Corporate Governance Lessons For the Blockchain World

Corporate Governance Lessons For the Blockchain World

7/7/2018

In November of 2017, the planned hard fork to the Bitcoin blockchain called SegWit2x was canceled. During a May conference called the “New York Agreement” Bitcoin miners had gathered to discuss and agree on changes to the Bitcoin core code meant to overcome mounting scaling problems being experienced at the time. They agreed upon a two phase upgrade to the core code called segregated witness. The first phase was accepted in a soft fork in August 2017, but the second phase called Segwit2x later failed to be executed in November 2017 when a majority of largest miners pulled out. The hard fork was abandoned, but the event and issues made clear to the Blockchain & Cryptocurrency world that governance mechanisms were lacking. (See Bitcoin Hard Fork SegWit2x Cancelled)

Digital governance of Blockchain has taken focus in the last year with development teams proposing a variety of systems. If you are unfamiliar with Blockchain, you might ask why this would be necessary at all? Isn’t Bitcoin and other Cryptocurrencies immutable ledgers that can’t be manipulated or changed?? Well the answers is yes & no.

Bitcoin is an immutable ledger, however, to address practical technological issues such as scaling, speed, privacy, security the development team that holds the keys to the code base called the core development team can implement changes. However, for their changes to be accepted they need to get consensus from network participants such as miners, large exchanges, third party developers, services and of course BTC users. Hard forks are when code changes create parallel Blockchains based upon the time of execution of the update. If market participants chose not to update, then code change will not be adopted. The participants are free to stay on the original ledger. (See: Ethereum DAO Hard Fork Controversy)

There is no mechanism in place to gain this consensus for Bitcoin. It is done through organizing the major players to conference. Additionally, in Bitcoin there is no inherent funding system in place to pay the developers. In the case of Bitcoin it isn’t much of an issue since the developers were early adopters and have made millions already and have a continued vested interest in Bitcoin’s success. There is also the idealogical motivation that spawned Bitcoin to begin as a counter to government & central bank corruption, unaccountability, and abuse of power. However, it does cause potential conflict in the community in how to handle change.

Other Blockchain project with fundamental difference from Bitcoin (a currency/asset) such as platform coins like Ethereum are far more experimental and need an efficient system of gathering consensus to quickly address scaling, security, usability issues.

In this article, I will present that Blockchain developers could learn from the history of shareholder voting for traditional stocks & funds. This is especially true for Blockchains that end up classified as securities by the SEC.

Furthermore, I believe that despite recent SEC communications that BTC and Ethereum are not securities, that they will eventually compel financial institutions such as exchanges & custodians to implement governance practices to protect mainstream investors from controversial hard forks.

ABOUT ME:

My career began working at a communication firm named DF King, A Proxy Solicitor that specializes in matters of corporate governance.

Proxy Solicitors hired by corporations and mutual funds. I supported the Mutual Fund division which is regulated via the SEC Investment Company Act of 1940.

ABOUT SHAREHOLDER VOTING:

All publicly traded companies are required to have annual meetings of shareholder to do basic things such as elect the board of directors & auditors to more complex or contention moves such as mergers & acquisitions, stock splits, and proxy fights or changes to a corporate or mutual fund charter & by-laws (EOS ring a bell? See: EOS: Dan Larimer Proposes Changing the Constitution)

A proxy contest is when an activist investor(s) seeks to gain greater influence over the direction of the company by proposing their own candidates to the board. They can even push to oust CEO and other high level management stakeholders. This can at times result in a proxy fight when the companies management is in conflict with the activist investor(s), but usually remains civil unless the shareholder is perceived as or known as a corporate raider looking to seize control & replace the management to extract value through dividends otherwise sell or liquidate a portion or all of the company.

All of that aside, this is what I want to share with you from my experience in the proxy industry: SHAREHOLDER VOTING IS NOTORIOUSLY LOW!!!! Proxy Solicitors exist to confront this reality. I have news for you, it won’t be any different in the Blockchain world.

THE SHAREHOLDER MEETING PROXY PROCESS (HIGH LEVEL):

1. Companies hold an annual or special meeting of shareholders to vote on substantive proposals that could effect the value of shareholders investment.

