Labor inaction leaves 3.3 million ‘exposed’ to risky investments

The head of a leading wealth management business accused Labor of being weak on consumer protection by allowing risky products with hidden commissions of up to 8 per cent to be sold to a potential pool of 3.3 million Australians.

Cameron Harrison managing partner Paul Ashworth said it was essential that the federal government stop dithering and lift the threshold of the so-called sophisticated, or wholesale, investor test before “things go pear-shaped”.

There isn’t much sophistication to the test – it is nothing more than an income or asset threshold for an individual – set at $250,000 a year in income or $2.5 million in assets since 2002.

Investors who don’t meet those numbers have a raft of consumer protections, such as getting financial advice that is free from conflicts, and the right to complain to a government dispute resolution body.

But “passing” the test opens the door to investments in alternative assets, such as private equity, venture capital credit funds and hedge funds.

Ashworth, who advises both “sophisticated” and retail clients, said increases in asset prices and inflation had made the thresholds decades out of date. If the thresholds had been indexed, they would be closer to $475,000 in income and $4.75 million today.

And with the number of sophisticated investors forecast to rise to 11.5 million people – or 43.6 per cent of Australian adults – in 15 years, according to research by the Australian National University, the situation needed to be fixed.

“Advisers and product issuers can avoid the retail rules, push higher margin products and collect commissions – sometimes as high as 8 per cent – without ever having to spell it out in black and white who gets what commission for recommending these products,” Ashworth said.

He said the government needed to urgently act on recommendations by the Australian Securities and Investments Commission to increase them, while he acknowledged some people who qualified as a wholesale investor might not like to lose that classification.

“It’s just another form of bracket creep,” Ashworth said. “Was it ever intended that this proportion of the investing population be truly part of the wholesale investment regime? You’d have to argue in terms of the original establishment of these tests that clearly it wasn’t.

“Politicians don’t want to upset the sector, wealthy investors and other vested interests. It’s a Pandora’s box … ASIC isn’t a prudential regulator with independence from political interference.”

Ashworth said ASIC was stuck in the slow lane, waiting for the political mood to shift or for a scandal to force action. In the meantime, more ordinary investors were classified as wholesale and missed out on basic protections – until their losses hit the front page.

Ashworth is not alone in calling for changes, with everyone from the Australian Shareholders Association through to the Financial Services Council and Chartered Accountants Australia & New Zealand acknowledging that the thresholds should rise by some degree in submissions to a parliamentary inquiry that reported in February. So far, Labor has stalled on ASIC’s calls to raise the thresholds.

Under the Corporations Act, sophisticated, or wholesale, investors are considered wealthy enough to look after themselves. But someone with a house worth $4 million could have a mortgage of $1.5 million, a car loan and expenses such as school fees to cover. They qualify as sophisticated under the current rules, Ashworth said.

“At that level, do you really have the ability to absorb losses from a wholesale investment? I would argue no,” Ashworth said. Others pointed out that the qualification stipulated net assets so the above hypothetical may not apply.

Removing the family home would solve part of the problem, said Jeremy Cooper, a former ASIC deputy chairman who led a review into the super system under the Gillard government.

“A quick way of meaningfully changing the wealth test would be to take the principal place of residence out of the calculation,” Cooper said.

People who advise on wholesale products do not have to be qualified financial advisers, they don’t have to take the client’s “best interest” into account, nor do they have to disclose what fees they might get for recommending a product.

Ashworth cited the example of someone who might be advised to invest $250,000 in a data centre by a wholesale adviser. At 8 per cent, the commission on that advice would be $20,000. That’s apart from the 2 per cent management fee and 20 per cent outperformance fee typically charged on wholesale products. None of those fees need to be disclosed.

That has created a “regulatory asymmetry” between retail and wholesale investors.

‘Unsophisticated’ investors locked out of raisings

“The result is a gross mismatch: a system which assumes income or asset size equals financial acumen. In reality, it’s a very weak, shaky proxy,” Ashworth said.

Paul Heath, the CEO of ultra-high net worth adviser Asteri Asset Management, agreed that an investment threshold number was a poor way to judge whether a client was financially aware enough to make the kinds of investments offered to wholesale investors.

“I’ve met plenty of people who have $250,000 of funds to invest who are more sophisticated than clients I’ve met with $20 million in funds to invest. It’s no real measure of sophistication, it’s just a number,” Heath said.

If the threshold was raised, Heath said it would increase the cost of advice because the regulatory burden on retail investment already priced many people out of getting financial advice.

Wilson Asset Management’s submission to the parliamentary inquiry agreed that retail investors were disadvantaged by the current rules.

Retail investors were locked out of certain capital raisings but could buy these same shares on the market the very next day, Geoff Wilson, the chief executive of Wilson Asset Management, said in his submission.

“This has the perverse outcome that retail investors are considered to need the protection of disclosure when they subscribe to buy shares directly from a company, but need no such protection when they buy those same shares on market the next day.”

AFCA has $10m threshold for advised SMSFs

As if that contradiction wasn’t enough, at least one regulator is acting as if there already is a $10 million threshold.

Advised self-managed superannuation funds are only deemed to be sophisticated by the Australian Financial Complaints Authority if they have assets greater than $10 million, according to some recent determinations by the regulator.

In AFCA’s view, SMSFs do not qualify as wholesale unless the assets in the fund total more than $10 million – the trustee’s income or asset levels outside the fund are not taken into account. That is a marked difference from the broad group of assets that can be used by an individual to pass the sophisticated test.

“ASIC acknowledges the ongoing legal uncertainty about how these regulations work,” Peter Burgess, the chief executive of the SMSF Association, told The Australian Financial Review. In a further complication, ASIC indicated in 2014 it would not enforce the $10 million rule, but AFCA said it would allow SMSF trustees of funds with assets less than $10 million to pursue complaints against advisers through AFCA.

“We’ve got a couple of practical determinations out there now saying that the $10 million test should apply … We’re saying to the sector right now to be very cautious as to how you apply it … It means they [SMSFs] can’t invest in wholesale products in perhaps the way that they used to be able to,” Burgess said.

Ashworth said four things needed to be fixed.

First, the thresholds need to be increased, even if there was opposition from some people affected.

Second, the definition of an asset needed to be sharpened to include only investible assets. That was important because the current threshold exposed non-financial assets to investment risk.

“Thirdly, which would be highly desirable, is that wholesale wealth advisers should, as a minimum, operate with the same best interest duties and be registered advisers.”

Fourth, fees and risks such as illiquidity should be clearly articulated upfront in the information on wholesale products: “It should be absolutely crystal clear where the fees on that investment are going.

“There should be simple, basic, mandatory disclosure … We can mitigate those risks by having a better disclosure regime, a little bit like a tobacco warning on a cigarette packet.”

Ashworth said the opposition to those measures had come from industry heavyweights who benefited from the status quo. He added that the government seemed allergic to any reference to indexation, whether that is for Division 296 tax or income tax thresholds.

The wholesale market is not a niche corner of the investment universe – it’s where a lot of serious capital flows.

“If misaligned incentives and patchy disclosure are allowed to persist, they undermine trust not only between advisers and clients, but in the financial system itself,” Ashworth said.

Read the article here: AFR – Wholesale Investor.