Tokenisation of shares in a Scottish company

Introduction

The benefits of the tokenisation of assets are well reported: enhanced liquidity, efficiency in asset management, reduction in costs and, in the context of real estate, the democratisation of investment, to name a few – as set out in detail in previous articles found here and here, for example. In its 28 July 2022 Consultation Paper on Digital Assets, the English Law Commission states that the law of England and Wales “has proven itself sufficiently resilient, flexible and iterative” in order to accommodate digital assets under English property law, but certain aspects of English law require reform. Further, its stated approach is to ensure that English law remains a “dynamic, highly competitive and flexible tool for market participants”. When it comes to digital assets and tokenisation, is Scots law similarly placed?

This Law-Now focuses on the Scots law considerations of the tokenisation of “certificated shares” (for the purposes of this Law-Now, meaning shares that are not traded through CREST) in a Scottish private limited company, taking into account the similarities and differences between Scots law and English law. In this Law-Now, references to the “tokenisation of shares” means the issue and registration of certificated shares on a blockchain (or using distributed ledger technology). That is to say, digitalisation and innovation projects, rather than cryptocurrency.

Tokenisation of Shares in an English Company

In current practice, certificated shares in an English private limited company are tokenised using a nominee structure. In this structure, a nominee entity holds legal title to the shares (the nominee entity is entered in the company’s register of members), and the investors hold the beneficial title to the shares, with ownership of that beneficial interest being recorded on a blockchain. The beneficial interest in the shares is represented by tokens, and the ability to transfer that beneficial interest is capable of being embedded in smart contracts.

Under English law, this model is referred to as a “proof of ownership” or “mirroring” model. The tokens are an additional layer to the shares. The company’s articles of association (and any shareholders’ agreement) remain in place, and the register of members records the person(s) who hold the legal title to the shares. This differs from a “native issuance” model under which the tokens are the shares, the blockchain records the ownership of the shares, and the rights attaching to the shas are embedded in smart contracts encompassing (or supplementing) the company’s articles of association (and any shareholders’ agreement).

Similarities with English law

The key provisions under the Companies Act 2006 (the “CA 2006”) relevant to tokenisation that are the same or similar for English private limited companies and Scottish private limited companies are as follows:

• the CA 2006 applies to companies incorporated in Scotland. Therefore, corporate law is largely the same in Scotland as it is in England. However, as there is no doctrine of equity under Scots law as there is under English law, property law is very different in the two legal systems;
• like English law, Scots law does not specifically provide for, or contemplate, the tokenisation of shares in a private limited company;
• in terms of the issue of certificated shares, the position is the same. The company must keep a register of its members, issue certificates, and comply with the rules on transfers of certificated shares set out in chapter 1 of Part 21 of the CA 2006;
• in terms of registration, the position is also the same. Under sections 112 to 121 of the CA 2006, a company is required to keep a register of its members and the register of members is prima facie evidence of the company’s shareholders and the information required to be maintained in it. The register of members must be available for inspection, either at its registered office or the single alternative inspection location, in either hardcopy or “electronic form” (provided that the electronic records can be reproduced in hardcopy too); and
• in terms of transfers, the position is also largely the same. Under section 770 of the CA 2006 a company may not register a transfer of shares unless a proper instrument of transfer has been delivered to it.

Differences from English law

Unititular – You Either Own It Or You Don’t

As set out above, in current practice a nominee structure is used when tokenising shares in an English private limited company. The CA 2006 requirements vis-à-vis the register of members do not require the beneficial ownership to be recorded and generally the CA 2006 does not prescribe how such ownership is recorded.

Scots property law is “unititular” meaning assets, including shares, can only have a single title of ownership: “only one title of ownership is recognised in any one thing at any one time”, Sharp v Thomson (1995 SC 455, Lord President (Hope) paragraph 469). Further, there is no doctrine of equity under Scots law as there is under English law. You either own an asset, or you don’t. Therefore, it is not possible to split the legal and beneficial interests in shares in a Scottish company in the same way it is in respect of an English company. The single title of ownership in a share in a Scottish company is held by the person that is entered in its register of members.

Therefore, it is not possible to follow the same English nominee structure under Scots law. However, this does not mean that the tokenisation of shares in a Scottish company is not possible in theory.

Express Trusts

The law of trusts in Scotland differs from that in England. A “dual patrimony” theory on the nature of trust law and express trusts in Scotland has developed. Under this dual patrimony theory, a trustee holds a trust patrimony (a so-called special patrimony) separate and distinct from their personal patrimony (their personal patrimony being all of that person’s legal rights and liabilities). As a result of the unititular nature of Scots property law, the trustee is owner of the trust assets and the beneficiary has a personal right against the trustee. Could this concept assist in the tokenisation of shares in a Scottish company?

