by Dina J. Moskowitz, assistant general counsel, Natalie Abrams, associate general counsel, and Amy Martin, director, Standard & Poor's
Electronic contracts (e-contracts) are contracts that are originated and "signed" electronically. Due to developments in technology and ever-rising costs for storing and retrieving paper contracts, e-contracts are becoming increasingly popular. Specifically, companies in the auto loan business that seek to securitize their auto loan contracts are increasingly entering into e-contracts with their customers. Accordingly, Standard & Poor's Ratings Services has analyzed the ways in which e-contracts differ from paper contracts in a securitized pool of auto loans. This article discusses the legal differences between e-contracts and paper contracts for the purposes of Standard & Poor's rating of securities backed by auto loan e-contracts.
Legality, validity and enforceability of e-contracts
There are state and federal laws that uniquely apply to e-contracts. These laws have two main goals: ensuring that e-contracts suffer no disadvantage in the commercial markets relative to paper contracts and that consumers benefit from all the legal protections they enjoy when entering into paper contracts. Standard & Poor's is comfortable that, under these laws, as to the issues of legality, validity and enforceability, e-contracts can be viewed as equivalent to paper contracts for rating purposes. Therefore, regarding these issues, Standard & Poor's has adopted the same approach to e-contracts as it has to manually executed paper contracts. That is, we request no special opinions regarding the legality, validity, or enforceability of e-contracts. On Sept. 17, 2002, Standard & Poor's issued a release to this effect. (see "No Additional U.S. Legal Criteria Required for Electronic Contracts," on RatingsDirect, Standard & Poor's Web-based credit analysis system, at www.ratingsdirect.com.)
Perfection and priority under the UCC
Legality, validity and enforceability issues are not, however, the only legal questions raised by the securitization of e-contracts, particularly in auto loan transactions. An additional central issue involves perfection and priority under the Uniform Commercial Code (UCC). For paper auto loan contracts (known under the UCC as tangible chattel paper), perfection of a transfer (whether it is a sale or a loan) may be achieved by transferring possession of the contracts (to the buyer/lender, or its agent) or by filing a UCC financing statement against the seller/borrower. However, as to priority (as opposed to mere perfection), a buyer/lender who takes possession generally will have priority over a buyer/lender who files a UCC financing statement. In the event that perfection against the originator is achieved by filing so that the originator may retain possession of the paper contracts to facilitate servicing, Standard & Poor's relies on covenants by the originator not to transfer possession of the paper contracts to a third party (other than a securitization trustee or special-purpose entity [SPE], which would enable the third party to have priority over the rated noteholders.
If the paper contracts had been purchased by the originator from an auto dealer (indirect origination), then the originator takes possession of the contracts from the dealer. Among other things, this generally enables the originator (and any subsequent transferees, for example, the issuing SPE) to have priority over creditors of the dealer. It is not sufficient merely to file the UCC financing statements against the dealer because auto dealers typically have existing creditors who have filed blanket liens against the dealers. As discussed above, such creditors would have priority over any buyers or lenders who subsequently file financing statements against the dealer.
If the loan contracts are in electronic form, they will likely constitute "electronic chattel paper" under the UCC. The UCC provides that perfection of a transfer (whether it is a sale or a loan) of electronic chattel paper may be accomplished by the filing of the UCC financing statements against the transferor or by effecting "control" (as defined in the UCC) over the electronic chattel paper. Control of electronic chattel paper is analogous to possession of tangible chattel paper. A buyer or lender who has perfected by control of electronic chattel paper will have priority over a buyer or lender who has perfected solely by filing a UCC financing statement to the same extent as it would have priority if such buyer or lender took possession of any tangible chattel paper.
For direct originations of electronic auto loan contracts, Standard & Poor's does not require perfection by control for transfers by the originator to subsequent transferees. As with possession of tangible chattel paper, Standard & Poor's relies on covenants by the originator not to transfer control to a third party (other than an SPE or securitization trustee), which would enable the third party to have priority over the rated note holders.
For indirect originations, an originator that purchases electronic auto loan contracts from a dealer must perfect against the dealer by control (analogous to taking possession of paper contracts) for the originator (and subsequent transferees) to have priority over creditors of the dealer. However, subsequent transfers by the originator of such e-contracts to an SPE or securitization indenture trustee may be perfected solely by filing. If control of the contracts remains with the originator, and subsequent transfers are perfected solely by filing, Standard & Poor's relies on covenants by the originator not to transfer control to a third party (other than an SPE or securitization trustee), which would enable the third party to have priority over the rated note holders.
Has perfection by control been achieved?
If our criteria require perfection by control of the e-contracts, we will request an opinion of counsel to the issuer (originator) to the effect that control has been achieved pursuant to the UCC when the securitized pool contains 10% or more of e-contracts, or a dealer or affiliated dealer group has originated more than 0.5% of the pool. Although the UCC control opinion will be based in part on certain factual assumptions, the opinion provider must analyze all the components of control under the UCC and conclude as a legal matter that the requirements are met. The factual assumptions underlying the opinion should be supported by officer's certificates provided by the originator and any third party providing electronic "vault" services to the originator.
Issuers who intend to securitize e-contracts should contact Standard & Poor's to discuss more specifically the form and content of such control opinion, including (among other matters) which are the relevant state UCCs for the opinion. The control opinion, if requested, is in addition to the applicable Article 9 representations and warranties (see "Revised Article 9 of the Uniform Commercial Code: New Standard & Poor's Criteria," published June 6, 2001, on RatingsDirect) and not in lieu of them.
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