The patchwork of regulations entangling Square, and every American internet startup that takes money

In this Dec. 18, 2009 photo, Willo O’Brien demonstrates Square on her iPhone in San Francisco.
In this Dec. 18, 2009 photo, Willo O’Brien demonstrates Square on her iPhone in San Francisco.
We may earn a commission from links on this page.

Illinois told eight financial companies to stop doing business in the state last week, and they have something in common: They’re using the internet in an attempt to do to traditional financial institutions what Microsoft Word did to the typewriter.

Among them are Square, the trendy payments company with the iconic card-reader that plugs into a tablet or smartphone; NetSpend, which aims to sell consumers on pre-paid debit cards to replace their checking accounts; and Pelican Personified, which sends immigrants’ money back to India.

As these companies have grown from start-ups into large, in some cases multi-billion-dollar institutions, state regulators have taken notice. They argue that they are engaged in the transmission of money, which requires a license to ensure the company handling your money isn’t a fraudster and at minimum, isn’t likely to go bankrupt without paying you.

Companies in the emerging payments sector do what banks and other financial institutions do, but more cheaply, using the internet. Square lets anyone take a credit-card payment without the fee-laden process of partnering with a bank; more usefully for merchants, it offers them simpler pricing and more data about their customers. For people unhappy with the high fees on their bank accounts, pre-paid card companies like NetSpend say they offer a cheaper, easier way to store and access your paycheck.

The grand-daddy of such companies is PayPal. It tapped into the demand for online credit-card processing that arose when e-commerce started allowing small merchants to sell to buyers around the world. And it too went though problems with regulators before its IPO. Following pressure from a multi-state alliance of regulators, it became a licensed as a payment transmitter around the country, as have Amazon, Facebook, and Google for their payments services. (Both PayPal and Square declined to comment for this story, as did Illinois’ financial regulator.)

Regulators are catching up—and even overtaking

Money transmission laws were initially written for companies like Western Union, who promise to take your money and get it somewhere else. Some emerging payments companies, like Pelican, clearly offer this kind of service. Others, like NetSpend, arguably require treatment more like that of banks. Square, at least at first, was arguably not a money transmitter, since it merely processed credit card transactions; the money from the transactions was transmitted by existing payment networks.

States, however, have been expanding their interpretation of money transmission laws. California passed a broad money transmission law in 2010 that not only obliged Square to get a license there, but could also affect non-financial companies as varied as AirBnB and Zynga—basically any firm that accepts payments from people destined for other people. California is currently re-thinking how it will apply that law, which has many companies with innovative business models feeling nervous, and the results of that debate could have a big impact on Silicon Valley.

In Square’s case, it started negotiations with Illinois regulators months before they issued last week’s cease-and-desist order. One reason it likely ran into trouble was that it began to do things it hadn’t done before, such as offer electronic gift cards, which would mean holding on to customers’ money rather than simply transferring it to their accounts.

“In the last 15 to 20 years, the extension of money transmitter laws has slowly crept up,” Judith Rinearson, an attorney specializing in payments law, says. “The states have become much much more aggressive in asserting coverage over routine payments activities, and it’s reached the point where I tell a client, if they are going to be receiving money in a bank account that they own, even if they’re doing it as an agent, even if it’s on a business to-business basis, even if they are serving as a vendor or processor, even if the account is a ‘custodial’ account — they are still going to be at risk in certain states for being deemed a money transmitter. And that’s true even if no consumer has lost any money, no consumer accounts are involved, even if they’ve run their business perfectly.”

Rinearson says there is “good reason for these laws, but it’s terrifically difficult for small busineses to get these licenses, a huge barrier to entry.” The license is an expensive and busy proposition, requiring audits, background checks, personal financial statements from the board of directors, and surety bonds based on the amount of money the company handles. And the company needs one from each of the 47 US states that require them, with a total cost of around $500,000 plus surety bonds, according to Terry Maher, another attorney familiar with these issues.

There is a simpler way—in Europe

The biggest difficulty for payments firms is that states don’t share the same rules or procedures. Firms that are licensed nationwide may be audited 20 or 30 times a year by individual states, although efforts to share examinations are underway to reduce the burden on businesses. Efforts to create a national framework for money transmission haven’t really gotten off the ground, though a model exists in the European Union’s “passport” system of regulation, which allows companies credentialed in one country to participate in the common market.

“I’ve talked to companies coming from outside the US, coming from Europe, who say, ‘You mean you don’t have a passport? We have to do this state by state?'” Rinearson says. ”The good news is that, once you have these licenses, it gets you a lot of capabilities. You can start your own payment network without having a bank, which is how American Express and PayPal started their businesses.”

While Square is still talking to regulators, experts expect it will obtain transmission licences around the country. But that will take time and money. Meanwhile, its competitors are catching up: PayPal has rolled out its own Square-style card reader, and even old-guard firms like Visa and Mastercard are introducing their own innovations.