Establishing client type

3 April 2020

A number of developments in the financial advice industry have caused many financial services professionals (advisers) to consider a shift in focus towards the ‘wholesale’ end of the client spectrum. These developments largely stem from the Hayne Royal Commission recommendations and the Financial Adviser Standards and Ethics Authority (FASEA) professional standards for financial advisers. But there has been, for many years, a natural bias towards wholesale client advice due to the larger amounts of funds typically involved, different compliance obligations and the wider range of financial products available to wholesale investors.

So, the distinction between retail and wholesale is crucial. This article, for the benefit of advisers, explores the issues and recent (and not-so-recent developments) in the distinction between retail and wholesale investors. 

RECAP OF THE STATUTORY TESTS

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Legislative reform in 2001 established a distinction between retail and wholesale clients, for the purpose that:

'The consumer protection provisions will apply only to retail clients, as it is recognised that wholesale clients do not require the same level of protection, as they are better informed and better able to assess the risks involved in financial transactions.'

The starting position is that all clients are, by default, retail clients. A client will only be treated as wholesale if they meet certain criteria, described below. Most financial advice clients will be retail clients.

The wholesale client exception

To determine if a client can qualify as a wholesale client, firstly consider the type of financial product or service being provided.  For general insurance, the specific rules that apply are beyond the scope of this article. 

If the financial product or service relates to superannuation, the client is always treated as a retail client unless the product or service is provided to the trustee of a superannuation fund with net assets of at least $10 million.  

Note that the Australian Securities and Investments Commission (ASIC) has the view that a non-superannuation product or service (such as investment advice) provided to a self managed superannuation fund (SMSF) trustee is not in regard to a superannuation product, so the tests for other financial products (see below) would apply, rather than the $10 million threshold. So when providing financial advice to an SMSF trustee, the trustee may be treated as both a wholesale and retail client, depending on the type of advice being provided.

Generally, for other financial products and services, there are five tests. Satisfying any one of these indicates that a client may be treated as a wholesale client.

  1. Product value: the financial product to which the advice relates is at least $500,000. Products of the same class from the same issuer can be aggregated for the purposes of this test;
  2. Business test: the product or service is provided in connection with a business that is not a small business;
  3. Individual wealth: net assets of $2.5 million or gross annual income of $250,000 for the last two years, demonstrated by a qualified accountant’s certificate, valid for up to two years;
  4. Professional investor: includes financial services licensees, bodies regulated by Australian Prudential and Regulation Authority (APRA) other than superannuation trustees acting for a trust holding less than $10 million in net assets, persons controlling $10 million or a corporate body or unincorporated body that carries on a business of investment in financial products, interests in land or other investments following an offer or invitation to the public; or
  5. Sophisticated investor: the financial services licensee is satisfied that the client has previous experience in using financial services and investing in financial products that allows them to assess the merits of the product or service, the value of the product or service, the risks associated with holding the product, the client’s own information needs, and the adequacy of the information given by the licensee and product issuer.

The product value and individual wealth tests have been criticised for the lack of indexation of the thresholds since inception, resulting in an increasing number of Australians meeting the thresholds over time. Back in January 2011, the Department of Treasury suggested increasing the product value test threshold from $500,000 (a threshold which in effect dates back to 1991) to $1 million. But there has been no increase.

The sophisticated investor test was introduced in 2007 as a solution for those investors who can’t otherwise qualify as a wholesale client but have sufficient investment experience such that they don’t require the consumer protections generally offered to retail clients. The law places a heavy onus on the financial services licensee to certify that a client meets the required standard to be a sophisticated investor.

A MORE SUBJECTIVE ASSESSMENT

The introduction of the sophisticated investor test in 2007 added a more subjective assessment criteria to the existing four tests, which are generally more quantitative and administratively easier to apply. In theory, the sophisticated investor test allowed more investors to be treated as wholesale clients, although anecdotally its practical use is limited.

Since 2007, there has been a more general trend towards overlaying the four original tests with a qualitative assessment of the financial sophistication of the investor.
In particular, two Federal Court of Australia decisions handed down in 2012 provide a lucid warning to advisers against treating clients as wholesale investors when in practice they are not financially sophisticated enough to understand the financial products recommended.

Three local councils commenced a class action against Lehman Brothers Australia. Despite being recommending financial products described as suitable for sophisticated investors, the councils were found to lack the sophistication to understand a number of financial products recommended, including synthetic collateralised debt obligations (SCDOs). 

The financial products subsequently failed during the global financial crisis, and many millions were lost by the councils and their investors. The court ordered compensation for the losses.

Another Federal Court of Australia decision in 2012 formed a similar conclusion: the fact that an entity qualified as a wholesale investor for the purposes of the act did not necessarily indicate that it would have the capacity to understand very complex financial products.

THE CODE OF ETHICS

The policy intention behind legislation is more relevant than ever for those financial advisers who are required to abide by the FASEA Code of Ethics from 1 January, 2020. The code is relevant when financial advisers are providing personal advice to retail clients.

Standard 1 of the code states:

'You must act in accordance with all applicable laws, including this code, and not try to avoid or circumvent their intent.'

In relation to the distinction between retail and wholesale clients, example two from FASEA’s Code of Ethics Guidance provides an example which is consistent with the subjective trend mentioned above.

In that example, a couple have previously used the services of an adviser, who is authorised to provide personal advice to retail clients. The adviser holds a current accountant’s certificate indicating that they meet the individual wealth test.

One of the partners (Donna) later approaches the adviser independently, seeking advice on investing an inheritance without the other partner’s knowledge. Donna has no previous investment experience.

The adviser treats Donna as a wholesale investor and provides a financial product recommendation and placement service without the protections usually provided to retail clients. This is a breach of Standard 1, as it circumvents the intention of laws designed to protect inexperienced investors like Donna.

CONCLUSION

Assessing a client as either retail or wholesale is not as straight-forward as applying the statutory threshold tests. Consideration begins with the type of financial product being considered. If the product is superannuation related, then generally the client must be treated as a retail client (unless they are a trustee of superannuation fund with at least $10 million of net assets).

If other financial products are in consideration (excluding general insurance), the original statutory tests in the Corporations Act (product value test, business test, individual wealth test and professional investor test) are generally quite definitive and straightforward to apply to a client’s circumstances.

However, the addition of the sophisticated investor test in 2007 introduced more subjective considerations – if a client, who would otherwise be treated as a retail client, meets the experience threshold, they may be treated as a wholesale client.

More recently, the industry (supported by case law developments and the FASEA Code of Ethics) applies a more subjective test of the level of financial experience, requiring that a client with little investment experience is treated as a retail client, despite having met the requirements of one or more of the statutory threshold tests. 

David Barrett is head of Macquarie Technical Advice Services.




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