Financial Technology (fintech) is a catch-all term to describe new technology used to improve and automate financial services. Although the concept has existed for some time, breakthroughs in blockchain and other distributed ledger technology, artificial intelligence, quantum computing, and biometrics have accelerated the rate of change. This recent evolution has created an influx of a broad range of startups with diverse business models looking to gain market share or offer new products or services.[1]
Similar to other industries that have reached this stage in their development cycles, fintech will likely experience an increase in M&A activity as the industry consolidates and incumbent companies look to capitalize on emerging disruptive technology to improve the financial services they provide through a buy-or-build model. Deal lawyers need to be keenly aware of industry-specific risks to engineer transactions that maximize value and ensure that their clients receive a commensurate share of the gains.
Mechanisms to Reduce Transaction Costs in M&A Deals
Representations and warranties (reps and warranties)—along with their associated disclosure schedule, indemnifications, covenants, conditions to consummate the deal, and earn-outs—are ubiquitous in M&A transactions as means to contractually reduce information asymmetry, efficiently allocate risk, and minimize moral hazards between the buyer and seller. In the hands of a skilled transactional lawyer, these tools and mechanisms have the potential not only to sway the allocation of gains from a transaction in favor of their client but to increase the deal’s value net legal fees by reducing transaction costs and helping to close the valuation gap between the parties.[2] As such, deal lawyers can play an integral role in the fintech ecosystem’s development by helping to facilitate value-creating transactions and the efficient use of capital in the industry.
Along with information provided in the diligence process, representations (statements of facts about a business’s past or present operations) and warranties (promises about future business operations) help minimize information gaps between the buyer and seller in a transaction. To enforce the reps and warranties, acquisition agreements typically contain an indemnification clause in which the breaching party compensates the non-breaching party for losses or damages sustained from the breach. Drafted carefully, indemnity provisions create an incentive structure for the parties to accurately disclose material information to each other, allowing the parties to allocate risk efficiently.
Additionally, the parties to a transaction ordinarily enter into a set of covenants in which the parties promise to take or not to take certain actions before and after closing to preserve the anticipated value of the deal gleaned during the diligence process. Unless a deal is structured as a simultaneous sign and close, many acquisitions will have a significant gap between when the acquisition agreement is signed and when the transaction is closed. Covenants help mitigate the risks between signing and closing and the risks following the consummation of the transaction by incentivizing the parties to refrain from taking unusual risks that might jeopardize the value of the deal.
Lastly, acquisition agreements generally contain a set of conditions that must occur before the parties are obligated to close the deal. Two customary pre-closing conditions are (1) that the parties remain in compliance with the pre-closing covenants and (2) that the reps and warranties remain true and accurate as of the closing date. Additionally, the indemnification clause typically includes breaches of the conditions as a cause for compensation. The pre-closing conditions, along with the indemnification clause, provide a powerful incentive for the parties not to breach the terms of the agreement while the transaction is being consummated and help to reduce transactional costs.
Although deal lawyers have many tools to help reduce transactional costs and facilitate agreement on key issues, parties often disagree on the prospective value of the target business, creating a barrier to what would otherwise be a value-creating transaction. To help bridge the valuation gap, earn-outs or deferred payments provide a valuable tool to help the parties reach an agreement. Earn-outs, when appropriately structured, can benefit both parties, minimizing risk and providing an incentive for management to continue working diligently to achieve agreed-upon benchmarks. As such, the seller has the opportunity to receive the full value for its business, and the buyer can protect itself and ensure that the asset performs as anticipated.
The reps and warranties, disclosure schedules, indemnification provisions, and closing conditions work in tandem in M&A deals to reduce transaction costs by helping to minimize information asymmetry between the negotiating parties and allowing them to efficiently allocate risks, price the deal, and plan for future operations. Along with these mechanisms, deal lawyers have various levers at their disposal to calibrate a party’s risk exposure—particularly knowledge, materiality, scope, and time qualifiers. These mechanisms and levers are essential for transactions in sectors fraught with risk and uncertainty.
