One of the biggest challenges for fintechs is ensuring that their services comply with federal and state money transmission laws. For example, a fintech operating as a payment facilitator faces significant money transmission risk when settling funds to its sub-merchants through the payment facilitator's own bank account. Likewise, a fintech that facilitates bill payment services or loan disbursements may trigger money transmission risks if the fintech receives and transmits any funds as part of the service.
A common trend among fintechs for managing these risks is to partner with banks that offer custodial accounts opened for the benefit of (FBO) the fintech's customers. In these arrangements, funds flow through an account owned and controlled by the bank and not the fintech. Because banks are exempt from money transmission licensing requirements, fintechs use FBO accounts to provide banking-like services while avoiding money transmission regulation and licensing.
How do regulators view the FBO model? Is getting an FBO account as simple as it may seem? As we discuss below, the FBO model remains largely untested among regulators, and fintechs must structure their relationships and services to fit within the contours of the bank's FBO offering. These operational requirements may be inconsistent with the fintech's existing business strategy and service offerings. Furthermore, not all banks offer FBO accounts, and those that do may impose heavy compliance requirements or hefty fees in connection with the service due.
Overview of Money Transmission Laws
Under federal law, money transmission is defined as the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person. In general, most states use a similar definition. For example, New York defines money transmission as receiving money for transmission or transmitting the same. Federal and state regulators have interpreted the definition of money transmission to apply to such activities as payment processing, bill payment, payroll processing, peer-to-peer (P2P) payments, loan disbursements, and other, similar activities.
Money transmission is highly regulated and subject to licensing requirements to help protect consumers and companies that send and receive payments. At the federal level, money transmitters must (1) register with the federal Financial Crimes Enforcement Network (FinCEN), a division of the Treasury Department; and (2) implement a Bank Secrecy Act (BSA)/anti-money laundering (AML) program, including appointing an officer responsible for the program, collecting required information on customers, monitoring for and reporting suspicious transactions, training appropriate personnel in anti-money laundering procedures, and engaging an independent auditor to review the program on an annual basis.
Forty-nine states (excluding Montana) and the District of Columbia (as well as Puerto Rico and the U.S. Virgin Islands) require money transmitters to obtain a license from the state's financial regulatory agency to send funds to, or receive funds for transmission from, their residents (generally, both individuals and businesses). The license application process requires extensive disclosures on the company and its officers, financial statements, surety bonding, and other supporting documentation. In addition, once licensed, compliance requirements apply in each state, including maintaining appropriate capital relative to the licensee's transmission obligations, reporting and recordkeeping requirements, and consumer-facing disclosure and advertising requirements, among others.
While obtaining money transmission licenses on a nationwide basis may provide significant competitive advantages for a fintech, obtaining such licenses takes time and financial resources, and complying with applicable requirements involves a significant amount of work. Accordingly, most fintechs, particularly startups, seek ways to launch products and services without triggering federal or state money transmission requirements.
Doing so, however, is difficult, given the scope of these laws. While there are certain exemptions to money transmission at the federal and state levels, these exemptions are limited and are not available in all jurisdictions. For example, the agent-of-the-payee exemption frequently relied on by payment processors is available in about only half of the states and has certain technical requirements that may need to be met. Accordingly, any fintech that operates nationally and engages in money movement activities will likely need to either obtain money transmission licenses in a number of jurisdictions, or structure its operations to minimize the risk of triggering such requirements in the first instance.
Benefits and Risks of the FBO Model
The FBO model has become a popular way to mitigate potential money transmission risk on a nationwide basis. This model, in essence, relies on a banking relationship whereby funds flow through an account owned and controlled by the bank and not the fintech.
