The Australian Securities and Investments Commission's (ASIC) initial review of compliance by investment product issuers (eg issuers of managed investment schemes and other products) with their design and distribution obligations (DDO) - Report 762 Design and distribution obligations: Investment products (REP 762)concludes there is significant room for improvement. Our key takeaways are below.

What are DDOs?

Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Act 2019 (Cth) amended the Corporations Act 2001 (Cth) to introduce a new design and distribution obligations (DDOs) regime for financial products. The DDOs commenced in October 2021. 

Broadly, the DDOs impose requirements for: 

• product issuers to prepare a target market determination (TMD) identifying the target market for a financial product that meets the 'content' and 'appropriateness' requirements in s944B of the Corporations Act 2001 (Cth)
• product issuers and distributors to take ‘reasonable steps’ that are reasonably likely to result in financial products reaching consumers in the target market defined by the issuer
• product issuers to monitor consumer outcomes and review products to ensure products are appropriately targeted

The purpose of these requirements is to: 

'assist consumers to obtain appropriate financial products by requiring issuers and distributors to have a customer-centric approach to designing, marketing and distributing financial products'.

DDO enforcement is included in the list of ASIC's top priorities for 2023.

ASIC calls on investment product issuers to ‘lift their game’ 

As flagged, the overall message in the report is that ASIC considers there is significant scope for improvement with 'DDO deficiencies' observed 'across the board, and by large and small product issuers alike'. ASIC points to the volume of stop orders issued - 26 stop orders on investment products have been issued in nine months - in support of this.  

We recap some of the key issues identified in the report below.  

Product design and TMD development process

ASIC's review of the product design and TMD development process of the 12 issuers of managed investment schemes reviewed identified the some 'good practices': 

• process oversight: ASIC found that 'most issuers involved key senior staff in their product and TMD development process, with ultimate oversight and sign-off by the board'.
• product testing: ASIC found that some issuers performed 'stress tests' on a scheme to aid in understanding the scheme's potential outcomes under both average conditions and market stress.  
• distributor engagement: Most issuers were also found to actively engage their distributors during the product design and TMD development process. ASIC comments that:

'Distributors may provide helpful feedback that can help set a scheme’s overall distribution strategy. However, issuers should be mindful of any potential conflicts in relying on views from distributors'.  

ASIC also identifies three areas where it considers issuers of managed investment schemes could improve. Namely: 

• Addressing 'over-reliance on TMD templates': ASIC found that a number of issuers 'relied on a TMD template to drive the process of determining an appropriate target market for a scheme'. ASIC considers that 'in all cases, issuers still need to critically assess a product'.
• Consumer centric approach to design: ASIC found that some products were designed with 'niche or unusual features where issuers had not given enough attention to designing the product with consumers in mind'. 
• Assessing a scheme's features on its own merits: ASIC found that some issuers developed their TMD by assessing a scheme’s features relative to peers or a benchmark.  ASIC considers that 'the TMD for each scheme should be assessed on its own merits, rather than in comparison with other products or against a benchmark'.

Appropriateness of Target Market Determinations

The report flags a number of 'concerns' in the TMDs reviewed, based 'principally' on the issues ASIC identified in the 26 stop order actions taken to date against issuers of investment products. Broadly, these issues include the following.

Use of 'inappropriate risk profiles'

Use of 'inappropriate risk profiles' – ie where higher risk products are inappropriately targeted at consumers with lower levels of risk tolerance - appears to be the most prevalent issue ASIC identified, with this issue a factor in 21 of 26 stop orders reviewed.  

The report highlights the following as specific examples of where ASIC took action and ASIC's expectations in each case: 

• Where issuers relied on the standard risk measure (SRM) as the only measure of risk. ASIC comments that:

'Risk is multi-faceted, and the use of a single measure may be problematic. Issuers should consider all important indicators of risks that affect their product, including the drawdown (the quantum of negative returns when they are observed), returns volatility, and the risk that returns may be positive but not meet a consumer’s objectives, financial situation and needs'.  

• Where issuers understated a product's risk level (and included consumers in the target market that had a lower risk tolerance) or placed 'undue emphasis' on a product's (potential) returns without 'sufficiently considering the potential loss from investing in the product'. 
• Where issuers took 'a narrow view of performance'. ASIC cautions that:

'Issuers should not assume that past performance is always an indicator of future performance. To appropriately assess the risk level of a product, issuers should consider how a product is likely to perform both under conditions of market stress and average market conditions'.

Failing to clearly define a target market 

This issue was identified as an issue/factor in 15 of the 26 stop orders reviewed.  ASIC considers that issuers should 'ensure that their target markets are defined unambiguously', noting that the 'use of qualified language' can be 'problematic'.  

