ASIC ‘Lifts Its Game' On DDO - Retirement, Superannuation & Pensions

The Design and Distribution Obligations (DDO) regime is increasingly becoming a cornerstone in ASIC's supervision and enforcement arsenal. In the latest, on 18 May 2023, ASIC announced that it had made 8 new interim stop orders preventing the issue of derivatives including contracts for difference (CFDs) to retail clients because of deficiencies in their target market determinations (TMDs). And a few weeks before that, on 3 May 2023, ASIC called on investment product issuers to 'lift their game' on DDO compliance, and released Report 762 Design and distribution obligations: Investment products (REP 762) in relation to its initial review of the compliance of investment products (including interests in managed investments schemes, listed investment company shares, preference shares and debentures) with the DDO.

DDO surveillance and enforcement is a key regulatory priority for ASIC, demonstrated through heightened ASIC scrutiny of TMDs, distribution conditions, and the 36 interim stop orders issued by ASIC to date under the DDO regime. Further, in December 2022, ASIC commenced civil penalty proceedings against American Express Australia in the first court action alleging breaches of DDO.

However, DDO continues to pose practical challenges across the superannuation, insurance, investment funds and banking sectors. In particular, the identification and articulation of target markets and appropriate distribution conditions is continuing to prove challenging for issuers of broad, mass market financial products (such as car insurance, home and contents insurance, basic superannuation products and banking/deposit products).

In this article, we examine these challenges against the backdrop of ASIC's latest announcements with respect to DDO.

ASIC Report 762

REP 762 focusses on investment products but provides important learnings across the Australian financial services market. In REP 762, ASIC considers that there is 'considerable room for improvement' on DDO compliance based on its review, which has resulted in 26 interim stop orders, 18 amended TMDs and 7 withdrawn TMDs in respect of investment products.

REP 762 identifies the following key findings:

defining a target market too broadly was a factor in 15 stop orders. For example, a target market potentially including a consumer seeking income when the product generated no to very little income;
the use of inappropriate risk profiles in the target market was a factor in 21 stop orders. For example, a TMD stating that a high risk product was appropriate for consumers with a medium risk tolerance;
including inappropriate levels of portfolio allocation in the target market was a factor in 10 stop orders. For example, a target market suggesting an investible asset allocation of up to 75% for a single, high risk product was reduced to 25% following ASIC intervention;
inappropriate intended investment timeframes or withdrawal needs in the target market were a factor in 18 stop orders. For example, a target market stating that consumers requiring 'annual or longer' withdrawal rights were in the target market despite the product not having any withdrawal rights before the end of the fixed term;
inappropriate or no distribution conditions was a factor in 13 stop orders. For example, a TMD with a very narrow target market that did not include any distribution conditions;
inappropriate use of a TMD template was a factor in 13 stop orders. For example, an issuer inappropriately relied on a pre-set asset allocation in a template of up to 25% for a single asset (which was subsequently amended to an asset allocation of 5% before the product was ultimately withdrawn). ASIC noted that issuers must always consider the individual features and risks of a product and appropriately tailor any template used, so that the target market reflects a suitable group of consumers for a product;
the use of investor questionnaires to meet issuers' reasonable steps obligations was prolific but ASIC considers that using investor questionaries alone is insufficient and should be supported by a broader governance and distribution framework; and
issuers could improve on their use of review triggers and the process undertaken to conduct a TMD review.

Defining the target market

Unsurprisingly, REP 762 focussed on ASIC's key concern regarding product issuers of investment products defining target markets too broadly. This focus on investment products follows ASIC's focus on superannuation trustees in August 2022, where ASIC stated that some superannuation trustees 'used descriptions of consumer classes that were too broad to be meaningful, e.g. 'those wishing to save for retirement''.

