ASIC v Firstmac Limited: Court makes first finding of contravention of design and distribution obligations 

What you need to know

• On 10 July 2024, the Federal Court handed down the first judicial consideration of the design and distribution obligations (DDO) regime in ASIC v Firstmac Limited [2024] FCA 737 following a contested trial.
• The Court found that there was a breach of section 994E(3) of the Corporations Act by failing to take reasonable steps to ensure that Firstmac's distribution conduct was consistent with the relevant target market determination (TMD), because Firstmac as distributor was sending to its term deposit clients a PDS for a product that was not capital guaranteed and had a longer investment time horizon, without a process to test whether the product could be suitable for them and in some cases where they had said it would not meet their requirements.
• The judgment provides guidance on how the court will interpret key obligations in the DDO regime – in particular, the obligation to take "reasonable steps" that will result in distribution conduct being consistent with the TMD.
• The Court has emphasised the importance of ensuring that reasonable steps to ensure distribution conduct is consistent with the TMD are taken before any distribution conduct occurs, including the giving of the PDS. This means you need to pay careful attention to the correct sequencing. The case highlights that it is not enough to have a TMD, but that before any PDS distribution or other retail product distribution conduct occurs there need to be appropriate measures taken so as to direct the product to the target market. Moreover, it is not enough to have measures set out in policies and procedures - there needs to be adequate training and implementation.

What you need to do

• Where the DDO regime applies, you should have in place robust processes, policies and controls to ensure that distribution conduct will be consistent with the TMD. It is important you also maintain a sufficient level of oversight over these processes to ensure that they are being implemented properly. Merely having a policy in place will not be sufficient if it does not reflect actual practice, or if it is not implemented effectively.
• As the giving of a PDS to a client is itself retail product distribution conduct, care should be taken to ensuring that the "reasonable steps" obligation is met before giving a PDS to a client. If the PDS is on a publicly available website, it may be appropriate to have an additional control in place to disclose prior to access the types of prospective clients for whom the product is appropriate (drawing on the TMD).
• Further, the implementation of those steps is critical to satisfying the court that what is reasonable has been done. You should ensure that the steps to be taken are effectively communicated to all relevant staff and there is training and oversight to reinforce them.

Design and Distribution Obligations regime

The DDO regime requires issuers of financial products to consider and define specific target markets for their financial products; and distributors of the financial products to take reasonable steps to ensure that the products are distributed in a targeted manner consistent with the TMD.

ASIC has undertaken a number of investigations and taken enforcement action since the introduction of the regime, including civil penalty proceedings for alleged breaches of DDO. However ASIC v Firstmac is the first case in which ASIC received a successful judgment on allegations regarding breaches of DDO following a contested trial.

Background

The defendant, Firstmac, is a non-bank lender that primarily offers finance loans. It distributed retail term deposit products with two key characteristics: a capital guarantee and a short investment timeframe.

Firstmac also distributed, managed and promoted a retail product known as High Livez. Under the High Livez TMD, the target market for the product excluded consumers with a capital guaranteed investment objective and consumers whose investment timeframe was short (less than two years).

From 5 October 2021 (being the date of commencement of the DDO regime) to on or about 9 September 2022, Firstmac adopted a cross-selling marketing strategy by which:

• Firstmac term deposit holders whose term deposits were nearing maturity received an email attaching, amongst other things, a High Livez application form, a High Livez Product Disclosure Statement (PDS), an information statement explaining the performance of the High Livez fund, and an instruction form providing options for Term Deposit holders to either invest in a new Firstmac term deposit, close their existing term deposit or invest in High Livez; and
• regardless of the maturity date of their term deposits, Firstmac Term Deposit holders were sent a hard copy letter enclosing a copy of a High Livez PDS and a High Livez information sheet

(together, Distribution Conduct).

A person to whom DDO applies (Regulated Person) contravenes section 994E(3) of the Corporations Act 2001 (Cth) (Corporations Act) if it fails to take reasonable steps that would result in, or would be reasonably likely to result in, retail product distribution conduct of a financial product being consistent with the TMD. ASIC alleged that Firstmac's Distribution Conduct breached section 994E(3) of the Corporations Act because Firstmac failed to take reasonable steps in relation to the distribution of High Livez.

This occurred in circumstances where:

• unlike the Firstmac Term Deposits which were "capital guaranteed" by the Commonwealth government, capital invested in High Livez was not subject to any such guarantee and the unit price was subject to volatility, meaning that unitholders could suffer a loss or gain in capital upon exiting the fund; and
• Firstmac Term Deposits were offered on the basis of investment periods of two years or less, whereas the recommended minimum investment timeframe for High Livez was three to five years.