2. A Proxy firm is hired to perform analysis, projection and strategy work on the constituent demographic (This is done before filing with the SEC).

3. The solicitation period goes live, and mailings, emails and phone calls to shareholders are undertaken.

4. As the vote is returned it continues to be analyzed, if voter turn-out is low, then further active measures are taken such as increased phone calls to large holders and institutions, specialized mailings.

5. Institutions are contacted in regards to confirm the delegated voting rules of the collective plans they manage on behalf of beneficial owners. Some plans give the asset manager delegated authority to vote the shares proportionately cast based upon the beneficial owners of the plan who do vote. Each plan is different and companies rely on proxy firms to contact, confirm and remind institutions to vote.

COMMONS ISSUES ENCOUNTER IN SHAREHOLDER VOTES:

Shareholders lack interest, perceived incentive, understanding, or prefer that their decision to be delegated to a broker (If they are the holder of record, It can’t be unless they had a fund manager listed on the account as of the date of record)

Traditional mailings and emails usually garner about 8-15% on an initial mailing. Further mailings have diminished response rates. At that point the proxy firm will engage in attempting to directly contact shareholders via telephone to record their vote. This comes at increased costs. Ultimately, if the quorum is not met by the expiration of the SEC mandated proxy period then the meeting expires and any future attempt would require a new effort and further expense.

Proxy firms can’t directly mail to the beneficial owners (underlying holders of retail accounts “Street Accounts” held at brokerages) They must use a government granted monopoly named Broadridge Financial Services to print and then send those physical proxies to the brokerages, who then must send out the proxies to their clients (beneficial owners). This creates an inefficiency and increased cost for corporations and funds. The system was put in place decades ago to facilitate the shareholder voting process in less organized times, but has in the recent decade come under scrutiny amongst other needed changes in the industry. See: SEC 2010 Proxy Plumbing

Each corporation or fund has a registered list of shareholder held at their custodian bank. However, this list is an aggregate holdings and does give transparency to the various underlying pension, insurance plan, company and/or street accounts at any given brokerage.

Reconciling the accounts on the registered list is an investigative process filled with old data that has not been updated. This requires proxy firms to do phone and email searches for underlying shareholders to get updated contact information and contact institutions directly to reconcile large account that may be managed broker and wealth managers.

SEC MITIGATES LOW SHAREHOLDER PARTICIPATION WITH LESS STRINGENT RULES FOR MUTUAL FUNDS:

The rules for Corporations are different than Mutual Funds. Corporations tend to be held by large institutional investors who have authority to vote large managed positions. Mutual Fund are held mostly by mom and pops investors (beneficial owners) and thus must be contacted via their brokerage. Additionally, there is a designation of NOBO/OBO meaning non/objecting beneficial owner. This designates whether they agree to be contacted by proxy firms. For certain funds, with large OBO populations attaining a vote can be extremely difficult. The only way to reach these shareholders is through mailing or directly from their brokers who have no incentive to spend their time doing that work.

Furthermore, Corporations by regulation need a majority of shareholders (50%) to vote and to vote FOR a proposal for it to pass.

Mutual Funds on the other hand need only 50% of shares to vote and 67% (33.5% of total share outstanding) to vote in favor. Even with this lower quantitative standard, professional proxy firms are engaged and a significant period of time to solicit the vote is needed (90-180 days).

Most funds have a self imposed quorum for a meeting to be considered valid, and it’s usually 33% of the outstanding shares, this is not enough to pass the vote, but if quorum is met the funds have the option to adjourn the meeting to a later time rather than the vote failing and the process needing to begin anew.

GOVERNANCE ISSUES FOR BLOCKCHAIN DEVELOPERS TO SOLVE:

With the last section in consideration and recent Blockchain governance debacles in mind, I believe that developers and the community need to dig deeper into the precedents set by both traditional civic and corporate governance.

Here is the reality: Bitcoin will one day be the world reserve currency and replace the US dollar. It will facilitate direct transactions amongst individuals, corporations and governments while removing middlemen, increasing speed and providing trust and stability. Further regulation and transparency for constituents by their local governments is guaranteed. Thus, I believe you will see further regulation compelling exchanges and custodians to comply with both KYC-AML laws securities laws regarding proxy voting.

