Building sandboxes in the desert
By MIKE PATTERSON and CAROLINE LYNCH
When Arizona Gov. Doug Ducey signed into law House Bill 2434 last year, he established a fintech regulatory sandbox administered by the Arizona Attorney General, the first of its kind in the United States. The sandbox offers an oasis, if you will, for financial technologies stymied by America’s onerous financial regulations. It is fitting that the first U.S. sandbox was launched in Arizona, a state dedicated to promoting technology and innovation, spurring economic growth and job creation, and reducing regulatory barriers to entry for businesses.
As Arizona Attorney General Mark Brnovich, who spearheaded creation of the sandbox, noted last year, “Arizona has always been a state for big ideas and this is just one more place where we are trailblazing in entrepreneurship and innovation. I hope to see the sandbox serve as a catalyst for capital investment in Arizona and provide opportunities for Arizona businesses and consumers to thrive.”
Under the law, which took effect Aug. 3, 2018, the Attorney General’s office has received 15 applications for entry into the sandbox. Six participants have been admitted, offering products ranging from blockchain-enabled auto title liquidity to mobile hospitality payment solutions. Arizona followed up on its groundbreaking fintech sandbox with the enactment on March 20 of House Bill 2673, which creates a property technology sandbox. This sandbox, administered by the Arizona Commerce Authority, will take effect on August 27, 2019.
A sandbox is a regulatory program, typically premised on a particular trade, which provides relaxed regulatory requirements in exchange for limited access to the market and customized regulatory requirements. A sandbox gives temporary regulatory relief by allowing companies to test their products for a finite period of time before seeking a formal license, enabling innovators to perfect their technology and establish market viability. The test is approved and supervised by a regulatory agency without compliance with expensive reporting obligations from day one.
Sandboxes also serve as testing grounds for regulators. Antiquated regulations and licensing structures simply do not account for rapidly changing technology. From e-signatures and remote notarization to digital records and virtual businesses, technology is changing not just the products and services offered to consumers, but how companies operate. Distributed ledgers and digital tokens are being harnessed to offer digital payment and liquidity products. Unlike traditional corporations, these networks are decentralized across multiple operators, lacking the central authority typically subject to licensing, audit and reporting requirements. State and federal regulators can utilize sandbox testing to study and modernize their licensing regimes to account for the new ways of doing business.
21st Century Technology; 20th Century Regulations
Technology is revolutionizing financial products and services. Global interconnectivity, smart phones, and accelerated computing power enable consumers to deposit, send, and borrow money, shop and apply for mortgages and other lending products, or trade digital currencies and stocks through a website or an app on their phone. These financial technologies or “fintech” offer 21st century alternatives to traditional financial services such as banking, payment systems, or investment advice.
There are a wide array of fintech products coming onto the market today, but each at its core delivers a financial service to a consumer in an innovative way. These financial technologies don’t simply meet modern-day customer demands for convenience and efficiency, they bring an unprecedented level of accessibility to unbanked and underbanked consumers.
As financial innovation marches forward, U.S. financial regulations remain stuck in the past. The U.S. Department of Treasury noted in its July 2018 report on “Nonbank Financials, Fintech, and Innovation:”
Many statutes and regulations addressing the financial sector date back decades. As a result, the financial regulatory framework is not always optimally suited to address new business models and products that continue to evolve in financial services. This has the potential negative consequence of limiting innovation that might benefit consumers and small businesses. Financial regulation should be modernized to more appropriately address the evolving characteristics of financial services of today and in the future.
It is not simply an issue of quality, but quantity, when it comes to U.S. financial regulations. Fintech innovators must adhere to more than 50 jurisdictions — federal, state, and territorial — with overlapping, redundant, and, worse, contradictory laws and regulations. And it is not simply an issue of complying with 50-plus jurisdictions, but with multiple regulators within each jurisdiction. As the Treasury Department report noted, “… many stakeholders expressed frustration with the sheer number of agencies at the federal and state levels that need to be consulted when bringing a new product or service to market. Frequently, firms find that it is not even clear which agencies — or which units within those agencies — need to be engaged. The result is that innovators, particularly smaller firms, face significant and unnecessary burdens in terms of time, money, and opportunity costs.
A 2016 report by the Government Accountability Office identified a dozen federal regulators, in addition to state regulators, with varying degrees of jurisdiction over the financial sector. Describing the U.S. financial regulatory structure as complex and fragmented, the report noted there are multiple agencies with overlapping authorities, potentially placing financial entities under the regulatory authority of multiple regulators.
