Urgent review of sophisticated investor criteria needed

This article was current at the time of publication.

Do you, or don’t you?

It’s a question many accountants and financial advisers should ponder if clients ask to be certified under the Corporations Act (the Act) as a sophisticated investor.

To be able to pass the sophisticated investor test, individuals must prove they’ve earned at least $250,000 in pre-tax income in each of the two previous years or have net assets of $2.5 million, which can include the family home and superannuation.

The thresholds haven’t been adjusted since they were set 20 years ago. Accordingly, the number of people eligible to be certified sophisticated investors continues to grow.

Recent modelling by the Australian National University’s Centre for Social Research & Methods found that when the Act’s sophisticated investor definition was legislated in 2002, only 1.4 per cent (104,000) of Australian households met the minimum criteria.

However, because of growth in average wages and asset prices – especially property – the figure has now blown out to more than 11 per cent of all households (one million).

Put another way, above three million Australians effectively meet sophisticated investor rules.

Passing the sophisticated investor test

Gaining sophisticated investor certification opens more investment doors.

Those who meet the financial thresholds and are certified by an accountant as being “sophisticated” can access wholesale investment products out of the reach of average retail investors.

These can be wholesale investments requiring a high initial entry amount; for example, a boutique unlisted managed investment fund that has a minimum level of $500,000 or higher.

Sophisticated investors with enough capital can also gain access to wholesale bond issues, venture capital deals, private capital raisings by companies seeking to list on the stock market, and mezzanine finance products.

As a part of Future of Financial Advice (FOFA) reforms, the Australian Government’s Department of the Treasury released a paper in 2011 in which it discussed deficiencies with the current definition of wholesale and retail clients.

Among other things, the paper proposed updating the monetary threshold for the wholesale product value test to $1 million and updating income and asset thresholds to take inflation into account.

Treasury also floated the option of excluding the family home and superannuation as permissible assets.

However, no action has been taken by any sitting government over the decade since the FOFA review to amend the Act.

“It’s well and truly time [the sophisticated investor qualification thresholds were reviewed],” says CPA Australia’s Senior Manager, Advocacy and Retirement Policy, Michael Davison.

“They haven’t been reviewed in 20 years and [are] woefully out of date. The government never responded to the FOFA review in 2011.”

Risks of sophisticated investor certification

Retail investors have enforceable protections under the Act designed to reduce their risk of making poor investment decisions.

These include specific legal requirements incumbent on investment product issuers and promoters –  including financial advisers – around disclosure, dispute resolution, product design, and conduct.

The rules are different for sophisticated investors. Once certified by an accountant, sophisticated investors effectively relinquish any such legal protections.

They’re regarded under the Australian Securities and Investments Commission’s sophisticated investor test as having sufficient experience in using financial services and investing in financial products to allow them to assess the advantages and disadvantages of different products or services.

They’re also considered to understand the value of investment products or services and the risks associated with investing in specific products, financial securities or other assets.

As a result, there’s no legal obligation on the part of product offerors or financial advisers to provide designated sophisticated investors with either a prospectus, product disclosure statement, target market determination document, or a statement of advice.

In 2021, Treasury recommended that the Australian Financial Complaints Authority exercise its discretion on whether to accept complaints from sophisticated investors unless there was evidence they were incorrectly certified.

Managing clients

The dilemma for accountants is at the client management level, especially if it’s evident a client seeking to be certified as sophisticated clearly lacks the knowledge or skills to understand the risks around the product or products they’re intending to invest in.

“Our advice to accountants and advisers is to use your professional judgement to make sure your clients understand the risks involved, because their protections are removed,” Davison says.

“Accountants also need to consider their obligations under APES 110 Code of Ethics. We have problems where accountants are being pressured by clients to provide certification or are being approached by financial advisers to provide certification.”

Director at Melbourne-based specialist insurance broker Fenton Green & Co, Drew Fenton CPA, says accountants should also be aware of potential liabilities if a certified client suffers an investment loss.

“I think a client would be hard-pressed to come back on an accountant [from] a liability perspective to say they didn’t understand an investment, they’ve lost their money, and they’re going to sue,” Fenton says.

Nonetheless, he concedes that because of proportional liability there could be a case to answer if a client takes legal action against the various parties involved in the investment loss.

“They may try and drag in everybody possible that was associated into their statement of claim,” Fenton warns.

“What I would be doing is putting a clarification on their certification statement that says it’s based on your understanding of the personal or business position of the person or the company at that specific time.”

In short, practitioners should tread cautiously in certifying clients and always exercise professional judgement.