In illustration, ASIC points to the option for certain types of consumers to be 'potentially' included in a target market (as is the case in the Financial Services Council (FSC)) as a concern. This is because ASIC considers that:

'"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. The design and distribution obligations require the issuer to clearly define the class of consumers that falls within the target market in order to meet the statutory test in s994B(8)(b). Issuers should ensure there is sufficient granularity to clearly delineate consumers in their target market and avoid using imprecise terms, such as a "potential" rating'.

Portfolio allocation

ASIC observed that most issuers of investment products identified specified percentages of a consumer’s portfolio that should be allocated to their product in their target market.  

The report identifies specifying 'inappropriate levels of portfolio allocation' – eg overstating levels of diversification, using inappropriately broad ranges of portfolio allocation in a target market (e.g. 25–75%) or assuming that consumers would hold the investment product as part of a well-diversified portfolio (rather than defining the target market for the product on a standalone basis) - as a factor in 10 of the 26 stop orders reviewed.  

In terms of how issuers can improve in this area, ASIC considers that issuers should: 

• 'only treat an investment product as highly diversified where it is invested across multiple asset classes (excluding cash). Issuers should carefully assess the diversification of their product on this basis when defining their target market'
• 'describe levels of intended portfolio allocation with sufficient granularity in a TMD' (ie avoid using inappropriately broad ranges of portfolio allocation)
• assess products on a standalone basis (not as part of an hypothesised 'well-diversified portfolio')

Intended investment timeframe and withdrawal needs

The report found that the TMDs for investment products reviewed:

'generally identified intended investment timeframes and withdrawal needs of consumers in the target market for their schemes that were appropriate'.

However, ASIC observes that this was not always the case. Failure to identify an appropriate intended investment timeframe and/or withdrawal needs in the target market was a 'factor' in ASIC issuing stop orders in 18 of 26 stop order actions against issuers of investment products.  

ASIC's expectation is that issuers of investment products define a consumer’s intended investment timeframe based on both:

• 'the exact investment term of an investment product, where the product is close-ended, and
• the risks of an investment strategy, where a riskier strategy typically requires a longer time horizon for an investment'. 

ASIC further expects that: 

'consideration of a consumer’s withdrawal needs for an investment product would be based on: the liquidity features of an investment product, including any limitations on the ability of a consumer to redeem their product, and the usual timeframe for the issuer to process and meet a withdrawal request'.  

Distribution conditions

Issuers are required to specify distribution conditions in their TMDs. Examples of the distribution conditions specified for investment products were observed to include: 

• requiring that consumers complete a questionnaire during the application process
• restricting a product’s distribution to personal advice and/or platforms
• restricting a product’s distribution to certain distributors that have been subject to due diligence by the issuer.

However, the report highlights that 'many issuers' did not include any distribution conditions in their TMDs and that this was a factor in eight of the 26 stop order actions taken against issuers of investment products to date.  

Inclusion of appropriate distribution conditions is also highlighted as an area for improvement.  

According to the report, five of the 26 stop order actions that have been taken against issuers of investment products included 'inappropriate', 'self-certification' conditions ie a requirement for consumers to self-certify that they are in the target market for a product based on their (the consumer's) own reading of the TMD.  

ASIC makes clear that this is 'not sufficient as a distribution condition' because: 

'This places the burden on the consumer to determine whether they are in the target market, based on their reading of the TMD…Relying on a consumer to certify that they are in the target market is inconsistent with the objectives of the design and distribution obligations. The TMD is not a consumer-facing document, and the obligations place the responsibility on the distributor and issuer to understand their target market and direct distribution of a product to that target market'.

ASIC also emphasises that 'distribution conditions should be tailored for each product' rather than chosen 'from a prescribed list of distribution conditions set out in TMD templates'. 

Use of TMD templates

The report highlights widespread use of TMD templates. While acknowledging that templates 'designed specifically for investment products have assisted issuers with preparing an appropriate TMD', the report highlights inappropriate use of templates as a concern, noting that this has been a factor in 13 stop orders placed on investment products to date.  

More particularly, ASIC has issued stop orders where the template used: 

• was used without appropriate customisation for the specific product
• was not tailored for investment products (ie the template was designed to be used for a broad range of products and was not 'fit for purpose')

The report cautions against using TMD templates in a 'tick a box way'. ASIC states that:

'In all cases, issuers must critically assess and carefully consider the specific risks and features of their product to develop an appropriate target market…The responsibility lies with the issuer to properly understand the class of consumers whose likely objectives, financial situation and needs are met by their product. The issuer must ensure that the target market reflects this group of suitable consumers'. 

Distribution and oversight arrangements

In order to comply with their obligation to take 'reasonable steps' that are reasonably likely to result in distribution of a product being consistent with the product’s TMD (reasonable steps obligation), issuers and distributors need to have in place arrangements that are likely to direct distribution of the product to the target market.  

