Wholesale fiasco: Changes confuse rules around sophisticated investor status

As debate intensifies around whether $2.5m in assets is enough to allow any investor to be classed as a “sophisticated” investor, an unlikely development has thrown a spanner in the works.

As most readers would know, $2.5m in assets allows anyone to become a wholesale or sophisticated investor, and that certified status allows investors to access a range of supposedly upmarket products unavailable to retail investors.

It also is generally understood that once you become a sophisticated investor you do not get access to many of the consumer protections available to retail investors, such as having AFCA – the financial complaints office – on your case. The rules around qualifying for this special investor status have not changed for decades and there is a push to raise the bar closer to somewhere between $4m and $10m.

In a submission to Treasury last year, ASIC recommends the bar for a wholesale investor be raised in line with inflation to about $4.6m including the family home, and the gross income requirement be $450,000. (The income requirement, an alternative criteria, is currently $250,000.)

The Financial Services Council recommends that the threshold be increased to $5m if the family home is included, otherwise remain at $2.5m if the family home is excluded. The current rules do not specifically say whether the family home is included or excluded in the net assets test and is up to the interpretation and discretion of the accountant, who ultimately is responsible for signing the wholesale investor clearance certificate to decide this.

In short, there is already a lot of questions swirling around over the exact nature of the sophisticated investor rules: Are they too low? Is it too easy? Should you be able to use the value of your home?

And just when you thought you had a grip on it all, a remarkable case with a remarkable outcome has just appeared to muddy the waters more than ever.

This is what happened … The trustee of a self-managed super fund lost $442,520 in a failed foreign exchange trading scheme. He then took the case to AFCA and achieved a surprise win.

The AFCA case revolved around an SMSF trustee, who in 2021 invested in an investment structure that traded foreign exchange and could be geared up 1000:1. The SMSF trustee was assessed as a wholesale investor, having met the $2.5m net assets test, and provided the financial services company with a signed accountants certificate to confirm.

In September 2022, when there was a sharp devaluation of sterling, substantial losses were incurred on the SMSF trustees account and when they withdrew their funds, only $160,522 was left.

The SMSF trustee complained to AFCA seeking compensation for the losses, and AFCA ruled in the SMSF trustee’s favour.

AFCA acknowledged that the SMSF trustee met the wholesale investor test of $2.5m in net assets contained in section 708(8) of the Corporations Act. However, in section 761G (6) of the Corporations Act, a separate clause that states that a superannuation fund must have at least $10m to be classified as a wholesale investor was referenced in the AFCA ruling.

Tracey Scotchbrook, head of policy and advocacy at the SMSF Association, says: “While the 2001 legislation that defined the wholesale investor test was poorly designed, there was a broad industry consensus that a $2.5m asset test (and a single investment of $500,000) in a financial product set the wholesale parameters for investments acquired by SMSF trustees. “But the recent AFCA determinations have cast a cloud over this consensus, creating a situation where a $10m asset test could be the new benchmark for a consumer to claim wholesale status.”

For those who have not invested in a wholesale investment before, you may be thinking what all the fuss is about. Tim Cheung, CEO of Mantis Funds, says: “Wholesale investors have access to a much wider variety of high-quality alternative funds than their retail peers. Many of these products are offered by global managers who need to consider both Australian regulation and their own local rules. High global compliance standards mean these managers are unlikely to shift to offering retail products which will be to the detriment of investors.”

Taking the AFCA outcome to its logical limit, for SMSF trustees who currently enjoy access to the exclusive investment opportunities offered within the wholesale investment world, many may need to be reclassified from wholesale investors to retail investors. This in turn may result in SMSFs being forced to sell out of their wholesale investments.

On other hand, what would be the point of lifting the qualification level higher if more than a million SMSFs are already covered up to $10m?

Regardless if a wholesale fund manager acts like a retail fund manager, we have uncertainty over the $2.5m assets threshold used by the financial services sector versus the $10m assets threshold that AFCA has used in its decision in favour of a SMSF. Then separately we have a broader change looming regarding the baseline amount of net assets required to be classified as a wholesale investor. With these multiple moving parts regarding wholesale investors, this is a mess – it’s time for a complete review.

James Gerrard is principal and director of planning firm financial adviser.com.au

This article first appeared in The Australian.