CPD: When disclosure harms, rather than protects, consumers – an adviser guide to DDO compliance

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Financial disclosure regimes can unintentionally harm those they are designed to protect.

Whilst the Hayne Royal Commission undoubtedly put a wrecking ball through most rooms in the financial services house, it is worth remembering that some walls were already crumbling long before that particular show hit town.

The reliance on disclosure as a central pillar of financial consumer protection, for example, had already been seriously questioned for some time, and came under particular scrutiny during the 2014 Financial System Inquiry. The Inquiry’s Report concluded that:

“Disclosure can be ineffective for a number of reasons, including consumer disengagement, complexity of documents and products, behavioural biases, misaligned interests and low financial literacy.[1]

The Inquiry made several specific recommendations relating to disclosure, discussed in more detail below, and prompted several follow-up reports, including ASIC’s Report 632, Disclosure: why it shouldn’t be the default[2]. This report examined in more detail some of the major shortcomings previously identified in financial disclosure regimes.

The world is complex and so are people

One of the central assumptions on which disclosure – as a consumer protection – has traditionally been premised is the idea that correcting information asymmetries between buyer and seller will allow buyers to make optimal choices. Unfortunately, this assumption is at odds with the extensive body of work that exists around consumer choice behaviour.

Research by behavioural economist Pete Lunn and colleagues[3] found that, once we need to take more than two or three factors into account, our ability to differentiate good and bad deals decreases alarmingly. Their research found that even those with high levels of numeracy and education struggled to consider more than three product attributes.

As humans, we are emotionally complex, and we each react to different situations in different ways. This in itself represents a challenge to the virtue of a ‘one size fits all’ approach to disclosure.

Research quoted in ASIC Report 632 found that some consumers, for example, increase their trust in a salesperson who has made a disclosure, in effect rewarding that salesperson for their ‘candour’[4]. Conversely, a 2012 consumer behaviour study[5] concluded that whilst disclosure can decrease a customer’s trust in the advice being given, it can also increase pressure to comply with that advice if the customer feels obliged to satisfy their advisers’ personal interests or are afraid to signal their distrust of the adviser. In this sense, disclosure can actually burden those it is meant to protect

Relying on disclosure as a consumer protection can backfire

Whilst advisers and licensees don’t intentionally act in a way which is contrary to consumer interests, there are pitfalls in treating disclosure as an ironclad proxy for doing the right thing by customers.

In Australia, the distinction between ‘personal advice’ (which triggers a number of important consumer protection obligations) and ‘general advice’ (which affords minimal protection to consumers) is an important one. A common aspect of the sales process for many direct-to-consumer financial products – and in some financial advice scenarios – is the ‘general advice warning’. But despite its ubiquity, there are dangers for both buyers and sellers who rely on such a warning. This was underlined by ASIC research[6] which found:

  • most consumers do not understand the limitations of general advice despite the general advice warning
  • more than one third (38%) of participants incorrectly thought that the adviser had a responsibility to consider the consumers’ financial circumstances
  • almost one third (31%) of participants incorrectly thought that the adviser had a responsibility to consider the consumer’s financial goals
  • less than half (41%) of research participants understood the limitations and most did not indicate that they would take steps to check whether the advice was appropriate for them.

Does the SOA really protect consumers?

Is there any better (worse?) example of disclosure working against consumer interests than the humble SOA?

Despite being the primary document that formally addresses a client’s most important dreams, goals and concerns, and which includes recommendations and action plans for achieving those goals, the truth is SOAs are rarely read – let alone understood – by clients. Indeed, a recent industry panel discussion concluded that SOAs have become “big, alienating, and defensive documents that are more likely to increase the anxiety of consumers who are accessing advice for the first time”[7].

FSI and the genesis of DDO – protecting customers complexity and harm

From a consumer protection perspective, the 2014 FSI Report contained a number of important recommendations.

One, which has yet to be meaningfully implemented, relates to finding more innovative ways to communicate disclosures to consumers:

FSI Recommendation 23: Government should amend the law to remove regulatory impediments to innovative communication of product disclosure information, such as the use of online communication tools, new media, self-assessment tools and videos.”[8]

Another recommendation, designed to shift some of the disclosure burden from the point of sale, and back on to the product issuer, related to product appropriateness. This recommendation was heavily influenced by product governance regulations which now apply in several overseas jurisdictions, including the European Markets in Financial Instruments Directive (MiFID II)9.

FSI Recommendation 21: Government should amend the law to introduce a principles-based product design and distribution obligation. The obligation would require product issuers and distributors to consider a range of factors when designing products and distribution strategies.[8]

In this recommendation lies the genesis of the Design and Distribution Obligations (DDO) legislation, embodied in ASIC’s Regulatory Guide 274 Product Design and Distribution Obligations[10], and effective from 5 October 2021.

