By Jackie Pearson, AFR Smart Investor 24 December 2013
Our personal wealth is growing. It is now much more the norm for retail investors to have net assets of $2.5 million and annual incomes in excess of $250,000.
They are the current thresholds in Corporations Law regulations that enable a retail investor to be certified as a “sophisticated investor”.
All you need to do is ask your regular accountant to certify that you meet those thresholds and you are on your way to accessing wholesale and institutional offers, usually the preserve of the big end of town.
It sounds straightforward and has some definite advantages. Perhaps that’s why some brokers are actively encouraging their retail clients to switch to sophisticated/wholesale.
“If you get a ticket to a bigger game, you should take it,” says Sue Dahn, partner with Pitcher Partners Accountants. “But that doesn’t mean you have to play. You should take the ticket to get through the door to have a look at all the rides in the fairground but if they are too scary, you shouldn’t ride.”
As the market picks up and more companies wish to raise money quickly – without the time and expense of issuing prospectuses and product disclosure statements to retail investors – the number of retail investors being certified as sophisticated tends to swell.
So if you’ve received an offer from your broker or adviser to join the ranks of their sophisticated clients, should you be flattered and fall over yourself to do so, or take a cold shower and consider what you might be giving up?
What does it mean?
The term sophisticated investor is used in the Corporations Act to describe a class of investor that can be offered securities without the usual product disclosure requirements that apply to everyday mum and dad investors.
To become a sophisticated investor, you have to acquire a certificate from a qualified accountant, stating that you have net assets of $2.5 million and/or that your gross income for the past two financial years has been at least $250,000 a year. That certificate must have been obtained within six months of accepting any wholesale offer to acquire securities.
Money lent by the person or entity offering the securities cannot be counted as part of the investor’s net assets. The net assets of a company or trust controlled by the person can be included.
The other way securities issuers (companies) can get out of issuing product disclosure information is if the amount invested is more than $500,000. Anything above this threshold is deemed to be a wholesale investment.
Securities offered under Section 708 of the Corporations Act don’t need disclosure if the offer is made through a financial services licensee and that licensee is satisfied that the investor is experienced enough to be able to assess the merits of the offer, the value of the securities, the risks involved, their own information needs and the adequacy of the information provided by the party offering the securities.
The licensee has to give the investor written notice before or at the time of the offer, that they have a reasonable basis for being satisfied the investor is experienced enough to deal with such matters. The investor has to sign that they have not received an offer document.
So what do you lose?
“Nothing,” says Dahn. “You don’t lose anything, you get more access to opportunities.”
However, even federal Treasury and the Australian Securities and Investments Commission have suggested that the rules surrounding the definitions of wholesale, sophisticated and professional investors may need review.
As part of the Future of Financial Advice consultancy process, Treasury issued an Options Paper in January 2011, inviting submissions about the application of the wholesale client and sophisticated investor tests in the Corporations Act. Submissions produced during that process provided some useful criticism of the current rules.
Thus far, the federal Government has not acted to make any changes to the rules. However, director of technical and professional standards for the Self-managed Superannuation Professionals’ Association of Australia (SPAA) says the organisation has put it “on the agenda with the current government” and is hopeful issues will be addressed as part of the Abbott government’s proposed review of financial services regulation.
The big “watch out” with the current rules, according to Dahn, is that just because an investor meets the objective definition of sophisticated investor, doesn’t mean they are “sophisticated in any commonly held definition of the word”. The current thresholds are more a measure of a person’s wealth than their financial IQ.
The current test means it is possible for inexperienced or unsophisticated investors to fall through the cracks and lose their opportunity to have access to product disclosure statements and prospectuses that reflect the nuts and bolts of a security offer.
“If there are retail offerings, becoming a sophisticated investor doesn’t stop you from participating,” says a senior private client sharemarket adviser.
“It gives you additional offerings because you are included in opportunities that retail investors cannot access.”
However, in exchange for those opportunities, the investment risk is regarded as being born by the investor.
“They are effectively deemed to be professional investors. At the end of the day it is their call whether they want to accept an offer and take on the risk. We will certainly provide them with information and explain our views on where the company is going but the risk is borne by them,” he said.
The assumption, he continues, is that the investor has been there and done it before. They are deemed to have a better understanding of the opportunity before them than a retail investor. They bear the risk.
