Fintech Startups Navigate Legal Gray Areas To Build Billion-Dollar Companies

TECHCRUNCH: Innovation, growth, technology, user experience, revenue and gross margin have become synonymous with how you define success for a tech startup. What is missing from this list is local, state, and federal regulation; terms that startups in the financial technology sector understand far too well as either barriers to or catalysts for growth and early success.

Regulation is one of the most significant hurdles for fintech companies to overcome. As stated so eloquently by Charles Moldow of Foundation Capital when referencing marketplace lending platforms, “it’s neither quick to start nor easy to scale a marketplace [lending] platform. And out of all of the barriers to entry, none are as significant and necessary to get right as state and federal regulations.”

Yet despite these regulatory hurdles and barriers, fintech pioneers like LendingClub, Motif Investing, Betterment and CircleUp are making it possible to get a loan in hours, invest your money seamlessly with low or no fees and access investments based on ideas and common sense themes rather than ambiguous stock quotes.

That is because these companies and others like them are pushing the envelope and navigating uncertain regulatory waters and legal gray areas to create disruptive technologies and marketplaces that change the way we invest and borrow money. But they understand far too well that navigating unsuccessfully can prove daunting and oftentimes fatal. In 2008, the SEC issued a cease-and-desist letter to P2P lender Prosper after deeming its activities to be in violation of the Securities Act of 1933. That same year, LendingClub went offline to comply with SEC regulation.

So while the SEC’s recent ruling to promulgate rules to implement Title IV of the JOBS Act was indeed cause for celebration in many ways, fintechs were slightly more temperate in their responses, knowing that they must continue to carefully navigate their way through regulatory issues. These regulations fall within both state and federal jurisdiction and include lending laws, securities regulation and broker dealer and investment adviser licensing requirements.

Lending laws. Companies like LendingClub, OnDeck and SoFi are disintermediating the traditional banking industry as we know it. And although a large part of their success is due to the nimbleness and efficiency with which they operate, an attempt to replace banks is not an easy one.

These companies must deal with state lending laws that regulate who they lend to, how much they can lend and the interest rates they can charge to borrowers. In order to mitigate some of this regulatory scrutiny, LendingClub has forged a partnership with WebBank, an FDIC-insured bank, to issue the loans.

Securities regulation. Platforms like AngelList and CircleUp have come a long way in terms of providing individuals with greater access to startups and small companies. However, due to securities laws and regulations that were created during and have changed little since the great depression, their services are restricted to high net worth or high-income investors (deemed accredited investors under the Securities Act of 1933) and fail to address a majority of the population. Alas their visions of greater access are only partially being realized.

Broker dealer and investment adviser licensing requirements. When platforms like Betterment, Motif Investing and Wealthfront decided they wanted to take on incumbents such as Charles Schwab and Fidelity, they realized doing so would require more than just a better product and would include navigating complex broker dealer and investment adviser licensing requirements.

These licensing requirements stem from the fact that these platforms provide investors access to investments that are classified as “securities” under the 1933 Act. Betterment, for example, is not only an SEC-registered investment adviser but its subsidiary Betterment Securities is also a broker-dealer regulated by FINRA and the SEC.

Accordingly, while startups like Uber or Airbnb have their own regulatory concerns, they tend to be at the municipal level and, therefore, easier to navigate, whereas fintech startups are regulated at every level making innovation that much more difficult.

But the same reasons that makes these fintech startups superior incumbents such as banks and traditional investment advisors – i.e. efficiency, technology and innovation – also make them well-suited to view regulation as an opportunity rather than an insurmountable challenge.

Founders of these companies realize that greater regulation also brings with it, as Charles Moldow has stated, greater barriers to entry and the need for flawless execution. And successful fintech startups have embraced this as a challenge and have ingrained it in their cultural DNA. It isn’t a surprise then that incumbents, out of fear of being disintermediated, are urging regulators for even stricter regulations in order to level the playing field.

And of course regulation isn’t all bad. If done right, it tends to bring with it legitimacy that can elevate fintech companies above competitors and can go a long way towards more sustainable growth.

LendingClub, for example, registered with the SEC at a time when they were second in line to their once larger competitor, Prosper. Understanding the importance of and need for the SEC’s stamp of approval, they worked with regulators and emerged in first place where they remain today as the market leader.

Another check in the pro-regulation column: the influx of an ecosystem of startups that help fintechs navigate the regulatory complexities. Companies like WealthForge, which targets broker/dealer services, and Epiphyte, which focuses on compliance surrounding bitcoin and cryptocurrency, are capitalizing on the business of regulation.

Although regulation is therefore not only necessary but at times beneficial, it’s important that regulators understand the changing nature of how we do business made possible through the Internet.

Consequently, it is time for regulators to take a step back and assess whether laws and regulations that pre-date the Internet (sometimes considerably) fit within the digital environment. And if the answer is no, it is their duty to find ways to expand their frameworks to include the demands of the digital investing revolution and the incredible innovation it enables across the financial services industry.