Key lessons from first DDO case against Firstmac
The case of ASIC v Firstmac Limited (Firstmac case) highlights important lessons for fund managers when complying with the design and distribution obligations (DDO) to distribute financial products to consumers in identified target markets. In this case, the Federal Court considered what constitutes ‘reasonable steps’ and emphasised the need for robust compliance frameworks to ensure products are sold to consumers in the right target markets.
- The Firstmac case is the first time an Australian court has considered what constitutes ‘reasonable steps’ when complying with DDO.
- The obligation to take reasonable steps applies to not only the issue of a product but also the distribution of the PDS.
- We eagerly await ASIC’s updated guidance which will hopefully provide some clarity around these issues.
- Some key takeaways for funds managers in the meantime:
- have robust systems, policies, practices, and procedures – including a process of oversight and supervision – to address identified or reasonably identifiable risks of retail product distribution conduct which is inconsistent with a TMD;
- having robust systems in place could be important to demonstrate you have met your reasonable steps obligation even if there is an instance where the system has failed due to human error;
- implement clear steps prior to the issue of a PDS to indicate the target market has been considered prior to the issue of the PDS;
- regularly review and update compliance frameworks;
- monitor distribution practices to identify and fix potential misalignments with the target markets for their products; and
- when initiating a marketing strategy (particularly a new strategy), engage in scenario planning to anticipate and reduce compliance risks.
The Firstmac case relates to the distribution by Firstmac of a product disclosure statement (PDS) for a fund which invested in mortgage-backed securities (High Livez). Firstmac also distributed term deposits to clients. The case involved Firstmac’s conduct when promoting High Livez to clients who held term deposits when those term deposits matured.
The target market determinations (TMDs) for High Livez and the term deposits identified the key attributes of consumers who were likely in the target market for each product. Relevantly, the term deposits were a low-risk product which benefited from a capital guarantee supported by the federal government and the suggested investment period was up to two years. Conversely, High Livez did not have a capital guarantee and the recommended investment term was more than two years. The products clearly had different target markets.
In promoting High Livez, ASIC alleged (and the Court agreed) Firstmac failed to take reasonable steps that would have resulted in, or would have been likely to have resulted in, the distribution being consistent with the High Livez TMD (reasonable steps obligation). The decision is important because it is the first time an Australian court has considered the reasonable steps obligation.
When does the reasonable steps obligation arise?
The Court concluded the reasonable steps obligation is a ‘forward-looking’ obligation, meaning it is a breach of DDO to give a PDS to a retail client without first taking reasonable steps that would have resulted in or would have been reasonably likely to have resulted in, the giving of the PDS being consistent with the TMD. The Court said it is not acceptable to take reasonable steps concurrently with (or after) the giving of the PDS.
What constitutes ‘reasonable steps’?
The Court said the provision is not expressed as an obligation to take all reasonable steps, and nor does it require identification and performance of either the universe of possible reasonable steps, or the ‘one true path’ that must be followed. Whether the requirement to take ‘reasonable steps’ has been met is to be determined objectively by reference to the standard of behaviour expected of a reasonable person in the distributor’s position that is (or was) proposing to engage in the relevant retail product distribution conduct regarding the same product.
Until now, generally speaking, industry has focussed on taking reasonable steps prior to the actual issue of interests in a product. However, the Firstmac decision makes it clear the obligation also applies to the distribution of the PDS and reasonable steps must therefore also be taken before the distribution of the PDS.
It is important to note the case involved Firstmac cross selling a product to its own database of investors which Firstmac knew (or ought to have known) had a different target market. Where fund managers undertake a targeted distribution strategy (e.g. by cross-selling or direct marketing) the Firstmac case suggests that what constitutes reasonable steps could be different to what are reasonable steps for a fund manager who markets its product to the world at large, for example, by placing its PDS on its website.
