Out of touch: the ‘retail’ versus ‘wholesale/sophisticated’ divide and the case for reform, not trauma

Introduction

The distinction between ‘retail’ and ‘wholesale clients/sophisticated investors’ is crucial to the operation, regulation and function of financial services in Australia.  The problem is, the definitions underpinning this critical distinction are hopelessly out of date – on average, about 20 years out of date.

Why does it matter?  

Because the ‘retail’ / ‘wholesale/sophisticated’ binary is central to the consumer protections and disclosure regime underpinning our capital markets and financial services industries.  It’s also central to the financial services licensing regime.  These are two key pillars of our financial services laws and regulation, each undermined by these outdated definitions.  Further, ASIC’s recent forays into interventionist regulation of ‘risky’ financial products have turned on these definitions, as to what products they ban and for whom.

What’s the upshot?  

Likely hundreds of thousands of consumers who laws were designed to apply to and protect, are excluded from those laws’ application and protections.

So why not just update them?  There are good reasons why they need reform.  But a blunt approach will have potentially significant adverse flow-on effects for a financial services industry struggling to adapt to the ad hoc, reactionary reform of the last decade.  It will undermine the ‘wholesale/sophisticated’ only models to which many financial services businesses have pivoted towards and reduce availability of advice to some consumers.  Changes in isolation will fix some issues but exacerbate, and create, others.

What’s the solution?  

Proper, considered, regulatory reform.  Something that has been missing for about 20 years.  But is it coming?

What are these definitions?

What is a wholesale client/sophisticated investor?

Under section 708(8) of the Corporations Act 2001 the key criteria are:

• Product value – section 708(8) deems that an investor is ‘sophisticated’ where the minimum amount payable on acceptance of the relevant offer is $500,000:

• Individual wealth – a person, or a company or trust controlled by 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

Under sections 761G and 761GA there are five eligibility criteria.  Three are relevant here.  If you meet one of the following you are wholesale:

• Product value – the investment under consideration/advised on has a value of at least $500,000;
• Individual wealth – a person owning net assets of $2.5 million or having a gross annual income of at least $250,000 in each of the two preceding financial years, as certified by an accountant;
• Sophisticated investors – an AFSL holder can determine the investor is experienced in using financial services.

As explained below, a number of crucial aspects of the financial services laws operate differently with respect to retail investors, as opposed to wholesale clients or sophisticated investors.  Put simply, sophisticated investors/wholesale clients are excluded from a number of disclosure, licensing and conduct based protections.

The key crossover between the two definitions is in the Product Value and Individual Wealth tests.  Elements of these tests have been in place since the 1990s and have not been updated since at least 2004.  As for the ‘sophisticated investor’ exclusion, AFSL holders are reticent to use it because of its subjective nature and the potential liability risk involved.

The rationale behind the monetary limit carve-outs

In 2006 ASIC said that the rationale for the sophisticated investor exception is that individuals meeting one of these criteria:

“…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”.  

In our view, asset accumulation is an over simplistic and at times misleading test for financial literacy, let alone sophistication.  

There are many circumstances in which an otherwise unsophisticated investor in obvious need of consumer protections may accumulate a high level of assets; retirees who have withdrawn their superannuation, and individuals inheriting assets from their parents or other relatives are but two common examples.

Leaving that serious and practical fact aside, assuming the rationale stated by ASIC may have been reasonable in 2001, and perhaps even in 2006, it certainly cannot seriously be entertained in 2021, for reasons explained below.

Old law, based on old economic facts

The Corporations Act 2001, as the title suggests, came into effect in 2001.  While parts of it have been added to or amended several times as a result of policy shifts, inquiries, court judgments and market developments, some parts have been gathering dust and left unchanged.  One of those is the characterisation of a sophisticated investor and wholesale client.  

The ‘$500,000’ distinction between retail and ‘wholesale’ clients has been in the securities laws since 1994 and remained unchanged.  While the ‘net assets’ and ‘income’ criteria are similarly out of date.  

