Fintech 2020

Last Updated March 02, 2020

USA

Law and Practice

Authors



Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates advises businesses, financial institutions and governmental entities around the world on their most complex, high-profile matters, providing the guidance they need to compete in today’s business environment. The financial technology industry presents businesses and private equity, venture capital and other investors with extraordinary opportunities as well as challenging legal and regulatory issues. Skadden has helped clients to navigate this complex environment since the industry’s inception. The FinTech practice draws on the firm’s global platform and market-leading corporate finance, financial regulation and enforcement, intellectual property and technology, privacy and cybersecurity and M&A capabilities, making it uniquely qualified to offer clients exceptional depth of experience and full-service capabilities. Skadden would like to thank complex litigation and trials partner Alex Drylewski; M&A and financial institutions partner Jon Hlafter; financial institutions regulation and enforcement counsel Collin Janus; derivatives of counsel Jonathan Marcus; investment management associate Prem Amarnani; financial institutions associate Patrick Lewis; financial institutions associate Tim Gaffney; financial institutions associate Han Lee; and M&A associate Marcel Rosner for their invaluable contribution to this chapter.

"Fintech", the intersection of finance and technology, is a term that has enduringly entered the financial services lexicon. The term originally referred to the back-office operations of established financial institutions, but now refers to a broad range of activities designed to change and improve the delivery of financial services through the use of technology, encompassing every subsector of finance, including banking, non-depository lending, insurance, broker-dealer and investment adviser activities.

Deal-making activity in the fintech space increased in 2019, building off a strong 2018. Volume in venture capital investing and M&A activity reached new highs. Notably, the US fintech market showed signs of maturing, with venture capitalists focusing on later-stage funding rounds and M&A activity concentrated around larger deal sizes.

Venture capitalists continued to invest heavily in US fintech companies in 2019, including in the second quarter when a record high was set for quarterly venture investments at USD4.3 billion. Venture capitalists invested a total of USD6.8 billion in US fintech firms in the first half of 2019, continuing the upward trend from 2017 and 2018, when the total venture investments in the first half of the year were USD3 billion and USD5.7 billion, respectively. The trends show that – importantly – venture investment is continuing to pour into US fintech firms. The US fintech market is showing signs of maturing, as 2019’s 18% annual growth rate is more measured compared to 2018’s 90% annual growth rate.

Another sign of maturation in the US fintech venture market is the dominance of later-stage funding rounds. Deal activity increased for post-Series D venture investments in 2019 as compared to the first half of 2018. But deal volume decreased markedly for angel/seed and Series A-D ventures over the same time period. Now that venture capital-backed firms have had the opportunity to utilise the capital to grow, winners and losers are emerging. And venture capitalists are eager to continue to back winners. Carta, a leading player in the valuation software space, raised a USD300 million Series E round, while Affirm, a leading player in instalment loan consumer financing, raised a USD300 million Series F round after previously raising USD620 million in equity in prior rounds. Most importantly, Plaid, which raised USD250 million in venture capital in a Series C round in 2018, recently announced that it had signed a definitive agreement to be acquired by Visa for USD5.3 billion. The authors expect to see more large funding rounds in 2020, which has the potential to fuel the M&A market for the foreseeable future.

However, the market’s outlook is not entirely rosy. Amidst concerns that some fintech firms may not increase their already high valuation in their next financing round and could be forced to raise funds at a lower implied equity value than in prior rounds (a "down round"), investors are increasingly approaching the fintech sector conservatively. The economic and governance rights of existing investors are becoming of paramount importance as the industry matures because existing investors are seeking to avoid economic dilution and maintain their pre-existing governance rights in a down round. In last year’s version of this article, the authors noted – anecdotally – that they were aware of several fintech companies at risk of down rounds during 2019. The authors suspect this may have contributed to the decrease in early-round venture investment in 2019.

M&A activity in the fintech sector also continued to grow in 2019. In the first half of the year alone, M&A activity in fintech surpassed USD120 billion in transaction value, almost tripling the USD49 billion in deals announced for the same period in 2018. The surge in M&A activity was largely attributable to three mega-deals in the consolidating payments space: (i) Fidelity National Information Services' USD43.6 billion acquisition of Worldpay, (ii) Fiserv's $22 billion acquisition of First Data, and (iii) Global Payments' USD21.2 billion acquisition of Total System Services.

M&A activity in the first half of 2019 also generally showed a shift towards larger deal sizes, even setting aside the three aforementioned mega-deals. In the first half of the year, over 65% of deals had a disclosed transaction value above USD100 million, compared to 54% in 2018. Median deal size for the first half of 2019 also increased to USD193 million from USD137 million in the first half of 2018. Consistent with the trend in venture capital investments, this indicates maturing of the fintech sector, in that larger established companies are favoured over smaller players.

Emerging subsectors in fintech – such as insurance technology (insurtech), wealth management technology (wealthtech) and property technology (proptech) – experienced different trajectories. Deal value in insurtech was just over USD1.1 billion, compared to USD10 billion and USD7.6 billion in 2017 and 2018, respectively, showing a clear decrease in transactional volume. Wealthtech, on the other hand, rebounded in the first half of 2019 with deal value of USD2.2 billion, showing a marked growth from USD1.8 billion in all of 2018. Proptech, still a small niche sector, continued to grow, with just over USD1 billion deal volume in the first half of 2019 compared to USD1.4 billion in value in all of 2018.

There are several factors that suggest that M&A activity in the fintech sector will continue to be robust in 2020. According to one survey, 85% of banks and other financial institutions stated that fintech M&A is very important to their overall business strategy. Moreover, 79% of existing fintech firms believe that M&A in the industry is critical or transformative to their overall business strategy.

Traditional forms of investment in blockchain projects continued to advance in 2019 as the industry showed signs of maturing from the “initial coin offering” (ICO) rush of 2017 and 2018. Much of the investments continue to be for funding development projects for the underlying blockchain technology, but an increasing number of projects are focused on stablecoins, in which a cryptocurrency is pegged to a fiat currency or other digital assets to stabilise its value or is stabilised through a computer algorithm. Projects to "tokenise" non-digital tangible assets such as real estate and securities are also attracting increased investment by traditional sources of funding. In addition, cryptocurrencies such as bitcoin continue to attract attention, although primarily as a means of speculative investment. It remains to be seen which, if any, of the hundreds of available cryptocurrencies will survive and become true mediums of exchange.

