The movement towards the Direct Registration System (“DRS”) has been a key initiative of the securities industry for more than a decade. DRS is a service that enables companies to issue shares in book-entry form. Public companies listed on the NYSE, NASDAQ, and AMEX must ensure their shares are eligible for DRS by Jan. 1, 2008. Knowing the conceptual background, potential advantages, and eligibility considerations are critical for companies approaching DRS.
The traditional notion of corporate ownership is denoted by physical certificates of stock. Since the late 1960s, public company equity ownership has shifted to an indirect holding system through which investors hold shares in “street-name” registration on the books of broker-dealers and banks. The actual shares beneficially owned by street name investors are deposited with a securities depository. The Depository Trust Company (“DTC”) dominates this industry and its nominee, Cede & Co., is the recordholder of most publicly traded securities in the United States.
DRS is an alternative to street-name ownership designed to reduce the transactional burdens of stock certificates. Modeled after systems used by mutual funds and in company dividend reinvestment and stock purchase programs, DRS allows shareholders who do not want stock certificates to register their shares directly through a book-entry system. Currently, the only DRS program is operated by DTC and is known as “DRS Profile.” In place of brokerage communications, DRS record shareholders receive a statement of ownership and periodic account statements, dividends, annual reports, proxies, and other mailings directly from the issuer. Many shareholders are content to continue familiar street name beneficial ownership. Holding in DRS, however, still enables shareholders to readily sell by notifying the transfer agent to electronically move shares to a brokerage.
An uncertificated trading mechanism such as DRS assists the Securities and Exchange Commission, stock exchanges, and transfer agents in promoting efficient markets by faster and more secure clearance and settlement. In turn, DRS is advantageous to both companies and shareholders through:
- reduced printing and delivery costs associated with creating and transferring stock, including corporate actions such as mergers and splits;
- minimized risks and replacement costs of lost or stolen certificates; and
- greater speed and ability to process shareholder inquiries and deliver shareholder communications.
Given the advantages of DRS, stock exchanges since the mid-1990s have permitted listed companies to issue uncertificated shares, provided they are DRS eligible. This permissibility shifted to mandatory DRS eligibility for newly listed shares starting in 2007, and all listed shares starting in 2008. There is no similar mandate for companies on the OTC Bulletin Board or Pink Sheets, yet companies with shares traded there may opt for compliance to facilitate transactions or future migration to an exchange.
Significantly, the exchange rules for DRS eligibility do not necessitate that companies eliminate certificates. Shareholders who prefer to maintain ownership by means of physical stock may continue, provided doing so is permitted by state law and company bylaws. In this vein, beyond avoiding the expenses, risks, and delays associated with physical stock, DRS sets the stage for companies to move to dematerialization—the reduction and eventual elimination of stock certificates.
To ensure shares are eligible for DRS, the key legal consideration is a review of company bylaws. Generally, although they need not explicitly permit the issuance of shares in uncertificated form, the bylaws must not mandate the issuance or transfer of shares in certificated form. State corporate laws generally permit book-entry shares and, thereby by extension, uncertificated shares. In particular, Delaware amended Section 158 of its General Corporation Law in 2005 to specifically permit the issuance of uncertificated shares. While Delaware further permits the elimination of all certificates, some states still empower shareholders to demand physical certificates. Therefore, companies should exercise caution moving beyond basic DRS eligibility to full dematerialization. Of note, for negotiability purposes, all states have adopted some form of UCC Article 8 governing the establishment and transfer of rights in uncertificated securities.
As a practical matter, DRS eligibility necessitates companies utilize a transfer agent that satisfies the insurance and connectivity requirements for DTC’s DRS Profile. Not all transfer agents qualify. Coordination with a qualifying transfer agent is essential to meet advance notice standards and technical provisions such as participation in DTC’s Fast Automated Transfer Program (“FAST”). Finally, companies should be prepared to mail book-entry statements to DRS-registered owners at least once a year. In the long run, public companies stand to benefit by carefully approaching the DTC, stock exchange, and legal standards governing DRS.