The case for change, or not
As part of the Future of Financial Advice reforms, the Federal Minister for Financial Services and Superannuation, Mr Bill Shorten announced in January that the Federal Government plans to
revisit the wholesale and retail client distinction under the Corporations Act.
According to the options paper Wholesale and Retail Clients Future of Financial Advice released by Minister Shorten on 24 January 2011 (Options Paper), the global financial crisis, otherwise affectionately known in Australia as the GFC, has been the catalyst which has caused us to revisit our regulatory landscape, and this is the next item up for review.
So what is the current law?
Wholesale clients are defined in the Corporations Act to be those who are not retail clients. Broadly speaking, a retail client is any client investing in superannuation or certain insurance products, or any client other than a client who:
- invests at least $500,000 in a financial product, or
- has at least $2.5 million in net assets or had a gross income of at least $250,000 for each of the last two financial years, or
- has been classified as a ‘sophisticated investor’ by the product issuer.
Why differentiate between wholesale and retail clients?
The distinction between wholesale and retail clients was developed as a means to identify those clients considered to be in need of greater regulatory protection. Generally speaking, retail clients are considered as having lower levels of financial understanding and money to invest than wholesale clients. Wholesale clients are not subject to the same regulatory regime that applies to retail clients. For example, wholesale clients do not receive the same disclosure documents (PDSs, FSGs, SoAs and so on) when they invest in a financial product.
It is assumed that a client who meets certain financial thresholds has a sufficient understanding of the financial implications of investing in a wholesale financial product. This is not always the case and increasingly (as highlighted during the GFC) clients without an appropriate level of investment experience have been exposed to riskier financial products.
What is the approach overseas?
Overseas, there are moves to clarify the treatment of retail and wholesale clients, in some instances, leading to new post-GFC definitions. The existing (and in some jurisdictions, proposed) regulatory landscape is largely consistent with that in Australia, however on the whole, higher monetary thresholds apply
to classify a wholesale client outside Australia.
Australia is one of the few jurisdictions that allow all financial products to be offered to retail and wholesale clients. In other countries, such as the UK, a retail client may be prohibited from investing in certain products. For example, hedge funds generally can’t be offered to retail clients.
The case for change
In Australia, the distinction between retail and wholesale clients has not been significantly updated for about 10 years. The current product threshold tests were developed about 20 years ago, which raises the question as to whether these tests and thresholds are still appropriate.
On the whole, Australians are wealthier now than they were when the threshold for product value was set at $500,000 (which is currently less than the median value of a house in Australia). The Options Paper suggests that increasing numbers of Australian clients may now qualify as a wholesale client but may lack the financial understanding that wholesale clients were intended to have when the test was introduced.
Practical examples of defects in the current distinction
The Options Paper demonstrates the reality of the situation in Australia by recalling how prior to the GFC, some local government bodies invested heavily in double-A rated collateralised debt obligations (CDOs), and then suffered significant losses when the financial markets collapsed. Because these local government bodies would have been classified as wholesale clients, either due to their net worth or the size of the investment they were making, they did not fall within the product disclosure regime of the Corporations Act. Accordingly there was some contention by the local councils that perhaps the risks of investments in CDOs were not adequately explained.
An underlying premise of the Options Paper is that simply because a client has large amounts to invest, this of itself does not mean the client possesses a sufficient level of financial understanding of the products they are investing in or the risks associated with those investments. The Options Paper suggests that, had the local government bodies in question been classified as retail clients, they would have benefited from a more rigorous product disclosure and advice regime, which may have allowed them to decide that the risk profile of the CDO products was too great.
Minister Shorten’s proposal for reform proceeds on the basis that the existing disclosure regime for retail and wholesale clients under the Corporations Act with its PDSs, FSGs and SoAs is essentially an effective one. But what about all the discussions the industry has been involved with over the past 2 years about the effectiveness of the PDS as a disclosure document? Would the local councils really have changed their investment decision as a result of reading the risks disclosure in a PDS given to them?
It is also worth noting the role that credit ratings may have played in the investment decision making process. The Federal Government and ASIC have introduced measures to now impose regulatory requirements
on credit rating agencies. It would be interesting to explore feedback from clients as to whether a double-A credit rating or a PDS was more influential to their investment decision.
Are the current thresholds too onerous for certain clients?
