Sophisticated investors: special treatment trap for accountants and in…


Australia’s special treatment of sophisticated investors can create traps for both investors and their accountants.

At a glance

  • Investors are exempt from receiving regulated disclosure documents, such as a prospectus, if their accountant has certified them to be either a sophisticated investor or a wholesale client.
  • The rule can create a dilemma for accountants when they receive a request for such certification from a client deemed to lack business smarts.
  • FASEA guidance states that financial advisers have an ethical obligation to ensure that a client is eligible under the law for the status of sophisticated investor or wholesale client.

By David Walker

In the wake of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and a series of financial scandals, Australian financial professionals are under more pressure than ever before to deliver high ethical standards.

Being impacted by that expectation are the special rules designed for a special group of so-called sophisticated investors.

Australian law assumes that ordinary mum-and dad investors are likely to have a fairly rudimentary understanding of investment matters. The rules for these investors aim, however imperfectly, to cater to this limited understanding.

The law, however, also allows for a class apart – a category of investor to whom the normal rules don’t always apply. These are called sophisticated investors and wholesale clients.

They gain this status from Australia’s Corporations Act. As the Australian Securities and Investments Commission (ASIC) notes, the Act requires that investors must usually receive a regulated disclosure document, such as a prospectus or product disclosure statement.

Investors are exempt from this requirement if a qualified CPA or other accountant has certified that they have enough net assets or gross income to be classed as either a sophisticated investor or a wholesale client.

Writing a disclosure document such as a prospectus takes real effort from a company, so it’s not surprising that some prefer to make such exempt offers.

For an investor, however, gaining status as a sophisticated investor or wholesale client carries new risks as well as benefits.

This prompts repercussions for their accountant – particularly if the accountant is acting as a financial adviser, but sometimes even when they are not.

Financial capability

The sophisticated investor rules can create a special problem for one group of people: those who are better at earning and saving money than they are at investing it.

As Keddie Waller, CPA Australia head of public practice, puts it, some advice clients are “put in these products and strategies that they probably don’t have the financial literacy or capability for”. There are, she says, “no protections in place” for such clients.

This in turn may create a problem for the accountants the law requires to certify sophisticated investors and wholesale clients: what should you do with a request for such certification from a client you feel lacks investment smarts?

“If you know your client, then you have a good idea whether they’re in a position where they could actually make decisions as a sophisticated investor.” Michael Davison, CPA Australia

CPA Australia’s advocacy manager and former superannuation policy manager, Michael Davison, has dealt with many member queries on the issue, and describes ASIC’s guidance as “pretty sparse”. The issue of how to deal with such certificates has been “bubbling along for a while”, he notes.

“We often get queries from members [seeking] to fully understand what their obligations are and what they can actually provide, and on what basis they can actually decide if a client is a sophisticated or a wholesale investor.”

Davison says the certificate is a statement of fact: does the prospective investor have either gross income of A$250,000 per year for each of the previous two years, or net assets of at least A$2.5 million.

If not, Davison says, CPA Australia confirms to members that they should not sign the certificate.

Accountants’ concerns

The complication comes where an investor passes the formal ASIC test, but the accountant still believes the investor lacks sufficient skills to be classified as a sophisticated investor or wholesale client. 

As Waller points out, the accountant is not the one providing the advice; they simply assess a person’s assets and income.

However, Davison says CPA Australia believes accountants have an obligation to go beyond the facts of income and assets, and exercise their judgement of financial fitness.

“They’re potentially legally liable if that client is then disadvantaged or suffers a loss,” he says. They are bound by their legal duty to act in the client’s best interests.

“If you know your client, then you have a good idea whether they’re in a position where they could actually make decisions as a sophisticated investor,” he says.

If the accountant concludes they should decline to sign the certificate, “you’d hope if you had that relationship with that client, then you can explain what the risks are and why you don’t want to sign it”.

Critics also point out that the hurdles for income and assets specified in the legislation have not been updated in some time.

