Written by Senior Regulatory Counsel Michael Mathieson
As the 'design and distribution' obligations for issuers and distributors of financial products inch closer, there is a good deal of hand-wringing taking place. Much of it concerns what a target market determination should look like. Guidance from the European Securities and Markets Authority on MiFID II provides a sense of what local issuers may be in for. But first – Treasury's proposal.
The draft legislation prepared by Treasury contemplates that a target market determination for a financial product will do two things: describe the class of people who comprise the target market for the product, and set out any 'distribution conditions' (such as a condition that the customer must have received personal advice about the product before they acquire it).
Target market determinations will have to be 'appropriate'. Specifically, a determination must be such that it would be reasonable to conclude that, if the product were issued or sold to people in the target market in accordance with the distribution conditions, 'the product would generally meet the likely objectives, financial situations and needs of the persons in the target market'. Treasury has been informed that this test does not work well, and that the section should turn, instead, on whether the product 'would be likely to be consistent with' the matters referred to.
Leaving aside the basic requirements outlined above, the contents of a target market determination are not prescribed. This leaves many people uncomfortable, and it is not just lawyers yearning for a precedent. What if two Australian fund managers, each operating an unlisted, unleveraged, passively-managed fund invested in domestic equities, were to produce significantly different target market determinations?
Australia is a follower, not a leader, in many areas of financial regulation, and this is certainly true when it comes to product design and distribution. One benefit of this rather ovine approach is that you get to see what others are doing (and then you go ahead and do it yourself, irrespective of the merits). This takes me to some guidance issued by ESMA on MiFID II in June last year.
Those engaged in hand-wringing over the design and distribution obligations are unlikely to take much comfort from ESMA's guidance.
ESMA says issuers should use at least five factors in describing a target market. They are:
- Client type, using the MiFID II client categorisation of 'retail client', 'professional client' and/or 'eligible counterparty'.
- Knowledge and experience, with ESMA providing examples of a knowledge description ('for structured products with complicated return profiles, firms could specify that target investors should have knowledge of how this type of product works and the likely outcomes from the product') and an experience description ('a time period for which clients should have been active in the financial markets') and an acknowledgement that knowledge and experience are, to some extent, substitutable ('an investor with limited or no experience could be a valid target client if they compensate missing experience with extensive knowledge').
- Ability to bear losses, specifying the percentage of losses target clients should be able and willing to absorb (eg 'from minor losses to total loss'), along with any additional payment obligations that might exceed the amount invested (eg margin calls).
- Risk tolerance and risk/reward profile, with 'basic risk-attitudes' to be categorised (eg 'risk oriented or speculative', 'balanced', 'conservative') and clearly described.
- Objectives and needs, with ESMA suggesting that 'reference could be made to the expected investment horizon (number of years the investment is to be held)' and that 'a product may be designed to meet the needs of a specific age demographic, to achieve tax efficiency based on clients' country of tax residence, or be designed with special product features to achieve specific investment objectives such as 'currency protection', 'green investment', 'ethical investment', etc, as relevant'.
ESMA says the target market should be identified in more detail for 'more complicated products, such as structured products with complicated return profiles', while less detail is needed for 'simpler, more common products'.
But wait, there's more. MiFID II requires not just 'positive' target market identification but also 'negative' target market identification. My favourite line in ESMA's guidance is this: 'a firm could define the negative target market by stating that the product or service is incompatible for any client outside the positive target market'. For those who are unaware, ESMA is headquartered in Paris and this statement could perhaps be explained as the result of too much wine or too much Derrida.
For those still insisting on a precedent, ESMA provides some example target market descriptions at the end of its paper. There is a rather lengthy example for a structured product. However, I have set out the slightly shorter example for a 'non-complex' managed fund (ie a UCITS). As you read it, I urge you to ask yourself whether you think this is likely to leave the average member of the public any the wiser.
Here is ESMA's example:
The type of clients to whom the product is targeted
- Type of clients: given the nature of non-complex UCITS funds: retail, professional clients and eligible counterparties
- Clients' knowledge and experience: clients with basic capital markets knowledge or experience (about funds' and bonds' characteristics and risks)
- Clients' financial situation with a focus on the ability to bear losses: clients that can bear a [x]% capital loss
- Clients' risk tolerance and compatibility of the risk/reward profile of the product with the target market: due to the volatility of the bond market, the product has an [x] risk & reward profile and is therefore compatible with clients' need to have a low to medium risk tolerance. They should be willing to accept price fluctuations in exchange for the opportunity of possible higher returns
- Clients' objectives and needs: depending on the duration of the product, the UCITS may be suitable for clients who seek capital growth and have a medium-term investment horizon (at least three years)
- Clients who should not invest (the 'negative-target market'): this product is deemed incompatible for clients which:
- require full capital protection and / or seeking on-demand full repayment of the amounts invested
- are fully risk averse/have no risk tolerance
I do like 'fully risk averse'. I suspect someone who is 'fully risk averse' will not reach the end of the description.