FBO accounts: What banks and fintechs need to know | Venable LLP
One of the biggest challenges facing fintechs is ensuring their services comply with federal and state money transmission laws. For example, a fintech operating as a payment facilitator faces significant remittance risk when they settle funds to their sub-dealers through the payment facilitator’s own bank account. Similarly, a fintech that facilitates bill payment services or loan disbursements may trigger remittance risk if the fintech receives and transfers funds as part of the service.
A common trend among fintechs to manage these risks is to partner with banks that offer custody accounts opened for the benefit of (FBO) fintech customers. In these schemes, funds flow through an account owned and controlled by the bank and not the fintech. Because banks are exempt from remittance licensing requirements, fintechs use FBO accounts to offer bank-like services while avoiding remittance regulation and licensing.
How do regulators view the FBO model? Is getting an FBO account as easy as it seems? 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 banks’ FBO offerings. 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 large compliance requirements or large fees in connection with the service to be paid.
Overview of money transfer laws
Under federal law, money transfer is defined as the acceptance of currency, funds, or other value in lieu of currency from one person and transfer of currency, funds or other value that replaces currency to another place or person. In general, most states use a similar definition. For example, New York defines money transfer as receiving money for transfer or transferring the same. Federal and state regulators have interpreted the definition of money transfer to include such activities as payment processing, invoice payment, payroll processing, peer-to-peer (P2P) payments, loan disbursements, and other similar activities.
Money transfer is highly regulated and subject to licensing requirements to 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 necessary customer information, monitoring and reporting suspicious transactions, training appropriate personnel in anti-money laundering procedures, and engage 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 their state’s financial regulatory agency to send funds to, or receive funds for transfer from, their residents (usually both individuals and companies). The license application process requires extensive disclosures about the company and its managers, financial statements, surety bonds and other supporting documentation. Additionally, once licensed, compliance requirements apply in each state, including maintaining appropriate capital relative to the licensee’s transfer obligations, reporting and recordkeeping requirements, and consumer disclosure and advertising requirements, among others.
Although obtaining nationwide money transfer licenses can 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, especially startups, are seeking ways to launch products and services without triggering federal or state remittance requirements.
Doing so is difficult, however, given the scope of these laws. Although there are certain federal and state remittance exemptions, these exemptions are limited and are not available in all jurisdictions. For example, the payee-agent exemption that payment processors often use is only available in about half of the states and has certain technical requirements that may need to be met. Consequently, any fintech that operates nationally and engages in money movement activities will likely either need to obtain money transfer licenses in a number of jurisdictions, or structure its operations to minimize the risk of triggering such requirements in the first place.
Advantages and risks of the FBO model
The FBO model has become a popular way to reduce potential remittance risk on a nationwide basis. This model essentially relies on a banking relationship where funds flow through an account owned and controlled by the bank and not the fintech.
In such a situation, the fintech either issues payment instructions to the bank to withdraw funds from a bank-owned settlement account or instructs the 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 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 not owned by the fintech). Importantly, the bank is the sole entity responsible for moving the funds, and all dormant funds are in the bank’s custody and control.
Not all banks will issue FBO accounts in the fintech space. Particularly where transaction records are monitored and the bank may have little specific information about the fintech’s end-user customers, the bank may not be comfortable with its ability to monitor transactions and reduce financial fraud. The banks must also rely on fintech’s ledger system to ensure proper management and distribution of funds. The FBO model requires strong accounting and reconciliation on the fintech’s part, and small mistakes can lead to big headaches that affect the entire FBO account.
These concerns are greatly heightened in cases where a BaaS (banking-as-a-service) provider opens one FBO account for the benefit of multiple fintechs, each with their own portfolio of end-user clients under them in the fund flow. One problematic end user in a receiving end of the FBO account can expose the entire account to greater scrutiny, potentially jeopardizing the entire BaaS provider’s business if the bank suspends or permanently suspends service.
Contract provisions and operational procedures between the bank and the fintech will be necessary to give the bank comfort that proper transaction monitoring and accounting will be performed. In our experience, these negotiations require thorough discussion and planning among the business teams and lawyers involved in the setup. There may be other regulatory requirements to consider and discuss between the parties. For example, consider the issue of deposit insurance for FBOs, and the extent of the benefit of deposit insurance for the FBO account. The Federal Deposit Insurance Corporation (FDIC) and the Board of the Federal Reserve System have cracked down on false and misleading statements about the extent of FDIC insurance coverage for funds held in an FBO account.
Does using an FBO account avoid remittance license requirements?
Despite variations in state law, it can be argued that federal and state definitions of money transfer exclude those who do not receive or transfer funds. Thus, where a fintech only sends payment instructions to a financial institution and never “receives” the funds, there is a reasonable argument that the company is not engaged in money transfer.
However, there is little precedent or guidance that specifically addresses whether the use of an FBO account precludes a fintech from “receiving” funds for remittance purposes.
Some states have evaluated money movement through an FBO account on a case-by-case basis, with favorable rulings for fintechs. 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, for example to distribute wages to its customers’ employees. The payroll provider received similar rulings 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 opportunity to remain compliant with money transmission requirements without the need for nationwide licensing, there are important steps to consider. First, a fintech needs to identify and engage a bank partner that offers an FBO account, as not all banks offer that type of relationship. Furthermore, in order to establish such an account, the fintech must go through an extensive due diligence process, obtain approval for the structure described, and negotiate the authorization agreement.
Additionally, without remittance licenses, a fintech may be limited going forward with respect to the types of ACH transactions authorized under the relationship. The fintech needs to ensure that 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 case the bank closes the account. Finally, while fintechs would have a reasonable argument against the need for government money transfer licenses, the existence of this type of structure does not preclude regulatory inquiries, and fintechs will still have to incur the costs of responding to these inquiries. In summary, bank-fintech partnerships are complex legal arrangements with risk management and operational considerations on both sides, shrouded in significant regulatory considerations. Although the FBO model can offer important advantages, fintechs wishing to use this model must carefully consider current and future operations, weigh the various risks and be careful in structuring banking and customer relationships.
