On 13 December 2016 the government published its much-anticipated paper in response to the Financial System Inquiry (FSI) recommendations for the introduction of product suitability obligations on issuers and distributors of financial products and the granting of a “product intervention power” to ASIC. The “Design and Distribution Obligations and Product Intervention Power Proposals Paper” (Paper) makes preliminary proposals on how the government will action its accepted FSI recommendations. A full copy of the Paper can be accessed here.

These proposals raise a number of questions for financial institutions to consider, including:

  • Given the proposed scope of the proposed design and distribution obligations, how to draw a distinction between a design and distribution obligation and “personal financial advice”.
  • What will be the scope and obligations of testing customer target market to make sure they understand whether a product is “suitable”?
  • How do we ensure that potential regulatory tools and consumer remedies as part of an intervention by ASIC do not result in exposing issuers and distributors to significant loss, or litigation, in the event of a product failure?

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

Context

The current regulatory framework governing the activities of financial product issuers and distributors is a “disclosure based model” developed following the Wallace Inquiry in the late 1990s. Effectively, under the current regulatory model, the issuer or distributor of retail financial products is requiredto disclose the key features and risks associated with any particular product and the onus is largely placed on the consumer to read and understand that disclosure, and decide for himself or herself whether a particular product is “suitable” for their individual circumstances.

Following a series of high profile failures of investment schemes during the global financial crisis, this approach to the regulation of financial products was revisited as part of the FSI. The Paper forms part of the Government’s response to two recommendations coming out of the FSI:

  1. to create new accountability obligations for entities that issue or distribute financial products (recommendation 21); and
  2. to strengthen consumer protection by introducing financial product intervention powers (recommendation 22).

The Proposal seeks to move away from disclosure as the main form of consumer protection in the financial product lifecycle, similar to what has already occurred in other jurisdictions (including the United Kingdom and Europe). However, importantly, the Proposals Paper emphasises that consumers are still to be ultimately responsible for their own investment decisions.

Summary of Proposals

Design and Distribution Obligations

The Paper proposes the introduction of 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”.

If the proposed reforms are enacted, these design and distribution obligations will apply to “financial products made available to retail clients except ordinary shares” by both issuers and distributors. Examples given in the Paper include insurance products, investment products, margin loans and derivatives. However, the design and distribution obligations will not apply to credit products, other than margin loans.

Questions may arise as to how “issuer” and “distributor” should be defined (and therefore what kinds of entities will be captured by the design and distribution obligations). The Paper describes “issuers” as “the entities that are responsible for the obligations under the product”, for example insurance companies and fund managers. “Distributors” are entities that “either 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”.

The Paper outlines in detail what will be expected of entities that fall within the definition of “issuer” and “distributor” if the proposed reforms contained in the paper are enacted. Namely issuers would be required to:

  1. 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;
  2. select distribution channels that are likely to result in products being marketed to the identified target market;
  3. have robust approval processes for new products; and
  4. review the arrangements in place “with reasonable frequency” to make sure that those arrangements continue to be suitable and appropriate.

Distributors would be required to:

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

It is proposed that there will be a reasonable lead in time in implementing these design and distribution obligations, with the obligations applying to new products issued six months after the reforms would occur. For products currently on the market, compliance will not be required until two years after the reforms set out in the Proposal Paper are enacted.

Product Intervention Power

The second measure proposed in the Paper is to grant ASIC a “product intervention power” to “proactively intervene where it identifies significant consumer detriment” and remove financial products from the market where they are unfair or would cause significant detriment to consumers. In addition to the power to remove products, ASIC will be able to mandate other changes (for example that there be a mandatory warning statement given with a particular financial product).

ASIC’s product intervention power is proposed to apply to “all financial products made available to retail clients”. Examples given in the Paper include securities, insurance products, investment products and margin loans. The power is also proposed to apply to credit products regulated by the National Consumer Credit Protection Act 2009 (Cth) (for example, credit cards, mortgages and personal loans).

If the reforms set out in the Paper are adopted, ASIC will be able to intervene “in relation to the product (or product feature), the types of consumers that can access the product or the circumstances in which consumers access the product”. Some examples of potential interventions given in the Paper include “additional disclosure obligations, mandating warning statements, amendments to advertising documents, restricting or banning the distribution of the product”.

ASIC will be able to exercise this proposed 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”.

It is proposed that ASIC also be required to comply with a series of procedural steps before exercising the proposed new power. Specifically, ASIC will be required to engage in consultation with interested parties and consider alternative powers that may be more appropriate in the circumstances. Through these mechanisms, the Paper acknowledges the need for transparency in consultation and the consideration of alternative powers.

There is proposed to be duration limits placed on interventions (for example, interventions will be limited to an initial period of 18 months). Affected parties would be given the ability to seek merits review and judicial review of ASIC’s use of this power and that there be parliamentary oversight of any market-wide interventions. It is proposed that the Product Intervention Power will apply from the date after Royal Assent of the legislative amendments (however, the Paper notes that ASIC should consider whether a “transitional period” may be required).

