Sophisticated investors – An essential guide for financial advisers
Who are Sophisticated Investors?
One of the more evergreen topics in financial advice circles is ASIC’s ‘Sophisticated Investor’ definition. It’s a topic that has received even more prominence in the wake of recently released research[1] showing that almost 1 in 6 Australians are now eligible to be classed as ‘financially sophisticated’, a figure that could rise to 43% over the next 20 years.
With the designation of clients as Sophisticated definition to be investigated as part of the forthcoming Quality of Advice Review[2], this article serves as a timely reminder of the legislative intent behind the definition, the advantages, and pitfalls, of the definition for clients and advisers alike, its procedural implications, and the consumer protection and compliance considerations for financial advisers who wish to work with selected clients on a non-retail basis.
When is an individual not a retail client?
The Corporations Act (the Act) distinguishes between retail and wholesale clients in relation to financial products and services.
The very basis of this distinction can be viewed in consumer protection terms. Simplistically, retail clients are considered in law to have lower levels of sophistication (i.e., financial literacy) than wholesale clients, giving rise to an extensive framework of protections designed to mitigate their increased risk of making poor decisions. This includes a wide range of retail only requirements around disclosure, dispute resolution, product design and conduct.
The starting point of the Corporations Act is that all clients, by default, should be regarded as retail clients, and in the case of advice relating to personally held general insurance products (including car, home, and travel), then this will generally always be the case.
For other products, however, it is possible for the client to be treated as wholesale if they meet one of the 5 eligibility tests referred to in Sections 708 and 761G of the Act:
- Price or Value Test – the product being invested in or advised on has a price or value exceeding $500,000 (Products of the same class from the same issuer can be aggregated for the purposes of this test)
- Wealth or Income Test – a person owning net assets of $2.5 million (including the family home but excluding non-SMSF super) or having earned a gross income of $250,000 or more per annum, in each of the two previous years, as certified by an accountant
- Professional Investor Test – a range of institutional investors with defined attributes, including licenses, bodies regulated by APRA and those controlling a trust or body with at least $10 million in net assets
- Size of Business Test – having more than 20 employees – or more than 100 employees if the business is or includes the manufacture of goods
- Sophisticated Investor Test – persons that an AFSL holder is satisfied have sufficient experience in using financial services and investing in financial products to allow them to assess the merits of the product or service, the value of the product or service, and the risks associated with holding the product.
Note that there some circumstances where even Sophisticated Investors must be treated as retail clients, and these are explained below.
(An accountant’s certificate is valid for 2 years only. ASIC determines a ‘qualified accountant’ to be an accountant who is either a chartered accountant, CPA, or member of the Institute of Public Accountants, and satisfies the ongoing professional development requirements of those bodies.)[3]
Why the distinction matters
Being classed as a Sophisticated Investor, and stepping outside the retail realm, carries both risks and opportunities for both clients, and their advisers.
For a client, the main upside is the ability to access investment opportunities offered not generally available on a retail basis. These can include unlisted bonds, pre-public IPOs, and private and venture capital opportunities. Clients may also be able to benefit from lower fees if the adviser passes on the cost savings inherent in the less stringent compliance requirements.
From an adviser perspective, the potential cost savings inherent in a less stringent compliance framework can be a compelling reason to work with clients on a non-retail basis, as can the economic benefits of working with clients who have more to invest and are (potentially) more willing to pay fees.
And for those advisers who see themselves as true investment specialists, the ability to access a bigger universe of opportunities is almost a matter of professional pride.
But the legislation as it currently stands is problematic for many reasons:
- Using wealth or income as a proxy for financial sophistication/literacy is flawed. Some people are wealthy by courtesy of an inheritance, not through their own sound financial judgement.
- The thresholds are not indexed, so with surging real estate prices, and the impact of wage inflation, the thresholds are becoming easier to reach and therefore less meaningful than when first introduced
- Tests based on quantification of wealth exclude clients who have the requisite level of financial literacy but not the requisite wealth
- In many cases a client can be treated as wholesale without requiring their consent – or even knowledge.
- The eligibility tests can be complex to apply where assets are jointly owned (as is common for most couples)
- The sophisticated investor test is based on the judgement of the AFSL holder, and many are reluctant to apply it for fear of later liability.
- Guidance around the business use criteria used in some tests is vague.
Furthermore, a major downside for non-retail clients is that they forfeit a number of important protections against their own sub-optimal decision making, poor product design and inappropriate advice.
The list of protections forfeited by non-retail clients includes:
- Disclosure and informational protections including the right to receive an FSG (s941A), and a PDS (s1012B). Where advisers deal with both retail and non-retail clients, an FSG must still be provided at the very first point of contact, before any services have been provided.
- Annual renewal of ongoing fee arrangements (s962R & s962S).
- The Statement of Advice.
- Access to free dispute resolution services, including AFCA.
- The right to be compensated for losses or damage suffered because of breaches of the relevant obligations by the licensee or its representatives.
- The minimum training requirements applicable to providers of retail financial services under RG 146.
Sophisticated and Wholesale are not the same
Whilst many people use the terms ‘Sophisticated Investor’ and ‘Wholesale Client’ interchangeably, they are actually different, and there are important legal reasons to respect the distinction.
Firstly, the introduction of the FASEA Code of Ethics in 2020 placed a great responsibility on advisers to consider their client’s actual financial literacy. Prior to that point, all a retail client had to do to be classed as wholesale was to have a qualified/registered accountant certify that they had passed the Individual Wealth test. All an adviser had to do was to see that certificate.
