The Financial Markets Authority (FMA) this week opened a consultation on a draft guidance note that will communicate the FMA's expectations for financial institutions that distribute financial products and services via intermediaries.
The draft guidance is relevant to entities that will need to be licensed as "financial institutions" under the new COFI regime in the Financial Markets (Conduct of Institutions) Act 2022 (Act) as well as their intermediaries. The FMA is seeking feedback on its draft guidance until 14 April 2023.
Key aspects in the guidance are:
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The FMA recognises the need for proportionality in the face of the large work programme needed by financial institutions and their intermediaries to comply with the Act. The guidance helpfully dispels uncertainty by making clear what is not required in order to comply with the Act.
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A draft framework is provided for financial institutions to assess how, in relation to each financial product and service they offer, their chosen distribution methods could interact with other risk factors to impact the "totality" of the risk of unfair treatment.
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The guidance recognises that the potential for inconsistent approaches being taken by financial institutions is a key risk that may increase the compliance costs for intermediaries that distribute products and services of multiple financial institutions. The FMA recognises that industry bodies may be useful vehicles to develop industry standards and to lead to a convergence of practices.
A more detailed summary of the draft guidance note follows. Note that, in relation to intermediaries generally, financial institutions will also need to:
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ensure they comply with conditions four and five of the standard licence conditions which relate to outsourcing, business continuity and technology systems; and
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comply with incentive requirements. These include specific regulations. In late-2022, the Ministry of Business, Innovation and Employment separately consulted on an exposure draft of the Financial Markets Conduct (Conduct of Institutions) Amendment Regulations 2022 that will prohibit sales incentives determined or calculated by reference to a target or other threshold.
Please get in contact with one of our experts if you would like to discuss your submission on the draft guidance or the development of your organisation's fair conduct programme.
Background
The Act will establish a new regime regulating the conduct of all registered banks, licensed insurers and licensed non-bank deposit takers (financial institutions).
The regime centres around an overarching fair conduct principle and will introduce statutory duties for financial institutions to: (i) establish, implement and maintain a fair conduct programme (FCP) to operationalise the fair conduct principle; and (ii) comply with their FCP. Financial institutions will also be required hold a market services licence and to comply with standard licence conditions.
The Act requires that a financial institution's FCP is documented and must include effective policies, processes, systems and controls for designing and managing the provision of the financial institution's financial products and services, including by:
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providing for the methods by which the financial products and services will be provided to consumers (distribution methods) to operate in a manner consistent with the fair conduct principle;
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regularly reviewing whether the distribution methods are operating in a manner consistent with the fair conduct principle; and
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ensuring that any deficiencies identified are remedied within a reasonable time.
Who is an intermediary?
An "intermediary" is any third party that is involved in the sale and distribution of a financial institution's financial products and services to end consumers. Examples could include mortgage and insurance advisers, online investment platforms and strategic partners.
Many financial institutions use intermediaries to distribute their financial products and services, but may also be intermediaries themselves for other financial institutions (for example, banks entering into arrangements to distribute insurance on behalf of other financial institutions).
Some intermediaries that are FAPs or operate under a FAP licence under the Financial Markets Conduct Act will be subject to their own set of conduct duties and must comply with the Code of Professional Conduct.
Assessing and designing distribution methods
In considering what policies, processes, systems and controls are effective, a financial institution must have regard to the factors in section 446J(2) of the Act (eg nature, size and complexity of its business, products and services it offers, types of consumers). The draft guidance elaborates on several of these factors to explain how a financial institution may wish to address them when developing its FCP.
The draft guidance provides that for each of their financial products and services, a financial institution should consider identifying and documenting:
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Likely consumers: the intended purpose, likely consumers (or circumstances), and the requirements and objectives of the consumer. This could take into account the features of the product or service (eg simple / standardised terms versus complex / customisable features) and the likelihood vulnerable customers may use the product or service.
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Appropriate distribution methods: how each distribution method is appropriate for the financial product or service and likely consumer identified above. For instance, complex / customisable products (eg income protection insurance or retail bonds with complex convertible features) may be best distributed via licenced FAPs with the requisite knowledge and skill to assess customers' circumstances and advise on the suitability of the product. While for simple products, such as term deposits, online investment platforms may be sufficient.
