26/04/2018

DISCLAIMER:  Please note that these comments are for your consideration only and are provided to assist you in deciding whether to proceed to obtain a formal opinion on the issue. The following comments cannot be relied upon by either you or any of your clients until and unless we issue that formal opinion.

We had a lot of reaction, comment and questions following last month’s Business Law Brief article on SMSFs as ‘wholesale clients’ or ‘sophisticated investors’ so we decided to provide a more detailed analysis of the subject.  Here is a more detailed outline of the situation that could substitute for last month’s article.

Background

The Corporations Act 2001 (Cth) (“the Act”) permits the selling of securities and the provision of financial product advice and other financial services to so-called ‘retail clients’, ‘wholesale clients’ and ‘sophisticated investors’, the latter two without all the necessary bells and whistles that are generally required for the first.

It can be beneficial sometimes for an SMSF to be considered a ‘wholesale client’ or a ‘sophisticated investor’ in order to get access to investments that might not be open to ‘retail clients’ because the promoter doesn’t want to go to all the expense and trouble of fully complying with the securities laws and their requirements for ‘retail clients’.  

The loss of protections available to retail clients is a significant trade-off which ASIC has noted in its media release 14-191MR dated August 2014.  It is in that media release that ASIC confirms that an SMSF can be a ‘wholesale client’ or a ‘sophisticated client’ if the fund meets the standard legislative requirements.

When can an SMSF benefit from reduced disclosure relating to an offer of securities?

Where the offer relates to ‘securities’ the following applies;

Sections 708(8)(c) and (d) of the Act permit an offer of securities to be made without the usual disclosure if the potential investor
•    has minimum net assets of $2.5 million, or
•    has a minimum gross income of $250,000 for the last 2 financial years or
•    is a company or trust controlled by a person who has net assets of $2.5 million or a minimum gross income of $250,000 for the last two financial years.

In determining the net assets or gross income of a person, the net assets or gross income of a company or trust controlled by that person may be included (s.708(9B) and s.708(9C)).

The proof of the potential investor’s net assets or gross income must be provided through a certificate to the relevant effect by a ‘qualified accountant’.  The certificate must have been given not more than 6 months before the offer is made to the potential investor.

ASIC Corporations (Qualified Accountant) Instrument 2016/786 declares a ‘qualified accountant’ to be a member of CPA Australia, CA ANZ, IPA or an “eligible foreign professional body” where that member meets the additional requirements set out in the Instrument.

The test in section 708(8)(c) must be met by the person to whom the offer is made. By contrast, the test in section 708(8)(d) is satisfied where the offer is made to a company or trust and that company or the trustee of that trust is controlled by a person who meets the net assets or gross income levels.

The question of ‘control’

Section 50AA of the Act says that a person controls a company or a trustee if that person has the capacity to determine the outcome of decisions about the company’s or trustee’s financial and operating policies.  It is a very practical test that applies, namely the practical influence the person can exert (rather than the rights it can enforce) and in this regard any previous practice or pattern of behaviour must be taken into account, regardless even of the lawfulness of that practice or behaviour.

Don’t overlook the ability to include more than one person in the definition of ‘trustee’ for the purposes of calculation of net assets or income.  For example, where an SMSF is controlled by a married couple who are the member/trustees the net assets and or income of both of them can be assessed to determine qualification under the rules.

Even though the legislation says 'person', s.23 of the Commonwealth's Acts Interpretation Act 1901 states that in any Commonwealth legislation the singular includes the plural.

Can an SMSF be a ‘sophisticated investor’?

Finally in relation to securities, a person, a company or a trustee of a trust can also be classified as a sophisticated investor under s.708(10) if a financial services licensee is satisfied on reasonable grounds that the person, company or trustee has sufficient experience in investing in securities so as to allow them to assess:

•    the merits of the offer,
•    the value of the securities,
•    the risks involved,
•    their own need for information, and
•    whether what the promoter has provided is adequate.  

The licensee has to give the potential investor a written statement of why the licensee thinks the potential investor has the requisite experience and the investor must provide a written statement acknowledging that they haven’t received full disclosure.

SMSF’s can be classified as wholesale clients or sophisticated investors for the purpose of investing in securities (including bonds), if a qualified accountant certifies:
 
1.     that the trustee/s of the fund or the fund itself have net assets of at least $2.5 million and or gross income for the past two years equal to or greater than $250,000; or

2.     that the trustee is controlled by a person or persons who have that level of net assets or gross income.

