In Thirty Days, Payments Innovation Will Stop In Silicon Valley
The California Money Transmission Act is no joke.

June 1, 2011
Also published on Quora

Topics = { Payments + Silicon Valley + Technology }

Since the last time I wrote on this topic twenty days ago (In Fifty Days, Payments Innovation Will Stop In Silicon Valley), I have had conversations with several concerned entrepreneurs affected by the California Money Transmission Act, with California State Assembly staffpeople, and with the California Department of Financial Institutions (DFI).

As you might expect, there's good news, and then there's bad news.

The good news is that the State of California doesn't appear to care if a money transmitter has $500,000 in the bank to back up every dollar of a $500,000 surety bond. (Of course, transmitters must have money in the bank to back up deposits, but those are separate.) In other words, as far as the State is concerned, an entrepreneur can spend that $500,000 on developing a product once the bond has been posted.

The bad news is that the insurance company underwriting the bond cares, and it cares a lot. No insurance company wants to underwrite a company that can't meet its obligations, which is why obtaining a surety bond requires signing contracts with some fairly draconian provisions. So perhaps entrepreneurs shouldn't go spending that $500,000 after all, lest they receive demands for immediate payment from their underwriters.

Unfortunately, it gets much worse. According to a high-ranking official at the California DFI, there exists an unwritten rule that applicants must have a minimum total net worth of one million dollars.

That's right. The problem just got twice as bad.

In addition, the Money Transmission Act actually breaks down stored value, per § 1817(d), and money transmission, per § 1817(e), into two separate categories of risk. The former requires a $250,000 surety bond. The latter requires a $500,000 surety bond. Then there's § 1817(f), which acts as a giant plus sign: any company that wants to compete with a bank has to comply with both. (See

In summary, payments companies hoping to improve the options available to consumers and merchants beyond incremental (i.e. largely useless) changes are required to raise $1,000,000 that must be in the bank at all times to satisfy an unwritten rule that the California DFI follows. Then, they are required to raise $750,000 that really should be in the bank at all times to satisfy the insurance underwriters who issue the surety bonds that the DFI requires. Then, they are required to raise at least a few thousand more dollars, perhaps from angel investors, to cover the annual bond premiums, usually around 1% to 5%—so to be safe, let's assume the rate is 5%, or $37,500 per year for California's requirements alone. The average startup might need some legal help with all of this, so it might be necessary to add $50,000 or so as a one-time cost.

So far, we're at $1,837,500 to meet California's requirements—and we haven't even started talking about building a product yet. (One could argue that I am exaggerating because the initial $1,000,000 could also cover the underwriters' $750,000 requirement—but underwriters won't insure a company without the right to demand cash immediately at any time if necessary, based on their definition of "if necessary." Should that demand come in, one probably does not want to risk going into the red with the DFI, even though there is no statutory basis for the DFI's $1,000,000 requirement. § 1820 of the law actually says "in no event shall tangible shareholders' equity be less than five hundred thousand dollars ($500,000).")

At this point, it's worth taking a step back to ask what the point is of all of this. Why are there these laws with such huge, complex requirements? Is it because government is out to get us? A lot of people argue that, but it's rarely that simple.

The answer is a good one: consumers need protection. There is no federal insurance program (also known as the FDIC) for funds held with non-banks, and so the system has evolved to the current point where state governments protect consumers in these strange cases instead. This is where it becomes problematic.

These strange cases are increasingly becoming the norm. Google isn't a bank. PayPal isn't a bank. Amazon isn't a bank. Verizon, Sprint, T-Mobile and AT&T aren't banks. Yet these companies already hold or are planning to hold billions of dollars of consumers' funds.

The obvious solution is to extend the FDIC's scope to Money Services Businesses (MSBs) as well as banks, and to establish a combined system whereby MSBs fund the general insurance pool with weighted annual premiums, just like the banks do. This would completely negate the need for surety bonds and a complex patchwork of psuedo-insurance regulations, which don't even work in the first place.

Why don't the current regulations work? Because each MSB today effectively insures itself, even if through a proxy (the insurance underwriter). As I have pointed out previously, even $1 million worth of surety bonds isn't enough to insure a company the size of PayPal. If PayPal went out of business, the most 1 million of its California customers could hope to get back would be $1.00 each. Obviously there are many, many people with a PayPal balance in excess of $1.00.

There's also an incredible irony to the current regulatory framework, which is the implication that rich people and companies—those with a million dollars in spare change—are inherently more trustworthy. Nothing could be further from the truth. Notorious scam artist Bernie Madoff would have met all of the State's criteria in an instant. He could have acquired hundreds of surety bonds, and he's not the only one. I can rattle off (as can most people) a long list of extremely untrustworthy individuals with lots of money. The State's role is to ensure that financial institutions are trustworthy in order to protect consumers, but from an accounting perspective that should mean focusing not on "total net worth," or "tangible shareholder equity," but on the part of the balance sheet that outlines the assets backing up the liabilities (customer deposits). Having a cushion below is certainly nice, but it also has no bearing on the fundamental character of the company founders, and may even lead otherwise "good" founders to attract outside capital fraught with enormous risk.

Finally, it's worth noting that money does cure this particular legal ill—except that money is nowhere to be found in Silicon Valley for serious endeavors. The news that Andreesen-Horowitz just invested an astounding $100 million in Airbnb, Inc. is almost sickening given the news that followed a day later: that its "amazing" growth could be attributed to high volumes of illegal spam. Sadly, I'm not surprised.

As for Venmo, Xipwire, Cimbal, LendingKarma, Noca, Dwolla, my company, which runs FaceCash, and countless others that haven't even got their start, we each have 30 days left to do business in California.


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