Where fund managers are distributing products using direct marketing techniques, then in light of the Firstmac decision they should consider undertaking a review of their processes. For example:
- reviewing their marketing and distribution strategy;
- ensuring investor-facing personnel are appropriately trained regarding DDO;
- reviewing sales scripts, checklists and operating guidelines; and
- reviewing investor/customer call centre procedures.
While this targeted distribution conduct can be distinguished from publication of a PDS on a website where it is generally accessible, extrapolating the principle that reasonable steps must be taken before distributing the PDS, fund managers need to consider what constitutes reasonable steps before allowing prospective investors to access a PDS?
What constitutes reasonable steps in this context remains unclear. However, the legislation provides that what constitutes ‘reasonable steps’ is to be determined after taking into account all relevant matters, including:
- the likelihood of the conduct being inconsistent with the determination;
- the nature and degree of harm that might result from an issue to an investor not in the target market or that is inconsistent with the TMD;
- what the issuer knows, or ought reasonably to know, about those matters and the way to eliminate that harm; and
- the availability and suitability of ways to eliminate or minimise the likelihood (emphasis added).
ASIC has indicated it expects to provide further guidance in relation to DDO within the coming months. In our view, the interpretation of the Firstmac case can (and should) be limited to its facts, being that Firstmac knew (or ought to have known) the target market for the term deposits and High Livez were different and failed to take any steps to ensure it was unlikely High Livez would be acquired by consumers outside its target market. In these circumstances, the standard of what reasonable steps could and ought to have been taken before directly distributing the PDS to clients is in our view higher than for a fund manager who makes its product available by merely posting a PDS on a website. We expect (and hope) ASIC will provide guidance on what it expects in this regard.
That said, fund managers need to acknowledge they could be involved in two kinds of ‘distribution conduct’. Firstly, in giving a copy of (or possibly even access to) the PDS, and secondly, in issuing the financial product. The question arising from the Firstmac case is whether there are some steps which are ‘available and suitable’ to take in respect of the first aspect which would satisfy their reasonable steps obligation?
If some steps are to be taken when providing access to a PDS, then they might include:
- investors who seek to access a product via the internet are first provided with a brief summary of the target market or key features of the product and are asked to acknowledge factual information about themselves which would mean it is likely they are within the target market prior to accessing the PDS. This would not be a self-certification, but an acknowledgment of the features of the product they intend to review; or
- requiring the filtering questions which would typically be asked prior to the issue of the product to be answered prior to granting access to the PDS. In our view, this would be an over-reach and unnecessarily limit an issuer’s ability to promote its product.
The Firstmac case has made it clear having appropriately worded TMDs is only one aspect of DDO. We eagerly await ASIC’s updated guidance which will hopefully provide some clarity around some of the issues raise here. In the meantime, there are some general ‘takeaways’ from the case which are relevant to all fund managers:
- Fund managers should have robust systems, policies, practices, and procedures – including a process of oversight and supervision – to address identified or reasonably identifiable risks of retail product distribution conduct which is inconsistent with a TMD;
- Fund managers should regularly review and update compliance frameworks;
- Fund managers should monitor distribution practices to identify and fix potential misalignments with the target markets for their products; and
- When initiating a marketing strategy (particularly a new strategy), fund managers should engage in scenario planning to anticipate and reduce compliance risks.
The HW Funds team will continue to monitor ASIC’s response to these issues and provide regular updates. If you require any assistance in the meantime, then please contact us.
As this edition of Fundamental was released for publication, ASIC released Report 795 Design and distribution obligations: Compliance with the reasonable steps obligation (REP 795) calling on product issuers to ensure distribution practices are up to scratch. REP 795 provides further guidance for product issuers around the obligation to take reasonable steps when distributing their products and details the findings of its surveillance of 19 issuers of high-risk investment, insurance and credit products between October 2023 and August 2024.
The HW Funds team will shortly provide an update on the key lessons and practical implications of REP 795 for fund managers.