When can an SMSF benefit from reduced disclosure relating to an offer of a financial product that is not a security?

Where the offer relates to financial product advice or the provision of a financial service (so the investment product is not a security but rather some other investment product covered by the managed investment rules) different provisions apply with many similarities but one major difference.

In this context the issue becomes whether the investor is a so-called ‘wholesale client’ or a ‘retail client’.

Section 761A of the Corporations Act defines a retail client as having the meanings given by sections 761G and 761GA. Section 761G provides that everyone is a retail client unless they fall into a specific other category.

Section 761G(4) confirms that a financial product or financial service is provided to a person as a wholesale client if it is not provided to the person as a retail client.
    
The relevant conditions to determine if a SMSF is a wholesale client are those set out in sections 761G(7) and 761GA.

Making an SMSF a ‘wholesale client’ – the Act

Section 761G(7)(c) says that (subject to some stated exceptions) a financial product or financial service is provided to a potential investor as a retail client unless the “person who acquires the product or service” provides a certificate from a ‘qualified accountant’ (same definition) that the person’s net assets or gross income are of the same level as set out earlier in this article.  Similarly the six-month rule applies again.

There are no equivalent provisions in the managed investment context to sections 708(9B) and (9C) which specifically apply in relation to offers of securities and permit less disclosure to persons whose assets and income include assets and income held on trust.

Nonetheless it is arguable that the word ‘person’ referred to in section 761G(7)(c) can include the trustee of an SMSF. This is because an SMSF is a trust which is not a legal entity but rather a legal relationship. The trustee is the relevant legal entity being the owner at law of the assets of the fund which it holds for the benefit of the members.  

In the context of an offer to an SMSF, the person who receives the financial product or service and who holds the assets or earns the income is the trustee of the fund.

If the fund has assets of at least $2.5 million or gross income of $250,000 then the trustee is a person who “has net assets” or “has a gross income” of the required levels and therefore can be a wholesale client within the meaning of section 761G(7)(c). The beneficial ownership of those assets or that income should not be relevant to disqualify the legal owner (the trustee) as a wholesale client.

This would appear to be in line with the purpose of the Act because clearly a trustee who has that level of assets/income held on trust is as competent to be treated as a wholesale client as they would be if the assets/income were their own (ie. held beneficially as well as legally).

Making an SMSF a ‘wholesale client’ – the Regulations

Regulation 7.6.02AB takes the issue further.  It operates to effectively add a further subparagraph to s.761G being s.761G(7)(ca).  That virtual subparagraph has the effect of providing that (subject to some stated exceptions and for the specific purposes of Parts 7.6, 7.7, 7.7A, 7.8 and 7.9 of the Act) a financial product or financial service is provided to a potential investor as a retail client unless the product or service is acquired by a company or trust controlled by a person who meets those asset and or income tests.

Parts 7.6, 7.7, 7.7A, 7.8 and 7.9 of the Act deal with such things as:

•    the requirement to be licensed,
•    licensee obligations,
•    compensation arrangements for retail clients (there are limited such arrangements for wholesale clients),
•    financial services disclosure (FSGs, SOAs and other disclosure obligations),
•    the best interest rule (which only applies to retail clients – s.961),
•    financial product disclosure, and
•    other conduct connected with financial products and services.  

For all those purposes (particularly product disclosure) acquisition by a company or trust controlled by a person with the requisite assets or income is acquisition by a wholesale client.

This therefore permits an SMSF to be classified as a wholesale client if the fund is controlled by a trustee who has net assets of at least $2.5 million or has gross income for each of the last two financial years of at least $250,000, regardless of the value of the trust itself.

An SMSF as a ‘sophisticated investor’ in financial products

Finally s.761GA substantially mirrors s.708(10) in the ability of a licensee to provide a financial product or service to an investor as a ‘wholesale client’ where similar requirements are met as stipulated in s.708(10) with minor amendments for the different context.

Other matters the SMSF trustee should consider

The ability of an SMSF to be a ‘wholesale client’ and or ‘sophisticated investor’ is clear and the benefits may be substantial, though in acquiring an investment as such, the trustee of the SMSF must meet all requirements (including all SIS Act obligations on the trustee), must make proper assessment of the protections it loses in not being a retail client (in particular the inability of a wholesale client to receive compensation available to retail clients) and must adhere to the investment strategy of the fund which must permit any such investment.

For further information, please contact Peter Townsend of Townsends Business & Corporate Lawyers on (02) 8296 6222 or info@townsendslaw.com.au to see how we can assist.