General Advice Warning: The information contained in this article is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.
Sadly, many investors are “duped” into investments with promises of high returns yet little to no risk disclosure from the finance product provider. The Federal Government has tried to manage this risk by classifying investors into “retail” or “wholesale” and regulating disclosure obligations from finance product providers. Arguably, this has helped to ensure the less experienced investor has access to appropriate levels of information when making investment decisions, and recourse through the law if there is miss-selling or similar unlawful conduct on the part of the product provider.
The Corporations Act 2001 S708
The Corporations Act 2001 (Cth) (the Act) defines a “sophisticated investor”1 and a “professional investor”2 as investors not requiring “offer disclosure documents” and, by their exclusion from these definitions, all other investors are deemed “retail”3 investors. Retail investors require product disclosure documents and statements of advice (SOAs) and enjoy protections and recourse under the law.
Exclusions – Offers That Do Not Require a Disclosure Under S708
- Small scale offerings (“2-12-20 rule”): product disclosure documentation is not required if the offering does not exceed $2M, in a 12-month period and does not have more than 20 investors participating. There must also be some sort of professional or similar relationship between the parties and a belief that the investor would be interested in receiving such a financial offer.4
- $500,000 minimum investment: if a person invests a minimum of $500,000, they do not require disclosure documents.5
- Accountant’s certification: where a qualified Accountant certifies the person has met the minimum income threshold of $250,000 p.a. (either individually or controlled by that person) or net assets of $2.5M.6
- Investor risk assessment: financial securities offered by an Australian Financial Services Licensee also does not require a product disclosure if the licensee is satisfied the investor has sufficient experience to assess the merits and risks of the securities.7
- Professional investors: refers to investors who either hold an Australian Financial Services Licence (AFSL) or have control of in excess of $10M in gross assets.
Retail Investors Slipping Through the S708 Cracks
If you cannot be “squeezed into” one of the above categories, then you are a retail investor under the Act. Unfortunately, some financial product providers have managed to sidestep the intent of the disclosure obligations by using the current exemptions, which means the very laws designed to protect retail investors are being used to expose them to inappropriate levels of risks to their capital.
Small Scale Offering
This exemption to disclosure has the propensity to be the cause of many poor investment outcomes for retail investors. It encompasses smaller dollar investments that often involve less sophisticated parties which can result in lower levels of independent governance and oversight. The Act provides no detail as to the qualifications and experience of a product promoter under this exemption other than they have a “professional connection” which is an undefined term in the Act.
This category of investment does have a role to play in our financial securities market however, given the nature of the investment, there should be greater obligations on the product promoter including registration of their investment and the promoter and investor’s details lodged with ASIC. In addition, Accountant certification should still be required. There have been many instances where an investor has mortgaged their home to raise funds to participate in an investment under this exemption that has ultimately been unsuccessful. The investor is then left in debt and another 20 years of mortgage repayments.
$500,000 Minimum Investment
This is a curious exemption because it presupposes an investment ticket size is a proxy for investor financial IQ, which is not necessarily the case. The limit of $500,000 was set 20 years ago and arguably be revised up to circa $750,000, if only to reflect CPI growth. A higher amount won’t guarantee financial IQ, but it may potentially reduce the pool of investors who could otherwise be “channelled” through this exception. This category does not seem to serve a useful purpose and could potentially be incorporated in the Accountant’s certification category.
Accountant’s Certification
To date, we at TierONE Capital have found this method of investor classification to be effective because of the requirement by an investor to engage an independent third party who has oversight of their financial matters and is financially qualified themselves. From our experience, it appears Accountants take the certification process seriously and do not hand it over based solely on their client’s income or net assets. Unfortunately, some Accountants have not necessarily applied the definition of “control” under s50AA of the Act which has made the calculation of income and asset certification problematic for some investors. Notwithstanding our positive experiences with this exemption, we believe the income levels should be adjusted in line with the CPI from their original setting in 2001 and would be more appropriate if closer to $350,000 and/or $3,500,000 of net assets, with a broader definition of assets under the investor’s control including Self Managed Super Funds (SMSFs).
Investor Risk Assessment
This method of classifying an investor puts the burden of risk back to the investor. The Act talks about the licensee being satisfied on reasonable grounds the investor has previous experience in investing in financial products, but does not provide any guidance as to a what type of risk profile approach nor its design, implementation, or assessment other than the product offering must be made through a financial services licensee.
Asking the investor to complete a questionnaire or a risk profile assessment allows the product provider to better understand an investor’s experience, expectations and tolerance around potential capital loss. The product provider can then assess whether the investor is deemed eligible to participate in an investment. Importantly, assessment and acknowledgement of non-disclosure by both parties is recorded in writing.
In Closing
From 1 January 2020, legislation from the Hayne Royal Commission has increased the reporting regime making the licensee criminally liable in circumstances where they fail to report, in the requisite timeframe, an investigation into a potential breach of the obligation that the credit activities are provided, efficiently, honestly and fairly. There is also more emphasis on regulators such as Australian Securities and Investments Commission (ASIC) and Australian Prudential Regulation Authority (APRA) to seek to attribute liability to individuals for misconduct by the institution.
Arguably, there needs to be changes made to the definitions under s702 and s716, but that alone will not address the misclassification of investors. Additionally, wholesale investors need greater protections under the Act and financial product providers need to face meaningful consequences if found to have breached their duties under s912 of the Act.
The misclassifying of investors as wholesale investors has the risk of undermining our financial system by creating distrust in financial product providers. The Hayne Royal Commission has exposed many legitimate deficiencies in our financial system and shone a spotlight on the need for increased regulatory oversight and consequences for those product providers doing the wrong thing, including misclassifying investors. This is something that TierONE Capital supports and encourages.
Kevin Said
Director, Chief Investment Officer
TierONE Capital
1 Corporations Act 2001 (Cth) s708 (8) & (9), s761 G(4)
2 Ibid s708 (11) & (12), s761 GA
3 Ibid s761 G
4 Ibid s708 (1) – (7)
5 Ibid s708 (8)(a) & (b)
6 Ibid s708 (8)(b)-(d), (9)(a)-(c)
7 Ibid s708 (10)(a)-(d) and s761GA
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