The Caveats of Whitelisting
A transfer restriction of the shares of a company is often equated with greater control. In the case of tokenized shares, it is possible to restrict the transfer of shares and the associated rights at two different levels. First, the transfer can be restricted at the blockchain level by requiring every recipient address of share tokens to be explicitely whitelisted by the issuer. In this case, a buyer of a share must contact the issuer in advance and have their own address whitelisted. Second, a transfer restriction can be implemented on the level of the shareholder registry, allowing the company to refuse to recognize a token holder as a shareholder. In this case, the shareholder rights will stick with the previous token holder until a new shareholder is recognized.
Even though a white-listing at the blockchain level enables an issuer to arbitrarily refuse transfers, the issuer is not legally allowed to do so and must approve all transfers that fulfill the criteria outlined in the articles of association. Pursuant to Art. 685b para. 1 OR, the company can only refuse a transfer if it (a) names an important reason as specified in the articles of association or (b) if it offers the seller of the shares to buy the shares at their real value (the market price).
Pros and Cons of Whitelisting
Whitelisting represents a significant restriction on the tradability of a company’s shares. Especially in the case of shares traded on stock exchanges, whitelisting usually makes little sense, since the purpose of listing shares on a stock exchange is to boost trading in the respective shares. Consequently, the case is similar for “private” companies wishing to offer their shares on a secondary market.
Pros of Whitelisting
- Control: Better control over the composition of the shareholder base.
- No undesirable shareholders: Rejection of strategically undesirable shareholders, such as: owners or employees of competing companies; foreigners from countries that cause a conflict with applicable laws; or purchase of shares from members of a political party (as a famous example, the Swiss newspaper NZZ only recognizes shareholders with a liberal political view).
- Theft protection: In the case of tokenized shares, a transfer restriction can protect against share theft by hackers.
On the other hand, share restriction comes with some drawbacks, especially when the restriction is implemented at the blockchain level in the case of tokenized shares.
Cons of Whitelisting
- Limited scalability: Every approval of a new address requires a human intervention by the issuer, limiting the token to use cases with a limited circle of token holders.
- Higher costs: A smart contract with whitelisting function has a higher complexity than a smart contract without. Higher complexity comes with higher transaction costs, especially when the token supports adjustable transfer restrictions such as the ERC-1404 standard. While a minimally implemented blacklist such as that found in USDC only increases transaction costs by about 5% in comparison to those of the USDT, a more flexible implementation like that proposed in ERC-1404 increases transaction costs by up to 200%. That is also one of the reasons why the minimal ERC-20 standard is still the “king of the hill” and the more feature-rich standards struggle to find adoption.
- Transaction slowdown: Manual review and approvals partially or even completely prevent the automation of stock trading.
- Time delay of the trades: Due to the manual verification step, the trades are executed with a time delay. Depending on the duration, the share price may change in the meantime or other circumstances may develop to the disadvantage of the investor and/or the company.
- Limitation of the free float: A manual release of share transfers is hardly compatible with the concept of the “free float” of shares. The potentially increased liquidity of freely tradable shares is greatly reduced by the release process of a whitelisting. The additional value of the increased liquidity of a tradable share is thus severely limited.
- Significantly lower share price: Transfer restrictions cause shares to be traded at a significant discount in the stock market in comparison to the same freely transferrable shares. See also the Nestlé example at the end of this post.
Thus, it is clear that whitelisting greatly reduces the efficiency of stock trading. Especially if the transfer restrictions are implemented at the smart contract level, because then not only additional manual steps are incurred, but also additional transaction costs of the blockchain.
How less inefficient whitelisting is implemented
If a private company decides to offer part of its shares on a secondary market in order to benefit from the positive effect of the free float, we generally advise against a transfer restriction on this part of the shares. Since liquid assets are much more valuable to investors than illiquid ones, the free float increases the value of these shares and thus the value of the entire company (more on Free Float). A restriction on the transferability of these shares prevents the effect of the free float from unfolding.
However, if a client decides to do so, we are happy to offer assistance with implementation. That said, we always recommend implementing the more efficient variant of whitelisting at the shareholder registry level instead of a whitelisting at the smart contract level. Also, contractual transfer restrictions (for example, a lockup) can be mapped more flexibly via secondary registers (e.g. the shareholder registry). The simpler the main register is kept, the lower the transaction fees in the Ethereum system and the better the token can be integrated into the blockchain ecosystem. For example, many decentralized exchanges reject tokens that are subject to whitelisting or similar restrictions.
In practice, whitelisting at the share register level looks as follows:
- The general assembly defines what constitutes “important reasons” for refusing the recognition of a shareholder.
- Having a freely transferrable token without whitelisting. Legally, the smart contract represents the “Wertrechteregister” (securities registry), which is distinct from the “Aktienbuch” (share registry).
- Only accept those tokens holders into the shareholder registry that fulfill the criteria that the general assembly has put into the articles of association.
This mode of transfer restrictions closely resembles the traditional way of how this was handled with paper-based registered shares. With paper-based registered shares, the issuer cannot prevent a shareholder from handing over the paper to a new person, but it can refuse to recognize the transfer, thereby causing all the shareholder rights to be stuck with the old holder until a new shareholder is recognized.
Unbelievable Economic Impact
The question every issuer has to ask themselves is: are the transfer restrictions worth the economic harm they impose? It is a general economic wisdom that free and open markets create a lot of value for everyone, and that consequently, all frictions in transferrability of an asset reduce that value. In order to quantify that value, let us have a look at a concrete example of a big company that for a long time had both freely transferrable shares and restricted shares traded on the stock market.
That company is Nestlé, one of the oldest and biggest Swiss companies, listed on the stock market since 1873. Until 1992, it had two classes of shares with two distinct tickers, NESI (“Nestlé Inhaber”) and NESN (“Nestlé Namen”). They both represented the same share in the capital, and came with the same voting and dividend rights. The only difference was their transferrability, with NESN requiring a registration in the shareholder registry, and NESI being freely transferrable. Note that this is not about staying anonymous or hiding wealth, as shareholders had to identify themselves with their banks anyway in order to be able to trade on the stock market.
Without knowing more, one could have expected a difference of perhaps 5%, similar to the difference between GOOG and GOOGL, which differ in voting rights only. However, looking at the historic data, that difference is actually 50% to 100%! For example, by the end of 1987, NESI traded at 7.90 CHF whereas NESN traded at 3.95 CHF, a markup of 100%. Only after it became clear that both types would be merged into one type, prices started to match each other. This demonstrates how valuable free transferrability is and that companies should think twice about transfer restrictions. They are much more expensive than one might think.