Construction of section 994E

Meaning of "would have resulted in, or would have been reasonably likely to have resulted in…"

The Court rejected ASIC's submission that the two components of the expression "would have resulted in, or would have been reasonably likely to have resulted in" as it appears in section 994E should be read together as constituent elements of a "compound conception". Instead, having regard to previous case law, it agreed with Firstmac's preferred construction that the provision postulates two alternatives. Accordingly, a contravention of section 994E(3) would be established if Firstmac failed to take reasonable steps that either would have resulted in, or would have been reasonably likely to have resulted in (ie there was a real and not remote chance) the Distribution Conduct being consistent with the High Livez TMD.

Meaning of "reasonable steps"

In determining the meaning of "reasonable steps", which is not defined in the Corporations Act for the purposes of DDO, the Court considered other provisions in Chapter 7 of the Corporations Act containing a "reasonable steps" obligation. It accepted that previous judicial consideration of such provisions provides guidance on the scope of "reasonable steps" in section 994E(3).

Read as a whole, section 994E(3) requires a Regulated Person to take reasonable steps that result in a real, not fanciful or remote, chance that the distribution conduct will not be inconsistent with a TMD.

The entity is not required to take optimal steps or all reasonable steps.

Making this assessment requires a holistic analysis, considering the full framework of the entity's policies, procedures and contracts.

The assessment is made objectively, having regard to what a reasonable person in the position of the Regulated Person and subject to the same legal obligations would have done.

The Court then considered the temporal limitations of the wording in section 994E(3). Importantly, it held that the use of the words "would have resulted in" and "would have been reasonably likely to have resulted in" imparts a forward-looking element to the provisions, which are concerned with whether the Regulated Person had at the relevant time "adequate systems, policies, practices and procedures in place to address identified or reasonably identifiable risks of retail product distribution conduct which was inconsistent with the TMD". This means that "reasonable steps" must be be taken before engaging in retail product distribution conduct (in this case, the provision of the High Livez PDS to a client) and cannot be taken concurrently with or after that conduct. Such steps would have no bearing on the likelihood of the conduct being consistent with the TMD. Whilst such measures may affect the likelihood of a person outside the target market acquiring the financial product, section 994E(3)(d) is concerned only with pre-conduct steps.

The content of the High Livez PDS and its accompanying material, was therefore not relevant to establishing that Firstmac took "reasonable steps".

Breach of section 994E

Investment objectives of Firstmac Term Deposit holders

To assess the likelihood of Firstmac Term Deposit holders being within the High Livez TMD target market, the Court was required to consider the likely investment objectives of such customers. It held that just because a group of customers invests in a particular financial product with certain characteristics, this does not mean that all such customers will necessarily have particular investment objectives aligned with those characteristics. This is because a customer may invest in a financial product as part of a diversified portfolio, or have changing investment objectives over time.
Nevertheless, on the evidence, there was a real chance that some of the Firstmac Term Deposit holders may have had a capital guaranteed objective or a short investment timeframe objective and were therefore outside of the High Livez target market. As it is not in itself a contravention for a retail client who is not in the stipulated target market to acquire the relevant product, the offence turns on whether the Regulated Person took "reasonable steps".

Did Firstmac take "reasonable steps"?

ASIC pleaded a list of processes and procedures that it alleged Firstmac should have taken prior to the Distribution Conduct. The Court held that that was not the correct way of approaching the inquiry: it was not simply a matter of pleading hypothetical reasonable steps which could have been taken. Rather, the focus was on what Firstmac in fact did and whether those steps were reasonable, including having regard to potential additional or alternative steps.

The evidence relevantly established that Firstmac had a practice of calling customers before sending the High Livez PDS. Scripts were used for those calls which could lead to disclosures about the fact that the investment did not have a capital guarantee and had a longer time horizon than a term deposit. However, (i) these disclosures were not always required by the script, but depended on what questions the customer asked; (ii) the Firstmac Investment Specialist using the script did not consider they were required to follow it and did not always do so; (iii) customers were not always called before the PDS was sent by email, and (iv) the PDS was sent by email to customers even if they indicated that the investment was not suitable on the call.

Firstmac executives were not aware of the above practices. Instead, they understood that the Firstmac Investment Specialist followed the scripts, spoke to all investors prior to them investing in High Livez, told customers that High Livez would not be suitable for them if they had a capital guaranteed objective and/or a short term investment objective, and only provided the High Livez PDS to customers who had expressed interest in the fund.

Essentially, in the Court's view there was a breakdown in communication between the person making the calls and Firstmac executives, and that person had not been trained specifically in relation to DDO obligations or given supervision and directions in relation to DDO obligations.

Further, although Firstmac had prepared a written policy in relation to DDO, this was never distributed to staff during the relevant period, and did not provide any substantive guidance on how Firstmac would comply with its DDO obligations.

