What we can we learn from the European Union’s experience.
The Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Act 2019 was passed in April 2019 and amends the Corporations Act 2001 to introduce design and distribution obligations (DDO) for financial products.
The amendments also give the Australian Securities and Investment Commission (ASIC) power to intervene in relation to a financial product if it is satisfied the financial product has resulted in, or will or is likely to result in, significant detriment to retail clients.
The product intervention powers given to ASIC commenced on 6 April 2019 while the amendments introducing the DDO will commence on 5 April 2021.
These reforms were introduced by the Australian Government in response to recommendations made in the Financial System Inquiry Final Report (FSI) released in 2014, which recognised shortcomings in the existing disclosure regime. These shortcomings were reinforced by a joint report by ASIC and the Dutch Authority for Financial Markets (AFM) on a disclosure titled Disclosure: Why it shouldn’t be the default. The report observed that ‘disclosure and warnings have often failed to deliver intended consumer outcomes, or have backfired’. ASIC and the AFM agree that while disclosure is essential, it alone is not enough to promote good consumer outcomes.
The DDO represent an intentional shift beyond disclosure and a significant development in the regulation of financial products and services in Australia. The DDO are intended to assist consumers in obtaining financial products that are appropriate for them by requiring issuers and distributors to have a customer-centric approach to the design and distribution of financial products.
Among other things, issuers and distributors of financial products to whom the DDO apply will have to consider and determine the class of retail clients that make up the target market for that product. By contrast, the disclosure regime alone generally relies on the consumer determining whether the financial product is appropriate for their needs. The disclosure regime is not displaced by the DDO except that the DDO now requires the issuer and distributor to make their own determination with respect to the target market for their product.
In December 2019, ASIC released Consultation Paper 325 (CP 325) on the DDO outlining its proposed approach to regulating the design and distribution regime. CP 325 also includes ASIC's draft regulatory guidance (Draft DDO Guidance). The closing date for submissions is 11 March 2020.
How helpful is ASIC’s guidance on making a target market determination?
The target market determination is the starting point for the DDO. In CP 325, ASIC explains that its proposed approach does not involve definitive guidance on the content and form of a target market determination. CP 325 takes a general, high-level and principles-based approach to guiding issuers in making a target market determination. This is consistent with the FSI’s recommendation that there should be a principles-based DDO.
ASIC propose to provide guidance that the DDO be documented, fully implemented, monitored and reported on, and regularly reviewed to ensure that it is up to date.
ASIC states that the requirement to make a target market determination promotes discipline in product design by ensuring that issuers develop financial products for a target market that can be defined. In this respect, ASIC's proposed guidance paraphrases the legislation by stating that issuers should identify the target market and design products that are likely to be consistent with the ‘objectives, financial situation and needs’ of consumers in that target market.
ASIC propose to give guidance that explains the process and key considerations for identifying and describing the target market through examples across different product sectors, including credit cards, reverse mortgages, cash options in superannuation, consumer credit insurance low-value products and basic banking products.
It also proposes to give guidance that, in certain circumstances, require the issuer to manage the risk of the product being sold to consumers who do not have a diversified portfolio. ASIC also propose that issuers also identify for whom the financial product is clearly unsuitable (ie. ‘negative target market’).
Unfortunately, ASIC does not flesh out what is expected in making the target market determination in their draft guidance. Its specific product “examples” do not effectively illustrate how the objectives, financial situation and needs of the customers in a given target market can be determined. This is because the examples are often vague and piecemeal articulations of ASIC’s general expectations. In the examples, there are also several references to related regulatory guidance and reports which are opaque and add a level of complexity that makes it difficult to discern the applicable principle with sufficient certainty.
We considered whether there could be unintended consequences of the DDO for retail investors. For instance, we considered whether retail investors could be excluded from target market determinations of products that carry a higher risk and return, as a result of the regulatory risk associated with the DDO. There is no clear path forward on this point, nor many other regulatory decisions associated with the DDO, as the development of ASIC’s proposed approach will continue to be a challenging task for the regulator.
The European Union experience
In this respect, Australian policy makers and regulators often consider regulatory developments in other jurisdictions, and the DDO are no exception. ASIC has said that the DDO “bring Australia into line with comparable jurisdictions, including the United Kingdom, Netherlands and European Union, where similar product governance regimes are already in place.”
