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“We broke the essence of what blockchain is all about”: StartEngine Unveils ERC-1450 Security Token Standard

StartEngine unveiled its ERC-1450 token standard at the StartEngine Summit, which took place October 19 at the Fairmont Miramar Hotel and Bungalows in Santa Monica, California.

CEO Howard Marks spoke to the press about the announcement from Santa Monica’s Halloween-themed Bungalow Cocktail Bar, a small maze of retro-style and surf-themed rooms, a billiard table and table tennis on the patio.

This particular afternoon, however, the Bungalow served as an upscale venue with a view of the Pacific from Ocean and Wilshire Blvd. The revellers from the night before were nowhere in sight. On the walls are the sorts of framed pictures (of Bob Dylan and Patti Smith and Jimi Hendrix) unbefitting for most fintech conferences. One picture hangs over the press corps, while Mr. Marks speaks, and reads:

Circle Jerks

Bad Brains

Circle One

Public Nuisance

CSUN  – North Campus

$7.50

Mr. Marks says in thirty days his company will have issued the only smart contract with thousands of real shareholders. LDGR, a decentralized application for logging transactions in Regulations CF, D506(c) and A securities (and also designed by StartEngine), will be the first application to use the new, law-abiding standard. StartEngine will give shareholders their smart contract address via email.

“They can look it up with a link that they own fifty shares with Start Engine,” he said. “It will be all on the blockchain.”

Holders will be able to check their balance using any block explorer, and the new standard is compatible with ERC-20. The first 3,500 holders are StartEngine shareholders through StartEngine’s $4.9 million Reg A+, which closed in June this year. They won’t be able to trade until StartEngine’s regulated trading platform is available (It is currently pending SEC and FINRA registration).

The company has designed the standard based on open-source principals, but not decentralized ones. “We did something a little radical,” said Mr. Marks. “All the other smart contracts are trying to replicate regulation inside the smart contract’s logic, but the way the security rules work are complicated. Rule 144, for example. If you own shares in a company, are a 10% owner or an officer, you have restrictions as how you can sell, but [blockchain developers] can’t build [this] in, because they need to know what the float looks like. Even if the smart contract says the trade is good, it still could be in violation of Rule 144.”

He adds: “There are lots of other rules, including each state’s own rules: Can you solicit, can you not solicit? Are you trading between CA and TX? If you are a broker-dealer, you know these rules. You have lawyers who advise, write exemptions.”

To work around this complexity, StartEngine decided its smart contract would do nothing. An ERC-1450 smart contract instead simply represents a digital share.

“So, imagine a stock certificate,” says Mr. Marks. “Those beautiful railroad certificates you put on the wall –  they represent your ownership. If your dog ate that stock certificate you go to the company, sign a sworn affidavit, and they reissue a new one.” Then the marketplace got smart, he says. It needed to trade fast.

“So, now, they take shares and put it in their name, and you’re then the beneficiary,” explained Mr. Marks. “Recently, share issuances became book entries. [Holders] are in a transfer agent’s or company’s books, which is even more virtual than before.”

He wondered: Why not create this digitally on the blockchain? “Instead of on a wall it’s on a blockchain. The general public can then see how many shares are out there in a company, when new shares are issued, when someone trades, etc. They can see from birth to trade to trade to trade.” It’s immutable and its trustless, too.

“But…” he pauses, adding a bit of drama. “It’s not decentralized, because none of that issuance and trading can happen until the broker-dealer approves it. So, in a way, we broke the essence of what blockchain is all about, which is decentralization, and made it commercially viable, because it can follow every regulation. You have to use a broker-dealer.”

StartEngine CTO John Shiple notes that decentralized blockchains make it difficult to know whom to trust in the network. ERC-1450 solves this by entrusting a registered transfer agent with the authority to take equity from a company and give it to initial investors.  

“If you lose your private key or you get hacked because you’re human, we just reissue it for you,” says Mr. Marks. “That is weird, but its important, because [the US] was built on people’s assets, not concepts. You own a house, you don’t lose your house. The idea that, if you have the ownership share, you lose everything because you made a mistake is untenable. We are not hackable, if you hack us, we just [set] it back. What is the incentive if you hack the system, then?”

The smart contract can mint and burn accordingly. “If someone sells ten shares and only have five left, we burn the five they sold, and then someone else is minted the five they are to receive. And it works because there is a trusted source – a broker-dealer.”

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