Pressure remains to tighten up ‘sophisticated investor’ rules abused by market operators

Many Australians are unaware they are ‘sophisticated investors’ and don’t understand the risks involved. Now, potential changes to the system may be postponed.

If you would like a VIP pass to the world of investments, all you need to do is answer one simple question correctly — are you sophisticated?

And to say yes, you do not need to be a Rhodes Scholar, nor do you have to be intelligent at all. Like most things, all you need is money.

The Corporations Act 2001 defines who can be deemed a ‘sophisticated investor’ and creates a divide.

On one side you have the average mum and dad investor who can access retail investments such as retail managed funds, term deposits, ETFs and shares.

On the other side you have three groups of investors which fall under a ‘wholesale investor’ umbrella. In addition to sophisticated investors, the other two groups are professional investors who hold a financial services licence and large investors who invest at least $500,000 into individual investments.

If you make the cut and satisfy the rules as a wholesale investor, the door opens to a network of exclusive investment opportunities. And, like the famous Spider-Man quote, “With great power comes great responsibility.”

While it is true being a wholesale investor gives you access to more opportunities, there have also been many occasions when ‘wholesale only’ investments collapsed, resulting in a significant loss for investors.

The attraction for investment promoters to set up a wholesale-only investment scheme is reduced disclosure requirements, minimal consumer protection, less compliance oversight and less regulation.

Want to feel like an investments VIP? Chances are you may already be one. Picture: iStock.

The government assumes sophisticated investors are experienced enough to make their own financial decisions without the usual protections. Consequently, the ‘buyer beware’ principle applies when it comes to wholesale investments.

Section 708(8) of the Corporations Act 2001 defines what a sophisticated investor is. The test, which has not been updated in over 20 years, requires an investor to have more than $2.5m in net assets or earn more than $250,000 per year for the past two financial years.

This means the 45 per cent of people who own their homes with no mortgage in Bellevue Hill in Sydney and 40 per cent of people in Toorak, Melbourne are automatically deemed as ‘sophisticated investors’ due to the average house prices in these suburbs being $9.17m and $4.7m respectively.

It does not matter whether the residents bought the house themselves or inherited it. Having more than $2.5m in net assets automatically qualifies them as a sophisticated investor.

And, this is the problem. There have been instances where investment promoters have used the rules to their favour and targeted elderly widows who fall into the sophisticated investor category due to the value of their home.

The legislation does not explicitly include or exclude the family home from the $2.5m net assets test. As such, many people in the 50 suburbs in Australia where the average house price is $2.5m or more are likely to be sophisticated in name only due to the value of their homes.

A 2021 Australian National University research paper from associate professor Ben Phillips found when the sophisticated investor test was established in 2001, only 1.4 per cent of Australian households qualified under this test.

However, the 2024 estimate is approximately 15 per cent of Australian households now qualify under the sophisticated investor test.

There have been rumblings for a while as to whether this test needs to be strengthened by the government. The financial services regulator ASIC recommend the income and asset threshold is increased to reflect inflation since 2001, and periodically increased in the future to ensure it continues to keep pace with inflation.

If the government listens to the regulator, the wholesale investor test is likely to increase to between $4m and $4.5m in net assets and $400,000 to $450,000 gross income.

Separately, the Financial Services Council, led by Blake Briggs, has recommended the threshold increase from $2.5m to $5m (including the family home) while leaving the income test unchanged at $250,000.

However, some industry participants are not happy with this. Fund manager Geoff Wilson has been vocal in his displeasure of the sophisticated investor test and the potential for the threshold to increase.

“It’s illogical. It’s farcical. Why transition to something new that leaves investors worse off?” says Mr Wilson.

Instead, Wilson recommends a financial literacy test be introduced so that only people who understand the risk of wholesale investments are able to invest in them.

For now it looks like any changes are not coming for at least another 12 months after reports the government has put the issue on the back burner until after the election.

The responsible minister for any changes is Financial Services Minister Stephen Jones who has a very full diary in the months ahead.

While Jones turns his attention to other matters, investors face the same risks and opportunities when it comes to so-called ‘sophisticated investor’ situations: The best advice is ‘buyer beware’.

James Gerrard is principal and director of Sydney financial planning firm www.financialadvisor.com.au