Sophisticated Investor Status: What are the Advantages?

Sophisticated Investor

Sophisticated investors are able to access a wider range of investment opportunities that are unavailable to retail investors. What is a sophisticated investor, though, and how is sophistication determined?

The personal wealth of the average Australian is growing rapidly. Every year, more investors in Australia have access to an annual income over $250,000, with net assets that exceed $2.5 million. These factors place many retail investors at the threshold of what Australian Corporations Law regulations allow an investor to become certified as a “sophisticated investor.”

Becoming a sophisticated investor is a relatively simple process — in most cases, a retail investor needs only to meet  eligibility thresholds and complete the certification process with their accountant.

While the process of becoming a sophisticated investor is simple, there are a number of important factors that should be considered when seeking this status. One of the most important factors is the advantages delivered by becoming a sophisticated investor — these advantages cause many brokers to encourage their clients to switch their status.

Qualifying as a sophisticated investor gives investors access to a wider market, but can remove the safety net that prevents retail investors from accessing higher-risk investment opportunities. While it’s possible to qualify as a sophisticated investor should you meet the eligibility criteria, that doesn’t mean you’re obligated to take advantage of the opportunities it provides.

Rapid market growth in Australia has created an economic ecosystem in which companies seek to raise capital quickly, often choosing to raise without spending significant amounts of time on creating product disclosure statements or prospectus to retail investors.

Prosperous market conditions means that the total number of these investors increases, with brokers offering their clients opportunities to utilise this investor status.

What is a Sophisticated Investor?

The definition of “sophisticated investor” is outlined in section 708 of the Corporations Act 2001 (Cth). Australian corporations law defines a sophisticated investor as an investor that can be offered securities without the need to provide them with the same product disclosure requirements that must be provided to retail investors.

In order to become qualified as a sophisticated investor, an investor must receive certification from a qualified accountant. This certification states that the investor possesses net assets of over $2.5 million or the gross income of the investor has reached at least $250,000 per year for the last two financial years. This certification must be acquired within six months of accepting any wholesale securities offer.

It’s important to note that when calculating the net asset value of an individual seeking sophisticated investor status it’s not possible to include money lent to the person or entity. The net assets of a company or trust that is controlled by the person, however, can be included in the calculation.

Issuing product disclosure information is a complex and time-consuming process. Securities issuers, or companies, are able to offer securities without providing disclosure information if the total investment amount is more than $500,000, which qualifies the investment as a wholesale investment.

Securities offered to investors under Section 708 of the Corporations Act aren’t required to issue disclosure information if the offer is made through a certified financial services licensee.

The licensee, however, must ensure that the investor possesses sufficient experience in order to accurately assess the risks involved with the offer, its potential merits, the value of the securities being offered, and their own specific information needs in addition to the adequacy of the information provided by the offering party.

Licensees are obligated to provide investors with written notice that they have a reasonable basis to assume that the investor possesses sufficient experience at the time of the offer or before it — the investor must also provide written confirmation that they have not received an offer document.

What Rules Govern Sophisticated investors?

In simple terms, sophisticated investor status provides investors with access to a wider range of opportunities with no downside. The rules that govern the definition of sophisticated, professional, and wholesale investors, however, are complex — the Federal Treasury and the Australian Securities and Investments Commission have suggested that these rules may potentially require review.

The Treasury issued an Options Paper in 2011 as part of the Future of Financial Advice consultancy process, requesting submissions regarding the application of  investor and wholesale client tests under the Corporations Act. A series of submissions during the process delivered criticism of the rules that govern sophisticated investors in Australia.

To date, the Federal Government has not yet acted to alter the rules that govern sophisticated investors in Australia. Potential changes to the way these investors are handled in Australia, however, could see the definition and testing process involved in qualifying investors change to take into account the possibility that unsophisticated or inexperienced investors may gain access to sophisticated investor status — losing the security net provided by product disclosure statements and prospectuses.

What is the Advantage of Sophisticated Investor Classification?

Sophisticated investor status allows an investor to access much more than retail investment opportunities. These sophisticated investor opportunities might include:

  • investments in private companies prior to IPO
  • hedge funds or VCs
  • property syndicates
  • unlisted shares, such as capital raisings for private companies.
    Often these shares are priced at a discount to listed securities.

