Why Using a Transfer Agent is a Critical Component for Truly Compliant Digital Securities Offerings

And not just because they’re required for Regulation A+ offerings…

By Vanessa Malone

Key Points:

• Blockchain technology may not eliminate third-parties from a digital securities offering, but it will definitely evolve them
• Regulators have hinted that the blockchain is not a valid source of truth, making the use of a transfer agent crucial
• Technology can be used to provide the necessary digital securities custody tools to transfer agents

Take out the word “digital” in digital securities offering and you’re left with good old fashioned securities. These come with all the laws, regulations and nuances that come along with them.

While blockchain technology may someday have the ability to remove some intermediaries involved in a traditional securities offering, we don’t anticipate them going away anytime soon. What we do anticipate is the roles of these market participants adapting to accommodate the new age of securities.

One of these market participants that play a critical part now, and who will inevitably play a critical role in the future of digital securities offerings are transfer agents. But what do they do, and what does their role look like when blockchain is involved?

First, the role of transfer agents prior to digital securities:

Summarizing from the SEC, transfer agents perform three main functions:

1. Keep secure records of who owns a company’s stocks and bonds, how much is owned, and how they’re held.
2. Act as an intermediary for a company. This includes serving as a paying agent to pay out dividends, cash, or other distributions to shareholders, sending out annual reports and sending proxy information for shareholders to vote.
3. Handle lost, destroyed, or stolen certificates.

But wait, why are they necessary for digital securities?

I know what you’re thinking: smart contracts on the blockchain can be programmed to accomplish the majority of these things in a decentralized manner, why use a transfer agent?

Sure, the blockchain could end up replacing various aspects of what a transfer agent does. Yet in today’s regulatory landscape, the ball is still in the SEC’s court, and for those who want to play, you have to stay in line with SEC rules. This is leading issuers who wish to conduct digital securities offerings to pursue Rule 506(c) of Regulation D — typically alongside Regulation S to allow foreign investment — and Regulation A+.

For Rule 506(c) of Regulation D

To date, all compliant digital securities offerings have been conducted utilizing Rule 506(c) of Regulation D, which notably doesn’t require the use of a transfer agent.

But recently, the SEC has hinted that the blockchain is not a recognized source of truth when it comes to shares ownership, which is where the use of a transfer agent comes in handy.

Regulators already recognize transfer agents as “good control” locations and valid sources of truth when it comes to maintaining the identities and ownership of shares. They’ve been doing it for years.

In addition to providing the SEC peace of mind, using a transfer agent here also greatly expands the capabilities of digital securities, which we get into a little further down.

For Regulation A+

The industry is working hard to reach a key milestone this year with issuers attempting to become the first Regulation A+ (Reg A+) digital securities offering to be qualified by the SEC. With Reg A+, a transfer agent’s role is already solidified.

The SEC mandates that issuers conducting a Tier ll offering under Reg A+ must engage the services of a stock transfer agent who is registered with the SEC as outlined in Section 17A of the Exchange Act unless 12(g) exempt.

As we discussed in a previous blog which considered whether Blockstack’s Regulation A+ filing will be approved or not, a section 12(g) exemption is very difficult to accomplish as it requires an offering to have less than 500 non-accredited investors, less than 2000 investors of all levels, and for the company conducting the offering to have less than $10M in assets on its balance sheet.

As the nature of a Regulation A+ offering attracts high volumes of investors with low investment minimums, it’s easy to see why that may not work out.

Thus, in both Reg A+ and Reg D DSOs, the role of a transfer agent stays relevant and necessary.

Now, what do transfer agents roles look like when paired with blockchain technology?

This is where we are forced to add a shameless plug because until recently, the tools necessary for a transfer agent to expand their services to custody digital securities didn’t exist.

Globex created Custodyware, what we believe to be the first regulatory compliant product for U.S. transfer agents to custody and manage digital securities on behalf of their clients pursuant to an SEC-registered or a registration-exempt digital securities offering.

The Custodyware portal integrates with ERC-20 issuances and supports all major transfer agent functions including issuance, custody, transfer, query, reporting, affiliates, and release. For example, Vstock, a leading registrar and SEC-registered transfer agent, licenses Custodyware to expand their business into digital securities.

The goal here was to provide transfer agents with the tools necessary to fulfill the same role for digital securities as they do for traditional securities while enhancing capabilities, investor protection, and transparency

Here’s how transfer agents’ three main functions evolve as it pertains to digital securities using Custodyware:

1. The transfer agent still maintains the records of ownership and good control location in order to keep regulators happy and to act a paying agent for distributions. All transactions are signed by the transfer agent and are transparently and immutably stored on the Ethereum blockchain. This adds an additional layer of protection and transparency for investors and issuers, as anyone can view the public ledger at any time.
2. The transfer agent can perform legend lifts. While smart contracts can be programmed to automatically lift legends, this gets tricky when you’re dealing with multiple holding periods, affiliates, etc. For example, if a holder becomes the CEO of the issuer (e.g. an affiliate who is now restricted from “insider” trading in the security), the issuer could be forced to burn the holder’s digital securities, reprogram with the new restrictions and issue a new token. With Custodyware, the issuer can simply notify the transfer agent and the transfer agent can input the CEO’s KYC’d wallet ID into the Custodyware portal and apply relevant affiliate status restrictions on the securities in that wallet. This approach puts control in the hands of properly SEC regulated transfer agents instead of developers or CEOs, thereby adding investor protection.
3. Handle lost, destroyed, or stolen certificates. Typically, if an investor loses their private key to a wallet, there isn’t a third party an investor can go to for a new password. Using a transfer agent makes it possible to return digital securities. Another item that’s important here is escheatment, the legal process of re-allocating unclaimed or abandoned property. For example, if someone passes away and wished to pass down their digital securities to a relative, this would be possible using a transfer agent and the Custodyware portal.

Final notes:

One critical issue in the ICO-era came from the lack of responsibility anyone had when something went wrong. I think we can all agree that there needs to be an appropriate level of regulation and a significant level of investor protection as it pertains to digital securities.

When utilizing transfer agents, the cryptographic assets remain the property of the investor, which is signed and immutable via a blockchain transaction, but the transfer agent is able to securely and compliantly manage an investor’s holding.

It’s clear that blockchain technology will evolve the way we issue, manage, and trade securities. We’re under the impression that traditional financial market participants will not disappear, merely evolve alongside it.

To learn more about our proprietary software solutions for the compliant issuance and secondary trading of digital securities, please visit us at https://horizon-globex.com/.