DDO phase 2 – adviser compliance ‘need to know’
DDO is back in the spotlight with ASIC stepping up its enforcement of DDO compliance.
From a consumer protection perspective, the Design and Distribution Obligations (DDO) regime, which came into effect in October 2021, represents one of the most significant regulatory reforms of recent years.
In the wake of ASIC’s recent review into the first year of the regime’s implementation – resulting in a ‘do better’ directive from the regulator – and with DDO-related recommendations an important plank of Michelle Levy’s QAR report, it is timely to revisit the DDO through an adviser lens.
DDO recap
Assumed by many to be a direct outcome of the Hayne Royal Commission, the origins of DDO can actually be traced as far back as the 2014 Financial Systems Inquiry (FSI).
Among the recommendations of the FSI Final Report was 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.”[1]
Although disclosure is generally regarded as one of the key pillars of financial consumer protection, there has for some time been a recognition that an over-reliance on disclosure can actually harm, rather than protect, consumers. This recognition was one of the catalysts for the game-changing DDO regime, which requires firms to take a consumer-centric approach to designing and distributing financial products.
DDO adopts an outcomes-based approach, bringing together product governance with distribution processes, to ensure financial products are fit for purpose and that they reach their intended target audience. Putting positive consumer outcomes at its heart, DDO in simple terms can be thought of as a constant, organic feedback loop, where:
- a product issuer articulates the target market the product is suitable for (via a Target Market Determination, or TMD)
- distributors (including AFSLs and their authorised representatives) provide data to issuers that help them assess whether the product design – or the definition of the target market – needs to change, and
- issuers then provide data to ASIC, for them to assess the appropriateness of products and product categories.
Adviser impacts
Although largely an intervention aimed at product manufacturers/issuers, DDO carried some serious, and potentially onerous, obligations for financial advisers. These centred around:
- the use of TMDs
- dealings outside notional target markets
- reporting of these dealings
- reporting of product related complaints, and
- reporting of other distribution data as required by the product issuer.
Reinforcing the intent of DDO to drive a better match between consumers and products is a ‘reasonable steps’ obligation, under which distributors must take reasonable steps to ensure distribution of that product is in accordance with the TMD.
While personal advice is exempt from this requirement (Best Interests Duty in essence being a proxy for this step), this exemption does not apply in general advice or execution only scenarios. The administrative burden on advisers implicit in these reporting requirements – and the associated impact on the cost to serve – was understandably condemned by many stakeholders. As a result, Michelle Levy made specific recommendations about DDO in her final QAR report. We will cover those recommendations – and the Government response – in more detail later in this article.
ASIC flags the next phase of DDO
Ahead of their 2023 report into DDO[2], explored below, ASIC were already flagging that their focus on DDO was shifting from the introductory phase (focused largely on TMDs) to the compliance phase.
In November 2022, ASIC Deputy Chair Karen Chester told Company Director magazine:
“Our regulatory focus has now shifted to compliance. Reducing the risk of harm to consumers — by bringing a DDO compliance lens across our work — is now a whole-of-ASIC priority.”[3]
Chester went on to make two more points of particular relevance to advisers. The first concerned ASIC’s intention to focus more on the way issuers were monitoring distributors to ensure they were remaining within defined target markets. Her second point was around a heightened focus on data gathered from distributors:
“It is critical that companies get their TMDs and product governance settings right and have robust and meaningful data to test and monitor these settings. Firms must collect and understand data about the outcomes of their product distribution and who their products are getting to.”
2023 ASIC review of DDO implementation
In May 2023, ASIC released Report 762 – Design and distribution obligations: Investment products[4].
Focusing their initial attention on investment products, where the potential for consumer harm was relatively higher than some other product categories, ASIC observed there was “considerable room for improvement” in issuers’ compliance with the DDO regime.
As a result of the review, ASIC noted it had issued 26 interim stop orders against 18 issuers for breaches of TMD requirements. (A stop order essentially means a product cannot be offered for sale while the order is in place).
Particular areas of concern noted in the report included:
- the use of inappropriate risk profiles in the target market (for example, stating that a high-risk product was suitable for clients with a medium risk profile) – a factor in 21 stop orders
- inappropriate investment timeframes or withdrawal needs – a factor in 18 stop orders
- defining a target market too broadly (15 stop orders)
- inappropriate or no distribution conditions and inappropriate use of a TMD template (13 stop orders), and
- inappropriate levels of portfolio allocation (10 stop orders).
ASIC summarised their findings and actions through three main ‘areas for improvement’:
- Avoid over-reliance on TMD templates: Some issuers relied on a TMD template to drive the process of determining an appropriate target market for a scheme. A template may be useful as a starting point, if used properly. However, in all cases, issuers still need to critically assess a product.
- Design products with consumers in mind: ASIC identified products with niche or unusual features where issuers had not given enough attention to designing the product with consumers in mind.
- Assess product features on ‘absolute’ basis: Some issuers developed their TMD by assessing a scheme’s features relative to peers or a benchmark. ASIC makes it clear the TMD for each scheme should be assessed on its own merits, rather than in comparison with other products or against a benchmark.
FSC revises templates in response
The FSC was specifically called out in ASIC’s report for shortcomings in the TMD templates it had created for the use of its members.
For example, their template for investment products included options for certain types of consumers to be ‘potentially’ included in the target market. ASIC noted:
“‘Potentially’ including consumers in the target market can lead to uncertainty about who is in or outside it and is likely to result in a TMD failing to meet the appropriateness requirements. For example, an issuer that is unlikely to have any funds to pay distributions in the short term should not have consumers seeking income as ‘potentially’ in the target market.”
In response, the FSC announced in June 2023 that it had revised its templates[5].
