Executive Summary:
In the summer and fall of 2022, electronic transactions were undergoing a sea change, but riding different tides: in the summer, the Uniform Law Commission approved a set of amendments to the Uniform Commercial Code (UCC), including recommending adoption of a new UCC Article 12, designed and built for electronic transactions. By the fall, market values for cryptocurrencies (crypto) and non-fungible tokens (NFTs) were plummeting, and major industry players failing.
Investors paying attention only to the meltdown in crypto and NFT prices could have been forgiven for thinking that blockchain had had its 15 minutes of fame, and that it was now suitable only for those with a considerable appetite for risk. But while crypto and NFTs generally run on blockchains, the technology of blockchain is much more robust and adaptable than its crypto and NFT use cases would suggest. In fact, by working with the 2022 UCC amendments, blockchain technology may revolutionize secured transactions. Versions of the 2022 UCC amendments have been enacted in 11 states (including California), and enacting bills have been introduced in 17 states and the District of Columbia (including Texas and New York, but not Florida).
Outline:
This Legal Update focuses on the residential mortgage market, and specifically mortgages that were originated electronically. Part I provides some context regarding the existing laws on electronic transactions known as UETA1 and ESIGN,2 differentiates electronic notes (eNotes) from electronic home equity lines of credit (eHELOCs) and describes the current approach for perfecting a security interest in a HELOC. Part II summarizes the 2022 UCC amendments.3 Part III reviews the promises of blockchain in light of the 2022 UCC amendments, and discusses both the benefits and potential challenges. Finally, we end with some conclusions to be drawn and observations for the future.
Part I: eNotes, eHELOCS and the Current UCC Perfection Analysis
Traditional home mortgage loans require a promissory note in which the mortgagor promises to pay the mortgagee (or its assignee) the principal amount of the debt, plus interest as agreed. Since 2005, Freddie Mac and Fannie Mae have had published criteria for electronic promissory notes (eNotes).4 Paper promissory notes for home mortgages are designed to be “negotiable instruments” under Article 3 of the UCC, and the industry has historically required these to be indorsed on the instrument or an allonge, and perfected in these instruments by possession,5 usually via a document custodian that acknowledges that it is holding possession for the secured party’s benefit.6
The federal Electronic Signatures in Global and National Commerce Act (ESIGN) and Uniform Electronic Transactions Act (UETA) provide two important statutory supports for eNotes. First, they codify the enforceability of electronically signed contracts, subject to meeting their requirements, and second, they create the concept of a “transferable record.” If a person has “control” of the transferable record (as prescribed in the statute), under ESIGN and UETA, they are deemed to be the holder, as defined in UCC 1‑201(20), of the transferable record, and to have the same rights and defenses as holder of an equivalent record under the UCC, including—if the applicable requirements are met—the rights and defenses of a holder in due course. Delivery, possession and indorsement are not required to obtain or exercise any of these rights. MERCORP Holdings, Inc. developed the MERS® eRegistry to manage eNotes, and to meet the requirements of ESIGN and UETA.7
HELOCs, on the other hand, are evidence by a line of credit agreement, rather than a promissory note, and are thus, from a UCC perspective, payment intangibles and general intangibles, rather than negotiable instruments. Accordingly, perfection for acquirers of HELOCs—or for warehouse lenders financing HELOCs—has been primarily via the filing of a Form UCC1 financing statement. In order to meet evidentiary requirements, typically paper copies of the relevant documents—and, in some cases, electronic scans—have been stored by a custodian. The residential mortgage industry has leveraged the evidentiary and statutory authority for electronic signatures and electronic contracts, established by ESIGN and UETA, to create electronically originated HELOCs (eHELOCs). While this is a valuable first step, ESIGN and UETA do not provide for a mechanism for perfecting a security interest in an eHELOC, and the MERS® eRegistry does not currently contain the functions necessary to support eHELOCs.8 Before adoption of the 2022 UCC amendments, perfection in an eHELOC is therefore the same as perfection in a paper HELOC, and stakeholders have been managing eHELOCs in ways that track the management of paper HELOCs. The efficiencies of electronic origination and management, so amply demonstrated with eNotes and the MERS® eRegistry, have yet to be realized for eHELOCs.
