ASIC begins enforcement of ‘design and distribution’ obligations

ASIC has announced its first round of enforcement action under the ‘design and distribution’ (DDO) provisions of the Corporations Act 2001 (Cth) (Corporations Act) issuing a number of ‘stop orders’ in respect of the issue and distribution of financial products.

Possible DDO enforcement action was foreshadowed by ASIC earlier in 2022, and, given the broad remedies available to ASIC, we consider this to be the first of many similar enforcement actions in the years ahead.

We analyse below ASIC’s reasons for making the stop orders. Having regard to these reasons, we recommend product issuers and distributors re-focus on DDO systems and processes to manage the risk of non-compliance with the DDO regime requirements.

Particular attention could focus on:

• testing of controls;
  
  
• adequacy of product governance arrangements; and
  
  
• engagement mechanisms between issuers and distributors.

ASIC’s 28 July announcement of DDO enforcement action

On 28 July 2022 ASIC announced that it had issued its first stop order under DDO provisions of the Corporations Act.

This action follows ASIC Chair Joe Longo’s statements in March that ASIC’s corporate governance priorities for this year include pursuing a ‘targeted surveillance approach’ and enforcing the DDO provisions.

A quick refresher: the DDO regime impacts issuers and distributors of in-scope financial products

The DDO regime commenced on 5 October 2021 through the Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Act 2019 (Cth) and is now set out in Part 7.8A of the Corporations Act 2001 (Cth).

The regime is intended to ensure that consumers ‘obtain appropriate financial products by requiring issuers and distributors to have a customer-centric approach to designing, marketing and distributing financial products’.[1] Generally, amongst other things the DDO provisions apply to basic banking products, offers made under a Product Disclosure Statement or prospectus, and consumer credit products. However, there are some exceptions, such as in relation to MySuper products and margin loans[2].

In summary, under these obligations:

• The product issuer must make a ‘target market determination’ (TMD). The TMD must be public, contain specified mandatory information, and be subject to a review plan.
  
  
• The product may not be issued if the TMD requires review.
  
  
• Issuers and distributors must take reasonable steps to ensure distribution is consistent with the TMD.
  
  
• Distributors must provide complaints information and other information as required by issuers to those issuers.
  
  
• Distributors must not distribute an in-scope financial product unless a TMD is in place.
  
  
• Both issuers and distributors must maintain certain specified records.
  
  
• ASIC notification requirements apply where there have been significant dealings outside a TMD.
  
  
• ASIC will use its information-gathering and stop order powers to ensure compliance.
  
  
• Contravention of the DDO regime is subject to a range of criminal and civil penalties, civil recovery of loss or damage, and other court orders.

ASIC has a range of powers under the DDO regime

ASIC has powers that are aimed specifically at the enforcement of the DDO regime. These include:

• ASIC can require the production of information about:
  
  
  • distribution information;
    
    
  • the decision-making process of a product issuer (e.g. setting out reasons for a decision in respect to a TMD) and[3]
    
    
• ASIC has the ability to make an administrative ‘stop order’, on an interim or final basis. Such an order can require that specified conduct not occur for the period the order is in force.[4]

Such stop orders were recently used by ASIC. We have set out detailed analysis on ASIC’s DDO regime stop order action below.

It is worth noting that the making of a DDO regime stop order by ASIC is able to be reviewed in the Administrative Appeals Tribunal (on the merits of the decision) and also is subject to judicial review.

While not specific to the DDO regime, ASIC could also require the entry into an ‘enforceable undertaking’ under s 93AA of the Australian Securities and Investments Commission Act 2001 (Cth) as a further tool in relation to DDO regime non-compliance.

In addition to the administrative action above, ASIC can also commence civil penalty and civil proceedings for contraventions of the DDO provisions.

DDO breaches: criminal offences, civil penalties, and civil remedies

Breaches of a number of provisions of the DDO regime constitute criminal offences. These include where an issuer fails to make a TMD under section 994B, and where issuers or distributors do not take reasonable steps to ensure distribution of a product is dealt with consistently with the TMD under section 994E. Certain offences contain elements which are subject to strict liability, which shift the evidentiary burden on a defendant in respect of the availability of defences.

A number of requirements of the DDO regime are civil penalty provisions and as noted above ASIC has the power to commence such proceedings. Similar to the criminal offences discussed in the previous paragraph, civil penalties are potentially available for an issuer failing to make a TMD, and issuers or distributors not taking reasonable steps to result in the distribution of the financial product being consistent with the TMD.

To impose a civil penalty, the court must be satisfied that the breach of the DDO regime:

• materially prejudices the interests of acquirers or disposers of the relevant financial products; or
  
  
• materially prejudices the issuer of the relevant financial products or, if the issuer is a corporation, scheme or fund, the members of that corporation, scheme or fund; or
  
  
• is serious

The maximum civil penalty that a court may impose for a breach of the DDO regime contravention by a body corporate is the greatest of:

• 50,000 penalty units – currently $11.1 million; and
  
  
• if the Court can determine the benefit derived and detriment avoided because of the contravention--that amount multiplied by 3; and
  
  
• either:
  
  
  1. 10% of the annual turnover of the body corporate for the 12-month period ending at the end of the month in which the body corporate contravened, or began to contravene, the civil penalty provision; or
     
     
  2. if the amount worked out under subparagraph (i) is greater than an amount equal to 2.5 million penalty units--2.5 million penalty units.

The DDO regime also includes provisions enabling investors and third parties to recover loss or damage for contravention of certain provisions. Such actions are subject to a six year limitation period. Importantly, in connection with a civil action a court may:

• void a contract
  
  
• require the return of money paid
  
  
• require the payment of interest
  
  
• make any other orders it considers necessary or desirable.

