On October 10, 2019, the Conference of State Bank Supervisors (CSBS) published a draft model money services business (MSB) law, which, once finalized, could be adopted by state legislatures across the United States to create a consistent approach to state licensing and oversight of MSBs. The draft model MSB law (Draft Model Law)1 is part of the CSBS’s Vision 2020 initiative, which reflects an effort by states to lower the regulatory burden on non-bank financial service providers by modernizing and harmonizing the existing state-by-state regulatory structure.
The Draft Model Law includes a number of agreed upon positions by the state regulators who participated in the Draft Model Law working group (Working Group),2 but also describes outstanding questions and more complex issues upon which the drafters have not yet reached consensus. The public is invited to provide comments to the Draft Model Law that may influence the outcome of these outstanding items, as well as the specific proposed language.
The Draft Model Law is the product of collaboration by state regulators and the payments industry. In 2017, a group of 33 fintech firms formed the Fintech Industry Advisory Panel (Advisory Panel), and in January 2019 the payments subgroup of the Advisory Panel provided a set of recommendations to the CSBS to standardize varying interpretations of state money transmission laws. The goal of the recommendations was to reduce the unnecessary burdens on innovative payments products that arise from the lack of uniformity in regulation and interpretations from state to state and uncertainty as to how to apply existing laws and regulations to innovative practices. The CSBS also solicited public comment to identify some of the greatest challenges for MSBs.
Taking into account the feedback from the Advisory Panel and the public comments, the CSBS established the Working Group to publish a Draft Model Law that would serve the twin interests of making supervision more efficient by implementing common standards while continuing to protect consumers and the financial system. In this regard, the Working Group sought to reflect in the Draft Model Law the three key missions of state MSB laws:
- Protect consumers from harm, including all forms of loss
- Prevent bad actors from entering the money services business
- Preserve public confidence in the financial services sector, including the states’ ability to coordinate
At the same time, the Draft Model Law focuses on the greatest pain points to MSBs operating on a national scale. The Draft Model Law is not intended to entirely replace existing state laws and regulations for all MSBs. On the contrary, the CSBS anticipates that while MSBs operating or seeking to operate on a national scale could avail themselves of the uniform approach, smaller MSBs operating within a single or small group of states may opt to remain within a state’s existing framework. Accordingly, certain aspects of the Model Draft Law, particularly with respect to financial condition requirements, are drafted with a focus on nationally operating payments companies. While the Working Group was often able to reach agreement, there remain certain areas where consensus has not yet been reached or that require additional consideration and feedback. Those complex or controversial areas are noted in the Draft Model Law and accompanying materials.
Key Areas of Draft Model Law
The Draft Model Law provides proposals on harmonizing areas of MSB law that can provide the greatest challenges to both startup payments firms and larger payments firms operating on a national scale. These include provisions addressing (a) whether an activity is subject to licensure and supervision, (b) control of a licensee and (c) financial condition of a licensee.
Activity Definitions and Exemptions
When a payments firm decides to launch a new payments product, it is often required to invest significant resources in determining whether the new activity is subject to regulation under each state money transmission law, based on the statute, regulations and available interpretive guidance. These determinations are generally made based on the definitions of various MSB activities and their exemptions. While there is a great deal of similarity in these areas across states, each state defines and interprets its definitions and exemptions differently, creating uncertainty and requiring significant outlays of time and money.
The Draft Model Law attempts to address this challenge by including standardized definitions of “money transmission,” “stored value/prepaid access,” “sale of payment instruments,” “money” and, for those states that intend to regulate virtual currency pursuant to their money transmission laws, “virtual currency.”
Furthermore, while not part of the Draft Model Law, we note that the UMSA (Uniform Money Services Act), into which the Draft Model Law would be incorporated, requires licensure for a person that advertises, solicits or holds itself out as providing money transmission, even if not engaged in money transmission, which is not a widely used standard. If additional states were to adopt the UMSA once the Draft Model Law is finalized, this could have a significant impact on the types of activities for which a license is required across those states.
The CSBS also sought to harmonize and clarify certain common exemptions. The Draft Model Law includes exemptions for agent of the payee and payment processors, which are exemptions currently embraced by a significant number of states but that often have different parameters from state to state. If states adopt the finalized MSB model law, payment companies would be able to more easily and efficiently determine if a proposed product would be subject to these exemptions. The CSBS also is proposing exemptions for agents and service providers of banks, and providers of certain types of prepaid access, but elected not to propose exemptions for business-to-business activities and payment of business taxes, for which the industry has advocated. In addition, the CSBS is seeking comment on the possibility of an exemption for transfers that are prefunded by the service provider before accepting funds from the payor, an exemption that has been publicly recognized in California.
Control of a Licensee
The recommendations by the Advisory Panel indicated that the different standards and processes used by the states with respect to a change in control cause significant administrative burden. These burdens could be reduced by standardizing what would constitute a “change in control” as well as creating a streamlined process for notifying and/or seeking approvals from state regulators.