Part II: The Promise of the 2022 UCC Amendments
In July 2022, the Uniform Law Commission at its meeting in Philadelphia approved and recommended for enactment in all states a set of amendments to the UCC. For purposes of this Legal Update, the key proposed amendments9 were those that proposed a new Article 12 and made companion amendments to Article 9. The proposed new Article 12 creates a class of digital assets defined as “controllable electronic records” (CERs).
A CER is a “record stored in an electronic medium that is susceptible to ‘control.’” For a person to have “control” of a CER, the person must have: (i) the power to enjoy “substantially all the benefit” of the CER, (ii) the exclusive power to prevent others from enjoying “substantially all the benefit of the CER,” and (iii) the exclusive power to transfer control of, or to cause another person to obtain control of, the CER.
A person holding a CER perfected by “control” would have lien priority over a security interest in the CER perfected by the filing of a financing statement. In addition, the proposed Article 12 establishes a “take free” rule, giving the person that perfects in a CER by control a UCC status analogous to a holder in due course of a negotiable instrument. “Accounts” or “payment intangibles” (as those terms are defined in UCC Article 9) can be evidenced by a CER, creating a “controllable account” or “controllable payment intangible” if the party obligated on the account or payment intangible has agreed to pay the person in control of the CER. Adopting this statutory structure, an eHELOC could be originated that is eligible to be treated as a controllable payment intangible, and the associated CER susceptible of both perfection and tradability similar to that currently enjoyed by eNotes.10
While superficially similar to UETA and ESIGN, the architecture of the 2022 UCC amendments differs in at least one material respect that residential mortgage loan market participants should bear in mind: UETA and ESIGN depend upon the notion of an “authoritative copy” of the eNote, whereas the proposed Article 12 dispenses with this notion and relies on the control concepts summarized above. While the evidentiary aspects of enforcement are beyond the scope of this Legal Update, part of the premise of CERs is that there does not need to be a single, unalterable and unique statement of the controllable payment intangible; so long as the representation of the eHELOC is accurate, each copy is equivalent and there is no inherent collateral in the eHELOC itself.11
Part III: the Promise and Potential of Blockchain for UCC Article 12
The Benefits of Blockchain
The MERS® eRegistry does not store eNotes. eNotes are stored in electronic vaults (eVaults), and the eRegistry is the system by which control of the eNote is both established and managed. eHELOCs, like eNotes, depend on a registry system to manage them. And, for purposes of establishing control of a CER under the proposed UCC Article 12, a registry system is the obvious solution, building on the technology of eNotes. Currently, the MERS® eRegistry is the only registry system approved by Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Banks for eNotes to be delivered to those investors.
However, as noted, the MERS® eRegistry does not currently have the functions to support eHELOCs. The proposed UCC Article 12 is agnostic as to the specific technology used to meet its requirements, and this is where blockchain may be able to deliver robust results at minimal cost.
By design, blockchain and similar distributed ledger technology depend on multiple nodes that, with appropriate cryptographic proofs (or consensus mechanisms), create immutable records that establish permanent (and often public and auditable) records of transactions. Unlike in centralized recordkeeping models and traditional financial services, there is no single operator upon whom the recordkeeping system depends and no single repository of records. In some respects, blockchain technology may offer significant advantages over single-point-of-authority systems when it comes to secured transactions, including improved security, immutable records, enhanced transparency, streamlined processes, reduced costs and increased trust.
When implemented in a broad, robust network, blockchain technology can significantly enhance security by leveraging its decentralized and transparent nature. Unlike traditional centralized systems, where data is stored in a single location and susceptible to breaches of the central authority’s system and records, a blockchain distributes data across a network of computers, or nodes, on the network. As a result, a robust decentralized network comprised of numerous nodes makes it extremely difficult for hackers to compromise the entire network. Each record of a transaction on the blockchain is cryptographically linked to previous transactions, creating an unchangeable chain of information. This immutability and transparency enables participants to verify and validate transactions without a centralized recordkeeping authority to ensure the integrity and authenticity of data.
By utilizing smart contracts—which are self-executing contracts with predefined rules encoded on the blockchain—secured transactions can be automated and streamlined. Smart contracts can automatically enforce terms and conditions, trigger actions upon certain events, and reduce the need for intermediaries.