Compliance with this web of regulations is cumbersome and resource-intensive. Fintech innovators must engage legal and compliance experts to first determine the applicable laws and regulations and resolve uncertainties of federal vs. state jurisdiction and preemption, an assessment that can takes months and not yield definitive answers. Beyond that are application fees, fingerprinting and background check requirements, physical presence and agency rules, and financial and other disclosures.
Companies estimate a process of two years and costs typically ranging from $200,000 to several million. The Treasury Department report indicates that financial licensing costs can range from $1 million to $30 million. Even the low end of this estimate can be cost prohibitive for a startup’s entry into the U.S. market. In many instances, this compliance must be completed before a fintech product or service can be offered in the marketplace, even to test the technology or assess market adoption and viability.
These untenable licensing regimes present a Hobson’s choice for fintech businesses, particularly startups — expend precious time and resources complying with numerous licensing regimes or don’t. As a result, some forego compliance and hope they don’t get caught, while others leave the U.S. for friendlier regimes. Neither of these choices is good and places the U.S. at a significant competitive disadvantage. In 2018, the United States captured only roughly a third of the $39.6 billion in worldwide fintech venture capital investment.
The Growing Trend of Regulatory Sandboxes
While novel in the U.S., regulatory sandboxes have been implemented by a number of other countries, including the United Kingdom, Australia, Canada, the United Arab Emirates, Taiwan, Mexico, Hong Kong, Singapore, South Korea, and even China. In 2018, a dozen international regulators — including the Consumer Financial Protection Bureau (CFPB) — joined together to form the Global Financial Innovation Network to explore the creation of a global sandbox.
Despite these efforts, U.S. regulators have been slow to embrace regulatory sandboxes or other proposals to address the financial regulatory quagmire. But momentum appears to be growing. Following Arizona’s enactment of HB 2434, regulatory sandbox proposals were introduced or enacted in eleven states (Illinois, Kentucky, Nebraska, New York, North Carolina, South Carolina, Texas, Utah, West Virginia, and Wyoming), the CFPB launched a sandbox for businesses subject to its regulations, and the District of Columbia Mayor Muriel Bowser established the Financial Services Regulatory Sandbox and Innovation Council in January 2019. The Council is expected to study and issue a report within six months on the feasibility of implementing a financial services regulatory sandbox.
Notably, the Treasury Department report touts a regulatory sandbox as a means to enhance and promote innovation, recommending, “federal and state financial regulators establish a unified solution that coordinates and expedites regulatory relief under applicable laws and regulations to permit meaningful experimentation for innovative products, services, and processes.”
Arizona’s Fintech Regulatory Sandbox
The Arizona Regulatory Sandbox Program enables businesses to test innovative financial products and services for two years to up to 10,000 Arizona consumers. At the end of the testing period, participants must wind down the test and either exit the market or seek the appropriate state license.
Businesses seeking to test an innovation must apply and be admitted to the program by the Attorney General’s Office. Applicants must provide a detailed description of the financial product or service, explain how such product or service is “innovative” under the statutory definition, and describe how such innovation would be subject to Title 6 or the relevant portions of Title 44 of Arizona law were it offered to Arizona consumers outside the sandbox.
Applicants must submit to the Attorney General a testing plan explaining the objectives of testing within the sandbox, the metrics for measuring the test’s success, why testing needs to be done in the market, why the product or service would benefit from the sandbox, and, if applicable, why an applicant cannot proceed with a test outside the sandbox. A timeline, including key milestones and any anticipated extensions, must also be provided.
The Attorney General’s Office requires applicants to provide a detailed consumer protection plan describing marketing plans, identifying consumer risks and how the applicant intends to address those risks, and explaining how they will monitor the testing to assess the test and protect consumers from the test’s failure.
Once admitted to the sandbox, participants must adhere to a number of statutory requirements, including caps on individual and aggregate consumer loan and money transmission transaction amounts, and certain statutory requirements for consumer loans, money transmission, sales financing, and investment management. Under limited circumstances, applicants can seek permission to test the product or service with up to 17,500 Arizona consumers or seek an increase in individual and aggregate transaction caps if testing as a money transmitter.
Before testing begins, all participants must clearly and conspicuously disclose, in both English and Spanish, a variety of information to consumers, including:
Participant’s name, contact information, and sandbox registration number.
The innovative financial product or service is offered pursuant to the sandbox.
The state does not endorse or recommend the innovation.
The innovative financial product or service is a temporary test that may be discontinued at the end of the testing period, including the expected end date of the testing period.
