As we prepare to put 2020 in the rearview mirror, many of us will not have fond memories of the year. Quarantines, masks, social distancing, unspeakable tragedy, economic ruin for some industries. But the fintech world proved it was equal to the task. Despite, or perhaps because of, the physical barriers established by the COVID-19 pandemic, fintech had a transformational year. We take a closer look below at fintech and lending transactions, regulatory and litigation, and decentralized finance.
With the excitement of Bitcoin hitting all-time highs and the noted move to blockchain and decentralized finance, you would be forgiven for forgetting the now ho-hum world of marketplace lending and online credit. What was once the innovative is now the banal. As COVID-19 transformed the economy, savings rates in the United States actually increased. Loan portfolios (apart from commercial real estate) held their value as consumers by and large continued to perform without significant increases in defaults. Moreover, loan demand increased as some hoarded cash or drew down on lines, expecting a rainy day. No doubt the CARES Act assisted in the stabilization of the industry, but the real impact of COVID-19 on fintech was that digital became the norm. Venmo and Square became standardized, as contactless payments and deliveries were preferred.
A number of fintechs are striving to fill the gap in their business models between payments, lending and investing. An investment platform introduces a credit card; a lending platform announces a partnership with a broker-dealer; a payment platform expands credit and lending. This three-legged-stool model to become the financial services firm of the future is in its early stages, as incumbent banks see their customer base start to age, and millennials and Generation Z are not accustomed to branch banking nor wedded to the same firms their parents use.
A few other trends of note:
- Specialty platforms focused on investment – 2020 might have been the year of the fintech investor. Several platforms had banner years in 2020, specializing in investment verticals. Investors can turn to platforms and invest in trade receivables, small-business loans, artwork, and loans to consumers for plastic surgery, orthodontia, motorcycles, boats—you name it. These platforms allow for tailored risk investing and innovative products such as high-coupon first loss and fund aggregation.
- Tokenization – Beyond Bitcoin and cryptocurrency, many platforms are using tokens as a means of transmitting ownership in investments and assets. Tokens have advantages over traditional securities—they are transparent, and transactions therein are immutably recorded on the blockchain. In certain instances, tokens are also more easily transferred among investors, which frequently provides for faster transactions than traditional ownership transfers. Decentralized finance also took off in a meaningful way (see below).
- M&A – A number of notable transactions were announced this year: Intuit to acquire Credit Karma, American Express to acquire Kabbage and Enova acquiring OnDeck. In addition, a number of special purpose acquisition companies (known as SPACs) made their debut and have a limited window to complete an acquisition. Also, the NYSE direct listing approval in December will enable more companies to go public at lower cost.
- Buy the bank, build the bank – In addition to bank partnerships, some platforms opted to buy or form their own banks. Capital investment in fintech has enabled fintechs to buy banks, such as Jiko Group and LendingClub, while others filed for their own bank charters, such as Varo Money and SoFi. LendingClub also announced the discontinuation of its retail investment platform.
Finally, asset-backed securitization continued to demonstrate its efficiency in recycling capital for the industry. It was also assisted by the courts—in another victory for bank defendants, a judge in the Eastern District of New York tossed a case filed by plaintiff credit card accountholders against a securitization trust established by Capital One Bank. In a seminal defeat for plaintiffs looking to impose Madden standards (see below) to the structured finance market, Judge Kiyo Matsumoto held in Cohen v. Capital One Funding, et al. that the National Bank Act pre-empts New York State usury laws, and that a commonly established securitization trust where the bank continues to sell receivables to a trust and service the underlying accounts does not change the character of the credit card arrangement between bank and customer. Heated amici briefs were filed on both sides—by the consumer credit lobby for the plaintiffs and by the Structured Finance Association for the bank, which argued that a contrary holding would disrupt hundreds of billions of dollars each year in ordinary course bank and receivables financing.
Fintech Regulatory Outlook
2020 was a big year for the Madden and “true lender” issues which certain regulators and private plaintiffs have employed to challenge bank-model lending programs, where fintechs or other nonbank entities partner with banks to make loans available to their customers. In 2015, the Second Circuit ruled in Madden v. Midland Funding that when a national bank sold charged-off debt to a nonbank debt buyer, the debt buyer did not inherit the bank’s ability to charge interest at the rate permitted by the bank’s home state. Similarly, regulators and private plaintiffs have attacked bank-model lending programs on the basis that the nonbank program sponsor is the “true lender,” so the origination of the loan by a bank should be disregarded for purchases of determining the applicable usury limit. These cases have reached varying conclusions.
In May and July 2020, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) respectively adopted “Madden-fix” regulations rejecting Madden’s holding. In October 2020, the OCC adopted a regulation rejecting the true lender theory and stating that the true lender is the lender identified in the loan documents or that funded the loan. State attorneys general and regulators are challenging these rules on a variety of grounds. There also have been important developments on these issues in the courts. Perhaps most significantly, the Colorado attorney general in August 2020 settled ongoing litigation concerning two bank-model programs, creating a safe harbor for similar programs that many believe could be a national model going forward. There also have been decisions in class actions challenging bank-model programs, with favorable outcomes for the industry.
