FOFA: Review of the wholesale and retail clients definition

On 24 January 2011, Treasury released an options paper titled “Wholesale and Retail Clients Future of Financial Advice” (Options Paper) as a part of its Future of Financial Advice (FOFA) reforms.  Broadly, the Options Paper discusses:

• deficiencies with the current definition of wholesale and retail clients contained in sections 761G and 761GA of the Corporations Act 2001 (Cth) (Corporations Act);
• how comparable regimes in the United States, United Kingdom, New Zealand, Hong Kong and Canada distinguish between retail and wholesale clients and the merits of each approach; and
• three options for reforming the current regime for distinguishing between wholesale and retail clients.

The public can make submissions to the Treasury on the Options Paper by 25 February 2011.

This Update summarises the current distinction between wholesale and retail clients under the Corporations Act and the proposed options for reforms.

How does the Corporations Act currently distinguish between retail and wholesale clients?

The definition of wholesale and retail clients in section 761G of the Corporations Act applies differently to different types of financial products.  Broadly, for investment based financial products and services (ie financial products and services other than general insurance, superannuation, retirement savings accounts and traditional trustee services), a client will be a wholesale client if they satisfy either one of the below threshold tests:

• Product value test: the value of the financial product or financial service is greater than $500,000;
• Small business test: the consumer of the financial products or services is a business which is not a small business (ie a non-manufacturing business with more than 20 employees or a manufacturing business with more than 100 employees);
• the client satisfies either:
  • Assets test – having net assets of more than $2.5 million; or
  • Income test – having gross income of at least $250,000 per annum in each of the last two financial years;
• Professional investor test: this includes Australian Financial Services Licensees, Australian Prudential Regulation Authority regulated bodies, trustees of public superannuation funds and persons controlling at least $10 million.

Under section 761GA of the Corporations Act, clients who are unable to satisfy the above threshold tests, may ask an Australian Financial Services Licensee to certify them as a “sophisticated investor”. However, the licensee must be satisfied that the client has, amongst other things, sufficient financial literacy and the client must waive their right to certain consumer protections.

The attraction of marketing financial products and services to wholesale clients includes fewer disclosure requirements (wholesale clients do not need to be given financial services guides, product disclosure statements or statements of advice) and compliance costs (eg wholesale managed funds do not need to be registered).  Wholesale clients may be able to access investment opportunities not commonly available to retail clients, or at a lower cost.

Shortcomings with the current wholesale/retail client distinction:

The Options Paper highlights a number of shortcomings with the current retail/wholesale distinction, including:

• the thresholds for the product value, asset and income tests, which had been determined on the basis of 1991 figures and have not since been adjusted, have become too low;
• a client’s income or assets may bear no relevance to their level of financial literacy. This was highlighted in the case of Lehman Brothers Asia Holdings Limited (in liquidation) v City of Swan & Ors in which local councils complained that, as a result of  being classified as wholesale clients, they were sold high risk collateralised debt obligations (CDOs) without receiving full disclosure of risks; and
• the licensee certification test in section 761GA is too subjective.

Options for a new regime

To address these shortcomings, the Options Paper proposes a number of options:

Option 1: Retain and update the current system

This option involves updating the current system by doing one or more of the following:

• updating the monetary threshold for the product value test to $1,000,000 or, alternatively, periodically update the monetary thresholds for the product value, income and asset thresholds to take inflation into account;
• excluding illiquid assets (eg family home and superannuation balance) from the assets test to ensure clients whose wealth consists mainly of real estate or superannuation would be retail clients;
• requiring that clients acknowledge that they will not receive protection given to retail clients before being treated as wholesale clients;
• requiring that clients satisfy at least two of the threshold tests in section 761G(7) to be treated as  wholesale clients. Currently, clients only need to satisfy one test to be treated as wholesale clients;
• requiring that clients satisfy additional requirements to be considered wholesale clients in relation to certain complex financial products such as CDOs; and
• repealing the sophisticated investor test in section 761GA on the basis that it is too subjective.

Option 2: Remove the distinction between wholesale and retail clients

Under this option, all investors will be given protections and disclosures currently given to retail clients. However, Treasury acknowledges that this is unlikely to be acceptable to the market given intermediaries will no longer be able to offer financial products quickly and cheaply to large investors.

Option 3: Introduce a “sophisticated investor test” as the sole way of distinguishing wholesale and retail clients

Under this option, financial services providers will be required to determine the financial literacy of their clients when a product or service is provided and, if appropriate, deem them to be a wholesale client. This option would reduce the risk that clients who satisfy threshold tests in section 761G may nevertheless lack sufficient financial literacy to make informed financial decisions without the protection of mandated disclosures. However, the test would be subjective and financial services providers may take an excessively cautious approach resulting in only a few clients being classified as wholesale.

Option 4: Do nothing

Whilst this option has the advantage of not increasing compliance costs for the industry, it does not address any of the shortcomings of the current retail/wholesale client distinction.

Comments

The retail and wholesale client distinction was last substantively reviewed in March 1997. Since then, the experiences of industry and regulators, especially during the global financial crisis, have shown that simple monetary thresholds tests do not accurately measure the financial literacy of investors and can fail to protect wealthy investors with limited investment experience.

Treasury’s current efforts in refining the retail and wholesale investor distinction will ultimately involve a balancing act between the need for investor protection and the need for commercial efficiency (companies and institutions must be able to cost effectively raise funds from sophisticated investors without bearing unnecessary disclosure and compliance burdens).

Options 2 and 3 outlined above depart dramatically from current practice and may be seen by the industry as impractical or inefficient to administer.  It is therefore likely that both regulators and industry participants will prefer something along the likes of Option 1, or perhaps no reform at all.