BNA INSIGHTS: Fintech Innovation and Opportunity Meet the Regulators

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Financial Technology

In this first article in Troutman Sanders' series on fintech, the authors focus on the major areas of fintech's innovation and disruption, examine the regulatory and legal challenges in these spheres, and discuss how fintech companies can better exploit the opportunities created by emerging regulation.

Aurora Cassirer Katherine  McDaniel

By Aurora Cassirer and Katherine McDaniel

Aurora Cassirer is a Partner in the New York office of Troutman Sanders LLP , and is a member of its Fintech practice group. Her practice focuses on business related ligation and regulatory and compliance issues.

Katherine McDaniel is counsel in the Business Litigation Department of Troutman Sanders LLP.

Broadly defined, fintech (short for financial technology) is an industry of forward-thinking companies using technology to deliver new types of financial services or to improve on the delivery and efficiency of standard financial services. Many fintech companies are startups that aim to disrupt the market and supplant incumbent players. However, established financial services companies are increasingly fighting back by adopting or looking to adopt some aspects of the fintech business model.

With disruption and innovation inevitably come legal challenges – especially in the form of evolving regulatory landscapes. But increased industry regulation is not always a drawback. fintech companies that are responsive to the emerging regulatory environment may be able to influence it and turn proactive compliance measures into a competitive advantage.

In this first article in Troutman Sanders' series on fintech, we focus on the major areas of fintech's innovation and disruption, examine the regulatory and legal challenges in these spheres, and discuss how fintech companies can better exploit the opportunities created by emerging regulation.

Banking

Many fintech companies seek to supplement or supplant services traditionally offered by banks. fintech innovations include peer-to-peer lending platforms, loan repackaging, and alternative forms of payment processing. fintech companies compete with traditional banks with the promise of greater consumer efficiency and lower or more transparent pricing.

Because these companies are not chartered banks, they are not regulated by the Federal Deposit Insurance Corporation (FDIC). However, many fintech companies have recognized that they need to acquire banking licenses with various states. Moreover, depending on their business model, they could be subject to regulation by the Consumer Financial Protection Bureau (CFPB), the FTC, or the SEC.

The Department of the Treasury recently released a report on the current landscape and its predictions for future action. Optimistically, the Treasury recognized that fintech companies can offer real benefits to consumers, especially by expanding access to credit to non-traditional borrowers. However, the report also proposed several reforms, including increased regulation.

Specifically, the Treasury recommended introducing “more robust small business borrower protections and effective oversight” and promoting greater transparency by adopting “[s]tandardized representations, warranties, and enforcement mechanisms,” “consistent reporting standards for loan origination data and ongoing portfolio performance;” and making “[l]oan securitization performance transparency” transparent.

Similarly, The Office of the Comptroller of the Currency (OCC) released an “Enterprise Risk Appetite Statement” in April, in which it analyzed the various risks posed by fintech banking companies and outlined the OCC's tolerance for each of those risks. As admitted by the OCC in the accompanying press release, the Risk Appetite Statement reflects the agency's “overall conservative risk appetite.”

Though the stated goal of the paper was to provide “clearer signposts by which to guide [the OCC's] decisions” and to allow “external stakeholders” to “better understand OCC actions in the context of the risks facing the agency,” the actual guidance provided was painted with a very broad stroke, leaving the landscape still largely unsettled. On the positive side, the OCC indicated that it “will accept more risk in some areas to remain nimble, and can adapt to the changing needs of supervising national banks and federal savings associations.”

While the Treasury and the OCC have provided forward-looking guidance, other regulatory authorities have forecast their approach by taking direct action against fintech companies. For example, the CFPB recently flexed its muscles by levying an action against Dwolla, a digital-payment company, alleging that Dwolla had misrepresented its data protection and security measures. Without admitting wrongdoing, Dwolla agreed to pay a $100,000 civil penalty and to change certain security practices. Separately, the CFPB announced that it would begin investigating complaints about online marketplace lenders brought directly by consumers.

