Understanding the difference between wholesale and retail clients under FOFA

The distinction between wholesale and retail clients has been a fundamental part of the financial services laws since the 2004 Financial Services Reform legislation. However, as David Court explains, with the enactment of the Future of Financial Advice legislation, the distinction has taken on a whole new importance. 

Under the financial services laws a person is either a wholesale client or a retail client. Before the Future of Financial Advice (FOFA) legislation came into effect, the main effects of the distinction were as follows: 

• Only a retail client was required to be given a Financial Services Guide, a Statement of Advice or a Product Disclosure Statement; 
• To determine whether a managed investment scheme needs to be registered or not; 
• A limitation on the authorisations of particular licensees under their AFSLs; 
• Dispute resolution and compensation arrangements only apply to retail clients; and 
• ASIC’s mandated RG146 training obligations only apply to advisers of retail clients. 

Similar rules also apply to the need to issue a disclosure document (such as a prospectus) for the issue of securities.

Although the eligibility for non-disclosure under those rules is largely the same as under the financial services laws, the terminology of ‘wholesale’ and ‘retail’ is not used.   

FOFA and wholesale clients 

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The FOFA legislation creates three new areas of regulation, all of which apply only to retail clients: 

• best interests obligations
• charging ongoing fees; and 
• conflicted remuneration. 

The FOFA legislation also regulates the payment of volume-based shelf fees, but draws no distinction between retail and wholesale clients in this regard. Both parties to such an arrangement would usually be wholesale clients in any event.   

As a result, there has been a renewed focus on the ability to treat clients as wholesale in order to avoid the restrictions imposed by the FOFA legislation.

In view of this, it is timely to look again at the detail of the distinction and, in particular, how eligibility to be a wholesale client is determined. 

The eligibility tests 

A person is required to be treated as a retail client unless the legislation allows otherwise. However, three overriding rules must be kept in mind:  

• For most personal, motor vehicle and domestic types of general insurance products, clients who are individuals and small business clients must always be treated as retail clients regardless of their eligibility to be a wholesale client. 
• For superannuation products the client must generally (except for some large superannuation funds) always be treated as a retail client, regardless of their eligibility to be a wholesale client. 
• If a body corporate is a wholesale client, then any related body corporate is also a wholesale client. 

The legislation creates five main classes of eligibility to be a wholesale client for other financial products and services, and these are described below.

Note that for traditional trustee company services, only the large business and professional investor tests apply. 

Class 1: Product value 

Product value applies if the product being invested in or advised on has a value exceeding $500,000.

However, it does not apply in relation to risk-based products (such as life insurance) or to the extent that investment funds are sourced from a superannuation fund.

If a person meets this test in relation to a product then they can be treated as a wholesale client in relation to that product for as long as they hold it. 

Practical considerations: This is a simple, objective test, the only real complication of which is determining the value of the product in question. The main downside is having to find investors with $500,000 to invest! 

Class 2: Individual wealth 

This requires a person to have net assets of at least $2.5 million or gross income for each of the last two financial years of at least $250,000, as certified by an accountant.  The certificate lasts for two years before requiring renewal. 

In determining the net assets or gross income of a person, the net assets or gross income of a company or trust controlled by that person can be included. Similarly, if a person is eligible to be a wholesale client then a company or trust controlled by that person is also a wholesale client. 

Control is defined as the capacity of one entity to determine the outcome of decisions about another entity’s financial and operating policies. 

Practical considerations: this is frequently used by financial advisers as it is a relatively straightforward test and the adviser can rely on the certification provided by the accountant. The ability to include controlled entities in the calculation is also useful. 

However, due to the superannuation rules, a self-managed superannuation fund (SMSF) will be controlled only in limited circumstances (essentially, a person will control an SMSF only if they are the sole member and the SMSF has a corporate trustee with the member as sole director and shareholder).

As with the product value test, there is also the downside of finding investors with that level of income or assets. 

Class 3: Professional investors 

This category includes a range of investors with one of the following specific attributes: 

• An AFSL holder; 
• A body regulated by APRA, other than a trustee of a superannuation product; 
• A body registered under the Financial Corporations Act 1974; 
• A trustee of a superannuation product with more than $10 million in assets; 
• A person having or controlling more than $10 million in gross assets (including moneys held by an associate or on trust); 
• A listed entity and its related body corporates; 
• An exempt public authority; 
• A person who carries on an investment business that is offered to the public; or
• A foreign entity that would meet one of these requirements had it been established in Australia. 

Practical considerations: this exemption basically covers large institutional and specialised investment organisations.

It is objective in operation and relatively easy to apply in practice. One downside is that it only applies to large superannuation funds and therefore will not apply to the overwhelming majority of SMSFs. 

Class 4: Large businesses 

This category applies where the product is to be used in connection with a business that is not a small business.

A small business is one that has less than 20 employees – or less than 100 employees if the business is or includes the manufacture of goods. 

Practical considerations: while this test appears to cover a wide range of entities, the need to have the product used in connection with the business can be problematic and the test will, obviously, not help in relation to small businesses.

In practice it can also prove to be difficult to ascertain the number of employees a business has at a particular time or whether it manufactures goods. 

Class 5: Sophisticated investor 

The category includes persons who the AFSL holder has determined to be experienced in using financial services. The test consists of five elements which can be summarised as follows: 

• The product is not a general insurance product, a superannuation product or an RSA product; 
• The product or financial service is not used in connection with a business; 
• The licensee (note that a representative of a licensee cannot make the assessment for this test) is satisfied on reasonable grounds that the client has previous experience in using financial services and investing in financial products that permits the client to assess a range of specified factors; 
• The licensee gives to the client a written statement of its reasons for being so satisfied; and 
• The client signs a written acknowledgement in relation to certain matters. 

Practical considerations: while this exemption appears, on its face, to offer a fair degree of flexibility to classify as a wholesale client an experienced investor who does not meet another eligibility test, it does not seem to be commonly used in practice.

The main downsides are: 

• It cannot be used for general insurance or superannuation products; 
• It cannot be used for financial products used in connection with a business; 
• There is a need to go through the formal requirements; and  
• The subjective (and, to some extent, self-serving) nature of the assessment which can make it subject to later challenge by either the Australian Securities and Investments Commission (ASIC) or a disgruntled client.   

In most cases, a person with the potential to be classified under this test is probably likely to meet one of the other criteria anyway.

For those that do not, a licensee should carefully consider whether they can (or should) classify an investor as a wholesale client under this test. 

Proposals for reform 

At the time of the announcement of the FOFA reforms the Government indicated that it would also consider the appropriateness of the wholesale/retail distinction.

As a consequence, the Government released an Options Paper in January 2011 which looked at the current legal position, identified perceived problems, considered international comparisons and raised four options for a new regime. 

The perceived problems with the present system were broadly as follows: 

• The $500,000 threshold had first been set in 1991 and has reduced considerably in real value since that time. 
• Wealth is not always a good proxy for financial literacy.
• It allows some investors to be treated as wholesale without them having appropriate (or any) investment knowledge.
• It prevents other investors from being treated as wholesale even where they do have appropriate investment knowledge.
• The reluctance of licensees to use the sophisticated investor test. 

Since the issue of the Options Paper there have been no further developments in this regard.  However, it is likely that the Government will revisit this issue at some time in the future.

David Court is a senior lawyer at Holley Nethercote Commercial and Financial Services Lawyers.