In theory, an express trust could operate as follows:

• a company is incorporated for the purpose of holding shares that will be tokenised (similar to the English nominee structure) (the “Registered Owner”);
• the Registered Owner declares a trust in favour of the token holders as beneficiaries;
• as this is a trust in respect of the Registered Owner’s own property (the shares issued to it by the Scottish private limited company) and therefore a “truster-as-trustee trust”, this would require (1) a written declaration of trust, and (2) notice of the trust to be intimated (or notified) to the beneficiaries; and
• thereafter, the Registered Owner (as trustee) would hold the shares for the benefit of the token holders as beneficiaries. The beneficiaries would have a personal right against the trustee to perform the purposes of the trust as set out in the trust deed. The beneficiaries would also have rights against the Registered Owner for any breach of trust. In an insolvency of the Registered Owner, the trust property would be protected (as part of its special (trust) patrimony), although there are potential difficulties that the truster’s creditors may not be aware of the existence of the trust.

While the express trust structure could be considered, it would present practical difficulties in terms of scaling and frequent transfers. It is possible to designate a class of persons as beneficiaries under a private trust. This class could be the token holders relating to specific shares in a specific company. As the complete ownership and transfer history is verifiable on the blockchain and recorded indefinitely, identifying the token holders at any time would be straightforward. There would also be tax considerations relative to an express trust structure, which are not covered in this Law-Now. Further, at the time of writing, we note that the Trusts and Succession (Scotland) Bill is making its way through the Scottish Parliament (albeit the proposed changes to the law relate to the administration and management of trusts).

Rights Under Contract

Separate to the law of trusts, tokenisation could be achieved by way of contract. If tokens are recognised as property under Scots law,* then a token holder could exercise personal rights associated with its ownership of the tokens. This is similar to exercising personal rights associated with direct ownership of a (non-tokenised) share in a company, such as voting rights or the right to dividends.

This means that, if a token holder’s name is not entered in the register of members, any rights or agreement in respect of rights attaching to those shares can only be by contract; personal rights enforceable between the parties to that contract and not real rights enforceable against the world. The real rights in those shares would be held by the person entered in the register of members.

Therefore, token holders could enter into a contract with a company incorporated for the purpose of holding shares that will be tokenised. The contract entered into between the Registered Owner and the token holders would document the rights of the token holders in respect of those shares, and the tokens issued would represent or mirror these rights. The contract could be documented in a traditional written contract and/or embedded in smart contracts (assuming such contracts are valid under Scots law),* including the adoption of bespoke articles of association or entry into a shareholders’ agreement. This approach is similar to the English nominee structure.

While the law of contract may provide a more flexible approach than the law of trust, contractual rights are not insolvency remote (as there is no separate patrimony). Instead, token holders with contractual rights against the Registered Owner (as the registered holder of the shares) would, on the Registered Owner’s insolvency, rank alongside the unsecured creditors of the Registered Owner.

*In respect of the recognition of tokens as property, we assume, broadly, that the courts of Scotland would follow the approach of the courts of England and Wales in the recognition of cryptoassets as property (leaving aside considerations as to the categorisation of property). The initial cases in England focused on whether or not proprietary injunctions could be granted where cryptoassets had been stolen; these assets were recognised as property in order to provide a remedy to victims of fraud (see previous Law-Nows on this here, here and here, for example). In respect of the recognition of smart contracts, again we assume that the courts of Scotland would follow the position taken under English law that smart contracts are legally binding and enforceable contract if the existing requirements under Scots law for creation of a contract are met.

Conclusion

Government-led bodies such as the English Law Commission and the UK Jurisdiction Taskforce are undertaking ground breaking work on digital securities and digital assets. The UKJT is due to publish a legal statement on digital securities in December this year to clarify English law support for the issuance and transfer of digital securities and the types of digital security models that English law can support. The English Law Commission’s report on digital assets is also expected to be published in 2023. In Scotland, we will monitor these developments closely. There is no easy alternative in Scotland to the position in England, and the possible options outlined above have their challenges. While this Law-Now has explored the theoretical possibilities available, ideally a change in the law is required. For example, a native issuance model would address the challenges set out above, but would require amendments to the CA 2006 generally. With changes afoot in England, clarification of the position for Scotland in the world of digital assets is needed.

Article co-authored by Fiona Henderson, Bruce Harvie, and Euan Reid.