For further discussion of the blockchain and digital asset regulatory environment, see 12 Blockchain.

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Robo-advisers use algorithms based on a variety of inputs, such as the investor’s age, investable assets, investment horizon, risk tolerance and other factors combined with modern portfolio theory-based investment strategies to provide wealth and investment management services without the human element of, and typically at a lower cost than, a traditional financial adviser. Traditional financial advisers and robo-advisers provide similar types of services, and therefore both (to the extent that they provide advisory services in the USA) are typically registered as investment advisers with the SEC or one or more state securities authorities. Both must also comply with the securities laws applicable to SEC or state-registered investment advisers. The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has provided guidance that, as a statutory fiduciary, when an investment adviser has the responsibility to select broker-dealers and execute client trades, each has an obligation to seek to execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favourable, taking into account the circumstances of the particular transaction.

As a general matter, many robo-advisers tend to focus on ETF investments, which reflects the increasing preference among the next generation of investors for low-cost, passive, diversified investments. The clients of robo-advisers tend to be younger, cost-conscious, hands-off investors who may initially have less capital available to invest. Because of the increased online presence of this next generation of investors, robo-adviser business models focus more on addressing the needs of their clients primarily through a greater online and social media presence. Many legacy players themselves are building their own robo-advisers, so they are able to offer a comprehensive set of products and services that appeal to a wide variety of investors.

Given the increasing role of electronic advice among providers of wealth and investment management services, OCIE has indicated in its examination priorities for 2020 that one of its areas of focus will be on robo-advisers, in particular with respect to SEC registration eligibility, cybersecurity policies and procedures, marketing practices, and adherence to fiduciary duty, including adequacy of disclosures and effectiveness of compliance programmes.

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Many online lenders are organised as non-bank entities. Lending activities by non-banks are governed not only by federal laws, but also significantly by state laws. Non-bank lenders must be mindful of the jurisdictions where their borrowers and applicants are located, as this factor significantly affects the legal and regulatory requirements applicable to the lender.

It is understandably difficult for regulators to keep pace with the rapid changes in online lending technologies. As such, the manner in which regulatory regimes are applied to online, mobile and other innovative delivery channels is evolving and often uncertain. Some states and federal authorities have amended their laws or regulations in this area, but those changes have often been incremental. The principal objective of these changes is the protection of borrowers and other customers. Although some laws apply only to consumer-purpose or residential mortgage lending, some key provisions generally apply to all types of lending, albeit sometimes with different specific parameters. For example, most types of non-bank lending are subject to maximum interest rates established under state law (usury rates), fair lending laws, data security requirements and the federal prohibition on engaging in unfair or deceptive acts or practices (UDAP).

State laws include non-bank licensing requirements that vary significantly from state to state. Even within a single state, the licensing requirements tend to vary based on the type of lending and the type of activity (eg, lending, servicing, brokering, collections). In many states, licensing of non-banks is required only for consumer or real estate-oriented lending activities. However, there are a smaller number of states (including California) that require licensing even for business-oriented, non-real estate lending.

Licensed non-bank lenders are generally subject to supervision, examination and enforcement jurisdiction of the state regulator where they conduct business, which is typically the state banking authority. The regulatory regime for such non-bank lenders differs from that applicable to banks. For example, licensed non-bank lenders are generally not subject to bank-like regulations regarding capital and liquidity, service to the community under the Community Reinvestment Act and deposit insurance assessments.

Many online lenders in the USA that are organised as non-bank entities have partnered with an unaffiliated bank. This bank partnership model seeks to take advantage of certain regulatory advantages (eg, federal pre-emption of state-by-state licensing and usury limits) and operational features (eg, access to traditional card and payment systems) available to banks. The specifics of each bank partnership vary and must navigate risks related to a complicated and fact-sensitive interplay of federal and state laws (eg, "true lender" risk).

In recent years, online lenders and other industry participants have begun to employ a growing variety of underwriting models. Lenders are implementing advanced algorithms and artificial intelligence (AI) in their underwriting processes to evaluate the credit of consumers, small businesses and other borrowers. These processes rely on a variety of data, such as FICO credit scores, bank transaction data, model-based income, social media, rent history, employment history, phone-number stability, browsing history and behavioural data. Federal and state laws have been slow to keep pace with technological developments used in the underwriting credit models.

Lenders (particularly when lending to consumers) should be mindful that the application of many federal and state laws to new and innovative types of underwriting inputs is evolving and uncertain. For example, the use of non-traditional data sources or automated processes could result in an unforeseen or unintentional "disparate impact" on a protected class of borrowers or applicants and create a potential risk under fair lending laws or a risk of UDAP.

Lenders rely on a variety of funding sources for loans, including deposits, peer-to-peer, lender-raised capital and securitisations.

Non-bank entities are not permitted to accept deposits. Therefore, banks are unique in their ability to accept deposits as a source of funding. Because they are generally insured by the Federal Deposit Insurance Corporation, deposits are generally viewed as a stable and low-cost source of funding. Banks are subject to extensive supervision, regulation and enforcement from the applicable federal and state banking regulators. Nonetheless, non-bank lenders have been exploring bank charters, such as the Office of the Comptroller of Currency’s so-called fintech charter and industrial bank charters, which may provide benefits to their specific business models that outweigh the costs associated with being a regulated bank.

As compared to banks, non-bank lenders generally have more limited balance sheet capacity and may rely more on funding from sources like equity raises, long-term debt, secured borrowing, securitisations and peer-to-peer funding. Marketplace lenders have historically employed a peer-to-peer funding model, where specific loans are funded mostly by individual investors. Securitisation is also a significant source of funding for non-bank lenders. Securitisation requires an assessment of applicable federal and state securities law, and generally requires extensive disclosure to prospective and existing investors.

Marketplace lenders generally serve as an intermediary for individuals, institutional investors and others to providing funds for a loan. The processes vary and continually evolve but generally are facilitated by an online platform that connects the potential borrower with investors. These platforms allow the loan funding process – from customer acquisition to underwriting and origination, and through servicing – to be entirely digitised. Borrowers may have reduced borrowing costs, more seamless customer experiences and shorter lead times to closing as a result of electronic delivery channels. As noted above, lending is regulated by a number of federal and state regulators in the USA and the nature of regulation varies across the bodies, and depends on the type of lender. This regulatory environment was generally developed in the context of traditional lending through physical delivery channels and has not necessarily kept pace with electronic or other innovative delivery channels.

