15 December 2016

First glimpse of game-changing reforms to product design and distribution, and ASIC’s intervention powers

On 13 December 2016 the government published its much-anticipated paper proposing reforms to the regulation of the design and distribution of financial products, and new intervention powers for ASIC.

These proposals respond to recommendations made in the final report of the Financial System Inquiry (FSI). A full copy of the “Design and Distribution Obligations and Product Intervention Power Proposals Paper” (Proposals) can be accessed here.

The proposals affect issuers, advisers and distributors of financial products, and they raise a number of key questions, including:

  • Where does the line fall between a design and distribution obligation and providing “personal financial advice”?
  • How should customer target markets be tested to make sure they understand whether a product is “suitable”?
  • What are the implications for market diversity and innovation?
  • What are the liability implications in the event of a product failure?
  • Will the distributor obligations eliminate benefits currently paid to entities in the distribution chain so they will not be subject to the distribution obligations?

The government has requested feedback and comments on the measures outlined in the Proposals. The closing date for submissions is 15 March 2017.

Consumer-centric design & distribution

Based on consumers’ needs

The Proposals would introduce new obligations on issuers and distributors of financial products to design and distribute those products in a manner which is targeted at consumers “based on the ability of the product to meet consumers’ needs”. This is a shift towards putting consumers’ needs, rather than the needs of the issuer at the heart of product design.

Retail focus

The Proposals focus on products made available to “retail clients”. 

There needs to be clarity on how Proposals will apply to products that are initially made available only to wholesale clients and acquired subsequently directly or indirectly by retail clients.

For affected financial products, it is clear that issuers and distributors will need to develop a deeper understanding of segments and channels within the retail market.

Broad range of products – but some sensible carve outs

The proposed design and distribution obligations would apply to financial products made available to retail clients, whether simple or complex, but would exclude ordinary shares.

The exemption of ordinary shares is a practical position. It reflects both a regulatory perspective that retail investors better understand the risks of ordinary shares (although that is debatable), and a realistic perspective that it would be very costly to apply these obligations to ordinary share issuance. Oddly there is no exemption proposed for basic deposit products.

Credit products (other than margin loans) are also excluded – avoiding a potential overlap with responsible lending obligations.

The Proposals would apply to hybrid securities, convertible securities, debentures, insurance products, investment products, margin loans and derivatives.

Curiously, listed stapled securities and units in listed managed investment schemes are not carved out, nor are “simple corporate bonds”. That produces odd outcomes, and a strange divide in the listed market. No doubt this will be debated in submissions.

Obligations on issuers 

Under the Proposals - issuers would be required to: 

  • identify appropriate target and non-target markets for their products based on the needs the product satisfies and the target market’s ability to understand the product; 
  • select distribution channels that are likely to result in products being marketed to the identified target market; 
  • have robust approval processes for new products; and 
  • review the arrangements in place “with reasonable frequency” to make sure that those arrangements continue to be suitable and appropriate, and to assess whether any changes are necessary to design or distribution going forward.

This means that design and due diligence processes will need to be supplemented to clearly identify target and non-target markets, and connect needs of the target market with features of the product. The Proposals clearly contemplate that issuers may need to conduct market testing, as well as stress testing of products, as part of the design process.

The Proposals will have an impact on the processes for the selection and engagement of distributors, and the terms of engagement to support compliance with issuers’ obligations. There is specific guidance to issuers regarding factors that they should consider when assessing distribution channels and marketing approaches, including arrangements that the distributor has in place.

The “review” requirement is a new type of obligation. Similar to the UK, it will involve:

  • monitoring distribution to ascertain who actually receives the financial products, and reporting to ASIC if products are distributed outside the intended target market; and
  • monitoring performance of the financial products (including any consumer feedback, claims outcomes and profit margins) to see whether they perform as expected, and continue to meet the needs of their target market.

Unlike the UK, it is not (yet) clear that these obligations would directly affect advisers involved in the product design process. However, this may emerge in later detail, through accessory liability provisions.

Obligations on distributors

“Distributors” are entities that arrange for the issue of the product to a consumer, or engage in conduct likely to influence a consumer to acquire a product, for benefit from the issuer. That is a broad definition and a new concept.

It would potentially capture all of the links in a distribution channel – from lead arrangers, to the sales desk, brokers, financial planners and direct marketers, but the Proposals indicate that it is not intended to capture financial advisers who provide personal financial advice, as these are already regulated. It will not include media companies that provide advertising, but would capture those who arrange for the advertising.

