This article was originally published at Data Driven Investor on June 5, 2021.
Louis Lehot and Catherine Zhu of Foley & Lardner LLP discuss the rise of financial technology startups and the legal and regulatory scrutiny they may face.
This year has seen a surge in investor interest in fintech startups. CB Insights1 reported that the first quarter of 2021 was the largest funding quarter on record for fintech, surpassing Q2 2018, which included Ant Group’s $14B funding round.
Venture capital-backed fintech companies raised $22.8 billion across 614 deals in the first quarter of 2021, representing 15% growth in deal volume and 98% growth in capital, both measured on a year-over-year basis. Every continent saw growth. Exit activity also broke records. Datatrek recently concluded2 the following:
Consider that if you annualize Q1’s pace of global fintech VC investments you get $91 billion, which is more than the market cap of Bank of New York and State Street combined. It is also about 75 pct of American Express’ market cap, or 60 pct of Citigroup’s valuation. VCs clearly see a very large opportunity in financial services, and they’re moving quickly to disrupt the sector.
Considering how the pandemic has accelerated remote access and the digital transformation of many industries, the surge in fintech investment and exit activity seems poised to keep rocking through 2021. But setting up a new fintech startup is not for the faint of heart. Fintech startups need to design legal compliance into each stage of the path to monetization to capitalize on consumer and investor appetite.
Financial technology or fintech leverages information technology to disrupt traditional financial services. Fintech encompasses everything from payments to banking to digital lending, from wealth management to insurance to the capital markets.
In recent months, we saw decacorn funding rounds for popular stock-trading applications, blossoming of blockchain-based decentralized exchanges and crowdfunding sites gaining traction. Fintech encompasses broad and complex categories that rely on massive data inputs, complex software, and a multiplicity of algorithms to gain efficiencies that disrupt incumbent players.
But handling other people’s money demands accountability. Even a small breach of trust could be devastating for a bank, and governmental regulations tightly control how financial institutions may operate.
Navigating these regulations requires careful planning and meticulous attention to detail. As a result, the financial industry is typically very cautious, carefully considering the ramifications of even small changes. This caution leads to inefficiencies — exactly the kind of thing targeted by entrepreneurs seeking to disrupt the status quo.
In the U.S., there are seemingly orthogonal layers of regulation applicable to financial services and institutions, from the Gramm-Leach Bliley Act, know-your-customer (KYC) and anti-money laundering (AML) requirements, securities laws, money transmitter regulations, the Fair Credit Reporting Act, and that’s just at the federal level!
Even if a fintech startup may not be directly subject to a specific regulation, in many cases, as a necessary part of its growth strategy, it will need to engage with other ecosystem players that are subject to such rules, and who will impose compliance on adjacent counterparties.
Said another way, compliance obligations can flow to a fintech startup from its partners, customers, suppliers, and other associated institutional parties, and significantly expand regulatory exposure for even the smallest activity.
Fintech companies innovate at breakneck speed to get ahead and stay ahead. Decision points to excel in technological innovation are inherently risky, but when radical ideas catch on, they can change the world. Consider how different mobile technology would be today if a certain fruit-themed company had not introduced a radically different cellular phone in 2007. Where would mobile computing be today?
Fintech sits at the crossroads of cautious, heavily regulated industries that thrive on revolutionary new ideas. In many cases of disruptive fintech, the regulations predate the technology and need to catch up.
Legal and compliance guidance is vital for positioning a startup so that it straddles both fields without running afoul of the law, but it is also vital for helping a company navigate murky legal issues when technological innovations and regulations clash.
One interesting example is Ripple, which offers cross-border payment solutions through its digital currency, XRP. At the end of 2020, the SEC sued Ripple,3 claiming that the XRP token was a security and that Ripple was therefore using the sale of the token as a de facto initial public offering.
Ripple, however, claimed that XRP is a medium of exchange, a digital currency like Bitcoin that can be used to facilitate faster, cheaper transactions.
The definition of a security was created long before Bitcoin introduced the world to a radically different idea of digital currency, and as a result, Bitcoin and related technologies are classic disruptors. They do not fit neatly into the existing paradigm. If we give Ripple the benefit of the doubt, we can see that this lawsuit is a clash between the old paradigm and the new one.
Another example is the SEC’s lawsuit against Robinhood following the social-media-fueled rise of GameStop4 and the gamification of trading.5 What happens next if a trading interface makes investing feel like a game? The point here is that technological design choice can have legal ramifications in unexpected ways.
If you are looking at building something new in fintech, make sure that you have competent legal counsel. A good lawyer will examine not just at what the current law says but also at how the law could be interpreted, and how your company could structure its product or service to minimize any legal complications.
The reality is that in fintech, you probably will encounter unresolved legal issues even when you try to do everything the right way. Good counsel can guide you to help mitigate your risk exposure and so that you, your customers, and the law are satisfied.
Notes
Louis Lehot is a lawyer who focuses on emerging growth companies, venture capital, and mergers and acquisitions at Foley & Lardner LLP in California’s Silicon Valley. He provides entrepreneurs, innovative companies and investors with practical and commercial legal strategies and solutions at all stages of growth, from the garage to globally. He can be reached at [email protected].