John Popeo of the Gallatin Group on the intersection Fintech and US financial regulations

John Popeo of The Gallatin Group - Podcast Transcript

Speaker 1:	(singing). It’s Kruze Consulting Founders and Friends with your host Scotty Orn.
Scott:	Welcome to Founders and Friends podcast. Before we get to a great podcast with John Popeo of the Gallatin Group, quick shout out to our friends at Rippling. Rippling is a fantastic startup payroll system. It’s super automated. They integrate with your IT stacks. You can spin new employees up. We did a little study at Kruze, and it takes us about three hours and $140 bucks an hour for IT services for them to spin someone up on a new computer. So, you save that every time you hire someone, let alone if someone departs, but Rippling does payroll, does HR and again, it integrates in your IT infrastructure. They are just a great firm to work with. I highly recommend them. Now we’re going to cover a really cool topic, Fintech charters, Fintech regulatory, Fintech, legal with John Popeo of Gallatin Group. Welcome, John.
John:	Thank you so much for having me.
Scott:	John and I met because we were going back and forth about the Google and the Apple credit cards and what’s happening there. I’m a total Fintech nerd, so I wanted to cover that. But before we get into it, let’s establish John’s expertise here. John, retrace your career and tell us how it led to starting the Gallatin Group.
John:	Sure, absolutely. I started my career at the Federal Reserve back during the financial crisis, and I moved over to the FDAC. I was traveling the country doing failed bank receiverships. So that’s where a bank fails on a Friday night, and then contemporaneous at the time of failure, a new bank acquires assets and liabilities of a failed institution. I did that for a few years and then Dodd Frank was passed in 2010. I relocated to Washington DC to work on drafting regulations that would implement that law. And what happened was a few years into that I transitioned to private practice where I worked on bank M&A. And during that time, I first got exposed to Fintech. And one of the interesting things about Fintech is that you’ve got a lot of technology firms that are interested in working with and gaining access to the financial system, and it was around that time.
Scott:	That’s where the money is thing, right, be where the money is. That’s why people rob banks. So yes, they want to get access. Yeah. Sorry I jumped in there but keep going.
John:	No, it’s totally accurate. So, for me, a journey started in 2015 when Fintech started approaching me, probably expanding their lending operations in a different state, and that entailed a series of different state licensing applications, which ultimately was consummated in a bank partnership, and that was really the precursor to what will become more significant and evolving area of regulatory practice for me. And since then, obviously, the landscape has changed a great deal. It started, like I said, with Fintech looking at regulatory licensing issues, then works more closely on bank partnerships and integration, and now expanded to advise investment companies, looking at opportunities to invest in different technology companies as well as prospective regulations that may hamper their investment. And what might happen in the event of a regulatory enforcement action.
Scott:	That’s when the feds call you, and you’re in trouble from the regulatory perspective. So, let’s talk about, let’s break this down for the audience. Dodd Frank is a reason why I know some of this stuff because at lighthouse I was, if any lighthouse people are listening. Thank you so much for this life experience, but I had to be the chief compliance officer, so I learned a ton about Dodd Frank, learned how lending really works, learned about all the regulatory hurdles you need to jump through. And the United States regulatory environment for lending is really set up for banks. It’s a bank centric world and bond offerings, like wall street bond offerings, but banks are the main lenders. And then what, like ten years ago, the Fintech companies came on the scene. They recognized the Internet was going to be huge, and you can actually lend to people directly to the Internet. And so, a lot of different iterations started happening, right, and it sounds like that was the point in your career where you got pulled in the private practice and started advising these companies.
John:	That’s exactly right. 2010, as you know, was an interesting time because the CFPB came on the scene and essentially started taking a closer look at a lot of the loans that in some ways prompted financial crisis, and they started picking apart different securitization deals and assets structures and looking more carefully at where risks were hidden in the banking system itself and doing so, started to more carefully regulate institutions that originated those loans. And that unto itself presented an opportunity for non-bank lenders or lesser regulated institutions or entities like Fintech to really enter the scene and start participating and engaging with traditional borrowers in different ways.