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Roles and responsibilities: the respective roles and responsibilities of the financial institution and intermediary. There should be clear policies describing the role of the financial institution and intermediary, including in relation to product design and review, assessing product suitability for consumers, communicating with customers and how post-sale interactions are split between the financial institution and intermediary.
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Distribution arrangements: how arrangements with intermediaries will be managed. This could be through formal legal arrangements or controls and processes.
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Product information and training: the information, training or accreditation provided to intermediaries and their staff. This should take into account the standards of competence, knowledge and skill of the intermediary.
When determining whether a distribution method is operating in a manner consistent with the fair conduct principle, the draft guidance provides a financial institution should consider how the chosen distribution method could interreact with other risk factors to impact the "totality" of the risk that customers could be treated unfairly. For example, a distribution method that uses FAPs may be viewed as lower risk, but when combined with other factors, such as reliance on the product by vulnerable consumers, the overall risk of the distribution method operating in a manner inconsistent with the fair conduct principle may be increased.
The draft guidance includes a non-exhaustive list of factors a financial institution may consider when assessing the potential risk of unfair treatment for each financial product and service:
Factors that may decrease risk
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Factors that may increase risk
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Simple product (e.g. simple terms and few exclusions, short duration)
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Complex product (e.g. complex terms and many exclusions, long duration)
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Likely consumers are likely to have a low number of vulnerability characteristics
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Likely consumers are likely to have a high number of vulnerability characteristics
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FAP intermediary licensed by FMA and subject to financial advice regime
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Non-FAP intermediary
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An intermediary is a financial institution itself
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An intermediary is an NZX participant subject to the NZX participant rules
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Short distribution channel with few parties between the institution and the end consumer
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Long distribution channel with multiple parties between the institution and the end consumer or otherwise involved in the distribution
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Experienced intermediaries with established relationships with the institution
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New or inexperienced intermediaries
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Contractual or other written agreements in place
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No contractual or other written agreements in place
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Strong controls over the distribution method and arrangements
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Weak controls over the distribution method and arrangements
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Reviewing distribution methods and addressing identified deficiencies
The Act requires financial institutions regularly review their distribution methods to ensure they are operating in a manner consistent with the fair conduct principle. The guidance provides that the frequency and intensity of the review should by driven by a financial institution's assessment of the risks outlined above.
For distribution methods assessed as carrying higher potential risk of unfair treatment, the FMA's view is that a financial institution should apply a more intensive approach to reviews, e.g. by proactive quality assurance processes. For distribution methods assessed as carrying lower potential risks, a financial institution can apply a less intensive review approach, e.g. relying on sampling and red flags.
Managing compliance costs
The FMA notes it is aware of industry concerns that the Act may result in onerous measures being imposed on intermediaries by financial institutions. In the guidance, the FMA makes clear some of its expectations for the review of distribution methods:
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Attestation: The FMA's view is that requiring an intermediary to periodically attest to their compliance with contractual and legislative requirements is a "lighter" compliance measure if not supported and verified by the financial institution. The FMA notes attestation may only be appropriate for lower-risk distribution methods and in combination with other processes (e.g. assessment of lead and lag indicators).
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Monitoring of individual advice and sales: The FMA's view is that a financial institution is only responsible for reviewing distribution methods at the general or collective level, not the individual consumer level. A financial institution may use sample testing as a control, but it does not require the financial institution to review interactions with each customer.
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External audits: The FMA confirmed it does not consider external audits or independent assurance reports of intermediaries are necessary to comply with the Act and would not expect to see these as a routine compliance measure in most situations. They may be suitable only for higher risk distribution methods or to respond to a specific risk.
This article is intended only to provide a summary of the subject covered. It does not purport to be comprehensive or to provide legal advice. No person should act in reliance on any statement contained in this publication without first obtaining specific professional advice. If you require any advice or further information on the subject matter of this newsletter, please contact the partner/solicitor in the firm who normally advises you, or alternatively contact one of the partners listed below.