Electronic Chattel Paper

Initially, the drafters set a high technological threshold for showing control of electronic chattel paper. Lenders subsequently began to implement the necessary infrastructure modifications in an effort to meet the guidelines. However, the 2008 financial crisis slowed the adoption and implementation of electronic chattel paper. The economic recovery, and the 2010 amendments to Article 9 that lowered the technological threshold requirements, have opened doors to the adoption of paperless transactions in numerous commercial and consumer contexts.

The use of electronic chattel paper, which presents potential benefits to lenders by reducing costs and increasing the speed of administrative processes, and which could ultimately lower the cost of securitizing loans and leases, is not a passing fad. Key factors driving the trend toward the increased implementation of electronic chattel paper include:

1. Increased awareness of technology by users;
2. Movement to secure cloud-based storage systems;
3. The proliferation of complex mobile devices;
4. Heightened security, and compliance obligations and requirements;
5. The sheer speed at which business transactions move; and
6. Increased flexibility in the way transactions are memorialized.

Ultimately, it is inevitable that more commercial and consumer transactions will be managed in an electronic and paperless format. What this means for counsel to lenders is that electronic chattel paper is here to stay. Thus, awareness and understanding of how to obtain and maintain perfection of security interests in electronic chattel paper will become increasingly important.

Tangible Chattel Paper

The UCC generally defines chattel paper as a record or records evidencing both:

1. A monetary obligation; and
2. A security interest in or a lease of specific goods.

See UCC ' 9-102(a)(11).

For tangible chattel paper, an assignee can perfect its interest by:

1. Filing a UCC Financing Statement; or
2. Possession of the tangible chattel paper.

See UCC ” 9-312(a) and 9-313(a).

Perfection by filing is often impractical and ineffective as a means to protect a lender's interest because of the difficulties in establishing priority. A purchaser of chattel paper wants to ensure that its ownership rights are superior to any other. To establish first priority by filing, however, a lender would have to file before all other competing claimants, including any blanket or floor plan financiers. Difficulties arise as generators of chattel paper may have one or more blanket lenders and they may generally wish to sell paper to more than one finance source.

Accommodating multiple financing sources would require an unmanageable and complex set of inter-creditor agreements addressing priority in an often changing environment and revolving cast of characters. To address the issue, UCC Article 9 gives first priority to parties who purchase chattel paper in the ordinary course of the purchaser's business if the purchaser:

1. Gave new value; and
2. Perfected its interest by taking possession of the chattel paper.

See UCC ' 9-330.

Electronic Chattel Paper

Electronic chattel paper is simply chattel paper that is evidenced by a record or records consisting of information stored in an electronic medium. See UCC ' 9-102(a)(31).

For electronic chattel paper, an assignee can perfect its interest by:

1. Filing a UCC Financing Statement; or
2. Obtaining control of the electronic chattel paper.

See UCC ” 9-312(a) and 9-105.

Perfection of electronic chattel paper via a UCC Financing Statement is plagued by the same uncertainly and ineffectiveness as perfection of tangible chattel paper in that manner. However, because a purchaser cannot take “possession” of electronic chattel paper, perfection by control represents the UCC Article 9 drafters' attempt to replicate the essential attributes of possession in order to obtain special priority.

Requirements for Control

An assignee has control of electronic chattel paper if a business management system employed for evidencing the transfer of interest reliability establishes the assignee as the person to which the chattel paper was assigned. See UCC ' 9-105(a). That standard is arguably met if the authoritative copy of the record or records comprising the chattel paper is created, stored, and assigned in a manner such that:

1. A single authoritative copy of the record or records exists that is unique, identifiable, and, except as provided in paragraphs (4), (5), and (6), unalterable;
2. The authoritative copy identifies the secured party as the assignee of the record or records;
3. The authoritative copy is communicated to and maintained by the secured party or its designated custodian;
4. Copies or revisions that add or change an identified assignee of the authoritative copy can be made only with the participation of the secured party;
5. Each copy of the authoritative copy is readily identifiable as a non-authoritative copy; and
6. Any revision of the authoritative copy is readily identifiable as an authorized or unauthorized revision.

