CPD: Sophisticated and Wholesale investors – changes coming in 2024

07 May 2024

From AdviserVoice - this Regulatory Compliance and Consumer Protection CPD article is proudly brought to you by Russell Investments

The Sophisticated Investor Test – a vital component of the financial consumer protection framework in Australia – is the subject of a series of changes by regulators.

One of the most topical conversations around financial consumer protections is the forthcoming changes to the Sophisticated Investor Test. The subject of much scrutiny and debate since its introduction in 2001, the Sophisticated Investor Test is once again in the news, forming part of a wide-ranging Government review into Managed Investment Schemes.

Whilst at the time of publishing, the outcomes of this review were not yet finalised, submissions and recommendations on changes to the test – including those made by ASIC at the end of 2023 – almost universally have called for the test to be tightened, especially the assets and income thresholds under which a person can qualify as ‘Sophisticated’. To the extent these thresholds have not been changed since 2001, the number of individuals qualifying to invest on a wholesale basis – and therefore forfeiting retail investor protections – has skyrocketed^[1], from 1.9% of the population in 2001, to around 16% in 2022.

This article will examine the current context for Sophisticated Investors, from the current criteria and the inherent flaws to the potential changes and their implications, for individual investors, financial advisers, and other parts of the financial services ecosystem.

The current context – why Sophisticated Investors are ‘in the news’

In the 22/23 Federal Budget announced a review into the regulatory framework for Managed Investment Schemes^[2]. The stated purpose of that review was to examine whether the existing regulatory framework is fit‑for‑purpose, identify potential gaps, and consider what enhancements can be made to reduce undue financial risk for investors.

Treasury kicked off the review by releasing a consultation paper^[3]in August 2023, seeking submissions on a number of matters including the Sophisticated Investor test.

Among the many submissions made to Treasury was one from ASIC^[4], which contained recommendations to apply inflation indexing to the various financial thresholds underpinning the Sophisticated Investor tests (Assets, Income, and Product Value thresholds). Were indexing to be applied on a blanket basis, the financial thresholds would increase dramatically, with the annual income threshold rising to $450,000 and the assets threshold rising to $4.6 million in 2024 including the family home.

While the Treasury consultation process on Managed Investment Schemes closed in September 2023, and is yet to be formally responded to by the Government, a separate Parliamentary Joint Committee (PJC) review of the Sophisticated Investor test remains very much in progress^[5], issuing a call in March 2024 for written submissions, thus effectively re-opening the door to feedback.

Wholesale v retail investors

First of all, it needs to be clarified that the terms Wholesale Investor and Sophisticated Investor are NOT interchangeable. Sophisticated Investors are just one category of investor who is able to access wholesale investments. There are four other categories, as explained below.

A client can be treated as wholesale if they meet one of the 5 eligibility tests referred to in Sections 708 and 761G of the Corporations Act^[6]:

Price or Value Test– the product being invested in or advised on has a price or value exceeding $500,000 (excludes life insurance and superannuation funds)
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.

Looking through a consumer protection lens

The various thresholds in place – including the Sophisticated Investor test – to limit access to wholesale investment products exist entirely to protect consumers from financial harm, by limiting their ability to invest in products that are likely to be more complex, involve higher investment amounts, and carry a higher risk of loss. These products can include unlisted bonds, pre-public IPOs, infrastructure, and private and venture capital opportunities. They can be illiquid in nature, and many come with capital calls.

The list of consumer protections an investor forfeits when they take the wholesale, rather than retail, path is extensive:

the design and distribution obligations (DDO) regime, which requires financial product issuers to identify a target market for their financial products and take reasonable steps to ensure that distribution of those financial products to retail clients is consistent with that target market
various obligations that AFS licensees must comply with including the requirement that licensees have an appropriate internal dispute resolution system to deal with complaints from retail clients, and membership with the Australian Financial Complaints Authority (AFCA)
entitlements to receive financial product and service information disclosure such as a Product Disclosure Statement (PDS) or a Financial Services Guide; and
a range of protections under Ch 5C of the Corporations Act that apply to registered schemes (where registration is generally required when retail clients are scheme members), including the duty for the responsible entity of a registered scheme to act in the best interests of scheme members.

