Senate

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Josh Frydenberg MP)

Chapter 3 Regulatory Impact of Design and Distribution Obligations and Product Intervention Power

Outline of reforms

3.1 On 20 October 2015, as part of its response to the Financial System Inquiry (FSI), the Government agreed with the recommendation that the Government should introduce targeted and principles based product design and distribution obligations and a product intervention power. In committing to these recommendations and subsequent decisions on the details of the legislative amendment package, the Government was informed of the regulatory impacts of various reform options by the findings of the FSI and targeted consultation with industry stakeholders. ^[55]

3.2 The Australian Government Guide to Regulation identifies seven questions that a Regulatory Impact Statement (RIS) should address. The following is the analysis of these questions that occurred as part of the FSI and stakeholder consultation process.

Consultation

3.3 The FSI received over 180 submissions, complemented by extensive stakeholder engagement through meetings and roundtables.

3.4 A range of relevant industry and consumer group stakeholders have participated in the consultation process. The December 2016 consultation paper and December 2017 exposure draft each received 38 submissions, four of which were confidential. The July 2018 exposure draft received 34 submissions, four of which were confidential.

3.5 Treasury also met with key industry stakeholders and consumer groups as a part of these consultation processes.

3.6 As a result of these consultation processes, the regulation impact costing for the design and distribution obligations was adjusted to reflect stakeholder feedback on the expected system changes and number of affected businesses; and policy changes were made to allow the desired outcomes to be achieved in a more efficient manner.

Design and distribution obligations

The problem

3.7 The FSI found that the existing regulatory framework governing financial products relies heavily on disclosure, financial advice and financial literacy. However, 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. Many consumers do not seek advice, and those who do may receive poor-quality advice. Many products are also distributed directly to consumers.

3.8 Such issues contributed to consumer detriment from financial investment failures, such as Storm Financial, Opes Prime, Westpoint, agribusiness schemes and unlisted debentures, which affected more than 80,000 consumers. Losses from these failures totalled more than $5 billion (or $4 billion after compensation and liquidator recoveries). Although these losses have a number of contributing causes, poor product design and distribution practices that disregarded consumer behavioural biases and information asymmetries played a significant role.

3.9 The quality of product design and distribution controls was found to be variable. The Australian Securities and Investments Commission's (ASIC) 2014 report on Regulating Complex Products observed that some consumers acquire structured products that are riskier than they realise. For example:

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insufficient information provided in the disclosure documents, advertising and seminars relating to over-the-counter contracts for difference (CFD) made it difficult for retail consumers to make informed investment decisions.

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some firms distributing hybrid securities included sales information in addition to, or inconsistent with, the information in the prospectus. This information tended to emphasise high yield while downplaying risk.

3.10 The FSI was also concerned that certain less complex add-on insurance products may not meet the needs of some consumers. For example, a 2013 ASIC report revealed that Consumer Credit Insurance (CCI) products were being bought by consumers whose situation made them ineligible to claim under the policy.

3.11 The financial services industry had already attempted to address this problem through broader risk management processes and specific initiatives. For example, the Australian Financial Markets Association (AFMA) developed product approval principles for retail structured finance products. However, they do not cover all issuers and distributors, and, in any event, are not enforceable. Government intervention is required to ensure that ASIC has the necessary toolkit to prevent consumer detriment by subjecting product issuers and distributors to more positive obligations in regard to the appropriateness of their products to the end consumer.

Policy options and net benefits

3.12 The FSI considered a range of policy options to reduce the number of consumers buying products that do not match their needs. These included:

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introducing individual appropriateness tests at point of sale for complex products; and

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implementing a new obligation through a fully self-regulatory approach by setting expectations for industry and monitoring their progress, with regulatory follow-up if progress is not made.

3.13 An individual appropriateness test requires the assessment of some of an individual's personal circumstances before making the product available to them. An individual appropriateness test, where no personal advice is provided, would introduce significant costs for issuers and distributors due to necessary changes to the sales process. Appropriateness tests are also open to manipulation. The FSI found that the objective can be achieved by taking a principles-based approach to product design and distribution that is less prescriptive.

3.14 Implementing a new obligation through a self-regulatory approach would build on the work of AFMA, relying on the financial services industry to monitor how standards are applied and taking relevant disciplinary action if required. However, experience with industry self-regulation in the financial sector suggested that improving the design and distribution of products for consumers would not be achieved by self-regulation alone.