Having regard to the above, the Court considered each of the "reasonable steps" that Firstmac pleaded it had taken to discharge its obligation under section 994E(3) as follows:

• Education on DDO requirements – this was not a "reasonable step" because Firstmac's DDO policy was "wholly deficient" and did not set out what steps Firstmac needed to take to comply with DDO.Further, Firstmac failed to recognise that the Firstmac Investment Specialist needed to be trained in DDO and/or be subject to supervision and explicit directions to ensure Firstmac complied with DDO;
• Firstmac Investment Specialist – it was not a "reasonable step" to have the Investment Specialist perform her role in the manner described above. A lack of supervision by Firstmac meant that the High Livez PDS was sent to customers, even where the Firstmac Investment Specialist had actual knowledge of facts that meant customers were outside of the High Livez target market;
• Disclosures on High Livez website – simply placing information about the risks of the High Livez product on the website was insufficient to meet the "reasonable steps" obligations, in circumstances where its placement required a potential investor to choose to seek the relevant information out and review the disclosure;
• Complaints Policy, disclosures in High Livez PDS, and requiring investors to warrant and provide acknowledgement before signing – applying the construction of "reasonable steps" discussed above, these were not capable of constituting "reasonable steps" as they either occurred as part of or subsequent to the Distribution Conduct.

Accordingly, the Court concluded that Firstmac did not have in place adequate systems, policies, practices and procedures to address identified or reasonably identifiable risks of retail product distribution conduct which was inconsistent with the High Livez TMD.

The Court also considered the mandatory factors in section 994E(5) which must be taken into account when assessing whether "reasonable steps" have been taken:

a) Likelihood and Distribution Conduct being inconsistent with the High Livez TMD – for the reasons above, there was a real chance (ie a real possibility) that some of the Firstmac Term Deposit Holders may have had capital guaranteed and/or short investment timeframe objectives, and were therefore outside of the High Livez target market;

b) Nature and degree of harm – here, the relevant nature and degree of harm was the investment by a customer into High Livez where they held capital guaranteed and/or short investment timeframe objectives and who, for example, experienced a reduction in their invested capital due to volatility in High Livez and either did not want to, or could not, continue with their investment for three to five years to recoup the loss of capital;

c) Knowledge of Firstmac – evidence established that Firstmac was aware of the matters above;

d) Ways to eliminate or minimise the likelihood and harm – the Court considered that Firstmac could have taken various measures, including:

• requiring customers to answer 'knock out' questions to identify their investment objectives, after which customers with a capital guaranteed and/or short investment timeframe objectives would not be sent the High Livez PDS (noting that Firstmac later did introduce such 'knock out' questions);
• sending emails to Firstmac Term Deposit holders whose deposit was approaching maturity containing explicit information of the kind referred to in the 'knock out' questions and inviting them to call the Investment Specialist;
• re-instating the previous practice of contacting by telephone Firstmac Term Deposit holders whose term deposits were due to expire rather than simply sending the PDS by email;
• preparing and disseminating a written DDO policy identifying the processes and procedures for staff to undertake to comply with DDO; and
• training the Firstmac Investment Specialist in the DDO requirements and requiring her to read and be aware of the content in the High Livez TMD.

For the above reasons, the Court was satisfied that Firstmac failed to take reasonable steps that would have resulted in, or would have been reasonably likely to have resulted in, the Distribution Conduct being consistent with the High Livez TMD. Penalties will be considered at a subsequent hearing.

Key takeaways

This judgment has significant implications for Regulated Persons under the DDO regime, particularly in relation to the scope of "reasonable steps".

Given the forward-looking construction of this expression, Regulated Persons must have robust controls and procedures in place to ensure retail product distribution conduct will be consistent with the TMD, prior to engaging in retail product distribution conduct. This means that to demonstrate "reasonable steps" it will not be sufficient to rely on disclosures in the PDS, at least where giving the PDS is part of the distribution conduct.

At a minimum, Regulated Persons should ensure that they are aware of their obligations under DDO and maintain substantive policy or procedure documentation which clearly describes the steps they will take to discharge their obligations under the DDO regime. All policies and procedures must also be effectively implemented to ensure that customer-facing staff act consistently with DDO.

The vice the Court found lay in a breakdown in communication between executives and the frontline. It is critical to consider whether you have effectively embedded your DDO-compliance strategy through the whole of your organisation and that relevant people are aware of the TMD and what they need to do to take reasonable steps to ensure that retail product distribution conduct is consistent with it. That should be supported by oversight and control testing processes to help you to demonstrate that you have taken reasonable steps.

Authors: Jonathan Gordon, Partner; Lorraine Hui, Partner; Greg Patton, Senior Associate; Claire Potter, Lawyer and Vivien Lin Lawyer.