Sophisticated investor thresholds proposed to change

A Labor government proposal will make it harder for retail investors to qualify as sophisticated investors as regulators warn access to riskier products such as private equity and other alternative investments should be limited to those with more than $4.5 million in net assets.

The proposal has been raised in connection with a broader government consultation into managed investment schemes amid rising concerns about retirees losing their life savings in bad investments they never fully understood.

An investor can currently qualify as a “sophisticated investor” if they have $2.5 million in net assets (including the family home) or have a gross income of more than $250,000 for two consecutive years.

Investors who qualify as sophisticated investors can legally access complex but often lucrative investment opportunities in alternative assets like private equity, private credit, and venture capital. But they also forgo important consumer protections, such as the right to seek redress from a government agency.

The issue is that the test thresholds have not increased since they were set in 2002. In that time, nominal property prices have increased by about 290 per cent and it is estimated that more than 16 per cent of Australians now qualify as sophisticated investors (when less than 2 per cent of Australians qualified in 2002).

Regulators are now pushing for a complete overhaul of the sophisticated investor test. The Australian Securities and Investments Commission has recommended the test thresholds be indexed to adjust for two decades of property price growth and inflation. If Labor were to adopt ASIC’s recommendation, the result would be a net asset test of about $4.5 million, a gross income test of about $450,000 per annum and a ‘product value’ test (being the threshold price payable for securities that deem a person to be sophisticated) of approximately $900,000 (an increase from $500,000).

The Financial Services Council is supporting a net asset test of $5 million but has recommended no change to the current gross income test of $250,000, which captured less than 1 per cent of individuals in 2002 when the test was first applied and still captures less than 1 per cent of individuals. The FSC further supports grandfathering for existing investors who may not meet the tougher test. Without grandfathering, the FSC has estimated that increasing the net asset threshold to $5 million would result in hundreds of thousands of sophisticated investors failing to meet the new criteria, potentially opening them to forced redemptions and adverse tax consequences.

Meanwhile, other industry stakeholders have warned that tougher criteria that preclude investors from accessing alternative investments will only serve to limit access to capital in sectors that rely heavily on investment from high-net-worth individuals rather than financial institutions, such as private credit and venture capital and otherwise push investors back into retail investment products that typically have lower returns yet carry similar investment risks.

Whilst it is fundamentally important to find the right balance between the use of wholesale products in capital markets and the need to maintain consumer protections, the awkward truth behind the discussion on increasing the monetary thresholds ‘as appropriate’ is that there is absolutely no correlation between assets and income and financial sophistication. It was acknowledged by the Howard government in 2002 that the introduction of the original regime was somewhat of a blunt instrument to achieve the stated aim of consumer protection. That makes it incredibly difficult to see how simply increasing the monetary thresholds is any less blunt.

The law firm Clyde & Co has suggested there should be exemptions available for investors who have undertaken an education-based certification to demonstrate their financial literacy or can demonstrate such by virtue of their vocation or otherwise. Whilst the former would at least still be an objective standard, the latter is clearly a subjective one. Yet the Corporations Act does already contain certain deeming provisions that deem a person to be a sophisticated investor (or equivalent) in certain circumstances. These provisions allow a subjective test to be applied.

For example, section 761GA of Chapter 7 of the Corporations Act deems a person not to be a retail client (and therefore a wholesale client) if provided a financial product or financial service by a financial services licensee, and the licensee is satisfied on reasonable grounds that the client has previous experience in investing in financial products or using financial services that allows the client to assess the merits of the product or service, the value of the product or service, the risks associated with holding the product and the adequacy of the information given by the licensee and the product issuer.

In current practice, investment managers and fund administrators will rely extensively on third-party certification from a qualified accountant that a prospective investor satisfies the sophisticated investor test and can be excused for not wanting to accept the risk of liability or penalty if self-certifying on behalf of a prospective investor, particularly when there is a patent conflict of interest in doing so.

Whilst the proposed changes are only recommendations in response to the current consultation, the monetary thresholds are expected to increase. Those investors who currently qualify as sophisticated investors and those who aspire to be will no doubt be anxiously waiting to see exactly where the new monetary thresholds are set. As will investment managers in the alternative investment space who have good reason to worry about future access to capital. But there may be relief if certain thresholds are mispriced or if certain of the subjective deeming provisions are retained. In these scenarios, investors may have new avenues to satisfy the requisite tests, and capital can continue to flow towards alternative investments without significant disruption.