These battles are likely to continue in 2021. If the new administration replaces key regulators as expected, the OCC and FDIC rules may be revisited. Furthermore, federal and certain state regulators appear likely to scrutinize bank-model lending more than under the current administration.
Cryptocurrency and Blockchain—The word of the year is “DeFi”
In the cryptocurrency and blockchain space, 2020 brought the rise of decentralized finance (DeFi) over innovation in the traditional financial sector. This year underscored DeFi’s advantages—the ability to automate and disintermediate the legacy financial system in order to bring access to the financial markets to a wider group of individuals and entities. This “access” allowed for, among other things, increased liquidity in spot transactions and the ability to earn interest on various cryptoassets. It was accompanied, however, by an increased focus on how and when laws and regulations apply to transactions in DeFi as well as on the developers who create the software through which these transactions may occur.
The growth in DeFi was spurred by a number of “automated market makers” (AMMs), which allowed for near-instant liquidity in almost any spot transaction. Developers pushed the idea for AMMs even further, proposing and creating use cases for AMMs, such as swaps and options. At the same time, interest rate protocols—which allow users to deposit cryptoassets and earn interest on them—continued to remain a dominant and important force in DeFi. Notably, both AMMs and interest rate protocols formed the foundation for DeFi this year—both with users, who frequented these types of protocols, and with other software developers, who used both of these types of protocols as foundations for new and innovative software protocols that permit different types of DeFi transactions, given that DeFi allows one piece of software to build on top of another (and without any permission from any software developer).
As noted, along with this growth came a focus on the regulatory risks and legal requirements that could apply in a new way to this type of software. There are numerous regulatory regimes that must be considered when assessing DeFi transactions today—whether it be securities, commodities, lending, money transmission, banking or OFAC. Unlike traditional finance, software protocols may have no person or company controlling any aspect of it; no way to alter or stop it; and, in some cases, no way to comply with regulations. Thus, given the decentralized nature of AMMs, interest rate protocols and other DeFi software, there is no clear answer as to whether and what regulatory regimes may apply, nor is there a clear path to how a “decentralized” piece of software could comply with laws and regulations once deployed and once used and/or governed by a dispersed group of users. In those situations, the applicability, desirability and enforceability of those regulatory regimes are challenging and ambiguous.
With that in mind, 2020 was a year of transition in DeFi with the implementation of “decentralized governance” for each of these protocols. This new type of “governance” of the protocol is intended to transition control (in whatever degree) over the development and maintenance of these software protocols from the development team to a broad range of participants in or users of the protocol unaffiliated with the development team. Those participants may take an extremely active role in “governance” by, among other things, further developing the code underlying the software protocol, making all key decisions related to the protocol and implementing changes to the way the protocols function.
Much of this new type of governance has been facilitated through the issuance of “governance tokens,” digital assets that grant rights to holders of those tokens to participate in governance of the protocol. As seen by the Securities and Exchange Commission’s (SEC) enforcement actions beginning in 2017 and continuing on, including through this year, the way in which these tokens may be used and are distributed is crucial to the regulatory analysis. Two court decisions out of the Southern District of New York, SEC v. Telegram Group, Inc. et al. (19 Civ. 9439) and SEC v. Kik Interactive, Inc. (10 Civ. 5244), reinforced much of the informal guidance the SEC had promulgated previously regarding token issuances. Both Telegram (a decision on the SEC’s motion for preliminary injunction) and Kik (a decision on the SEC’s motion for summary judgment) found that the token issuers had violated Section 5 of the Securities Act of 1933, as amended (Securities Act), by providing a series of agreements, which included the right to receive tokens in the future after each of the issuers had completed building the software on which those tokens would be used. Both the Telegram and Kik courts found that these series of agreements (which included the tokens) constituted “investment contracts” as defined under the Securities Act and thus, because neither Telegram nor Kik had registered these offerings with the SEC nor qualified the offerings for a proper exemption from registration, they had violated the Securities Act. Both courts applied the test set forth in SEC v. W.J. Howey Co., a 1946 Supreme Court case setting forth the “test” for when an instrument constitutes an “investment contract”—bringing age-old financial caselaw into the digital age.
2021 will likely bring continued aggressive enforcement by the SEC and potentially other regulators against fraudulent actors involved in the digital asset space, as well as those actors who have taken an overtly lax approach to regulatory matters. The SEC reinforced its intention to vigorously pursue enforcement in the space on December 22, 2020, when it filed a complaint in the Southern District of New York against Ripple Labs, Inc. (Ripple) and two of its executives—Brad Garlinghouse and Christian Larsen—alleging that Ripple sold and continues to sell an unregistered security, the cryptocurrency known as “XRP,” which is native to the Ripple blockchain. The Ripple complaint brings claims against Ripple, Garlinghouse and Larsen for violation of Section 5 of the Securities Act, and against Garlinghouse and Larsen for aiding and abetting such violations.
It remains to be seen whether any regulator is willing to take aggressive action against any of the actors in the DeFi space who have taken a more “buttoned up” approach to regulation or have taken steps to show that they intend to be “good actors” in this emerging space in order to ensure that DeFi continues to grow throughout 2021 and beyond.