Scott:	And so like in those days, at lighthouse, we did a deal was Zess finance, which was an early pioneer in that on-deck capital of our East coast office, did small business lending and lending club popped up, prosper popped up, tons of these startups, and it became this amazing growth sector for VCEs and for entrepreneurs because the costs of reaching, especially through Facebook and direct marketing through Google, was actually pretty cheap and as long as you secure a capital source, you were in pretty good shape. But they also started looking at creative arrangements with banks, right? They started like sniffing out partnerships, and how do we cover the whole United States, and how do we lend legally across the country?
John:	That’s exactly right. So, as you point out, lenders are subject to a multi-state licensing regime, which entails examinations and regulation by different state regulatory authorities and state licensing authorities. That said; however, if they engage in a constructive partnership with a bank, they can circumnavigate some of that regulation and also still retain many of the benefits that would endure as a result of such customer interaction. So that was part of the incentive to partner with banks, and that led to the Fintech charter or its announcement in 2016.
Scott:	And the Fintech charter. So, when you say partners back up one second before the Fintech charter, so I remember there was a bank out of Utah that was like lending its charter to I think maybe prosper and lending club, so they could lend across the country. But it was a real problem for other lenders because you couldn’t, like, you couldn’t charge certain interest rates in certain places, or you couldn’t even lend in certain states. And is that what happened? Like the lending of a charter, a bank charter, did that get shut down or did that just evolved into the Fintech charter conversation, or what happened there?
John:	The rent a charter model is still really popular. What happened was around the time of 2014, there was a case involving a national bank, and this is in the second circuit that had originated alone as Bank of America and they did so relying on their powers as a national thing and subsequently sold the loan to a third party, third party sought to rely on the originating institutions, powers and authorities under the national bank act as well as law regulations that implement that would be otherwise subject to OCC supervision jurisdiction, and what happened was, ultimately, the loan was deemed uterus in violation of New York state law, and this case is actually referenced more often than not as the Madden case, probably heard some news about that. What happened with that complicated banks and tech relationships within the confines of the second circuit and has still presented itself as an issue cross different partnership even today, and even as recently as last week, it’s still discussed as the OCC and the FTIC issued a proposal on that very issue to provide clarity with respect to the firms that they regulate. That alone in itself is valid when made.
Scott:	And so, the lenders that were using the bank charters or the other originators, they got stopped in their tracks, right, and so then they, people start talking about the Fintech charter, and the Fintech charter was… I’m totally layman’s terms, but was going to give these new age Fintech companies the benefits of being a bank but without being a bank. But when that came out, I was like, “Oh, that’s probably not going to work.” Because the banks aren’t going to stand for it. And you got to play by the regulatory rules if you’re going to get those benefits. And if that’s what’s happening is that’s how it’s playing out right now.
John:	So, what this thing is just give you the quick history there, like in 2016, you’ve got the federal banking regulators, [inaudible] the currency of the OCC, they announced the proposal for what would be a special purpose limited national bank charter. The charter would ideally have reduced regulatory complexity and uncertainty for Fintech as well as afforded Fintech on federal preemption with respect to state licensing laws, which is the issue that we just touched on with Madden, and we’ve got a national bank here, so these national federal banking laws, regulations, and then we’ve got state laws that could interfere with a loan that was originated by a national bank, and what this would’ve done is allowed for federal preemption of state licensing laws, regulations. So, we don’t have to worry as often about the multi state licensing regime as well as it would have leveled the playing field for banks and syntax as would have caused such Fintechs that would have applied for the charter that accepted to actually become directly subject. Those you see supervision, regulation and oversight. So, will it level the playing field between the banks and the Fintechs and viewed as a compromise in the industry. And in 2017; however, there was a lot with the conference of state bank supervisors and New York department of financial services, and that lawsuit was initially dismissed without prejudice. And the lawsuit was initiated once again in 2018. It was renewed by both the New York DFS and CSPs because the OTC had announced its intention to start accepting charter applications from Fintech. So more recently what happened was there are two separate lawsuits. One was proceeding in the district of Columbia, and the other is proceeding in the Southern district of New York. The district of Columbia lawsuit was once again dismissed again without prejudice. However, what happened is in the Southern district of New York, the OCC lawsuit was allowed to proceed, and an order was issued that enjoined the OCC from issuing that charter.