Whilst the emphasis of DDO, and the associated Product Intervention Powers (PIP) is to ensure product manufacturers (including platforms) are designing products that protect consumers by being ‘fit for purpose’ – by putting customer needs at the heart of product design – product distributors are also impacted.

From a practical perspective, DDO has the potential to reshape both adviser relationships (with clients and product issuers) and advice processes.

Products covered under DDO

DDO extends to a wide range of financial products sold to retail customers, including managed investment schemes, life & general insurance, listed and exchange-traded offerings, superannuation (excluding MySuper offerings) and many credit products. As a rule of thumb, if the product needs a PDS, or some sort of disclosure, then it is likely to be captured. Note that DDO does not apply to products issued to wholesale investors, or to issues of fully paid ordinary shares (unless they are intended to convert to preference shares within 12 months or are shares in an investment company[11]). 

Bang on target

The central concept underpinning DDO is that of the Target Market.

Product issuers are obliged to identify a target market, and design products suitable for that target market.

Issuers and distributors must:

  • take ‘reasonable steps’ to ensure those products reach consumers in that target market; and
  • monitor consumer outcomes and, in turn, trigger the review of products by issuers to ensure that consumers are receiving products that align to their objectives, financial situation and needs.

The Target Market Determination (TMD)

One of the key instruments in reinforcing suitability of products for specific classes of customers is the Target Market Determination (TMD).

Under DDO, product issuers will be required to make publicly available a TMD for each product (although it is not mandatory to give the TMD to clients).

The TMD will describe the typical objectives, financial situation and needs of consumers in the target market, describe the product features, and explain why those features are likely to meet consumers’ needs. The TMD will generally also articulate time horizon, risk level, and other relevant suitability criteria.

Although not mandatory, ASIC have suggested it may also be helpful – and provide an additional level of consumer protection – if TMDs identify the ‘negative target market’ – those consumers for whom the product is not deemed suitable[12].

Distributors will be obliged to report any ‘significant dealings’ in the product to consumers falling outside the defined Target Market. To facilitate this, the TMD must also define what constitutes a ‘significant dealing’. RG 274 does not define ‘significant’ (nor does the Corporations Act) and recognises that its meaning is likely to vary between product types and issuers, depending on:

  1. the actual or potential risk of harm to a consumer including any financial loss
  2. the nature and extent of inconsistency (for example, two ambers and one green assessment versus three red)
  3. with insurance products, some consideration of premiums or gross income
  4. the time period during which these dealings took place.

The TMD will also specify any events that suggest the TMD is no longer appropriate – known as ‘review triggers’ – along with the normal schedule of TMD reviews.

Importantly for distributors, the TMD will also specify when the distributor should provide information about the numbers of complaints to the issuer; and what information distributor(s) must report to the issuer and how frequently, in order to enable the issuer to identify whether the TMD may no longer be appropriate.

It is these data collection and reporting obligations that represent the biggest practical impact of DDO on financial advisers, and this will be explored in more detail below.

TMD Format

Whilst ASIC does not specify the exact format of a TMD, the Financial Services Council (FSC) has been advocating for the adoption of standardised templates across the industry, to help streamline the product comparison process. They have made more than a dozen templates[13] – across many product categories – available to their members free of charge (and available to be licensed by non-members).

How granular will TMDs be?

It remains to be seen just how granular TMDs will be. Certainly, a more narrowly defined target group may represent more robust consumer protection, but could be problematic if it denies customers access to a product and increases the compliance risk to advisers who choose to recommend the product to customers outside this defined group. Anecdotal comments reported in the media[14] suggest some issuers may err on the side of vague, which does, to extent, bring into question how effective this reform will be.

Where DDO, general advice and personal advice intersect

Under DDO, distributors are required to take ‘reasonable steps’ to ensure that the distribution of a product is in accordance with the TMD. Whilst ASIC does not specify what these steps are, they will likely be enshrined in a series of questions designed to quantify the extent to which the customer falls within the defined target group.

Practices engaging in ‘general advice’ or execution only arrangements, should consider whether to refine their process to ask consumers more direct questions to enable an assessment of whether the client is within the TMD.

To the extent that this process could be seen as gathering personal information, it should be noted that ASIC provides a personal advice exemption where questions have been asked purely for the purpose of determining whether the consumer is in the target market. Similarly, telling customers that – based on their responses – they fall within the target market defined in a TMD will not, in itself, constitute personal advice.

Furthermore, whilst ASIC maintains that a financial adviser should consider the TMD for a product when providing personal advice and meeting their best interests duty, and whilst licensees must take reasonable steps to ensure products are aligned with client segments, RG 274 also notes that financial advisers providing personal advice are not required to meet the reasonable steps obligation under DDO[15].

