ABA Section of Business Law

M r. and Mrs. Homebuyer purchase their new home from Developer, Inc. The Homebuyers apply for their mortgage online from a dot-com lender, Online Lender, that originates, underwrites, processes and approves the loan using its online lending tools.

Online Lender prepares the loan documents, and Title Co. prepares the closing documents, all using electronic technology that creates and manages transferable records and other mortgage-related documents. The Homebuyers and other parties execute all of the documents at Title Co. using their electronic signatures.

Title Co. then transmits the electronic deed and mortgage to County Recorder, which verifies and records them and collects its fees by electronic funds transfer. The mortgage and deed are instantaneously available for public search at County Recorder's Internet site.

Title Co. also issues its title policy in electronic form, and Online Lender sells the loan and transmits the electronic documents to Mortgage Buyer, a home mortgage aggregator. Related servicing rights are transferred to Servicing Co., which receives all of the closing and credit documents electronically and incorporates the records into its own loan processing system.

The entire transaction, from closing through sale of the loan in the secondary mortgage market, takes less than three hours.

This story is not just a vision of the future. It describes a real transaction that closed in July 2000 – a completely paperless, fully electronic mortgage loan.

How is this possible? Technology combined with new laws and coordination among all of the participants in the mortgage transaction.

This article focuses on one of these legal developments – the new concept of "transferable records." Without the law creating transferable records, the Homebuyers could not have executed an electronic note that would have been acceptable for financing in the secondary market.

The Electronic Signatures in Global and National Commerce Act (E-Sign) and the Uniform Electronic Transactions Act (UETA) each contains "transferable record" provisions that authorize the use of electronic promissory notes, together with many other provisions addressing important issues in the law of electronic commerce.

UETA was approved as a uniform law by the National Conference of Commissioners on Uniform State Laws in July 1999 and by Jan. 31, 2001, had been adopted in 23 states and was pending in eight more. Congress enacted E-Sign to put the weight of federal law behind the principle that electronic contacts should have the same legal effect as equivalent paper documents signed in ink. E-Sign borrows many of its substantive provisions from the UETA. Most provisions of E-Sign became effective Oct. 1, 2000.

UETA created "transferable records." E-Sign followed UETA and now gives transferable records secured by real estate effect under federal law. These provisions are consistent with the general objectives of UETA and E-Sign, which is to remove unnecessary obstacles to the use of electronic media in commerce. Both give legal effect to electronic contracts and electronic signatures, but generally leave underlying substantive law provisions otherwise unchanged.

For example, since enactment of E-Sign, an online contract for the sale of widgets cannot be denied legal effect because it was formed online and exists only in electronic form. The particular terms of the contract and its performance, however, are subject to the applicable law governing sales of goods.

UETA and E-Sign are also "technology neutral," meaning that they do not endorse or favor any particular technical standard or process for creating electronic signatures or forming electronic contracts.

In order to permit greater adoption of electronic commerce technologies in lending markets that today depend heavily on paper promissory notes, the drafters of UETA and E-Sign created the electronic equivalent to a paper promissory note and named it "transferable record." UETA Section 16 and its E-Sign counterpart (Section 201) authorize this new type of electronic financial asset because electronic negotiable notes cannot exist under current UCC Article 3.

Article 3 notes must be "written," which means printed, typewritten or otherwise reduced to tangible form, according to UCC Article 1. As a result, holders of electronic records that otherwise look like notes do not get any of the rights and benefits given holders of paper notes under Article 3.

Transferable records bridge a gap until Article 3 is revised to accommodate the electronic equivalents of notes. The UETA transferable record provision applies to all notes (as well as to documents of title); the E-Sign provision applies only to notes secured by real property. For convenience, the balance of this article refers to UETA, which except for its broader scope, is substantively the same as its E-Sign counterpart.

The UETA drafters created transferable records because they recognized that real estate markets, among others, had resisted adopting some popular electronic commerce technologies because of the uncertain legal status of electronic promissory notes. Prior to this new legislation, lenders had no choice but to continue handling paper notes notwithstanding the costs. The drafters observed in commentary that the benefits of negotiability, holder-in-due-course status and good-faith-purchaser status are considered critical to investors in mortgage-backed securities. UETA replicates some of the rights and benefits given by Article 3 to holders of paper notes.

