Synapse Used Customer Funds For Reserve Requirements, Partner Bank, Ex-Staffers Say
Synapse Used Customer Funds For Reserve Requirements, Partner Bank, Ex-Staffers Say
OCC Calls IL Law "Ill-Conceived, Unworkable," Fiserv Awarded Limited-Purpose Georgia Bank Charter
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Synapse Used Customer Funds For Reserve Requirements, Partner Bank, Ex-Staffers Say
A largely overlooked detail about how Synapse funded program reserve requirements in an earlier filing in the bankruptcy case may take on new importance as the situation progresses towards some kind of conclusion.
If Evolve is able to complete its reconciliation efforts by the October 18th deadline the bank set, there should be additional clarification about the size of any shortfall of end user funds — and, potentially, the beginning of a battle over who is responsible for the shortfall.
The requirement for Synapse to hold reserve funds with its partner banks was intended to help protect the banks and end users from potential losses.
Reserves are necessary to help mitigate risks that cannot be addressed in real time, such as chargebacks, fraud, and ACH reversals. Reserve accounts can also be used to ensure payment of fees a bank partner incurs on behalf of its programs, such as card network fees, to cover credit losses, and, in some cases, to ensure there are adequate funds to cover winding down a program.
For example, Synapse’s master services agreement with Lineage Bank, included as an exhibit in the bankruptcy case, specifies:
The parties agree that Servicer’s [Synapse’s] Reserve Account shall maintain, at all times, a balance equal to at least $25,000. The parties agree to meet and confer three (3) months after execution of the Agreement to reevaluate the minimum reserve balance and to work together in good faith to develop a formula that shall determine the minimum daily balance of the Servicer’s Reserve Account thereafter.
Servicer hereby authorizes Bank’s right to offset funds in the Servicer Reserve Account for any financial obligation of Servicer pursuant to this Agreement or necessary in order to maintain the functionality of the Program.
While the contract specifies a relatively low minimum reserve requirement, the reserve calculation is often tied to the dollar volume of deposits, payments (ACH, card, wire, etc.), loans, and so forth, and can grow to become quite significant.
Typically, it would be best practice to setup separate reserve accounts as needed for each fintech program.
When Synapse was unable to meet reserve requirements with its own funds or funds of its fintech programs, it filled the gap with end users’ funds, according to a May court filing by Lineage Bank and statements from numerous sources, including multiple former Synapse employees, who are familiar with the matter.
In the May filing in the bankruptcy case by Lineage objecting to the terms of Synapse’s proposed asset sale to TabaPay, the bank alleged that Synapse used approximately of $60 million of end user funds to meet its reserve requirement (spacing adjusted and emphasis added):
“Lineage discovered that approximately $60 Million in funds transferred by the Debtor in late 2022 to the Reserve Account from an account explicitly titled in the Debtor’s name at Evolve Bank and Trust — initially considered to be the Debtor’s own funds — were actually End-User funds.
Consequently, Lineage moved the funds in the Reserve Account to an FBO account to protect the interest of End-Users. Following this revelation Lineage demanded that the Debtor allocate $60 Million of the Debtor’s own funds to the Reserve Account to continue ACH/wire processing services, but the Debtor failed to meet this requirement.”
Despite Synapse’s inability to meet the reserve requirement, Lineage continued to process payments on its behalf until shortly before all funds and accounts were effectively frozen in May 2024.
According to one former Synapse employee, the necessary reserve amounts should have been funded from Synapse’s fintech programs’ capital.
Indeed, Synapse’s agreements with its programs typically specified how such reserve amounts would be calculated:
Only, the reserves from Synapse’s fintech programs weren’t adequate to meet the minimum reserve requirements Synapse had agreed to with its partner banks.
End user funds were used to fill the gap, multiple former Synapse employees said. One source recollected that the volume of end user funds deployed to meet reserve requirements “had to be in the tens of millions,” while another source estimated that, between Lineage, American Bank, and AMG, the amount was nearly $100 million.
Risks Posed By Incorrect Account Titling
It appears that part of what enabled Synapse to convince Lineage it was funding its reserve requirement with its own funds was how Evolve titled Synapse’s FBO accounts.
According to Lineage’s statement, the account at Evolve from which Synapse transferred funds was “explicitly titled” in Synapse’s name.
Copies of statements exclusively obtained and reviewed by Fintech Business Weekly show that a Synapse account at Evolve used to process end user inbound and outbound ACH transactions — meaning it held funds that belonged to end users — was, in fact, titled to Synapse itself.
