The Royal Commission and Wholesale Clients – A Missed Opportunity?

The continuing increase in retail client regulation over recent years (such as the FOFA reforms) and the increasing ease with which clients can meet the wholesale client eligibility tests has led many financial services businesses to adopt, or consider moving to, wholesale only business models.  This means that clients using the services of these businesses do not receive the regulatory protections (such as in relation to disclosure, conduct, complaints and compensation) which apply to retail clients.

The Australian wholesale client system regards wealth as a proxy for financial literacy – but it is increasingly easy for “mum and dad” investors to meet these eligibility tests due to:

• the lack of indexation of the thresholds on the one hand¹; and
• increases in real wealth (due to factors such as higher levels of superannuation and rising real property values) on the other hand.

It would appear that the Government and ASIC are increasingly uncomfortable in having clients with low levels of financial literacy being treated as wholesale clients and there has been several recent occurrences of tinkering with the standard wholesale/retail distinction when dealing with specific situations.

Accordingly, when the Government called the Royal Commission into the financial services industry it was anticipated that wholesale client eligibility was an area that would be looked into.

So what did the Royal Commission have to say about wholesale client eligibility?

In a word – nothing!

Somewhat surprisingly, the topic didn’t appear to come up during the public hearings and was not mentioned in either the Interim Report or the Final Report.

Was that a missed opportunity?

Given the areas that the Commission was tasked to look into it is certainly surprising that the issue never arose and it would have been helpful if the Commission could have explored some of the issues raised above.

Further, there are a number of paths which the Government could take if it wished to reform the wholesale client eligibility rules and the Commission would have been well placed to recommend a direction for the Government to take.

Are there any other reform plans in this area?

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 4 options for a new regime.

Since the issue of the Options Paper, there has been no indication that the Government intends to conduct a full scale review of the wholesale/retail client distinction.

More recently though, the Government and ASIC have both taken steps to either restrict or modify the full application of the wholesale client rules in relation to particular products.  A particular focus has been in relation to restricting the use of the “sophisticated investor” eligibility test².

The rationale for the mandatory treatment of sophisticated investors as retail clients in certain situations has been described by the Government as:

“This ensures that the sophisticated investor carve-out contained in section 761GA cannot be exploited to circumvent the amendments […] .  While sophisticated investors are generally high net worth individuals, like other retail clients, they may not always have the requisite knowledge of complex financial services such as derivatives to adequately evaluate the risks associated with how licensees use derivative retail client money.” ³

A similar approach in relation to sophisticated investors was taken when the crowd sourced equity funding (“CSEF”) regime was introduced.

The Government seems to be increasingly wary of the sophisticated investor eligibility test and its complete removal in the future is certainly a possibility⁴.  They appear to have two concerns with the concept:

• that product issuers are “exploiting” the test to “circumvent” the retail client protections; and
• that sophisticated investors are not regarded as having requisite knowledge of “complex” financial services.

The first concern is not without some foundation as the eligibility decision can be a self-serving one for the AFSL holder making the assessment.  As to the second concern, the same criticism can be made of the “product value” test⁵ and “individual wealth” tests⁶.

There are also indications that, rather than providing a complete regulatory exemption for wholesale clients, a base level of regulation might apply to wholesale clients in certain situations with “additional protections” applying to retail clients⁷.

Just because you can doesn’t mean you should

It should also be noted that ASIC has also been increasingly willing recently to invoke the “efficiently, honestly and fairly” AFS licence condition⁸ to impose an ethical overlay over business conduct.

Although we have no public evidence of them having done so to date, it is certainly possible that ASIC might invoke that licence condition against an AFSL holder who was perceived to be “exploiting” the eligibility tests to classify financially illiterate clients as wholesale.

In effect, ASIC would be taking the view that just because you can classify a client as wholesale doesn’t necessarily mean that you should.

It would also appear that overseas regulators are approaching this issue from a similar perspective.  We are aware of some regulators requiring that a client who is otherwise eligible to be treated as wholesale must:

• initiate a request to be treated as wholesale; or
• only be treated as wholesale with their prior, informed consent.

We suggest that AFSL holders carefully consider whether it is appropriate to treat “mum and dad” investors as wholesale clients based purely on their level of wealth – some assessment of such a client’s level of financial literacy would also appear to be prudent.

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Author: David Court (Partner)

1 The dollar amounts have not changed since 1991.
2 Persons that an AFSL holder has determined to be experienced in using financial services.
3  Explanatory statement for the Corporations Amendment (Client Money) Regulations 2017.
4  Noting that the sophisticated investor test presently also cannot be used in relation to traditional trustee services or for general insurance, superannuation and RSA products.
5 Where the client has more than $500,000 to invest.
6 Where an accountant certifies that the client has more than $2.5M in net assets or $250,000 in gross income.
7  This was the approach taken with the CESF regime.
8  Section 912A(1)(a) of the Corporations Act 2001.