Wholesale clients also forfeit a number of significant additional protections afforded retail advice clients under the Corporations Act, including requirements for advisers to:

act in the best interests of their client (s961B)
ensure their advice is appropriate (s961G)
give priority to their client’s interests where there is a conflict of interest (s961J), and
in many cases, and potential QAR changes notwithstanding, give a retail client a statement of advice (s946A)

Nor do they benefit from provisions around conflicted and other banned remuneration, designed to align the interests of providers of advice on financial products more closely with the interests of their retail clients.

Recognising the flaws and the need to change

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 – a situation that will only increase in frequency as the Great Intergenerational Wealth Transfer unfolds.
The thresholds are not indexed, so with surging real estate prices (especially in capital cities), and the impact of wage inflation since 2022, 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, leading to misclassification on one hand, and a reluctance to apply it for fear of liability on the other.
Guidance around the business use criteria used in some tests is vague.

The misclassification issue

A frequent criticism of the Sophisticated Investor test is the extent to which it can be ‘gamed’ to avoid providing protections to investors who actually need them.

ASIC is on record with their concern that some accountants were inappropriately providing ‘Sophisticated Investor’ certificates.^[7]

The FAAA also observed that mis-classifying retail clients as Sophisticated Investors was “unfortunately becoming much more prevalent and quite widespread” throughout the industry^[8].

More recently, The Australian Financial Complaints Authority (AFCA) warned of an increase in complaints from clients who satisfied financial thresholds but were clearly not ‘sophisticated’^[9]. Indeed, this has led to AFCA revising its guidelines such that it can consider complaints regarding wholesale products, where there is evidence of misclassification (more on this below).

The greater the number of wholesale investors, the greater the risk of harm

As the various thresholds for wholesale investing become easier to satisfy, the number of individuals investing in risky, poorly understood products increases, as does the likelihood of financial harm.

This was neatly summed up In Mayfair Wealth Partners Pty Ltd v Australian Securities and Investments Commission (2022), when the Full Federal Court held that it could not be assumed that all people who meet the product value or individual wealth test have knowledge or experience in financial products^[10].

Potential changes to the tests

Ahead of the recommendations of the abovementioned PJC Inquiry and the subsequent Government response, it is hard to know if the changes to tests will be limited to simply changing the financial thresholds – either by CPI or some other amount – or include other changes, such as tightening the rules around assessing investor knowledge and/or experience.

The simple act of indexing the thresholds (as proposed by ASIC) significantly reduces the number of individuals who would have access to wholesale investments, as shown below.

The FSC’s alternative proposal

Perhaps feeling that the hefty increase in indexed limits was an over-correction, and might inappropriately deny some client segments (e.g. young professionals) access to the greater earnings potential of wholesale investment opportunities, the FSC proposed a different approach revising the various tests.

Their submission^[12] to the MIS Review, released publicly in January 2024, made several specific recommendations, within an overall intent to:

expand the number of consumers who were ineligible to be treated as a wholesale client (and therefore increasing the number of ‘protected’ retail clients) and
make it clearer in what circumstances the Sophisticated Investor test can be used (Noting in their submission the lack of standardised approach to its implementation and some reluctance of Responsible Entities due to the risks of investors claiming they were misclassified, given the test is subjective and lacks implementation guidance).

Specifically, the FSC proposed:

Product value test – retain this at $500,000. (The FSC argues this is still a substantial amount, and it is still reasonable to assume people investing such amounts either have adequate knowledge or can afford to acquire advice.)
Individual wealth test –either
- increase to $5 million (including the family home) OR
- maintain at $2.5 million (exempt the family home).
Gross income test – retain at $250,000.
Improve the Sophisticated Investor test through regulatory guidance or a safe harbour.
Rather than indexation, periodically review the limits to determine appropriateness.
Accompanying these changes should be a two-year transition and grandfathering of existing clients.

How do other markets deal with this issue?

The approaches of international markets have been given particular relevance by many stakeholders in this process. Indeed the terms of reference for the PJC Inquiry specifically call out the experiences of overseas jurisdictions^[13].

