Don’t Let Fear of Missing Out Guide Tech Due Diligence

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In September 2021, JPMorgan Chase & Co. purchased the college financial planning platform Frank for a cool $175 million. For that price, the big bank expected to gain a purported five million potential new customers — students, parents and low-to-moderate income households. The bank kept Frank CEO Charlie Javice as head of student solutions as part of the deal, paying her a $20 million retention fee, according to The New York Times.

But JPMorgan said it didn’t get what it was promised. In a lawsuit filed in December 2022, the bank alleged Frank had fewer than 300,000 customers — roughly four million had been faked. JPMorgan shut down Frank’s website in early 2023.

Jamie Dimon, JPMorgan’s CEO, called the acquisition “a huge mistake” in the bank’s fourth quarter 2022 earnings call, and indicated that more details would be disclosed after the litigation has been resolved. JPMorgan didn’t respond to Bank Director’s request for information. Javice is suing JPMorgan; her lawyer told The New York Times that the bank realized it couldn’t work around student privacy laws and tried to “retrade” the deal.

The cost of the Frank acquisition seems eye-popping, but it’s a mere drop in the bucket for the big bank. JPMorgan reported $34.5 billion in net revenue in the fourth quarter 2022; that’s around $375 million earned daily. It’s an experienced fintech acquirer, with seemingly endless resources it can dedicate to vetting these deals. If a fintech company managed to trick the largest of the big banks, what does that mean for other banks looking to acquire tech companies in 2023? 

The number of financial institutions acquiring technology companies remained few in 2021-22, according to an analysis from information from Piper Sandler & Co. using compiled for Bank Director with data from S&P Global Market Intelligence. Those buyers are primarily above $50 billion in assets. Crispin Love, senior research analyst at Piper Sandler, says those deals tend to complement the bank’s strategy, via deposit, lending or payments platforms, or niche services. “It tends to be the larger players buying some of these smaller fintech players to enhance solutions at the bank, rather than being [a] big transformational deal,” he says.

Sixteen percent of the bank executives and directors responding to Bank Director’s 2023 Bank M&A Survey, sponsored by Crowe LLP, say their institution is likely to acquire a technology firm in 2023. Due to last year’s drop in fintech valuations, it could be a great time to buy, says Crowe Partner Rick Childs. But price isn’t the only factor in an acquisition, and acquiring a technology company requires additional due diligence.

Dion Lisle, director of corporate ventures at $183 billion Huntington Bancshares, has more than 100 items on his due diligence checklist for any fintech the Columbus, Ohio-based bank may choose to invest in or acquire. At a high level, he and his team want to know:

  • Who are the founders, and what are their backgrounds? Who are the investors?
  • Is the tech stack modern, and will it fit with the bank?
  • How much technology has been outsourced?
  • Does the company own its intellectual property?
  • Have there been lawsuits against the company?
  • What about the company’s books? How much money do they have, and how have they spent it?

Lisle also seeks customer references. This was easy with Huntington’s recent acquisition of Digital Payments Torana, which worked with two of the bank’s customers. “We had assurance from that,” says Lisle. “We knew the people that said, ‘Yeah, this product uniquely solves this business case.’”

Code review is also part of Lisle’s checklist and is among the few items he’s willing to outsource. Most is covered by the bank’s ventures unit. “We’re a team of 10 folks with expertise around banking, venture investing, due diligence [and] compliance, so we’re able to do a pretty good job in house,” says Lisle.

Clayton Mitchell, a principal at Crowe, says banks should examine controls, processes and potential compliance gaps, particularly where the technology could pose significant regulatory, legal, financial or reputational risk, including potential fair lending or Unfair, Deceptive, or Abusive Acts or Practices (UDAAP) violations. And he advises banks to build a team that includes the CFO and finance staff, relevant business leaders, technology and information security, and risk and compliance. “Don’t get enamored with the tech,” he cautions. “[Fintechs have] been pitching for money since the day they were born. It’s the only way they’ve existed. So, they’re really good at sales.”