Transferable records are not a complete substitute for a note subject to Article 3. The transferable record provisions resolve certain issues, such as whether a party can be a holder or a holder in due course of an electronic note. Other issues remain unresolved. For example, UETA does not address the rights of a party in control of a transferable record against prior transferors, an issue that would be answered with respect to a paper note by the Article 3 provisions governing warranties and the obligations of endorsers.

In their comments, the UETA drafters anticipated that parties may create by agreement other rights and obligations equivalent to those established by Article 3 or that courts might extend by analogy the application of certain Article 3 doctrines to electronic notes. However, until courts rule on these questions or Article 3 is revised to accommodate the use of electronic media, some legal uncertainty surrounding the use of electronic notes will remain.

Returning to our example, before UETA, the Homebuyers could have signed an electronic note but, as a practical matter, Online Lender could not have freely transferred the note. Few mortgage lenders today expect to hold notes for the full term of the mortgage. Online Lender's fundamental business model would have been seriously undermined if it could not sell the note in the secondary market for real estate obligations.

In the Homebuyers' case, however, Online Lender used specialized technology to create a transferable record, securing rights under a UETA equivalent to those of a holder in due course under Article 3. Because Online Lender could then transfer rights like those of a holder in due course, Mortgage Buyer was willing to buy the Homebuyer's mortgage.

A transferable record can only be created if the substance of the record otherwise meets the Article 3 requirements for a negotiable note and the obligor expressly agrees that electronic record is a "transferable record." A transferable record must be created in electronic form. Paper notes converted into electronic form do not qualify as transferable records.

In order for the owner of an electronic promissory note to enjoy the benefits conferred by Article 3 on the holder of a paper promissory note, the "control" requirements of UETA must be met. Only those who can achieve "control" of a transferable record can qualify for a status equivalent to that of a holder in due course. Unlike Article 3, UETA does not require delivery, possession and endorsement of transferable records in order to achieve the equivalent of "holder" status.

By creating a transferable record and obtaining control, our Online Lender can abandon its paper documents for electronic notes and still be able to market its loans in the secondary market. How does Online Lender establish that it has created a transferable record and that it has control of the transferable record?

The concept of "control" in an electronic transaction substitutes for the concept of possession of a paper equivalent. Possession of a paper note is important in negotiable instruments law because rightful possession normally establishes who can enforce the rights described in the note. Control of a transferable record is likewise important because it will normally indicate who can enforce the rights described in the record.

What constitutes "control" will have to be determined with reference to the technology used to create and store the transferable record, and the business policies and procedures developed to support that technology. Because the UETA and E-Sign are technology neutral, a number of different approaches to achieving "control" should be able to compete in the marketplace.

Such technologies are just now emerging, and it may take several years before industry standards and business practices become widely established in this area. Lawyers advising clients who wish to use transferable records will have to do a case-by-case evaluation of the package of technological solutions and business processes that are supposed to achieve "control" in light of the general guidance provided by the statute.

"Control" of a transferable record is a complex undertaking that will require sophisticated computer system design, operation and security. This is because technology does not currently exist to create a computer record that is physically unique the way a paper promissory note is unique. Unlike a paper note, which is at least moderately difficult to forge, a transferable record is a digital file is stored in a computer system and can be perfectly replicated an unlimited number of times.

The uniqueness of a paper promissory note is not an end in itself, however, but a means of assuring that there is only one person at a time that can claim to be the owner of the note based on being in possession of it. Similarly, control of a transferable record does not turn on physical uniqueness but on the ability of the computer system within which the record is stored to assure that no more than one person at a time can claim to be the owner of it.

If a computer system can assure that there is never more than one person at a time that can give instructions transferring control of, or making changes to, a transferable record, then it has solved the same problem that possession of a paper note solves.

UETA Section 16(c) sets forth the characteristics a system must have in order for a party to show that it has control of a transferable record. Section 16(c) creates a very rigorous standard that few computer systems in use today could meet. Under UETA, control is attained only if there is a single "authoritative copy" of the transferable record that is unique, identifiable and unalterable, that identifies the rightful holder and that is maintained by the rightful holder or its custodian. The authoritative copy must be maintained in such a manner that it cannot be altered except with the consent of the rightful owner.

