© MORRISON & FOERSTER LLP 2017 | mofo.com

Fintech 2017 – Models,

Charters and More

May 25, 2017

Oliver Ireland and Sean Ruff

NY2 791157

• Money Transmission

• Marketplace Lending

• Bank Charters

• Distributed Ledger Technology

Agenda

2

Money Transmission

3

• Money transmission is regulated by a comprehensive set of state and federal laws • State

• 48 states and the District of Columbia require a license to transmit money (in some form)

• Federal • Regulators and programs primarily focus on anti-money laundering (AML)

and anti-terrorism financing

• There is a new focus on consumer protection and compliance from the Consumer Financial Protection Bureau (CFPB)

• Federal oversight of money transmitters may include:

• FinCEN (Financial Crimes Enforcement Network) – handles anti-money laundering and terrorist financing

• CFPB – handles remittance transfer rule and general oversight of consumer financial services and products including money transmission

• Office of Foreign Assets Control (OFAC) – handles sanctions

• FTC – handles general consumer protection

• IRS – examines licensees for Bank Secrecy Act (BSA) compliance

Regulatory Landscape for

Money Transmission

4

• Some states, by statute, regulation or guidance, have explicit exemptions for situations in which an entity receives funds on behalf of the merchant (or payee), as opposed to receiving funds for transmission on behalf of the consumer (or sender)

• In some states, the statute simply exempts an “agent” of the payee/biller

• In other states, the exemption is more detailed • Both California and Virginia exempt payee agents subject to specific conditions

• Illinois has determined that certain types of “payment processing” are not money transmission

• These exemptions acknowledge that when a consumer gives his or her money to a (common law) agent, it is as if the funds have been received by the principal, and the consumer faces no risk of harm

• From the consumer’s point of view, the transaction is complete

State Regulation – Exemptions

5

• Must obtain licenses in each state where you will do business (i.e., have customers) with a few exceptions

• Getting licensed • Process varies by state, but generally involves

• Completing applications (most states have their own application, but the National Mortgage Licensing System [NMLS] allows for a single, simultaneous electronic filing of applications in a number of states)

• Bonding

• Application fees

• Applications generally require • Background information about the entity

• Business plan

• AML program

• Biographical and financial information about the executive officers and directors

• Money transmitters must register with FinCEN and have an AML program (same program for state and federal compliance)

If You Are a Money Transmitter…

6

• Maintaining licenses

• Renewal requirements

• Maintaining an AML program

• Examinations of compliance with state and federal law

• Federal examiners include FinCEN, IRS and CFPB

• Recordkeeping, reporting and disclosure obligations

• Receipt disclosures

• Maintenance of permissible investments

• Recordkeeping requirements

• Records of payments and outstandings, a general ledger

• Additional records relating to money laundering compliance, such as suspicious activity reports and reports relating to large transactions

• Reporting requirements

• Ordinary (annual financial audits, changes to the business)

• Not so ordinary (significant events such as filing for bankruptcy or reorganization)

Life as a Licensee

7

• The BSA was enacted in 1970 in response to concerns about the proceeds of illegal activities being laundered through bank accounts. It requires financial institutions and other entities to maintain copies of checks and other financial records, and to report certain financial transactions to federal authorities

• The USA PATRIOT Act (Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001) significantly amended the BSA and authorized the U.S. Treasury Department to promulgate rules to encourage further cooperation among financial institutions, their regulatory authorities, and law enforcement authorities to facilitate sharing of information regarding individuals and entities suspected of engaging in terrorist acts or money laundering activities

Federal – Bank Secrecy Act

8

• FinCEN regulations implementing the BSA identify seven types of money services businesses (MSBs), including providers and sellers of prepaid access and money transmitters

• Exemptions and limitations to the definition of an MSB: • Activity-level thresholds relating to prepaid access

• Exemptions for certain types of “payment processing”

• Whether an entity is an MSB is a “question of facts and circumstances” • A number of FinCEN rulings and interpretations provide guidance on

whether specific scenarios are “money transmission” under the BSA

• An entity that is not an MSB under FinCEN’s definition may still may be considered a “money transmitter” under state licensing laws • And if you are an MSB under state law, you need to register with FinCEN

and have an AML program in compliance with the BSA

Federal – Bank Secrecy Act,

cont’d. 9

• FinCEN regulations require non-bank MSBs to: • Register with FinCEN

• Maintain an AML program that adheres to BSA program requirements

• Adequately monitor to detect suspicious activity

• File currency transaction reports (if applicable)

• File reports of suspicious transactions (SARs)

• Identify persons conducting certain transactions

• Maintain records of financial transactions

• The BSA provides for civil penalties for willful violations of these requirements

• The Treasury Department may assess civil penalties on any domestic financial institution or nonfinancial trade or business and on any partner, director, officer, or employee of a domestic financial institution who willfully participates in a violation