Scott:	And so, they got blocked basically.
John:	They got blocked.
Scott:	That’s amazing. So where does it stand out? Like where do the late stage or pre IPO Fintech companies turn? Are they just going to become banks or get bought by banks, or what’s going to happen?
John:	So, we got a couple of options. They could become full service national banks meaning, full service that they accept deposits, and they have a national bank charter or federal same association charter. And you’ve seen this simpleminded by Barrow money. The University Preliminary Approval and Robinhood recently submitted an application last spring, and that would allow them to become members of the Federal Reserve System in the national bank, and they’d be subject to a single regulatory authority such as the OCC. You’ve got other players like Square looking at industrial loan company charters, which are charters that are issued to entities typically in Utah that are non-bank commercial entities. What’s interesting there is they still subject to FTAC insurance, so entails and application the FTC for regulatory approval, but would afford federal preemption at some level as well as allow for full service banking powers provided that the ILCs have total assets of less than a hundred million. But what’s curious about the ILC charter is that there’s no bank holding company treatment for our parent company, which is a huge issue because the bank holding company as itself is this somewhat restrictive legal or law that provides us legal framework that says essentially if you’re a holding company to a bank, you can’t do a bunch of things that would not otherwise be consistent with bank.
Scott:	You can’t be Walmart and have a bank, but also run like a giant retail organization.
John:	Bingo. You got it. You got it.
Scott:	From that answer, it sounds like people are still searching. There’s no de facto path. Basically.
John:	There’s no de facto path, but what you’re seeing more now than ever before I see in my practice is a lot more partnerships with Fintechs than banks and a lot more banks willing to enter the fray on that front.
Scott:	I love it. And John, you should be like a host of this podcast because the next thing we wanted to talk about was Apple and Goldman Sachs and their credit card and Google possibly getting into banking. So that’s the partnership model, right? That’s what you’re talking about.
John:	That’s exactly right.
Scott:	So, replay what’s going on with Apple and Goldman and also there’s some pretty recent controversy there. Started by someone I follow on Twitter, one of the base camp founders who also is one of the people who originally built Ruby on rails or invented Ruby on rails, which is a software center that like tons of companies use in the startup world. But maybe explain what’s going on with Goldman and Apple, and how they’re dealing with this.
John:	Absolutely. So, it’s interesting in the Apple case is you referenced, it started on Twitter with the founder of Venture and Ruby on rails and he cited that his wife received, I think, twenty times less credit than he did despite having the same [inaudible 00:13:41]. And then you had Wosniak, Steve Wosniak, Apple co-founder, responding on Twitter as well, saying that his wife received ten times less credit. And yeah, I mean it’s absolutely amazing. And that prompted the New York regulator to take a look at whether the practices were essentially violating what’s called the equal credit opportunity act and regulation B, which essentially, among other things requires creditors to make credit available borrowers without regards to protected class gender or things like that.
Scott:	Makes perfect sense. So, Apple and Goldman partnered on this, but Apple is very, very particular about their brand and this isn’t what they expected, right? They weren’t expecting to be bashed all over Twitter, and maybe even have some lawsuits. Like how did this go wrong, and how do they approach fixing this?