It isn’t known if this is the specific account from which Synapse transferred funds from Evolve to other banks to meet its reserve requirements.
In June 2020, more than $500 million passed through this single FBO account in 43,747 transactions.
By October 2022, the volume of activity in the same account — still titled for the benefit of Synapse itself, rather than end users — reached nearly $6 billion across more than 30,000 transactions.
The issue of account titling may sound pedantic, but it can have serious ramifications.
In addition to apparently facilitating Synapse’s inappropriate use of customer funds to meet reserve requirements, taking ownership of the funds poses at least two other significant issues.
First, because, in the example account above, the funds are legally titled to Synapse, Synapse itself appears to be sitting in the “flow of funds.” This is something non-bank fintechs often seek to avoid, as, in most cases, it necessitates holding money transmission licenses in each state the company operates in.
Synapse did not hold any state-issued money transmission licenses, per a search of NMLS and state registries.
This requirement may not have applied to the cash management programs operated through Synapse’s brokerage entity, but Synapse didn’t transition to that model until late 2023.
The second significant issue: FDIC pass-through insurance. According to the FDIC, for pass-through insurance to apply, several conditions must be met (emphasis added):
Funds must be in fact owned by the principal and not by the third party who set up the account (i.e., the fiduciary or custodian who is placing the funds). To confirm the actual ownership of the deposited funds, the FDIC may review:
The agreement between the third party establishing the account and the principal
Applicable state law
The IDI’s account records must indicate the agency nature of the account (e.g., XYZ Company as Custodian for employees, XYZ for the benefit of (FBO) customers, Jane Doe UTMA John Smith, Jr.).
Note that in some instances, an account might be titled in the name of the insured bank itself while reflecting that it is held for benefit of another party (e.g., AnyTown Bank FBO XYZ Company Customers).
The FDIC notes that (emphasis added) “[i]f all of these requirements are not satisfied, the deposits will be insured to the named account owner (typically the third party), aggregated with any other funds that the third party holds at the same bank in the same deposit insurance category. This could result in uninsured deposits.”
Synapse maintained numerous accounts at Evolve and its other partner banks, Lineage, American National, and AMG, and, apart from the single example above, it is unknown if these accounts were properly titled.
In the event they weren’t correctly titled, end users whose funds were held in them likely would not have qualified for pass-through coverage, meaning that, regardless of the number of end users and the aggregate balance, the deposits would have only been protected up to the statutory maximum of $250,000.
Evolve Internally Has Acknowledged Mercury “Over Migration Issue,” Source Says
With less than two weeks until the date Evolve has said it will complete its reconciliation efforts, it’s unclear what progress the bank and its third-party consultant, Ankura, have made — though, one source familiar with the effort said that Evolve has now internally acknowledged the Mercury “over migration issue,” in which more funds were moved than should have been when Mercury transitioned off of Synapse’s systems to Evolve’s in late 2023.
Representatives for Evolve did not respond to a request for comment; representatives for Mercury declined to comment on the matter.
It’s not clear that Evolve will be able to meet its own deadline of October 18th to complete reconciliation efforts. Sources close to Evolve have said they wouldn’t be surprised if takes another two months, or longer, to complete the reconciliation effort — if it’s possible at all.
As the Chapter 11 trustee, former FDIC Chair Jelena McWilliams, has previously explained, Synapse moved funds among partner banks in its “ecosystem,” including through deposit aggregation network ADMC, in order to try to maximize its own returns by placing funds where they would earn the highest rates of interest. But, this means that the bulk movements of funds among Synapse’s partner banks often had no relationship to specific end user accounts or transactions.
The estimated shortfall in end user funds remains between $65 million and $96 million, potentially creating a dispute over who is entitled to any reserve funds.
Evolve has previously stated it holds approximately $35.3 million in such reserves, which, the bank says, “it will distribute to end users if the reconciliation determines that such distribution is appropriate.”
The amount of reserves, if any, still held by AMG, Lineage, and American is currently unknown.
The reserves seem likely to become a flashpoint because multiple parties may have claims to them: end users, the four partner banks, numerous fintech programs that have contributed reserves — and the Synapse bankruptcy estate itself.
Synapse, still technically “operating” in Chapter 11, owes its secured creditors, SVB and TriplePoint, a combined $9.7 million. Numerous unsecured creditors also have claims against the company.