Federal – Bank Secrecy Act,

cont’d. 10

• All entities must comply with sanctions programs administered by OFAC • The sanctions laws enforced by OFAC bar engaging in trade or financial

transactions with certain specified countries and/or “specially designated nationals” (SDNs)

• OFAC administers and enforces economic and trade sanctions based on U.S. foreign policy and national security goals

• Under OFAC guidelines, although a sanctions compliance program is not required, the existence of a risk-based OFAC compliance program is used by that agency in determining whether to seek civil penalties and/or criminal penalties for violations

• The statutes administered by OFAC generally impose strict liability

• U.S. companies (both banks and non-banks) typically screen customers against the OFAC SDN list

Federal – Office of Foreign Assets Control

11

Marketplace Lending

12

• There are two potential ways in which to lend • The non-bank partners with a bank or state-licensed lender

(bank partnership model)

• The non-bank serves as the lender

• Each potential option may require a license • Lending license to originate loans

• Debt collection or servicing license to collect payments on the loans

• Loan brokering license to assist in the procurement of loans

Lending Framework – Overview

13

• The non-bank enters into an arrangement with a bank (e.g., national bank, state-chartered bank) or a state-licensed lender in which the bank or the licensed lender originates the loans for the individuals, and the non-bank purchases the loan receivables from the bank/licensed lender

• Under this arrangement, the non-bank would perform certain functions for the bank/licensed lender, such as marketing, servicing and facilitating the platform

• For example, the non-bank may assist in collecting application information, perform underwriting using the bank/licensed lender’s credit criteria, etc.

• This arrangement would be formalized into an agreement with the bank or state-licensed lender

• The bank or state-licensed lender would enter into an agreement with the individuals, and be able to charge interest on the loans

Lending Structure – Bank Partnership Model

14

Lending Structure – Bank

Partnership Model, cont’d. 15

• In May 2015, the U.S. Court of Appeals for the Second Circuit issued a decision in Madden that created uncertainty for the bank-origination model used in connection with marketplace lending platforms

• Issue: whether interest charged by a non-bank assignee of debt originated by a national bank is protected by the National Bank Act from state usury laws

• The plaintiff in Madden defaulted on her bank-issued credit card account, and the bank sold the debt to Midland Funding

• The interest rate on the credit card account was higher than the maximum rate permissible under the usury law of Madden’s state, New York

• Under the NBA, the bank could rely on federal preemption of the state usury law because it is a national bank that could charge the interest permitted under the laws where the bank is located, i.e., exportation

• Nonetheless, Madden sued non-bank debt collector Midland Funding for charging a rate in excess of the New York usury limit after the bank sold the debt to Midland

• In 2013, the U.S. District Court for the Southern District of New York found for Midland Funding, but the Second Circuit overturned that decision

Madden v. Midland Funding LLC

16

• In November 2015, Midland Funding petitioned for certiorari

• On June 27, 2016, the U.S. Supreme Court denied certiorari in Midland Funding

• The case could have significant implications for the secondary loan market, which relies on the long-standing ‘valid when made’ principle of contracts

• And in particular for marketplace lenders, which routinely purchase and sell bank-originated loans

• At present, the Madden holding applies only in the Second Circuit, which is comprised of Connecticut, New York and Vermont

• The federal Financial CHOICE Act, H.R. 10, includes a “fix” for the Second Circuit decision

• On February 27, 2017, the U.S. District Court for the Southern District of New York ruled that Madden may proceed with a class lawsuit against Midland Funding

Midland Funding LLC v. Madden

17

• Some cases have held that the bank partner rather than the bank is the “true lender”

• Results in violation of state licensing laws

• Usury issues

• No clear test • Predominant economic interest

• Substance over form

• Factors • Bank partner funds the loan

• Bank partner sets underwriting criteria

• Bank partner indemnifies bank

• Bank return on interest in the loan

• Type of loan

Bank Partnership Model – True Lender

18

• The non-bank would act as the lender to the individuals

• The non-bank would enter into a loan agreement with each individual in which the individual agrees to repay the non-bank as the lender

• The non-bank may be required to file applications to obtain state lending licenses

• License application requirements include net worth, experience, bond and approval by state regulators

• The non-bank would need to obtain funding or have funds to originate the loans

Lending Structure – Non-Bank as Lender

19

Lending Structure – Non-Bank

as Lender, cont’d. 20

Bank Charters

21

• In December of 2016 the Comptroller of the Currency solicited comment a white paper, “Exploring Special Purpose National Bank Charters for Fintech Companies”

• The white paper addressed issues associated with, and conditions for, extending national bank charters to Fintech companies

• The White Paper said the OCC could grant a special purpose national bank charter to companies that either engage in fiduciary activities or engage in at least one of the three core banking functions: (1) receiving deposits, (2) paying checks, or (3) lending money

