Design and Distribution Obligations – A Recap on Recent ASIC Reports and Scrutiny

In May this year, after an initial review of compliance by issuers of investment products with the design and distribution obligations, ASIC released Report 762: Design and distribution obligations: Investment products (Report 762) summarising its findings.

As a result of its review, ASIC issued 26 interim stop orders for breaches of the target market determination (TMD) requirements by issuers of investment products. ASIC announced its concerns that the review had found “considerable room for improvement” and called on product issuers to ‘lift their game’ in relation to their compliance with the design and distribution obligations (DDO).

Fast forward four months to today— ASIC’s scrutiny on the DDO continues, pivoting the industry’s attention from investment product issuers to issuers of retail over the counter (OTC) derivatives.  In Report 770: Design and distribution obligations: Retail OTC derivatives (Report 770) ASIC outlines its findings on the compliance with DDO by issuers of retail OTC derivatives with several concerns that echo the messages ASIC made back in May in relation to issuers of investment products.

ASIC’s issues an interim stop order against Storehouse Residential Trust

Less than a week prior to the release of its Report 770, ASIC made an interim stop order against Storehouse Residential Trust ARSN 135 182 072 (Fund or Storehouse Fund) due to “deficiencies in the target market determination”. The deficiencies related to the Fund’s TMD being too broadly defined, failing to properly consider the risks and features of the Fund, and inconsistencies within the TMD.

Specifically, ASIC is concerned that:

  • there was a “mismatch” between the investment profiles of the Fund (very high-risk) and the risk profiles of investors (and potential investors) within the target market;
  • investors seeking to hold the Fund as a core component of their portfolio were included in the target market despite the Fund has very low portfolio diversification and is of high risk;
  • the target market potentially included investors seeking capital preservation despite a material risk that Fund would result in capital loss;
  • the target market potentially included investors seeking income generation even though the Fund may not make regular income distributions; and
  • the target market included potential investors seeking access to their capital over the short term despite the Fund requiring a longer investment period and of illiquid nature.

Further, ASIC is concerned that the Fund’s distribution conditions were inadequate to ensure that the Fund would be distributed to the investors within the target market.

Unremarkably, none of the above factors which formed the basis for ASIC’s stop order are novel. These concerns were raised in Report 762 back in May and repeated in Report 770 which we will discuss further below.

The design and distribution obligations

By way of a recap, the DDO regime commenced on 5 October 2021 and was introduced to require product issuers and distributors to have a “consumer-centric approach” (RG 274.5) when designing and distributing financial products.  To comply with the DDO provisions, product issuers must:

  • prepare a TMD that satisfies the “content and appropriate requirements” in s994B(5) and s994B(8) of the Corporations Act 2001 (Cth) (Act);
  • make the TMD publicly available;
  • take reasonable steps for the financial product to be distributed to the target market which includes specifying appropriate distribution conditions;
  • review the TMD to ensure it remains appropriate including considering if changes to the financial product and its distribution are required;
  • monitor and review outcomes for consumers who have obtained the financial product including notifying ASIC of “significant dealings” that are inconsistent with the TMD ; and
  • keep records of decisions made in relation to compliance with the DDO.

The continuing challenges by issuers to satisfy the requirements by the DDO (and particularly by the “content and appropriate requirements” in s994B(5) and s994B(8) of the Act) is reflected in the findings and recurring messages from ASIC in both Report 762 and Report 770.

ASIC’s Report 762 (Design and distribution obligations): Investment products

A key message from ASIC’s Report 762 from May this year was that product issuers needed to take a more “consumer centric” approach in the design, distribution, and distribution monitoring process of their products.

An obvious step in the design and distribution process (for which one would be forgiven for underestimating the complexities of) is the process to determine a target market in which a product would be objectively considered as being “appropriate” for.

As required by the Act, a TMD for a financial product must “describe the class of retail clients that comprises the target market”— a requirement that is “central to the design and distribution obligations” (RG 274.67) yet a consistent challenge for issuers as evidenced by the basis for several interim stop orders reported by ASIC to date.

ASIC’s expectations for describing a target market

ASIC has set out its expectations for describing a target market in RG 274.67-94 and explains that to meet the “appropriateness” requirement, the issuer will need to generally set out in the TMD:

  • a description of the key objectives, financial situation and needs of consumers in the target market;
  • a description of the product, including its key attributes; and
  • an explanation of why the product is consistent with the objectives, needs and financial situation of consumers in the target market.

ASIC further outlines its expectations that issuers must describe the target market with “objective, tangible parameters and with sufficient granularity” (RG 274.69).

In Report 762, ASIC outlined that of its 26 interim stop orders made against issuers of investment products, a majority were due to product issuers failing the required factor(s) in describing (and ensuring the appropriateness of) the target market which included:

  • defining a target market too broadly (a factor in 15 stop orders);
  • inappropriate risk profiles being used in the target market (a factor in 21 stop orders);
  • including inappropriate levels of portfolio allocation in a target market (a factor in 10 stop orders); and
  • a mismatch with intended client timeframes and/or investment needs with a product’s features (a factor in 18 stop orders).

As noted, these findings which ASIC released back in May echo much of the basis for ASIC’s recent interim stop against the Storehouse Fund (above).  Considering these recurring concerns, it is worthwhile revisiting some key messages from ASIC’s Report 762.

Clearly define the target market for the product

ASIC urged issuers not to “sit on the fence” when identifying a target market, noting the use of qualified language as problematic (e.g., stating that a consumer was “potentially” in the target market).  Instead, issuers are required to be more specific and ensure “sufficient granularity to clearly delineate consumers” in a product’s target market.