ASIC's focus on the breadth of the target market for a product poses a fundamental challenge for many product issuers. While ASIC's comments make sense in many scenarios (e.g. high risk investment products referenced in REP 762), certain products are, by their nature, designed for mass market suitability and consumption. For example, most home and contents insurance policies are designed to be suitable to a very broad target market, being any person who owns a home or has contents requiring protection. Similarly, there are a range of 'basic' superannuation products available in the market with investment options to suit low, medium and high risk customers – which means that in all likelihood, the relevant target market will be customers wishing to save for retirement.

We recognise that it is important to carefully define a target market, and it is essential for product issuers to consider the design of their products in the context of appropriate consumer outcomes. However, unduly narrowing a target market for simple, mass market products can cause a mismatch beyond the actual target market and the stated target market in the TMD, which heightens the risk that a product may be distributed in a manner that is not consistent with the TMD or that the distribution conditions in the TMD may not be considered adequate. In these cases, ASIC's policy rationale of seeking to narrow the target market is not immediately apparent.

Scrutiny on reasonable steps and distribution conditions

ASIC also states in REP 762 that the use of investor questionnaires to meet 'reasonable steps' obligations is insufficient and should be supported by a broader governance and distribution framework.

While ongoing governance and monitoring is required, and customer 'self-certification' as being in the target market is clearly inadequate, it is unclear what other governance ASIC is expecting in this context. Realistically, at the point of sale, there are a limited suite of options available. Beyond proactively asking questions of the customer, the product issuer or distributor can, for example:

provide additional disclosure to the customer about the target market (which ASIC has also indicated that it considers inadequate and indeed, the DDO regime was designed to move away from a mere disclosure model for consumer protection); or
prevent the customer from acquiring the product (an approach which some have adopted across the market but which is not required or mandated by the DDO regime).

This, perhaps, is where the importance of distribution conditions comes in. A key focus of ASIC's case against American Express Australia is on the lack of distribution conditions on the relevant credit cards, in line with the stated target market for each credit card. While there is an ongoing debate about the necessity of including distribution conditions from a legislative perspective (i.e. the legislation does not expressly mandate the inclusion of distribution conditions, but rather requires 'any' distribution conditions to be set out in the TMD), it is certainly the case that distribution conditions can and should form an essential element of a product issuer's 'reasonable steps' framework.

While not entirely clear from REP 762, it appears that what ASIC is ultimately saying is that DDO is about, well, product design and distribution. That is to say, DDO is not about creating TMDs and distribution conditions – it is about the process by which a product is designed and distributed, and the processes by which the product design and distribution arrangements are reviewed having regard to whether they are delivering appropriate consumer outcomes.

What are the next steps in ASIC's gameplan?

It is clear that ASIC will continue to review TMDs and take regulatory action where it considers appropriate in respect of the quality of those documents. ASIC continues to undertake targeted surveillance across the industry on DDO compliance.

However, we believe it likely that ASIC's approach to enforcing compliance with the DDO will evolve in the next 12-18 months to focus on how products are designed in the first place and the adequacy of governance processes around the product design and review process.

ASIC also states in REP 762 that it will next turn its regulatory attention to a closer examination of how entities are complying with their reasonable steps obligation. We expect this to capture both issuers and distributors, and it is likely to include a trail of regulatory action with respect to past conduct, similar to the array of stop orders we have seen against product issuers.

To anticipate queries from ASIC, we recommend that issuers and distributors consider the adequacy of their evidence to demonstrate compliance with the reasonable steps obligation (if queried by ASIC), and to make any adjustments if necessary. This includes examining, for example:

for issuers, whether there is sufficient documentation to show that reporting data is being continuously monitored and assessed for review triggers;
for issuers, the procedures for monitoring the extent to which distributors are providing reporting data and disclosing significant dealings inconsistent with the TMD;
how a significant dealing inconsistent with the TMD has been defined, and whether any such dealings have been identified;
for distributors, the adequacy of the reasonable steps framework, and whether this framework is being followed in practice. This includes an examination of how reporting data is recorded, stored and supplied to issuers; and
for issuers and distributors, the adequacy of steps taken to meet the reasonable steps obligation, including any client questionnaires.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.