Last week, I wrote about taking consumer loan promissory notes and installment sales contracts in electronic format. See here. This week, I address the repercussions of such electronic contracts serving as collateral for lenders to consumer finance companies and installment sellers.

Let’s get started.

Electronic contracts constitute “chattel paper” under the Uniform Commercial Code (UCC); and, the UCC allows chattel paper to be collateral to secure the repayment of debt. So, just as finance companies and credit sellers often take a security interest in consumer goods to help secure repayment by their consumer/customers, the lenders to finance companies and credit sellers take a security interest in the notes and installment sales contracts to help secure repayment of loans to their borrower—the consumer finance company or credit seller.

Now comes the fun part.

When the chattel paper (the promissory note or installment sales contract) is tangible, it is easy enough for the lender to either take physical possession of the paper contract, or otherwise place a restrictive statement on the paper contract indicating the security interest of the lender in the chattel paper. But, what about when there is no tangible paper—when the transaction creating the chattel paper is in electronic format?

In this scenario the concept of “perfection by control” comes into the picture. Under the UCC, “control” of the chattel paper is required to establish perfection of the security interest for the purposes of Article 9 of the UCC. I discussed “perfection” in a blog here.

Accordingly, the lender to the creditor wants to perfect its interest in the chattel paper; and it accomplishes the same in the electronic format, by having the finance company or credit seller enter into a control agreement with a company that agrees to “control” or hold the electronic collateral in a custodianship or bailment relationship. This relationship is established by a control agreement. That agreement allows the flexibility that the creditor needs to deal with its customers, while at the same time completing the perfection of its lender’s security interest in the electronic contracts that serve as collateral.

Interestingly, the control agreement for electronic contracts often refers to the custodian as an “electronic vault provider,” and the holding of the electronic contracts as being placed in an “electronic vault.”

And, now, you know more of the rest of the story…

Please Note: This is the one hundred seventy-second blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking here.