However, under FASEA’s guidance[4], a client should not be classed as wholesale purely because they hold an accountant’s certificate. Put another way, investors previously considered to be wholesale are effectively now seen as retail investors holding a certificate, until the adviser uses their professional judgement to assess whether the client would pass the Sophisticated Investor test.
(This tension between the Corporations Act and FASEA remains an extremely grey area, a point noted by FPA head of policy and standards Ben Marshan, who suggested the lack of consistency could cause widespread confusion amongst advisers.)[5]
The second reason to respect the distinction is that for certain categories of products, Sophisticated Investors must still be treated as retail clients. These products include forward FX contracts, options and CFDs).
The easiest way to think of the distinction is that the Sophisticated Investor test is just one way you can be eligible to access wholesale opportunities. (There are 4 other tests),
Complexities involving SMSFs
The popularity of SMSFs continues to grow. According to the ATO[6], in 2020 there were 597,000 active SMSFs in Australia, comprising 1.1 million members. The average fund balance was $1.3m, and in this context, the ability to access a wider universe of investment opportunities can be extremely appealing.
SMSFs can generally be regarded as sophisticated if:
- the fund holds net assets of at least $2.5 million or has income for the past 2 years equal to or greater than $250,000, or
- the fund is controlled by a person that already meets the assets test for sophisticated investors as an individual.
Furthermore, in some circumstances, trustees of SMSFs can use the assets of the fund towards themselves meeting the sophisticated investor threshold as an individual.
But there is a caveat to the above criteria for advisers to be aware of with multi member SMSFs, arising from the concept of ‘control’.
ATO data[7] suggests around 70% of funds have 2 members. The majority of these would be ‘mum and dad’ funds, where both are trustees, and have equal decision-making power. For the purposes of s50AA (3) of The Act, this means no single person is deemed to be in control.
According to the SMSF Association[8], ASIC guidance suggests that, unless it can be clearly determined that one person has a controlling interest in the SMSF (for example, because they are the sole trustee or they are the managing director of a corporate trustee), then:
- The assets of the SMSF can’t be used in the wealth test for either mum or dad as individuals, (as neither control)
- The fund can’t take advantage of mum or dad’s own (existing) Sophisticated Investor status, (as neither control)
- Even if both mum and dad separately meet the wealth test given their other assets, because neither control the fund, Sophisticated Investor status cannot apply to the fund.
ASIC and the problem of misclassification
A frequent criticism of the sophisticated investor exemption is the extent to which it can be ‘gamed’ to avoid providing protections to investors who actually need them.
In 2017 ASIC said it was concerned that some accountants were harming retail investors by inappropriately providing ‘sophisticated investor’ certificates.
In a media release, issued in response to a specific share listing, ASIC pointed out that:
“Under the Corporations Act accountants are entrusted with an important role: by providing a certificate of attesting to the assets or income of a person the accountant can attest that a person is a ‘sophisticated investor’ and therefore does not need the protections that apply to a ‘retail investor.”[9]
They made it clear that accountants had more than a ‘black letter law’ responsibility beyond certification of assets.
More recently, The Australian Financial Complaints Authority warned of clients being shoe-horned into risky financial products by advisers who are dubiously classifying them as “sophisticated” investors.
Speaking at the time, AFCA Ombudsman Jacqueline Pirone said she had witnessed “not very financially savvy” widows, beneficiaries of wills, self-managed superannuation funds and homeowners surpass the income and asset thresholds to be defined as sophisticated investors.
“We see significant debate between parties as to whether they were retail or sophisticated wholesale investors,” she said[10].
The Financial Planning Association also observed that mis-classifying retail clients as sophisticated investors was “unfortunately becoming much more prevalent and quite widespread” throughout the industry[11].
Overcoming the weaknesses in the current system
There is no shortage of opinion on how to overcome some of the many flaws inherent in the current system.
Many, including industry bodies such as the FPA and FSC, have called for an increase in the assets test threshold (the FSC supporting a doubling to $5 million[12]).
It seems obvious that the benchmarks should also be indexed.
Limiting assets to truly investable assets is another suggestion (which would mean excluding the family home).
More explicit communication about status – including having people ‘opt in’ as sophisticated investors has also been proposed.
But as meritorious as these ideas are, they do seem to miss the underlying issue of a person’s underlying financial sophistication and capability.
In Singapore, an approach based on actual financial knowledge was introduced in 2012.
The Customer Knowledge Assessment[13] attempts to judge whether an investor has the knowledge or experience to understand the risks and features of investment products such as managed funds. Individuals passing the test have largely unrestricted access to retail investments. Those that “fail” the assessment are deemed to lack suitable experience or knowledge and are required to receive financial advice before investing.
In Australia there is a growing chorus of stakeholders calling for knowledge tests to replace assets tests. After all, a financial services worker earning $100,000 is likely to be more financially savvy than a builder earning $250,000.
But perhaps the issue was best summed up by the founder of a local fintech, who noted that:
“Having less money doesn’t make you stupid. More opportunities mean more options, which means more diversification and, strangely, potentially lower risk.”[14]
In summary
The topic of sophisticated investors has become far more prominent recently, as advisers encounter more and more clients who – because of wage inflation and surging property prices – meet the criteria to be classified as ‘Sophisticated’. Furthermore, the forthcoming Quality of Advice review will examine many issues surrounding the Sophisticated Investor definition, including the process of classifying investors as ‘Sophisticated’ and the associated consent mechanisms.
In addition to the practical realities of dealing with a segment of clients on a non-retail basis, the potential for major changes to result from this forthcoming review make this topic one of the most important for retail financial advisers to be across.
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