John:	I would surmise that they never anticipated this, right? I mean, I don’t think any technology company partnering with a bank, this is like their worst nightmare. They’re being looked at right now by the New York regulator, the New York regulatory authority in New York DFS, and you’ve got Elizabeth Warren and Shirad Bribery urging the CFPB to actually take a closer look at them at the federal level. And that’s one of the things that’s complicated for banks, but it’s also complicated for Fintechs as well, that you’ve got this multi-tiered system that allows for federal and state regulatory enforcement. One of the things that they ran a foul of though it would seem, according to the tweets I’ve read, it sounds like they’re asserting that there is a potential regulation B or equal credit opportunity act violation that would essentially break these and [inaudible] require creditors to make credit available to borrowers without regard to protected class status, which would include gender among other things.
Scott:	And so, they thought they were partnering with Goldman, Goldman would take care of all of this, but now their partner maybe didn’t work as well as they thought they were going to work.
John:	There’s that and I think one of the things that I’ve discovered in advising banks and Fintechs is they speak two different languages. You’ve got the technology folks that are speaking one language, and they’re strictly focused on integrating the technology, and how that’s going to work. And then you’ve got the bank compliance and regulatory folks really focused on French laws, rates, license, regulatory compliance, and you would think that would be a perfect partnership. But sometimes things get lost in translation. And I’ve seen that unfortunately in a few too many partnerships, which is where we get called into to work on different aspects, remediation.
Scott:	So, what’s the way out of this? I mean they’re not going to cancel the Apple credit card, are they? It’s like too popular and people are using it. It seems like it’s a pretty big part of Apple pay going forward.
John:	I think it’s a huge part of their play to move deeper into financial services for sure. What I think is ultimately going to happen is they’re getting looked at more closely by regulators now, they’re going to actually have to prove to them that their reliance on data and machine learning, whatever it is else that they’re using, that they’re fully compliant, and that they’re going to proceed in a way that ensures that they’re compliant going forward, not only with federal laws and regulations, like eCOA and rank B, but also with state laws and regulations as New York state has more restrictive laws and regulations with respect to consumer protection.
Scott:	That’s unbelievable. Now, Google’s watching this, and I think it was like almost like the same day that all this stuff came out with Apple and Goldwind problem. Google announced they were going to get into like actual banking, right? Like what’s happening there, and do they have some regrets after seeing this whole Apple thing play out?
John:	Maybe not. I mean competitively speaking.
Scott:	Yeah, it’s kind of nice.
John:	They may benefit here. Project cash is interesting, right? I mean that to me is Google saying, look, we were feeling the pressure. We’re feeling the need to keep pace with our competitors, and they’re really looking for ways to keep consumers inside their ecosystem. They want to monetize their transactions with customers while deepening the customer relationships. I think an important point though is as you saw with, unlike I would say the Apple Goldman relationship, is that City appears to, at least publicly, downplayed Google’s involvement in new checking account, and I think that happened for a few reasons. One, you see that there’s more scrutiny with respect to consumer data privacy and use of that data and two, the company itself, Google, certainly doesn’t want to be regulated as a bank because there are a lot of attendant laws and regulations that accompany that status.
Scott:	Well also like, I don’t know if anyone’s doing this, but like the Holy Grail for Google is to know when someone clicks on an ad and then actually goes through checkout, right? Actually, pays money because that’s like attribution at its core. And so, there’s got to be something there to where I’m sure they want to be super nice and help all of us consumers have a better checking account experience and all that kind of stuff, but they’re probably after attribution at the end of the day, and so it makes sense to me they’d want to do this. I don’t know if I would trust it, and this is just me speaking, trust Google with my data in the same way I would trust Apple, like Apple messages privacy first has built a lot of that stuff into their products where Google is like, Hey, just trust us, don’t do evil and yada, yada yada. But like do you really know what’s happening?
John:	That’s exactly the point. I think that’s an excellent point, and a lot of customers I think would be inclined to agree, with the recent hearings and I think you see Mark Zuckerberg appearing before Congress, I think there’s an inherent mistrust around consumer data and consumer protection, so that’s something certainly I think any Fintech and banks alike are going to have to consider in their partnerships going forward.