DDO and QAR
The operation of the DDO regime and its impact on advisers was an area of considerable focus for Michelle Levy in her QAR Final Report[6].
From the very first consultations with stakeholders, advisers had made clear the extent to which it had created a burden which they were passing onto consumers:
“Financial advisers have told us that the design and distribution obligation reporting requirements are onerous and add an additional compliance burden and expense to the conduct of their practices.”
Levy had previously noted in her Proposals Paper[7], issued earlier in the review process, that two reporting requirements in particular were problematic:
- the requirement for distributors to notify the issuer of matters specified in the TMD, which effectively allows issuers to impose legal obligations on financial advisers (and other distributors) ‘at will’, and
- reporting of significant dealings outside the target market, which she felt provided little value to issuers or consumers, given the DDO regime specifically acknowledges and permits a financial adviser to recommend a financial product to a client who is outside the target market for the product.
In the QAR Final Report, Levy went on to make two specific recommendations relating to DDO, shown below.
Recommendation 12.1 – DDO (Distribution Requirements)
Amend the DDO distribution obligations in the Corporations Act to limit the exception to the requirement to take reasonable steps to ensure the distribution of a financial product is consistent with its target market to personal advice provided by relevant providers.
Where personal advice is provided by someone who is not a relevant provider, the AFS licensee should, like any other distributor, be required to comply with the distribution obligations and take reasonable steps to ensure the financial product is only recommended in accordance with the target market determination.
The objective of this recommendation is to ensure that, where personal advice is provided by a person who is not a financial adviser, financial products are distributed to consumers within the target market for the product.
Recommendation 12.2 – DDO (Reporting Requirements)
Amend the DDO reporting requirements in the Corporations Act to remove the requirement for relevant providers to:
- report significant dealings outside the target market to the product issuer
- comply with the additional reporting obligations specified by the product issuer in the target market determination, and
- report to the product issuer where there have been no complaints during the specified reporting period.
These exceptions will not apply to someone who is not a relevant provider.
All providers of personal advice (including relevant providers) will need to report the number of complaints received during a reporting period (if there have been any), as well as a description of the nature of these complaints to the product issuer.
The objective of this recommendation is to ensure that the reporting obligations under the DDO regime are appropriate for relevant providers and do not impose an unwarranted compliance burden.
The government responds with ‘Delivering Better Financial Outcomes’ package
In May 2023, the Federal Government issued its formal response to QAR, in the shape of its ‘Delivering Better Financial Outcomes’ reform package[8].
While the Government accepted 14 of Levy’s 22 Recommendations in full, or in principle, Recommendations 12.1 and 12.2 were referred for further consultation, along with:
- Introduction of a ‘good advice’ duty to replace the existing best interests duty (Recommendation 4).
- Broadening the definition of personal advice (Recommendation 1).
- Removal of the general advice warning (Recommendation 2).
- Allowing non-relevant providers to provide personal advice (Recommendation 3).
The consultation process, which will operate alongside the review of the FASEA Code of Ethics, is expected to conclude by the end of 2023[9].
Where does that leave financial advisers?
The deferral of Recommendations 12.1 and 12.2 means the DDO regime will continue to operate in its current form until at least the end of 2023.
The challenge for advisers in this regard is that with ASIC stepping up its enforcement of DDO compliance, product issuers will feel themselves under increased scrutiny and increased pressure to ensure watertight adherence to the obligations. Some of this pressure is likely to be referred onto distributors, including advisers.
Importantly, many experts expect ASIC’s approach to enforcing compliance with the DDO will evolve in the next 12-18 months10, focussing less on TMDs and more on the adequacy of governance processes around the product design and review process. In terms of products, ASIC has said it will prioritise those where it sees the most chance of consumer harm, including Managed Funds.
To the extent that distributor reporting is an important input into product design processes, advisers should expect issuers to be increasing, and more strictly monitoring, their reporting requirements. Issues product manufacturers are likely considering at present include:
- How they are collecting and understanding product distribution outcomes.
- What data and metrics are being used, and the timeliness of measurement.
- How they are collecting, assessing, and responding to data relating to consumer outcomes.
It is possible that some issuers may extend their requirements beyond the mandatory complaints and significant dealings data, to other data they deem relevant to their product governance processes.
For advisers offering General Advice and execution only services, extra scrutiny should also be expected in respect of the Reasonable Steps obligations, with ASIC using Report 726 to flag its concerns with the overreliance on Investor Questionnaires.
The widespread inadequacies with TMDs identified by ASIC should also put advisers on alert as to their own reliance on these documents. Although legislation does not mandate that TMDs are given to clients11 (only that they must be available on request), it is likely some advisers may be seeing these as an additional way of supporting their recommendation of a particular product. The increasing issuance of stop orders, and the concerns flagged by ASIC with templates previously issued by a major industry association, suggests advisers should tread with caution.
In conclusion
When it first came into effect in October 2021, the DDO regime represented one of the most significant financial consumer protection reforms in many years. The intent of the DDO regime is to reduce consumer harm by ensuring a better match between financial products and consumers, and whilst largely seen as matter for product manufacturers, product distributors are also central players in this matching process.
The onerous reporting burden on financial advisers associated with DDO – and their consequent impact on the cost of financial advice – have been widely condemned, a point recognised by Michelle Levy in the QAR Final Report. The widespread optimism that her recommendations to reduce the DDO burden on advisers – without compromising consumer protections – would be accepted, were dashed when the Government released its formal response.
Whilst Levy’s recommendations have not been rejected outright, but rather are subject to further consultation, the resulting state of limbo actually creates more challenges for advisers, as it comes against a backdrop of ASIC stepping up its enforcement of DDO.
For the time being, this is likely to see product issuers under increased pressure and scrutiny, some of which may well be referred onto advisers in the form of more onerous and more strictly monitored reporting requirements.
