Guest ContributorWhen 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.
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 [1]. 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.
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.
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 [2], 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 [3]. A 2018 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.
Arizona’s FinTech Regulatory Sandbox
The Arizona Regulatory Sandbox Program enables businesses to test innovative financial products and services for two years [4] to up to 10,000 Arizona consumers [5]. 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.
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 [6]. 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.
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.”
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.”
Conclusion
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.”
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.
Footnotes
[1] Evan Daniels, FinTech Sandbox Counsel, Arizona Attorney General’s Office, “Innovative Regulation for Innovative Business”, November 14, 2018, State Bar of Arizona, p.3.
[2] Some have proposed awaiting a federal solution, but there is conflict between federal and state authorities on jurisdictional issues. In December 2016, the Office of the Comptroller of the Currency (OCC) proposed a special purpose national bank charter for FinTech companies, but the Conference of State Banking Supervisors (CSBS) and the New York State Department of Financial Services (NYSDFS) sued the OCC, arguing the charter exceeds the agency’s authority and unlawfully preempts state law. Both lawsuits were dismissed on standing and ripeness grounds given that the OCC was not yet accepting charter applications. In July 2018, the OCC issued an update to the proposed charter and announced that it would begin accepting applications. The CSBS and NYSDFS filed new complaints in Fall 2018 challenging the OCC’s legal authority. On May 2, 2019, the U.S. Court for the Southern District of New York denied the OCC’s motion to dismiss the NYSDFS complaint.
[3] Arizona Attorney General Mark Brnovich, American Banker, September 5, 2017, p. 1.
[4] Participants can request from the Attorney General an extension of up to one year for the purpose of pursuing a license or other authorization. A.R.S. § 41-5608.
[5] Legislation adopted during the 2019 legislative session, HB 2177, making technical improvements to the FinTech regulatory sandbox program, allows participants to seek from the Attorney General permission to exceed the consumer cap while seeking a license from the appropriate state authority.
[6] HB 2177 now also requires applicants to describe how they “will employ cybersecurity measures to avoid breaches and protect consumer and transaction data.”
Noemi Santaella
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