On target

Imagine if the Government required car makers to have a target market for each of their models. Utes are for tradies. Luxury sedans are for professionals. Mini hatchbacks are for under 25’s. Car dealers would then have to take reasonable steps to sell the models in accordance with the target market. If they didn’t, a regulator could issue orders stopping the dealer from selling outside the target market. A manufacturer or distributor that failed to comply with these requirements would face criminal and civil penalties.

Sounds far-fetched? It’s actually very close to what is being proposed for financial products.

These are the so-called design and distribution obligations, which have been slowly moving their way through the legislative process.

First recommended by the Financial System Inquiry in its November 2014 report (FSI Report), they were endorsed by the Federal Government in October 2015. The Government then released a proposals paper in December 2016, followed by draft legislation in December 2017. The Government has now released new draft legislation to take account of comments received on the earlier draft Bill. Comments close on 15 August.

What are the design and distribution obligations?

The design and distribution obligation will require a person offering a financial product (offeror) to make a “target market determination” (TMD) for the product. The TMD must set out the class of retail clients which is the target market for the product. It also must specify any conditions or restrictions on retail distribution of the product, which could include restrictions on advising or dealing in the product. A TMD would as well have a review mechanism, including a regular review period and triggers for when a review would occur. Any member of the public will be able to get a free copy of the TMD.

The offeror will have to keep records about its decisions in relation to the TMD, including the reasons for those decisions.

The TMD will also have to meet some tests.

First, it must be reasonable to conclude that if an issue of the product occurred to a retail client in the target market, it would likely be consistent with the likely objectives, financial situation and needs of the retail client. This means that the TMD will have to be reasonably aligned with the requirements of consumers in the target market. For example, a TMD for car insurance which had a target market of people who don’t drive cars would probably not meet this test. This is like a product suitability test.

Second, it must be reasonable to conclude that if a product was issued in accordance with any conditions of distribution in the TMD, it would be likely that the retail client who acquires the product is in the target market. This is what could be called a ‘distribution suitability’ test.

The offeror will also be required to specify distribution information that product distributors must collect and keep.

Distributors will be prohibited from distributing a financial product unless a current TMD is in place, and both the offeror and distributor of the product will have to take reasonable steps so that distribution is consistent with the most recent TMD. (However, the Bill clarifies that asking questions of a consumer to determine if they are in the target market, and telling the consumer if they are in or not in the target market, will not constitute personal advice).

The “reasonable steps” that an offeror or distributor must take have a complicated definition in the draft Bill. They are defined as steps that in the circumstances the person is reasonably able to take to ensure that the product distribution conduct is consistent with the TMD, taking into account all relevant matters including:

  • the likelihood that the conduct is inconsistent with the TMD;
  • the nature and degree of harm that might result from issuing the product to a client who is not in the target market, or issuing the product inconsistently with the TMD;
  • what the offeror or distributor knows, or ought reasonably to know, about the above, and about ways to eliminate or minimise the likelihood and harm; and
  • the availability and suitability of ways to eliminate or minimise the likelihood and the harm.

Distributors will have additional obligations to keep records, provide information to the offeror about complaints, and notify the offeror about any significant dealing in a product that is not consistent with its TMD (which the offeror will then have to notify to ASIC).

Products covered

The design and distribution obligations will apply generally to offers of financial products where the product offeror has to make a disclosure under the Corporations Act in the form of a product disclosure statement (PDS) or prospectus.

There will be some exceptions, including MySuper products, margin lending facilities, securities issued under employee share schemes, fully paid ordinary shares in domestic or foreign companies, and financial products prescribed by regulations. However the obligations will apply to ordinary shares that are convertible to preference shares where the company intends on issue that they be converted into preference shares within 12 months after the date of issue.

In the latest draft Bill, the Government has slipped in an amendment to the Corporations Act which would enable regulations to declare anything is a financial product for the purposes of any provision of Chapter 7 of the Corporations Act (Financial Services). This amendment has implications beyond the design and distribution obligations, and could allow any form of product or thing to be regulated as a financial product.

Why have design and distribution obligations?

The FSI Report argued that design and distribution obligations were needed because the existing regulatory framework

relies heavily on disclosure, financial advice and financial literacy. However, disclosure can be ineffective for a number of reasons, including consumer disengagement, complexity of documents and products, behavioural biases, misaligned interests and low financial literacy. Many consumers do not seek advice, and those who do may receive poor-quality advice. Many products are also distributed directly to consumers.

To improve consumer outcomes, the FSI Report said that the regulatory framework “should promote the targeting of products to those consumers who would benefit from them.”

The FSI Report claimed that a design and distribution obligation could reduce the incidence of cases such as Storm Financial, where margin lending products did not suit the risk profiles of the customers who were sold its products.

The design and distribution obligations are therefore seen as a preventative measure to stop mis-selling of products, rather than having to rely on cleaning up the damage afterwards.

Why is such a measure thought to be necessary for financial products but not other products and services? Perhaps because mis-selling of financial products can sometimes lead to serious damage for consumers, as occurred with Storm Financial.

Preparing for the design and distribution obligations

The draft Bill proposes that the new obligations would commence two years after the Bill is enacted. It’s likely that the Bill will eventually be passed by the Parliament once it is introduced. Financial services providers should therefore have at least two years to prepare for the new regime.

The obligations will apply to existing products as well as any new products, so each affected product will have to be put through a TMD.

Financial product issuers should start to think about how they will structure and implement their TMD process and rollout obligations to product distributors. The TMD will need to become an integral part of product design, development and review, as well as product marketing, sales and distribution.

Patrick Dwyer and Kathleen Harris
Legal Directors