Is the end coming for the Sophisticated Investor?

is the sophisticated investor eligibility test no longer relevant


The distinction between wholesale and retail clients is a fundamental part of the financial services laws.  The continuing increase in retail client regulation over recent years (such as the FOFA reforms) and the increasing ease with which clients can meet the wholesale client eligibility tests has led many financial services businesses to adopt wholesale only business models.

However, a recent, countervailing trend by legislators to tinker with wholesale/retail eligibility has put the continuance of the sophisticated investor eligibility test in some doubt.

The sophisticated investor eligibility test

The sophisticated investor test is one of the 5 eligibility tests for wholesale client status.

Sophisticated investors are persons that an AFSL holder has determined to be experienced in using financial services.  The test consists of 5 elements which can be summarised as follows:

  • the financial service is not a traditional trustee service and the product is not a general insurance product, a superannuation product or an RSA product;
  • the product or financial service is not used in connection with a business;
  • the licensee is satisfied on reasonable grounds that the client has previous experience in using financial services and investing in financial products that permits the client to assess a range of specified factors;
  • the licensee gives to the client a written statement of its reasons for being so satisfied; and
  • the client signs a written acknowledgement in relation to certain matters.

Upon completion of this process the client can be treated as a wholesale client in relation to the provision of financial services and the offering of securities.

The test was not part of the original wholesale client eligibility tests.  It was introduced to allow clients to be treated as wholesale on the basis of their experience and professional training rather than due to their level of wealth.

In addition to the exclusions noted above, we now have 2 recent, specific examples of where the legislators have required sophisticated investors to be treated as retail clients.

The derivative retail client money rules

As the name suggests, the client money rules deal with the handling of client moneys prior to being placed in a financial product.  Such moneys must be kept in a trust account with an ADI pending their application to the issue of a financial product or return to the client after a certain period of time.

Client money rules generally apply to both retail and wholesale clients.  However, special rules relating to the use of client money apply in relation to derivatives (such as forward FX contracts, options and CFDs).  Those derivative client money rules have recently been amended such that different rules now apply to retail and wholesale clients.

However, sophisticated investors are required to be treated as retail clients under these rules.

The rationale for this treatment of sophisticated investors has been described by the Government as:

“This ensures that the sophisticated investor carve-out contained in section 761GA cannot be exploited to circumvent the amendments […] .  While sophisticated investors are generally high net worth individuals, like other retail clients, they may not always have the requisite knowledge of complex financial services such as derivatives to adequately evaluate the risks associated with how licensees use derivative retail client money.”

This explanation seems contrary to the professed rationale for the introduction of the test in the first place – to prefer experience and professional training over level of wealth.

It is also strange that a sophisticated investor will still be a wholesale client for other purposes (e.g. they do not need to be provided with a Product Disclosure Statement before investing in derivatives).

Crowd sourced equity funding

The rules governing the public offering of securities generally require a prospectus to be provided to retail clients – with no disclosure at all required for wholesale clients.

However, when the new crowd sourced equity funding rules were introduced in 2017, a different approach was taken by the legislators.  A base level of disclosure requirements was mandated for all types of clients with a set of “additional protections” applying only to retail clients.

Again, the sophisticated investors were singled out and must be treated as retail clients in relation to a crowd funding service.  No explanation was provided as to why that is the case here.

The perceived problems with the sophisticated investor test

The Government seems to be increasingly wary of the sophisticated investor eligibility test and its complete removal in the future is certainly a possibility.  They appear to have two concerns with the concept:

  • that product issuers are “exploiting” the test to “circumvent” the retail client protections; and
  • that sophisticated investors are not regarded as having requisite knowledge of “complex” financial services.

The first concern is not without some foundation as the eligibility decision can be a self-serving one for the AFSL holder making the assessment.  Many businesses prefer to use accountant’s certificates under the individual wealth tests as providing a better “safe harbour” in relation to wholesale client status.

As to the second concern, the same criticism could be made of the “product value” test and “individual wealth” tests and seems to overlook the reason why the sophisticated investor test was introduced in the first place.

The Australian wholesale client system generally regards wealth as a proxy for financial literacy – but it is increasingly easy for “mum and dad” investors to meet the dollar based eligibility tests due to:

  • the lack of indexation of the thresholds on the one hand (the dollar amounts have not changed since 1991); and
  • increases in real wealth (due to factors such as higher levels of superannuation and rising real property values) on the other hand.

That said, these products do join the exclusions relating to general insurance and superannuation products which the sophisticated investor test has never applied to.

The future of the sophisticated investor test

At the time of the announcement of the FOFA reforms, the Government indicated that it would also consider the appropriateness of the wholesale/retail distinction.  As a consequence, the Government released an Options Paper in January 2011 which looked at the current legal position, identified perceived problems, considered international comparisons and raised 4 options for a new regime.

Since the issue of the Options Paper, there has been no indication that the Government intends to revisit the general issue of the wholesale/retail client distinction.  In the absence of such a general review it seems that we can expect to see more tinkering around the use (and non-use) of the sophisticated investor test.

Author: David Court (Partner)