Community Banker January, 2001

ABCs Of The E-SIGN Act For Community Banks By John Kromer On October 1, 2000, the paperless mortgage loan became a legal reality as the federal Electronic Signatures in Global and National Commerce Act—the E-SIGN act—became effective. The E-SIGN act is expected to have a profound impact on the banking industry, providing the legal tools for banks to not only initiate transactions online, but also to conclude them electronically. While the Gramm-Leach-Bliley Act has been heralded as a significant milestone in the modernization of the financial services industry, many believe that the E-SIGN act will ultimately have a larger impact on how banks and other financial services providers develop, market and implement their products through electronic commerce. With the adoption of this new federal law, and the enactment by more than 20 states of the Uniform Electronic Transactions Act, or the UETA, the uniform state law on which the E-SIGN act is modeled, electronic records and signatures have—subject to certain exceptions— the same legal validity and enforceability as paper documents and ink signatures. It is expected that these laws will enable banks to substantially reduce the time and cost of originating, servicing and selling mortgages and consumer loans into the secondary market. Moreover, the laws provide the ability for banks and regulators to simplify and improve the consumer experience by providing disclosures and other information in a more timely and user-friendly fashion.

This article addresses the key provisions of the E-SIGN act as they relate to community banks. As community banks continue to expand their use of the Internet as an interactive tool to offer products to their traditional communities, as well as to markets throughout the country, knowledge of the requirements of the E-SIGN act will be an important part of each bank’s product development and regulatory compliance process.

Basic Rule of Validity and Scope The E-SIGN act’s core principal is that a signature, contract or other record related to any transaction in or affecting interstate or foreign commerce may not be denied legal effect, validity or enforceability solely because it is in electronic form. The E-SIGN act is generally technologically neutral, and does not favor any one form of electronic signature. An “electronic signature” means an electronic sound, symbol or process, attached to, or logically associated with, a contract or other record and executed or adopted by a person with the intent to sign the record. With the exception of the consumer consent provisions discussed below, the E-SIGN act respects party autonomy and leaves to the involved parties the decision of whether or not to do business electronically and what type of signature methods and record formats are to be used.

Although both simple “click trough” type signatures and digital signatures using public key— private key cryptography have the same standing in the eyes of the law, there is substantial discretion for community banks and the marketplace to determine what signatures are appropriate in particular transactions. While a bank may be satisfied with a process that identifies an online user and requires them to click an “I agree” button to acknowledge receipt of a consumer disclosure, such as the good faith estimate or initial truth in lending disclosure in a mortgage transaction, the bank may require the use of a digital signature to execute the note and other closing documents. In addition, banks that sell loans to investors, including Fannie Mae and Freddie Mac, must be guided by the specifications investors establish for electronic transactions. The law expressly does not affect the substantive provisions of consumer protection laws, the content or timing of disclosures required by law, or any requirement by a federal or state regulatory agency that records be filed in a specific format, such as paper. Also, the E-SIGN act excludes from its coverage several significant categories of transactions, records and notices that are deemed by Congress to be inappropriate for electronic communication, subject to other rules authorizing electronic commerce, or not involving interstate commerce. Specifically, the E-SIGN act does not affect: • Laws governing the creation and execution of wills, codicils or testamentary trusts; • Laws governing adoption, divorce or other matters of family law; • The Uniform Commercial Code, other than sections 1-107 and 1-206 and Articles 2 and 2A regarding the sale of goods and leases, respectively; • Court orders or notices, or official court documents required to be signed in connection with court proceedings;

• Any notice regarding the cancellation or termination of utility services; • Any notice regarding default, acceleration, repossession, foreclosure or eviction, or the right to cure, under a credit agreement secured by, or a rental agreement for, the primary residence of an individual; • Any notice regarding the cancellation or termination of health insurance benefits or life insurance benefits (excluding annuities); or • Any notice regarding the recall of a product, or material failure of a product, that risks endangering health or safety.