History shows at least some advisers find well-to-do but ignorant investors an attractive target. In 2017, ASIC took action to make clear that trust structures can’t be used to get around the sophisticated investor test. It sent accountants a letter singling out investments being made in two tech start-ups, messaging app Kwickie and entertainment streaming business Guvera.

In 2018, ASIC secured a A$6.6 million damages order against securities firm AMMA Private Equity, which had convinced a client in his 80s with Alzheimer’s to buy Guvera shares.

FASEA’s code

As Waller points out, a further complication springs from the new professional and ethical standards framework for financial advisers, which is now being administered as a statutory code of ethics by the Financial Adviser Standards and Ethics Authority (FASEA).

Recent FASEA guidance states that financial advisers – including accountants who act as financial advisers – have an ethical obligation to ensure that a client is eligible under law to be a wholesale client or sophisticated investor. That applies regardless of whether the client has the financial capital capacity or the financial literacy to be treated as a wholesale client. “If you believe they don’t,” Waller says, “you shouldn’t treat them as a wholesale client, even though they’re eligible.”

Waller says this part of FASEA’s guidance has become “an area of controversy”, because existing clients will already have invested in products as sophisticated investors or wholesale clients. Now, under the FASEA code, advisers will have to ask the question anew – do these clients have the financial knowledge or capacity to be sophisticated investors or wholesale clients?

If the answer is no, advisers and clients are in a tricky situation. Says Waller: “[Clients may already be] in wholesale funds, and they’re already in these investments, and they’re already generating these returns.”

FASEA’s code also formally forbids any action where an adviser has a conflict of interest or duty – a particular issue for accountants, who will usually be involved in other aspects of a client’s financial affairs. Waller, however, notes that in discussions FASEA is “taking a more step-back-and review approach”.

Rather than saying that advisers can’t act, she reports, “they are saying you should step back and consider all the factors, and decide whether it’s appropriate for you to act”.

Stephen Glenfield, FASEA’s chief executive, tells INTHEBLACK that the code does not itself create new restrictions for accountants, but says that where an adviser relies on accounting certificates based on assets such as a client’s family home, the client will still not be covered by the exemptions if it is clear they lack an understanding of finance.

The code “would suggest that ethically you should treat this person in a manner consistent with their level of financial understanding”, he says.

“There’s an ethical expectation that an adviser would review the situation – and if the client is eligible to be a wholesale investor [but] their financial literacy would say otherwise, that they should be treated as a retail client,” adds Waller.

The challenge for the sector, she says, is that the code is very black and white, but FASEA’s guidance is more interpretive.

FASEA’s new professional standards are just one aspect of an increasingly complex ethical and regulatory landscape for anyone advising on investments.

Conflicts of interest are under new scrutiny. The royal commission and its aftermath are throwing up challenges throughout the space. More new legislation is expected soon.

“It’s a very challenging time for the sector,” Waller says.

When sophisticated investors get bitten

The idea of establishing a special class of investor has been criticised by at least one Australian academic, Jason Zein, associate professor at the University of New South Wales. As he wrote in The Conversation in November 2016, “there’s nothing particular about having money that makes you a good investor”.

A look at US experience also shows the weaknesses of the sophisticated investors exemption.

For example, US blood analysis start-up Theranos has been the subject of a book, Bad Blood, by John Carreyrou, suggesting it made false claims about its capabilities, and its leadership is scheduled to stand trial this year on fraud and conspiracy charges. Who invested in Theranos? Not retail investors, as the company never issued a prospectus.

Theranos’s investment victims were a string of business celebrities, such as venture capitalist Tim Draper, Oracle founder Larry Ellison, the Walton family (of Walmart fame) and media mogul Rupert Murdoch.

These people are the model of informed investors. They hire people to manage their money and could survive the losses Theranos handed them. Their experience is a reminder that the sophisticated investor exemption removes some important protections. Investors who take advantage of them should be prepared for losses as well as gains.

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Does ethical investment pay higher returns?


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