Can product suitability rules succeed where disclosure has failed?

Banking Financial Services Superannuation

In brief

Written by Partner Matthew McLennan and Senior Associate Frances Dunn

One of the more interesting possibilities raised in the Interim Report of David Murray's Financial System Inquiry is the introduction of product suitability requirements as a complement to the current disclosure regime. The Interim Report presents a case for change but does not set out in detail what change might look like.

What the Interim Report says

The Financial System Inquiry's (FSI) interim report makes some blunt findings about disclosure as a regulatory tool: the disclosure documents that product issuers must prepare at great effort and expense are not necessarily helping buyers make informed decisions about their products. The interim report considers options to make disclosure more effective – through rethinking its volume, format and timing, for example. But it also raises the possibility of introducing product suitability requirements, recognizing that disclosure alone cannot solve the problem of unsuitable financial products.

The interim report flags three policy options for product suitability:

  • Subject product issuers to a range of product design requirements, such as targeted regulation of product features and distribution requirements to promote provision of suitable products to consumers.
  • Provide ASIC with additional powers such as:
    • Product intervention powers to prescribe marketing terminology for complex or more risky products.
    • A power to temporarily ban products where there is significant likelihood of detriment to consumers.
  • Consider a move towards more default products with simple features and fee structures.

In order to assess the nature and degree of the change that could flow from such options, it is useful to consider existing suitability rules and other rules that can function in the same way.

Product suitability in action

Examples of suitability rules in action can already be found in our financial system. The national credit regime includes design restrictions such as bans on certain anti-competitive exit fees, as well as distribution restrictions in the form of obligations on lenders and intermediaries to ensure the loans they offer are 'not unsuitable' for the particular client. Similarly, suitability assessments have been a mandatory part of margin lending to retail clients since 2010. In that context the Corporations Act 2001 (Cth) defines 'suitability' by reference to the client's ability to comply with a margin call without suffering substantial hardship.

MySuper is another active example of product design requirements. In order for super funds to qualify to manage the superannuation savings of disengaged Australians, their MySuper products must meet a list of strict requirements around investment risk profile, fee structure, insurance coverage and the like.

In the context of structured products, suitability requirements apply on a voluntary basis. In 2012, the Australian Financial Markets Association (AMFA) developed product approval principles which it encourages its members to apply to new structured financial products. AFMA's principles call for suitability considerations to be incorporated throughout the product development process, from initial product conception and approval through to selection and periodic review of distribution arrangements.

It is also worth noting that obligations that are, arguably, functionally equivalent to suitability requirements already apply across the board. The consumer protections under the Australian Securities and Investments Commission Act 2001 (Cth) (the ASIC Act) require a financial product to be reasonably fit for any particular purpose or desired outcome the client conveys to the distributor. The general obligation on all Australian financial services licensees to provide their services honestly and fairly could also be viewed as including an obligation to ensure the products they issue or recommend are suitable for the client.

What change might look like

The first option flagged by the interim report is to subject product issuers to a range of product design requirements. The interim report mentions 'targeted regulation of product features' and 'distribution requirements'.

In an environment in which the ASIC Act already requires financial products to be reasonably fit for purpose, the 'targeted regulation of product features' will presumably consist of some specific prescriptions. It might (like AFMA's product principles) mandate a consideration of the likely ability of a retail client to understand key elements of the proposed design. Or it might (like the margin lending rules) require issuers to investigate the particular financial circumstances of their target market and only issue the product where the issuer has determined it is suitable for the client. Alternatively, regulation could be less prescriptive and (consistent with ASIC's approach in its Report 384 Regulating complex products) instead target 'relative complexity', ie. a product whose risk profile is more likely to be misunderstood by consumers due to complexity in its structure or in the factors which may affect its performance.

As to distribution requirements, we might see, for example, product issuers being required to prepare a marketing statement that lists the classes of investor for whom the product is suitable (or unsuitable). Or issuers could be required to take into account a product's complexity and target only certain customers when deciding appropriate distribution channels (as is encouraged under AFMA's product approval principles). Perhaps a general obligation to ensure the product is suitable for the client could be imposed, on the product issuer and (where a different entity) potentially the distributor also.

More interventionist suitability rules might entail restricting the availability of a particularly complex or risky product to investors who have received personal financial advice, or else making it unavailable altogether for certain categories of investor. However, the margin lending reforms opted for a general obligation to confirm suitability instead of placing restrictions on access. While ASIC's submission to the FSI raises various types of restrictions as 'further ideas to consider', in its Report 384 and follow-up Report 400, it appears more comfortable with working with industry to develop standards, such as AFMA's product approval principles, which support the responsible selection of distribution channels for complex products.

Whatever the content of the rules, perhaps the most significant change is that new positive obligations would be imposed on product issuers, making them more vulnerable to claims by retail clients who suffer loss after acquiring their financial products. Suitability requirements would therefore go at least some way to addressing the 'apparent imbalance', which Richard St John noted in his 2012 report to Treasury on Compensation arrangements for consumers of financial products, in how the law currently allocates responsibility between product issuers and financial advisers for their retail clients' financial outcomes.

ASIC noted in its submission to the Inquiry that its UK counterpart, the FCA, now has at its disposal a more flexible regulatory toolkit that includes powers to impose conditions on the development and sale of products, or even ban their promotion altogether, for periods of up to 12 months pending a decision whether a more permanent remedy is appropriate. These powers are supplemented by a Statement of Policy which was issued following industry consultation before the powers took effect, to clarify when and how they might be exercised. By including new intervention and banning powers for ASIC among the policy options, the interim report seems amenable to an equivalent expansion of regulatory tools here. Under the FCA regime, proposed interventions are workshopped then screened by a separate committee before going to the regulator's Board for formal consideration and, if appropriate, approval. Whether new powers for ASIC would be subject to a tiered approval process such as this or take some other form, they would be a more precise and transparent regulatory tool than ASIC's current power simply to refuse to accept lodgement of a disclosure document.

The possibility of a 'move towards more default products with simple features and fee structures' is perhaps the most conceptually challenging policy option for improving consumer outcomes identified in the interim report. Both ASIC's submission and the interim report itself discuss MySuper as an example. However, a product which is relatively simple, low-risk and inexpensive is inherently well suited to the very specific policy objective MySuper is designed to meet, ie safeguarding the compulsory retirement savings of financially disengaged citizens. It is less easy to see what this would involve in the context of non-compulsory products. Perhaps, as ASIC seems to suggest in its submission, it might be a rule that optional bells and whistles on products can't be standard but require informed opt-in.

However, a fundamental difficulty remains. If the availability of poorly understood complex products is the problem which suitability measures are trying to address, then if we ban that complexity by moving to simple default products, doesn't the justification for suitability rules fall away? Shouldn't disclosure be sufficient to protect consumers from the products that are not banned? In light of the FSI's clear view that it isn't, the tail appears to be wagging the dog. It will be interesting to see whether the FSI's final report gives a clearer picture of this policy option and its rationale.

Where to from here?

Product issuers will understandably be hoping that any recommendations regarding suitability rules we see in the final FSI Report, and any legislative changes that follow, will be well justified and won't increase the expense or due diligence required to get a product to market. As David Murray recently told the National Press Club, the challenge is to develop a viable alternative to product disclosure which isn't simply more detailed rules. An alternative model based on product suitability would amount to a significant shift in policy and regulatory focus. It would also need to allocate clearly responsibility where clients suffer bad financial outcomes notwithstanding that suitability requirements were duly met. Interested parties have until 26 August to make submissions on the pros and cons of suitability requirements or indeed any other way of fixing the shortcomings of the current disclosure rules.