The creeping characteristics of inflation, alongside the unprecedented and sustained boom in Australian home values, has placed the old definitions out of step with economic reality.

Adopting 2001 as the starting point (the Corporations Act’s introduction) using the inflation calculator of the Reserve Bank of Australia (RBA), assets worth $2.5 million in 2001’s dollars have inflated to be worth around $3.9 million today, an increase of over 55%.  Inverting that equation, assets worth $2.5 million today were only worth $1.6 million when the law’s draftsperson put pen to paper.  Specifically looking at home values, again according to the RBA, over this period Australian housing values have benefited from a record long run of sustained growth, of around 7% year on year, well ahead of the general rate of inflation.

Similarly, on income, according to the Organisation for Economic Cooperation and Development (OECD), average annual wages in Australia were around $48,000 in 2001’s dollars.  Since then, the average has increased to around $84,000, an increase of 57%.

All of this is intended to emphasise that, in relative and absolute terms, the average Australian has significantly more assets and income than they did 20 years ago.  

This means that hundreds of thousands more individuals are now captured by the “sophisticated” and “wholesale” definitions than were in 2001.

Why does it matter so much?

Recent cases, regulatory actions and developments in financial services highlight how crucial the distinction between ‘retail’ and, ‘sophisticated investor’ and ‘wholesale client’ (and their related definitions) are to Australia’s financial services regulatory regime.

Centrality of disclosure and other consumer protections for ‘retail’ clients

For better or worse, the financial services regulatory regime still relies heavily on disclosure as a cornerstone for its system of regulation. In financial services the emphasis on disclosure is influenced by the efficient market hypothesis in respect of capital markets as well as informed consent and individual decision making by investors with access to relevant information.

However, the disclosure regime is largely designed for ‘retail’ clients or investors.  Two keystones of this protective regime are the general disclosure requirements under parts 6D.2 and 7.7 of the Corporations Act 2001:

• Part 6D.2 generally requires certain disclosures to be made when making offers of securities to investors, such as a prospectus or an offer information statement; and
• Part 7.7 of the Act generally requires certain disclosures to clients when they receive financial services, such as a Product Disclosure Statement, Financial Services Guide, or Statement of Advice.

However, these bedrock requirements don’t apply to ‘wholesale clients’ or ‘sophisticated investors’.

There are additional requirements of specific disclosure which must be given to retail investors around fees, conflicts and independence.  These sit alongside the ‘prospectus’ and ‘product disclosure statement’ regimes described above which provide mandated, detailed requirements for the content and form of information which must be provided to retail investors and clients.  On top of this there are specific conduct requirements applying only to retail clients.

Conversely, these requirements largely do not apply at all to dealings or advice to wholesale clients or sophisticated investors.  Instead, there is limited guidance or requirements about what advice to them looks like, about what information they must have or be provided with.  Instead, a number of general conduct requirements provide only a high level overlay.

The contrast between disclosure required for retail clients or investors, and that required for wholesale client or sophisticated investors is stark.

In addition, retail investors also receive a host of other protective measures such as dispute resolution, training, product design and conduct requirements.

The licensing divide

Another key pillar of financial services regulation is the Australian Financial Services (AFS) licensing regime.

Subject to specific exclusions, in general a person who provides financial services to another person in Australia is required to hold an AFS licence authorising it to provide those specific financial services and prescribing various conditions about how they are provided.

At the heart of the AFS licence regime is the ‘retail’ versus ‘wholesale/sophisticated’ distinction.  AFS licences themselves distinguish explicitly between financial services provided to ‘retail clients’ and ‘wholesale clients’.  It is faster and easier to obtain and retain a ‘wholesale’ only AFS licence.  Conversely, the requirements to obtain and comply with a ‘retail’ AFS licence are much more onerous.

These requirements dovetail with specific conduct and competence requirements under the financial services laws.

Making easy prey

All this means that some people intended to be classed as retail, and receive the requisite levels of disclosure and consumer protection, are not getting that disclosure and protection because they are falling outside the out of date definitions.  