Reliance upon existing payment rails is not required for payment processors. However, as consumers and corporations demand faster or “real-time” payments, payment service providers may consider addressing these demands by building upon the existing model or starting anew. The Clearing House's RTP network, for example, uses a Mastercard service to offer a real-time payments platform that US banks are eligible to use. Alternatively, some in the fintech space have chosen to build their own payment systems, such as ATCE Holdings's EtudePay Payments System, which is a real-time payments rail delivered on its own settlement platform for processing transactions.

In any case, banks remain key players in the broader payments industry. Therefore, the ability to convince banks to adopt new payment systems is an important consideration when building upon existing models or starting anew. As the industry evolves, both existing and new payment rails are being employed in novel ways to support traditional payment flows, while facilitating up-and-coming payments technology.

A payment processor based in the USA generally will be under the oversight of multiple regulators, including potentially multiple federal and state banking regulators. The scope of such oversight depends in part upon the services that the payment processor is providing and the types of banks with which it has certain relationships. Compliance with requirements established by the Office of Foreign Assets Control and the Financial Crimes Enforcement Network are particularly important considerations regarding cross-border payments given their requirements related to anti-money laundering practices. Cross-border payments and remittances also must comport with the various operating standards of the industry. For example, the payment card industry issues requirements applicable to merchants who process, store or transmit credit card information in an effort to ensure a secure transaction environment is maintained. A payment processor may also need to comply with the rules or standards applicable to the various credit card networks, such as the interchange fees that credit card networks may charge merchants. In short, there are several rules or standards that a payment processor must be aware of in order to operate in the USA.

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In the USA, blockchain-based assets, such as digital tokens and cryptocurrencies, are currently characterised as "securities" or, broadly speaking, "something other than securities". Blockchain-based assets that are securities (ie, security tokens) are, to the extent traded on an exchange, required to be traded on an SEC-registered national securities exchange or an alternative trading system (ATS). Conversely, blockchain-based assets such as bitcoin and other "pure" cryptocurrencies that are not currently characterised as securities are not subject to such a requirement. Therefore, trading platforms are subject to regulation based upon the type of asset that trades on such platform.

Based on recent estimations, there are hundreds of cryptocurrency exchanges and trading platforms around the world (collectively referred to herein as "trading platforms") and new ones seem to launch regularly. The explosion in number of these trading platforms has recently drawn significant attention from US regulators. Although standards vary, as a general matter, many trading platforms will not list any token that could potentially be viewed as a security, but will instead opt to list "utility tokens" or "pure" cryptocurrencies. This allows trading platforms to avoid the regulatory requirements associated with securities.

Trading platforms that advertise themselves to be so-called peer-to-peer trading platforms may fall within the definition of an "exchange" under the federal securities laws (which is broadly defined) and consequently such trading platforms may be subject to a variety of penalties, including monetary fines and orders to cease operations. The rules under the Securities Exchange Act of 1934 (the Exchange Act) provide for a functional test to determine whether a trading platform is, in fact, operating as an exchange.

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See 7.1 Permissible Trading Platforms for information on cryptocurrency exchanges.

The SEC does not set listing standards; rather, the various trading platforms set their own standards for listing and continuing to trade securities. Trading platforms that are willing to list securities tokens will often require that the token be linked to a high-quality, differentiated and value-adding product or service; have high-quality code that is as much as possible not susceptible to hacking; and have detailed information regarding technical specifications and legal rights and restrictions.

Given the rapid growth of the blockchain-based assets market and the risks it poses to retail investors who may not understand the difference between these relatively new assets and more traditional assets, OCIE has reiterated in its examination priorities for 2020 that it will continue to identify and examine SEC-registered market participants engaged in this space.

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See 7.1 Permissible Trading Platforms for information on peer-to-peer trading platforms.

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See 8.6 Rules of Payment for Order Flow.

High-frequency and algorithmic trading strategies (HFT strategies) are increasingly being utilised by proprietary trading shops and hedge funds (trading firms) as an enhancement to implementation of traditional trading strategies. At a high level, HFT strategies involve the application of software-based algorithms to trade in and out of high-volume positions of equities and other financial products at speeds faster than achievable by their human counterparts. HFT strategies vary significantly and can be used for exchange-based and OTC (or off-exchange) trades, as well as trades in currently unregulated markets such as the cryptocurrency markets.

Depending on the role and activities of the particular trading firm utilising HFT strategies, different regulatory regimes may apply to such firm. Hedge funds using HFT strategies are generally treated the same as hedge funds using other strategies and therefore may be regulated as investment advisers and required to register with the SEC or one or more state securities authorities. Such hedge funds must comply with securities laws applicable to SEC or state-registered investment advisers.

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Some trading firms employing HFT strategies operate as market makers or dealers, in which case such a firm would be required to register with the SEC as a broker-dealer. Certain broker-dealers rely on Rule 15b9-1 of the Exchange Act, which exempts them from the statutory requirement to become a member of the Financial Industry Regulatory Authority (FINRA). As a result of the exemption, FINRA has no jurisdiction over these broker-dealers and is therefore unable to enforce compliance with federal securities laws and rules. The SEC has recently proposed amending this exemption, as it prevents FINRA from being able to monitor use of HFT strategies and manipulative behaviour. Despite such trading firms being members of their respective exchanges, the exchanges are not able to regulate OTC activity as typically they only have access to the trade data for trades conducted on their own exchanges.

Trading firms operating as market makers often pay retail brokers in order to compete for retail order flow. Market makers that are willing to provide improved prices, made possible by utilising HFT strategies, may be better able to compete for such order flow. This leads to a potential conflict of interest for retail brokers, who are required to seek out the option that provides the best chance of execution, best speed of execution and best price, rather than selling their order flow to the highest bidder.

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The term "insurtech" covers a wide variety of technological innovations that aim to harness the power of technology to reinvigorate an age-old industry. Disruptors such as Oscar, Root and Lemonade seek to displace the traditional provider-customer relationship for a newer, app-based dynamic. Mature market players in turn have embraced innovations to fill a wide range of niches, ranging from policy pricing to fraud detection. Although the fractured regulatory environment insurance companies are subject to may stymie any one-size-fits-all solution, the inexorable march of progress nonetheless continues.

