United States: Pledging Electronic Contracts As Collateral: Out Of "Control"?

Reprinted with permission of the Dispatch, published by the Central Station Alarm Association.

The benefits of "going paperless" and switching to an electronic form of alarm system and services contracts are undeniable. Time and cost efficiencies enjoyed by security alarm dealers that go paperless may, depending on the sales and marketing methods used by the company, make paper contracts antiquated.

The advantages of electronic contracting, however, must be weighed against significant legal challenges they create as commercial law is chasing technology. One of the challenges arises when an alarm company seeks to obtain financing using electronic contracts as collateral. For reasons explored in this article, banks and other financiers have been reluctant to accept electronic contracts as a satisfactory form of collateral.

Traditional Paper Contracts

Lenders typically provide financing to alarm companies based on the amount of the recurring monthly revenue (RMR) generated by alarm companies' subscription contracts. The actual contracts are therefore pledged as the collateral securing the debt.

Properly taking and perfecting the security interest in the subscription contracts ensures that, if the borrowing alarm company defaults on the payments due from it, the lender can take over the contracts and revenues generated by them. The creation and perfection of security interest in various types of collateral is governed by Article 9 of the Uniform Commercial Code (the UCC). The proper method of perfection depends on how the collateral is classified under Article 9. While Article 9 may vary from state to state, it is generally consistent nationwide.

Regular paper alarm contracts are often classified as "chattel paper" under the UCC, or at least this is how the lenders have been treating them for purposes of perfecting security interest. "Chattel paper" is defined as "a record or records that evidence both a monetary obligation and a security interest in specific goods, a security interest in specific goods and software used in the goods, a security interest in specific goods and license of software used in the goods, a lease of specific goods, or a lease of specific goods and license of software used in the goods."¹ UCC §9-102(a) (11).

Security interest in tangible "chattel paper" is perfected by filing a UCC-1 financing statement or by "possession," with perfection by "possession" having priority (sometimes referred to as "super-priority"). That is, taking "possession" of chattel paper enables a secured party, in some circumstances, to obtain a higher priority security interest than that of other secured parties who perfected their security interest by filing, even if they were first in time to do so.

Understandably, most lenders want to achieve "super-priority" of their security interest by obtaining possession, in addition to filing a traditional financing statement. However, rather than taking actual physical possession of the original paper contracts, banks usually enter into so-called "custodian agreements" with a third-party storage company that acts as a custodian of the original paper contracts.

Electronic Contracts

Alarm contracts in electronic form are treated as "electronic chattel paper."² The method of achieving super-priority of a security interest in "electronic chattel paper" is by "control" rather than by "possession." UCC §9-105 sets out the elements of achieving perfection in "electronic chattel paper" by control.

A closer look at the elements of UCC §9-105 explains why the concept of "control" has been controversial. Under UCC §9-105, a secured party has control of electronic chattel paper "if the record or records comprising the chattel paper are created, stored, and assigned in such a manner that:

Fulfilling each of these requirements raises certain practical, technical and legal issues.

Identifying the Electronic Originals

The creation and identification of the "authoritative copy" - the key requirement for meeting the elements of control – presents particular challenges. The concept of an electronic authoritative copy was intended as an analog to the paper contract with original ink signatures. Unlike original paper documents, however, electronic files can be replicated in a split second producing a multitude of identical copies indistinguishable from the original authoritative copy.³ Additionally, an authoritative copy can be copied when emailed to a third party. How can one ensure that any copy of the "authoritative" copy is "readily identifiable as a non-authoritative copy," as required by the UCC? How can one ensure that electronic copies of a contract created before the authoritative copy are "readily identifiable as non-authoritative"?⁴

The UCC provides no answers to these questions and offers very little practical guidance on how to achieve other elements of control under UCC §9-105. In fact, the Official Comment to UCC §9-105 notes that the UCC "leaves to the marketplace the development of systems and procedures, through a combination of suitable technologies and business practices, for dealing with control of electronic chattel paper in a commercial context." Without much guidance from the drafters of the UCC, the development of systems and procedures for achieving "control" would require creative legal and technological solutions by all parties to the secured lending transaction and their legal counsel.

Until recently, lenders have been avoiding electronic chattel paper issues by limiting percentage RMR generated by electronic contracts to 1-10% of the pool of collateral. This approach is becoming unacceptable as operations of an increasing number of alarm companies are becoming substantially "paperless" and the electronic contracts generate most or all of these companies' RMR. Lenders and borrowers eventually will have to face the challenge of meeting the elements of "control" under UCC §9-105.

Electronic Control Agreement

The first step in facing this challenge is to prepare an appropriate "electronic control agreement" among the lender, the borrower and the custodian of electronic contracts, that is, the company that stores and processes electronic contracts for the borrower (such as eOriginal, EchoSign, etc). In an electronic control agreement, the electronic custodian agrees to implement procedures to meet the elements of control under UCC §9-105 and to follow the instructions of the lender in case of the borrower's default under the loan agreement.

In a way, an electronic control agreement is similar to the deposit account control agreement that is used to perfect the security interest in borrower's deposit account maintained by a third-party bank. The main difference is that "control" over deposit account is not subject to challenging technological requirements as found in UCC §9-105.

Of course, merely reciting the elements of "control" in an electronic control agreement without a clear understanding of how each element will be actually implemented would be meaningless. The parties have to collaborate in establishing the mechanisms for creation and identification of an authoritative copy, marking of non-authoritative copies and identification of any revision of the authoritative copy as an authorized or unauthorized revision. It is important that the company's electronic custodian is sufficiently sophisticated, flexible and willing to participate in this process.

Overall, while particular mechanisms of achieving "control" over electronic chattel paper remain to be tested by the courts, a meaningful implementation of the elements of UCC §9-105 appears plausible. The legal challenges and administrative burdens posed by this process may be outweighed by the benefits of switching to a digital format. The parties to financing transactions have to admit that the paperless evolution is inevitable, and must take proper steps to adapt.

Daria K. Boxer is an attorney with Mitchell, Silberberg and Knupp, LLP, where she specializes in corporate finance, securities regulations, enforcement of creditors' rights, corporate governance and business regulatory matters.

Footnote

1. Many alarm contracts arguably meet the definition of "chattel paper" because they evidence a monetary obligation by the subscriber to pay monthly charges, as well as the right of an alarm company to repossess the alarm equipment in case of the subscriber's default. A pure monitoring contract that does not give the company any right to repossess the alarm system and does not entail the lease of any equipment probably is not chattel paper.

2. "Electronic chattel paper" is defined as "chattel paper evidenced by a record or records consisting of information stored in an electronic medium." UCC §9-102(a)(31).

3. Use of the metadata information of an electronic document may provide a means for identifying such electronic originals. Metadata is the electronic DNA of an electronic document which shows when and by whom the document was created, modified, copied etc. The actual technology for using the metadata as means of identification of a unique "authoritative copy" remains to be developed.

4. Another problem arises when tangible chattel paper (a paper contract) is scanned into an electronic medium, and thus, converted to electronic chattel paper. Official Comment 4 to UCC §9-105 provides that, "in order to establish that a copy of the electronic chattel paper is the authoritative copy it may be necessary to show that the tangible chattel paper no longer exists or has been permanently marked to indicate that it is not the authoritative copy." The UCC, however, is silent on how exactly one can demonstrate that the tangible paper original no longer exists.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.