The Fintech Industry’s Idiosyncratic Risks
The framework above of the mechanisms and levers deal lawyers use to facilitate efficient capital asset transfer is by no means exhaustive. Rather, this framework illustrates the potential for transactional lawyers to add value to deals and the fintech ecosystem by engineering efficient transactions to help foster synergy and economies of scale in the fintech industry.
The fintech ecosystem is vast and encompasses an extensive range of businesses offering various products and services, ranging from digital payment platforms, robo-advisors, non-fungible tokens, and digital currencies to digital lending platforms. The variety of idiosyncratic risks in the fintech industry is equally broad, including regulatory uncertainty, fintech companies’ heightened operational risks stemming from handling consumer financial data, the volatility associated with certain crypto assets, cybersecurity risks, and unique intellectual property risks. These risks can create tremendous friction in the deal-making process; however, well-crafted deal documents can help mitigate these risks and facilitate the efficient transfer of fintech assets.
For instance, cybersecurity and data breach issues are prevalent in the fintech industry, giving rise to data privacy risks. Reps and warranties from the seller regarding IT and data security policies, historical breaches, and compliance with regulatory obligations (along with indemnifying the buyer for breaches of those reps and warranties) are instrumental to reducing information asymmetry between the parties and efficiently allocating data privacy risks associated with handling sensitive customer information.
Further, buyers of fintech assets should consider including in the deal documents disclosures of and indemnification from the use of open source software in the development of business technologies of the seller. This can mitigate the risk that the source codes of the seller’s products derived from an open source software could be required to be distributed or disclosed to the general public, which could materially reduce the value of the fintech asset.
The deluge of fintech activity has garnered an influx of regulatory attention at the federal, state, and international level,[3] as evidenced by the President’s recent Executive Order 14067 on Ensuring Responsible Development of Digital Assets (EO).[4] The EO provides an excellent example of the litany of regulatory risks in the fintech industry, as it requires a number of federal agencies to submit reports on various issues that directly impact fintech companies’ operations. The issues covered include consumer and investor protection, data privacy and security, preventing illicit finance (AML/CFT/KYC), financial inclusion and stability, and central bank digital currencies (CBDCs). Notably, the EO does not enact any explicit policies but rather establishes a coordinated, interagency process to deliberate the issues.
It will take some time for the federal government to operationalize a coordinated approach toward regulating digital assets. Additionally, state and international regulators add another layer of uncertainty and complexity to the fragmented fintech regulatory regime. The lack of regulatory clarity in fintech provides a prime opportunity for deal lawyers to add extraordinary value to transactions through the private ordering of regulatory risks.
Illustratively, the investor protection regulatory regime of digital assets has been in a state of flux as the SEC and CFTC attempt to provide regulatory guidance on the characteristics of digital assets that will deem a product a security or a commodity—a factor that could have a substantial impact on the value proposition of a project. However, the principle-based definition of securities does not bode well for bright-line rules. Central to the analysis are the nuanced and fact-intensive “reasonable expectation of profits” and “from the efforts of others” prongs of the Howey test.[5]
Ordinarily, the seller will have more knowledge and information about the regulatory status of a business, whether through interactions with regulators or advice previously received from financial and legal advisers—information that would be difficult or expensive for the buyer to obtain and would have a significant bearing on the valuation of an asset. Carefully crafted reps and warranties coupled with a set of bespoke indemnity provisions can help reduce the information asymmetry between the buyer and seller to allocate the risks between the two parties appropriately and efficiently price the asset. Additionally, innovative use of earn-out provisions can be extremely useful to allocate regulatory risk among the parties efficiently—for example, making part of the consideration contingent on obtaining an SEC no-action letter.
Undoubtedly, the evolving fintech regulatory regime will tremendously impact fintech companies’ operational risks and create endogenous risks within the fintech industry. The EO prominently features the specter of a potential deployment of a US-issued CBDC. It is difficult to determine if the US will eventually launch a CBDC or its design function. However, the possibility of a US Federal Reserve-issued CBDC (US CBDC) for retail consumption creates competitive risks for privately developed payment systems and stablecoins. The design function for a potential US CBDC would have a consequential impact on the fintech ecosystem; particularly of interest would be whether or not the US CBDC undermines the two-tiered banking system and whether the US CBDC is interoperable with other forms of digital currencies.
