Fixing The Stock Market's 'Clogged Toilet' Starts In Delaware

Patrick Byrne may finally get his vindication.

The chief executive officer of Overstock.com Inc. has fought for a dozen years against a market abuse called naked short selling, where investors bet a stock will drop without first taking the required step of borrowing shares. He says it was used back in 2005 to drive down his company’s stock, an episode that spurred a Securities and Exchange Commission probe and set Byrne on a crusade to improve accountability in the system that underlies U.S. stock ownership.

Finally an answer is near, thanks to Delaware. Last month, the home state for most incorporated companies in the U.S. made it legal for corporations to offer digital shares that would be recorded and tracked on a blockchain, the ledger that powers cryptocurrencies like bitcoin. Delaware officials hope the move will increase ownership accountability and clarity. The new law, more than a year in the making, is also a shot across the bow for the Depository Trust & Clearing Corp. and its little-known partner Cede & Co., the legal holder of the vast majority of U.S. stocks.

“It eliminates naked short selling completely as well as other forms of mischief,” Byrne said of Delaware’s overhaul in an interview. “If this had come along 10 years ago, I would’ve recognized it as the solution.” (While defendants in lawsuits filed by Byrne eventually settled, no one was ever held liable for naked short selling Overstock’s shares.) Overstock lawyers are currently working to convert the company’s shares to digital, he said. “If we get to a world of digital securities, then there isn’t a need for DTC and Cede & Co. any more,” Byrne said. “It’s a really huge step in returning to clean capital markets.”

Paperwork Crisis

The effect digital shares could have on the $27 trillion U.S. stock market goes far beyond stopping naked shorting. What was bugging Byrne had a lot to do with the U.S. system of stock-certificate ownership that he says is toxic to corporate governance. The system dates to the late 1960s “paperwork crisis,” when Wall Street brokerages were drowning in securities certificates, leading to routine shutdowns of the stock market so they could catch up. Before the advent of electronic trading, the shares investors bought and sold had to be hand-delivered by messengers.

To modernize the system, DTCC was created as an industrywide clearinghouse to track and settle ownership. Its unit Cede & Co. became the registered owner of all U.S. shares, which dealt only with large brokerages. Investors who don’t opt out of this arrangement 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,” while average investors are considered to be “beneficial owners.”

Takeover Confusion

While these changes added convenience and security to how the U.S. stock market operates, they put in place a system that can’t sort out who owns which stock in real time. This can make it difficult to track ownership, especially during mergers and buyouts, when hundreds of millions of shares switch accounts in seconds, according to Larry Hamermesh, a Widener University law professor who specializes in Delaware corporate law issues.

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