UKJT publishes legal statement on the viability of digital company shares

The UKJT was established in 2019 to support the digital transformation of the UK legal sector. Its new legal statement follows a consultation it launched in August 2022 on the validity and viability of digital securities under English law.

The statement examines whether English private law can support the issue and transfer of equity, debt or other contractual securities using blockchain or distributed ledger technology (DLT).

The issue and transfer of shares in a UK company is governed by UK company law, principally the Companies Act 2006 (the Act). Any framework for digital securities will need to comply with formalities set out in the Act.

The UKJT notes that certain aspects of the issue and transfer of shares in UK companies can already be accommodated by a DLT-based system. However, in other respects, formalities under the Act may prove to be impediments to a fully “on-chain” system.

We have set out below the key points from the legal statement that touch on equity securities. Our colleagues from our Lawtech practice have published this separate piece on the policy aspects coming out of the legal statement.

Issuing shares

When a UK company issues a share, or when it registers a transfer of any of its shares, it is required to provide the shareholder with a share certificate. A share certificate is, on the face of it, evidence of title to the underlying shares (although ultimately legal title rests with the person whose name appears in the company’s register of members).

(A system already exists for the issue and transfer of shares without share certificates, in the form of the Uncertificated Securities Regulations. However, that system applies only to securities that are held through the CREST system, pretty much limiting its use to publicly traded companies.)

Traditionally, share certificates have been issued on paper, but there is nothing in law that prevents a share certificate from taking electronic form. In the UKJT’s view, therefore, a DLT-based system can be used to issue shares if it automatically generates an electronic share certificate.

Alternatively, the UKJT notes that companies can choose in their articles of association to dispense with the statutory requirement for share certificates altogether. In this case, proof of title would rest solely with the company’s register of members.

This is true, although, in our experience, there are practical implications of adopting either route which we already see when attempting to issue purely electronic share certificates.

• Where a paper certificate is issued, it is customary for the company to ask for the original, wet-ink-signed certificate back when registering a transfer (or, if the certificate has been lost, to request an indemnity from the shareholder). With electronic certificates, the question becomes: which share certificate is the original and which are merely electronic copies?
• If the company decides to dispense with share certificates completely, how will it satisfy itself that the transferor has title to the shares and the right to transfer them? This is by no means an impossible obstacle to overcome, but it will require careful thought and planning.
• A shareholder may wish to pledge their shares as security for debt financing. For an English company, it has been customary for the lender to take physical possession of a paper share certificate while the debt remains outstanding so as to hinder a transfer of the shares. This is not possible if the certificate exists solely in electronic form, or if there is no certificate at all.

However, these are merely practical hurdles to overcome. In principle, as the UKJT says, there is no legal obstacle to issuing purely digital shares.

Recording title to shares

The Act requires a company to keep a register of members setting out details of the persons who hold shares in it.

A company is perfectly entitled to keep an electronic register of members, as long as the register is capable of being reproduced in hard-copy form. As the UKJT notes, there is therefore no legal reason why a register of members cannot be kept within a DLT-based system.

However, the UKJT notes that, for this to work, the company would need to satisfy three conditions.

• It must be possible to reproduce the register in hard-copy form. This does not simply mean printing the blockchain information out. The hard copy would need to be intelligible to the human eye (so that a person reading it can see the names of the company’s members) and not simply a stream of computer code.
• The register must contain certain prescribed details of the company’s shareholders, such as their names and addresses. This information could be kept either “on” or “off” the chain, but it must be integrated into the register.
• The company must maintain control over the register of members so as to be able to fulfil its statutory obligations to keep it up to date. This includes the ability to register (or refuse to register) share transfers and to rectify the register if so ordered by the court.

Fundamentally, this means that the register would need to sit on a “permissioned” system, or some other kind of system over which the company has ultimate control. The UKJT believes that a “fully decentralised and permissionless blockchain or DLT-based system” would not be acceptable.

This is certainly a significant impediment and one that we noted last year when we contemplated the prospect of decentralised autonomous organisations (DAOs) in the UK.

In addition, a company’s register of members must be available for inspection by the company’s shareholders and members of the public who can show a proper purpose for obtaining a copy. Fundamentally, this means it must be possible to provide access to the blockchain (or, at least, a right to a copy of the information on the blockchain) in a format that can be readily understood.

These are not insuperable problems. Although the law probably cannot currently accommodate a fully decentralised and permissionless system for shareholder registers, it is theoretically possible to structure around this by utilising private keys or parallel off-chain registers. The principal question in each case is whether the additional administrative burden is justified.

Transferring shares

Transferring shares in UK companies is relatively straightforward. However, the Act prevents a company from registering a share transfer unless it is provided with a “proper instrument of transfer”.

A proper instrument of transfer is one which attracts stamp duty (a form of duty which is payable on certain documents and not to be confused with stamp duty land tax (SDLT), which is payable on transfers of real estate).

Fundamentally, this means there must be a written instrument which can be sent to HM Revenue & Customs (HMRC). The instrument can be in physical or electronic form, but it must be in writing and intelligible. The usual form of instrument of transfer used in the UK is the familiar “stock transfer form”.

The UKJT notes that any DLT-based system would likely need to be “paired with software which produces a document that is as close as possible to a standard stock transfer form” which can be sent to HMRC for stamping.

Even where stamp duty is not payable because an exemption applies (for example, where the transfer is for £1,000 or less), there would still need to be an instrument of transfer.

(Shares can be transferred without the need for an instrument of transfer if they are uncertificated under Uncertificated Securities Regulations. In that case, technically speaking, no document is sent to HMRC and a separate tax – stamp duty reserve tax (SDRT) – arises. However, as we note above, that system applies only to securities that are held through the CREST system, pretty much limiting its use to publicly traded companies.)

Effectively, this currently rules out a DLT-based system where transfers take place completely on the chain without any need for an instrument.

What does this mean for digital shares?

The UKJT’s legal statement is not intended to paint a bleak picture of the future of digital securities. Rather, it highlights some of the existing impediments or obstacles to a fully digital system that need to be considered and addressed.

It is already possible to overcome or bypass some of these hurdles. For example, it should be possible to issue digital shares through a permissioned DLT-based system that can automatically produce instruments of transfer and excerpts from the company’s register of members.

Alternatively, developers who wish to create a fully decentralised organisation still have the option to structure the system differently, such as by adopting a different legal form for the network and issuing tokens. That network could incorporate one or more legal entities for some of its functions. For more information, see our separate in-depth piece on decentralised autonomous organisations (DAOs).

At a more fundamental level, all the challenges the UKJT identifies can be overcome through legislative reform. Amendments to the Companies Act 2006 and other pieces of legislation could be made to facilitate fully “on-chain” registers.

In some areas this will entail significant changes to the UK’s company law framework and will require extensive review and consultation. How quickly that happens will depend on the UK Government’s appetite to drive reform towards a more digital way of holding shares.