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Lenders 360

eSign & Commercial Finance: A License to Trash the Original Note?

Posted in Compliance, Regulatory, Technology Notes, Training

Are “electronic document” provisions appearing in your commercial loan documents?  This is the second in a series examining two provisions recently reviewed by me in commercial real estate transactions.   Unfortunately, the two provisions have serious problems: for UCC Article 3 notes, making a copy of it will not clothe the copy with Article 3 protections.

Copy & Trash the Original Note: No No & No

Electronic documents are not a passing fad:  the growing use of eSign tells me that the bank examination “report card” in 2016 or 2017 will include the use of electronic documents by banks.  This topic is not going away.  We will see more of these provisions, even in commercial loan documents.

In my last post, I summarized two laws that support these provisions (federal e-Sign law and the UETA [the form suggested for use by the states]).  As a general proposition, these laws are designed to preserve existing legal principals.  Like “paper” documents, electronic documents must comply with applicable state laws.

Following these laws into real world becomes very interesting:  the nuances of these laws create a couple of important traps for the unwary.  Let’s take a familiar office task, and then look at two provisions from several commercial mortgage loan documents.

A FAMILIAR TASK

Here is the scenario: after closing, you take the original (blue ink) real estate note and then,

  • scan it;
  • rename it;
  • forward it to a hard drive; and then
  • deposit the original (blue ink) real estate note in the trash can (or shredder)

Now, let’s look at the provisions.

TWO PROVISIONS

Example #1 (emphasis added):

Borrower hereby acknowledges the receipt of a copy of the Agreement and all other Loan Documents.  Bank may, on behalf of Borrower, create a microfilm or optical disk or other electronic image of the Agreement and any or all of the Loan Documents.  Bank may store the electronic image of such Agreement and Loan Documents in its electronic form and then destroy the paper original as part of Bank’s normal business practices, with the electronic image deemed to be an original.

Example #2 (emphasis added):

Borrower hereby acknowledges and agrees that Lender may create electronic images and destroy paper originals of any imaged documents received or generated by Lender in connection with the Loan.  Any such images maintained by Lender as part of its normal business processes shall be given the same legal effect as the paper original(s) thereof.  Borrower hereby agrees that Lender may convert any instrument into a “transferable record” under the Uniform Electronic Transactions Act (California Civil Code Section 1633.1, et seq.) (the “UETA”), and that the image of such instrument in Lender’s possession shall constitute an “authoritative copy” under the UETA.

In these examples, the following terms are problematic:  the image will be –

  • deemed an “original” (of the paper original document)
  • recognized as a “transferable record” (under eSign and UETA)
  • recognized as an “authoritative copy” (of the transferable record) (under eSign and UETA)

CORRECT: AN ORIGINAL

As a general proposition (and when using the term “original” in a broad sense), the image will be treated as an “original” and as an electronic record under Sections 12 and 13 UETA.  Of course, this assumes that the image was created and preserved in accordance with an electronic records plan.  In a future post, we’ll touch on key topics for a plan.

Note, however, there are special rules for particular types of electronic records.

WRONG: A TRANSFERABLE RECORD? AN AUTHORITATIVE COPY?

Of course, there are tangible differences between “paper” documents and “electronic” documents. The differences require different approaches in order to achieve the same results.  These differences, however, mean that making a copy of an original (paper) note will not create a “transferable record” and an “authoritative copy” of the note.  Once a paper note is created, it is the only “original” note.  There can be only a single such note.  We can’t create another one in the future.

The reason for this outcome is that UCC Article 3 does not work well when the note is an electronic record. The Article 3 holder in due course provisions (no notice of alterations or of an unauthorized signature) are good examples of this disconnect.  Consequently,  UETA and eSign each implement a parallel approach for UCC Article 3 notes, using a form of electronic record called a “transferable record”  (eSign Sec. 7021; UETA Sec. 16).  A transferable record is a unique type of “electronic record,” with unique rules and characteristics.

An electronic record, when recognized as a “transferable record,” gives the holder of the “authoritative copy” the same status as a UCC holder in due course.

Unfortunately, the two provisions overlook the requirement that consent to create a transferable record can be made by the maker of the electronic document only at the creation of the electronic document, and only when utilizing technology that creates a unique token.

These two concepts mean that making a copy of an original note does NOT create a transferable record nor does it create an authoritative copy of the note.

DO NOT TRASH THE BLUE INK NOTE.

TWO PROBLEMS

Only at Creation.  Under UETA and eSign, the parties to the actual electronic record, as part of and during the process of executing the eNote, must expressly agree that the electronic record is a “transferable record.”  In contrast, consenting in a paper note to create (at a future date) an electronic record by imaging the paper note does not comply with UETA and eSign, because the person who signs a paper note is not (at that time) signing and creating an electronic record.  In other words, the person imaging the paper note at the copier is not executing the eNote.  The person at the copier is not the same person described in UETA and in eSign as the “issuer of the electronic record.”

UETA Sec. 16, Comment No. 2 (pp 51-52) directly addresses this “at the time of creation” concept:

The definition of transferable record as “an electronic record that…the issuer of the electronic record expressly has agreed is a transferable record” indicates that the electronic record itself will likely set forth the issuer’s agreement, though it may be argued that a contemporaneous electronic or written record might set forth the issuer’s agreement. However, conversion of a paper note issued as such would not be possible because the issuer would not be the issuer, in such a case, of an electronic record. The purpose of such a restriction is to assure that transferable records can only be created at the time of issuance by the obligor. The possibility that a paper note might be converted to an electronic record and then intentionally destroyed, and the effect of such action, was not intended to be covered by Section 16.

Unique Token.  UETA Sec. 16, Comment No. 1 (p. 48)  addresses the unique challenges and requirements involved in adapting paper note rules to electronic forms:

“Paper negotiable instruments and documents are unique in the fact that a tangible token – a piece of paper – actually embodies intangible rights and obligations. The extreme difficulty of creating a unique electronic token which embodies the singular attributes of a paper negotiable document or instrument dictates that the rules relating to negotiable documents and instruments not be simply amended to allow the use of an electronic record for the requisite paper writing.”

Consequently, creating a transferable record (with these unique tokens) cannot be established by merely scanning a document at your typical scanner.

Finally, since the imaged copy will not produce a “transferable record,” there is no “authoritative copy” of such record.  In other words, there is no “original, sole and only” electronic note.

In the next post: a few comments on the “normal business plans” portion of these provisions.

If you have any information or a story to add, please comment below.