Longstanding legislation around wholesale investors is both flawed and outdated according to regulation experts, with the existing definitions for ‘sophisticated’ investors exposing them to undue risk and potential harm.
Under the Corporations Act anyone earning $250,000 for two years or holding $2,500,000 in net assets can be classified as a wholesale investor and accept securities offers without receiving a product disclosure statement or other basic protections afforded to retail investors.
According to Pamela Hanrahan, a professor of commercial law and regulation at UNSW who advised at the Hayne royal commission, the regulation is fundamentally flawed for using a monetary threshold rather than a barrier linked to understanding and experience.
“As time has gone on it’s become less of a proxy for knowledge,” Hanrahan says.
The reasoning behind the regulation is sound; anyone over the threshold should theoretically have either the financial know-how or the resources to source legal and financial advice.
But almost 20 years after the law was enacted, with more people qualifying as wholesale, a host of unregulated providers are targeting wealthy investors willing to forgo protection to access deals marketed as wholesale.
“In securities law theory the idea is that if you’re asking someone to put in a big lump of money they can look after their own information needs,” explains Hanrahan. “But that theory doesn’t translate into these widely advertised public offers.”
Hanrahan points to Mayfair 101 as an example of an investment firm with products seemingly designed for wholesale investors that appear to be marketed to a broader mass-marketed client. This type of targeted mass-marketing, she believes, can be “misleading and deceptive” if it is targeted at people who lack experience with complex illiquid investments.
“I would restrict the general advertising of wholesale offers,” she says. “You shouldn’t be able to advertise in the newspaper, especially without the kinds of warnings that are routinely required elsewhere, including in the UK.”
Using old thresholds
In 2011 Treasury asked for submissions on a number of concerns it had around the distinction between wholesale and retail clients, including whether an indexing mechanism should be applied.
The three monetary thresholds – there is also a $500,000 product value benchmark – stem from a 1997 recommendation made in the Financial System Inquiry that advocated the removal of prohibitions on retail participation in derivatives trades.
The problem is that the figures used in that inquiry were based on figures from 1991. Worse, nobody thought to index them. Treasury addressed this in its discussion paper.
“The threshold for product value was set at $500,000, as compared to average total earnings for Australian full-time workers which were around $29,3004 in 1991,” the Treasury paper notes. “The level of $500,000 is a level now within reach of an increasing number of Australians”.
Somehow, figures that were acknowledged nine years ago to be 10 years out of date remain in place.
“[The] definition needs to be revisited, not only to accommodate for the rise in asset values and incomes but to address the issues arising from your assets not being an accurate proxy of your level of sophistication,” says Mark Bland, a financial services lawyer at Mills Oakley.
As pointed out by Treasury, indexing would ensure the test remains relevant and appropriate. On the other hand, it states, indexing “significantly increases complexity and implementation costs and reduces transparency”.
The number counters
The fulcrum of the classification arrangement is the accountant, who certifies that a client meets one of the three thresholds.
According to Margaret Munetsi, a principal at financial and accounting firm Countplus One, the accountant is best placed to fulfil the role.
“You’ve got the overall view and you’ve also got a sense of the nature of a clients’ investments,” she says.
Munetsi estimates she does “at least one” certification per week. There is little room for subjectivity, she notes, but she can refuse to provide it.
“There is scope to say no, I’m not comfortable with that,” she says. “But I’ve never been in that predicament.”
The notion of objectivity was broached by several lawyers in their 2011 submissions to Treasury. The Law Council of Australia argued that an “arbitrary but objective” threshold would be preferable as it provides “greater certainty”, while law firm Johnson Winter & Slattery advocated a purely objective test that “should not be arbitrary”.
The definitions took a strange turn in relation to SMSF trustees in 2014.
The threshold here is set at $10 million, but ASIC took the unusual step of clarifying “legal uncertainty” by saying trustees with between $2.5 million and $10 million in assets could be treated as wholesale.
In a move Bland calls “unhelpful and unclear”, ASIC added the caveat that it would not step in if anything went wrong.
“Although ASIC will not take action where such financial services are provided on a wholesale basis to trustees… with less than $10 million in net assets… this will not affect any private rights of action that may be available to third parties,” ASIC noted.
Despite being overdue, reform to the sophisticated investor definition faces a number of roadblocks.
Foremost among them is that the existing legislation provides compliance and cost efficiencies – something sorely needed in a financial advice environment groaning under the weight of regulatory change.
While Bland acknowledges the issues with the existing legislation, he also warns against building a nanny state. “We need to be careful about building automatic protections for everyone from themselves,” he notes.
The royal commission recommendations have also created a logjam of regulation that could take some time to push through.
“I doubt it’ll be addressed soon,” Bland says.