Product issuers and distributors may now be facing a new regulatory frontier as a result of a key recommendation in the FSI’s Final Report. However, are such laws likely to achieve this result, how can they be effectively implemented and what are the risks of unintended consequences?
Product issuers and distributors may now be facing a new regulatory frontier as a result of a key recommendation in the FSI’s Final Report. The Report has amplified concerns around the heavy reliance existing regulation places on disclosure, financial advice and financial literacy and that this has led to consumer detriment in a number of instances. Failures such as Storm Financial, Opes Prime, Westpoint, agribusiness schemes and unlisted debentures are identified as scenarios where poor product design and distribution practices played a significant role. Targeted product design and distribution laws have therefore been recommended by the Report, with a view to reducing the likelihood of future failures. However, are such laws likely to achieve this result, how can they be effectively implemented and what are the risks of unintended consequences?
Creating further accountability for design and distribution
The Report has put a spotlight on improving consumer outcomes and makes a variety of recommendations in this context. The recommendations are targeted at promoting the fair treatment of consumers, improving efficiency and building confidence in the financial system. The Report has highlighted the need to align the governance and corporate culture of financial firms and that the current regulatory framework is too focussed on the point of sale. With this in mind, the Report’s key recommendation around product design and distribution looks away from the point of sale and up the chain toward product issuers and distributors. The Report points to overseas regulation as leading the way for this type of initiative and while the new regulation is not being targeted at the point of sale, it will nevertheless carry with it a number of challenges in terms of implementation.
The Report proposes that product issuers and distributors be placed under obligations that promote the targeting of products to those consumers who would benefit from them. The regulation has been envisaged as a set of principles rather than prescriptive requirements. However, the “look” and substance of such a new regime is nevertheless likely to be hard to capture in a coherent set of legal rules.
The key elements of the new regime identified by the Report are as follows:
A design obligation would be placed on product issuers which would require them to identify target and non-target markets, taking into account the product’s risk profile and other characteristics. Integral to this obligation at the design phase would be that the product issuer will stress-test the products to see how consumers may be affected in different contexts and consumer-test their products to ensure their key features are clear and easy to understand. A preliminary issue in this context is that it is difficult to see how a design testing phase can be undertaken separately to identifying the target market. For example, a high risk product may be acceptable provided it is delivered to an appropriate market segment. How then can an issuer accurately assess whether a product, in and of itself, has been appropriately designed? It seems that the answer to this question lies partly in ensuring the product balances the interests of the issuer and the consumer.
One of the examples to illustrate how a product may be poorly designed is contained in ASIC’s Report on regulating complex products (Report 384). Report 384 is referenced in the FSI Final Report and gives the example of a product designed with an over-emphasis on product issuer returns which are at the cost of the investors. This appears to be identifying the need for an explicit principle of equity and a balance of interests in product design, which would go beyond existing generic statutory obligations such as those imposed on responsible entities to act in unitholders’ best interests and to manage conflicts of interest. However, the challenge with striking a happy medium in this context will be for regulation to allow sufficient flexibility for products to exist which allow for material investor returns as well as performance returns for the issuer. The devil will be in the detail, particularly for setting any principles which impact how fund managers provide for management fees. In particular, performance fee metrics may need to be navigated carefully, since they can incorporate complex concepts such as series classes, high watermarks and benchmarking.
An obligation in connection with the distribution process would be introduced whereby product issuers would be required to agree with distributors how a product should be distributed to consumers. What is this obligation likely to look like in practice? One way to answer this question is to break down the distribution process into the key areas where risks are posed to consumers. In its report on complex products, ASIC analysed the product distribution stage in terms of distribution channels, disclosure, advertising and the broader context of information about the relevant product. While various initiatives have been introduced by the regulator in recent times around disclosure and advertising, the FSI’s recommendation arguably heads into new territory. In particular, it envisages an approach which regulates the specific arrangements between issuers and distributors.
One approach to regulating arrangements between product issuers and distributors could be to mandate content requirements for the agreements entered into between them in a similar style to how content has been required for custody agreements (see ASIC Regulatory Guide 133). This could place the parties under contractual obligations directed at meeting the policy objectives. However, it would also rely on the parties enforcing those terms in order for there to be force behind the regulation. Supplementary initiatives could include a more flexible set of standards set at a broader industry level, which could take into account changes in future distribution channels such as the increasing role of technology and online investing.
Whatever the approach, a key challenge will be introducing issuer accountability around the distribution channels chosen and doing this in a way which does not require issuers to double check the suitability of individual sales. The surrounding messaging will also be critical so that individual consumers do not place undue reliance on the new regulation. For example, unintended consequences could arise if consumers incorrectly perceive issuers to be assuming an equivalent role to financial planners, with issuers having an obligation to determine the suitability of a distribution channel being confused with taking into account the consumer’s individual circumstances, needs and objectives. Likewise, any principles developed around how distributors are selected by product issuers will need to be carefully considered.
After the sale of a product, the issuer and distributor would be required to review periodically whether the product still met the requirements of the target market and whether the risk profile was still consistent with the approach taken to distribution. While it appears that this review should only be forward looking to inform future product design and distribution, it is unclear how obligations of this nature would fit with issuer and distributor liabilities, particularly in the face of any potential class action risk. For example, issues could arise if it became apparent that a product were being heavily invested in by consumers without the benefit of receiving financial advice and that certain features of the product were not being understood. If the outcome in this scenario were that the distribution should be limited to channels where personal advice were received from a financial planner before the consumer entered into the product, this could leave an uneasy relationship with the earlier investors who did not receive advice.
While the Report carries a clarification at the end of the section that “circumstances beyond those reasonably foreseeable at the time would not be expected to be taken into consideration by issuers and distributors,” this arguably does not create a bright line for accountability. The obligation could in practice play out inconsistently depending on the context and the position of the firms involved.
If this recommendation is taken up, the resulting new regulation has the potential to bring in a range of new regulatory concepts and accompanying concerns for an industry operating in an increasingly regulated and litigious environment. Product issuers and distributors will be well served to track closely how any principles are developed in order to ensure that they can be managed and implemented appropriately. It will also be important to chart how this recommendation is assessed in the context of the broader recommendations of the FSI’s Report, for example if ASIC is granted (as recommended) greater enforcement and product intervention powers.