First impressions count
Mid-October saw the FMA release an updated guidance on advertising standards. Advertising offers of financial products under the FMC Act (“Guidance”) is the newest go-to reference for those responsible for publishing this type of advertisement. Parts of the Financial Markets Act 2013 (“FMCA”) applicable are fair dealing provisions in Part 2 and specific advertising provisions in Part 3. The categories of financial products captured include:
- Managed investment products
- Debt securities
- Equity securities
- Derivatives
As with previous guidance issued by the regulator, such as April’s Managed fund fees and value for money, the latest offering is principles-based. The Guidance is organised around a set of three distinctive principles:
- What is the overall impression created by the advertisement when viewed for the first time?
- Ensure the advertisement includes all relevant information, as omissions can be misleading, deceptive or confusing.
- Any claims in the advertising must be substantiated.
Organisations governed by FMCA Parts 2 and 3 are required to “consider” these principles in relation to advertising their financial products or services. Not only should these entities carefully undertake such consideration, but they should also be able to evidence that they in fact have done so sufficiently in the event that their advertisements are challenged upon publication. There are strong implications concerning the quality of record-keeping desirable when the principles are being considered within the decision-making context that leads to an FMCA-governed advertisement seeing the light of day.
Moreover, as the Guidance points out, the ambit of FMCA constraints upon financial product and service advertising includes a very wide range of possible communications. Definitionally, the Guidance states:
The term “advertisement” is given a broad definition in the FMC Act. In relation to an offer, or intended offer, of financial products, it means any form of communication made to the public or a section of the public for the purpose of promoting the offer or intended offer. An advertisement may not need to specifically mention an offer of a financial product or even a financial product to be captured by the fair dealing principles and advertising expectations outlined in this guidance. (Guidance, p. 4)
The Guidance goes on to provide a list of eleven kinds of communications captured by the definition, which is no doubt non-exhaustive (p. 4-5). There are standard entries such as magazines, newspapers, radio, television, outdoor signage, product brochures, direct mail, and newsletters. In other words, the sorts of communications that most readily spring to mind as advertising and can usually be subjected to tight production controls. But electronic communications via the internet, social media, professional networking, and digital conferencing are also included, such as mobile phone applications, postings by social media influencers, and forums staged to connect issuers with investors. This fluid and interactive complex of communications is more difficult to manage than conventional advertising and instances may arise wherein financial product and service providers do not recognise that advertising is what in fact they are doing.
From the diversity of communications the FMA deems to be advertising, the magnitude is readily seen of the potential risks that organisations could run in falling foul of the law. For example, when external parties like social media influencers are performing an advertisement, or when a representative speaker at a digital forum responds ad lib to questions in a manner that advertises to members of the audience. Financial product and service providers will need to maintain close, professionally-organised, ideally centralised control of all such advertising communications, taking into account that every instance needs to be duly considered in respect of the Guidance’s principles.
Fortunately the Guidance gives examples and case studies to help interpret what it means.
Advertising to wholesale investors
The Guidance is interesting in the way in which it tackles advertising to wholesale investors (meaning also the subcategory of eligible investors), who are separately classed and treated under the FMCA and its regulations. Usually it is retail investors who are the focus of attention. There are carve-outs permitted under the FMCA for the ways in which providers of financial products and services can legitimately deal with wholesale investors, but not in the case of advertisements:
The fair dealing provisions in Part 2 … apply regardless of whether the person advertising the financial products is licensed or authorised by the FMA, or whether those products are aimed at retail or wholesale [our emphasis] investors. (Ibid. p. 7)
Under the first “overall impression” principle, the Guide specifies:
[T]he form or context of an advertisement is relevant to the assessment of whether it is misleading (see section 13 of the FMC Act). For example, an advertisement for a product suitable for wholesale investors that appears in a national Sunday newspaper may be misleading to some readers, but the same advertisement that is only mailed out to a limited audience of wholesale investors might not be misleading (Ibid.)
The Guidance then goes on to dedicate an entire section, headed “Identify offers made only to wholesale investors” (p. 15), to describing how steps must be taken to avoid potentially misleading, deceptive or confusing advertising – including in respect of context – to wholesale (and eligible) investors as the intended audience versus retail investors. Accordingly, the range over which organisations with advertising exposure to the FMCA regime must expand their principles-based considerations encompasses not just the types of communications being used, but the kinds of investors being appealed to.
The Guide has signalled very clearly to financial sectors subject to the FMCA that there are significant risks that must be engaged with and managed effectively with respect to advertising. The implications clearly extend not only to the likes of debt issuers and licensed MIS Managers, but also to licensed Supervisors who are charged with ensuring that their clients comply with the law.
Wholesale investors and independent custody
The FMCA’s overall regime, which covers advertising to wholesale investors, has some gaps where it comes to other aspects of wholesale investing. One such gap is the lack of any statutory requirement for investments made into wholesale funds to be held by independent custodians. This gap can pose a risk to retail investors whose monies are invested on their behalf by wholesale investors acting as intermediaries such as managed investment scheme (MIS) Managers.
To give an illustration of the potential risk, under the FMCA a MIS, including a KiwiSaver scheme, is required by law to have an independent custodian appointed to hold the assets of retail investors in the scheme. The FMCA’s default option for the custodian is the scheme’s Supervisor, but in practice the Supervisor normally delegates independent custody to a specialist third-party provider. Independent custody of retail investors’ assets is imposed to act as a bulwark and receivership-remote lockbox against loss of their investments due to misconduct on the part of the MIS Manager.
