Do Australia's sophisticated investor rules need a rethink?

By Gary Anders

The Australian Parliamentary Joint Committee on Corporations and Financial Services recently made two recommendations following an almost year-long inquiry into whether the current rules that determine who can be classed as “sophisticated” and “wholesale” investors remain relevant.

Yet, after extensive hearings and receiving almost 130 submissions, the list of recommendations contained in the committee’s final report relating to the existing wholesale investor and wholesale client tests, effectively add up to no changes for the foreseeable future.

Recommendation one is “That the government consider establishing a mechanism for periodic review of the operation of the wholesale investor and client tests; and that any such mechanism include mandatory requirements for engagement and consultation with Australia’s investment industry.”

Recommendation two is “That, subject to a period of stakeholder consultation, the government amend the Corporations Act 2001 to remove the subjective elements of the sophisticated investor test (SIT) and introduce objective criteria relating to the knowledge and experience of the investor.”

Richard Webb, CPA Australia’s superannuation lead, policy, standards and external affairs, says the parliamentary review has “kicked the can down the road” for the time being.

“We are quite downhearted about the fact that what we thought were some fairly reasonable updates to the tests haven’t been recommended by the committee. But, at the same time, I think we knew it wasn’t going to come out with anything earth-shattering anyway,” Webb says.

What are the current rules?

The current sophisticated and wholesale investor tests, covering individual wealth levels and investment values, were introduced by the Financial Services Reform Act 2001 amendments incorporated in the Corporations Act.

They prescribe that individuals can ask an accountant to certify them as a sophisticated investor if they can prove they earned at least A$250,000 in pre-tax income in each of the two previous financial years or that they have net assets of A$2.5 million (which can potentially include the family home).

An individual can also be classified as a wholesale investor if they make an investment of A$500,000 or above. Certified sophisticated and wholesale investors can gain access to investment products that are not available to general retail investors.

But, by being certified as such, they may also lose access to many of the consumer protections that are readily available to retail investors under the Corporations Act.

 

"It’s somewhat terrifying that, if something is not done, you’re going to have people with very small amounts to invest being put into some probably riskier investments, compared to what they would have had access to many years ago — just given the effects of inflation."

 

When the sophisticated and wholesale-test levels were first set almost 25 years ago, only 1.4 per cent of Australian households (104,000) met the minimum criteria for income or net assets. Very few were able to access the capital needed to make wholesale investments.

However, the substantial growth in average wages and asset prices since 2001, especially in property prices but also in share market holdings, means millions of Australian households are now eligible to be certified as sophisticated investors.

Research by Australian National University projects that almost 20 per cent of Australians (11.5 million individuals) currently qualify by 2041, and more than 40 per cent of Australians are likely to qualify under the current threshold rules.

“It’s crazy that there haven’t been any changes after nearly a quarter of a century,” Webb says. “It’s somewhat terrifying that, if something is not done, you’re going to have people with very small amounts to invest being put into some probably riskier investments, compared to what they would have had access to many years ago — just given the effects of inflation.”

The risks of being sophisticated

Being classified as a sophisticated investor can open new investment opportunities, but it may also expose those investors to greater risks, as wholesale investment product issuers aren’t under any obligation to provide them with a regulated disclosure document.

Similarly, there is also no legal requirement for sophisticated investors to be provided with a prospectus, a target market determination document, or, where the investor has received personal financial advice, a formal Statement of Advice.

According to the Australian Securities & Investments Commission (ASIC), certified sophisticated investors “are more likely to be able to evaluate offers of securities and some financial products (such as interests in managed investment schemes) without needing the protections of a regulated disclosure document”.

They’re also considered to be sufficiently skilled to understand the value of investment products or services and the risks associated with investing.

But there are many examples of investors, having been classified as sophisticated, losing large sums of money because were not fully aware of the investments they were buying into.

Recourse to the Australian Financial Complaints Authority is provided on a discretionary basis to sophisticated and wholesale investors and varies depending on the specific circumstances.

Calls to raise the bar

In a joint submission to the parliamentary inquiry, CPA Australia along with Chartered Accountants Australia & New Zealand, the Institute of Public Accountants and the SMSF Association, recommended amendments to the current sophisticated and wholesale investor client rules, particularly regarding the thresholds for each of the tests. 