Fintech companies and incumbents looking to enter the space are clearly taking note of these developments and have taken a variety of measures that range from internal housekeeping, to scaling back operations, to exiting the market altogether. Earlier this year, LendingClub ousted its own founder and CEO, Renaud Laplanche. The ouster followed an internal probe of the company's sale of $22 million in loans whose characteristics violated the investor's express instructions. Though LendingClub notified the SEC in an effort to mitigate damages, the SEC's Enforcement Division and the Justice Department are still pursuing a formal investigation. Civil litigation is likely to follow. Blackstone took a more drastic measure, delaying its plans to enter the online lending market. Only seven months ago, Blackstone had announced its intention to launch Lending.com, which was supposed to provide consumer and small business loans.

While the regulatory developments and recent high-profile scandals may scare off some players in the market, the emerging regulatory environment can actually create a greater opportunity for those fintech companies that choose to remain in the banking space. The ability to navigate the regulatory and litigation landscape will be the key to maximizing rewards and minimizing risks.

Investment & Advisory Services

In addition to disrupting the banking sector, fintech has also entered into the market investment and advisory space. One of the biggest areas of potential growth is crowdfunded securities trading. Early crowdfunding sites like KickStarter and GoFundMe paved the way by allowing businesses and individuals to raise money online for projects, charity, or personal causes through small contributions.

However, no crowdfunding platform has yet allowed companies to exchange equity or other forms of participation in the proposed business or project itself. That is about to change, as the SEC's final rules on crowdfunded security sales just went into effect. While the new SEC rules place restrictions on how crowdfunding can be used and who can use it, the rules also provide much needed clarity.

Moreover, the rules created a new category of SEC registrant, a funding portal, which provides greater opportunities for fintech companies that operate as intermediaries and that don't wish to deal with the burden of full registration as a broker. SEC Chair Mary Jo White recently addressed the SEC's expectations that these funding portals would “serve as a classic gatekeeper” and that the SEC would “closely monitor the funding portals through rigorous inspections and examinations as well as close coordination with FINRA.”

But fintech can also use SEC scrutiny to a competitive advantage by touting regulatory compliance and engendering consumer trust. Thus, while the new SEC regulations present some hurdles, they have also reduced uncertainty, and thus risk, by providing clarity and by giving fintech companies a new metric on which to compete – namely, compliance.

Fintech companies are also disrupting the market for financial advice and investment analysis. Of course, the use of technology in this space is not new (for example, the first Bloomberg Terminals hit the market in 1982), but fintech is decentralizing the power of big data and delivering it to the people. Companies like Betterment provide robo- or AI-guided advice, beginning with user-generated inputs ( e.g., age, assets, risk profile) and then use proprietary algorithms to create individualized investment portfolios.

The SEC has made clear that companies offering robo-advice must register as advisors, but there is uncertainty as to whether they will be held to the same standard as human advisors are. SEC Commissioner Kara Stein recently acknowledged that regulators were grappling with how to parse the role of robo-advisors, posing the rhetorical question, “what would a fiduciary duty mean to a robo-adviser?”

Meanwhile, the Department of Labor recently revised the Fiduciary Rule such that advisors dealing with IRA assets now must act as fiduciaries, whereas prior to the revision, they only needed to ensure that an investment was “suitable,” i.e., that it met the objectives and means of an investor.

The Fiduciary Rule is not yet in effect, and the U.S. Chamber of Commerce, along with other business groups, have sued the DOL over the revised rule. But many in the fintech advisory community have reacted differently, suggesting that the revision to the Fiduciary Rule is a positive development from a business perspective. For example, Betterment and Wealthfront have publicly supported the revised DOL Fiduciary Rule. As Betterment's two co-founders explained in a public letter, technology-driven advice allows fintech companies to “offer[] lower, transparent prices, fiduciary advice, and superior experiences,” which “will prevail in the market against heavily conflicted, legacy business models.” Wealthfront's CEO, Adam Nash, echoed the sentiment that fintech would benefit from the rule by forcing incumbent players to operate on the same standard, stating “[Wealthfront's] mission isn't just to provide better value and service to our clients, but to force the entire industry to do the same.”

Monetary Exchange, Currency Exchange, and Crypto-Currency

Fintech has also changed the way consumers exchange money. Cash is no longer king, and P2P payment companies, like Venmo and Square Cash, have promised consumers an easy way for individuals to square up without resorting to wire transfers or personal checks. Other fintech companies, such as CurrencyTransfer, seek to disrupt the foreign exchange (FX) markets. Finally, the creation of cryptocurrencies, such as bitcoin and Ethereum, offers consumers a wholesale departure from reliance on government-backed monetary systems. Each of these fintech areas faces both challenges and opportunities.