Consumers may contact the Attorney General to file complaints regarding the innovative financial product or service, including the Attorney General's telephone number and website address where complaints may be filed.
Participants must retain all records, documents, and data produced in the ordinary course of business regarding the test and must alert the Attorney General’s office to a testing failure or data breach. Beyond the statutory requirements, the Attorney General’s Office has implemented procedures to routinely engage with applicants and participants as they move through the sandbox process. This degree of engagement, which far exceeds that provided by licensing agencies, affords participants a unique degree of flexibility with their innovation and enables the Attorney General to closely monitor testing, consumer engagement, milestones, and an innovation’s success or failure in the market.
A critical feature of the fintech and proptech sandboxes is reciprocity, empowering Arizona to enter into agreements with other states — or other countries — to enable sandbox participants to test their innovations in other jurisdictions. Businesses seeking to offer financial products or services in the U.S. must often obtain one or more licenses from each state on top of complying with federal regulations. But the reality is that having 50 licenses doesn’t make a business 50 times more compliant and it doesn’t afford consumers 50 times more protection. States are just now contemplating the notion of reciprocal licensing as the realities of America’s competitive disadvantage come into greater focus.
If other states follow Arizona’s lead in adopting reciprocity for sandbox innovations, they can further incentivize companies to bring and keep their businesses in the U.S.
Arizona Sandbox Participants
The Attorney General has received 15 applications, and to date has admitted the following six companies:
Omni Mobile, Inc. (admitted Oct. 11, 2018) is developing a financial service platform implementing an array of avante garde technologies to improve payment systems through the utilization of direct ACH payments through Omni’s centralized wallet infrastructure. Omni will test its product at the Westward Look Wyndham Grand Resort and Spa in Tucson.
Grain Technology, Inc. (admitted Oct. 29, 2018) is developing an application that offers consumers personalized savings plans and credit opportunities through the consumer’s existing bank account.
Sweetbridge NFP, Ltd. (admitted Oct. 29, 2018) is developing a blockchain-enabled product designed to enable asset liquidity without a credit check and offer affordable, consumer-friendly vehicle title loans with an APR cap of 20 percent.
Align Income Share Funding, Inc. (admitted March 20, 2019) is developing a business model for income-sharing agreements that provide qualified consumers with a fixed amount of money in exchange for a percentage of the consumer’s future income over a scheduled period of time, subject to contingencies involving periods of unemployment or lowered income.
ENIAN, Ltd. (admitted May 8, 2019) is building a platform to help investors compare potential investment opportunities by providing an algorithm-based evaluation tool for potential solar and wind power projects looking for funding.
Verdigris Holdings (admitted May 8, 2019) offers a solution that combines custom technology and industry expertise to deliver simple transactional financial services at a low cost to unbanked people and the companies that serve them.
Reaction to the Sandboxes
Proponents of the fintech and proptech sandboxes tout the benefits of these initiatives. Sweetbridge CEO Scott Nelson said, “The Arizona Sandbox makes it possible for startups, like Sweetbridge, to test their products quickly in a controlled environment without the cost and time delay that is typical for licensing new financial products. The Sandbox is the perfect environment to develop and iterate new financial technology in a way that is safe for consumers but also more feasible for fintech innovators.”
Grain Co-founder and COO, Carl-Alain Memnon, noted the company “sought to join the Arizona Fintech Sandbox because it provided the unique opportunity for us to beta test our innovation in the market. With guidance from the AG’s office we were able to more efficiently navigate the regulatory requirements to go to market. Access to the Arizona market has been invaluable to both our product development and product market analysis. It has allowed us to work closely with those consumers to iterate on our offering and more specifically tailor it to actual consumer needs. Ultimately, we hope to graduate from the sandbox with a consumer centered product that improves the financial health of individuals across the country.”
Sandra Watson, President and CEO of the Arizona Commerce Authority, noted, “Under Gov. Ducey's leadership, and with the support of the Arizona legislature, our state is consistently first in advancing policies that foster innovation and support economic growth. Our first-in-the-nation fintech sandbox, laying the groundwork for 5G technology, leading the automated vehicle revolution, and embracing the sharing economy have earned Arizona a reputation as one of the most forward-thinking states in the nation. Passage of the proptech bill is certain to contribute to the excellent momentum and job growth in Arizona's tech industry.”
Individual cities have robust programs to target and attract potential fintech companies to Arizona. Jeanine Jerkovic, Director of the City of Surprise Economic Development Department, said, “As a community which launched an innovation center with global services at the AZ TechCelerator as a primary economic development strategy, it is always exciting when the State of Arizona takes a leadership role in innovation. Reducing cost barriers for global companies looking for a U.S. entry point is an important way to demonstrate that Arizona understands the challenges that these companies face.”