Underwriting processes often vary by product and industry participants. Innovative participants have begun relying on technologies such as big data, AI, wearables and telematics to improve underwriting and provide more accurate conclusions. That said, regulations in a particular jurisdiction may require that rates be filed with, and approved by, the appropriate insurance regulator. Such regulator may also prohibit specific factors from being considered, or may even prescribe the precise factors that must be considered, sometimes at odds with overall technical trends.

As the regulation of insurance in the USA is largely state-based, the regulations may vary significantly. For example, while some states expressly permit credit scores to be considered when rate-setting for property and casualty policies, numerous other states apply strong limitations. Some states expressly permit genetic data to be used in the life and disability space. Others expressly prohibit it. Other regulations, including those related to data privacy and anti-discrimination laws, may also impact the underwriting process. As a result, the process is often a bespoke one by necessity, taking consideration of the variances between jurisdictions. The National Association of Insurance Commissioners, consisting of representatives from each US state, has set up a number of workgroups and task forces to consider regulatory changes in response to technological developments in the industry.

Industry participants and regulators treat different types of insurance in significantly different ways. For example, they require different licences and different regulations governing the production of such business. This necessarily imposes impediments to any unified national solution. Instead, market participants often need to tailor their products and services to meet not one but 50 different approaches to insurance regulation.

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Blockchain technology, which uses a distributed ledger system and a consensus protocol to verify transactions, has the potential to transform any industry that today relies on a single trusted third party. Nowhere is this more true than across the financial services sector. Over the last few years, numerous firms in the financial services sector have been building out proof of concept platforms that rely on blockchain technology, with some projects already active. This trend is likely to continue and expand. In most cases, financial services firms are using so-called private, permissioned blockchains when transacting amongst themselves because these ecosystems limit who can join and employing the power of public permissionless blockchains when exploring consumer-facing projects. Potential applications include global payments, clearing and settling, syndicated loans, trade finance, convertible bonds and proxy voting. A number of financial institutions have also filed, and in some cases been granted, US patents on different blockchain applications.

In the USA, regulators are coping with how existing regulations, drafted to apply to centralised ecosystems, apply to decentralised systems where the actors may not be readily identifiable. The concept of blockchain regulation is, of course, anathema to many proponents of the technology who believe that its transparency and decentralisation means that there is no need for regulation. Set forth below are some key developments in the US regulatory landscape, with the caveat that this is a quickly evolving field.

As of the end of 2019, 21 bills addressing blockchain technology have been introduced in the US Congress. Two bills in particular stand out; one would exempt tokenised assets from securities laws, while the other seeks to establish a common definition of blockchains or stablecoins, and seeks to promote new ways of leveraging and innovating the technology. For example, in September 2019, the House of Representatives passed a bill requiring the Financial Crimes Enforcement Network to conduct a study on the implementation and use of blockchain and other technologies.

Although federal laws are still in their relative infancy, close to 30 states have enacted cryptocurrency or blockchain-related legislation as part of efforts to become hubs for blockchain innovation. As of May 2019, upwards of 237 pieces of blockchain-related state legislation had been introduced. Some states – including Arizona, North Dakota, Oklahoma and Washington – have amended laws so that records or contracts secured through blockchain technology are deemed enforceable electronic records. For example, in June 2019, the State of Nevada enacted legislation that revised the definition of “electronic transmissions” to include the use of blockchain technology, and authorised the Nevada secretary of state to adopt regulations that will allow business entities to carry out their duties using the most recent technology available, including blockchain. In January 2020, the Illinois Blockchain Technology Act went into effect, which affirms the contractual enforceability of smart contracts and other records for which blockchain technology was used. The State of Delaware, where more than half of US companies are incorporated, is also exploring a blockchain-based business filing system that will allow corporations to employ smart contract technology to track stocks and collateral assets. It is likely that, from a legislative perspective, states – as opposed to the federal government – will continue to take the lead.

In 2019, the SEC released new guidance regarding how to determine whether cryptocurrencies constitute securities. The SEC relies on the Howey Test as the current regulatory framework, first articulated in SEC v WJ Howey Co, 328 US 293 (1946). Under the Howey Test, courts analyse whether the instrument or offering in question satisfies all three of the following prongs: (i) “an investment of money”, (ii) “in a common enterprise” and (iii) “with profits to come solely from the efforts of others.”

The SEC first applied the Howey Test to cryptocurrency on 25 July 2018 in its so-called DAO Report, in which the SEC concluded that a particular cryptocurrency called DAO Tokens was a  security subject to regulation. Since then, there have been a number of SEC orders and court decisions applying Howey to analyse other ICOs: Paragon Coin, Inc, Securities Act Release No 10574 (16 November 2018); CarrierEQ, Inc, D/B/A AirFox, Securities Act Release No 10575; SEC v Blockvest, LLC et al, No 18-CV-2287-GPC (11 October 2018). In some of these cases, cryptocurrency developers have been required by the SEC to register under the Exchange Act, pay fines and offer rescission to investors. SEC enforcement action in this space picked up considerably in 2019, with a number of settlements announced. For example, in February 2019, the SEC required Gladius Network LLC (Gladius) to compensate investors and register tokens it offered in an unregistered ICO in 2017, but did not impose a fine on Gladius (see Gladius Network LLC, Securities Act Release No 10608 (20 February 2019)). The SEC's lenience with regard to the lack of a penalty was due in part to the fact that Gladius self-reported the ICO, which raised approximately USD12.7 million, to the SEC in 2018, took prompt remedial steps and co-operated with the SEC's investigation (id). In September 2019, the SEC settled charges against Block.one for conducting an unregistered ICO that raised the equivalent of several billion dollars over approximately one year. The company agreed to settle the charges by paying a USD24 million civil penalty. The SEC highlighted, in part, that Block.one’s offer began shortly before the SEC released the DAO Report of Investigation (the DAO Report) and continued for nearly a year after publication of that report. In December 2019, the SEC settled charges against Blockchain of Things Inc. (BCOT) for conducting an unregistered ICO of digital tokens. Here too, the SEC focused on the fact that BCOT conducted the ICO starting after the DAO Report was issued. The SEC’s settlement with BCOT allowed the company to register the tokens offered in an unregistered “pre-sale” and a “public sale” between December 2017 and June 2018, and to compensate investors (see Blockchain of Things, Inc., Securities Act Release No 10763 (18 December 2019)). The SEC also imposed a fine on BCOT of USD250,000.