A US CBDC has the potential to spur or stifle private economic innovation. Even improvements to the payment rails of our current Federal Reserve System can create risks for the value proposition of private payment system projects. Deal lawyers will need a deep understanding of the policy priorities of key regulators to help clients navigate the risks government action or inaction creates in the fintech ecosystem. Concretely, deal lawyers can play a vital role in helping clients manage the risk of acquiring a fintech asset susceptible to increased regulatory scrutiny, which could result in a material loss of value.
Lastly, many M&A transactions’ projected value derives from the patentability of a product. However, fintech products stemming from blockchain technology on a peer-to-peer network to validate transactions create endemic impediments to clearing the Alice/Mayo two-part test for patent subject matter eligibility. Particularly, the likelihood is high that a claimed invention derivative of blockchain technology will be deemed directed at an abstract idea, which the Supreme Court has held is not patentable as an implicit exception to the four statutory categories of invention pursuant to 35 U.S.C. §101. Although a claimant can overcome a judicially recognized exception if it recites additional features that amount to significantly more than the abstract idea, in light of the proliferation of Satoshi Nakamoto’s white paper, the code supporting blockchain technology is “well known in the art,” casting a hurdle for novel and non-obvious applications.[6]
The United States Patent and Trademark Office (USPTO) has granted numerous blockchain patents. However, prosecuting a patent in the blockchain technology space is laden with risk. Although the USPTO has provided guidance on issues related to patent subject matter eligibility deriving from the Alice/Mayo test, applying the test in practice has been murky. Deal lawyers can play an instrumental role in helping allocate the risk associated with patent issues when structuring transactions to help bring the parties to closing.
Conclusion
Fintech is revolutionizing the way we transfer value and conduct commerce. Commensurately, the industry has attracted an enormous amount of capital and has surpassed a $3 trillion market cap. Along with the considerable capital inflow, the fintech industry has garnered the attention of regulators at the federal, state, and international level. As illustrated, the increased regulatory scrutiny and market dynamics engender significant risks and friction in deal-making, creating an opportune environment for deal lawyers to add tremendous value not just for their clients, but for the fintech ecosystem as a whole. Beyond having a keen understanding of deal structures, and the fintech industry’s idiosyncratic risks and market dynamics, transactional lawyers need impeccable judgment, foresight, and ingenuity to become trusted advisers when helping clients structure efficient transactions in a constantly evolving industry full of risks and opportunities.
Ishaan Seth, Zane Williams, Max Flötotto, Oliver Engert, and Sean O’Connell, “Realizing M&A value creation in US banking and fintech: Nine steps for success,” McKinsey & Company, November 15, 2019. Available at: https://www.mckinsey.com/industries/financial-services/our-insights/banking-matters/realizing-m-and-a-value-creation-in-us-banking-and-fintech-nine-steps-for-success. ↑
Ronald J. Gilson, “Value Creation by Business Lawyers: Legal Skills and Asset Pricing,” Yale Law Journal December 1984. Available at: https://scholarship.law.columbia.edu/cgi/viewcontent.cgi?article=1956&context=faculty_scholarship. ↑
Andy Lorentz and Thomas Kost, “Fintech Laws and Regulations 2022,” Davis Wright Tremaine, LLP, September 8, 2022. Available at: https://www.dwt.com/-/media/files/blogs/financial-services-law-advisor/2022/09/fintech-laws-and-regulations-2022.pdf. ↑
Executive Order 14067, March 9, 2022. Available at: https://www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/. ↑
Frantz Jacques, “Securities Law and Digital Asset Products,” Bloomberg Law, January 22, 2021. ↑
Chaudhry, Inayat. “The Patentability of Blockchain Technology and the Future of Innovation.” ABA: Landslide, March/April 2018. Available at: https://www.americanbar.org/groups/intellectual_property_law/publications/landslide/2017-18/march-april/patentability-blockchain-technology-future-innovation/. ↑