This means it is easier for rogue operations to target a so-called ‘sophisticated investor’ or ‘wholesale client’ with higher risk products.  There is evidence of these operators targeting inexperienced investors through these outdated definitions, to avoid consumer protections and disclosure requirements.  See the recent Federal Court judgment in favour of ASIC in its case against Mayfair Wealth Partners Pty Ltd and others, handed down on 23 March 2021.

The Mayfair 101 Group raised money through various investment products and used it to acquire real estate and invest in private equity investments, often through loans to related parties.  The case involved fundraising from members of the public who met the ‘sophisticated’ investor test through various ‘notes’ or debentures.  Mayfair promoted the products through its websites, another website ‘www.termdepositguide.com.au’ and newspaper and online advertising, including through google ‘ad words’.  ASIC alleged that Mayfair misrepresented that the Mayfair products had similar characteristics to bank deposits and/or were secured, when in fact they had little effective security if any.

The Federal Court found that Mayfair Wealth Partners Pty Ltd and others engaged in misleading or deceptive conduct, and made false or misleading representations, including false claims that:

• the debenture products were comparable to, and of similar risk profile to, bank term deposits;
• the principal investment would be repaid in full on maturity; and
• the debenture products were specifically designed for investors seeking certainty and confidence in their investments and therefore carried no risk of default.

In reaching his judgment, Justice Anderson quoted from a report by the provisional liquidator.  The report concluded that, whilst investors targeted by the scheme “…typically met the legal definition of a ‘sophisticated investor’’, their characteristics frequently were more reflective of a retail investor”.  

In our view, the operators of the scheme benefited from the outdated definitions, which operate to remove important protections for otherwise unsophisticated investors.

His Honour also criticised the companies’ reliance on sponsored link internet advertising, lamenting that:

“…it is tolerably clear that the Defendants’ marketing strategy was addressed to persons searching for a term deposit in order to divert them to the Defendants’ websites.”  

We believe this further demonstrates the motivation to target unsophisticated investors, while relying on the antiquated legal loophole.

Following its finding of wrongdoing, the Court scheduled a hearing in late September 2021 on the penalties to be imposed.  So, watch this space.

This is not an isolated instance in our experience.  In around 2018 we were involved in a number of actions flowing from the use of the sophisticated investor definition and an investment structuring loophole that led to someone who met the eligibility criteria being proxied for investors who did not meet the asset and income test, a further abuse of the definition.

Underpinning ASIC interventions

These outdated definitions also undermine the effectiveness of ASIC’s shiny new regulatory tools.  

In March and April 2021 ASIC used its product intervention powers to restrict the issue and distribution of CFDs and ban outright the issue and distribution of binary options to retail clients.

Assuming that it was right for ASIC to intervene in the market to prevent harm, then that intervention may not be protecting all those it is intended to, applying only to retail clients.

The industry is changing

These potential risks are heightened, and the regulatory response is complicated by the structural changes occurring in the financial advice industry.  

Increased retail regulatory requirements, imposition of adviser professional and education requirements via the Financial Adviser Standards and Ethics Authority (FASEA), coupled with the continued increasing cost of retail advice, is pushing advisors away from retail clients.  Many financial advice and broking businesses are giving up retail advice entirely, moving to a wholly sophisticated/wholesale client advice model.  

Because the definitions are out of date, people intended by the law to be protected by the requirements for ‘retail clients’ will not be receiving these protections.  

If the definitions are updated:

• It may render some businesses (which have already moved away from advice to retail clients) unviable as the pool of potential clients shrinks; and
• This may exacerbate the decreased availability and affordability of financial advice.

Legislative inaction causing potential harm

There are significant consequences which flow from the ancient definition.  It means a wider range of potentially risky or unsuitable products or services are made available to investors without mandated levels of disclosure and other protections.  Investors who don’t receive a disclosure document will not learn about the risks involved, and so they may invest blindly.  Further, they cannot later argue they relied on the provision of a defective disclosure document to them as a retail client – because they never got one.  