For certain contraventions of the DDO regime, ASIC also has the power to seek a court to make non-damages-related orders (including against persons involved in a contravention) including where consumers are involved (non-party consumers) which are not party to proceedings under the Corporations Act in relation to the contraventions.

The court can only do so if it considers that the orders will redress, reduce or prevent loss or damage to non-party consumers. Such an order will be binding on the non-party consumers, and may include orders:

• voiding, including from inception, a contract or related collateral arrangement
  
  
• varying a contract or arrangement, including from a specified date;
  
  
• refusing to enforce any or all provisions of a contract or arrangement;
  
  
• requiring the refund of monies to non-party consumers.

Analysis: ASIC’s recent DDO regime enforcement action

ASIC’s DDO stop orders prohibit certain advice and dealings

On 28 July, ASIC announced that it had made stop orders in respect to three issuers of financial products subject to the DDO regime – see ASIC Media Release 22-194. The stop orders ASIC announced were in relation to:

• interests (Interests) in a fund (Fund); and
  
  
• shares (Shares) in two separate but related companies (Companies).

As between the affected issuers, these stop orders:

• prohibited the provision of:
  
  
  • general advice in relation to the Fund; and
    
    
  • providing financial product advice – i.e. both general advice and personal advice – in relation to the Shares
    
    
• prohibited issuing Interests and issuing Shares
  
  
• prohibited giving a Product Disclosure Statement for the Interests and giving a ‘disclosure document’ under Chapter 6D of the Corporations Act for the Shares

The stop orders applied to the above conduct in relation to retail clients. ASIC further prescribed that while in one case the stop order would last for 21 days, in two other cases the stop orders were indefinite. In the case of the indefinite stop orders, ASIC said this was to give the Companies time to address ASIC’s concerns.

The reasons ASIC made the stop orders

ASIC has stated the stop orders were made for the following reasons:

• High-risk, illiquid, unlisted single asset underlying investment: ASIC noted that the sole asset of the Fund was a loan to a related party of the issuer. This loan was for the development of a sandstone quarry. ASIC stated:
  
  [the] TMD included two categories of retail investors for whom investment in [the Fund] would not have been consistent with their likely objectives, financial situation and needs. These were: investors intending to use an investment in [the Fund] as a core component of their investment portfolio and investors with an objective of high capital growth or a mixture of capital growth and income.
  
  
• Distribution occurring prior to TMD: ASIC stated that it was:
  
  concerned that the [Companies] may have engaged in retail product distribution before preparing a TMD for their high risk offers.
  
  This concern justified the use of the stop orders and provides guidance as to where ASIC intends to set the regulatory bar.

ASIC’s general approach to taking DDO regime enforcement action

ASIC’s approach reflects the beginning of what appears to be a gradated enforcement action in relation to the issuing and distribution of DDO regime in-scope financial products.

In Regulatory Guide 274.225, ASIC foreshadows the use of DDO regime stop orders ‘to protect consumers from breaches of the [DDO regime]’, as well as more serious enforcement action in order ‘to promote the confident and informed participation of investors and financial consumers in the financial system more generally’.

This approach can be viewed in light of the legislative intent of the DDO regime stop order power and enforcement remedies, which is as follows:

The power to make stop orders with respect to these contraventions reflects their key role in promoting the provision of suitable financial products to consumers. The intent of stop orders in relation to the new regime is to protect retail clients from breaches of the design and distribution regime.

…

A contravention of every obligation in the new regime is both a civil penalty provision and an offence. This allows the regulator or prosecutor (as the case may be) to take a proportional approach to the enforcement of the new regime.

ASIC’s recent DDO stop orders foreshadow future enforcement action

In announcing the stop orders, ASIC also stated as follows about the DDO regime:

ASIC’s focus has now shifted to compliance. Industry has had sufficient time to bed down its implementation of the DDO regime.  [ASIC has] targeted surveillances underway to check whether product issuers and distributors are complying with their design and distribution obligations. [ASIC] will continue to look at defective TMDs, as well as issuers who have not made TMDs or not made them publicly available. [ASIC] will review how product issuers interact with their distributors to confirm they are not straying beyond their target market. [ASIC] will also review how they monitor and review consumer outcomes to ensure consumers are receiving products that are consistent with their likely objectives, financial situation and needs...

Issuers and distributors should re-focus on DDO regime compliance

While the DDO regime was somewhat delayed due to industry wide concerns regarding readiness, DDO was nevertheless implemented at a time of very significant regulatory reform with the concurrent implementation of a number of Financial Services Royal Commission-related laws. These laws included reforms to the anti-hawking and breach reporting regimes, reforms which are continuing to be subject to ongoing uncertainties in their operation and effect. In this light, it is perhaps unsurprising that the DDO regime could be seen to have been addressed, with the priority now with other regulation.

Despite this, and given ASIC’s publicity here of DDO regime enforcement action, we recommend renewed focus by issuers and distributors on DDO regime compliance. Amongst other things, we suggest this focus be on:

• controls to mitigate and minimise the likelihood the issuance or distribution is inconsistent with the TMD;
  
  
• the requirements of the DDO regime in respect to product design, product distribution, and monitoring and review should be revisited given the time which has elapsed since the introduction of the DDO regime. Lessons learned from pre-existing monitoring and review should be addressed; and
  
  
• engagement mechanisms between issuers and distributors to capture relevant information about the distribution of the product, including any complaints from consumers, should be promptly passed from distributors to issuers.

ASIC has indicated that one of its strategic priorities in the coming year is to ensure compliance by firms with DDO obligations. We can therefore expect ASIC to conduct a broad range of surveillance programs and undertake enforcement action if non-compliance is found.