ASIC reviewed the product design arrangements of 12 issuers of around 640 registered managed investment schemes to assess how they are meeting their 'reasonable steps' obligations.  

While some 'good' practices were identified, eg some issuers requiring that all marketing/promotional material undergo a compliance check to ensure the material aligns with their TMDs and would not make it likely for consumers outside a target market to invest in a scheme, the report also highlights the following as improvement areas.  

• Inappropriately shifting onus onto the consumer by asking consumers to 'acknowledge that they had read the TMD and Product Disclosure Statement (PDS), without taking any further steps to check if the consumer was in the target market'. 
• 'Over-reliance on questionnaires…to try and direct distribution of a scheme to consumers in the target market'. ASIC cautions against relying on questionnaires alone. Instead ASIC considers that issuers should:
  'consider the effectiveness of their assessment process behind questionnaire responses to determine if a product is distributed to an applicant. Issuers should consider their distribution strategy and sales process in their entirety to determine if they meet the reasonable steps obligation, including the choice architecture they employ'. 
• Use of 'inappropriate questionnaires' for example, questionnaires that ask consumers to 'self-certify that they are in the target market', or questionnaires that 'address only part of a target market or confuse consumers into guessing answers, making errors or falsely representing their preferences'. 
• ASIC also raises concerns that 'most issuers did not test or audit their sales processes, either before or after a process was put in place'. That is, issuers did not periodically audit questionnaire responses to assess whether consumers had accurately completed the questionnaire/determine whether the questionnaire was working as intended. On this point, ASIC comments that:

'As part of a broader set of monitoring practices, it is potentially a useful practice for issuers, particularly when using external distributors, to audit consumer questionnaire responses and test if the questionnaire is working as intended or needs improvement. Issuers should also consider if other information collection tools should be used to support an overall distribution strategy or sales process'

Third party distribution arrangements

ASIC considers that the issuers reviewed could improve their third-party distribution arrangements by: 

• 'Gather[ing] evidence that distributors are meeting the obligations' rather than (in some cases) relying on distributors to self-certify that they are doing so (without having to supply any evidence in support)
• Requiring more detail from distributors about their compliance practices. 
• Auditing distributors’ practices to verify whether a distributor’s statements about their compliance practices were followed in practice.

Monitoring and supervisory arrangements

ASIC found that:

'Most issuers of managed investment schemes we reviewed had documented design and distribution policies. Issuers also established specialised committees on design and distribution compliance'.

Areas for improvement identified in the report include the following.  

• Having substantive, documented DDO governance policies in place 
• Undertaking ongoing monitoring of DDO compliance in order to be able to 'respond to ongoing design and distribution issues across an issuer’s business, whether through centralised working committees or another similar facility for oversight'.
• Ensuring ongoing board involvement: ASIC comments that:

'The obligations encompass all aspects of a product’s life cycle, from its initial design, through to its distribution, monitoring and review. The board should be across compliance with the obligations across these stages and ensure it has ongoing and adequate oversight of the business’s product governance, distribution and review arrangements'.

Monitoring and review arrangements

The report found that all 12 issuers of managed investment schemes reviewed had arrangements in place for collecting information and reviewing their TMDs. Areas for improvement identified in the report include the following.

• Review triggers: ASIC found that:

'Some issuers of managed investment schemes we reviewed used review triggers that lacked specificity and required more detail. Issuers should consider a fuller range of factors that can help them identify if a TMD is no longer appropriate: see RG 274.107 and Example 7 in RG 274 for specific factors that issuers of managed investment schemes can consider'.  

• ASIC also considers that issuers of managed investment schemes could improve their review frameworks.  
  • Reactive reviews: ASIC considers that these reviews should be targeted and address the 'specific issues with the TMD or scheme raised by the relevant review trigger, event or circumstance' (as distinct from being a general review). 
  • Periodic reviews: ASIC considers that this form of review should be 'comprehensive and cover all aspects of a TMD and scheme to ensure they are working as intended'. 

'Closer scrutiny of DDO is coming'

As flagged, enforcing DDO compliance is a key focus for ASIC and the report underlines ASIC's continued focus and willingness to act where required to ensure compliance.  

ASIC states that to date it has undertaken or is in the process of undertaking surveillances of the following sectors: small amount credit, buy now pay later, credit cards, superannuation, derivatives and investment products.
ASIC states that it:

'will continue to monitor compliance and we will take regulatory action for breaches of the obligations across our entire regulated population'.

Stronger focus on compliance with 'reasonable steps' obligation

Looking ahead, ASIC has flagged that it plans to step up its focus on compliance with 'reasonable steps' obligation in future surveillance work. ASIC Deputy Chair Karen Chester states that:

'In coming months, ASIC will begin to review how product issuers interact with their distributors to ensure they are not straying beyond their target market, how they monitor product governance arrangements and review data to ensure retail investors are receiving suitable products on an ongoing basis'.