In its MIS Inquiry submission^[14], ASIC references the approaches of several markets with similar regulatory frameworks, including:

New Zealand, where an investor is classified as a wholesale client if they have net assets of NZ$5 million or more (equivalent to around A$4.6 million based on current exchange rates)
The United States and the United Kingdom, where asset thresholds are lower, but in both cases exclude assets such as the primary residence. Both markets also supplement thresholds with restrictions on retail investor access to specific products, including illiquid investments.

But perhaps the truest and most accurate measure of a client’s level of sophistication should be based purely on their demonstrated knowledge and experience, rather than income and assets which can be poor proxies for knowledge. In this regard, Singapore should be held up as a shining example.

The Monetary Authority of Singapore denies retail investors access to certain products (including investment linked life insurance products and unlisted unit trusts) unless they can satisfy the Customer Knowledge Assessment (CKA)^[15]. Ways to satisfy the CKA include:

Holding a Diploma or Higher qualification in related fields (e.g. Accountancy, Finance, Economics etc.)
Hold finance-related professional qualifications (e.g. Chartered Financial Analyst, Certified Public Accountant etc.)
Have investment experience: Traded a total of at least 6 transactions in Unit Trusts / Mutual Funds over the preceding 3 years.
Working experience: A Minimum of 3 continuous years in the preceding 10 years of relevant working experience in Finance.
Undergone and passed a specified online course (available on many provider websites) on Unit Trusts and Investment-linked Insurance Products.

Those that “fail” the assessment are deemed to lack suitable experience or knowledge and are required to receive financial advice before investing.

AFCA and wholesale investing – changes to guidelines effective July 2024

One of the most important consumer protections forfeited by wholesale investors is access to redress via AFCA. However, AFCA will consider complaints from wholesale investors if there is evidence that they have been misclassified.

As previously mentioned, the incidence of misclassification has been growing in frequency, and AFCA has been exercising its discretion to consider an increasing number of such complaints.

However, the use of this discretion has, up until recently, lacked transparency and clarity, a point acknowledged by AFCA themselves. Speaking at the Stockbrokers and Investment Advisers Conference in June 2023, AFCA advice lead ombudsman Shail Singh responded to queries regarding the authority’s use of discretion when assessing cases brought by wholesale clients^[16].

“What Treasury said was for Chapter 7 purposes – for Sophisticated and Professional investors – they should be outside jurisdiction unless there is an issue with the classification,” Singh said. He went on to say that AFCA would be proposing changes to its Operational Guidelines in line with Treasury’s’ views.

In March 2024, AFCA announced^[17] that ASIC had approved the proposed changes, and new Operational Guidelines would come into effect on 1^st July 2024. As well as providing further guidance and clarity on the exclusion of complaints lodged by Professional or Sophisticated investors, the new Guidelines also provide AFCA more power to manage unreasonable or inappropriate conduct within the scheme from Complainants and Paid Representatives and ensure greater transparency and understanding of AFCA’s decision making.

Where to from here?

At the time of publishing, the PJC Inquiry into the Wholesale and Sophisticated investors had only just commenced, and so any potential changes remain unknown and some time away from implementation. Similarly, the QAR reforms which impact on some retail investor protections (such as the Statement of Advice) still lack detail as well as being uncertain in their timing.

Regardless of what changes are made to Wholesale and Sophisticated Investor tests, it is clear that working with clients on a wholesale basis – which undoubtedly comes with many advantages for both advisers and clients – is something that should be done with great care, full transparency, and comprehensive client communication, to ensure this is absolutely the right path for the client, and is done with their genuinely informed consent.

Summary

While the outcomes of the Federal Government review into the Sophisticated Investor Test are- at the time of publishing – still pending, there is a consensus among submissions to tighten the test’s criteria, especially the assets and income thresholds. Widespread concerns also exist about the growing incidence of misclassification and the resultant increase in the number of wholesale investors, potentially exposing more individuals to financial risk.

Various proposals have been put forward to address these issues, including indexing thresholds for inflation and refining the test’s application. International approaches offer fresh insights, suggesting a focus on knowledge and experience rather than solely on wealth. Additionally, changes to AFCA guidelines aim to enhance transparency of their decision making and address misclassification issues.

Whatever form the changes ultimately take, Advisers must apply cautious consideration and transparency when navigating wholesale investment scenarios, ensuring the best outcomes for clients.