Scott:	Is that part of like that mistrust. The mistrust, I think Google does a pretty good brand, and people still trust Google, but like Facebook does seem like it’s veered the other way and the American consumer’s pretty suspicious. Is that what you think is like hurting the Facebook Libra stuff or is it just the government doesn’t want someone else issuing a currency because it does feel like it could be competitive or weirdly competitive with other currencies around the world?
John:	There are three things I think that vary in that relationship. One, I think you’ve touched on it, it’s privacy, consumer protection, consumer data. There’s a lot surrounding Facebook and its operational platform, how it works, and then they’ve got to contend with the election results and the Cambridge Analytica challenges. So there’s a lot there in that regard. Two, I think competitively speaking, Libra is or could be viewed by the government as a competitive challenge to Fee Outback currency. What’s interesting to me particularly is that you heard some, or I should say cryptocurrencies generally received a great deal of attention in Washington, but you didn’t hear, apart from a few select hearings, you didn’t hear the president of the United States sounding off saying that he or she didn’t like cryptocurrency. Whereas now it’s actually gone so far as to the highest during the executive office, and they’re sounding off on Twitter saying they don’t like cryptocurrency. And that’s really a direct result of Libra.
Scott:	Yeah, and I’m sure, well it’s hard to, I don’t assign a lot of value to what Trump is saying on a day to day basis, but like the government is… It does feel like that really pushed them a little too far. And then the other big tech company that’s been exploiting this is Amazon. We were talking about it, what’s going on with Amazon, and how are they approaching the sector?
John:	So, what’s interesting is Amazon allegedly was exploring a partnership with JP Morgan Chase, and they sent back away from that for fear that they were going to be subject to banking laws and regulation. Now what’s interesting is when they were contacted by the press, Amazon neither confirmed or denied that. But there is a concern, certainly that across the board you’ve got these big tech companies that are eager to enter banking and financial services or eager to participate in the sector. But they’re concerned about being scrutinized for the use of consumer data and their business practices. And they certainly don’t want to be regulated as financial institutions
Scott:	For sure. And the funny thing about that is Amazon actually has a pretty big lending operation, I believe. It’s always been kind of quiet, but like they’re doing working capital loans for a lot of the Amazon sellers.
John:	and Amazon pay is…
Scott:	Oh yeah. I haven’t even thought about that. Yeah. So how do they… I guess they’ve got… They’re borrowing a charter or doing something like that on the lending side, but the whole deposit aspect of it, they don’t want to deal with or be regulated that way.
John:	And also, when you’re looking at handling consumer data in the confines of federal banking laws and federal financial laws and regulations, the treatments certainly different than handling it, or I should say slightly different at least, than handling it in a private capacity or even as a public company.
Scott:	Yep. So, you think Apple will press on? It makes sense to me. It seems super core. Google will probably do the same and be successful because they own Google play and can further solidify their place. And then Amazon and Facebook will chart their own course here.
John:	I think you’re going to see Apple press on, they may or may not be subject to regulatory enforcement action where they would owe money to or be subject to a fine by federal regulators and state regulators. I think Google would be interesting to watch that evolve. And then it’ll also be more interesting to watch the other participants or the bank participants in big tech where they come out on this, and how they interact with and participate in banking and financial services.
Scott:	It’s a really fascinating time. I love it. And then thank you for being on the podcast. Talk about stuff. Well, spend just a couple of minutes on cryptocurrency because it’s something that everyone loves to talk about, including me. I was joking before we turned the microphones that I think I’m the only person to ever lose money on Bitcoin because I buy it and then you get chicken and then sell it, and then it goes up and then feel so stupid. But what’s going on in the cryptocurrency sector right now?
John:	So about a month ago now, you got the chairman of the CFTC who spoke and publicly said that he considers ether, which is another cryptocurrency, I believe, second most popular or widely traded Bitcoin to be considered a commodity within the meaning of the Commodity Exchange Act and subject to federal commodities laws and regulations, which is slightly different than other cryptocurrencies that you’ve got the FCC and other state regulatory authorities looking at more generally.
