Retail vs Wholesale Clients – Regulatory Concerns and Responses
While there have been some changes to the wholesale client eligibility criteria since 2004, we appear to be reaching a point where a more fundamental reassessment of the distinction between wholesale and retail clients is warranted as a result of ongoing developments in:
- the manner in which the financial services industry operates;
- levels of client financial literacy and individual wealth; and
- regulatory methodology (moving from a disclosure based approach to a more active, interventionist approach in relation to conduct and product design).
This article looks at the regulatory issues and concerns which have arisen with the current legal definitions of wholesale and retail clients under the Corporations Act 2001 (the “Act”) and how the regulators might respond to them.
The distinction between wholesale and retail clients
Under the Act a person is either a wholesale client or a retail client in relation to a particular financial product or service.
Retail clients are considered by the law as less financially literate than their wholesale counterparts. While a basic level of regulation does apply to wholesale clients, the law requires financial services providers to meet a wide range of prescriptive disclosure, dispute resolution, training, product design and conduct requirements when dealing with retail clients that do not apply to wholesale clients.
The relevant provisions of the Act start from the position that clients should be treated as retail clients. If the advice relates to personal, motor vehicle and domestic types of insurance and superannuation products then this is always the case. For other products it is possible for the client to be treated as wholesale if they meet one of the eligibility tests – although some tests do not apply to all products and services.
- Product Value – the product being invested in or advised on has a value exceeding $500,000;
- Individual Wealth – a person owning net assets of $2.5 million or having a gross annual income of over $250,000 shown over two financial years, as certified by an accountant;
- Professional Investors – a range of institutional investors with specific attributes;
- Large Businesses – having more than 20 employees – or more than 100 employees if the business is or includes the manufacture of goods; and
- Sophisticated Investors – persons that an AFSL holder has determined to be experienced in using financial services.
Concerns with the current distinction
The continuing increase in retail client regulation over recent years (such as the FOFA reforms, adviser professional standards and ASIC’s product intervention powers) together with the increasing ease with which clients can meet the wholesale client eligibility tests has led many financial services businesses to adopt, or consider moving to, wholesale only business models. Consequently, more and more clients are being provided with financial services without the benefit of the consumer protections that are provided for under the Act.
The Australian wholesale client system regards wealth as a proxy for financial literacy. However, it would appear that the Government and ASIC are increasingly uncomfortable in having clients with perceived low levels of financial literacy being treated as wholesale clients and, therefore, not receiving the enhanced regulatory protections which apply under the Act.
Set out below are some of the perceived problems with the current law:
- It allows some clients to be treated as wholesale without them having an appropriate (or any) level of financial literacy.
- There is not always a positive correlation between wealth and financial literacy. For example, a person may exceed the individual wealth thresholds simply by the receipt of a windfall gain such as an inheritance or winning a lottery.
- With increased earnings, escalating property values, increased superannuation holdings and the effect of inflation, the individual wealth thresholds are becoming increasingly accessible to a range of clients who would not have been considered to be “wealthy” in 2004.
- There is no mechanism for the periodic review of the product value or individual wealth dollar thresholds (some have not increased since 1991).
- Tests based on quantification of wealth exclude clients who have the requisite level of financial literacy but not the requisite wealth (a good example being a FASEA compliant financial adviser).
- In most cases a client can be treated as wholesale without requiring their consent – or even knowledge.
- The eligibility tests are difficult to apply where assets are jointly owned (which commonly occurs in domestic relationships).
- A reluctance by AFSL holders to use the sophisticated investor test because of its subjective nature – with the resulting issues of conflict of interest, uncertainty and room for error in judgment which creates fear of later liability.
- Some of the eligibility tests have a business use criteria attached to them. In some tests this requires the product or service to be connected to a business use while in others it requires a non-business use. There is no guidance in the legislation as to what constitutes business use – which creates further uncertainty.
Somewhat surprisingly, there was no consideration of wholesale client issues at the Financial Services Royal Commission. The topic didn’t appear to come up during the public hearings and was not mentioned in either the Interim Report or the Final Report. The Government did issue an Options Paper on wholesale client eligibility in 2011. However, no particular action has resulted from it.
Introducing indexation for the individual wealth and product value dollar thresholds would seem to be a fairly obvious regulatory response. However, doing so does not address the issues that arise from using wealth as a proxy for financial literacy.
The Government and ASIC have both taken steps in recent years to either restrict or modify the full application of the wholesale client rules in relation to particular products.
A particular regulatory focus has been in relation to restricting the use of the “sophisticated investor” eligibility test – it presently cannot be used for a number of financial products. The regulators seem to be increasingly wary of this 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. As to the second concern, the same criticism can be made of the product value and individual wealth tests.
There are also indications that, rather than providing a wide ranging regulatory exemption for wholesale clients, a basic level of regulation might apply in the future to wholesale clients with “additional protections” applying to retail clients. This approach can be seen in the recent crowd-sourced equity funding rules.
Alternatively, the regulators might require that a client who is otherwise eligible to be treated as wholesale must:
- initiate a request to be treated as wholesale; or
- only be treated as wholesale with their prior, informed consent.
Just because you can doesn’t mean you should
It should also be noted that ASIC has also been increasingly willing recently to invoke the “efficiently, honestly and fairly” AFS licence condition to impose an ethical overlay over the conduct of financial services businesses.
Although we have no public evidence of them having done so to date, it is certainly possible that ASIC might invoke that licence condition against an AFSL holder who was perceived to be “exploiting” the eligibility tests to classify financially illiterate clients as wholesale.
In effect, ASIC would be taking the view that just because you can classify a client as wholesale doesn’t necessarily mean that you should.
Practical measures to take in relation to wholesale clients
If you presently have a wholesale client model or are considering moving to one we recommend that you:
- obtain legal advice on whether and how wholesale client eligibility applies to your products and services – the legislative provisions are complicated, not easy to find and involve many exclusions and exceptions;
- be careful in how you assess and evidence wholesale client eligibility and make sure that you implement controls to ensure that it is maintained (for example, accountant’s certificates need to be renewed every 2 years);
- carefully consider whether it is appropriate to treat individual investors as wholesale clients based purely on their level of wealth – some assessment of a client’s level of financial literacy would also appear to be prudent.
Holley Nethercote Lawyers are well experienced in assisting with all aspects of wholesale client issues. Please contact us at firstname.lastname@example.org if you require our assistance.
Author: David Court (Partner)