The trouble with sophisticated investors

This article was current at the time of publication.

Accountants across Australia are dealing with an ever-increasing administrative burden from clients directly, or via financial advisers, seeking sophisticated investor certification.

But, on top of growing paperwork, accountants agreeing to accredit clients face a heightened risk of having to claim on their professional indemnity insurance if clients pursue them for compensation for investment losses.

Accredited sophisticated investors with enough capital can potentially gain direct access to a wider range of financial products than general retail investors, such as in cases where the product issuer has decided to issue its product to a certain category of investor only.

These investments could involve specific bond issues, venture capital deals, investments in hedge funds, private capital raisings by companies seeking to list on the stock market, mezzanine finance for property developments, or other complex financial products. 

These types of investments can require a substantial minimum amount to be invested and can require an investor to be considered “wholesale” to access them. Wholesale products have a minimum A$500,000 entry level.

A lower investment bar

Under the Corporations Act, to qualify as a sophisticated investor, individuals must either be able to prove to their accountant that they have 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 include the family home and superannuation).

While these levels were considered high when legislation was introduced in 2002, many Australian households now potentially qualify to pass the sophisticated investor test purely based on the value of their home and super. It is also permissible for individuals to include net assets or gross income from any companies they control.

Sophisticated investors are unable to benefit from the same legal protections that the Corporations Act otherwise requires issuers of financial products to make available to retail investors.

In practical terms that means sophisticated investors can legally be offered access to wholesale investments without the product issuer being under any obligation to prepare and provide to them with a regulated disclosure document.

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 tailored personal financial advice, a formal Statement of Advice.

“All that’s required to go ahead and invest in a product suitable for a sophisticated investor is for someone to go in and see their accountant and have them signed off as being a sophisticated investor,” CPA Australia’s Senior Manager, Financial Planning and Superannuation Policy, Richard Webb, says.

“There's the general rule of thumb with managed investments that as your entry points increase you get the added advantage, generally, of having your management fees reduce. 

“But in addition to that, you also start to get access to more and more investments that are more or less off limits to retail investors.

“The problem with accountants signing off someone as being a sophisticated investor is that the test is really just a monetary one. It says that just by virtue of the fact that you've got A$2.5 million in net assets or A$250,000 a year in income you might be seen as being a sophisticated investor. 

“But what if you are someone who happens to have that through an inheritance? Do you necessarily have more financial acumen as a result of being a little bit wealthier than the person next to you?”

Treasury review of managed investment schemes

A Treasury review into managed investment schemes has been considering various reform options, focusing among other things on whether the thresholds that determine whether an investor is a retail client or wholesale client for the purposes of the Corporations Act remain appropriate.

A joint submission to Treasury in September 2023 signed by CPA Australia, Chartered Accountants Australia & New Zealand (CA ANZ), the Institute of Public Accountants, and the SMSF Association [the Joint Associations] called for regulatory amendments to enhance the governance and compliance of managed investment schemes and to improve investor understanding and protections.

The Joint Associations recommended that the wholesale product value test should be increased to A$1 million and indexed in line with Average Weekly Ordinary Times Earnings (AWOTE), but only increased in A$100,000 increments.

The Joint Associations also recommended that the net assets test should increase to A$4 million to reflect the impact of increases in asset values, inflation and wages since the threshold was first introduced. It should also be indexed in line with AWOTE, but only increase in A$250,000 increments. The gross income financial threshold should increase to A$350,000 and indexed in line with AWOTE, but only increase in A$25,000 increments.

The submission also called for individuals’ principal place of residence and super subject to preservation to be excluded, and for the requirement for accountants’ sophisticated investor certificates to be removed.

An accounting headache

Unless they are licensed to provide financial advice, an accountant is prohibited from providing personal financial advice. This includes advice to not invest in or dispose of a financial product.

This is problematic where it is clear to an accountant that it is inappropriate for the client to be moved away from the retail client environment. A conflict arises as the accountant has a duty to act in the best interests of the client and comply with Accounting Professional Ethical Standards Board APES 110 Code of Ethics for Professional Accountants.

Public practitioner David McRae CPA, a Director of BBB Partners, says requests for certificates generally come to him from financial advisers on behalf of high-net worth clients, directly from clients wanting to invest in wholesale products, and from others wanting to invest in unlisted assets including private property developments.

McRae follows a standard process whereby clients are assessed on the value of their assets and income, and those under the minimum required levels will not be certificated.

“We're certifying to a degree that the client is sophisticated enough that they don’t need to go through a full disclosure process when making an investment,” he says. “If that client isn’t sophisticated enough and doesn't understand the investment they’re getting into, what’s our exposure to that investment that they've made?

“A lot of financial planners can do this themselves, but they’re not. There’s a section of legislation that they can use, but they never use it because they want to palm it off to us.”