Delaware, arguably the most corporate-friendly state, is encouraging innovation in the fintech space. Earlier this year, Delaware Governor Jack Markell announced plans to update the state's legal and regulatory environment to make it more attractive to innovative companies. Gov. Markell also indicated that Delaware would observe the industry as it evolves, while working with the industry and consumer groups to determine best practices.

Federal regulators have already waded in. As noted above, the CFPB has already been involved in investigating and bringing actions against fintech companies, including an action against Dwolla, which resulted in a $100,000 civil penalty. Meanwhile, last spring, Venmo, the peer-to-peer payment company owned by PayPal, disclosed in a SEC filing that they are in the middle of an investigation by the Federal Trade Commission (FTC) over allegedly deceptive or unfair practices. Depending on the outcome of the investigation, civil litigation may soon follow.

Anti-money laundering (AML) regulations present another set of challenges to fintech companies whose business model relies on exchange of money. Last year, the Financial Crimes Enforcement Network (FinCEN) investigated Ripple, a currency exchange and remittance network that accommodates traditional and nontraditional currency including cryptocurrency, commodities, and other units of value such as frequent flier miles or mobile minutes.

Ultimately, FinCEN levied a $700,000 civil money penalty against Ripple for a variety of lapses, including not registering as an MSB, selling a virtual currency without registering, and failing to implement and maintain an adequate anti-money laundering program. Fortunately, fintech companies can avoid the same pitfall by proactively adopting AML compliance programs.

The fintech companies jumping into the FX market face a special challenge as they must deal with regulations in multiple foreign jurisdictions. Some companies, like TransferWise and Kantox, operate on a peer-to-peer basis. Whereas others, like CurrencyTransfer serve as a foreign exchange aggregator, offering live exchange rates from a variety of bidders and allowing users to book their transfers in real time. In a recent interview, Daniel Abrahams, the co-founder and CEO of CurrencyTransfer.com, acknowledged that because “foreign currency exchange is a regulated environment” overcoming “all the compliance hurdles for activation, and delivering an elegant and fast user onboarding journey is a real optimization challenge.” However, despite these challenges, CurrencyTransfer remains confident that its proactive and innovative approach towards compliance has given it a competitive advantage, noting that they built the “world's first multi-supplier compliance form” which allows users to interact with “many non-bank FX suppliers in one elegant onboarding form.”

Crypto-currencies, such as Bitcoin and Ethereum, have also attracted the interest of regulators. In 2013, FinCEN classified Bitcoin as a convertible decentralized virtual currency and made clear that Bitcoin and other crypto- or virtual-currencies were subject to its regulatory authority. FinCEN later clarified that individuals and businesses that mine virtual currency for their own use, or purchase and sell convertible virtual currency solely as an investment remain unregulated.

But exchanges and other trading models that rely on virtual currency or blockchain technology remain under target. For example, FinCEN recently issued guidance that companies seeking to tokenize commodities for blockchain-based trading were subject to FinCEN's regulations concerning Money Service Businesses (MSB) under the Bank Secrecy Act (BSA).

On the civil front, litigation continues to unfold following the collapse of Mt. Gox, the Japanese Bitcoin exchange, including the class action lawsuit, Greene v. Mt. Gox, currently pending in the U.S. District Court for the Northern District of Illinois. Despite these regulatory and legal developments, blockchain technology presents an enormous opportunity for innovation.

Conclusion

Fintech companies will continue to innovate, using technology to seek to improve on traditional banking and financial services and to create wholly new products and business models. However, as they do so, fintech companies must be constantly keyed into the regulatory environment as the very nature of their business is to serve consumers and smaller business, an area which is in the crosshairs of the CFPB, FTC, OCC, and other Federal agencies.

But fintech companies do not need to navigate the regulatory landscape alone. Experienced lawyers can provide important legal guidance aimed at mitigating risks and helping companies better exploit the opportunity presented by emerging technology. Further, fintech companies can turn increased industry regulation to their advantage by adopting compliance programs early, innovating more streamlined compliance processes, and communicating to their users that compliance allows them to offer a better, more transparent, or more secure type of banking or financial service.

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