Id. at ' 9-105(b).

The technological sophistication necessary to establish that a party is in control of electronic chattel paper consists of forcing a computer system to reproduce all of the relevant functional attributes of tangible chattel paper. Although this process may be technologically difficult, conceptually it means that if a certain set of bits and bytes comprising an electronic document has an audit trail created around it that captures all of the modifications of those bits and bytes, the electronic document will be treated the same as paper records for purposes of the UCC.

Challenges

The drafters of UCC ' 9-105 explicitly state in their official comments that they did not intend to create more stringent standards for control of electronic chattel paper than existed for possession of tangible chattel paper. However, they did create some significant challenges in that the drafters did not advise as to how to go about complying with the criteria set forth in UCC ' 9-105.

For example, no guidance is provided stating that if a lender completes certain specific tasks, it meets the required criteria. Instead, such guidance has largely been left to the marketplace to determine best practices. There is also little case law, or even additional revisions or comments to UCC 9-105 to offer help.

In addition, challenges abound for those developing the appropriate control systems. Indeed, it can be very difficult to identify any one electronic copy of a document as being the “original” because computers can generate an unlimited number of perfect copies of a document instantly. Also, electronic documents can be transmitted numerous times across a number of information systems thereby creating additional copies that could be identical in appearance to the “original.”

Further, although computers are designed to create a representation of data that appears to a user to mirror a paper document, that data is actually numerous separate bits and bytes of data stored in many different places on a computer hard drive. The computer knows the location of all of the bits and bytes associated with a particular document, so when viewed, all of the bits and bytes are assembled in order to present a coherent image to the user. Thus, it is difficult for business information systems to meet the “single, authoritative copy” requirement without a substantial change in process.

Potential Solutions

The requirements for control under UCC ' 9-105 are similar to the safe-harbor requirements for “transferrable records” under the Uniform Electronic Transactions Act (UETA) (section 16) and the Electronic Signatures in Global and National Commerce Act (ESIGN) (section 201). To date, the UETA has been adopted by 47 states. California enacted some notable exceptions to the model law and Washington, Illinois and New York apply their own state laws that generally conform to UETA. Federal ESIGN legislation preempts all state laws to the extent of any conflict.

There has been little case law interpreting UETA and ESIGN, but the pattern that has emerged from the few reported decisions available indicates that the reliability, integrity and authenticity of the business management system employed to memorialize and maintain the electronic transaction is key to meeting the requirements imposed.

The linchpin management system that has emerged to establish ironclad protection and maintenance of electronic chattel paper is electronic vaulting, either on its own or as part of a third-party system. Already in use for some time in a variety of business lines, electronic vaulting has generally been accepted as affording the necessary protections to securely manage electronically originated documents in a manner consistent with UCC ' 9-105.

Key to inside and outside legal counsel, electronic vaulting has been accepted by insurers and ratings agencies that support various secondary market transactions as meeting their requirements for securitization of electronic chattel paper on the secondary market. However, it is important to note that users of the business management system must know how to use it correctly so they can testify and authenticate the records if necessary.

The process generally involves parties to a transaction signing the documents electronically, either in person using an electronic signature pad or other signing device, or via the internet using their computer or mobile device by logging into a secure portal and applying their electronic signatures. Once the signatures are applied, the documents are instantly deposited in an electronic vault, which establishes the “authoritative copy” set forth in UCC ' 9-105. The documents are held and managed in the electronic vault and can be controlled or accessed only by the authorized parties.

Once electronically vaulted, all activities and functions affecting the documents are controlled and logged by the electronic vault. Such activities and functions include print, copy or view requests, generating legally admissible copies for use in court, transferring the “authoritative copy” to another vault, and the ability to export the data to paper.

