ETA Expert Insights: Money Transmission and Payment Facilitation — Risks and Mitigation Strategies Part 2

By Edward Marshall, Partner, Arnall Golden Gregory LLP and
Nicole Meisner, Partner, Jaffe Raitt Heuer & Weiss, P.C.
MTL Working Group • ETA Payment Facilitator Committee

PART TWO OF TWO
In part one of this article (here), we identified money transmission regulatory risks that payment facilitators face given their unique ability to step directly into the settlement funds flow on behalf of their sub-merchants.  In this article, we outline some mitigation strategies that, when properly implemented, may help payment facilitators reduce the risk of being characterized, and regulated, as a money transmitter.

Money transmitters are subject to stringent laws and regulations at the federal level and in virtually every state. To the dismay of payment facilitators, however, the laws defining money transmission and the recognized exemptions are not consistent. This leads to a confusing application of the law where a payment facilitator can find itself regulated as a money transmitter in some states but not in others – all based on the very same conduct.

While there is no uniform definition, as a general litmus test, a payment facilitator increases its risk of being regulated as a money transmitter if it is involved in the flow of funds. Stated differently, this risk is generally present when the payment facilitator accepts or receives funds on behalf of its sub-merchants into an account directly or indirectly owned or controlled by the payment facilitator.

Rather than voluntarily submit to regulatory oversight (which is both burdensome and costly), payment facilitators will often seek to structure their operations to be removed from the flow of funds to lessen the risk that their conduct would be subject to regulation.  When operational changes are not viable, payment facilitators may also attempt to avail themselves of an applicable exemption.

OPERATIONAL RESTRUCTURE
There are several different operational restructures that payment facilitators may be able to adopt to reduce their risk of regulation.  Unfortunately, however, there is no one-size-fits-all solution. And sometimes, multiple mitigation strategies may be used simultaneously as added layers of protection in the event that one approach does not pass muster with a particular regulator.

One option is for the payment facilitator to contractually require its acquirer to settle funds due to sub-merchants directly to the sub-merchants.  Under this modified flow of funds, the payment facilitator would issue the payment instructions to the acquirer as to the amount due to each sub-merchant and the amount due to the payment facilitator for its processing fees.  However, it would be the acquirer (not the payment facilitator) that actually transmits the funds due to the sub-merchant directly into the account owned by the sub-merchant.

Often with the above approach, the payment facilitator and acquirer will establish a “for the benefit of” account—commonly referred to as an FBO account to receive (from the card brands) the aggregated amounts due to the payment facilitator’s sub-merchants.  The acquirer would then push the funds from the FBO account to each individual sub-merchant settlement account based on the payment facilitator’s instruction.

The FBO account structure has been adopted as a common “best practice” by payment facilitators seeking to be removed from the flow of funds.  But beware. Not all applicable regulators have evaluated and expressly condoned adoption of the FBO model as a means to avoid characterization as a money transmitter. Thus, the payments industry is left with uncertainty as to this approach.

Furthermore, an FBO account must be carefully structured to afford the payment facilitator the best chance of avoiding regulatory scrutiny. The title (ownership) and tax identification number associated with the FBO account are important factors to be considered. And appropriate contractual language (both in the payment facilitator’s sponsorship agreement and its agreements with its sub-merchants) should be included to reflect and support the payment facilitator’s position that it does not receive or accept funds on behalf of the sub-merchant.

For companies that are considering becoming a payment facilitator but that have not already been sponsored as such, an alternative approach would be to form a strategic partnership with a registered payment facilitator to become its referral agent.  While the revenue streams are not as large, entities acting in such role (commonly referred to as a “managed payment facilitator” or a “payment facilitator lite”) will generally have less regulatory risk and less liability and responsibility for the referred sub-merchants.

REGULATORY EXEMPTION
For some payment facilitators, an operational restructure is not a viable option and they must (or prefer to) receive and accept the funds due to their sub-merchants. Generally, in those instances, the only way to avoid money transmission registration and licensure requirements is for the payment facilitator to qualify for an applicable exemption. If a payment facilitator qualifies for an exemption, it will not be subject to the applicable regulations despite that it engages in activity that would otherwise be regulated.

The most common exemption that may be appliable to payment facilitators is known as the agent-of-the-payee exemption. The qualification requirements vary among states but this exemption typically applies to entities that accept payments from payors (i.e., cardholders, customers, or debtors) on behalf of (as an agent of) a payee (i.e., merchant, creditor, or biller). Certain contractual language must be in place between the payee and the payment facilitator which authorizes the payment facilitator to act as the payee’s agent, among other things, in connection with the receipt of the payors’ funds.

While this exemption can be effective for payment facilitators that qualify, only about half the states currently recognize it. Other states have expressly rejected it or have remained silent on the issue. For companies operating nationwide, qualification for this exemption can only get them so far because it will only afford them protection in the states in which they qualify. There may therefore be a need to consider the application of other exemptions recognized in a particular state.

If no other exemption applies, the only remaining compliant approach for payment facilitators unable or unwilling to change their operational structure is to obtain licensure in states where they do not qualify for an exemption.

PROACTIVE APPROACH
The application of money transmission laws to payment facilitators is complex and inconsistent. The importance of minimizing the risk of non-compliance cannot be overstated given the severity of the civil and criminal penalties at play – not to mention the negative impact non-compliance has on business valuation and the payment facilitator’s contractual obligations.

Every payment facilitator should engage in a careful analysis of the laws, regulations, and regulatory guidance in each state where it operates (including any state where the payment facilitator has a physical presence, any state where it receives or sends money, and any state where its sub-merchants are located).  Once the payment facilitator understands its own risk of regulation, it can formulate a course of action to reduce such risk or, alternatively, take action to become registered and licensed as a money transmitter.

While there are almost always ways in which payment facilitators can mitigate their risk of regulation, such efforts must be properly implemented to afford the payment facilitator the greatest chance of protection.

The above is intended as general information only and should not be construed as legal advice or as creating or soliciting an attorney-client relationship. You should consult your attorney for guidance with respect to any particular issue or legal inquiry.