The SEC has also focused on trading platforms, seeking to have them register as exchanges and imposing fines (Zachary Coburn, Securities Act Release No 84553 (8 November 2018)). Beyond enforcement, the SEC has also encouraged developers to engage in voluntary discussions with staff regarding their projects and compliance issues. To that end, the SEC established FinHub in October 2018, which is specifically designed to provide guidance to developers in this space.

The CFTC has taken the position that cryptocurrencies are commodities. This position has been supported by multiple federal court decisions. For example, in CFTC v McDonnell, 287 F Supp. 3d 213 (EDNY 2018), a federal district court in New York held that the CFTC can regulate cryptocurrencies as a commodity because they are “‘goods exchanged in a market for a uniform quality and value” and they also “fall well within the common definition of ‘commodity’ as well as the [Commodity Exchange Act’s] definition of ‘commodities.’” Similarly, in CFTC v My Big Coin Pay, 334 F Supp 3d 492 (D Mass. 2018), a federal district court in Massachusetts held that cryptocurrencies are subject to CFTC regulation as a commodity class because futures trading exists on bitcoin, a subset of that class.

If a blockchain asset such as a cryptocurrency is a commodity, the CFTC has enforcement authority to police fraud and manipulation in spot markets for the asset. If there are derivatives contracts on blockchain assets (ie, futures, swaps and options), the CFTC will have full regulatory authority over those contracts. For example, futures contracts on bitcoin currently offered on some exchanges are subject to the full regime of futures regulation under the Commodity Exchange Act.

Thus far, the CFTC has focused its enforcement authority on protecting retail customers engaged in unregulated spot transactions in cryptocurrencies. However, the CFTC will face more complex questions with respect to the scope of its authority over blockchain as innovators begin exploring the use of smart contracts to facilitate decentralised trading in derivatives. To prepare for these types of questions, the CFTC upgraded its financial technology research wing in October 2019. Known as LabCFTC, the wing is dedicated to promoting the development of new financial technologies in order to ensure that innovators can easily access and understand the CFTC’s regulatory framework and the agency’s approach to oversight.

In 2019, the CFTC moved ahead with approving and allowing more digital asset/virtual currency products. For example, the CFTC approved the applications of two entities to register as a designated contract market and a derivatives clearing organisation, respectively, to offer or clear virtual currency derivatives products.

The CFTC approved LedgerX’s DCM application in June 2019 to offer bitcoin spot and physically settled derivatives contracts, including options and futures, to retail clients of any size. LedgerX had previously been registered as a DCO in July 2017 to clear fully collateralised digital currency swaps. The CFTC also approved Eris Clearing’s DCO application in July 2019 to clear fully collateralised virtual currency futures.

In October 2019, CFTC Chairman Tarbert publicly stated that ether, like bitcoin, is a commodity that falls under the CFTC’s jurisdiction. Previously, in December 2018, the CFTC had sought public comments on the Ethereum network and the cryptocurrency ether to better inform the commission’s understanding.

To the extent blockchain assets held by a fund are considered securities, the Investment Advisers Act of 1940, as amended, applies and, to the extent such assets are considered commodities, the Commodity Exchange Act applies. The investment advisers of such funds that invest in blockchain assets that are considered securities are typically registered with the SEC or one or more state securities authorities and must comply with the securities laws applicable to SEC or state-registered investment advisers. In this firm's experience, such funds are exclusively structured as "Section 3(c)(1)" or "Section 3(c)(7)" private funds. A trading platform on which blockchain assets that are securities are traded is required to be a SEC-registered national securities exchange or an ATS.

See 12.2 Local Regulators' Approach to Blockchain for information on classification of blockchain assets.

See 12.2 Local Regulators' Approach to Blockchain for information on issuers of blockchain assets.

See 12.2 Local Regulators' Approach to Blockchain for information on blockchain asset trading platforms.

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See 12.2 Local Regulators' Approach to Blockchain for information on virtual currencies.

Blockchain technology has the potential to revolutionise how personal information is stored and processed. However, the benefits of blockchain technology will need to be reconciled with California’s new privacy law, the California Consumer Privacy Act (CCPA), that went into effect in January 2020. Further guidance might be required on whether one can exercise a right of deletion on a blockchain-based system. US companies building out blockchain applications in the fintech space will need to take privacy laws such as the CCPA into account and monitor this area of the law closely.

Open banking, an emerging space within fintech, can be thought of as a system whereby financial institutions’ data can be shared with third parties, such as data aggregators and app providers, through application programming interfaces. Open banking may be a gateway to providing more services to customers and is generally considered a more secure method for sharing financial account and transaction data than so-called screen scraping, but it also introduces its own concerns.

Relative to Europe and certain Asian countries, the USA lags behind in its development of laws and regulations around open banking. Some have viewed the fragmented nature of financial regulation in the USA as an impediment to the development of a comprehensive regulatory scheme. Some argue that the lack of an industry standard or regulatory framework in the USA for open banking is an obstacle to the development of its full potential. As with many emerging areas, there is a debate as to whether the private sector or the public sector should lead the pathway forward. While the US Treasury and others have advocated for a private sector-led solution to open banking, others have raised concern that a solution determined by financial services companies – rather than consumers – may adversely impact the types of services that fintech data aggregators and consumer application providers may be able to develop. When entering into open banking relationships with financial institutions, data aggregators, app developers and others, it will be important to consider a multitude of data-related issues, including consumer protections, protections for data privacy and security, data ownership, allocation of liability in the event of breach and responsibilities for responding to any breach.

Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates

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Trends and Developments


Authors



Bradley Arant Boult Cummings LLP is a full-service law firm with a reputation for skilled legal work, exceptional client service and results-oriented strategic advice. With more than 500 attorneys, the firm serves as a vital partner to domestic and foreign clients ranging from market leaders to emerging companies across a variety of industries. The cross-disciplinary Fintech team assists clients in achieving their business objectives in a heavily regulated environment. It understands the nuances of applicable laws and regulations that affect clients’ businesses. It helps maximise client growth through mergers, acquisitions and other transactions, and assists clients in launching new products and services. The firm advises on federal and state lending and payments laws, including money transmitter licensing, anti-money laundering and sanctions compliance, cybersecurity, data protection, consumer protection requirements and risk management. The team includes former bank regulators, in-house counsel, information technology executives and prosecutors, recognised experts in emerging and alternative payments systems, and certified anti-money laundering specialists.

