‘Sophisticated’ investors are wealthy — but are they wise?

Investment firms have a vested interest in signing up investors as sophisticated because it reduces compliance overheads, but being a sophisticated investor can be a poisoned chalice.

Any regular investor is probably familiar with the concept of a sophisticated investor — a legal classification that allows you to invest in products that are restricted to wholesale investors.

Some investors aspire to gaining sophisticated investor status. Others already have the status but could hardly be tagged as “sophisticated” because the qualifications are entirely to do with money, not competence.

More recently, the whole notion of sophisticated Investors had been debated, especially in the context of the troubled investment outfit Mayfair 101.

Now the issue is in the courts, with a recent case involving Morgans, one of Australia’s largest full-service broking firms.

The case highlights the increased risk and reduced protection that comes with the territory of being a sophisticated investor.

Investor Caron Sweetser, who is up against Morgans before the Queensland Supreme Court, signed up as a sophisticated investor and alleges Morgans told her it could provide her with “access to investments only made available to the very best clients and … esteemed investors to make real money”. She is now seeking $1.3m for what she calculates is the amount lost on investments made while a Morgans client.

Included in her trades were $500,000 into a property fund operated by fund manager Blue Sky Investments (which was placed into voluntary administration last year) and another trade of over $450,000 buying shares in the company Blue Sky itself.

Investors can pass as a sophisticated investor if they meet one of the tests set out in Section 708(8) of the Corporations Act (2001) and have an accountant sign a certificate to confirm their gross income for each of the last two financial years has been more than $250,000 or their net assets are more than $2.5m. You can also qualify if you intend to invest $500,000 in a product (you do not need an accountant to sign a certificate on this variation).

Simon Carrodus, partner at financial services law firm The Fold Legal, says: “Many people will pass one of the quantitative tests and be classified as a sophisticated investor. However, some of them may lack the qualitative characteristics of a sophisticated investor, being the investment expertise and knowledge. There is a grey area between being wealthy and being sophisticated which needs to be addressed.”

 As such, there are a group of people out there who meet the definition of sophisticated in name only. House prices have risen significantly over the past 20 years while others have received inheritances and meet the $2.5m net assets test. Importantly, funds in SMSFs can also be included in the sophisticated investor criteria.

Although being sophisticated allows you to access some investments that are beyond the reach of the ordinary investor, is it worth the risk? You are deemed to be able to navigate investment markets with no safety net required and miss out on a lot of the protections that the government has put in place.

As a sophisticated investor you receive no product disclosure statement, no statement of advice, less regulations and lower legal protection. Carrodus says the rules are outdated: “The limits set out in the Corporations Act and Regulations are almost 20 years old. This is an area screaming out for law reform: At minimum the quantitative thresholds should be increased to better reflect community expectations of what a sophisticated investor is.”

Carrodus says there are other lesser-known tests that firms can apply should they really want a client to be classified as sophisticated, even if they do not meet the income or assets tests.

No knowledge test or background check is required. As long as the investment provider is satisfied on reasonable grounds that you should be treated as sophisticated, it can happen if you sign a letter acknowledging the same.

Officially, the licensee must be satisfied that the client has previous experience in investing in securities that allows them to assess: the merits of the offer, the value of the securities, the risks involved in accepting the offer, and their own information needs.

Investment firms have a vested interest in signing up investors as sophisticated because it reduces compliance overheads, but being a sophisticated investor can be a poisoned chalice.

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