In January 2014, ASIC published Report 384: Regulating Complex Products (Report). The Report sets out the recent work done by ASIC’s Complex Products Working Group and identifies opportunities for ASIC to undertake further work on complex products. The Report follows the 2013 International Organisation of Securities Commission's (IOSCO) report that sets out principles to govern the sale of complex financial products (IOSCO Report).
What is a complex product?
Rather than setting out a particular definition of “complex product”, the Report “focuses on ways to address the challenges posed by complexity in financial products”. The Report identifies the following product structures and/or features as inherently more likely to make a product complex:
- embedded leverage;
- inverse returns; and
- difficulty in being able to assess the potential performance and/or risks of the product.
The Report states that “a product may have features that by themselves are not complex but, in combination with a complex product, may lead to investor detriment”. The particular products identified as being complex include:
- agribusiness managed investment schemes;
- exchange-traded options strategies;
- hedge funds;
- hybrid securities;
- leveraged derivative products;
- managed funds with complex non-standard or non-linear payoffs;
- structured products; and
- non-vanilla warrants.
The stages of regulation
The Report identifies four different stages at which regulation applies to complex products:
- the product development stage;
- the product distribution stage;
- the point of sale stage; and
- the post-sale stage.
Product development stage
ASIC acknowledges that it has not traditionally focused its regulatory activities at the product development stage. According to the Report, ASIC could exercise its regulatory powers at this stage by virtue of administering the laws under the Australian financial services licensing (AFSL) regime.
For example, the obligation imposed on an AFSL holder to do all things necessary to ensure that it provides financial services in an efficient, honest and fair manner extends, in ASIC’s view, to taking steps before the issue of a product to ensure that the financial service of issuing the product occurs efficiently, honestly and fairly.
The Report also notes the “important but limited” role ASIC has in the registration of managed investment schemes.
ASIC will continue to consider product issuers’ product development processes as part of monitoring the risks posed to investors by complex products. ASIC may also issue guidance for product issuers in relation to complying with their AFSL obligations, including their obligation to do all things necessary to ensure that they provide financial services in an efficient, honest and fair manner.
Product distribution stage
ASIC acknowledges the traditionally strong role that disclosure has played in regulating financial services, in particular, at the product distribution stage. However, ASIC also recognises the limitations of disclosure as a regulatory tool when it comes to complex products. As a result of these limitations, ASIC may need to look to other areas of regulatory focus, such as the AFSL regime. In addition to the obligation to ensure that an AFSL holder does all things necessary to ensure that it provides financial services in an efficient, honest and fair manner, ASIC identifies two other particular obligations imposed on AFSL holders that could provide ASIC with regulatory powers in relation to complex products. These are the obligation to have in place:
- adequate risk management systems; and
- adequate arrangements for the management of conflicts of interest.
As with the product development stage, the obligation imposed on an AFSL holder to do all things necessary to ensure that it provides financial services in an efficient, honest and fair manner takes centre stage, requiring the AFSL holder to consider appropriate distribution channels for its products. Given that distributors of financial products must, themselves, hold an AFSL with the requisite authorisations in order to distribute the products, ASIC’s powers may be more effective at enforcing compliance with this obligation at the product distribution stage than at the product development stage.
Where ASIC identifies issues relating to distribution channels for particular complex products, ASIC will work with industry to address these issues. The Report also indicates that there may be scope for ASIC to issue guidance on its expectations of product issuers when selecting distribution channels for complex products in the future.
Point of sale stage
According to the Report, the point of sale stage is typically where advice (if any) is provided to an investor. Given that investors are more likely not to understand complex products (due to their evident complexity), the quality of the advice provided to the investor becomes even more critical. The Report refers to the obligations imposed on AFSL holders providing personal advice, but also acknowledges that there is no legal requirement for advice to be given before a person invests in a complex product. Further, unlike other jurisdictions, there is no requirement for product issuers or sellers to assess product suitability for investors in an execution-only situation. ASIC will explore the potential for using self-assessment tools to assist investors with testing their understanding of particular products before investing in them.
Post sale stage
The focus at this stage is on investors receiving ongoing information about the product and being able to assess the significance of that information and determine whether and how to act on it (i.e. whether they should dispose of the product, if possible).
The Report refers to the various legal obligations imposed on product issuers to provide ongoing disclosure under the current law. If ASIC identifies issues relating to the provision of post-sale information for particular complex products, it will work with industry to address those issues. ASIC may also issue more guidance on its expectations of product issuers in relation to the provision of time-critical post-sale information about complex products.
While the Report provides an interesting narrative on complex products, it is little more than a starting point for future discussion on any regulation of complex products. The Report refers to specific action ASIC has already taken in relation to particular products (such as requiring benchmark disclosure), and it makes frequent references to the IOSCO Report, as well as the regulatory approach taken by foreign regulatory bodies in relation to complex products. To date, there has been no uniform regulation in Australia that applies to all products on the basis that they are complex. This ad hoc approach to regulating these diverse products, and risks associated with them, may prove to be more effective than the uniform approach taken by regulators in foreign jurisdictions.