Scott:	And so, does that mean that they have like… What advantages does that give them?
John:	So, what’s interesting too is that there’s this dichotomy between being treated as a commodity versus a security. There’s a test that was articulated by the Supreme court in 1946, and it’s a four-prong test that essentially looks at whether a tokenized offering, or you’ve probably heard a little bit about initial coin offerings or ICOs is to see whether or not an offering satisfies the definition of investment contract. Namely it’s an investment of money. Is there an extra reasonable expectation of profits from the investment? Is the investment money in the common enterprise and do such profits? Are they derived from the promoter or a third party? What’s interesting is the term common enterprise is precisely defined, the courts themselves have used different interpretations. So that’s been somewhat stifling in terms of the ICO market, and the SEC taking a look at different things, but what was particularly of interest I think to your question about, okay, what’s this mean for treatment is you’ve got something that initially itself could have been a security at its inception, upon its initial offering, it would have been treated as a security, subject to securities laws and regulations, but for the fact that it becomes sufficiently decentralized, meaning that they’re administered by various parties and that the protocol itself allows for decentralization. It’s compared to being a more centralized model. Once it’s achieved sufficient decentralization, it would be treated as a commodity, being that distinction.
Scott:	That’s really interesting. And so, Bitcoin is treated differently than Ethereum because it’s not as decentralized or…
John:	Yeah. Let me clarify actually. So, Bitcoin, Ethereum would now be both sufficiently decentralized and be treated as commodities, but something in earlier stage. Let’s say you and I were to partner and then combine our efforts to issue this token to a prospective investor that would acquire that token. And if that token were to be more widely held, that would be considered generally a security. But once the nodes, once there are nodes and miners, they’ve achieved sufficient decentralization. It would no longer be treated as a security for purposes of federal laws and regulations. It’d be more viewed as a commodity. But what’s interesting is there’s no bright line rule to this. These are just the perspectives of different regulatory bodies. So, watching the space of all of it is certainly going to be interesting.
Scott:	Yeah. I mean it feels like cryptocurrency is the future and, obviously, hopefully, the dollar will always be there in other country currencies. But it does make sense to me that you can just hold this thing and it’s a store of value and easy to use and it seems like where the world’s going, and I was reading, Fred Wilson was talking the other day on his blog that we’re following the NASDAQ 1999 crash and recovery and the Gartner hype cycle where we’re in the trough where no one believes anymore, generally speaking. And then this is where cool things start getting built, and the people who are really paying attention hop on early and then they benefit five years from now or ten years from now.
John:	Yeah, you’ve got the segregation of groups that are supporters strong firms supporters of Bitcoin. They call themselves and hold themselves out to be Bitcoin maximalists. Then you’ve got other groups that are more interested in on what so-called alt coins or alternative coins and alternative currencies, and they hold that there’s going to be a competition and that one coin will ultimately trump Bitcoin, so it’s going to be certainly interesting to see how this all shapes out.
Scott:	I love it. I love it. Well John, thank you so much for coming by. Can you give everyone just a reminder what the Gallatin group does and where they can find you?
John:	Absolutely. You can find Galton group online at W-W-W T-H-E Gallatin, G-A-L-L-A-T-I-N. Dot com. Gallatin Group is an advisory firm focused on financial services regulation. We specialize in working with Fintechs, banks, investment companies on regulatory and transactional matters, and we leverage our network of forum financial regulators and experts to work in a variety of applications for state and federal banking regulators. We also advise on bank Fintech partnerships, product development and strategy.
Scott:	Love it, John. Thank you. You’ve been a great guest. Really appreciate it. And also, a shout out to Rippling startup payroll. They do payroll, they do HR, they integrate in your IT staff to make onboarding new employees really easy. Thank Rippling, and thank you John for coming by. This was awesome.

John Popeo of the Gallatin Group on the intersection Fintech and US financial regulations

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