Wholesale Client Eligibility – Sophisticated Investor and Individual Wealth Tests

In recent years, the issue of wholesale client eligibility has been attracting increased attention as an area in need of reform.

Of particular interest are recent developments in relation to the sophisticated investor and individual wealth tests. Meeting these tests means that the client is eligible to be treated as a wholesale client – with the consequence that most of the disclosure, conduct and educational requirements of the financial services laws do not apply.

What is a Sophisticated Investor?

Sophisticated investors are persons that an AFS licensee has determined to be experienced in using financial services.

What is the Sophisticated Investor test?

The Sophisticated Investor test consists of 5 elements which can be summarised as follows:

1. the product is not a general insurance product, a superannuation product or an RSA product;
2. the product or financial service is not used in connection with a business;
3. 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;
4. the licensee gives to the client a written statement of its reasons for being so satisfied; and
5. the client signs a written acknowledgement in relation to certain matters.

It should be borne in mind that sophisticated investor status is not a "blank cheque" as it must relate to a financial product or a financial service – and those products and services will need to be set out in the licensee statement and the client acknowledgement. If the client subsequently uses other products or services, then sophisticated investor status would need to be provided anew.

What are the Individual Wealth tests?

Individual Wealth tests require a person to have:

1. net assets of at least $2.5 million; or
2. gross income for each of the last 2 financial years of at least $250,000, as certified by an accountant. The certificate lasts for 2 years before requiring renewal.

In determining the net assets or gross income of a person, the net assets or gross income of a company, or trust controlled by that person, can be included. Similarly, if a person is eligible to be a wholesale client, then a company or trust controlled by that person is also a wholesale client.

The individual wealth tests also do not apply where the advice provided by the Licensee is for use in connection with a business.

These tests are frequently used by financial advisers as they are relatively straightforward, and the adviser can rely on the certification provided by the accountant. The ability to include controlled entities in the calculation is also useful.

SMSFs and the eligibility tests

Subject to our comments below, SMSFs can only be treated as wholesale when the advice is being provided to the trustee, rather than the member. As with all trust situations, it is the trustee that must meet the eligibility test for wholesale advice, not the trust.

Where the SMSF has a corporate trustee, then the company is the client and it is the status of the company that needs to be considered.

Where the SMSF has individual trustees, then the client is the joint individual trustees. It is crucial in this regard to keep in mind that individual trustees must be considered as a joint entity and not as the sum of their individual circumstances.

The individual wealth tests have been frequently used by financial advisers for SMSFs as they are relatively straightforward tests. The adviser can rely on the certification provided by the accountant and the control tests can be used to include net assets or income held in controlled entities.

However, it should be kept in mind that the net assets of a trustee will likely be only a nominal amount (unless it also holds non-trust assets) because of the need to recognise the liability which represents the interests that the beneficiaries have in the assets of the trust. For this reason, the control test becomes important – it permits the net assets of the trust to be counted rather than the net assets of the trustee. While it is relatively easy to ascertain control over a family trust, it is more difficult in relation to an SMSF due to the structure which those funds must take.

That said, it should also be noted that, where a financial service 'relates to a superannuation product', a trustee of an SMSF will be classified as a retail client unless the SMSF holds net assets of at least $10 million at the time the service is provided. Accordingly, the meaning of the expression 'relates to a superannuation product' has become a key area of uncertainty when treating the trustee of an SMSF as a wholesale client.

In August 2014, ASIC issued Media Release 14-191MR which set out the following 'no action' position:

Following ASIC Media Release 14-191MR, it was generally accepted in the financial services industry that all of the wholesale client eligibility tests were available to an SMSF where the advice related to the investment of the SMSF's assets (that is, the advice 'relates to' underlying securities, derivatives or real property, etc. – and not to superannuation itself).

However, AFCA has taken a narrower view of what 'relates to a superannuation product' means. AFCA's view appears to be that a financial service will 'relate to a superannuation product' (including an SMSF) where there is a connection between the financial service and the superannuation product. AFCA has stated that the words 'relates to' have an extremely wide meaning and that 'the phrase can refer to a direct or indirect connection between two subjects'.

AFCA's position appears to be that, where financial services are provided to an SMSF that does not have at least $10 million in net assets at the time the financial services are provided, the individual wealth and sophisticated investor tests are inapplicable and the SMSF will be a retail client on the basis that the financial services provided to the SMSF 'relate to a superannuation product'.