A robust and properly maintained electronic vault must generally perform the following functions to meet the requirements imposed pursuant to UCC ' 9-105:

1. Protect, encrypt and time-date stamp the electronic records and wrap them in a virtual “tamper-evident seal” that will instantly identify and reject any changes to the record post execution;
2. Grant and maintain privileged access rights to the party in control;
3. Maintain an extensive audit trail on the records, tracking access to the records, the number of copies made and by whom, any transfer of location of the records, and any transfer of location of the records;
4. Perform regular integrity checks on the records to ensure that no alteration or degradation of the bits and bytes have occurred since execution; and
5. Recognize a method to destroy the electronic records after predetermined periods or status changes, while also providing the ability to create a paper document that will thereafter be recognized as the “original.”

Conclusion

The dearth of established legal authority concerning electronic chattel paper certainly impacts how comfortable legal counsel may be with early adoption of the technology, particularly due to the scarcity of tangible paper evidence that results if the systems are properly employed. However, there is little question that the market appetite for paperless and electronic commercial and consumer transactions is insatiable and that the movement is toward the implementation of electronic transactions and the use of electronic chattel paper. Those who have already adopted it report that is has streamlined the lending process, increased efficiency, decreased opportunities for errors in execution by lessees, borrowers and guarantors, and generated cost savings. There is no doubt that increasingly more finance transactions will be conducted in this manner going forward.

Benjamin J. Court is an attorney with Messerli & Kramer P.A. in Minneapolis. His practice focuses on equipment leasing and structured finance transactions and bankruptcy matters for banks, private lenders, equipment finance organizations, creditors and more. Reach him at [email protected]. The author gratefully acknowledges the assistance of Barry Marks and Matt Evans of Marks & Associates, P.C., in the preparation of this article.

Traditional or tangible chattel paper has long been used to finance equipment purchases. One of the significant benefits bestowed upon chattel paper financers is the ability to perfect a security interest via possession, and in so doing potentially achieve priority over pre-existing secured lenders who perfected by filing a UCC Financing Statement. This system generally worked well, and trillions of dollars have been financed in this manner.

In 1999, provisions of Article 9 of the UCC relating to secured lending were updated to permit the creation of “electronic chattel paper.” Electronic chattel paper is essentially chattel paper evidenced by records existing electronically (i.e., a file on a computer). It is distinguished from tangible chattel paper in that electronic chattel paper is not actually paper at all. Electronic chattel paper also is not tangible chattel paper merely executed via electronic signatures or tangible chattel paper converted to electronic form via a facsimile machine or scanner. Instead, and as explained in more detail below, electronic chattel paper is data that memorializes the original record of a financing transaction and that exists and is stored in a secure electronic medium.

Due to the inherent difficulties in “possessing” electronic data, the UCC revisions, in part, defined a new form of control over electronic chattel paper that would be treated as equivalent to possession of tangible chattel paper. In concept, this would permit chattel paper financiers to retain their priority with electronic documents.

Initially, the drafters set a high technological threshold for showing control of electronic chattel paper. Lenders subsequently began to implement the necessary infrastructure modifications in an effort to meet the guidelines. However, the 2008 financial crisis slowed the adoption and implementation of electronic chattel paper. The economic recovery, and the 2010 amendments to Article 9 that lowered the technological threshold requirements, have opened doors to the adoption of paperless transactions in numerous commercial and consumer contexts.

The use of electronic chattel paper, which presents potential benefits to lenders by reducing costs and increasing the speed of administrative processes, and which could ultimately lower the cost of securitizing loans and leases, is not a passing fad. Key factors driving the trend toward the increased implementation of electronic chattel paper include:

1. Increased awareness of technology by users;
2. Movement to secure cloud-based storage systems;
3. The proliferation of complex mobile devices;
4. Heightened security, and compliance obligations and requirements;
5. The sheer speed at which business transactions move; and
6. Increased flexibility in the way transactions are memorialized.

Ultimately, it is inevitable that more commercial and consumer transactions will be managed in an electronic and paperless format. What this means for counsel to lenders is that electronic chattel paper is here to stay. Thus, awareness and understanding of how to obtain and maintain perfection of security interests in electronic chattel paper will become increasingly important.

Tangible Chattel Paper

The UCC generally defines chattel paper as a record or records evidencing both:

1. A monetary obligation; and
2. A security interest in or a lease of specific goods.

See UCC ' 9-102(a)(11).