The Draft Model Law addresses these concerns by proposing standardized definitions for what constitutes a “control person” and the triggers that constitute a change in control. For a “control person,” the Draft Model Law proposes a threshold of 10% ownership of a class of voting securities, eliminating the rebuttable presumption used in some states in favor of a more certain standard. The law does, however, create an exemption for a “passive investor” that meets certain thresholds, including entering a standardized passivity attestation. The Draft Model Law does not, however, resolve all ambiguity within the definition of a “control person” and includes within its definition a person that has “the power to exercise directly or indirectly, a controlling influence over the management or policies of a licensee or person in control of a licensee.” The application of this standard, which is currently part of the UMSA, creates a challenge to payments companies, as there are currently no interpretive precedents.
The Working Group appeared to have greater difficulty reaching consensus on a standardized change in control process, which represents the majority of the burden for licensees. The Draft Model Law contains a draft Nationwide Multistate Licensing System and Registry (NMLS) checklist that conceivably could replace the state-by-state change in control checklists; however, the draft NMLS checklist is not complete. Similarly, while the Working Group agreed that control persons should be subject to an FBI background check, it was not able to reach agreement as to whether the FBI background check would be sufficient to substitute for the state background checks required by certain states, such as Pennsylvania.
State regulators monitor and promote the financial condition of licensees through three major financial requirements: net worth, permissible investments and surety bonds. The Working Group sought input from the CSBS Non-Depository Supervisory Committee as to the effectiveness and appropriateness of the existing financial condition requirements and, based on that input, the Draft Model Law includes a number of proposed changes aimed at making the financial requirements more suited for large nationally operating payments companies.
The Draft Model Law proposes two potential approaches to financial condition requirements. The first is to modify the existing three-prong structure of net worth, permissible investments and surety bonds to make them more consistent across the states so firms operating on a national basis are required to meet only one clear standard. The second is to eliminate the existing three-prong structure and replace it with a newly proposed “Suspension Bridge” approach, which creates more flexible, but potentially more onerous, financial requirements with a greater focus on liquidity coverage.
With respect to the existing three-prong approach, the Draft Model Law proposes to standardize tangible net worth requirements at the greater of $100,000 or 3% of total assets but allows for flexibility by providing the state with discretion to increase the net worth requirement based on specified criteria. In addition, the Working Group addressed an existing challenge licensees face whereby states are inconsistent in their acceptance and limitations on certain types of permissible investments. The Draft Model Law would standardize the acceptable types of permissible investments and the haircuts applicable to riskier types of permissible investments. The drafters elected not to address funds held in foreign bank accounts, which can be an important asset for licensees who engage in cross-border payments and must keep a certain amount of funds overseas and in other currencies for operational purposes. The Working Group requested additional input with respect to the treatment of foreign assets.
CSBS describes the Suspension Bridge approach as “a melting pot of the Liquidity Coverage Ratio and the EU’s Second Payment Services Directive approaches to safety and soundness, creating a ratio-based financial condition requirement that dictates how consumer funds are safeguarded.” The approach is dynamic and multitiered, and due to its newness and complexity the Draft Model Law does not contain proposed draft language but rather a general presentation of the proposed concepts. The presentation is fairly detailed, but the main focus of the Suspension Bridge approach is a tangible asset buffer, which is calculated by dividing the licensee’s tangible assets by its total liabilities.
Licensees with a higher tangible asset buffer are better able to absorb losses and therefore pose a lesser risk of financial failure. While the Suspension Bridge approach maintains certain permissible investment requirements, it also provides entities with a higher tangible asset buffer greater flexibility to maintain riskier assets to satisfy these requirements as compared to licensees with a low tangible asset buffer. Commenters may want to make the opposite point — that entities holding less risky permissible investments should have lower buffer requirements. In addition, the Draft Model Law adopts the EU’s Second Payment Services Directive prohibition on commingling consumer and corporate funds. While the existing permissible investment structure implicitly includes this prohibition, an explicit adoption of the prohibition could allow states to provide greater flexibility on how a licensee may protect customer funds by, for example, allowing smaller startups to maintain a surety bond in the amount of its customer liabilities and eliminating other restrictions on how its assets are held. Entities that operate in physical retail environments, however, may wish to address the challenges of segregation of funds at the point of sale.
Last, with respect to larger licensees, the Suspension Bridge approach attempts to address the mismatch between the stated purpose of surety bonds under existing state MSB laws and their realistic value in the context of a large nationally operating payments firm. For MSBs operating on a national scale, the amount of surety bonds they are required to maintain fall far short of the potential losses to consumers in the event of bankruptcy — the stated purpose of surety bonds. In those cases, permissible investments are the core of consumers’ protection rather than the surety bond. On the other hand, in the event of bankruptcy of a large national payments firm, the administrative costs of receivership may be quite large. While the Draft Model Law requests additional feedback on how to operationalize the approach, the Working Group proposes repurposing the surety bonds for larger payments companies to cover the administrative costs associated with receivership rather than reimbursing customer losses.
The CSBS is accepting public comments to the Draft Model Law until November 1, 2019 and has encouraged commenters to “provide actionable language and redline edits to the proposed language.” Upon review of the comments, the CSBS may finalize certain aspects of the model law that are less controversial while continuing to work on proposed language for more complex areas, including the newly proposed financial conditions approach. Although the UMSA itself has been adopted in only a handful of states to date, interested parties should consider commenting on the Draft Model Law, as the policy choices reflected there may be influential in the interpretation of existing laws, regardless of the challenges to enactment of truly uniform state requirements in this area.