• The OCC said that issuing debit cards or engaging in other means of facilitating payments electronically is the “modern equivalent of paying checks”

• This should include money transmission

• In March of 2017 the OCC released a draft supplement to its licensing manual for Fintech Charters and a Summary of Comments and Explanatory statement responding to the comments received on the white paper

OCC Special Purpose National Bank Charter

22

• The OCC stated that three principles would guide national bank Fintech charters:

• The OCC would not allow inappropriate comingling of banking and commerce

• The OCC would not allow products with predatory features or unfair or deceptive acts or practices

• Fintech charters would not receive a light touch in the supervisory process

• A Fintech charter would be limited banks that do not take deposits thereby opening them up to companies where the parent company does not want to become bank holding companies subject to the Bank Holding Company Act

• The OCC’s also noted capital and liquidity requirements would be tailored to the particular activities of the Fintech company

• The OCC also emphasized the importance of financial inclusion in a Fintech company’s business plan

OCC Special Purpose National

Bank Charter, cont’d. 23

• In April 2017, the Conference of State Bank Supervisors filed a lawsuit challenging the legality of the OCC Fintech charter

• In May 2017, the New York Department of Financial Services filed a similar suit

• Also in May, the CSBS announced Vision 2020 for Fintech and Nonbank Regulation including:

• Redesign and expansion of its multistate licensing system

• Creation of a working group to harmonize multistate supervision

• Plans to establish an industry Fintech advisory panel

• Education programs to assist state banking departments

• Efforts to make it easier for banks to provide services to non-banks

• Support for federal legislation that would allow state and federal regulators to better coordinate supervision of bank service providers

OCC Special Purpose National

Bank Charter, cont’d.

24

• On May 1, 2017 the Federal Deposit Insurance Corporation released a new Handbook for Organizers of De Novo Institutions

• The Handbook does not establish new policy or guidance, but seeks to clarify the process

• State-chartered industrial banks are not considered to be banks under the Bank Holding Company Act, so the parent Fintech company would not become a bank holding company

State Bank Charters

25

Distributed Ledger

Technology

26

• “A set of synchronized ledgers managed by one or more entities”

• Potential to: • Reduce reliance on centralized ledgers

• Reduce complexity and improve end to end processing speed

• Decrease the need for reconciliation

• Improve transparency

• Improve network resilience

• Reduce operation and financial risks

• BIS Committee on Payments and Market Infrastructure February 2017 Report, “Distributed ledger in payment, clearing and settlement - an analytical framework”

• Federal Reserve Board December 2016 Working Paper, “Distributed ledger technology in payments, clearing, and settlement”

What Is It?

27

• Most financial assets are maintained in book entry with a central registry of ownership that may involve layers or tiers of owners or record keepers

• Central counterparties may be used to transfer financial assets from one party to another

• Common structure for financial market intermediaries

• A single ledger may limit uncertainty as to ownership

• A single ledger also may • Limit transparency

• Make the system vulnerable to risks that may affect the single ledger

• Advances in communications and data management allow for multiple ledgers that can be updated more or less simultaneously

What’s Different?

28

• Assets or records of assets are maintained on a set of ledgers

• Ledgers can be updated through entries in multiple nodes

• Participants are identified and authenticated

• Consensus across nodes leads to an agreed upon common ledger

• Access can be restricted or unrestricted

• Ledgers may be limited to current balances or contain a history of transactions

• Transaction can be recorded in batches or blocks and added to the previous transaction when the block is confirmed, forming a blockchain

How Does It Work?

29

• Applicable law

• Integrity of and proof of records

• Transaction timing and finality

• Transaction enforceability

• System accountability and responsibility

• Regulatory issues for the distributed ledger

Key Issues

30

• The lack of a central administrator complicates accountability in the distributed ledger context

• Access points for the distributed ledger (e.g., exchangers) or the software or protocol publisher, if known, may be held accountable

• What entity is responsible for addressing a system-level breach or systemic fraud and should be the focus of examination or enforcement?

Regulatory Issues

31

• Legal issues arise at different points in the technology lifecycle

• UCC Article 4A established a legal framework for wire transfers that had been going on for decades

• NACHA Rules and the Automated Clearinghouse were designed for a technology that had not yet been implemented

• Check21 cleared the way for banks to employ existing technology that was inconsistent with existing legal requirements

• Whether or when a new legal infrastructure is necessary or appropriate to address new technologies must be decided on a case-by-case basis

• Focusing on the various use cases for distributed ledgers, ledger structures, and assets stored on the ledger can obscure the core legal and regulatory issues

• The lack of a central administrator complicates accountability in the distributed ledger context

• Access points for the distributed ledger (e.g., exchangers) or the software or protocol publisher, if known, may be held accountable

• What entity is responsible for addressing a system-level breach or systemic fraud and should be the focus of examination or enforcement?

How Will the Legal and Regulatory

Framework Evolve?

32