Overview and Outlook for Fintech in 2020

Technology continues to redefine our expectations in almost every area of our lives and shape the way we interact with the world. Although technology has been almost synonymous with financial services for more than half a century, the rapid acceleration of financial technology (fintech) developments in the last few years has dramatically altered the way we interact with traditional financial institutions, introduced us to new financial services providers and created new classes of financial products and services for consumption.

The beginning of a new decade provides legal practitioners a good opportunity to review recent developments and gain perspective on how and why the legal and regulatory landscape may change in the near future.

To start, fintech is complex. While it often offers simple and elegant solutions to problems that have plagued the traditional financial services industry, the solutions may also open the door to complicated legal, regulatory and jurisdictional issues.

These issues are exacerbated by the fact that fintech innovation (i) is not limited by geography and (ii) is not limited solely to regulated financial institutions (FI) or established technology companies. The marketplace is global; state and national borders are often meaningless. And, although traditional financial institutions and their technology partners continue to be vital players in fintech development, ready access to the necessary tools for creating fintech solutions has significantly lowered the barriers to entry. In fact, enterprising entrepreneurs often need little more than a computer, an internet connection and, sometimes, a bank account, to develop an innovative fintech application that can transfer value half way around the world in seconds, allows small dollar purchases of securities almost instantly, or writes a smart contract that facilitates peer-to-peer lending with no intermediary.

Moreover, fintech development is often a communal project, raising additional legal and, potentially, regulatory issues. FIs, like fintech companies, may independently develop fintech solutions, but increasingly they incubate young companies, set up joint ventures or simply buy the technology. FIs also collaborate with other FIs to develop fintech, establishing various types of legal relationships, including consortium arrangements. Where fintech solutions begin outside of the traditional, regulated banking system, FIs frequently partner or even acquire these companies, integrating them into their existing business models.

The nature of the fintech solution, location of the developers, whereabouts of the fintech company’s customers when using the fintech solution, relationship (or lack thereof) with a traditional financial institution, and a host of other factors can influence the legal and regulatory environment in which fintech companies operate. These complexities can leave fintech companies and their partners asking: What laws apply to me? How can I balance the need to move quickly against a regulatory process that often moves at a more deliberate pace? How will future legal and regulatory changes affect my ability to conduct business?

The question for lawyers and their clients as they survey fintech’s current legal and regulatory landscape and review the factors that are forcing changes in this landscape, is how these changes may ultimately impact the evolution and viability of fintech.

Regulators are engaged and wrestling with how best to regulate fintech

US regulators face the challenge of balancing traditional mandates that dictate a measured response, against the demand of users for immediate answers and solutions. No regulator wants a fintech failure to result in the demise of a regulated entity or financial loss to consumers. At the same time, no regulator wants to be the ogre, denying consumers compelling benefits offered by the technology.

In many ways, Facebook’s June 2019 proposal to organise a foundation to issue Libra, a global currency backed by sovereign currencies and low risk government securities, served as a wake-up call for government officials and legislators in many countries. The proposal offered a potential way to solve many of the existing problems facing the delivery of financial services especially to the underbanked and unbanked. However, the reaction was overwhelmingly negative. Identified issues included the potential disruptive effect of the Libra on the ability of sovereign governments to control their own monetary policies and the continued ability of the USA to dominate the global financial system. Criminal abuse of the new currency and significant privacy concerns emerged almost immediately. Potential antitrust violations were asserted based on a perceived unfair competitive advantage over business not using Libra.

The reaction in many countries, including the USA, underscored the extent to which a constructive discussion of both the positive and negative effects of fintech, and cryptocurrencies in particular, has been largely avoided for years. Indeed, more than a dozen years before Libra, a not dissimilar gold-backed digital currency that circulated globally was prosecuted by the US government which claimed at the time that digital currencies were the "wild west” of international remittances. Twelve years later, in the 2019 congressional hearings on Libra, members of Congress and regulators were still complaining about the wild west of digital currencies, demonstrating how little was known about that earlier case or learned in the interim. It was clear by 2008 that the proverbial genie was out of the bottle and was not going to be put back in.

A growing number of regulators and lawmakers in the USA and abroad have made significant progress on the issues. The conversation is maturing, and substantive policy discussions are underway. Pending in the US Congress are more than 20 pieces of legislation that address cryptocurrencies and/or blockchain technology. In several cases the proposals assign regulators to different classes of crypto-assets.

How these issues are addressed may have a broader impact on the future of fintech development. For example, one proposal that attempts to address Libra would ban large technology companies from financial services. In 1933, Congress decided to separate banking and commerce, in part to keep the fledgling telephone companies out of banking. That ban has never been revoked.

In the meantime, regulators are rushing to set up innovation units in almost every federal banking agency, the US Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), and even in some states like New York and California. These regulators are meeting with both fintech and regulatory technology companies to learn about their solutions, answer questions, and even start to incorporate some of the technology into their regulatory processes such as surveillance, examination and enforcement.

Regulatory co-ordination in the USA and between the USA and other countries is unparalleled

Financial services and financial markets regulators are engaged in unprecedented communication and co-ordination. This is occurring between federal and state regulators in the USA and between regulators in the USA and their counterparts in other countries. The pace of fintech development, especially with global 24/7 trading of cryptocurrency, has demonstrated the need for prompter regulatory action on a more co-ordinated basis. Regulatory inefficiencies can be costly and, in some cases, dangerous to the financial system and to consumers.

Although the foundation for cross border co-operation has been painstakingly laid over many years, such coordination accelerated in the wake of the initial coin offering mania that peaked in 2017-2018. Today, the US SEC and CFTC are working with their counterparts in more than 40 countries to address global trading in the ever-expanding class of crypto-assets.