However, if the MIS Manager decides to invest funds held on behalf of retail investors into an underlying wholesale fund, which is not an unusual arrangement and indeed standard industry practice, then the Manager, acting as an intermediary, becomes the wholesale investor in the transaction. The underlying wholesale fund is not required by law to have an independent custodian, and thus the protection of independent custody at the retail fund level is not replicated at the wholesale fund level. Retail investors under this structure do not have independent custodial “lockbox” protection of the portion of their investments that have been invested wholesale on their behalf. This loophole should be addressed.
The need for New Zealand to undertake regulatory reforms in the areas of custody and wholesale funds has been well recognised. In 2017, the International Monetary Fund published a Financial System Stability Assessment (“FSSA”) for New Zealand. This report stated:
The [FMA’s] regulatory perimeter could be reviewed to include wholesale asset managers and custodians, whose activities will become more relevant as the asset management industry matures, bringing potential new risks. (FSSA, p. 7)
The FSSA continued on to state:
The overall regulatory framework for asset management is well developed, but there is scope to consider broadening its perimeter. The provision of custody services does not require a license in New Zealand and, therefore, falls outside of direct supervision by the FMA—or by any other authority. The government could usefully require that these entities be subject to licensing and supervision. Also, wholesale asset management activities are not covered by the FMC Act. This sector may not be significantly larger than the retail sector, but there is insufficient data to assess its risks. (Ibid., p. 33-4)
In its Strategic Risk Outlook 2019 (“SRO”), the FMA picked up on the theme of greater regulation of custodians and wholesale managers. For example, in respect of wholesale funds, into which wholesale investors like MIS Managers routinely place investments, the SRO noted that, “Although we only license retail fund managers and not wholesale, we recognise that wholesale and retail investment management are interdependent” (p. 17). The SRO further stated, “Outsourcing – prevalence of outsourcing of fund management and the lack of regulatory oversight in wholesale funds and custody arrangements mean that we may not have a clear view of some stability risks (p. 20).
The FMA developed these ideas about the interrelationship between custody and wholesale funds further in its thematic review of 2019 entitled Thematic review of MIS custody arrangements – summary findings (“Thematic Review”). The core statements in respect of this interrelationship are set out as key findings, the relevant part stating:
Given wholesale funds make up a large proportion of retail MIS scheme property, custody of wholesale fund units is of particular interest. Wholesale funds and their custodial arrangements are not regulated (other than being subject to the fair dealing provisions of the FMC Act) in New Zealand. As such, the FMA has very little sense of the size, structure, practices or risks in this sector.
While we understand anecdotally that wholesale funds are typically established under a unit trust structure and their trust deeds would generally stipulate that underlying investments should be held with a specialist custodian, this is a matter of business practice and not a regulatory requirement. Retail fund ownership of units of a wholesale fund is evidenced by the wholesale fund’s registry.
There are no regulations regarding wholesale fund registries, though some wholesale fund registry providers obtain independent ‘controls assurance reviews’. These reviews support the MIS custodian in its oversight of the scheme property. This is especially important where the wholesale fund is a related party of the retail MIS manager and segregation of duties is less obvious.
We expect retail MIS managers to perform and document due diligence on the custodial arrangements of the wholesale funds they consider investing in, to ensure that retail scheme property held by the other managers is secured to the level required under the FMC Act. We expect supervisors to provide oversight of these practices. (Thematic Review, pp. 4-5)
The expectations stated by the FMA in the Thematic Review whilst excellent in themselves stop short of a simple regulatory reform that could be implemented in requiring that wholesale funds receiving investments derived from retail MIS must hold such investments within independent custody. This requirement would not only provide the appropriate level of protection for retail investors but would also help ensure further application of FMCA fair dealing provisions that the FMA has addressed from a different angle in the Guidance concerning advertising. There could be further reforms undertaken in requiring that wholesale investors need to obtain certification of their status from the FMA, and that wholesale issuers are made subject to regular FMA evidence-based auditing concerning the FMCA bona fides of their wholesale clients.
Conclusion
“The FMA’s Guidance Advertising offers of financial products under the FMC Act leaves no room for doubt or complacency about the high standards expected by the FMA and the risks potentially arising from non-compliant advertising of financial products and services,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.
“The Guidance is principles-based and has been written to address contemporary developments in advertising such as use of social media influencers to promote financial products and services to the public.”
“As with all principles-based rule systems, special care will need to be applied to correct interpretation of how the principles impact on best practice, with a prudent approach being to interpret the principles conservatively, that is to say, invariably from the perspective of what is in the best interests of investors.”
“The onus will be on providers of financial products and services to demonstrate that they have duly considered all three Guidance principles prior to undertaking publication of advertisements within any medium and proper records will need to be kept of such deliberations.”
“It is significant also that the Guidance addresses the subtleties of context influencing the perception of advertising and the inherent risks of potentially misleading, deceptive or confusing advertising arising, including across the legally-defined divide between wholesale and retail investors."
“As a licensed Supervisor, Trustees Executors is concerned to ensure that the advertising activities undertaken by its clients are in all respects FMCA-compliant, and the Guidance now serves both Managers and Supervisors as a benchmark for judging what good looks like.”
“In the regulatory reform space, Trustees Executors supports introduction of the mandatory requirement that wholesale funds should appoint independent custodians for investments that they receive from MIS Managers on behalf of retail investors, and also other reforms that would tighten up access to the status of the wholesale investor as defined under the FMCA.”
For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt at [email protected].
