Earlier this year, a rare window opened into the way the stock market currently operates when a class action lawsuit revealed that there were recently 12 million more shares of Dole Foods than the company thought existed.
The events that led up to the publication of a judge’s opinion on the matter last month, it turns out, were in many ways a symptom of the way the system was designed to operate. Via a series of rare circumstances, the lawsuit exposed its weakness in the starkest of terms.
What exactly happened, and why, still remains largely unclear. Even the presiding judge stated in his official statement that it wasn’t his problem, opting to leave the final division of the class action award up to the counterparties in the agreement.
But he did something else that was kind of extraordinary.
In the memorandum opinion dated 15th February, Delaware Chancery Court vice chancellor J Travis Laster offered a potential solution in a footnote at the bottom of the ninth page of the 16-page document: blockchain.
Specifically, Laster mentioned the US state of Delaware’s Blockchain Initiative, describing how the solution still being developed might have prevented the massive discrepancy.
Also an advocate of blockchain voting, the chancellor’s diagnosis that blockchain tech could provide “a single and comprehensive stock ownership ledger” coincides with the rapidly growing movement of many financial infrastructure providers to embrace the technology.
One of the first entrants into this burgeoning field working to move stocks to a blockchain was Overstock CEO Patrick Byrne, who in 2004 first encountered the so-called ‘slop’ in the financial system resulting from two main issues: 1) it takes three days for a trade to settle, and 2) the beneficiary of a stock rarely ever actually owns the stock, but rather an IOU.
What makes the Dole case unique, however, is that the lawsuit peeled back the metaphorical curtain that typically obscures this process, and by revealing the disorder, reignited a push by blockchain startups to bring order to the system.
Byrne describes the Dole discrepancies as an “expression” of the way the current system is “architected”, adding that without a certainty of how many stocks actually exist at any time, the price people are paying is little more than a guess at the actual value.
Blockchains, Byrne argues, both clarify who actually owns the stock, and make the time between when a stock is sold, and cleared, nearly instant.
In conversation with CoinDesk, Byrne said:
“To the extent shares get turned into blockchain shares, none of that Dole stuff can happen.”
Which brings us to Dole.
In 2013, the then-publicly listed Dole Foods was taken private by its CEO, David Murdock, at a rate of $13.50 per share to be paid out to stock owners. However, in response to a class action suit by those same stockholders (who alleged that the shares were actually worth more), the Delaware Chancery Court ordered Murdock to pay an additional $2.74 a share, with interest.
The problem was that, even after a review process revealed that some of the claims filed were false, there were about 49 million ‘facially valid’ stocks appearing to qualify for the additional funds. Dole only had a record of about 37 million shares.
One explanation for the discrepancy is the so-called ‘chill’ period instituted by the Depository Trust & Clearing Corporation (DTCC), which is the actual owner of record for most of the stocks traded in the US, even while others benefit from the dividends (as is nicely explained by Matt Levine for Bloomberg).
During a transition from a public to a private company, trades under the terms of a chill are allowed to continue, but for accounting purposes, the DTCC ignores them, possibly helping explain in the discrepancy.
Another possible explanation, in the opinion memorandum proffered by Laster, is the practice of short-selling, when stocks owned by one party are loaned to another, perhaps without their knowledge.
One of the results of such short-selling is the appearance of two legitimate owners of the stock at any given time, otherwise known as ‘phantom shares’. Careful manipulation of these shares can be very lucrative to those who know how.
“Those forces are going to fight because they want the slop to stay, because that’s their profit.”
In fact, when Byrne launched his own blockchain solution, called tØ, in October 2014, he argued that one of the main reasons for building the platform was to ensure that the actual owner of the stock benefited from any interest generated through its lending.
After years of development, the tØ platform executed its first blockchain-based stock transactions on 16th December, 2016, using a portion of Overstock’s own preferred stock options to demonstrate its functionality
But no other company has so far offered stocks on the blockchain platform and the shares currently being traded represent such light volume that, on some days, it appears that almost nothing has changed hands.
That could all change, though, if the project mentioned in Laster’s opinion letter gains traction.
Underpinned by blockchain startup Symbiont’s enterprise-grade Assembly blockchain, the Delaware Blockchain Initiative has a plan to standardize the ability for companies going public to do so on a blockchain.