3.15 The FSI found that past industry-led standards have not been sufficient by themselves to address serious conduct issues; for example, managing conflicts in financial advice driven by remuneration. The FSI found that, despite efforts over many years, the financial advice industry failed to improve financial advisers' conduct, leaving it unable to prevent or reduce the effect of recent serious cases of poor advice. Self-regulation alone would also fail to underscore the importance of this recommendation to improve consumer outcomes.

Agreed option

3.16 As part of its response to the FSI, the Government announced its agreement to creating targeted and principles-based financial product design and distribution obligations.

3.17 Increasing the accountability of product issuers and distributors in this way boosts consumer confidence and trust in the system. This view was supported in submissions to the FSI by many consumer groups and financial advice groups. However, industry submissions noted that many firms already have sophisticated controls in place, and regulatory intervention would increase product costs or decrease product offerings for consumers. Submissions from issuers, distributors and industry groups also raised concerns about the difficulty for product issuers in determining the suitability of products and the additional compliance cost involved with introducing new obligations. Firms believed their processes would need to be reviewed even if they already have controls in place.

3.18 Nevertheless, the FSI noted that the obligations are likely to have substantial benefits for consumers. As discussed earlier, in conjunction with other measures, product issuer and distributor obligations are intended to reduce the incidence of cases such as Opes Prime, where complex securities lending arrangements were not understood by consumers. As a result, hundreds of clients, many of whom were retail consumers, faced close to $400 million in net losses.

3.19 The FSI considered that industry concerns about implementation costs could be dealt with by ensuring the obligation builds on good practice, is principles based and is applied on a scaled basis, allowing scope for firms to adapt their existing practices. Thus, the new obligation imposes minimal costs on firms with existing good practices. Some incremental costs for industry may include client categorisation, record keeping, updating documentation and staff training, as well as monitoring changes in the external environment.

3.20 Some stakeholders suggested that a new obligation of this kind should be limited to the design and distribution of complex products. Although many of the cases of concern leading up to the FSI involve distribution of complex products to retail clients, examples of concern have also included distribution of less complex products such as add-on insurance and debentures. There were ASIC Enforceable Undertakings that raised concerns with the quality of distribution plans for credit cards. The FSI's view was that the obligations should not be restricted. As such, the obligations are broad in nature and scalable in line with the nature of the product.

3.21 This option delivers benefits to industry, including strengthening internal risk management for product design, which may mitigate future problems, as well as signalling a higher level of customer focus. This approach also avoids new, more complex and interventionist regulation in the future, promoting efficiency in the financial system overall.

3.22 A regulatory costing has been prepared, consistent with the Government's Regulatory Burden Measurement Framework.

3.23 For product issuers and distributors, implementation and ongoing costs are associated with:

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developing policies and procedures to ensure that they are complying with the new requirements;

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changing product review and distribution standards; and

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communicating with other distributors and issuers as relevant.

3.24 The costs also include updating IT systems to ensure that existing systems are compliant with requirements and that they will be able to monitor products and customers on an ongoing basis.

3.25 It is estimated that the increase in annual compliance costs for the industry as a whole will amount to $94.7 million.

Table 3.1: Regulatory burden estimate table

Product Intervention Power

The problem

3.26 The FSI identified that ASIC lacked a broad regulatory toolkit to respond effectively and in a timely way to an emerging risk of significant consumer detriment.

3.27 Australia had cases of significant consumer detriment where ASIC had exhausted its current regulatory toolkit and where there was no clear basis to take enforcement action. These include:

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Mortgage managed investment schemes (MISs), where close to 100 were frozen in the market downturn during the global financial crisis. More than 4,000 consumers received hardship relief, indicating that many did not expect an investment of this type to be illiquid.

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Unlisted debenture investments, such as Banksia Securities, where many consumers thought the products they bought were similar to bank term deposits - a much safer product than unlisted debentures. More than 1,500 consumers lost more than $100 million after recoveries. Prior to the collapses, ASIC took action to stop a number of individual pieces of marketing, but that did not correct consumers' overall impressions about the level of risk involved.

3.28 In both cases, ASIC responded to the emerging risk of significant consumer detriment by providing guidance on the nature of disclosure that should accompany these products. However, ASIC did not have power to impose such disclosure requirements, instead seeking to create an expectation on firms to provide clearer disclosure that outlined the risk and central features of the products.

3.29 There have also been cases where ASIC lacked a broad toolkit to respond effectively and in a timely way to an emerging risk of significant consumer detriment. For example, the following cases involved leveraged investment strategies that exacerbated the loss for many consumers:

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agribusiness schemes did not perform in the way that consumers were led to believe. This included schemes relying on ongoing sales to fund their operations. Many consumers did not understand the potential risk of borrowing to invest in these products. In total, more than 65,000 consumers invested and lost close to $3 billion.