Consumer Consent The E-SIGN act includes special provisions for consumer transactions. If a law requires that a disclosure, notice or other record be provided to consumers "in writing," such as the good faith estimate or truth in lending disclosure, an electronic record can be used to satisfy that requirement only if the consumer has affirmatively consented to the use of electronic records and has not withdrawn such consent. A community bank that wishes to do business electronically with a consumer must, prior to obtaining the consumer’s consent, deliver a clear and conspicuous statement informing the consumer of: • Any right or option of the consumer to have the record provided or made available in paper form; • The right of the consumer to withdraw consent and any conditions or consequences (including termination of the parties’ relationship) of such a withdrawal; • Whether the consent applies only to a single transaction or the entire relationship between the parties;

2

• The procedures the consumer must use to withdraw consent and to update his or her contact information; • How the consumer may obtain a paper copy of the electronic record and whether any fee will be charged for such a copy; and • The hardware and software requirements for access to, and retention of, the electronic records. After receiving this disclosure statement, a consumer must consent electronically, or confirm his or her consent electronically, in a manner that “reasonably demonstrates” that the consumer can access information in the electronic form that will be used to provide the information that is subject to the consent. After a consumer consents, if there is a material change in the hardware or software requirements needed to access or retain the electronic records, the consumer must be provided with a statement of the revised hardware or software requirements and a new opportunity to withdraw consent.

Federal Preemption One of the most significant issues arising from the E-SIGN act is the interplay of federal and state law. The E-SIGN act was originally conceived as a stopgap until the states could adopt the UETA. However, because some of the initial state adoptions of the UETA contained significant modifications—particularly with respect to consumer transactions—that threatened the uniformity of the law, and because the UETA only addresses state signature and writing requirements, Congress determined that it was appropriate to adopt a federal law that establishes a national baseline for electronic contracts and related records. The E-SIGN act provides that the states may override the preemptive effect of the federal law if they adopt the UETA in the form approved

by the National Conference of Commissioners on Uniform State Law in 1999. Also, given the experience with some states significantly modifying the UETA, the E-SIGN act limits the ability of states to utilize provisions of the UETA to limit the scope of the law, so as to close any loophole by which consumer transactions could be excluded from electronic commerce. Alternatively, a state may modify, limit or supersede the E-SIGN act if it specifies alternative procedures or requirements for the use and/or acceptance of electronic records or electronic signatures. To be effective as an override of the federal law, the state enactment must be consistent with the E-SIGN act’s general rule of validity and specifically reference the E-SIGN act (if adopted after June 30, 2000).

Record Retention The E-SIGN act sets out a host of rules related to the retention of electronic records. The act allows copies of contracts and other records (including disclosures) to be retained electronically in compliance with legal record retention requirements, so long as the electronic record (1) accurately reflects the information set forth in the contract or other record; and (2) remains accessible to all persons who are entitled to access by law, for the period required by law, in a form that is capable of being accurately reproduced for later reference, whether by transmission, printing or otherwise. A legal requirement that a contract or other record be retained in its original form is satisfied by fulfilling these requirements. Also, if a provision of law requires that a contract or other record be in writing, the legal effect of the record may be denied if it is not in a form that is capable of being retained and accurately reproduced for later reference by all parties. Finally, a legal requirement for the retention of a check is satisfied by retention of an electronic 3

record of the information on the front and back of the check in accordance with the record retention provisions of the E-SIGN act.

• The action does not impose or reimpose any requirement that a record be in a paper form;

Transferable Records—Electronic Promissory Notes

• The regulation does not add to the requirements of the E-SIGN act (such as the c consumer consent provisions);

The E-SIGN act includes a special provision for the creation of transferable records, which are intended as electronic equivalents to negotiable instruments, such as promissory notes. The act sets out rigorous conditions for the creation of transferable records and grants to the holders of such records the same legal rights as the holder of a negotiable instrument under the Uniform Commercial Code. Interestingly, while the UETA includes the same rules for the creation of transferable records, the E-SIGN act only provides authority for such records in the context of real estate secured loans, while the UETA authorizes their use generally. Thus, while a community bank has authority under the E-SIGN act to create an electronic promissory note for a mortgage loan, the bank would need to be located in a state that has adopted the UETA, or a similar law, in order to have the benefit of the transferable record provisions for an automobile loan or other consumer loan.

