CPD: Ethics and design and distribution obligations

13 Sep 2021

From AdviserVoice - This series of Ethics CPD is proudly brought to you by GSFM

As regulatory requirements change or are introduced, advisers need to be cognisant of the intersection between those requirements and FASEA’s Code of Ethics.

The Design and Distribution Obligations (DDO) legislation, as detailed in ASIC’s Regulatory Guide 274 Product Design and Distribution Obligations, comes into effect on 5 October 2021. This article, proudly sponsored by GSFM, examines how ethics (and FASEA’s Code of Ethics) intersect with DDO obligations.

The Treasury Laws Amendment (Design and Distribution Obligations and Product intervention Powers) Act 2019 (Cth) introduced the DDO to Chapter 7 of the Corporations Act 2001. RG 274 provides a detailed and comprehensive summary of ASIC’s expectations placed on issuers and distributors of financial products under this new regime^[1].

The introduction of a new piece of legislation that adds to the compliance burden on financial advisers and licensees was undoubtedly met with a collective rolling of eyes. The DDO legislation also impacts product providers – including platforms – which may also affect some licensees that develop and distribute their own investment or administrative products.

Alongside DDO sits the Product Intervention Powers (PIP), which aim to ensure product manufacturers design products that protect consumers by being ‘fit for purpose’. In other words, products that prioritise customer needs and best interests.

The DDO and PIP regulations have been developed in response to a plethora of situations where consumers were not adequately informed, where a product did not meet their needs and where their best interests were not considered. RG274 is in response to the 2014 Financial System Inquiry (FSI), which concluded that poor product design and distribution played a significant role in contributing to consumer detriment.

The FSI recognised that variable quality of design and distribution controls impact consumers and recommended the introduction of the design and distribution obligations to place additional responsibility for consumer outcomes on Issuers and Distributors.

RG274 repeatedly references the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry when describing elements of DDO, an event that also led to the introduction of FASEA’s Code of Ethics and its twelve standards.

The brave new world of DDO

How DDO intersects with ethical obligations

DDO is intended to help consumers get access to appropriate financial products. It requires Issuers and Distributors to take a consumer-centric approach to the design and distribution of products, in particular^[2]:

Issuers must design financial products that are likely to be consistent with the likely objectives, financial situation and needs of the consumers for whom they are intended.

Although product Issuers aren’t bound to abide by FASEA’s Code of Ethics (the Code), by designing products that are ‘likely to be consistent with the objectives, financial situation and needs’ of investors should help advisers act in their clients’ best interests. This underpins standards one, two and nine of the Code.

This will also assist advisers to uphold standard five, the requirement to ensure their client understands the recommendations made, the benefits of holding the recommended financial product, as well as the costs and risks involved in acquiring, holding and disposing of the recommended products.

As well as requiring advisers to act in each client’s best interests, the Code of Ethics also requires that all financial product advice is offered in good faith and with competence (standard nine); products that are true to label and consistent with the likely objectives, financial situation and needs of consumers will help advisers meet this requirement.

Issuers and Distributors must take ‘reasonable steps’ that are reasonably likely to result in financial products reaching consumers in the target market defined by the Issuer.

Section 961B of the Corporations Act 2001 requires that advisers not only act in each client’s best interests, it requires advisers to ‘know their client’. While Issuers cannot know the client, the information an Issuer provides to advisers (or Distributors) is designed to help ensure that appropriate financial product recommendations are made to consumers.

This supports advisers to meet the first standard in the Code, that which requires them to comply with their legal obligations, which from 5 October 2021 will include complying with DDO requirements. It also aids compliance with those standards concerned with client best interests (two and nine) as well as standard five.

Standard six requires advisers to consider the broad effects of the client acting on their advice; these effects are not limited to effects on the client but may include implications for other family members of the client. These ‘reasonable steps’ will assist advisers to meet the requirements of this standard.

Issuers must monitor consumer outcomes and review products to ensure that consumers are receiving products that are likely to be consistent with their likely objectives, financial situation and needs.

Such ongoing product review will assist advisers deliver product to their clients that are likely to be consistent with their objectives, financial situation and needs. This, in turn, will help advisers comply with relevant standards in the Code.

According to RG 274, 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

By taking ‘reasonable steps’, advisers will also comply with their obligations under the Code to know their client and act in their best interests (standards one, two and nine), to clearly explain the benefits of the financial product (standard five) and understand the broad implications of their client acting on the product advice (standard six).

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

By providing feedback to Issuers, advisers can improve the likelihood that ongoing financial product recommendations will meet the standards required of them.