Under such a relationship, the fintech either issues payment instructions to the bank to pull funds from a bank-owned settlement account or instructs its customer to deposit funds into the FBO account. Once the funds are received, the bank holds the payments until it receives instructions from the fintech to release them to the designated payee's bank account. The funds held in the account are "for the benefit" of the fintech's client(s), indicating that the funds in the account are owed to those parties (and are not owned by the fintech). Importantly, the bank is the only entity responsible for moving the funds, and all funds at rest are in the custody and control of the bank.
Not all banks will issue FBO accounts in the fintech space. Especially where transaction records are comingled and the bank may have little specific information about the fintech's end-user clients, the bank may not be comfortable with its ability to monitor transactions and mitigate financial fraud. Also, banks must rely on the fintech's ledgering system to ensure proper management and distribution of funds. The FBO model requires strong ledgering and reconciliation on the fintech's part, and small errors may result in large headaches impacting the entire FBO account.
These concerns are greatly elevated in cases where a BaaS (banking-as-a-service) provider opens one FBO account for the benefit of multiple fintechs, each with its own portfolio of end-user clients below them in the fund flow. One problematic end user in one beneficiary prong of the FBO account may subject the entire account to greater scrutiny, potentially putting the entire BaaS provider's business at risk if the bank temporarily pauses or permanently suspends service.
Contractual provisions and operational procedures between the bank and fintech will be necessary to give the bank comfort that proper transaction monitoring and accounting will be done. In our experience, these negotiations require thorough discussion and planning among the business teams and lawyers involved in the set-up. There may be other regulatory requirements to consider and discuss among the parties. Consider, for example, the issue of deposit insurance for the FBO, and the extent of the benefit of deposit insurance for the FBO account. The Federal Deposit Insurance Corporation (FDIC) and the Board of Governors of the Federal Reserve System have been cracking down on false and misleading statements made about the scope of FDIC insurance coverage for funds held in an FBO account.
Does Use of an FBO Account Avoid Money Transmission Licensing Requirements?
Despite variations in state law, it can be argued that federal and state definitions of money transmission exclude those who do not receive or transmit funds. Thus, where a fintech merely submits payment instructions to a financial institution and never "receives" the funds, there is a reasonable argument that the company is not engaged in money transmission.
There is, however, little precedent or guidance that specifically addresses whether the use of an FBO account precludes a fintech from "receiving" funds for purposes of money transmission regulation.
Some states have evaluated money movement through an FBO account on a case-by-case basis, with favorable determinations for the fintech. For example, in October 2022, the Arkansas Securities Department determined that a payroll services provider was exempt from the Arkansas Uniform Money Services Act because it never took possession or custody of any payroll funds. In the payroll provider's request for determination, the company explained that it maintained an "independent contractor relationship account" with its partner bank, and that the company only sends instructions to the bank, such as to distribute wages to its customer's employees. The payroll provider received similar determinations from other states, based on the payroll provider's specific facts.
FBO Accounts and the Bank-Fintech Partnership
While the FBO model presents a potential avenue for remaining compliant with money transmission requirements without the need for nationwide licensing, there are important steps to consider. First, a fintech would need to identify and engage a bank partner offering an FBO account, as not all banks offer that type of relationship. Furthermore, to establish such an account, the fintech must go through a comprehensive due diligence process, receive approval for the structure described, and negotiate the authorization agreement.
In addition, without money transmission licenses, a fintech may be limited going forward with regard to the types of ACH transactions approved under the relationship. The fintech will need to ensure the services it plans to go to market with can be supported by the FBO account services offered by the bank, and consider back-up planning in the event the bank terminates the account. Finally, while the fintech would have a reasonable argument against the need for state money transmission licenses, the existence of this type of structure does not preclude regulatory investigations, and the fintech would still need to incur the cost of responding to those inquiries. In summary, bank-fintech partnerships are complex legal arrangements with risk management and operational considerations on both sides, enveloped in significant regulatory considerations. While the FBO model may offer important benefits, fintechs looking to employ this model must carefully consider their current and future operations, weigh the various risks, and take great care in structuring their banking and customer relationships.