And the Chapter 11 trustee’s own firm, Cravath, has racked up substantial costs representing the trustee and estate in the bankruptcy proceedings. As of the end of July, Cravath had already billed nearly $1.4 million worth of work on the case.
The reserve funds may represent the firm’s best chance at getting paid for the work it’s done — if there’s enough money to go around.
Representatives for Evolve Bank & Trust did not respond to questions or a request for comment.
Synapse’s former CEO, Sankaet Pathak, and former General Counsel, Tracey Guerin, didn’t respond to questions or requests for comment.
OCC Calls Illinois Swipe Fee Law “Ill-Conceived, Highly Unusual, and Largely Unworkable” In Amicus Brief
The Office of the Comptroller of the Currency called a proposed Illinois law that would prohibit collecting interchange fees on the state and local taxes and tip portion of a transaction and limit how banks can use transaction data “both bad policy and an unlawful interference with federally granted powers” in an amicus brief filed in a suit seeking to block the law.
The OCC’s amicus brief describes the requirements of the law, the Illinois Interchange Fee Prohibition Act (IFPA), as “vague and ambiguous in many respects,” but argues that it is clear that “the IFPA prevents or significantly interferes with federally-authorized banking powers that are fundamental to safe and sound banking and disrupts core functionalities that drive the Nation’s economy.”
The brief argues the proposed Illinois law’s limits on interchange “erode” banks’ payment processing infrastructure, including their capabilities to detect and prevent fraud, which would leave “national banks with extraordinary operational burdens that likely will be passed on to consumers in the form of higher fees, reduced services, and weakened fraud protection.”
The IFPA would also prohibit issuing banks, card networks, and acquiring banks from using transaction data for any purpose beyond the processing of the payment itself.
The OCC argues this restriction would impede banks’ “abilities to prevent fraud, manage risk, and provide critical services to consumers,” a result that “is fraught with risk, including customer injury.”
The OCC thus says that both the interchange and data restrictions should be preempted by the National Bank Act, as both proposed restrictions would “‘prevent or significantly interfere with’ national banks’ exercise of powers under the NBA to process debit and credit card transactions and charge fees for those services.”
Fiserv Approved For Georgia Merchant Acquirer Limited Purpose Bank Charter
Core banking behemoth Fiserv has been approved for a limited purpose bank charter, Georgia’s Department of Banking and Finance announced last week. It is only the second such specialty charter to be granted in the state.
According to the Georgia banking regulator, “[t]he MALPB charter was created to allow entities engaged in merchant acquiring or settlement activities to directly access payment card networks.”
The charter type isn’t actually new, however. The state created the category about 12 years ago, but, because the card networks signaled they would not approve direct membership of banks holding the limited-purpose charter, no entity had sought one until recently.
The only other company to be awarded the specialty charter is Finaro, a payment service provider, which was acquired by Shift4 in October 2023. Despite landing the charter, the card networks refused to work with the company, Payments Dive has reported.
Assuming Visa and Mastercard grant Fiserv direct membership into their networks, Fiserv intends to use the capabilities that come with that to streamline its own operating model and to support smaller merchant acquiring bank clients who do not have network sponsorship themselves.
With the likelihood of any kind of national “fintech,” e-money, or payments charter seeming increasingly remote, state-issued special purpose charters offer an alternate avenue to licensing for non-traditional banking business models — though this approach isn’t without risk.
In addition to Georgia’s limited-purpose charter intended for merchant acquirers, Connecticut has offered an uninsured state banking charter, recently renamed as an “innovation bank charter,” since 1999, and Wyoming offers a “special purpose depository institution” charter, intended to facilitate digital asset activites.
Other Good Reads & Listens
Where the F(BO) is the Money? Part 2 — Adopting the Right Lessons from Synapse (Troutman Pepper)
The Limits of the Bank Service Company Act (Duke Law Journal)
Opening Remarks by CSBS Chair Charlie Clark at the 2024 Community Banking Research Conference (CSBS)
Financial Institutions Explore AI Uses Without AI Policies (FinXTech)
Is It Still Hip To Be Square? (Fintech Takes)
Defining Households That Are Underserved in Digital Payment Services (KC Fed)
Listen: Interview with Sinch’s James Doherty, Head of Business Development, Financial Services EMEA (Fintech Business Weekly)
Listen: Return to BaaS Island As FDIC Proposes “Synapse Rule” (Fintech Recap)
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