Continued concerns about criminal use of technologies and products with little regard for borders assure that a network of regulators and law enforcement agencies across the globe will continue to co-ordinate and collaborate in unprecedented ways. The Financial Action Task Force highlighted this focus in its June 2019 action to require its 37 member countries to take several actions to mitigate the money laundering and terrorist financing risks presented by virtual currencies and virtual asset service providers.

In the USA, state bank and money transmitter regulators continue to work together through the Conference of State Bank Supervisors to streamline some of the more cumbersome and costly aspects of the patchwork quilt of state laws impacting fintech, both from a lending and payments perspective.

Need for co-ordinated regulation

The dual federal/state system of regulating financial services has long encouraged regulatory arbitrage. In the USA fintech companies routinely chose to offer their product or service in one state rather than another because of the differences in the way the states regulate the offering. Differing supervisory philosophies in the federal banking agencies also continue to affect the kinds of fintech a bank may offer or support.

The recent debate and legal action regarding the Office of the Comptroller of the Currency's (OCC) special purpose national bank charter for fintechs (“fintech charter”) illustrates one regulator’s desire to protect its regulatory turf, provide shelter to those entities it already regulates and possibly streamline (but not necessarily lessen) the compliance obligations of nonbank fintech companies.

Nonbank financial services companies, like most fintech companies, are traditionally regulated at the state level, meaning that these companies must obtain a lender or money transmitter licences, as appropriate, from each state in which they operate. Given the online and mobile nature of their offerings, fintech companies often need to obtain licences in each of the 50 states, the District of Columbia and the US possessions and territories that require such licences. Obtaining the appropriate licences can be a costly, complex and time-consuming process. In July 2018, the OCC, ostensibly responding to the complexity of the state licensing process, announced it would begin accepting applications for fintech charters. The OCC reasoned the fintech charter would allow eligible fintech companies to operate nationwide without the need to acquire individual licences in all 50 states. Eligible fintech companies could also gain some limited relief from certain state legal restrictions.

However, the OCC’s decision was subject to a great deal of resistance and criticism from state regulators. Regulators from New York and California, in particular, described the move as a “regulatory train wreck in the making” and “not authorised under the National Bank Act.” Fintech companies, likely fearing that they would get caught in the battle between the OCC and state regulators, did not immediately apply for the fintech charter. Shortly after the OCC opened up the licensing process, several state regulators, including the New York Department of Financial Services, filed suit challenging the OCC’s authority to issue fintech charters. In October 2019, a New York federal district court entered a final judgment that effectively blocked the OCC from issuing fintech charters. The OCC subsequently announced its intention to appeal the district court’s decision to the Second Circuit Court of Appeals.

In the meantime, one of the 13 blockchain- and cryptocurrency- friendly laws enacted in Wyoming in 2019 provides for the chartering of a special purpose bank that can be used by cryptocurrency exchanges “to passport” into other states, theoretically pre-empting state money transmitter and the New York virtual currency licensing requirements. Several applications for the new charter are being processed. The experience of the OCC in New York is a likely harbinger of reception these newly chartered banks will receive if and when they attempt to begin operations in that state.

Likewise, the USA will continue to see an exodus of fintech ventures to other countries that have undertaken major efforts to develop more accepting and nurturing regulatory structures that offer greater clarity to companies operating there. Bermuda recently joined Switzerland and Malta and has already become a favoured destination for blockchain ventures.

The bank partnership model will continue to serve as a viable business structure that allows traditional financial institutions and fintechs to combine their strengths

In general, banks hold one license that allows them to operate nationwide whether is providing payment products like prepaid access or lending products like credit card where it can charge interest rates in accordance with federal law or the laws of the bank’s home state. Fintech companies, as discussed above, often need to acquire licences in all of the states in which they operate and are subject to each state’s interest rate limits. In response to these regulatory differences, a number of fintech companies have partnered with banks to reduce the burden of maintaining multiple licences and to be governed by one set of permissible interest rates. This bank partnership model faced a significant setback in 2015 when the Second Circuit Court of Appeals issued its decision in Madden v Midland Funding, which called into question the “valid when made” doctrine. Prior to the Madden case, loans were considered valid as long as they complied with the law applicable to the loan at the time it was made. The Maddencourt, in contradiction to industry precedent, found that a nonbank entity that purchased a charged-off debt from a bank did not acquire the bank’s right to charge interest under the federal law and that the loan effectively became subject to state usury laws at the time it was purchased.

In November 2019, the OCC and Federal Deposit Insurance Corporation (FDIC) each issued proposed rules that would codify the “valid when made" doctrine. The public comment period for these rules ended in January 2020, and the OCC and FDIC rules are expected to be adopted largely as published. If the rules are adopted without substantial changes, they would effectively restore faith in the “valid when made” doctrine in jurisdictions other than the Second Circuit. The final rules would also increase the chance that the Second Circuit will reconsider and overturn the Madden decision.

The Consumer Financial Protection Bureau (CFPB), despite challenges to its authority, will continue to play a significant role in fintech

The CFPB has broad jurisdiction over activities central to many fintech business models, such as consumer lending, payments, marketing practices, credit cards, deposit and prepaid products, and credit reporting.  The agency can impact fintech companies directly and indirectly through its powerful rulemaking, supervisory, and enforcement powers. Indeed, the CFPB’s ability to prohibit unfair, deceptive, and abusive acts and practices (UDAAP) can affect the viability of specific products and fintech companies.

One issue to watch in 2020 is a legal challenge to the constitutionality of the CFPB's structure, which grants significant power to a single director who is removable only for cause. In October 2019, the Supreme Court agreed to hear oral arguments in CFPB v Seila Law. The Court will address whether the “for cause” provision is constitutional and, if not, whether it is possible to strike the provision without invalidating the other portions of the CFPB’s authorising statute. While it is impossible to  predict the outcome, a decision that diminishes the CFPB’s authority would have significant effects on fintech companies as others in the consumer financial services ecosystem. The Court is expected to issue its opinion in early summer. 

Regulators in the USA and worldwide will continue to focus on data privacy and security

Fintech companies often collect and process significant amounts of data, including personal information of individuals. While this data collection is key to the ability to customise services to consumer demand, market trends and client expectations, it is also becoming an area that is subject to state regulation and legal liability.