Reporting obligations – the sting in the tail for advisers and licensees

Distributors are required under DDO to report to issuers:

  • whether it received complaints about the product during a reporting period and if so, the number of complaints received
  • information of the kind specified by the issuer in the TMD that was acquired by the distributor during a reporting period
  • significant dealings in the product that are inconsistent with the TMD.

In order to meet their own obligations, product issuers may require advisers to attest that the client has received personal advice in relation to the product recommendation and that the advice is current and consistent with the issuer’s stated TMD.

In the event of any inconsistencies, (i.e., where a product is recommended to a client not meeting the target market definition in the TMD), the product issuer may require further details to explain why the adviser believes the product is still suitable. This will be required to meet the ‘significant dealing’ reporting obligations for both product issuers and distributors.

Distributors, including advisers, will have a requirement to report significant dealings to product issuers within 10 business days of becoming aware of them. Issuers will form an aggregate view based on data from all distributors and will decide whether to report those dealings to ASIC.

Keeping track of complaints – upping the ante

Under DDO, both advisers and their licensees are required to report complaints to product issuers in writing during the reporting period specified within the TMD. Even if no complaints are received, a ‘nil’ complaints report is still required.

Maintaining a good complaints register will therefore become critical for advisers. It need not be sophisticated (a simple spreadsheet may suffice), but advisers should ensure they have a process for centralising records and documenting details of all complaints, including when the complaint was received, the context, whether it’s in relation to the product or advice and the resolution or steps taken to address the complaint. This will ensure quick, easy access to complaints records when they are requested by issuers and/or your licensee.

TMD attestation and significant dealings

Advisers will be required to attest that they received a TMD and will also need to record client assessments made against that TMD (including cases where the client fell outside the defined target). An important consideration is therefore how/where to maintain this record. In the SOA, for example, or in some other database?

Time to review the APL?

Some Licensees may choose to review their APL in light of DDO, seeking to identify any products offered to clients falling outside TMD specified groups, and whether the advice process sufficiently mitigates any risk of harm to these consumers

A brief word about PIP

Although the DDO requirements are, understandably, receiving most of the headlines, it should be remembered that DDO is essentially a double act, supported by the accompanying Product Intervention Powers (PIP) given to ASIC.

PIP commenced on 6 April 2019[16] and is intended to empower ASIC to proactively protect retail clients from detriment resulting from their use of financial products. ASIC released Regulatory Guide 272 ‘Product Intervention Power’ on 17 June 2020 which provides guidance on how this power operates. In essence it could see products and product classes withdrawn from the market, either temporarily or permanently. Decisions to invoke such powers will be influenced heavily by the observed market experience of products under the DDO regime.

 

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References
[1] https://treasury.gov.au/publication/c2014-fsi-final-report
[2] https://asic.gov.au/regulatory-resources/find-a-document/reports/rep-632-disclosure-why-it-shouldn-t-be-the-default/
[3] P Lunn, M Bohacek, J Somerville, AN Choisdealbha & F McGowan, PRICE Lab: An investigation of consumers’ capabilities with complex products, report, Economic & Social Research Institute, May 2016.
[4] D de Meza, B Irlenbusch & D Reyniers, Disclosure, trust and persuasion in insurance markets (PDF 425 KB), IZA Discussion Paper No. 5060, July 2010.
[5] Cain, DM, Loewenstein, G & Moore, DA, ‘The Burden of Disclosure: increased compliance with distrusted advice’, Journal of Personality and Social Psychology 2013, Vol. 104, No. 2, 289–304.
[6] ASIC, Report 614 Financial advice: Mind the gap (REP 614), March 2019.
[7] https://www.moneymanagement.com.au/comment/30080
[8] https://treasury.gov.au/publication/c2014-fsi-final-report
[9] https://www2.deloitte.com/au/en/blog/assurance-advisory-blog/2019/ddo-implementation-learning-lessons-from-mifid-II.html
[10] https://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-274-product-design-and-distribution-obligations/
[11] https://www.herbertsmithfreehills.com/file/52166/download?token=5oe6cnWY
[12] https://www.nortonrosefulbright.com/en-au/knowledge/publications/6239b52a/product-design-and-distribution-obligations-asics-consultation-and-implications-for-fund-managers
[13] https://fsc.org.au/resources/target-market-determination-templates
[14] https://www.afr.com/chanticleer/don-t-let-fraud-kill-financial-advice-20210305-p57858
[15] https://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-274-product-design-and-distribution-obligations/
[16] https://www.finity.com.au/2020/08/14/product-intervention-power-the-smart-bomb-in-asics-arsenal

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