Pan-American Surety Association Newsletter
"News@PASA 3/4 of 2007

Why E-Bonds Are Not Yet Widely Used in the United States

By: William J. Taylor, Esquire
Martha E. Johnston, Esquire
WHITE AND WILLIAMS, LLP
Philadelphia, Pennsylvania
USA

Electronic bonding is in increasing use worldwide, and is being hailed as the method of the future for the issuance of surety bonds in many national markets. At the recent International Seminar of the Pan-American Surety Association, speakers from Spain, the Netherlands, and Korea outlined the growing popularity of electronic bonds (or "E-bonds") in their surety markets. There is also an awakening of interest in the use of electronic bonds in the United States. Lynn Schubert, president of the Surety & Fidelity Association of America (SFAA), also spoke as a part of the panel on E-bonds at the Mendoza Seminar. Ms. Schubert described the development and growth of U.S. electronic bond methodology, particularly in the bidding and bonding of public construction projects - those that are initiated and controlled by the federal government or the various state governments and their regulatory agencies. The SFAA has fully supported the growth of U.S. electronic methodologies by partnering with the National Association of Surety Bond Producers (NASBP) and various construction industry organizations to develop guidelines for the electronic procurement of and bonding for U.S. federal and state public projects, promoting the use of an open and inclusive system so that electronic bidding and bonding can be widely implemented. Spearheaded by the SFAA efforts and state requirements, electronic bidding and bonding in the U.S. public sector has begun to take hold.

As also mentioned by Ms. Schubert, recent legislation at the federal and state levels has removed significant legal barriers to the growth of E-bonds in the United States. For example, the Uniform Electronic Transactions Act (the "UETA"), which was developed as a model law for each state and is currently enacted into law in 46 states, the District of Columbia and the Virgin Islands, and the federal Electronic Signatures in Global and National Commerce Act (the "E-Sign" Act), both provide that electronic documents and signatures, including notarized signatures and verifications, are legally enforceable in U.S. courts if the contracting parties have consented to their use in a transaction.

Despite these enabling statutes, enacted in 1999 (in some states) and 2000 respectively, and the example of electronic bond procurement on public projects, E-bonds have been slow to catch on in the U.S. surety market for nongovernmental projects. We will review in this article some of the remaining obstacles to the wide acceptance and use of E-bonds in the United States.

TECHNOLOGY AND UNDERWRITING ISSUES

Lynn Schubert described the successful use in the U.S. of electronic bidding and bonding in public construction projects, in which the federal or a state government is the owner/obligee. Most governmental entities appear supportive of electronic bond transactions. Various state Departments of Transportation, in particular, have led the way in adopting electronic bidding for highway construction contracts. Many of the state electronic bidding systems also include bond authentication systems so that bid bonds can be submitted along with the contractor's bid for the project. At least one state agency, the Pennsylvania Department of Transportation, also has in place an electronic final bond submission technology.

In the private sector, however, electronic bond transactions are still rare. Most private contractors, in contrast to government agencies, are not yet accustomed to preparing and reviewing construction contracts in an electronic format. Moreover, the more risky and complex contract bonds customarily used in the United States-such as 100% performance bonds required in connection with construction projects--require more comprehensive underwriting than either the 10% credit bonds described in some of the other Mendoza Seminar presentations or the bid bonds obtained at the initial phase of bid submissions for a contract. Bid bonds, such as those described in the electronic transactions supported by the SFAA and the NASBP for public projects, usually provide a penal sum limited to the difference between the low bid and the eventual contract price if the low bidder fails to complete a contract. Because of the surety's limited undertaking and financial exposure, bid bonds are normally issued for a nominal premium and with less underwriting.

Performance bond underwriting, on the other hand, usually requires a more thorough assessment of the principal's financial strength, especially if the contractor is a new client of the surety or the agent. The underwriters will want to review financial statements and progress reports for other projects, which are rarely maintained in electronic format. Additionally, the underwriter will need to assess the business judgment and management skills of the contractor, and investigate its on-going business operations. This type of intensive underwriting requires "paper" review as well as, at least occasionally, face-to-face meetings. Thus, the entire underwriting process cannot be accomplished electronically, and as a result the time-saving benefits of issuing an electronic bond are not as apparent as when the entire transaction can be underwritten and completed on-line.