In addition, blockchain’s decentralized nature and consensus mechanisms can help to establish trust among participants. By eliminating reliance on a central authority—such as a bank—and relying on cryptographic verification, blockchain can foster trust in secured transactions. By leveraging blockchain technology and its capabilities, market participants could establish a secure, transparent and efficient transaction environment, allowing them to operate with increased confidence and efficiency.
Blockchain and Proposed UCC Article 12
Proposed UCC Article 12 is agnostic as to the technology used to meet its requirements. As noted above, a CER is a “record stored in an electronic medium that is susceptible to ‘control.’” For a person to have “control” of a CER, the person must have: (i) the power to enjoy “substantially all the benefit” of the CER, (ii) the exclusive power to prevent others from enjoying “substantially all the benefit of the CER” and (iii) the exclusive power to transfer control or to cause another person to obtain control of the CER.
Consider a hypothetical eHELOC on a blockchain:
- A CER is a “record stored in an electronic medium that is susceptible to ‘control.’”
- A blockchain creates blocks which are held on a distributed ledger. Each of the blocks would constitute a record stored in an electronic medium.
- An eHELOC stored in an eVault with a hashed reference on a blockchain would, therefore, meet the first criterion.
- For a person to have “control” of a CER, the person must have: (i) the power to enjoy “substantially all the benefit” of the CER, (ii) the exclusive power to prevent others from enjoying “substantially all the benefit of the CER” and (iii) the exclusive power to transfer control or to cause another person to obtain control of the CER.
- A blockchain is built on immutable blocks, cryptographically hashed and related to each other.
- An eHELOC represented on a blockchain would, by definition, be represented by a unique and immutable hashed value. This makes the value exclusively tied to the underlying eHELOC, and—assuming suitable controls for the blockchain—the ability of the holder of that hash value the sole person able to meet the second leg of the test above.
In much the same way that MERS® eRegistry operates as the registry for eNotes, a blockchain, suitably designed or adapted for use with eHELOCs, could easily meet the requirements for establishing CERs for eHELOCs, and simplify the trading of them. Moreover, many blockchains are built with ‘smart contract’ software in mind. Smart contracts are self-executing software programs that can be designed to do any number of tasks. Again, taking the hypothetical origination—warehouse financing or trading of an eHELOC—smart contracts on a blockchain can automate many tasks:
- A smart contract can be built to validate fields such as verifying existence of the asset on the blockchain, its ownership and its availability (e.g., absence of contrary rightsholders), and the post-transaction transfer of rights to the eHELOC/CER.
- A smart contract can be built to track specific data fields within the eHELOC (e.g., matching mortgagor name and address on the HELOC and the mortgage, verifying maturity, maximum line of credit, and other fields that investors or warehouse lenders value) and generate reports accordingly, simplifying the “stare and compare” work of custodians with paper records.
- A smart contract can be built to execute transactions on an “if/then” basis. For example, in flow purchase arrangements, once an eHELOC meets defined criteria (e.g., “buy box” compliance, return of recorded mortgage, etc.) a sale ticket can be generated for confirmation and transmitted electronically, simplifying the manual tracking of the pipeline.
Challenges Associated with Blockchain
While blockchain holds much promise when it comes to implementing the benefits of proposed UCC Article 12 for eHELOCs, there are some pitfalls and potential challenges. These include recent scrutiny surrounding blockchain, the state of current regulations, and the lack of a clear market leader in the blockchain space for assets of this type.
As acknowledged, blockchain has been under close scrutiny as a result of certain recent scandals and incidents regarding crypto, including fraudulent initial coin offerings, exchange hacks, and Ponzi schemes which have exploited the decentralized and pseudonymous nature of blockchain. Such scandals have raised concerns about investor protection, regulatory oversight, and the overall security of blockchain-based systems. Additionally, the use of blockchain for illicit activities, such as money laundering or illicit transactions, has drawn the attention of law enforcement agencies and regulators. Despite these controversies, proponents of blockchain would argue that many of the recent scandals do not necessarily stand as evidence of inherent flaws of blockchain technology itself, but rather highlight the need for responsible use and a robust governance framework to ensure the integrity and trustworthiness of blockchain-based systems. Nevertheless, some stakeholders may be wary of interacting with blockchain, particularly as its success depends upon a critical mass of stakeholders agreeing to accept and transact using the technology. A number of potential market participants might decide to wait until blockchain technology and blockchain-based systems gain widespread adoption, which will itself impede such adoption.