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financial collapses, such as Storm Financial and Opes Prime, involved poor distribution practices. More than 3,000 consumers lost more than $1.4 billion, of which around half was recovered.

3.30 The FSI found that recent changes in technology have meant that consumers have had increasing access to complex products, which can involve complicated structures and heightened risk. These products may be difficult for consumers to understand, testing the limits of the disclosure-based regulatory regime.

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For example, some structured products have a high degree of risk, but are labelled, described and promoted in a way that suggests they have lower risk. In such cases, consumers may still not understand the risk/return trade-off or the central features of the financial product or strategy, even where they are accurately disclosed.

3.31 The FSI found that:

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although complexity does not necessarily correlate to higher risk, complex features make it particularly difficult for consumers to assess the risk and appropriate pricing of higher-risk products - ASIC found that 71 per cent of survey respondents, including industry participants, consumers and financial literacy specialists, believe that Australian consumers do not understand the risk involved with complex products;

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complex products are particularly influenced by behavioural biases - people respond automatically and unconsciously to try to simplify the decision-making process, leading to poor financial decisions.

3.32 The FSI noted, however, that the risk of consumer confusion about risk and features is not limited to complex products. Past case studies involving margin loans, mortgage schemes and debentures indicate consumers may also misunderstand less complex products and their core features and risk. Many consumers find information asymmetries or behavioural biases hard to overcome. Some current product distribution strategies also hamper understanding.

3.33 The FSI's recommendation also took into account the Senate Economics References Committee's 2014 report on ASIC's performance. The Senate Committee suggested that urgent attention should be given to providing ASIC with the necessary toolkit to prevent consumer detriment through allowing ASIC to intervene and prohibit the issue of certain products in retail markets.

Policy options and net benefits

3.34 The FSI considered a range of policy options to reduce instances of consumer detriment, including:

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introducing default products for a range of basic financial needs (for example, deposits, home and contents insurance and basic investments); and

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prohibiting the distribution of certain classes of non-mainstream products to retail clients.

3.35 Introducing default products would involve significant new powers and require considerable resources and skilled personnel. Although some areas may need default products, such as superannuation, where consumers are compelled to participate, the FSI did not believe this rationale extended to other product types. The FSI thought that widening the pool of default products may risk significantly limiting innovation and reducing competition.

3.36 In relation to prohibiting the distribution of products, some international jurisdictions have prohibited the distribution of certain classes of product to retail consumers.

3.37 Although such measures may reduce the risk of detriment, they take a broad approach and remove choice across a range of products for consumers who may understand the risk involved. For this reason, the FSI did not recommend them.

Agreed option

3.38 As part of its response to the FSI, the Government announced that it supported amending the law to provide ASIC with a product intervention power in conjunction with new design and distribution obligations for financial products. This will allow ASIC to take a more proactive approach to reducing the risk of significant detriment to consumers through more timely and targeted intervention.

3.39 This power can be used as a last resort or pre-emptive measure where there is a risk of significant detriment to a class of consumers. This power also enables intervention without a demonstrated or suspected breach of the law. However, consistent with the FSI, ASIC is held to a high level of accountability for its use, given the potential significant commercial impact of this power.

3.40 The power is not intended to address problems with pricing of retail financial products, where consumers might be paying more than expected for a particular product or where a large number of consumers have incurred a small detriment.

3.41 The FSI noted that targeted early intervention would be more effective in reducing harm to consumers than waiting until detriment has occurred. The regulator should be able to be proactive in its supervision and enforcement. Significant consumer detriment could be reduced if ASIC had the power to stop a product from being sold or, where the product had already been sold, to prevent the problem from affecting a larger group of consumers.

3.42 A regulatory costing has been prepared, consistent with the Government's Regulatory Burden Measurement Framework.

3.43 For product issuers and distributors, implementation and ongoing costs are associated with:

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changing their marketing materials for a particular product;

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infrequent instances of a product being banned; and

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changing the way products are distributed to clients.

3.44 It is not expected that the introduction of the product intervention power will result in an increase in annual compliance costs for industry. Any intervention made by ASIC as a result of it taking enforcement action will be subject to its own regulatory impact assessment.

Table 3.2: Regulatory burden estimate table

Implementation and evaluation

3.45 This Bill will introduce a targeted and principles-based product design and distribution regime and a product intervention power.

3.46 It makes amendments to legislation including the Corporations Act 2001 and the National Consumer Credit Protection Act 2009.