ASIC and RG274 require that Issuers and Distributors adopt a consumer-centric approach, placing consumer outcomes central to product design and distribution, as well as the monitoring and review stages of the product life cycle.

Who’s affected by DDO?

As detailed in RG274, two groups are the subject of DDO^[2].

Issuers include persons who:

issue a financial product
must prepare a disclosure document under the Corporations Act 2001.

At the design stage, Issuers must design financial products that are likely to be consistent with the objectives, financial situation and needs of the intended consumers. They are required to make a target market determination (TMD) publicly available.

While most Issuers will be external to the advice practice, there are licensees that offer their own financial products, whether investment or administrative (IDPS). Issuer requirements apply equally to such licensees.

Distributors means regulated persons, including:

AFS licensees
authorised representatives
credit licensees
credit representatives.

RG274 describes distribution as:

Distribution means ‘retail product distribution conduct’ in relation to a consumer, comprising:

dealing in the financial product
providing a disclosure document in relation to offering a financial product
providing a PDS
providing financial product advice.

At the distribution stage, Issuers and Distributors must take ‘reasonable steps’ that are reasonably likely to ensure that consumers are receiving products likely to be consistent with their objectives, financial situation and needs. Issuers must monitor consumer outcomes and review their products and TMD to facilitate these outcomes.

Providing personal advice or distribution that involves implementation of personal advice is ‘excluded conduct’ and there are DDO exemptions and exclusions that apply to excluded conduct.

What products fall under DDO?

Not all products are swept up by the DDO regulations; generally it’s those products that require disclosure documents, such as a prospectus or PDS that are subject to the DDO regime. However, as detailed in figure one, certain other products are also subject to the DDO requirements.

The target market determination

One of the key instruments to reinforce the suitability of products for specific client categories is the Target Market Determination (TMD). Its purpose is to ensure that Issuers design products for which an appropriate target market can be defined and is intended to help Distributors understand which clients the product is most appropriate for.

Issuers will be required to make a TMD for each financial product they offer that is included in the DDO regime. A TMD must be made in writing, must be publicly available and free of charge. As a minimum, a TMD must specify^[2]:

the class of retail clients that comprise the target market for the product
any conditions and restrictions on distribution of the product
the event and circumstances that would suggest the TMD is no longer appropriate (review triggers)
the maximum review period for the TMD
the complaints reporting period
the information required to determine that the TMD is no longer appropriate, who should provide that information to the Issuer and when it should be provided.

It is also recommended that a TMD include:

identification of the ‘negative target market’, or, in other words, those consumers for whom the product is not considered suitable^[3].

Issuers also need to take ‘reasonable steps’ that result in distribution consistent with the TMD.

The TMD will help advisers, particularly those providing product advice that is general and not personal advice, comply with the Code of Ethics. In particular:

Issuers will also be required to:

report any ‘significant dealings’ they’re aware of that are outside of the TMD to ASIC
regularly review their TMDs for appropriateness, and where appropriate, modify their product – or TMD – based on intel received from Distributors and other sources
maintain records as per the DDO requirements.

Distributors will be required to:

assess whether a client is within the target market
make enquiries about the client’s objectives, financial situation and needs, or any other information gathered solely for the purposes of assessing whether a client is within the target market
report any ‘significant dealings’ in the product to consumers falling outside the defined TMD.

It’s important to understand that a TMD is not set and forget. It’s a dynamic document that will evolve over time. Distributors will need a system for keeping up-to-date with the TMDs of the products they use regularly.

Distributors and DDO obligations

Under DDO, ASIC requires distributors to not distribute a product without a TMD, take ‘reasonable steps’ to ensure that the distribution of a product is in accordance with its TMD, to notify the issuer of ‘significant dealings’ and keep appropriate records (figure three).

Let’s examine these obligations in greater detail and within the framework of FASEA’s Code of Ethics.

Not to distribute a product unless a TMD has been made

Unless a financial product is an ‘excluded product’ (see figure one) or is engaging in ‘excluded conduct’ (personal advice), advisers cannot distribute that product. To do so would be a potential breach of the following FASEA standards:

Take reasonable steps in relation to distribution

Under DDO, Distributors are required to take ‘reasonable steps’ to ensure that the distribution of a product is in accordance with the TMD. ASIC has not quantified the substance or form of these steps, however, it is likely that they will take the form of a series of questions designed to evaluate the extent to which the customer falls within the defined target group.

When determining ‘reasonable steps’, ASIC suggests the Distributor must consider:

The circumstances of the interaction, including how the interaction takes place (online, in person, over the phone) and any information or advice provided to the consumer about the specific product before this interaction.
The nature and degree of harm that might result from the product being acquired by the consumer.
The steps that can be taken to eliminate or minimise the likelihood of harm.

