‘Sophisticated investor’ criteria under scrutiny due to financial pitfalls

Everyday investors who meet the criteria of “sophisticated” because their home gets counted can be seduced into investments where the ultimate cost can be damaging.

If you have ever thought about becoming a “sophisticated investor” then you had better move fast.

Powerful industry stakeholders are pushing the government to widen a newly announced inquiry to fully examine how the sophisticated investor regime is working. Industry groups want to return the regime to the exclusive use of multi-millionaire investors.

In one of the few unexpected moves of the budget, the government announced an inquiry into Managed Investment Schemes which is going to actively examine the classification of sophisticated investors. Specifically, the inquiry is expected to look at the distinctions between sophisticated investors and non-sophisticated investors in relation to MIS schemes.

Tracey Scothbrook of the Self Managed Super Fund Association says: ”We hope they fully examine this now – not just the MIS dimension but the entire area of sophisticated investors … it’s time to sort this out.”

Frustration with the easy access to sophisticated investor status has mounted in recent months and the The Australian Law Reform Commission has branded it “grossly out of date”.

Under current rules an investor must have either $2.5m in assets or an income of $250,000 for two years in a row. There is no “test” whatsoever to determine if the applicant is actually sophisticated in relation to finance or markets.

The entry criteria for the scheme has not been indexed or updated for 20 years. Moreover, since the family home can be counted in an application, the boom in residential property prices has meant it is now accessible to more than three million investors.

Many investors aspire to be classified as “sophisticated” in order to optimise their choices across the investment. However, with such lax entry rules the sophisticated investor regime has been regularly exploited by brokers, advisers and investors.

A string of failed investment schemes has left supposedly sophisticated investors with big losses. Sophisticated investor status allows investors to access schemes such as property deals and hedge funds, but it also excludes them from common consumer protections.

The problem for the Treasury – which has received nearly $3m in funding for the review – is whether the reform of the scheme should be a mere escalation in the financial entry point or whether it should involve some test of appropriateness.

Any moves against the current arrangements can expect a backlash, particularly from stock brokers.

The SMSF Association, along with the Advisers Association, fund manager Wilson Asset Management and law firm Minter Ellison have all come out in favour of having some form of a knowledge test as part of the new criteria.

On the other hand, some stakeholders suggest the government should simply lift the dollar criteria much higher.

The Financial Services Council suggests $5m in assets as a new minimum. This would instantly cut about 275,000 consumers from the sophisticated investor status. The Financial Planning Association wants the annual income test to go to $350,000.

Virtually all lobby groups want the criteria indexed to inflation in the future.

But any moves against the current arrangements can expect a backlash. Last year, stockbrokers moved quickly to make sure the Australian Financial Complaints Authority did not exceed its regulatory ambit when it ventured into policing the area.

Under a settlement, AFCA can only get involved if there is a dispute over whether the investor should have been classified as sophisticated or not in the first place.

If you look across recent cases where AFCA has got involved in disputes, you will see investors continually claiming they might have been classified as “sophisticated” but when things go wrong they put forward their earnest lack of actual sophistication as a defence.

Certainly the entire regime as it stands is a debacle. At its worst, everyday investors who fall over the line on the criteria – because their home gets included – are seduced into investments where they pay a high cost for the rare benefits of being classified as “sophisticated”.

Simply lifting the dollar threshold would be a blunt instrument.

It would mean wealthy but inexperienced investors would still get caught out. But there would, at least, be fewer people let down by the system.