Note ASIC follows up in Report 770 that this requires issuers of continuing products to “clearly assess the product and its key attributes to identify the target market by reference to consumers for whom the product is likely to be consistent with their likely objectives, financial situation and needs”.

A positive observation by ASIC in Report 770 was the practices of one retail OTC derivative issuer that used both qualitative and quantitative data as part of its TMD.  ASIC observed that the issuer reviewed its client history over previous years, the value of investments relative to total portfolio and the number of loss-making accounts (amongst several other client profiling factors). “From this, the issuer was able to refine its target market further, which enabled a clearly defined and narrow distribution strategy” (Case study 2, Report 770).

Characterising consumers of the target market

Additionally, ASIC in Report 762 called on product issuers to improve on ensuring that the objective needs, goals, and objectives of consumers in a target market align with the features and key attributes of the product.

As a starting point, this includes ensuring that the risk profile of consumers in the target market align with the risk profile of the product.  In particular, a product issuer should recognise that measuring a product’s risk requires adopting a “multi-faceted” approach (e.g., considering how a product would perform under average market conditions and under market stress).

Further, Report 762 (and as ASIC’s reasoning for its interim stop order against the Storehouse Fund also points out), product issuers are cautioned against assuming that a consumer within a target market will hold other assets as part of their portfolio to diversify their investments.  Instead, the asset allocation of a product should be assessed as if the product could be held on a standalone basis.

Additional considerations for determining the appropriateness of a TMD is the alignment of consumer’s need for liquidity, capital preservation and income needs with the attributes of the product.

Other improvement areas for investment product issuers

ASIC’s findings and recommendations were not limited to describing and ensuring the appropriateness of a TMD but also included other elements of DDO including issuers’ obligation to take reasonable steps for their product to reach consumers in the target market.  Further findings included:

  • inappropriate (e.g., consumer “self-certification”) or no distribution conditions (a message repeated again in Report 770 which we discuss further below);
  • inappropriate use of templates (e.g., lack of customisation) for preparing TMDs;
  • lack of specificity with review triggers and need for controls and systems to ensure compliance with TMDs and DDO more broadly; and
  • the need for more board involvement across all stages of a product’s life cycle and not just on a “perfunctory” basis at a product launch.

ASIC’s Report 770 (Design and distribution obligations): Retail OTC derivatives

Echoing its findings in Report 762, ASIC’s “areas for improvement” for retail OTC derivative issuers also concern the preparation of the TMD.  This includes determining the target market, which in this context is “an appropriate class of retail clients whose likely objectives, needs and financial situation align with the features and attributes offered by complex, high-risk derivatives”.  ASIC reported that this factor accounted for 9 interim stop orders and one product being withdrawn altogether from retail distribution.

ASIC also identified that retail OTC derivative issuers needed to improve on “taking reasonable steps that will, or reasonably result in the derivatives reaching consumers within the target market”, in addition to ensuring that the TMD and “product governance arrangements remain appropriate”.

Common concerns across both investment product and OTC derivative issuers

It should come as no surprise that ASIC is also urging OTC derivative issuers to more narrowly (i.e., with “sufficient granularity” (a term we observe is emphasised eight times collectively between both Reports).  ASIC noted that while nearly all TMDs it reviewed from OTC derivative issuers identified the high-risk nature of their product and generally reflected the appropriate risk profiles and consumer characteristics required, there remained a need for some TMD’s reviewed to be even more specific and provide further “detailed parameters” in describing the target market.

Further findings outlined by ASIC that are consistent with Report 762 are:

  • the objectives of the target market being inconsistent with the product’s features and risks;
  • inappropriate risk profiles for the target market, (e.g., a CFD issuer including consumers that had a medium risk tolerance and income requirement);
  • inappropriate investment allocation assumptions (due to OTC derivatives not being appropriate as a standalone or a core component of retail consumers’ portfolios);
  • mismatch in the investment timeframe of OTC derivatives and the investment timeframe required by a consumer in the target market.

In relation to OTC derivatives issuers complying with their reasonable steps obligation in distributing their products, ASIC found that (like issuers of investment products), there was an over-reliance by several CFD issuers on client questionnaires as a distribution condition.  ASIC recommends questionnaires as being a “final check” to be used only after the issuer has applied other filters and not as the primary or only method to determine if a consumer is in the target market for a product.

In Report 770, ASIC reminds issuers of their responsibility (rather than turning the onus on consumers) to implement arrangements that are likely to result in their product being distributed to consumers in the target market and cautions product issuers not to rely on consumers to self-certify as part of their distribution process.

ASIC’s ongoing focus 

Back in May ASIC’s Deputy Chair Karen Chester cautioned product issuers that a “[c]loser scrutiny of DDO is coming” and based on ASIC’s recent actions, product issuers should take heed.

The design and distribution obligations continue to remain a key focus for ASIC and based on the findings of Report 770, it is apparent that the challenges associated with preparing a TMD almost mirror across the two sectors that ASIC have put in the spotlight most recently. The recent stop order against the Storehouse Fund suggests that a key area of concern (i.e., defining a target market too broadly and failing to meet the appropriateness requirements of the TMD) continues to persist across the investment products sector despite the earlier ASIC findings and guidance in Report 762. For this reason, we anticipate that ASIC will continue to monitor these ongoing areas of concern and take the necessary regulatory action.

Please reach out if you would like our assistance with the TMD drafting process or any aspect of the DDO regime — we look forward to updating you on further ASIC findings and guidance as it is released.

For more information, please contact Erik Setio and Clarisse Berenger.