Regulatory Authority The E-SIGN act imposes significant limitations on the exercise of regulatory authority. First, the E-SIGN act is self-executing and is not dependent on the adoption of regulations by any federal or state regulatory agency. Second, although a federal or state regulatory authority may interpret the E-SIGN act pursuant to general rulemaking authority under another statute (for example, the Truth in Lending Act), a regulatory action is permissible only if:

• The regulation is consistent with the E-SIGN act;

• There is substantial justification for the regulation; • The methods selected to carry out that purpose are substantially equivalent to the requirements imposed on records that are not electronic records; • The methods will not impose unreasonable costs on the acceptance and use of electronic records; • The methods do not require, or accord greater legal status or effect to, the implementation or application of a specific technology or technical specification. A federal (but not state) regulatory agency may exempt without condition a specified category or type of record from the consumer consent provisions of the E-SIGN act if such exemption is found to be necessary to eliminate a substantial burden on electronic commerce and will not increase the material risk of harm to consumers. Nonetheless, a state or federal regulatory agency may require that records be filed with such agency in accordance with specified standards and formats (which could include that they be on paper). Also, the E-SIGN act gives regulators broad authority when interpreting record retention requirements, authorizing a federal or state regulatory agency to interpret the retention provisions of the E-SIGN act to specify performance standards to assure accuracy, record integrity and ensure accessibility of records that are required to be retained.

4

Special Issues

Industry Standards

Although the passage of the E-SIGN act will force many players to reconsider their role in lending transactions, two groups that have received particular attention are notaries and county recorders. Although both the E-SIGN act and the UETA provide authority for electronic notarizations, neither law addresses the underlying legal requirement for notarization of documents. As a result, notaries are expected to continue to have a role in the execution of transactions, and physical presence of a signatory before a notary will remain part of the process unless changed by applicable law.

Because the E-SIGN act is a self-executing, procedural statute, and because the hurdles to regulatory guidance are relatively high, it is expected that market participants, rather than regulators, will play the lead role in setting the operational rules for electronic records and electronic signatures.

The E-SIGN act, as it finally emerged from a conference committee of the House and Senate, raised a question regarding whether county recorders would be required to accept for recording electronic records. As noted above, state and federal regulatory agencies are not required to accept for filing electronic records and may specify whether or not paper records are required. Unlike earlier versions of the bill, the final conference report of the E-SIGN act did not define “state regulatory agencies,” leaving in doubt whether county records would be subject to the exception for regulatory agencies. Although the matter has not been litigated to date, many believe that the language of the statute, combined with the legislative history, supports a conclusion that county recorders retain authority to specify what records they will accept for filing. Unless this issue is resolved by the courts, it seems likely that the question of whether deeds, mortgages and other instruments relating to real property can be filed electronically will be determined at the county or even municipal level in each state.

Already in the mortgage industry, Freddie Mac has issued detailed preliminary specifications for electronic residential mortgage loans that would be eligible for sale in the secondary market. It is expected that Fannie Mae and other investors will also develop standards and specifications that will help form the rules of the road for electronic commerce, not only in the mortgage industry, but also in the consumer finance industry and other fields where there are similar regulatory requirements and market considerations. Community banks would be well-served to participate in the process for the development of these industry standards and specifications as they are likely to have a significant impact on how banks utilize the tools provided by the E-SIGN act and the UETA.

Effective Dates The E-SIGN act took effect generally on Oct. 1, 2000. The record retention provisions, applicable to records required to be retained by a state or federal law, become effective March 1, 2001, unless a state or federal regulatory agency initiates a rulemaking proceeding regarding record retention performance standards, in which case the record retention requirements will take effect June 1, 2001. Finally, June 30, 2001, is the effective date for certain transactions guaranteed or insured by the U.S. government.

5

The E-SIGN act provides legitimacy to electronic signatures and electronic records, and removes many of the most significant impediments to the development of electronic commerce, particularly in heavily regulated industries such as the banking and financial services industry. Community banks should be prepared to deal with the many challenges and opportunities presented by the E-SIGN act or they may miss the real modernization of the financial services industry.

John Kromer is an attorney with the Boston firm of Goodwin Procter LLP. He can be reached via e-mail at [email protected].

©Community Banker Copyright 2001. Reprinted with permission from the January 2001 issue of Community Banker magazine, published by America's Community Bankers, Washington, D.C. All rights reserved.

6