By Partners Marc Kemp and Matthew McLennan and Senior Associate David Harris
The Financial System Inquiry (inevitably, the 'Murray Inquiry') is the successor of the Campbell Inquiry (1979-1981) and the Wallis Inquiry (1996-1997). Both the Campbell and Wallis reports considered that investors were best protected through disclosure and market integrity rules. Both reports assumed that adequate disclosure would result in efficient markets and efficient capital allocation: caveat emptor ('let the buyer beware').
Australia is now entangled in a web of rules regulating disclosure by way of prospectus, short-form prospectus, transaction-specific prospectus, profile statement, offer information statement, product disclosure statement, transaction-specific product disclosure statement, short-form product disclosure statement and shorter product disclosure statement for simple managed investment schemes and superannuation.
In its submission to the Financial Systems Inquiry, however, ASIC has acknowledged what everyone has known for some time: disclosure has its limits and, alone, is not sufficient for the task of (in ASIC's words) 'arming investors and financial consumers with key information to guide decision making'. ASIC is not alone in drawing this to the Inquiry's attention (see, for example, the submission of Professor Dimity Kingsford Smith). These limits are serious: witness the losses suffered by investors in financial collapses since the global financial crisis, such as those of Trio Capital, Timbercorp, Storm Financial and Great Southern.
Why is this so? Over and above financial illiteracy (especially in relation to risk disclosures and fees and charges), some products may simply be too complex to disclose clearly, concisely and effectively, reducing the utility of disclosure (a phenomenon well-documented by ASIC in its January 2014 report on Regulating Complex Products). In addition, research in behavioural science which ASIC, walking in the footsteps of the UK's Financial Conduct Authority (the FCA), refers to both in its submission to the Inquiry and its complex products report provides evidence about biases and short cuts taken in financial decision-making. However comprehensive (and expensive) a disclosure document, the disclosure is of little use to an investor who does not read or understand it, and who may be motivated to acquire the product by non-rational, behavioural impulses as much as by the information on the page. As Professor Kingsford Smith puts it in her submission:
The expectations of the financial citizen in the 20 years prior to the GFC have been pitched too high. Particularly in relation to investment risk (as opposed to financial products with no investment element) the financial citizen who is compelled to be in the financial market deserves greater support from law makers and regulators.
While we do not expect disclosure to be replaced as a regulatory tool indeed, ASIC makes a number of suggestions in its submission to the Inquiry about how disclosure may be improved we expect to see a shift in financial services regulation.
In an earlier article in this edition, we have commented more extensively on the complexity and effectiveness of disclosure, ASIC's recommendations and other changes to disclosure proposed in the submissions.
What would such a shift mean? We think it will ultimately entail greater emphasis on product suitability and (possibly) greater responsibilities on 'gatekeepers'. This is supported by ASIC's recent utterances on the topic.
In its report on Regulating Complex Products, ASIC proposed requiring product manufacturers and distributors to ensure that their products are appropriate and suited to their target audience and are subject to proper internal approval. An example of what ASIC may have in mind is the Australian Financial Markets Association's Principles relating to product approval - retail structured financial products, which was prepared in consultation with ASIC, and which says that:
a sound business case should exist for the product, which is based on its capacity to satisfy what are expected to be genuine client demands the target market and the range of client segments for which the product would be suitable should be determined during the product design stage.
ASIC's current Strategic Framework emphasises its intention to 'hold gatekeepers to account'. 'Gatekeepers' includes auditors, advisers, product manufacturers and distributors. This follows the references by Richard St John in his April 2012 report on Compensation arrangements for consumers of financial services to 'gatekeepers' and the 'apparent imbalance in the responsibilities of issuers of financial products on the one hand and financial advisers on the other towards retail clients'. The suggestion is that aggrieved consumers tend to sue financial advisers because it is too difficult to sue product issuers.
What might this mean in practice?
In its report on Regulating Complex Products, ASIC seemed to suggest that it could use the existing obligations of holders of financial services licences (eg the obligation to act efficiently, honestly and fairly) to hold them to account for failing to take steps before the issue of a product to ensure that the product would meet the legitimate expectations of investors. It noted, however, that the UK's FCA had new product intervention powers enabling it to make rules to block the launch of a product or stop sales for up to 12 months where there are serious problems with a product or product features.
That reference to the FCA's power has proved to be advance warning of ASIC's next step. ASIC's submissions to the Financial System Inquiry propose a 'more flexible regulatory toolkit that could target market-improving actions'. One of the options proposed in ASIC's submissions is the power to '[intervene] in the way products are designed and developed, to improve the quality of products being sold to investors and financial consumers'. Another is the suggestion that certain products be required to be marketed in a particular way, or (in what would mark a significant policy shift) restricted to certain types of investors.
There could be much merit in a shift of regulatory focus from disclosure to suitability: there is no good reason why consumers of financial products should not be able to expect that financial products will meet their legitimate expectations (particularly in a country where, as a result of compulsory superannuation, they have no choice but to be 'financial citizens'). That is not to say that risk should be removed from the system, a point that David Murray made in his 1 May address to the Australian Business Economists; but it should be properly allocated.
However, as with any change, there may be unintended (albeit predictable) consequences.
No doubt a greater emphasis on the conduct of financial product manufacturers at all stages of the cycle (from design, through manufacture, disclosure, distribution and post-distribution) will cause diligent manufacturers (and their advisers, who may face liability if they are involved in breaches) to implement systems to demonstrate their compliance with the duty to act honestly, efficiently and fairly at all stages of the process. Such systems presently focus on the disclosure stage and involve significant time and cost. This cost might be expected to increase as systems are formalised at other stages of the process, more so if actual law reform is implemented to introduce statutory product suitability requirements and actionable remedies for aggrieved investors in the vein of, for example, the consumer protection provisions dealing with misleading and deceptive conduct.
A lot will turn on how the concept of product suitability becomes enshrined in legislation. As experience with the misleading and deceptive conduct provisions has shown, a broad and subjective standard could become a licence for disappointed investors to take advantage of hindsight to persuade courts to second-guess a financial product manufacturer's original assessment of suitability. A less demanding standard, such as the implied warranties of merchantable quality and fitness for purpose, might be a safer model.
The costs of complying with a new regime, and litigation resulting from it, will ultimately be borne by the consumers. The ultimate question will be whether that is a fair price to pay for a system that takes some of the caveat out of emptor.