The large, scary elephant in the room – will the decision to offer high risk ETPs be a breach of DDO?

This is a follow-up from my earlier article looking at reasonable steps obligations for Issuers relating to exchange traded products (ETPs). My earlier article looked at reasonable steps requirements around the preparation and dissemination of promotional materials.

I have a much bigger question that has been lingering from day 1 that I fear few have considered, is intrinsic to ETPs and one day could become a true nightmare of epic proportions as it will affect a large volume of ETPs.

Reasonable Steps obligations require 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.

My question is, could ASIC determine that a decision made by an issuer to distribute a managed fund on exchange breach your reasonable steps obligation?

My rationale being, if you have a fund with a narrow target market and a potential high risk of harm and you decide to make it available on exchange where you are aware that there is a much higher chance of people outside the target market investing, is this decision going to be scrutinised by ASIC as a possible breach of reasonable steps. Should an issuer only consider distributing on exchange funds that are deemed to have a broad target market? Would any fund with a narrow target market, or a high risk of harm, be deemed unsuitable?

Let’s take a look to see if we can find the answer in ASIC’s regulatory guide, RG 274 Product design and distribution obligations. I have extracted the relevant sections from RG 274 below:

"RG 274.142 An issuer must take into account all relevant factors in assessing what reasonable steps need to be taken in the circumstances. These factors include:

(a) risk—the likelihood of the distribution being inconsistent with the TMD;

(b) harm—the nature and degree of harm that might result from the financial product being distributed otherwise than in accordance with the TMD; and

(c) mitigation steps—steps that can be taken to eliminate or minimise the likelihood of the distribution being inconsistent with the TMD and the harm that might result (see s994E(5))."

"Distribution strategy

RG 274.144 In setting its distribution strategy, the issuer needs to consider whether the intended distribution channels and methods would likely result in distribution being consistent with the TMD."

These sections make it clear to me that selecting the distribution channel, i.e. where to make a fund available on exchange, is indeed part of an issuer’s reasonable steps obligations.

ASIC has prepared a dedicated Appendix within RG 274 specific to ETPs. Unfortunately, the Appendix does not address this key matter, skipping over the question product issuers must make of how to distribute a fund and looks at reasonable steps from the perspective of a fund once it is intended to be sold on a financial market.

I therefore have to ponder, has ASIC simply not turned its mind to this matter?

I guess the answer will one day be determined when it is tested in a court of law and let's hope I am wrong and worrying for nothing!