What if a regulator says you are an MSB?

I frequently get calls from companies saying they have received letters from state regulators requesting information related to whether they have acted as a money service business (MSB) or money transmitter (MT) with the state’s consumers.

When a company receives such a letter, it means the state has reason to believe it is violating the state’s law. If a company receives one, it needs to address the issue with the state and likely take measures to bring itself into compliance.

What are MSBs and MTs?

An MSB is the legal term used by financial regulators to describe businesses that transmit or convert money or provide money transmission services, as well as any other person engaged in the transfer of funds or other value.

Federal law requires any person that qualifies as an MSB to be licensed by the U.S. Department of the Treasury’s Financial Crimes and Enforcement Network as an MSB. Such businesses are also subject to separate requirements to be licensed as an MT in each state in which they do business.

An MT is a type of MSB that provides money transfer services or payment instruments. Examples of MTs include Plastiq and online wallets such as PayPal. Almost every state has licensure requirements for MTs.

How do I become an MT?

So, what’s the big deal? Just get licensed, right? Well, it is not as easy as it sounds. The licensing process with all states often takes two or more years to complete at a cost of $1 million to $2 million. California is notoriously expensive and time-consuming.

It’s against the law to do business as an MT without the proper licensure. State penalties may range from $10,000 to $2 million or more.

In addition to the application and lawyer filing fees, licensing requires showing proof of a minimum net worth of $500,000 to $1 million, surety bonding, and fully implemented anti-money laundering and know-your-client compliance programs for your business. Usually, you will need to devote at least one full-time employee to compliance issues demanded by the regulators.

Moreover, it is a crime to do business as an MT without having such licenses in place, and state penalties for such conduct may range from $10,000 to $2 million or more. Several states impose fines for noncompliance that equal the amount of gross merchant sales in the state.

Moreover, different states will keep in touch with each other regarding these issues. Thus, potentially, a letter from one state can result in a fine from that state and a referral to another state’s regulator that will send a similar letter that starts the process again.

Is there a work around?

Fortunately, some businesses can develop a work around to avoid licensure. One potential route is to become an authorized delegate of a properly licensed MT. In this scenario, the authorized delegate may generally use its own brand and board customers directly. However, the money must flow through the licensed MT’s bank account, and the authorized delegate must clearly apprise customers that its services are being provided under the MT’s license.

Often, state regulatory requirements stipulate that the MT is responsible for performing transaction reporting, oversight, and monitoring functions.

Although these rules vary by state, usually the MT is liable for the authorized delegate’s activities and must perform transaction reporting, oversight and monitoring functions to comply with regulatory requirements. In return, the authorized delegate pays the MT in consideration of its regulatory obligations and the associated risk, as well as for all transactions.

Unfortunately, this model does not work in all circumstances. For example, the Texas Department of Banking issued a Supervisory Memorandum regarding this issue in October 2014, advising that Texas law prohibits a licensed MSB from appointing an authorized delegate to offer its own distinct line of money transmission products or services (as opposed to offering the license holder’s own product or service).

Under this view, the license holder rather than the authorized delegate should have a contractual relationship with the customers, and should derive revenue primarily from the transactions performed by the authorized delegate on its behalf rather than from fees paid by the authorized delegate.

Such arrangements are also subject to close scrutiny by regulators in other states to ensure that they do not constitute a rent-a-license relationship. This is particularly true where the authorized delegate is offering a product or service that the MT license holder does not already provide, or where the license holder contracts to offer an entirely new service through the authorized delegate.

State regulators carefully scrutinize financial transactions in order to ensure that they do not constitute a rent-a-license relationship.

Federally chartered banks are generally exempt from money transmitter licensing requirements and may designate agents to provide money transmitter services on their behalf. Thus, another potential avenue is partnering with a nationally chartered bank as the bank’s agent to obtain an FBO (for the benefit of) account relationship, where all funds are held at the bank for the benefit of the agent’s customers.

In addition, the company can reengineer its business model to avoid transmission. This solution is usually the cheapest, but most companies are loath to change core activities that add value to their business to accommodate the concerns of the government. Nevertheless, all of these options should be considered, hopefully, prior to receiving attention from a state regulator.

What if I’ve already received that letter?

If you have already received a letter from the state regarding this topic, you should engage the regulators. It is possible your company has not engaged in activities that violate the state’s statutes. You may be able to explain mitigating factors, such as legitimate confusion, and that the company has stopped any offending activities. You may be in a position to explain how the company has brought itself into compliance by using one of the work-arounds identified herein. You should also engage an attorney to assist you with this effort. It will demonstrate you are serious about complying with the state’s MT statutory framework.

Have you received a letter from your state regarding this topic? Engage the regulators.

Becoming an authorized delegate or partnering with a federally chartered financial institution both require a company to find an MT or a bank that will be willing to work with the company. This is not an easy task, and likely, the MT or bank partner will require that it be well remunerated for its efforts and the risk it takes.

The information contained in this article is for educational purposes only. Please consult an attorney before relying upon it for your specific legal needs.

Theodore F. Monroe is an attorney whose practice focuses on the electronic payment and direct marketing industries. For more information, email him at [email protected] or call him at 213-233-2273.