Despite the overwhelming support from the business community, criticisms have been levied against the fintech and proptech sandboxes. Representatives from the William E. Morris Institute for Justice, Arizonans for Responsible Lending, the Southwest Center for Economic Integrity, the Society of St. Vincent DePaul, and the Arizona Coalition to End Sexual and Domestic Violence testified in opposition to these proposals, particularly with regard to consumer risk. Opponents questioned the efficacy of allowing businesses — without a license — to offer financial products and services to consumers; objected to authorizing money transmission outside the requirements of the statute, including state anti-money laundering reporting; opposed authorizing auto title lending products and services and allowing businesses to exceed consumer caps; and criticized excluding sandbox records from the state’s public records law.
Some questioned whether the sandboxes offer a backdoor for fraudsters and predatory lenders who often prey on the vulnerable members of our community. Consumer advocate Jean Ann Fox, speaking before the House Commerce Committee in opposition to HB 2177, said she is concerned that the fintech sandbox “undermines consumer protection; it creates duplicate regulation, and it sets up the opportunity for regulatory arbitrage as companies decide who they would like to have regulate them, the Department of Financial Institutions, the Corporation Commission, or the Attorney General’s Office.” As she put it: “Toddlers play in sandboxes and grownups play by the rules.”
Rather than enabling bad actors, sandbox proponents believe innovation has the potential to put them out of business by introducing new and competitive products into the market and placing more power in the hands of consumers. Evan Daniels, Fintech Sandbox Counsel at the Arizona Attorney General’s Office, said, “Being approved to come into the sandbox is not license to do whatever you want. We pay close attention to how proposed tests will be administered and what consumers will encounter both when the test begins and beyond. With that level of involvement on our part, we think that makes the sandbox a less than ideal environment for scams and fraud.”
Arizona Lawyers can Serve Fintech and Proptech Companies
Arizona lawyers provide important counsel to Arizona startups. Many local and out-of-state companies seeking to participate in the Arizona sandboxes need legal guidance to navigate the application process and carefully craft legally complete applications that meet the programs’ requirements and goals. Legal guidance is paramount throughout the sandbox testing process to address any modifications to the innovation, monitor changes in applicable federal regulations, ensure proper disclosures to participating consumers, and respond to inquiries from sandbox regulators who cannot provide legal advice to applicants or participants.
In addition to specific advice on the sandbox program requirements, these companies typically require the same types of advice that all companies need, including advice on corporate, tax, employment, intellectual property, technology licensing, a wide variety of business contracts, and of course, advice on dispute resolution and litigation, as needed.
The Arizona sandboxes afford a limited safe harbor to test a new product and get it to market, under a regulator’s scrutiny with the goal that the product will be proven economically viable when the company transitions to more expensive compliance and licensing. Arizona is spearheading these sandboxes in key areas to attract higher wage technology jobs, capital investment, and to create clusters of technology companies in leading edge developing industries.
“Arizona’s top-notch regulatory and business environment has positioned the state as a leader in innovation,” said John Ragan, chief operating officer of the Arizona Chamber of Commerce and Industry and invisionAZ CEO. “The creation last year of Arizona’s fintech sandbox served as a catalyst for tech growth in Arizona. That, combined with this legislative session’s passage of the proptech sandbox, further signals that Arizona is the place for innovative companies to develop cutting edge technology.”
“The passage of the recent proptech legislation further legitimizes our market’s reputation as America’s tech proving grounds,” added Chris Camacho, president and CEO of the Greater Phoenix Economic Council. “With policy achievements in autonomous vehicles, blockchain, fintech and now proptech, we are building a global identity centered on testing, validating, and scaling disruptive technologies.”
Mike Patterson is a partner at Spencer Fane LLP in the firm’s Phoenix office. He helps businesses navigate corporate, compliance and securities matters, and he has extensive experience in domestic and international mergers and acquisitions, joint ventures, strategic alliances, equity and debt offerings, foreign direct investment, distribution, agency and licensing matters and market entry strategies.
Caroline Lynch is founder and owner of Copper Hill Strategies LLC, in Phoenix, Arizona. She provides businesses with strategic federal and state government relations and business developments services. Caroline previously worked on Capitol Hill for over a decade, most recently as Chief Counsel of the House Judiciary Subcommittee on Crime, Terrorism, Homeland Security, and Investigations.