In trade, it's time to digitize a trusted old friend

Today, one can buy virtually anything with the click of a mouse.  Like the extinction of the quill pen, requiring handwritten signatures on pieces of paper is no longer necessary to do business.

Isn’t it somewhat anachronistic, therefore, that when it comes to one of the main instruments recognized under international law to settle payments in global trade for hundreds of years electronic signatures are a no-no?  The document in question is the bill of exchange, also known as a draft.

Simply defined, a draft is an unconditional written payment order by one person (the drawer) directing another person (the drawee) to pay a certain sum of money on demand or at a definite time in the future to a named third person (the payee) or to bearer.  Drafts are sometimes called Trade Drafts when used in general trade or a Bank Draft when drawn on a bank.  In Britain and the Commonwealth, drafts are called Bills of Exchange.  Drafts are negotiable instruments – allowing the unconditional promise of the obligor (drawee) to pay the draft be transferred or endorsed to subsequent parties.  A bonafide purchaser of an accepted draft for value (a “holder in due course”) takes the instrument free from the claims and free from most defences of the parties obligated on it.

The reason why electronic signatures are forbidden is that Article 3 of the Uniform Commercial Code (UCC), first published in 1952, as a way to harmonize the law of sales and commercial transactions of the 50 states of the U.S., requires that a bill of exchange must be executed in a “writing” or “tangible form”.  An electronic format is deemed intangible and therefore prohibited by the UCC.  The same requirement for written signatures on drafts is generally true of legislation in other countries – such as the United Kingdom’s Bill of Exchange Act of 1882, Canada’s namesake of 1982 and Singapore’s of 1949 (revised 2004).

Isn’t it about time that legislators bring the U.S. (and other jurisdictions) out of the age of green visors and fountain pens and allow trade drafts to enter the commerce of the 21st century in electronic form?  After all, other State and Federal law permits electronic signatures to create commercial obligations, such as:   

·       The Electronic Signatures in Global and National Commerce Act (“E-Sign”) is the Federal statute governing electronic signatures.  E-sign generally affords signatures, contracts and records in electronic form the same legal effect, enforceability and validity as other signatures, contracts and records.

·       The Uniform Electronic Transactions Act (“UETA”) has been adopted in all but three states – New York, Illinois and Washington.   UETA provides that negotiable instruments such as promissory notes and other commercial paper that are created electronically may also be transferred electronically.

·       The Electronic Signatures and Records Act (“ESRA”) is the New York law governing electronic signatures, contracts and records.

Digital signatures can be used to ensure the integrity, authenticity and non-repudiation of an electronic document. A digital signature typically comprises three main elements: (a) public/private key pair; (b) a one way hash function; and (c) a reliable mechanism for publishing public keys. These elements combine to produce a mechanism that can be used to confirm the identity of the person that signed the electronic document, the authenticity of the electronic document and the integrity of the electronic document.

Even though many countries are still stuck in the old ages, the Chinese have moved on!  In October 2009, the People Bank of China (the central bank) launched the Electronic Commercial Draft System (ECDS). The consequence has been a rapid growth in the use of trade drafts by financial institutions to finance commercial trade (they now represent 16% of total Chinese money supply according to the PBOC). They recognized that paper drafts faced a number of problems that could be solved via use of IT. These include operational inefficiency, errors in draft execution and discount, dishonor by non-payment and fake drafts, and unregulated innovation. The ECDS introduced a market and rules for trading and settling accepted drafts.

The reason why trade drafts are still used is that they offer key advantages in financing domestic and international trade:

·       Once a trade draft is accepted by a buyer it represents an unconditional legal obligation to pay that is separate from the underlying sale contract with a supplier.

·       The unconditionality of the buyer’s payment obligation removes dilution (dispute) risk and thereby encourages lenders to finance a higher percentage of the buyer’s payable

·       The accepted trade draft doesn’t affect the right of recourse the buyer may have to the supplier for non-performance

·       A “without recourse” endorsement of the accepted draft by the supplier shifts the credit risk of non-payment by the buyer to the lender (who can either accept this risk, insure it, or sell it to another party)

·       The use of trade drafts in reverse factoring can facilitate accounting treatment of such financing as trade payable discounting versus incurrence of bank debt on the buyer’s balance sheet

·       Since the trade draft is a payment instrument (i.e. not the invoice itself) it might be an effective way to circumnavigate restrictive covenants that a secured lender may require of a borrower (supplier) not to assign or pledge receivables to a third party.

·       As a negotiable instrument, a lender that discounts (or rediscounts) an accepted draft in good faith without notice that it is overdue or has been altered can rediscount it with another lender as a “holder in due course”. This facilitates funding/refinancing of trade receivables/payables.

The fact that trade drafts must be accepted in writing in paper format results in a cumbersome daisy-chain process that substantially detracts from the above benefits.  Drafts have to be created with information from an invoice or batch of invoices.  They need to be signed by the drawer/supplier, submitted to the drawee/buyer for signature, then held until maturity or discounted and ultimately presented for presentment for payment at maturity.

Electronic bills of exchange would facilitate straight through processing along with associated invoices.   They would also greatly enhance access by suppliers to early payment (and thereby improve liquidity and credit status) via platforms that provide receivables financing or reverse factoring/approved trade payable financing.   Once accepted by the buyer, lenders can make early payment to the supplier based on the certainty of buyer settlement at the maturity date.  And if buyers have a higher credit rating than the supplier, this can unlock cash to the supplier at a lower cost (reflecting the buyer’s superior credit rating versus the supplier’s).  Moreover, the transaction will be off balance sheet for the supplier since the discount of the trade draft will be without recourse for the buyer’s credit risk and therefore rank as a true sale.  Notwithstanding the lender’s early funding of the accepted draft to the supplier, the transaction remains as a trade payable (versus loan payable) on the buyer’s books. 

Lenders can arbitrage the respective borrowing costs of the buyer and seller and charge a fee for providing buyer credit insurance, if needed.  Since they are negotiable instruments, lenders who do not want to hold such assets on their books can sell electronic trade without recourse to a SPV.  This can be used as a conduit to attract funding by non-bank lenders such as hedge funds, insurance companies, family offices, accredited high net worth individuals and the like. 

The sooner we get to treat trade drafts like other contracts permitted by State and Federal law to be electronically executed the better.

To ensure certainty in the international trade, a uniform law regulating the issue of electronic drafts should be adopted. A good starting point would be to update the existing The United Nations Commission on International Trade Law Model Law on Electronic Commerce 1996, as amended in 1998, to provide for electronic execution and negotiation execution of drafts.  If adopted, this would could overcome deficiencies in the current statutory regimes and increase certainty in relation to the enforceability of electronic drafts. 

Trade drafts used to be signed by a quill pen (that’s how long they’ve been around). It’s now time to substitute an electronic signature!