testing blockchain technology to track cargo when it moves to parts of the supply chain that it doesn’t own, and that a division of United Parcel Service Inc. that offers insurance services is developing a blockchain product to manage and track the status of claims. A recent Gartner report estimates that by 2030, blockchain technology will generate business values of $1.76 trillion to $3.1 trillion.

Client Considerations

While a few other states have adopted similar legislation, applying blockchain technology to corporate record processes is still relatively uncharted territory, and the California bill’s ultimate effects are uncertain. On the one hand, businesses may find that the use of blockchain technology streamlines time-consuming record maintenance tasks, as well as related projects such as a corporate buyback of privately held stock. In addition, we expect that this law will enable California corporations to issue equity securities as “security tokens” in security token offerings, including through “crowd-funding” portals that have been established for such purposes. However, it is critical for such issuers to ensure that either such offers will be registered or that appropriate securities exemptions are available, and to fully comply with any exemptions. The bill’s author further touted the legislation as a tool to provide a more secure way for businesses to issue and transfer corporate share certificates, and to combat fraud.

Because the definition of “blockchain” in California’s new law does not restrict the term to public, Bitcoin-style blockchains, corporations choosing to encrypt data in a private blockchain network run by the company itself would have the ability to set whatever permissions it wished for accessing the information, and thus continue to have the ability to hold corporate records close to the vest. (Execution may not be difficult; companies such as Microsoft, IBM, and Hewlett-Packard Enterprise already have platforms that support blockchain, and offer blockchain deployment as a service for those who don’t wish to hire their own in-house developers.) Additionally, regulators may come to favor the use of blockchain ledgers because the fact that they generally cannot be altered may solve some enforcement problems; for instance, it is hard to imagine that companies could backdate stock option grants if the stock issuance records had been recorded on a blockchain.

On the other hand, owners and investors may wish to be cautious about immediately moving corporate records to a blockchain. First, although California’s new law requires that “encrypted information in the records can be decrypted and converted into a clearly readable format within a reasonable period of time,” no definition of “reasonable period of time” is offered within the statute, nor are any conditions under which the conversion must occur listed. This could be a problem if, for example, potential acquirers of privately held companies find their due diligence to be delayed. Additionally, it is uncertain whether regulators and oversight agencies may come to take a heightened interest in privately held companies that use blockchain technology to manage stock issuance and transfers. For example, earlier this year the U.S. Securities and Exchange Commission brought an action against a privately held California company for issuing employee stock options without a valid registration exemption from registration under Rule 701. If this company had been maintaining its records of stock issuance and transfer on an encrypted, private blockchain system, then it probably would have been more difficult for SEC enforcement to access or review the information in a timely manner. It is conceivable that for this reason, use of blockchain to maintain corporate records could become a red flag of sorts for regulators.

Whether California’s largest privately held companies in finance, technology, retail, and food & drink will switch to using a blockchain for stock issuance or other corporate records remains to be seen. Newly forming companies may want to include authorization to use blockchain in their articles of incorporation, if only to give themselves the option of adopting the technology later. (Authorizing the administration of records by means of blockchain does not require the use of blockchain.)

If you have any questions about the new law or its provisions, please contact the authors or any of the group’s attorneys to further discuss your concern.