Design and distribution of financial products - regulating 'retail product distribution conduct'

By Michael Mathieson
Capital Markets Financial Services Government Risk & Compliance

In brief

The revised exposure draft Bill concerning design and distribution obligations for issuers and distributors of financial products, and new intervention powers for ASIC, includes some modest, yet mostly welcome, changes to the December 2017 exposure draft. Senior Regulatory Counsel Michael Mathieson reports.

A recap

As we reported last December, after a lengthy gestation period (lasting roughly one-and-a-half times as long as that of an elephant), the design, distribution and intervention measures took their first, tentative steps with the release of exposure draft legislation.  We summarised the measures in our client update at the time, available here.

Under the original exposure draft, where a PDS had to be prepared or given for a product under Part 7.9 of the Corporations Act, or where an offer of a product would need disclosure to investors under Part 6D.2, the issuer would have to make a 'target market determination'. In the absence of a target market, it would be unlawful to deal in, or provide financial product advice about, the product. Further, the maker of a target market determination would have to take reasonable steps to ensure that dealings and financial product advice by third-party distributors were 'consistent with the most recent determination'.

The original exposure draft also included a new product intervention power for ASIC. Specifically, ASIC could make a product intervention order if satisfied that a financial product had resulted in, or would be likely to result in, 'significant detriment' to retail clients. ASIC would have to consult before making a product intervention order and an order could not last for more than 18 months.

Revised exposure draft – design and distribution obligations

An electronic comparison of the revised exposure draft materials against the original exposure draft materials reveals extensive textual revisions, at least to the Bill, if not to the Explanatory Memorandum.  The revisions are so extensive as to suggest that the original effort was not quite as good as it could or should have been. However, on closer examination, the changes are not as significant as first suggested.  We identify the main changes below.

Scope of distribution activities caught

Under the original exposure draft, the distribution activities caught were: dealing in, and providing financial product advice about, a relevant product. Under the revised exposure draft, the regulated activity is 'retail product distribution conduct'. This is a defined term which makes it clear that distribution activities relating to wholesale clients are not caught (even if the activities relate to both retail clients and wholesale clients). Also, providing personal advice is largely excluded, as are dealings by way of arranging where the personal advice is implemented. However, this excluded conduct will remain subject to specific record-keeping and notification obligations. Finally, according to a note issued by Treasury, the provisions result in 'secondary sales of financial products' being excluded from the regime – which does seem to be an accurate statement, although the path through the provisions to reach that conclusion is obscure.

Target market appropriateness – the client's objectives, financial situation and needs

Under the original exposure draft, the target market determination had to be such that 'the product would generally meet the likely objectives, financial situations and needs of the persons in the target market'.  The revised exposure draft includes some subtle yet important (and welcome) refinements: under the new test, the target market determination must be such that an issue or regulated sale of the product 'would likely be consistent with the likely objectives, financial situation and needs of' a retail client in the target market. According to a note issued by Treasury, this change was 'to address concerns that the previous provision required a financial product to meet 'all' of the objectives, financial situation and needs of the target market and issuers to know individual customers'.

Ordinary shares

Under the original exposure draft, ordinary shares in Australian companies were outside the regime, unless they could be converted to preference shares or were shares in an investment company. Under the revised exposure draft, the following changes have been made: ordinary shares in Australian companies are outside the regime only if they are fully paid, not if they are partly paid; fully paid ordinary shares in foreign companies are also out; and, the qualification for convertibility to preference shares has been narrowed, so that it only applies if, on the issue of the shares, the company intended that they be converted into preference shares within 12 months after the date of issue.

Clarifications – 'merely because'

The revised exposure draft includes a number of 'clarifications'. For example, there is a provision to the effect that an issuer will not breach their distribution obligations 'merely because' a third party distributor fails to distribute products in a manner consistent with the target market determination. Another provision is to the effect that a distributor does not fail to take reasonable steps to distribute a product consistently with the applicable target market determination 'merely because' a consumer who is not in the target market acquires the product. So far as these clarifications go (which may not be very far), they are welcome.

Transition period

The original transition period (during which the obligations are suspended) would have been one year after Royal Assent for a new product, and two years after Royal Assent for an existing product. The new transition period will be two years after Royal Assent, in all cases, irrespective of whether the product is a new product or an existing product. This is simpler and sensible.

A grumble

The draft Bill includes this note: 'an example of a distribution condition for a financial product is a restriction limiting the distribution of the product to specified methods of distribution'. A note is usually included in legislation because it is explanatory.  No one could say that this proposed note is explanatory.

Revised exposure draft – product intervention power

Interventions may only be prospective

The revised exposure draft includes a welcome clarification to the effect that the new intervention power will only apply prospectively and that an intervention cannot apply in relation to a product once it has been acquired.

Consultation requirement

While ASIC must consult on a proposed intervention order before the order is made, the consultation requirements are rather, ahem, 'light touch'. This is arguably reinforced by a new provision in the exposure draft to the effect that standard consultation requirements do not apply: 'Section 17 of the Legislation Act 2003 (rule makers should consult before making legislative instruments) does not apply to the making of a product intervention order.'

Notifying retail clients of order made

If an intervention order requires someone who is subject to the order to notify retail clients of the order then they will only have to take 'reasonable steps' to notify them.