Accordingly, some useful insight into the operation of the DDO and how ASIC may ultimately develop its approach may be gained from other jurisdictions.
In the European Union, comparable product governance regulations were introduced under the Markets in Financial Instruments Directive II (MiFID II) and took effect on 3 January 2018. Prior to the implementation of MiFID II, the European Securities and Markets Authority (ESMA) published their final report titled Guidelines on MiFID II product governance requirements on product governance regulations (Product Governance Guidance). This included guidelines on making target market assessment by manufacturers and distributors of financial products.
What can we learn from the European Union’s experience?
ESMA has issued detailed guidance to financial product manufacturers, explaining they should use the following categories to help identify their target market the:
type of clients to whom the product is targeted
knowledge and experience held by the target clients
target client’s financial situation, with a focus on their ability to bear losses
risk tolerance and compatibility of the risk/reward profile of the product with the target market
target clients’ objectives and needs
ESMA has gone into detail about what is expected to be detailed in each category above, including that the target market should be based on both quantitative and qualitative considerations.
ESMA also recognise that services for the mass market may require automation of processes and that this automation is usually based on formulas or algorithmic methodologies that process qualitative criteria for products and clients.
ESMA’s guidance in respect of the above matters is more substantive than ASIC’s draft guidance and may assist in understanding what a similar framework in Australia might also require issuers and distributors to do. Of course, in assessing the utility of guidance in other jurisdictions it is necessary to consider the statutory and policy differences and similarities between Australia and those jurisdictions.
ESMA also provided case studies of the target market determination and distribution channel for structured investment products, structured deposit products, products distributed in wholesale markets, blue-chip shares and non-complex UCITS.
ESMA’s approach to case studies is more effective at illustrating the product governance regulations and their expectations than ASIC’s examples. In this regard, ESMA more effectively offers guidance at a level of granularity to assist manufacturers in correctly identifying clients.
It is to be hoped that ASIC will provide similar case studies in their examples for common and widely held financial products.
Who is affected?
The DDO generally applies to financial products that require a product disclosure statement (subject to some exceptions) or offers of some securities that require disclosure. Credit facilities and ‘financial products’ regulated by the Australian Securities and Investments Commission Act 2001, including credit contracts and consumer leases listed in the National Consumer Credit Protection Act 2009 are also captured by the DDO.
What are the DDO?
The main design obligations that are relevant to issuers of financial products are that they must:
make a publicly available target market determination, which must:
describe the class of retail clients for the financial product
specify any distribution conditions or restrictions on distribution
specify when and in what circumstances target market determinations will be reviewed
specify when reviews of the target market determination must occur
specify a reporting period during which a distributor should provide information about complaints to the issuer
specify the kind of information needed to enable the issuer to identify whether a review trigger has occurred or the target market determination is no longer appropriate
take reasonable steps in relation to distribution
notify ASIC of any ‘significant dealing’ in the product that is not consistent with the target market determination
review the target market determination for appropriateness within 10 days of a review trigger
keep records of decisions made in relation to its target market and distribution information (where an issuer is also a distributor)
Intermediaries or issuers that distribute financial products to consumers must:
not distribute a financial product unless a target market determination has been made
take reasonable steps in relation to the distribution
notify the issuer of a ‘significant dealing’ that is not consistent with the product’s target market determination
keep complete and accurate records of distribution information
report to the issuer about whether any complaints have been received in relation to the financial product and, if so, the number of complaints
Advertising or other promotional material for a financial product must also reference the product’s target market.
Civil and criminal penalties apply to contraventions of the DDO.
What is ASIC’s role?
ASIC will administer the DDO, including the issue of regulatory documents and has power to enforce the DDO, similar to the powers held by ASIC under the current disclosure regime.
How we can help
We would be very happy to assist you in considering the draft guidance and consultation, identifying whether you are subject to the DDO, understanding your obligations or preparing for the implementation of the DDO.
About the author
Samuel is a member of our Financial Services and Funds Management team and is experienced in providing high quality advice on regulatory developments, including complex cross-border matters.
Please contact Samuel Jones on 0422 738 548 for more information.
The information contained in this article is for information purposes only and does not constitute legal advice.