Remember: regular brokerage and banking firms are moving into the industry quickly and they will conform Blockchain holding accounts to the historic system as much as is possible. This is actually a good thing for voting mechanisms, but will present many of the same challenges and plenty of unique ones not faced by traditional stocks and mutual funds. There will be a converging point where you can trade your stocks, bonds, options, futures and Cryptocurrencies all in one account. Once mainstream investors get on-board the industry will be changed forever.

While the SEC recently ruled that BTC and Ethereum are not considered securities and thus securities laws will not apply to them (for now) I believe that it is inevitable that there will be further high profile governance issues that will culminate in large connected investors, brokerages and banks to lose money they will push for regulation. It will probably fall under the SEC and while the SEC may continue to exempt BTC and other Blockchains from the bulk of securities law its doubtful to me that this will be true for governance.

While Currency/Asset coins like BTC can evolve at a slower pace and are less dynamic it platform, their coins and the Dapps and other utility coins sitting on top of them present further complexity and unknown territory. We simply can’t predict all the issues.

Other Thoughts:

Contacting inactive holders. The industry is new and there is much attention and participation relatively speaking, but that won’t be the case once mainstream adoption is complete. As recently seen with EOS consensus is not an easy task.

Addressing deflation of outstanding shares (coins, tokens, etc) forever gone due to lost wallets/keys. It is conceivable that at some future point, enough whole coins (value 1) are lost that a 50% outstanding majority is no longer possible to be achieved. How will we stop coins from effectively losing their ability to gain consensus? Relying on exchanges can help, but over time more users will move to personal cold storage.

What will be the communication strategy to holders given that coin issuers have no record (outside of an initial ICO) for who owns their coins. Furthermore, as those change hand on the secondary market there is no record of that. If you rely only on miners, nodes and exchanges you risk concentration of power and this could run counter to the value of decentralization that is fundamental to many Blockchain projects.

Voting Blocks: This makes Blockchains more akin to public stocks where a majority stake can be purchase given the owner absolute control. This is not the intention of decentralized coins and platforms.

POTENTIAL SOLUTIONS FOR DISCUSSION:

Institute and socialize a set voting period. The EOS issues were mostly perceptual in that most holders being inexperienced thought it would be a quick 24 hour process. This is unrealistic for numerous reasons, but if the assumption is that like traditional securities there will be an extended voting period and possibly a predetermined quorum to extend the vote then it can be mitigated. Furthermore, it will stop bad and unnecessary press for projects due to lack of experience in the community regarding voting.

Is there a way to identify lost wallets to reduce them from tally without disenfranchising users? This is problematic in itself. Possibly a voting majority could be coded into the Blockchain to analyze accounts that have been unaccessed or idle for a reasonable amount of time and reduce the outstanding shares needed for a vote to be valid, but still require a majority of that adjusted number.

Can voting be integrated into all wallets to make ignoring or missing out on votes highly unlikely? This would solve the issue of needing a proxy solicitor or requiring exchanges to participate in providing records to reach wallets for voting. Could wallets implement a forward features to link an email account to voting notifications?

Blockchain Developers would be well served to not only integrate voting into the wallet, but provide links to official voting debate forums that also provide mock votes, FAQS, etc.

In regards to POS maybe a maximum limit is placed upon voting rights. Example, you may own 70% of coins outstanding, but be limited to 10% of the voting power. However, this wouldn’t stop collusion of multiple 10% holders nor an individual or entity setting up an international shell game to accumulate larger positions. Given that it isn’t absolutely necessary to connect a wallet to a traditional brokerage or bank then full ownership could be thus concealed.

TO BE CONTINUED:

I hope you all enjoyed this article as it was meant to be informative and spur discussion in the community. My potential solutions are by no means my opinion on the matter, but simply ideas for evaluation to get things started. This analysis is not meant to be comprehensive of all potential governance issues nor solutions nor can it be due to the variety of Blockchain project that can differ on about half a dozen fundamental philosophical and practical choices. Please post your thoughts below!