According to ASIC, many protections in the Corporations Act are provided only for retail clients. If a person is certified as a sophisticated investor or a wholesale client, they do not have these protections, including: provision of a Financial Services Guide (FSG) and a Statement of Advice (SoA); the advisers’ best interests duty and related obligations under FoFA; and the bans on some forms of conflicted remuneration introduced by FoFA.
ASIC and the Financial Ombudsman Service (FOS) have both informed the sophisticated investor that access to the external dispute resolution scheme for non-retail clients is discretionary, and depends on the individual client’s circumstances.
Managing the risk
Wholesale offers are often made at lightning speed. A broker may inform their sophisticated clients that a placement will be available at close of market, that same day, and they will have two hours to decide whether or not to take up the offer.
“You need to put on your very highest amount of scrutiny for all investments but particularly for investments that are made without retail levels of disclosure,” says Pitcher Partners’ Dahn.
“What it should mean is that as the level of opportunity goes up, your level of caution should go up accordingly, as wholesale investment opportunities shouldn’t be considered less risky than those available to retail investors. In fact they are usually more risky.
“Because the sophisticated investor doesn’t get the same level of disclosure, it means they need to apply an appropriate degree of discretion, scrutiny and discrimination.”
Sophisticated investors can come from all different sizes of company from different sectors.
The investor needs to fully understand where securities on offer are coming from. They may even be from private companies, who are not permitted to sell securities to retail investors. In that instance, you may be entering a high-risk arrangement.
It’s also necessary to understand the nature of the relationship between your broker and the party offering the securities without disclosure. Of course, you will be paying normal brokerage for securities purchased but if your broker is also making money on the deal from the securities provider, they may have a vested interest in encouraging you to take up the deal.
Information on ASIC’s website is relatively obtuse when it comes to explaining whether or not an SMSF can be considered a sophisticated investor. It seems clear that if you wish to invest outside of super, in your own name, the amount you hold in super can be included in the $2.5 million threshold.
However, according to Graeme Colley from the SMSF Association, the current regulatory position is that an SMSF can’t itself qualify for wholesale deals unless it has $10 million in assets and is then classified as a professional investor.
Colley says feedback from SMSF investors indicates that brokers are using different interpretations of the rules. If clients have relationships with more than one broker, they may be treated as a sophisticated investor by one and as retail by another.
An uncertain future
If the current definitions of retail, wholesale, sophisticated and professional investor are reviewed as part of the Abbott government’s financial services overhaul, expect the following issues to be high on the agenda:
• Do the $2.5 million asset and $250,000 income thresholds need to be indexed?
• Should the individual’s home and superannuation continue to be counted as part of their $2.5 million asset base or excluded from it?
• Is it fair to put the onus on accountants to pass judgement as to whether an investor is sophisticated?
• Can an SMSF be treated as a sophisticated investor or not?
• Should investors be required to self-select as sophisticated or sit some sort of test to qualify?
Buyer beware for now
Consumer watchdog Choice says it is only a good idea to forego the disclosure available to retail investors if you fully understand the nature of capital markets.
“To receive certification, sophisticated investors must acknowledge and accept the loss of the retail protection provisions of the Corporations Act, which includes, but is not limited to, receiving a financial services guide, statement of advice, offer documents such as prospectuses and access to external dispute resolution services,” says Choice spokesman, Tom Godfrey.
Godfrey says many of the types of investments that are not available to retail investors, such as some IPOs and discounts, “can get people who don’t quite know what they are doing into a lot of financial trouble.
“It’s not too far-fetched to speculate that the designation is being touted by intermediaries, brokers and securities issuers looking to generate more business, whether or not potential clients are truly “sophisticated”. It would certainly be a misnomer for some, if not many,” he says.
“The bottom line is that the investor is opting out of a number of the retail investor protections that are built into the law,” says an ASIC spokesman.
“They should only do so if they themselves feel that they are actually a sophisticated investor, as opposed to someone who just meets the monetary threshold. It is important to weigh up the benefits of being labelled sophisticated with the cost of doing so; that is, loss of the disclosure protections in the law, and the obligations on the advisers to provide information that is personal to the investor’s circumstances.”
Original article here