Patrick Byrne may finally get his vindication.

The CEO of Overstock.com has fought for a dozen years against amarket abuse called naked short selling, where investors bet astock will drop without first taking the required step of borrowingshares. He says it was used back in 2005 to drive down hiscompany's stock, an episode that spurred a Securities and ExchangeCommission probe and set Byrne on a crusade to improveaccountability in the system that underlies U.S. stockownership.

Finally an answer is near, thanks to Delaware. Last month, thehome state for most incorporated companies in the U.S. made itlegal for corporations to offer digital shares that would berecorded and tracked on a blockchain, the ledger that powerscryptocurrencies like bitcoin. Delaware officials hope the movewill increase ownership accountability and clarity. The new law,more than a year in the making, is also a shot across the bow forthe Depository Trust & Clearing Corp. and its little-knownpartner Cede & Co., the legal holder of the vast majority ofU.S. stocks.

“It eliminates naked short selling completely as well as otherforms of mischief,” Byrne said of Delaware's overhaul in aninterview. “If this had come along 10 years ago, I would'verecognized it as the solution.” (While defendants in lawsuits filedby Byrne eventually settled, no one was ever held liable for nakedshort selling Overstock's shares.) Overstock lawyers are currentlyworking to convert the company's shares to digital, he said. “If weget to a world of digital securities, then there isn't a need forDTC and Cede & Co. any more,” Byrne said. “It's a really hugestep in returning to clean capital markets.”

The effect digital shares could have on the $27 trillion U.S.stock market goes far beyond stopping naked shorting. What wasbugging Byrne had a lot to do with the U.S. system ofstock-certificate ownership, which he says is toxic to corporategovernance. The system dates to the late 1960s “paperwork crisis,”when Wall Street brokerages were drowning in securitiescertificates, leading to routine shutdowns of the stock market sothey could catch up. Before the advent of electronic trading, theshares investors bought and sold had to be hand-delivered bymessengers.

To modernize the system, DTCC was created as an industrywideclearinghouse to track and settle ownership. Its unit Cede &Co. became the registered owner of all U.S. shares, which dealtonly with large brokerages. Investors who don't opt out of thisarrangement only have a claim to stock through their brokerage,which in turn has a claim to what is held in Cede & Co.'s name.This is referred to as owning shares “in street name,” whileaverage investors are considered to be “beneficial owners.”

While these changes added convenience and security to how theU.S. stock market operates, they put in place a system that can'tsort out who owns which stock in real time. This can make itdifficult to track ownership, especially during mergers andbuyouts, when hundreds of millions of shares switch accounts inseconds, according to Larry Hamermesh, a Widener University lawprofessor who specializes in Delaware corporate law issues.

“The whole idea of blockchain is to allow trades to be clearedimmediately and be tagged with who the buyer and seller are,”Hamermesh said. “That solves the M&A problem.”

The Delaware Blockchain Initiative aims to change all that. Theplan, which got its start under former Gov. Jack Markell, isdesigned to weave distributed ledger technology through the fabricof the state's business and legal systems. A critical point in theplan, which he detailed at a conference in May 2016, is the abilityfor companies to issue shares on a blockchain, making them easierto track. If companies take advantage of the new system, the statecan gain tax revenue from maintaining an accurate count of how manyshares are outstanding and ease the burden on its court system.

The Delaware initiative would change nothing about how sharesare traded on the New York Stock Exchange, Nasdaq Stock Market orother U.S. markets. It would allow investors to have directownership of their shares for the first time since the early1970s.

Billions Saved

The cost savings could be huge: $100 billion is spent on annualpost-trade and securities servicing fees, according to estimatesfrom Oliver Wyman and affiliates of Santander Bank.

Cede & Co. is, perhaps predictably, not the No. 1 fan of theDelaware game plan. By creating alternative systems to track stockownership, you risk fragmenting and needlessly complicating themarket, Dan Thieke, managing director of DTCC, said in a phoneinterview.

“We would be concerned by any development that would ultimatelycreate a greater level of fragmentation,” Thieke said.

Delaware and Overstock are working on the digital share planwith Symbiont, a blockchain startup that created smart contracts tomanage events in equity ownership like dividends, additional sharesales and franchise tax payments. Smart contracts interact with ablockchain, in this case a version of the distributed ledgermodeled on the ethereum system.

Hidden Shares

Corporations must get permission from Delaware to issue acertain number of authorized shares, say 1 million, said SymbiontCEO Mark Smith. The state collects filing fees and other revenuebased on the authorized number of shares, but sometimes companiesissue additional shares that Delaware is unaware of, he said. Asmart contract eliminates that possibility.

“The smart contract manages the authorized and issued shares,”Smith said. “It's impossible to issue more than 1 million shares onthe blockchain because the smart contract has that as alimitation.” Overstock recently invested in Symbiont with thisproject in mind, Smith said. He expects companies to go publicusing the so-called “distributed ledger shares” or to convert tothem within the next six months.

The DTCC isn't sticking its head in the sand when it comes toblockchain's potential to transform central parts of the financialworld. It's a member of the Enterprise Ethereum Alliance andHyperledger, industry groups creating standards for blockchainsystems. It also offers investors the opportunity to take directownership of their shares through its direct registrationservice.

“It's an electronic way for an asset to move in and out of Cede& Co.,” DTCC's Thieke said.

Dole Foods

Still, the current system appears to have lost the confidence ofimportant Delaware officials. As the corporate home to more thanhalf of the U.S.'s publicly traded companies and 63% of Fortune 500firms, Delaware had more than 1 million legal entities incorporatedin the 900,000-resident state as of 2012. That means the majorityof corporate disputes wind up in the Delaware legal system and areoften stymied by simple questions of stock ownership and votingrights. The 2013 take-private buyout of Dole Food Co. highlightedthe difficulties in identifying who owns what shares at whattime.

Investors sued company founder and CEO David Murdock inDelaware, accusing him of shortchanging shareholders in hisacquisition of the portion of the fresh-food producer he didn'talready own. Murdock agreed to pay $148 million plus interest tosettle the suit after Delaware Chancery Court Judge Travis Lasterconcluded the billionaire improperly drove down the value of thecompany's stock to acquire it on the cheap.

When it came time to divvy up the nearly $170 million recoveryin the Dole case, however, shareholders' lawyers were leftscratching their heads. Dole investors proffered more than 49million shares as qualifying for settlement payments even thoughthe company only had 36 million authorized shares.

After reviewing the discrepancy, Laster, who declined to beinterviewed for this story, said short sales and trades in the daysbefore the Dole deal closed, along with some DTCC proceduralissues, made it difficult for the DTCC system to accuratelyidentify who held settlement-qualified shares.

The Dole case and other similarly nightmarish legal sagasapparently left Laster at the end of his tether. Speaking inSeptember 2016 at a meeting of the Council of InstitutionalInvestors in Chicago, Laster compared the Cede & Co.-basedstock ownership system to a clogged toilet.

“You need to fix the proxy plumbing,” Laster said. “The currentsystem works poorly and harms stockholders. But the currentplumbers—financial intermediaries—do not have an incentive to fixit.” He said one solution would be intervention by the SEC, butsaid top down change is hard to accomplish and takes a lot oftime.

“Someone is going to do this. If a judge can see it, theopportunity is pretty obvious,” Laster said. “The good news is thatyou have a plunger that you can use to clean up the plumbing. Thatplunger is distributed ledger technologies.”

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