The Options Paper also considers which clients actually benefit from the protection of the retail wholesale distinction and whether certain clients are disadvantaged as a consequence. For example, many individuals may not meet the financial threshold for a wholesale client, but for varying reasons have
a high degree of financial understanding of the structure and risks of investing in a given financial product. Should the distinction between retail and wholesale clients then be based on a range of factors? On another note, should the level of regulation be in some way proportional to the amount of risk or complexity of a product, rather than the monetary level of investment made? It almost seems counter-intuitive that the more money an individual has to invest, the less information the client receives to help them understand the risks involved.
So what are the options?
The Options Paper puts forward four options to improve the current system for distinguishing between wholesale and retail clients:
Option 1 – Retain and update the current objective test system
This option assumes that the current system is generally effective but has become outdated. It also proposes that if the objective tests in the current system are modernised, then there would be less need for the subjective sophisticated investor test, which could be removed. The proposals put forward for discussion include lifting the monetary thresholds for wholesale financial products to $1,000,000 with CPI indexing, and excluding illiquid assets (such as the family home) from being counted to reach the net asset wealth threshold.
Regulation could also introduce objective tests based on the type of product being invested in. ASIC has been talking about differing levels of regulation for ‘complex’ and ‘simple’ products for some time now. However, how do you define a ‘complex’ product? Where are the boundaries? And is it open to product issuers to engineer their products to qualify as simple products? This is a similar approach to the shorter PDS regulation being developed at the moment. In that context there is current debate about whether using a liquidity test to determine the level of complexity of the product is the right approach.
Generally speaking, the current system assumes that wealth equates to financial understanding. As we saw in the case of the local governments, this is not always the case. That said, the monetary thresholds are at least objective, certain and consistent with the approach of international regulation.
Option 2 – Remove the distinction between wholesale and retail clients
An interesting proposal, but the regulatory burden would be a high cost to pay. This is not a realistic option for the industry and is not consistent with overseas approaches.
But putting that to one side, this option would level the playing field for information disclosure, which may be beneficial for clients for making investment decisions and also for product issuers for claims mitigation.
Option 3 – Introduce a ‘sophisticated investor’ test as the sole way to distinguish between retail and wholesale clients
This option would provide flexibility in approach and allow product issuers to assess clients on a case by case basis. One issue lies in the subjective operation of the test, with the potential for different issuers to apply the test differently. And then there is the question of liability. Would an issuer face liability because they formed an incorrect view as to the level of sophistication of a client who subsequently lost money? What if money was lost because of factors in the market and not specifically the performance of the product itself? Issuers would also need to skill up and ensure that they had the right level of expertise to make these assessments. And even if not legally liable, there would be reputational issues at stake if issuers get it wrong. The additional compliance burden and associated costs for issuers would not be insignificant and the potential for conflicts of interest is obvious.
Option 4 – Do nothing
The current regulation blends the objective tests with the subjective sophisticated investor test. It is not a bad system, but shouldn’t we always be on the lookout to improve and enhance our regulatory landscape?
In addition, we should devote more time to educating clients. The financial services industry as a whole would benefit from more educated clients making more informed investment decisions, rather than through increasing client protection, which adds to product issuers’ compliance obligations, responsibilities and potential liabilities. The real issue here is that increasing the financial understanding of clients is a long term solution, so this alone is not enough.
Conclusions and considerations for the industry
All these options have pros and cons. This is not an easy question to address and the Options Paper acknowledges that this is only one piece of the puzzle in looking at the fallout from the GFC.
Revisiting the wholesale and retail client distinction is arguably overdue. However, it is worth reflecting on the broader regulatory objective if the outcome is an increase in the number of clients who are classified as ‘retail’. The greater the number of retail clients, the greater the compliance and disclosure burden on product issuers and other financial services providers. The classification as retail is only the first step. This needs to be followed with the provision of effective disclosure to those clients.
There are a range of initiatives in the industry focussing on the effectiveness of disclosure. For example, ASIC has identified debentures, unlisted property and mortgage funds, and over-the-counter contracts for difference and hedge funds as needing enhanced disclosure, that is more detailed information about complex products. In contrast, the shorter PDS regime involves less information up front and a greater reliance on incorporation of information by reference, that is more concise information about simpler products. No doubt the debate on this issue will be continuing for some months to come.
Henry Davis York has prepared a submission for Treasury in response to this Options Paper.