While it may proceed slowly, we expect that the growth of electronic transactions in the U.S. surety industry will increase as more companies in the construction area become accustomed to electronic creation and storage of their financial documents. With continuing support and guidance from the SFAA and the NASBP, building on their work in promoting and coordinating bidding and bonding guidelines for public projects, as well as further clarification of the legal guidelines discussed below, more surety companies and non-governmental obligees should be convinced to implement the electronic execution and filing of surety bonds.

LEGAL UNCERTAINTY

Both the UETA and E-Sign are intended to remove barriers to electronic commerce by establishing the legal equivalence of electronic records and signatures to paper writings and manually executed signatures. The two statutes overlap in many respects, but they are not identical. UETA deals with more subjects than E-Sign, and certain subjects are addressed in a different fashion. Though a comprehensive review of the differences is beyond the scope of this article, one example is the issue of attribution. UETA provides, in Section 9 of the statute, that an electronic record or signature is to be attributed to a person as if it was the act of the person, and elaborates on the evidence that may establish the link between a person and an electronic signature. By contrast, E-Sign does not deal explicitly with the issue of attribution. Because disputes involving signed documents often center on not whether the document is signed but rather whose signature appears on a document, this issue remains open in the few states that have not adopted the UETA.

Another source of uncertainty is the question of how much does the federal E-Sign legislation preempt the provisions of the state UETA statutes. Under United States law, federal legislation takes precedence over a contrary state law which covers the same subject matter, if so intended by Congress. E-Sign affirmatively pre-empts state law only in its Section 101, which prohibits the denial of the validity of an electronic record or signature solely because of its electronic form "notwithstanding any statute, regulation or other rule of law. . . .". However, Section 102 of the E-Sign legislation then provides an exception to the pre-emption set forth in Section 101 - if a state has enacted UETA as originally approved and recommended by the Uniform State Law Commissioners in 1999, the state law will govern electronic contracting. Thus, any non-uniform provisions of UETA adopted by a particular state, must be evaluated separately under E-Sign Section 102(a)(2) to determine whether the state provisions are inconsistent with the federal law. If so, at least those non-uniform state provisions will be ineffective and pre-empted by the federal act. Before the advent of E-Sign, many states enacted the UETA with significant modifications or adjustments to the uniform statute, and as a result the question of whether the federal statute or state law governs particular issues in electronic transacting may be unresolved in those states. Further, although only four states in the United States have failed to enact some version of UETA, those four states-New York, Illinois, Georgia and Washington- all contain significant commercial hubs. The lack of state statutes governing electronic transactions in these states hinders the on-going growth of the use of E-bonds.

In addition, certain types of commercial transactions are specifically excluded from the coverage of both electronic transaction statutes. For example, both the UETA and E-Sign, in identical language, exclude from their coverage Articles 3 through 9 of the Uniform Commercial Code, which is enacted in some form in every state. These excluded UCC sections govern paper-based negotiable instruments, the checking system, letters of credit and secured transactions. Article 9 of the UCC, regulating secured transactions, is particularly significant for the surety industry because standard surety indemnity agreements often provide secured rights from indemnitors to sureties to protect the indemnity rights of the surety. Article 9 of the UCC governs how these security interests are perfected as against other creditors. Specifically, the perfection of a security interest is accomplished by the filing of a financing statement with the proper state authority to record the surety's potential claim to the principal's property (such as accounts receivable, equipment and inventory). A paper document supporting the financing statement, with a manually-executed signature by the principal, is required to be filed. The exclusion of UCC Article 9, which governs such filings, from the coverage of the UETA and E-Sign acts would seem to remove that part of the bonding transaction from the electronic realm. Fortunately, revisions adopted to Article 9 itself in most states provide for separate validation of electronic records and signatures. For example, Article 9 of the UCC as adopted in Pennsylvania has been revised to add definitions for "Electronic Chattel Paper" (". . .evidenced by a record consisting of information stored in an electronic medium") and to revise the definition of "authenticate" to include an electronic signature as an alternate method of authentication. 13 Pa. C.S.A. § 9102. The latter definition is significant because one of the conditions of enforceability of a security interest with respect to collateral is that the debtor has "authenticated" a security agreement which provides a description of the collateral.

Obviously, it would be preferable to have a more predictable body of law in place governing all electronic transactions throughout the United States. But the current statutes described above have at least set the stage for further development of electronic methodologies in contracting generally. Adjustments in the legal framework will no doubt occur after more experience with the model has been accumulated. Greater comfort with, and increase use of, electronic bonding systems in the United States should then follow.