For tangible chattel paper, an assignee can perfect its interest by:

1. Filing a UCC Financing Statement; or
2. Possession of the tangible chattel paper.

See UCC ” 9-312(a) and 9-313(a).

Perfection by filing is often impractical and ineffective as a means to protect a lender's interest because of the difficulties in establishing priority. A purchaser of chattel paper wants to ensure that its ownership rights are superior to any other. To establish first priority by filing, however, a lender would have to file before all other competing claimants, including any blanket or floor plan financiers. Difficulties arise as generators of chattel paper may have one or more blanket lenders and they may generally wish to sell paper to more than one finance source.

Accommodating multiple financing sources would require an unmanageable and complex set of inter-creditor agreements addressing priority in an often changing environment and revolving cast of characters. To address the issue, UCC Article 9 gives first priority to parties who purchase chattel paper in the ordinary course of the purchaser's business if the purchaser:

1. Gave new value; and
2. Perfected its interest by taking possession of the chattel paper.

See UCC ' 9-330.

Electronic Chattel Paper

Electronic chattel paper is simply chattel paper that is evidenced by a record or records consisting of information stored in an electronic medium. See UCC ' 9-102(a)(31).

For electronic chattel paper, an assignee can perfect its interest by:

1. Filing a UCC Financing Statement; or
2. Obtaining control of the electronic chattel paper.

See UCC ” 9-312(a) and 9-105.

Perfection of electronic chattel paper via a UCC Financing Statement is plagued by the same uncertainly and ineffectiveness as perfection of tangible chattel paper in that manner. However, because a purchaser cannot take “possession” of electronic chattel paper, perfection by control represents the UCC Article 9 drafters' attempt to replicate the essential attributes of possession in order to obtain special priority.

Requirements for Control

An assignee has control of electronic chattel paper if a business management system employed for evidencing the transfer of interest reliability establishes the assignee as the person to which the chattel paper was assigned. See UCC ' 9-105(a). That standard is arguably met if the authoritative copy of the record or records comprising the chattel paper is created, stored, and assigned in a manner such that:

1. A single authoritative copy of the record or records exists that is unique, identifiable, and, except as provided in paragraphs (4), (5), and (6), unalterable;
2. The authoritative copy identifies the secured party as the assignee of the record or records;
3. The authoritative copy is communicated to and maintained by the secured party or its designated custodian;
4. Copies or revisions that add or change an identified assignee of the authoritative copy can be made only with the participation of the secured party;
5. Each copy of the authoritative copy is readily identifiable as a non-authoritative copy; and
6. Any revision of the authoritative copy is readily identifiable as an authorized or unauthorized revision.

Id. at ' 9-105(b).

The technological sophistication necessary to establish that a party is in control of electronic chattel paper consists of forcing a computer system to reproduce all of the relevant functional attributes of tangible chattel paper. Although this process may be technologically difficult, conceptually it means that if a certain set of bits and bytes comprising an electronic document has an audit trail created around it that captures all of the modifications of those bits and bytes, the electronic document will be treated the same as paper records for purposes of the UCC.

Challenges

The drafters of UCC ' 9-105 explicitly state in their official comments that they did not intend to create more stringent standards for control of electronic chattel paper than existed for possession of tangible chattel paper. However, they did create some significant challenges in that the drafters did not advise as to how to go about complying with the criteria set forth in UCC ' 9-105.

For example, no guidance is provided stating that if a lender completes certain specific tasks, it meets the required criteria. Instead, such guidance has largely been left to the marketplace to determine best practices. There is also little case law, or even additional revisions or comments to UCC 9-105 to offer help.

In addition, challenges abound for those developing the appropriate control systems. Indeed, it can be very difficult to identify any one electronic copy of a document as being the “original” because computers can generate an unlimited number of perfect copies of a document instantly. Also, electronic documents can be transmitted numerous times across a number of information systems thereby creating additional copies that could be identical in appearance to the “original.”