Enforcing the Design and Distribution Obligations and Product Intervention Power

The FSI did not identify specific remedies or actions that should apply in relation to a breach of the recommendations for changes that were made. However, the Paper identifies a “range of alternative regimes” that might apply in the event of a breach of the design and distribution obligations including:

  1. Administrative actions (such as fines, monetary penalties and cancellation or variation of a financial services or credit licence)
  2. Civil penalties (including disqualification orders or pecuniary penalties)
  3. Criminal penalties (such as fines or imprisonment, for the “most serious conduct” and where dishonesty or recklessness is involved)
  4. Injunctive actions (where an entity is in breach or is continuing to breach the obligation).

The Government has sought feedback on the range of these regulatory tools which should be available in the event of non-compliance.

In addition, the Paper proposes that where a consumer has suffered loss or damage as a result of the breach of the design and distribution obligations or the breach of a requirement in an ASIC intervention, they should have access to appropriate redress. The possible forms of redress which are identified include:

  1. that a contract entered into in breach of the design and distribution obligations or any ASIC interventions be voidable at the consumer’s option;
  2. remedies enabling the consumer to obtain a refund or replacement product; and
  3. the ability to obtain orders declaring the whole or part of a contract void, or varying the terms of the contract.

The Paper also outlines the mechanisms through which these consumer rights may be redressed, for example through a consumer raising the matter through the internal dispute resolution procedure in place within the financial services provider, through a consumer commencing private civil litigation (for example class actions) and through ASIC initiating private court proceedings on a consumers behalf. The Government has also sought feedback as to the rights and avenues of redress which should apply.

Implications and Analysis

It is interesting to note that while the design and distribution obligations identified in the Paper are proposed to apply broadly to various different types of financial products which may be available in the market, certain products are singled out:

  • A margin loan is singled out as a product which many not be appropriate for consumers who are approaching retirement age who does not therefore have an extended working life to recover from a significant financial loss (the Storm Financial collapse is referred to as an example of this);
  • Insurance products which overlap with existing rights (eg. under a manufacturer’s warranty) are singled out as products which a consumer is unlikely to derive a benefit from; and
  • Any products which can be acquired by consumers without active engagement (ie. as the result of default options) are identified in the Proposals Paper as unlikely to be appropriate regardless of the target market.

Issuers and distributors dealing in these kinds of financial products should be alert to these comments and give consideration as to how these products may be re-designed or re-targeted going forward.

Some aspects of the Paper are unclear. In particular:

  • The scope of the proposed design and distribution obligations: The Paper anticipates that issuers will give consideration to how an issued product may operate in the context of an investor’s overall portfolio in identifying the target market for that product. For example, for high risk products, the Paper states that issuers should identify what is the maximum percentage of the portfolio that should be invested in a particular product offered by the issuer or distributor. This kind of recommendation blurs the line between a design and distribution obligation and “personal financial advice”.
  • The nature and scope of required testing of target market is unclear: the Paper states that issuers may need to do testing of their selected target market to ensure they understand the key features of the product. However, the scope and the exact nature of this obligation is an area that requires further exploration.
  • The potential regulatory tools and consumer remedies: The potential regulatory tools and consumer remedies identified in the Paper which may be available in the event of a breach of any design and distribution obligations or contravention of an ASIC intervention are extensive and may expose issuers and distributors to significant loss in the event of a product failure. In particular, the potential consumer remedies would likely increase the exposure of issuers and distributors to mass litigation (including potential class actions).

There are several positive aspects of the proposed reforms that should be supported, including the following:

  • The range of financial products which will attract the design and distribution obligations: The Paper has excluded credit products from those financial products which will attract the proposed design and distribution obligations on the basis that issuers and distributors of these products are already subject to responsible lending obligations. In contrast, we note that the product governance requirements in the United Kingdom now apply to consumer credit products.
  • ASIC accountability: The proposed reforms would provide affected parties with robust rights of review of ASIC’s exercise of the proposed product intervention powers. The proposed rights of review are valuable in light of the serious potential impact of these powers on issuers/distributors. The obligation on ASIC to consult before exercising the proposed new intervention power would serve to further enhance accountability.
  • Transitional arrangements: The proposal to have a transitional period before the proposed reforms come into operation is clearly sensible in light of the extensive business process changes which will be required by most issuers and distributors of products to implement these proposed reforms. However, the proposed transitional periods are relatively short. As a result, it is clear that, if these proposed reforms are adopted, issuers and distributors will need to act quickly to ensure that they can comply with the proposed new design and distribution obligations.

Where to next?

The Paper seeks extensive commentary and feedback and identifies clear questions for further exploration. Interested parties should consider making a contribution and shaping this important reform. Submissions are requested by 15 March 2017. Submissions can be made via email (ProductRegulation@treasury.gov.au).