A small word that sends a big signal there’s a governance issue ahead

I was halfway through drafting a Wholesale Client Policy for an AFS licensee when I found myself staring at a single word: “may”.

Section 761G of the Corporations Act provides that a client may be treated as a wholesale client if one or more of the statutory eligibility tests is satisfied. Licensees, lawyers and compliance professionals have read the provision countless times. Most probably pass over that small word without giving it much thought.

It occurred to me that “may” should not be construed as making wholesale treatment automatic. “May” instead leaves the licensee with a choice. 

When you spend your days building governance, you start to notice how often legislation stops after marking out the legal boundary. Legislation tells an organisation what it can do, what it must do and what it must not do. It is much less helpful about how a choice within those boundaries should be made. That remaining work falls to the people responsible for governance: deciding how a power will be used, by whom, in what circumstances and with what record of the decision.

That seemed especially important in the case of the wholesale client policy I was working on.

Entry or exception

Every client begins life as a retail client. Retail status is not something that must be earned or established; it is the default position deliberately adopted by Parliament. The Corporations Act then creates a number of exceptions under which a client may be treated as a wholesale client. Those exceptions are unfortunately described as eligibility tests. The term is problematic because it encourages a particular way of thinking. 

In ordinary language, eligibility is binary. A person is eligible to vote, to hold a driver’s licence or to receive the Age Pension. Or they are not. The default assumption appears to be if a client satisfies one of the tests, the door to wholesale status is immediately open. Licensees ought to be very careful with such an assumption.

The wholesale client provisions are better understood as exceptions to the retail default. A licensee considering wholesale treatment is essentially deciding whether to remove protections that Parliament chose to confer unless an exception applies. 

Put that way, it seems reasonable to ask not what test of eligibility can be used to usher in wholesale status, but why it is appropriate, in this client’s circumstances, to withdraw retail protections.

Incentives

Sometimes wholesale classification is sought in the first place because a client wants access to a financial product unavailable to retail investors. Wholesale status also relieves the licensee of many obligations associated with retail status. There are obvious commercial benefits, and I am not suggesting there is anything inherently improper about that.

Wholesale carve-outs also serve a genuine economic purpose. They allow specialist fund managers, innovative products and more sophisticated strategies to develop without carrying the full regulatory burden associated with retail clients. At the same time, they limit retail consumers’ exposure to products and strategies that may be complex or unproven.

The retail default may look like a commercial hurdle to a licensee trying to distribute a wholesale-only product, but it is also a protection deliberately imposed by Parliament. Before treating a client as an exception to that default, a licensee ought at least to consider why it exists.

The unanswered question

I turned to AFCA’s published determinations. There was no shortage of decisions in which AFCA concluded that the statutory requirements had not been met and the client had never been eligible for wholesale treatment. What was more interesting was what I could not find.

After reviewing a considerable number of determinations, I could not find one in which AFCA accepted that the client validly satisfied a statutory wholesale test but nevertheless decided that the licensee should have continued treating the client as retail.

AFCA’s published guidance offers little reason to expect otherwise. In its recent commentary on SMSFs, AFCA said its primary concern must be the legal classification of the fund and that investor sophistication affects compensation, not classification. That commentary concerned the particular statutory test applying to SMSFs, but it still treated classification as the result of applying the law rather than a separate governance decision.

ASIC, too, has repeatedly identified the harm that can arise under the present tests. And yet, ASIC’s own language may help explain the prevailing approach. Its guidance commonly describes a person who satisfies the relevant statutory test as being a wholesale client.

Little wonder, then, that licensees treat satisfaction of one of the eligibility tests as automatically resulting in wholesale classification. The available guidance gives them little help in separating the legal question (can we?) from the governance decision (should we?).

The consequence is significant: when eligibility and classification are collapsed into a single step, the statutory test does more than establish legal permission – it becomes the decision itself. No identifiable person is required to own or explain why the client’s retail treatment should change. That is at odds with governance best practice, particularly where consumer protections are being removed.

The distinction is not trivial and, indeed, it may soon receive judicial attention. A class action presently before the Federal Court includes claims concerning contract for difference (CFD) clients who were upgraded to professional accounts following the introduction of ASIC’s product intervention measures for retail clients. 

The proceeding may bring into focus whether satisfying the legal requirements for wholesale treatment necessarily answers the separate question of whether reclassification should have occurred. It is a question governance teams would be wise to answer before they find themselves in front of a court having it answered for them.

The missing gate

I began to think of the process as involving two gates. The legislation supplies the external gate by identifying when wholesale classification is legally available. A licensee could then impose an internal gate at which it decides whether to use that discretion. 

The internal gate would add no new statutory eligibility test. It would require the licensee to record why it considered the removal of retail protections appropriate in the circumstances. Parliament’s tests would remain untouched. The additional step would simply make the licensee’s professional judgement visible, rather than allowing the statutory test to stand in for that judgement.

On that view, satisfying an eligibility test gets the client to the point at which a lawful decision can be made. It does not necessarily make the decision for the licensee.

Where governance begins

Legislation frequently grants permissions, powers and discretions. It cannot realistically prescribe every circumstance in which those discretions should be exercised. That is the role of governance. Good governance does not exist to rewrite legislation or create additional legal tests. It exists to ensure that where the law confers discretion, organisations exercise that discretion deliberately, consistently and in a manner capable of being defended years later.

Whether a court would ultimately find that the law requires an internal governance gate for wholesale classification is, to my mind, less interesting than the practical question facing a board or licensee. An organisation that intends to be well run should want to know not only what the Act allows, but also why it chose to do what it did and whether it could defend that decision later.

When I eventually returned to the policy I had been drafting, I had a new appreciation for the significance of the word “may” – a small word sending a big signal that wherever legislation creates discretion, governance has work to do.

Scott Barlow is an independent regulatory compliance consultant.