Further, although computers are designed to create a representation of data that appears to a user to mirror a paper document, that data is actually numerous separate bits and bytes of data stored in many different places on a computer hard drive. The computer knows the location of all of the bits and bytes associated with a particular document, so when viewed, all of the bits and bytes are assembled in order to present a coherent image to the user. Thus, it is difficult for business information systems to meet the “single, authoritative copy” requirement without a substantial change in process.

Potential Solutions

The requirements for control under UCC ' 9-105 are similar to the safe-harbor requirements for “transferrable records” under the Uniform Electronic Transactions Act (UETA) (section 16) and the Electronic Signatures in Global and National Commerce Act (ESIGN) (section 201). To date, the UETA has been adopted by 47 states. California enacted some notable exceptions to the model law and Washington, Illinois and New York apply their own state laws that generally conform to UETA. Federal ESIGN legislation preempts all state laws to the extent of any conflict.

There has been little case law interpreting UETA and ESIGN, but the pattern that has emerged from the few reported decisions available indicates that the reliability, integrity and authenticity of the business management system employed to memorialize and maintain the electronic transaction is key to meeting the requirements imposed.

The linchpin management system that has emerged to establish ironclad protection and maintenance of electronic chattel paper is electronic vaulting, either on its own or as part of a third-party system. Already in use for some time in a variety of business lines, electronic vaulting has generally been accepted as affording the necessary protections to securely manage electronically originated documents in a manner consistent with UCC ' 9-105.

Key to inside and outside legal counsel, electronic vaulting has been accepted by insurers and ratings agencies that support various secondary market transactions as meeting their requirements for securitization of electronic chattel paper on the secondary market. However, it is important to note that users of the business management system must know how to use it correctly so they can testify and authenticate the records if necessary.

The process generally involves parties to a transaction signing the documents electronically, either in person using an electronic signature pad or other signing device, or via the internet using their computer or mobile device by logging into a secure portal and applying their electronic signatures. Once the signatures are applied, the documents are instantly deposited in an electronic vault, which establishes the “authoritative copy” set forth in UCC ' 9-105. The documents are held and managed in the electronic vault and can be controlled or accessed only by the authorized parties.

Once electronically vaulted, all activities and functions affecting the documents are controlled and logged by the electronic vault. Such activities and functions include print, copy or view requests, generating legally admissible copies for use in court, transferring the “authoritative copy” to another vault, and the ability to export the data to paper.

A robust and properly maintained electronic vault must generally perform the following functions to meet the requirements imposed pursuant to UCC ' 9-105:

1. Protect, encrypt and time-date stamp the electronic records and wrap them in a virtual “tamper-evident seal” that will instantly identify and reject any changes to the record post execution;
2. Grant and maintain privileged access rights to the party in control;
3. Maintain an extensive audit trail on the records, tracking access to the records, the number of copies made and by whom, any transfer of location of the records, and any transfer of location of the records;
4. Perform regular integrity checks on the records to ensure that no alteration or degradation of the bits and bytes have occurred since execution; and
5. Recognize a method to destroy the electronic records after predetermined periods or status changes, while also providing the ability to create a paper document that will thereafter be recognized as the “original.”

Conclusion

The dearth of established legal authority concerning electronic chattel paper certainly impacts how comfortable legal counsel may be with early adoption of the technology, particularly due to the scarcity of tangible paper evidence that results if the systems are properly employed. However, there is little question that the market appetite for paperless and electronic commercial and consumer transactions is insatiable and that the movement is toward the implementation of electronic transactions and the use of electronic chattel paper. Those who have already adopted it report that is has streamlined the lending process, increased efficiency, decreased opportunities for errors in execution by lessees, borrowers and guarantors, and generated cost savings. There is no doubt that increasingly more finance transactions will be conducted in this manner going forward.

Benjamin J. Court is an attorney with Messerli & Kramer P.A. in Minneapolis. His practice focuses on equipment leasing and structured finance transactions and bankruptcy matters for banks, private lenders, equipment finance organizations, creditors and more. Reach him at [email protected]. The author gratefully acknowledges the assistance of Barry Marks and Matt Evans of Marks & Associates, P.C., in the preparation of this article.