Regulatory regimes for industry participants vary across jurisdictions (and for the participants). Some banks in the United States may not be able to become participants on a public blockchain as a regulatory matter, or may need to retain a custodian or other vendor (that would need to be onboarded by the bank as a vendor) to perform blockchain-facing functions for it. Similarly, compliance with existing regulations—such as those related to money laundering, terrorism financing, consumer protection and compliance—may not be a simple process depending on the blockchain’s design and participation rules and procedures.
No blockchain network has yet emerged as a market leader for a blockchain-based system for perfecting a security interest in an eHELOC. Moreover, once information is referenced on a blockchain network, it is not clear how someone would remove the information from the blockchain network and create it on a new system, or if it would be possible to achieve interoperability between different blockchain networks. Further, ensuring seamless data exchanges and compatibility between different blockchain networks or platforms may require standardized protocols and interfaces. If standardized protocols and interfaces are required, it is unclear at this time if market participants would be able to reach a consensus themselves or if further regulations would be required to address this potential issue.
Conclusion
The proposed UCC Article 12 holds much promise for participants in the market for HELOCs and, specifically, eHELOCs. Much of this promise could be unlocked using blockchain technology, particularly if its value is maximized with appropriate smart contract design and implementation. As with all emerging technology, challenges abound.
There are bright spots, however: with well over a decade of experience with eNotes, the translation to eHELOCs will benefit from the lessons learned. The recent surge in home equity in the US residential market is driving demand for HELOCs, and the meaningful cost savings of eHELOCs over their paper ancestors could help to unlock this value quickly and efficiently. Finally, the use of technology to automate processes suggests the opportunity for more robust origination and life-of-loan management, with less scope for human error, and the ability to scale quickly for new entrants. The coming years are likely to see a change in the way HELOCs are originated and managed in the United States, as the 2022 UCC amendments become more widely adopted.
1 Published in Official Text by the Uniform Law Commission in 1999, and subsequently adopted in 49 of the 50 states (with variations in some cases). New York adopted its own statute, the Electronic Signatures and Records Act (ESRA), which differs materially from UETA.
2 The Electronic Signatures in Electronic Transactions Act (codified at 15 U.S.C. §§ 7001-31).
3 Adopted by the Uniform Law Commission at its meeting in July 2022 in Philadelphia, PA. Official text can be found at www.uniformlaws.org.
4 For an explanation from Fannie Mae, see www.singlefamily.fanniemae.com/applications-technology/eclosings-emortgages, and for Freddie Mac, see https://sf.freddiemac.com/working-with-us/electronic-loan-documents/emortgages.
5 UCC 9-313(a).
6 UCC 9-313(g).
7 See www.mersinc.org/products-services/mers-esuite/eregistry.
8 ESIGN’s and UETA’s requirements for a “transferable record” depend, in part, on the electronic record being a note under the applicable UCC were it in paper form. Since a HELOC does not typically have a promissory note, an eHELOC is not eligible to be a transferable record under ESIGN and UETA.
9 For convenience, this article describes the 2022 UCC amendments as “proposed” because, at time of writing, they have not been adopted by a majority of states.
10 There is a distinction in proposed Article 12 between a “controllable payment intangible” (in the context of this article, the eHELOC itself) and a CER (in the context of this Legal Update, the eHELOC, the bundle of rights associated with the eHELOC including the right to payment, the right to control the eHELOC, and the right to transfer the eHELOC).
11 This generally mirrors the status quo: investors and warehouse lenders store a copy of the HELOC with a custodian mainly for evidentiary purposes. The paper HELOC agreement does not need to be held in order to perfect in the HELOC since there is no perfection in a HELOC by possession. Conversely, the paper promissory note, including indorsements and allonges, does need to be possessed in fact in order to perfect by that method.
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