Those advisers who do not take ‘reasonable steps’ in relation to the TMD may be in breach of the following ethical standards:

Notify the issuer of ‘significant dealings’

If a Distributor becomes aware of ‘significant dealings’ in a specific financial product, and that dealing isn’t consistent with the product’s TMD, the Distributor is required to notify the Issuer as soon as practicable…but at least within 10 business days.

Product issuers (including platforms) also have obligations to meet, including ‘significant dealing’ reporting obligations. As a result, Issuers may require advisers prove each client has received personal advice in relation to the financial product recommendation and that this advice is consistent with the Issuer’s stated TMD. If there’s an inconsistency, the product Issuer may need more information to understand 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.

Those advisers who do not notify the issuer of ‘significant dealings’ as described above may risk breaching the following ethical standards:

Keep records

Record keeping is one of the substantial imposts of the DDO requirements and relates to situations where both general and personal advice is provided to clients. As well as reporting ‘significant dealings, under DDO, Distributors are also required 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.

Those advisers who do not keep records and notify the issuer product complaints (including nil complaints) and other information as detailed above may risk breaching the following ethical standards:

DDO and general advice

The TMD is particularly relevant where an adviser or practice provides general advice or execution only services. In these circumstances ASIC suggests the practice should potentially refine its process to ask questions that specifically enable the adviser to assess whether the client is within the TMD for the relevant financial products being distributed.

To clearly delineate general and personal advice, ASIC provides a personal advice exemption where questions are asked solely to determine whether the consumer is in a product’s target market. Advising a customer that, based on responses to those questions, they fall within the target market defined in the TMD will not, in itself, constitute personal advice^[4] (see s766B(3A)).

RG 274 notes that financial advisers who provide personal advice are not required to meet the reasonable steps obligation. However, ASIC asserts that a financial adviser should consider the TMD for a product when providing personal advice and meeting their best interests duty. This decisively links DDO and the Code of Ethics.

DDO and personal advice

Personal advice, which comprises the majority of financial advice, includes financial product advice where the adviser has considered their client’s financial objectives and personal circumstances and needs.

And while personal advice, including dealing to implement that personal advice, is ‘excluded conduct’, means that some DDO requirements do not apply, others do apply – and of those that don’t apply, some are recommended by ASIC.

Accordingly, advisers need to understand the DDO requirements for both general and personal advice. Importantly, ASIC states that a TMD “should be considered by financial planners in providing (personal) advice and meeting their best interests duty”^[5].

The following case studies are based on real complaints submitted to AFCA and/or investigated by ASIC; however the names of people and organisations have been changed, and some details altered to make them relevant in the new world of DDO. For each case study, it will be shown where the adviser has potentially breached any of the standards within FASEA’s Code of Ethics.

Case study one: General advice only

ABC Financial Planning is an execution only business and therefore provides general advice to clients. Josie and Paul approached adviser Carl to make some changes to their self-managed superannuation fund (SMSF) portfolio. They wanted to increase their exposure to global stocks and were hoping to do that via managed investments.

Carl suggested three funds – two managed funds and one exchange traded fund – that would provide a diverse international exposure for their SMSF. While Josie and Paul were within the target market as defined by the Issuer for two of the products, the third was a higher risk product and they did not meet the TMD. Despite this Carl recommended investment in the three products. He provided the couple with the TMD for each financial product, along with the disclosure documents for the unlisted funds.

Carl did not make Josie and Paul aware that they did not fall within the identified target market for the third product, nor did he note it in a register of ‘significant dealings’. Carl did not note or provide any rationale for recommending a product where the client did not fit the TMD. These actions are likely to be in contravention of the design and distribution obligations in Pt 7.8A of the Corporations Act. As a result, Carl would be likely to have breached the following FASEA standards:

Case study two: Personal advice

Jackson is a financial planner who is meeting with a new client, Max, who is aged 35. Max is an executive and wants to establish a financial plan with the objective to retire early. Jackson understands Max’s financial objectives and personal situation and is providing personal advice.

The adviser and client discuss a range of financial products that might be appropriate for Max and, as part of Max’s ‘due diligence’, Jackson provides him with the relevant PDS and TMD for each recommended product and explains the purpose of the documentation.

Although Jackson may not have been required to provide the TMD for his product recommendations, in doing so, he ensures he’s meeting his best interest obligations. By taking these actions, he can be confident that he meets which of FASEA’s standards?

In theory, DDO provides an additional form of protection for consumers and ensures better outcomes in relation to their purchase of financial products. In practice, with less than two months until the new regime commences, DDO has the potential to cause confusion and create an increased regulatory burden.