Banks should also take time with due diligence, and shouldn’t cave in to FOMO, or fear of missing out. “That’s never a good way to do deals,” says Lisle. “You never skip basic DD [due diligence].”

Earlier in his career, Lisle worked for Citigroup, which sent him to Brazil to check out a payments company that boasted a million signups. The company even paid soccer star Ronadinho Gaúcho $5 million to be its spokesperson. But Lisle dug deeper and uncovered just $10,000 in transactions — a low figure given the large user base the fintech claimed to have. Citi pulled the plug on the deal.

Lisle says it took 24 hours to pull the plug on the multi-million-dollar transaction. Problems aren’t always hard to spot, he explains. At JPMorgan, a few thousand emails would have quickly revealed the authenticity of Frank’s user base. “[It’s] literally two days of due diligence.”

What Crypto’s Falling Dominoes Could Mean for Banks

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On Nov. 11, the cryptocurrency exchange FTX declared bankruptcy. It’s a saga that’s played out through November, but here’s the bare bones of it: After a Nov. 2 CoinDesk article raised questions about FTX and a sister research firm, a rival exchange, Binance, announced on Nov. 6 its sale of $529 million of FTX’s cryptocurrency. In a panic, customers then sought to withdraw $6 billion and by Nov. 10, FTX CEO Sam Bankman-Fried was trying to raise $8 billion to keep the exchange alive.

This isn’t just a modern version of the old-fashioned bank run. FTX’s new CEO, John J. Ray III — who led the restructuring of Enron Corp. in 2001 — stated in a filing that he’s never seen such a “complete failure of corporate controls” in his 40 years of experience. “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented,” he said.

The fallout promises serious ramifications for the digital assets space — and may impact some banks. BlockFi, another cryptocurrency exchange that was bailed out by FTX last summer, filed for bankruptcy protection on Nov. 28. Those two bankruptcies have impacted Memphis, Tennessee-based, $1.3 billion Evolve Bank & Trust, which operates a banking as a service platform for fintechs including FTX.

The bank stated its exposure to FTX was in deposit accounts for a limited number of FTX customers, whose funds would be released once Evolve gets approval from the bankruptcy court handling the FTX case. Evolve also issued credit cards for BlockFi customers through a relationship with Deserve; those accounts were suspended. “Evolve has no financial exposure to BlockFi or to the credit card program they marketed,’’ Evolve said in a statement Thursday.

“To be clear, Evolve did not lend to FTX or their affiliates; we do not have corporate or deposit accounts with FTX or their affiliates; we do not lend against crypto; we do not offer crypto custodial services; and, we do not trade crypto,” Evolve said in an earlier statement to customers. Evolve also said the bank has never invested or transacted in crypto.

A larger bank also appears to be impacted. La Jolla, California-based Silvergate Capital Corp., with $15.5 billion in assets, said in a statement that its FTX exposure was less than 10% of its $11.9 billion in digital assets deposits; it later said that BlockFi deposits comprised less than $20 million. However, funds from digital assets clients make up 86% of Silvergate’s deposit base, according to its most recent earnings presentation. The rest are brokered, explains Michael Perito, a managing director at Keefe, Bruyette & Woods. And now, he says, “their targeted core customer base is under a lot of stress.” As a result, Kroll Bond Ratings Agency placed Silvergate’s ratings on watch downgrade on Nov. 21.

“As the digital asset industry continues to transform, I want to reiterate that Silvergate’s platform was purpose-built to manage stress and volatility,” said Alan Lane, CEO of Silvergate, in a press release. The bank declined comment for this article.

FTX may be the worst but it’s not the only crypto-related incident this year; it’s not even the first bankruptcy. The volatility has resulted in what has been dubbed a crypto winter, marked by a steep decline in prices for digital assets. The price for bitcoin peaked on Nov. 8, 2021, at $67,567. As of Nov. 29, 2022, that value hovered just above $16,000, with a market cap of $316 billion.