The different approaches taken by ASIC and AFCA in relation to this issue are, obviously problematic for advisers and product issuers dealing with wholesale clients. In the absence of a Court decision on this point or legislative intervention, the 'safe harbour' position would be to treat SMSF clients as retail clients when providing them with financial services.

Changes arising out of the Quality of Advice Review

The Quality of Advice (QoA) Review was conducted by Michelle Levy, a financial services lawyer, who was asked to consider how the regulatory framework could better enable the provision of high quality, accessible and affordable financial advice for consumers.

The Final Report of the QoA Review was provided to the Government in December 2022 and a Government response to the recommendations was issued in June 2023.

Why was the Quality of Advice Review looking into wholesale client eligibility?

The QoA Review was asked to consider whether the consent arrangements for sophisticated investors and wholesale clients were working effectively for the purposes of financial advice.

However, the actual definitions of retail client and wholesale client and the associated income and asset thresholds were outside of the Terms of Reference. Despite that, the Final Report did note that the assets and income thresholds for the individual wealth tests have not been reviewed or indexed since they were first introduced in 2001 and that "there does appear to be a need to consider whether they are appropriate".

For a fuller description of the QoA Review's analysis of wholesale client eligibility you can read our earlier article here.

What did the Quality of Advice Review recommend?

The QoA Review recommended that the individual wealth tests include both disclosure and consent obligations similar to those applying to the sophisticated investor test.

This would involve the following eligibility requirements for the individual wealth tests:

• An accountant's certificate as at present.
• An explanation of the consequences of being a wholesale client.
• The client to sign a written acknowledgement.

The written acknowledgement proposed by the QoA Review would need to explain the important consequences of being treated as a wholesale client, namely that:

• an advice provider is not required to be a "relevant provider" and accordingly will not have to comply with the professional standards;
• an advice provider will not have a duty to give good advice or to act in the best interests of the client under the Corporations Act;
• an advice provider is not required to give the client a PDS or FSG; and
• the client will not be entitled to complain about the advice under the licensee's IDR procedures or to AFCA.

The QoA Review also recommended that this form of acknowledgement should replace the existing form of acknowledgement provided by sophisticated investors.

What was the Government's response to the Quality of Advice Review?

The Government has accepted this recommendation "in principle". However, no details were provided as to the content of the written acknowledgement.

Neither was any specific timing for the introduction of the consent requirement announced. It could well be that the commencement of these requirements is delayed pending the report of the Managed Investment Scheme Review, discussed below.

What is the Managed Investment Scheme Review?

In March 2023, the Government announced that Treasury would undertake a review of the regulatory framework for managed investment schemes and report back to the Government with its findings in early 2024.

As part of that review, Treasury is to examine a number of issues. Of relevance to the present article is the appropriateness of the thresholds that determine whether an investor is a wholesale client.

In August 2023, Treasury issued a consultation paper which provides a background briefing and poses a number of questions. Although the paper deals specifically with managed investment schemes, it states in relation to wholesale clients that:

Interestingly, the consultation paper quotes from a 2021 research note which estimated that, due to a lack of indexation, the number of Australian adults that met the individual wealth tests has increased from 2% in 2002 to 16% in 2021 – and was likely to increase to 31% by 2031.

What does the consultation paper say about wholesale clients?

The consultation paper primarily looks at the $500,000 threshold for the product value test and the dollar thresholds for the individual wealth tests. As noted above, the dollar amounts have not been revised since the introduction of the Financial Services Reform (FSR) legislation in 2001.

The consultation paper does not make any recommendations concerning these tests but does invite submissions in relation to the following questions:

• Should the financial thresholds for the product value test and individual wealth tests be increased – and if so, to what level?
• Should certain assets be excluded when determining an individual's net assets for the purposes of the individual wealth test – and if so, which assets?

It also invites submissions concerning two questions about the consent requirements recommended under the QoA Review:

• How could these be designed to ensure investors understand the consequences of being considered a wholesale client?
• Should the same consent requirements be introduced for each wholesale client test?

Submissions to the Treasury consultation can be made up until 29 September 2023.

Practical measures to take now in relation to wholesale clients

If you presently have a wholesale client business model or are considering moving to one, we recommend that you:

• Obtain legal advice on whether and how wholesale client eligibility presently apply 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.
• Keep an eye out for further regulatory developments in relation to wholesale client eligibility.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.