The sophisticated investor test and why it matters

I once gave a talk at the Australian Shareholders' Association (ASA) conference and met a lovely couple who told me they had been offered the opportunity to invest in a 'wholesale' fund where the returns were much better than in a retail fund but they had to put in $500,000.

They were nervous but excited at investing with the 'smart money'.

I asked them if they knew what a sophisticated investor was and they replied 'no'. OK, stop right there!

What is a sophisticated investor?

Many of you will know this, but clearly some of you don't. It works like this.

You can read this on the Australian Securities and Investments Commission (ASIC) website: "Generally, people buying securities and other financial products must, under the Corporations Act 2001, be given a regulated disclosure document such as a prospectus or product disclosure statement (PDS). However, the Act has some exemptions from these requirements."

The exemptions from having to tell you in a legally prescribed manner what you are buying include:
• When someone is selling something worth less than $2 million to fewer than 20 people.
• When someone qualifies as a 'sophisticated investor' under section 708 of the Corporations Act.

Brokers call them s.708 clients.

What is a Section 708 client?

Section 708 clients are deemed by law to be financially sophisticated enough to rely on their own advice, so we can pretty much sell you anything and you can't sue us because the law has decided that if you are that rich, you do not need the protections of a regulated product disclosure statement.

We can't lie to you, but we can advise you to buy something without any comeback if it goes wrong.

There are a number of ways to qualify as a s.708 client, but there are two common ones.

The first is that you present a current certificate (they last for two years) from a qualified accountant certifying that you have prescribed net assets of $2.5 million or a gross income level of $250,000pa or more in each of the previous two years.

The second is if "the minimum amount payable for the securities on acceptance of the offer by the person to whom the offer is made is at least $500,000". In other words, if you buy $500,000 or more of a product, it is implied that you are a sophisticated or 'wholesale' investor.

In which case, you again have to rely on your own advice.

Why should investors beware?

So, when my delightful couple at the ASA conference said they had been told they 'have to' buy $500,000 of the fund, what they had slightly unwittingly been offered is a 'wholesale' product.

So, it does not have a 'regulated disclosure document' (no PDS) and if it goes wrong they are going to have no one to sue.

This is because they were deemed to be sophisticated enough to evaluate the product without advice and are instead operating under the core principles of caveat emptor, buyer beware, because they are not under the protection of the Corporations Law.

Maybe they would have picked all that up if they got to the point of reading and signing the paperwork. But maybe not.

Why does this system exist?

It is essentially a bureaucratic shortcut that allows companies to raise capital in short periods at a bearable cost.

If every deal (especially small deals) had to be done through a PDS, over months, involving lawyers, advisers and publishers, the largest listed companies would be corporate law firms, investment banks and printing companies.

The sharemarket exists to raise capital; it is simply a conduit for capital to pass between investors and investments.

When more risky ventures find the banks unwilling to lend, the sharemarket steps in - s.708 is a mechanism that allows companies and investors to voluntarily take themselves outside the disclosure requirements to speed up the process.

Is there more money to be made?

The main issue when a wealthy but unsophisticated investor buys $500,000 worth of securities is that they might inadvertently find themselves being labelled as a sophisticated investor, in which case they lose some of their protections.

The general advice, then, is to read your paperwork, know your rights, understand this $500,000 threshold and if you are asked by a broker if you want to join their select group of s.708 clients, it is not flattery.

It is because the broker will be able to offer you literally 'exclusive' sharemarket deals that they are not allowed to offer to the unsophisticated investor, a process that often enrages 
the excluded qualified masses.

You don't have to qualify as a s.708 client even if you can. Brokers want to build lists of clients that they can sell anything to.

Some financial planners only take on sophisticated (wholesale) investors because they do not have the qualifications or licence to sell to unsophisticated (retail) investors or are looking to avoid the long-winded, more constipated disclosure requirements for giving personal advice to smaller, unsophisticated investors.

It is an odd quirk of the industry that financial planners have to do more compliance to service their smaller, less profitable, unsophisticated clients. When larger clients are more profitable, you can see why the legislation denies smaller clients advice.

Despite being asked to do so, many clients resist being classified as sophisticated investors by their broker or adviser. Those clients know it's not flattery; they know it means they can be royally rooted without recourse.

Of course, even if you do qualify, you don't have to buy anything.

Back to our ASA couple.

The problem with the s.708 legislation arises because the current definition of a sophisticated investor doesn't consider financial sophistication; it takes into account wealth or income, and the two are (definitely) not necessarily related.

In Parliament, the Labour party has proposed changes that include redefining the definitions that apply before you can be qualified as a sophisticated investor, recognising that it would help if sophisticated investors were actually financially sophisticated rather than just meeting the criteria for being declared financially sophisticated under the Act. But they have been shelved for now.

The bottom line is that there is a fine line between 'smart money' and 'dumb money' and the rules of poker apply to everything financial. If you didn't know who the bunny is, it's you.

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