Distributors would be required to:

  • implement “reasonable controls” to make sure that financial products are distributed by them in accordance with the expectations of the issuer; and
  • comply with “reasonable requests for information” made by the issuer in conducting the review of the product.

Reasonable controls could include targeted warnings, scripts, self-assessment tools, training, supervision and audits, appropriate design of remuneration practices and avoiding bundling of certain products. Another control suggested is the use of consumer information that distributors have access to – for instance, where consumers have an existing client relationship with the distributor.

Sanctions

A broad array of sanctions for breach of the obligations is under consideration – from licence impacts, fines and penalties, to damages and compensation orders, criminal sanctions, and broad powers for courts to void or vary contracts.

When the reforms take effect

The obligations would apply to new products issued six months after the reforms are introduced.

However, the reforms would also be applied to products currently on the market that continue to be offered to consumers. For these products, compliance be required two years after the reforms are introduced.

New ASIC firepower - product intervention

Broad power to intervene with products, or product features

As foreshadowed, the Proposals will provide ASIC with power to “proactively intervene where it identifies significant consumer detriment”.

The power would enable ASIC to remove financial products from the market or to require mandatory warning statements, impose additional disclosure requirements, or limit the channels for distribution of the product. Implicitly, this would also give ASIC the power to intervene regarding product terms and features.

All retail financial products affected

The new power would apply to “all financial products made available to retail clients”, including ordinary shares and credit products.

This means it would affect ordinary securities, hybrid securities, convertible securities, insurance products, investment products, margin loans, credit cards, mortgages and personal loans.

Triggers for the power

ASIC will be able to exercise this power when it can identify a risk of significant consumer detriment having regard to:

  • the potential scale of the detriment in the market; 
  • the potential impact on individual consumers; and 
  • the class of consumers likely to be impacted.

ASIC would be required to engage in consultation with interested parties and consider alternative powers that may be more appropriate in the circumstances.

Limited duration of intervention and oversight

Interventions would be limited to an initial period of 18 months.

Affected parties could seek merits review and judicial review of ASIC’s use of this power. Oversight of ASIC was an important part of the FSI recommendations, but query whether merits and judicial review – rather than a commercial panel with market insight - fits the bill.

Market-wide interventions would be subject to parliamentary oversight and disallowance – this is already the case for any class order issued by ASIC.

When it comes into effect

The product intervention power is proposed to come into effect immediately upon the legislation being introduced.

A few things to think about

The Proposals will clearly have a profound impact on the processes for design and distribution of financial products, and the costs of new product development, as well as the risks for issuers in developing new products.

There are some aspects of the reforms that require further understanding and explanation. Some food for thought includes:

  • Blurring the line with “personal advice”: While “advised channels” appear to be carved out, it is difficult to see how some obligations can be met without effectively giving personal financial advice. For example, to assess how an issued product may operate in the context of an investor’s overall portfolio in identifying the target market.
  • Revisiting benefits paid by issuers: FOFA already has led to a reduction of the benefits paid by issuers. The distribution obligation applies to some entities only if they receive a benefit from the issuer and so the obligations might result in a further reduction of benefits paid.
  • Profound impact on complex products: The obligations are more challenging for complex products – which has the obvious potential to limit the capital that will be raised for those products and the development of more complex products.
  • How to test target markets: Issuers and advisers will need to explore how market testing can be carried out, and how it would interact with current restrictions on advertising financial products.
  • Defences that provide appropriate safe harbours: While the consumer logic of the Proposals is readily apparent, the sanctions have to be balanced with defences that protect issuers and distributors from outcomes that are only apparent with hindsight, or that give too much of a free swing to the class action industry.
  • Strange outcomes for some listed entities: Some thought needs to be given to the impact on listed trusts and listed stapled structures to conduct rights issues and other offers to their existing stakeholders.
  • Privacy and data implications: There is a suggestion in the Proposals that distributors should be making use of their existing consumer data, effectively to assess suitability. This would have implications for their privacy obligations, but also their practical capability to harness the data that they have.
  • Supporting responsible innovation: One of the strengths of the Australian market has been its capacity for responsible innovation in financial products. These reforms could have a negative effect, unless a clear mandate is given to ASIC to be supportive of innovation within appropriate policy parameters. That was a clear message from the FSI which seems to have been lost in the mix

What should you do?

Treasury’s paper seeks feedback and identifies clear questions for further exploration.

These reforms are coming like a freight train, so this is an important opportunity for interested parties to engage in the debate around the form that they should take.

Submissions are requested by 15 March 2017and can be made via email (ProductRegulation@treasury.gov.au).

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