The rigorous standard set for maintaining the "authoritative copy" does not forbid creation of an unlimited number of copies of the transferable record that are not authoritative. For example, the employees of a mortgage servicing company would be able to review "read only" copies of the transferable record freely, and even make additional copies of the transferable record, as long as there is no confusion between such informational copies and the single authoritative copy.

As the market develops, various technology vendors will compete to persuade transacting parties that they have met the statutory standards for control. Lawyers and technology professionals will have to work together to evaluate these claims critically. Also, while most of the control elements are likely to be met in practice by reliance on advanced computer security technologies, business policies and procedures implemented by humans are also likely to play a major role in meeting the transferable record-control standards.

At this point, we offer a few observations that may guide commercial lawyers asked to help evaluate this technology.

• Creating a system that establishes control over transferable records is almost certainly beyond the competence of most in-house tech departments except, perhaps, those with substantial expertise in information system security. Word processing documents stored in password-protected directories in legal department files were not what the drafters had in mind when they defined "control."

• Not all vendors that rush products to market claiming to meet transferable record control standards may actually understand the underlying rationale for the control requirement. Many business lawyers are no longer familiar with the arcane nature of negotiability, so it would hardly be surprising if many technology vendors without legal training misconstrue the requirements for control of a transferable record.

• Both lawyers and technology vendors may mistakenly believe that using advanced computer security technologies, such as cryptography, can be sufficient to meet the control standard. Technologies such as digital signatures, that require the use of cryptography, can guarantee who signed an electronic document and that the contents of the document have not changed since signing.

Digital signatures alone cannot establish control, however, because a digitally signed record can be reproduced an unlimited number of times. Unless digital signature technology is combined with rigorous access controls, it is not possible to determine which copy of a digitally signed record is the "authoritative copy."

Digital signatures without rigorous access controls can at best establish authenticity and integrity, which are necessary but not sufficient to establish control. Proving the authenticity and integrity of an electronic record is like proving a photocopy is a true and correct copy of an executed original note. While a photocopy may be sufficient for some purposes, an accurate copy is ultimately not the same for all purposes as the original note. The same would be true of an accurate copy of a transferable record that is not the authoritative copy.

• Vendors should be required to provide a sufficiently detailed description of their systems so that a lawyer working with a technology professional can evaluate each vendor's system against the statutory standards for control.

What system features ensure that only the rightful owner can transfer ownership of the record? How does the system prevent editing or alteration of the record? Who maintains the system? Does it create a chain of custody that identifies any access to or transfer of the record? How will records be transferred from one holder to the next? What business practices and system controls are followed to ensure that copies or revisions are made only with the consent of the person in control? What internal business practices does the person in control need to implement if it is using a third-party custodian? How are copies marked to distinguish them from the authoritative copy? These questions may begin the analysis.

• As with any technology licensing agreement, a prospective purchaser of transferable record control technology should ask what warranties, if any, the vendor is willing to give that the system satisfies the control requirements. Does the vendor have the financial resources to back up those warranties if problems arise? Many technology developers are start-up companies that may be thinly capitalized and may not be able to provide compensation for a breach of warranty without a surety bond or other form of third-party credit support.

• Do not limit your analysis to the transferable record provisions. These provisions are critical for transactions involving notes, but they are only part of the overall transaction. Lawyers must also consider issues like effective delivery of required notices and verifying the identity and authority of the parties to the transaction. Practices that have become second nature in paper transactions should all be re-examined when moved to an electronic environment.

UETA and E-Sign have removed a significant barrier to paperless commercial transactions. As of Oct. 1, 2000, when E-Sign took effect, electronic real estate promissory notes were given effect under federal law. As states continue to enact the UETA, electronic documents of title and other types of promissory notes will also be recognized. When Revised UCC Article 9 takes effect on July 1 of this year, it will recognize "electronic chattel paper" and include similar "control" provisions.

It will not be long until paperless closings become routine in a wide range of commercial transactions involving notes, leases and installment sales contracts.

Jones is a partner with Hahn Loeser & Parks LLP, in Cleveland. Her e-mail is cmjones@hahnlaw.com. Winn is a professor at Southern Methodist University School of Law in Dallas. Her e-mail is jwinn@mail.smu.edu.

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