Likewise, ASIC recommended increasing the test thresholds to account for inflation since their introduction to the Corporations Act. Based on Consumer Price Index data, ASIC recommended lifting the product value test to A$922,000, the individual wealth test to A$4.61 million, and income test to A$461,000.

Chair of the parliamentary committee, Labor Senator Deborah O’Neill, notes that there was significant stakeholder interest in reform of the SIT, on the basis this could provide an alternative to the wholesale investor and client tests based on product value, individual income and assets thresholds.

 

"The proposals included suggestions concerning the current requirements for accountants’ certificates for wholesale investors and clients. The committee did not reach any conclusive view or recommendations on these matters. However, the committee acknowledges that the issues identified raise significant policy considerations for government."

 

“The committee therefore considers that the Corporations Act should be amended to introduce objective criteria to the SIT,” O’Neill says. “This will ensure that potential wholesale investors are not unfairly or arbitrarily excluded from wholesale markets, and thereby promote participation in, and the flow of capital to, Australia’s wholesale markets.”

Dovetailing into this is the parliamentary committee’s second recommendation that the government amend the Corporations Act to remove the subjective elements of the SIT and introduce objective criteria that covers knowledge and experience.

“The proposals included suggestions concerning the current requirements for accountants’ certificates for wholesale investors and clients,” O’Neill says.

“The committee did not reach any conclusive view or recommendations on these matters. However, the committee acknowledges that the issues identified raise significant policy considerations for government.”

Overseas experiences

The parliamentary inquiry heard concerns from some investment industry participants that increasing the test thresholds could have unintended consequences, based on overseas experiences.

In 2023, to account for inflation, the United Kingdom adjusted a number of the thresholds for its wholesale investor and client tests by increasing the thresholds for its income (high net worth) test from £100,000 to £170,000 and assets test from £250,000 to £430,000 respectively.

However, due to the negative impact of the increases on the investment funding of start-up companies and early-stage venture capital funds, the UK government reversed the changes only three months after implementation.

“Australia is not [currently] out of step with international markets regarding our wholesale tests,” says Alternative Investment Management Association regulatory committee member, Paula McCabe.

“While there is some divergence in terms of the numbers used to meet income tests or the assets test, almost all comparable jurisdictions do use one such test or more.”

However, O’Neill points out that the subjective character of the SIT “increases the potential for conflicts of interest,” given it would generally be in the interests of product issuers for an investor to be classed as sophisticated so they can be sold wholesale investment products and services.

“At the end of the day, CPA Australia’s position is unchanged,” says Webb. “We’d like to see, wherever possible, the same kinds of protections for retail investors extended to wholesale investors.

“The amount of money that you have to invest shouldn’t really preclude you from getting access to decent consumer protections.”

Accountants’ certificates remain an obligatory part of the process for investors to be classified as being sophisticated.

However, the criteria for providing them remain opaque.

For example, some accountants are known to include the value of an individual’s home in their asset calculations while others exclude the home. In terms of gross income thresholds, some accountants also include income beyond wages such as franking credits and other one-off income.

“It’s not a very well-policed or well-regulated framework to begin with,” says Richard Webb, CPA Australia’s superannuation lead.

“Some firms do the process very well, though it can be a distraction from the majority of the work that they do.

Other firms come across these certificates less frequently and may not be fully aware of the role that they play.

“Our position on this is that accountants’ certificates should probably be abolished.”

Recommendations amendments

CPA Australia along with Chartered Accountants Australia & New Zealand, the Institute of Public Accountants and the SMSF Association, recommended the following amendments to the current sophisticated and wholesale investor client rules:

• removal of the requirements for the provision of accountants’ certificates
• increasing the product value test from A$500,000 to A$1 million and indexing it in line with Average Weekly Ordinary Times Earnings (AWOTE) in A$100,000 increments
• increasing the net assets test of the individual wealth test from A$2.5 million to A$4 million and indexing it in line with AWOTE in A$250,000 increments
• excluding an individual’s principal place of residence from the net assets test
• increasing the gross income test threshold from A$250,000 to A$350,000 and indexing it in line with AWOTE in A$25,000 increments
• excluding capital gains, employment termination payments and franking credits from the gross income financial threshold
• introducing a requirement for individual consent to be treated as a wholesale investor or client.