Even if banks don’t hold cryptocurrency on their balance sheets, there are many ways that a chartered institution could be directly or indirectly connected. Erin Fonté, who co-chairs the financial institutions corporate and regulatory practice at Hunton Andrews Kurth, advises all banks to understand their potential exposure.

She also believes that crypto could be at an inflection point. “Some of the non-sexy elements of financial services are the ones that keep you safe and stable and able to operate,” says Fonté. “It’s the compliance function, it’s the legal function, it’s proper accounting and auditing, internal and external. It’s all those things that banks do day in and day out.”

That could result in more regulation around crypto, and more opportunities for banks. “A lot of people are getting hurt, and have gotten hurt this year,” says Lee Wetherington, senior director of corporate strategy at Jack Henry & Associates. “That gets legislative attention and that certainly gets regulatory attention.”

What Could Change
Legislation could target crypto exchanges directly, but legislators are also looking at the banking sector. In a Nov. 21 letter, the Senate Banking Committee urged bank regulators to continue monitoring banks engaged in digital assets. They specifically called out SoFi Technologies, which acquired a chartered bank in February 2022 and subsequently launched a no-fee cryptocurrency purchase option tied to direct deposits. “SoFi’s digital asset activities pose significant risks to both individual investors and safety and soundness,” wrote the legislators. “As we saw with the crypto meltdown this summer … contagion in the banking system was limited because of regulatory guardrails.”

In a statement on SoFi’s Twitter account, the company maintained that it has been “fully compliant” with banking laws. “Cryptocurrency remains a non-material component of our business,” SoFi continued. “We have no direct exposure to FTX, FTT token, Alameda Research, or [the digital asset brokerage] Genesis.”

Currently, the Federal Reserve and Federal Deposit Insurance Corp. require notification from banks engaged in crypto-related activities; the Office of the Comptroller of the Currency takes that a step further, requiring banks to receive a notice of non-objection from the agency. More regulation is likely, says Fonté, and could include investor and consumer protections along with clarity from the Securities and Exchange Commission and Commodity Futures Trading Commission. “There’s a lot that’s going to come out there that is going to reshape the market in general, and that may further define or even open up additional avenues for banks to be involved if they want to be,” she adds.

Opportunities in crypto and a related technology called blockchain could include retail investment products, international payments capabilities or trade settlement, or payments solutions for corporate clients that leverage blockchain technology — such as those offered by Signature Bank, Customers Bancorp and Silvergate.

The risks — and opportunities — will vary by use case. “We’re being presented with entirely new risks that haven’t existed in the past,” says John Epperson, a principal at Crowe LLP.

Banks could be seen as a source of safety and trust for investors who remain interested in cryptocurrency. Larry Pruss, managing director of digital assets advisory services at Strategic Resource Management, believes banks could win back business from the crypto exchanges. “You don’t have to compete on functionality. You don’t have to compete on bells and whistles. [You] can compete on trust.”

James Wester, director, cryptocurrency at Javelin Strategy & Research, believes that with the right technology partners, banks can approach cryptocurrency from a position of strength. “We understand this stuff better,” he explains. “We understand how to present a financial product to our consumers in a safer, better, more transparent way.”

Wetherington recommends that banks consider cryptocurrency as part of a broader wealth offering. He’s visited bank boardrooms that have looked at how PayPal Holdings and other payments providers offer users a way to buy, sell or hold digital assets, and whether they should mimic that. And they’ve ultimately chosen not to mirror these services due to the reputational risk. “You can’t offer buy, hold and sell of a single asset class that is materially riskier than any number of more traditional asset classes,” he says. “If you’re going to offer the ability to buy, hold and sell a cryptographic monetary asset, you should also be making available the opportunity to buy, hold and sell any other type of asset.”

But all banks could consider how to educate their customers, many of whom are likely trading cryptocurrencies even if it’s not happening in the bank. “Help those customers with things like tax implications … or understanding how crypto may or may not fit into things that their retail customers are interested in. That’s one of the things that financial institutions could do right now that would be good for their customers,” says Wester. “There’s a real need for education on the part of consumers about [this] financial services product.”