Protecting investors from themselves

When even municipal councils were subjected to multi-million dollar losses through the global financial crisis, Mike Taylor writes that the Government has few options other than to lift the bar on differentiating between ordinary and sophisticated investors.

Some hard lessons were learned as a result of the global financial crisis (GFC) and it is now clear that those learnings will be reflected in the legislation evolving out of the Future of Financial Advice reforms.

That much was made clear last week when the Assistant Treasurer and Minister for Financial Services, Bill Shorten, released an options paper specifically canvassing changes to the way in which ‘retail’, ‘wholesale’ and ‘professional’ investors are defined.

What is made obvious in the options paper is that the GFC and the market events that gave rise to the GFC laid bare the failings of the regime which grew out of the implementation of the Financial Services Reform Act.

In particular, the GFC served to highlight that no one simple rule can be used to differentiate between a ‘retail’ and ‘wholesale’ investor.

So how does one currently differentiate between ‘retail’ and ‘wholesale’ investors? Well, according to the Corporations Act 2001, individuals who purchase insurance, superannuation or retirement savings products are ‘retail’ investors.

However, if those same people purchase other types of financial products then the assessment of whether they are a ‘retail’ or ‘wholesale’ investor is determined by four tests — the value of the product, their individual wealth and whether they could be deemed to be ‘professional investors’ or a ‘small business’.

Up until now, the threshold value of a product for a ‘retail’ investor has been $500,000 but there is already widespread support for doubling this amount because of the effects of inflation, rising average weekly earnings and other factors over the past 10 years.

Equally, the appropriateness of utilising individual wealth as a measure of someone’s investor status is also being questioned in circumstances where recent research has suggested that some very rich people actually exhibit very low levels of financial literacy.

It is in these circumstances that the wealth measure may well give way to a methodology that includes the measurement of a person’s level of financial literacy.

However, the lessons of the GFC do not stop there with discussion within the options paper suggesting that even local government bodies such as municipal councils may lack the financial literacy necessary to be deemed ‘wholesale’ investors capable of unilateral involvement in complex financial products.

The options paper specifically pointed to the problems encountered by Australian municipal councils that had, unwittingly or otherwise, invested in complex financial instruments sold by Lehman Brothers.

It stated that Lehman Brothers in Australia had operated by soliciting funds from investors that were used to purchase cash, bonds or other low risk financial products but then “used these low risk assets in far riskier credit default swap agreements which were intended to generate higher returns”.

The options paper said a good example of the way these investments were marketed to investors was the way that Lehman Brother’s Torquay fund was marketed to Parkes Council.

It said that Parkes Council had claimed it was not made aware of the risks of investing in collateralised debt obligations (CDOs) and that between 2005 and 2007 the council put more than $13.5 million of savings into CDOs, with the investments offering a return of 1.2 percentage points above the Australian bank borrowing rate and a double-A credit rating from Standard and Poor’s.

Parkes and other councils caught up in the problem claimed the risks of investments in CDOs were not adequately explained and the options paper makes clear that because the councils had been designated as ‘wholesale’ investors, there was no requirement to provide them with a prospectus, Product Disclosure Statement or even a general warning on the riskiness of the products.

The options paper makes clear that if the councils had been classified as retail clients they would have been entitled to a number of protections and that “potentially these protections would have allowed the councils to decide that the risks of CDOs were too great for the councils to countenance”.

What is clear from the Government’s options paper is that the product thresholds will be lifted to at least $1 million and that the measures by which a person is deemed to be ‘wealthy’ will be tightened by effectively removing some assets from the underlying equation.

The options paper also canvasses the total removal of the distinction between wholesale and retail investors — something that would ensure virtually everyone except those deemed to be ‘sophisticated’ investors would be subject to identical safeguards.

Where ‘sophisticated’ investors are concerned, the options paper also canvasses actually testing their financial literacy to ensure that they are as competent as is being assumed.

The one option canvassed in the Government’s document that will not be followed is option 4 — “To do nothing”.

Shorten has made it very clear that as part of the broader Future of Financial Advice changes, the Government wants to address the failings identified following the GFC. On that basis, financial planners can expect the bar to be raised all round.

Indeed, there are plenty of people suggesting that removing the distinction between wholesale and retail clients would be the most sensible thing to do.