Nor are the other protections available.  Without a sufficient internal and external dispute resolution system available to them, investors may be required to instead pursue private actions in court, which can be costly and time-consuming.  Without the cooling-off period, if they change their minds, they can’t reverse the transaction.

Urgent need for reform, but beware of all the consequences

It is clear that the current law is in desperate need of reform.  The premise upon which it was based (rightly or wrongly) is not applicable.

Other monetary amounts stated in laws do not suffer from the same inflation risk.  Criminal and civil monetary penalties are regularly stated in terms of “penalty units”.  For example, a civil penalty under the Corporations Act 2001 against an individual can be 5,000 penalty units.  As one penalty unit is currently $222, this equates to a maximum fine of $1,110,000.  

The penalty unit amount is regularly indexed and updated pursuant to the Crimes Act 1914.  This is done quickly and simply by the relevant Minister, in this case the Attorney General, publishing a legal notice.  It is unclear why no similar process for updating the 2001 monetary thresholds for sophisticated investors or wholesale clients has been implanted in the last two decades.

One obvious solution is simply to update the monetary thresholds and index these amounts.

But this does not address the question of the actual suitability of a blunt monetary measure as a proxy for financial sophistication.

Nor does it address the potential impact on the financial advice industry which is reeling from sustained changes to advice laws, sustained cost increases, reforms around adviser education and professional standards and prohibition of remuneration models paid for by product issuers.

This shift to wholesale advice only in the industry will be undermined by a blunt updating of the monetary thresholds.  The result? Advisers will go out of business and thousands of everyday Australians will be shut out of available or affordable advice.  

These are structural issues facing the industry and Australian society which do not have simple answers, and which cannot be addressed in isolation.

Former regulator and advisor to the Hayne Royal Commission, Professor Pamela Hanrahan, in an address to the Professional Planner Licensee Summit in June 2021, has again highlighted the need to update the definitions or radically alter them.  She has advocated a move away from the retail definition.

One alternative is to reverse the current structure.  Rather than providing an extensive exemption for wholesale clients, instead build in base-level protective regulation for wholesale, with additional protections for retail clients.  This would in part fill the regulatory vacuum around the content and form of wholesale advice.

ALRC report

Reform may be on its way, although no time soon.  The ALRC is currently considering reforms to simplify financial services laws, reporting over a three year period.  The ALRC’s review was prompted by the recommendations of the Hayne Royal Commission, which highlighted the complexity of financial services laws as a material issue.  The ALRC has been specifically directed to review the Final Report from the Hayne Royal Commission, and the Hon Mr Hayne AC QC is one 11 members of the ALRC’s advisory committee.

However, there are two problems here.  

First, timing.  The ALRC is set to report over a three-year period concluding in November 2023 with its final report.  Its first interim report on ‘Definitions’ is due in November 2021, but it is unclear what the prospect of reform on definitions is based on any interim findings, and in advance of the November 2023 final report.

Secondly, and perhaps more fundamental, why has it taken 20 years and an eviscerating Royal Commission to prompt a structured apolitical review of financial services laws.  Yes, there has been reform in the intervening period, some substantial (future of financial advice) but much of this reform has been heavily politicised and compromised through that process.  Overall this reform has been piecemeal or ad hoc, and ignores some of the bedrock elements of the system, such as the ‘retail’ versus ‘wholesale/sophisticated’ binary.  

In a sector which the entire populous relies upon, and where innovation and disruption is occurring at extraordinary speed the risks of a lack of structured, expert review and reform are concerning.  20 years is too long to be playing catch up.

We await the outcome of the ALRC’s first Interim Report on definitions, and when and what reform rather than reaction, will occur.

We are here to help

We are expertly placed to assist advisors or licensees looking to navigate these complex areas and keep doing business.

Likewise, it is important that individuals who may be improperly targeted by scheme operators looking to exploit the law obtain independent financial advice prior to investing.  

Here at Mackay Chapman, we are expertly placed to advise and assist any individual who is concerned about advice they have received, has been placed in an investment that was not appropriate for them, or has lost money in the process.

Dan Mackay, Managing Director, and Anthony Jensen, Senior Associate

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