Symbiont’s president and chairman of the board, Caitlin Long, described the project to CoinDesk as one that will “give the option, not the requirement” for publicly traded companies to offer their stocks on a blockchain.
“As companies register via the ledger, that means that their share issuance will happen automatically with their corporate registration,” said Long. “You will never have a separation between the beneficial owner and the record owner of securities.”
Unlike Byrne (whose own struggle against short-selling and other versions of slop in the system is widely documented), Long, a former pension fiduciary, argues that the looseness of the current financial system isn’t necessarily intended to deceive.
She explained that prior to digitization, investors for pension funds and other investment vehicles were required to allow audits that proved they owned what they said they owned.
But, as the process moved increasingly online, the speed of transactions made such audits impractical. What remains today, she argues, is simply an old system created by the DTCC to make the market more efficient.
Long described the Dole discrepancy:
“There wasn’t anything nefarious, per se, it’s just that’s the way the market works. The securities trade three days after the trade occurs and when you’re closing a merger you can’t settle today’s trades with shares that come in tomorrow.”
Exactly how much is wasted as a result of such slop is hard to quantify, in part because most of this type of confusion is resolved outside of the courts.
What distinguishes the Dole case is that only a few disputes “bubble up to the nature of this one where there’s public disclosure and litigation,” Long said. But that doesn’t mean the private costs of litigation don’t still take their toll on the system.
“It creates a lot of unintended consequences,” she said. “Aside from just the operational issues that I’m alluding to, where the system doesn’t keep perfect track.”
In addition to the armies of middle- and back-office employees that are employed by Wall Street and buy-side firms to help clean up such messes, there’s other waste in the system too.
For example, the SEC’s ‘Regulation AB’ requires that trustees must be given access to a list of stock beneficiaries, in order to ask them questions and perform other due diligence.
But such a list is almost impossible to provide as a result of the divorce between the owner of record and the actual beneficiary. As a result, cases like Dole “scare the heck out of long-only investors” with fiduciary responsibility, who can be held personally accountable to such “settlement failures”, Long said.
As part of her own personal and professional mission to help prevent similar discrepancies from occurring in the future, Long indicated she has taken two recent meetings with insurance commissioners, and that Symbiont is preparing to reveal a related project, adding:
“This is very much personally, philosophically, a problem that I would like to fix.”
While Symbiont and the State of Delaware prepare their own solution, Overstock’s is already live. But traction, so far, is far from promising.
Three months after Overstock kicked off the era of blockchain-traded stocks by raising $10.9m with a stock issuance on Medici’s tØ platform, not a single other company has followed suit.
Because the transactions are logged on a public blockchain, we can see that a particularly busy day in February saw a meager eight transactions processed.
Considering that fewer shares were offered on the blockchain when compared to those offered on Nasdaq, Medici president Jonathan Johnson said the volume is “about the level we expected.”
But he’s not shy about why he thinks the transition might be slow going. “Those that figure out how to make bad things happen, whether they’re illegal, or legal — titularly legal — they like confusion and dark places.”
Johnson called the official explanation of why the extra Dole shares existed “fishy”, and added that, if not for the legal dispute, the discrepancy would likely have continued to be exploited.
“People that had been acting nefariously in manipulating the stock, didn’t expect the sunshine of this class action suit and settlement to be put on it,” said Johnson.
“And when the lights came on, they were caught with their pants down.”
Change from within
Since Patrick Byrne first announced his intentions to build the tØ blockchain solution, however, a lot has changed.
In addition to parting ways with members of Counterparty (the team that later spawned Symbiont), the same kind of financial infrastructure providers that generated Overstock’s ire have become leaders in the space.
In particular, the DTCC, which emerged in the early 1970s to help solve the paper crisis around the increase of stock trading frequency, has proved it is still interested in evolving, and in January, announced it would move records for $11tn-worth of derivatives to a blockchain.
However, when Johnson read the Dole decision last month, he told CoinDesk it was a “clarion alarm bell” alerting him to a renewed sense of urgency.
“We kind of feel like Jonas Salk,” said Johnson. “We’ve injected ourselves with the polio vaccine and it worked. Bad things did not happen.”
“Now, the key is getting others to see the benefits of that polio vaccine. It doesn’t have a downside, and once there’s greater adoption, then I think it becomes easier and easier for more people to join.”