While sophisticated investor status provides exposure to a wider range of investment opportunities, however, it also exposes investors to a greater amount of risk. A sophisticated investor is functionally deemed as a professional investor.

This means that sophisticated investors are given the responsibility to determine whether they want to take on the risk associated with an offer. Client advisors and brokers will provide these investors with information and insight, but the final decision on whether or not the level of risk involved in an offering is borne by the investor.

The assumption that drives the sophisticated investor qualification process is that an investor possesses sufficient experience in investing and a greater understanding of opportunities than a retail investor.

    The Corporations Act provides many protections for investors — but a large portion of these protections are provided only to retail investors. An individual certified as a sophisticated investor or wholesale client is unable to benefit from these protections, which include:
  • Provision of a Financial Services Guide (FSG)
  • Statement of Advice (SoA)
  • Adviser’s best interest duty and associated obligations under FoFA
  • Bans on particular forms of conflicted remuneration introduced by FoFA

Both the Financial Ombudsman Service (FOS) and ASIC inform sophisticated investors that access to the external dispute resolution scheme for non-retail clients is provided on a discretionary basis and varies depending on the specific circumstances of individual clients.

Sophisticated Investors & Risk Management

Wholesale offers are typically executed extremely quickly. Clients are notified by brokers that placements may be available on the same day at close of market, which can often leave clients with just a few hours to determine whether they want to take up an offer.

Sophisticated investors are obligated to carefully scrutinize all investments, but are required to significantly increase the amount of scrutiny they apply to investments that are made without the disclosure provided with retail investment opportunities.

The level of caution applied to an investment opportunity typically increases in tandem with the level of opportunity and investment offers — wholesale investment opportunities are typically associated with far higher levels of risk when compared to retail investment opportunities.

Investors are responsible for understanding where the securities on offer originate from. Securities offered by a private company, for example, can not be offered to retail investors and may therefore represent a high-risk arrangement.

It’s critical that sophisticated investors closely example the nature of the relationship between the party offering securities without disclosure and their broker. An investor typically incurs normal brokerage when purchasing securities, but a broker that generates capital through a deal from the securities provider may, in some cases, have a vested interest in promoting a deal.

Sophisticated Investors & Self-Managed Super Funds

Determining whether or not a Self-Managed Super Fund (SMSF) can qualify as a sophisticated investor can be complicated — ASIC provides loose guidance on SMSFs and sophisticated investor status.

An investor that intends to invest outside of superannuation in their own name can, in some cases, include the total amount of capital held in superannuation as part of the $2.5 million threshold required to qualify for sophisticated investor status.

Under the current regulatory environment, however, it’s unlikely that a SMSF can qualify for sophisticated investors status. Exceptions can potentially occur if the SMSF holds more than $10 million in assets. For more in-depth information regarding SMSFs and sophisticated investor status, reach out to Fullstack for detailed guidance.

Sophisticated Investors & Retail Investor Protection

Surrendering the protections and disclosure provided to retail investors and in order to access opportunities only available to investors with a sophisticated status is best performed only by individuals that possess extensive experience with capital markets.

    In order to receive certification as a sophisticated investor, the investor must accept and acknowledge the loss of retail protection provided to investors under the Corporations Act. These protections include:
  • Financial services guides
  • Statements of advice
  • Documents such as prospectuses
  • Access to external dispute resolution processes and services

Sophisticated investors, however, are able to access many types of investment opportunities that are otherwise unavailable to retail investors such as specific IPOs.

Key Takeaways

Sophisticated investor status delivers a greater range of freedom and exposure to a wider selection of investment opportunities. An investor opts out of retail investor protections, however, so it’s important to carefully consider the benefits of this status versus the increased risk exposure. You may also be interested in Angel Investing: Getting Started.

Determining whether you are eligible for certification as a sophisticated investor is a complex process and must be carefully considered. For assistance with a sophisticated investor certificate, contact the chartered accountants at Fullstack today.

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Stuart Reynolds is the founder of Fullstack Advisory, an award-winning accounting firm for businesses leading the future. He is a 3rd generation accountant who specialises in tech & online companies.

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