The USA’s first comprehensive privacy law, the California Consumer Privacy Act (CCPA), came into effect on 1 January 2020. CCPA significantly restricts the way businesses collect, use, store and share personal data. This is particularly consequential for fintech companies for several reasons. First, the definition of personal data under CCPA is expansive and includes any information that “identifies, relates to, describes, is capable of being associated with, or could reasonably be linked, directly or indirectly, with a particular consumer or household.” This definition includes not only information obtained directly from consumers, but information that may be collected from their devices or through their interactions with a website. Many fintech companies operate exclusively “online” and collect a substantial amount of their data through a consumer’s interaction with their website or mobile application. This data collection could be subject to CCPA. Second, while CCPA does have exceptions for certain types of personal information that would apply to a traditional financial institution (such as personal information collected pursuant to a personal, family, or household financial product or service under the Gramm-Leach-Bliley Act), technology companies that operate in the financial services space and who are not a covered entity are unable to take advantage of the carve-out to the law.

While smaller fintech companies may not meet the scope and applicability standards of CCPA (ie, revenue under USD25 million or collect personal information on fewer than 50,000 California residents or their devices), fintech companies may still need to invest in CCPA compliance as part of their investment, market and M&A strategy.

Even if fintech companies do not meet the applicability standards directly, they often serve as vendors or service providers for companies that are subject to CCPA. Financial services companies are often required by their regulators to impose portions of their compliance obligations on their service providers, and fintech companies are no exception. As a result, we anticipate that an increasing number of financial institutions will require their fintech partners and service providers to integrate eliminates of the CCPA into their products, processes and services.

The focus on privacy and data security is also creating opportunities for fintech companies that are developing innovative solutions to help companies satisfy their data privacy and security obligations. We expect this trend to continue as US regulators and legislatures continue to focus on the privacy and security of consumer data.

US-based fintech companies that service clients globally should consider the requirements of other countries, especially those of the EU countries under the General Data Protection Regulation.        

Anti-money laundering (AML) and sanctions compliance remain a high priority

AML and sanctions compliance have always been perplexing for fintech companies. In 2019, any lingering doubt about what was expected in the world of cryptocurrencies was eliminated when the federal watchdog, the Financial Crimes Enforcement Network, provided the most comprehensive guidance since 2013 on how the Bank Secrecy Act (BSA) applies to various types of business models and crypto-assets. Entities that questioned whether they were money services businesses and subject to the BSA’s requirements or thought AML compliance was just "know your client" – collecting customer information – found themselves facing more difficult compliance challenges.

On the same day, the Financial Crimes Enforcement Network (FinCEN) released an advisory on illicit activity involving virtual currencies. The intended audience was not limited to cryptocurrency exchanges but also depository institutions and other entities subject to the various suspicious activity monitoring and reporting requirements of the BSA. The full impact of this advisory will become clearer in 2020 as bank examiners begin looking more closely at how banks are monitoring customer activity in this regard. The ultimate impact could be another round of account closures when the bank concludes the customer is interacting with crypto-exchanges and the risks cannot be mitigated.

The Office of Financial Assets Control (OFAC) has reinforced its message that the use of cryptocurrencies is subject to sanctions. And the Department of Justice indicted an individual who allegedly traveled to North Korea against US warnings and provided assistance to the government in setting up a cryptocurrency in violation of US sanctions.

The impact of the 2019 actions are likely to be seen in the coming months. Enforcement actions by both FinCEN and OFAC against cryptocurrency exchanges and other players in the space would not be a surprise. In the meantime, many organisations are investing significantly in developing and enhancing their compliance programmes, the first line of defence against criminal abuse and a substantial mitigating factor if problems occur.

Stablecoins are the future

Since the first appearance of bitcoin at the beginning of the last decade, the oft-heard reason for lagging mass adoption was the instability of its price and the lack of anything to support it value. A new class of assets, stablecoins, emerged to address these issues. In 2019, they began proliferating at a dizzying rate and by late 2019, Tether, a dollar backed stablecoin, became the most widely traded cryptocurrencies on a daily basis exceeding both bitcoin and ether. They come in many different types of flavours, are intended to serve different purposes and present a multitude of different legal and regulatory issues. The Libra coin has brought some of these issues into focus, but it is only one of many being introduced across many industries. Regulators and legislators will find more of their time consumed by this topic.

Conclusion

We are likely in the middle of the most dynamic and unpredictable debate ever over how to regulate financial services in the USA and globally. While the extent of seismic changes in this regulatory topography remains to be seen, the effects of fintech cannot be denied.

Bradley Arant Boult Cummings LLP

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Law and Practice

Authors



Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates advises businesses, financial institutions and governmental entities around the world on their most complex, high-profile matters, providing the guidance they need to compete in today’s business environment. The financial technology industry presents businesses and private equity, venture capital and other investors with extraordinary opportunities as well as challenging legal and regulatory issues. Skadden has helped clients to navigate this complex environment since the industry’s inception. The FinTech practice draws on the firm’s global platform and market-leading corporate finance, financial regulation and enforcement, intellectual property and technology, privacy and cybersecurity and M&A capabilities, making it uniquely qualified to offer clients exceptional depth of experience and full-service capabilities. Skadden would like to thank complex litigation and trials partner Alex Drylewski; M&A and financial institutions partner Jon Hlafter; financial institutions regulation and enforcement counsel Collin Janus; derivatives of counsel Jonathan Marcus; investment management associate Prem Amarnani; financial institutions associate Patrick Lewis; financial institutions associate Tim Gaffney; financial institutions associate Han Lee; and M&A associate Marcel Rosner for their invaluable contribution to this chapter.

Trends and Development

Authors



Bradley Arant Boult Cummings LLP is a full-service law firm with a reputation for skilled legal work, exceptional client service and results-oriented strategic advice. With more than 500 attorneys, the firm serves as a vital partner to domestic and foreign clients ranging from market leaders to emerging companies across a variety of industries. The cross-disciplinary Fintech team assists clients in achieving their business objectives in a heavily regulated environment. It understands the nuances of applicable laws and regulations that affect clients’ businesses. It helps maximise client growth through mergers, acquisitions and other transactions, and assists clients in launching new products and services. The firm advises on federal and state lending and payments laws, including money transmitter licensing, anti-money laundering and sanctions compliance, cybersecurity, data protection, consumer protection requirements and risk management. The team includes former bank regulators, in-house counsel, information technology executives and prosecutors, recognised experts in emerging and alternative payments systems, and certified anti-money laundering specialists.

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