Protecting financial consumers

Consumer protection has been the common thread connecting much of the reform agenda for financial regulation in 2019. The Hayne Royal Commission shone a bright light on the shortcomings of the consumer protection aspects of a financial regulatory framework – a framework that may have been too heavily skewed towards preventing systemic risks, and preventing failure of significant financial institutions – in the shadow of the global financial crisis.

But one critical piece of consumer protection reform in the financial services industry was on the agenda before the Hayne Royal Commission. There has been little attention given to the passage of legislation to enact the Murray Inquiry’s recommendations to introduce a targeted and principles-based product design and distribution obligation and providing regulators with a proactive product intervention power.

These independent but closely-related reforms are important consumer protections which are consistent with the principles in the Hayne reforms. Indeed, the April passage of the Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Act represents a significant change to the way in which financial product issuers and distributers operate their business.

It’s not only important that financial product issuers, distributers, and advisers are aware of the new obligations and possibility of regulatory intervention, but it is a significant opportunity for them to rethink business models to take a more client-centric approach which may prove more sustainable in the long term.

INTERVENTION POWERS

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The first part of these reforms has already come into force, and ASIC has already commenced exercising powers which are intended to protect consumers by intervening to prevent significant harm to retail investors. The intervention could range from an outright ban on certain products (or methods of distribution) to a requirement that the investor receives financial advice prior to investing.

ASIC was granted powers to proactively issue product intervention orders in circumstances where it determines that a financial product presents a risk of significant detriment to retail clients. There are prescribed factors and a process concerning how ASIC must arrive at such a determination, however the reforms do provide ASIC with some discretion on what would constitute significant detriment.

Intervention would most likely take the form of placing certain conditions on the product issuer, such as requiring the retail client receive personal financial advice before the product is issued to them. This power operates independently from the design and distribution obligations and would enable ASIC to proactively intervene to protect consumers from financial harm due to inappropriate financial products being sold to them.

ASIC is however required to consult with those likely to be affected by a product intervention order prior to making it.  This process is currently underway in relation to derivative products sold to retail investors that have suffered detriment from over-the-counter (OTC) binary options and contracts for difference (CFDs). Previous ASIC research has shown that the significant majority of retail investors in these products suffered losses, prompting ASIC plans to ban and limit distribution of these products to retail investors.

These ASIC intervention orders could also impact superannuation funds. The protection of consumers from underperforming default superannuation funds has been the subject of plenty of policy discussion and debate, particularly in the form of the member outcomes obligations and the prospect of the Australian Prudential Regulation Authority (APRA) utilising its revitalised directions power to force consolidation where underperformance in entrenched.

Underperforming superannuation products are also potentially the subject to the ASIC intervention power. While underperformance is not the same standard as significant harm, superannuation trustees should remain aware of the possibility of ASIC intervention in serious cases of entrenched underperformance.

While some may see these new intervention powers as a threat to the business of product issuers and distributors, financial products which exploit consumers and cause significant financial detriment have no place in a properly functioning financial system.

DESIGN & DISTRIBUTION OBLIGATIONS

The design and distribution obligations will commence from April 2021 and will require financial product issuers and distributers to make a target market determination for most retail financial products (MySuper products are a notable carve out). Product issuers will then be required to take reasonable steps to ensure that distribution of the financial product is consistent with the target market determination.

This obligation is interesting, in that it employs the terminology of marketing theory to achieve a consumer protection. In its conventional meaning, marketing is an approach to business which seeks to supply products to satisfy market or consumer needs rather than pushing products on markets which don’t really have a need for them or exploiting consumer behaviour to artificially create the feeling of need in consumers.

It’s a consumer first approach which has similarities with older legal and equitable concepts which also offer a form of paternalistic protection, such as fiduciary duties and unconscionable conduct. These prioritise the best interests of a consumer in arrangements where information asymmetry can place consumers in a position of disadvantage – and potentially at risk of exploitation.

In practice, the design and distribution obligations will require that product issuers identify a group of consumers based on measurable attributes (such as age, level of engagement, level of income, amount of investment, or any other relevant indicator) which make the group well suited or in need of the particular product, and require that reasonable steps are taken to ensure distribution is targeted to these groups.

An example of a target market determination may be that a product issuer identifies that a choice cash investment option in a superannuation fund is designed to service the needs of a target market of investors with an investment horizon of less than five years.

The distribution conditions would be likely to prohibit activities to promote or distribute this product to younger members with investment horizons well in excess of five years. Another more interesting example could be the targeting of a direct investment option within a superannuation fund (requiring active involvement and higher levels of engagement) to members who demonstrate low levels of engagement.

Interestingly, there are also significant similarities between the design and distribution obligations and the superannuation member outcomes and business performance review obligations which commence from 1 January, 2020. Notably, both the member outcomes and design and distribution obligations require trustees or product issuers to focus on market segments or member cohorts which share some common characteristics in terms of their financial needs.

A likely impact of the design and distribution obligations on financial product issuers will be the increased need to develop and maintain better consumer profiling and analytics to ensure that target markets remain well understood. They will need to ensure that the distribution of financial products is responsibly targeted to groups of consumers well suited to the needs which the attributes of the product are designed to address.

Data has a role to play here. The further development of the API ecosystem to promote easier sharing of data between consumers and institutions, and extension of the Consumer Data Right may provide product issuers with a much richer data set on which to rely on to understand the needs of their clients and members. While the initial motive for placing an increased focus on understanding the financial needs of investors more closely might be regulatory, the commercial benefits to those who are most successful in doing so will soon become a strong incentive.

GOOD FOR CLIENTS, GOOD FOR BUSINESS

Aligning the design and distribution of financial products with the needs of individual or segments of consumers will not only be good for consumers, but good for business for product issuers who get this right.

There is an increasing acceptance that sustainable business models are built not merely on the ability to generate short term profits from markets, but rather from the ability of a business to find purpose in satisfying a need in the market efficiently and competently. This also applies to financial institutions and advisers responsible for the design and distribution of financial products.  

Jonathan Steffanoni is principal consultant, legal and risk at QMV.