SEC and FASB Relax Fair Value Rules
By: Mark D. Perlow
On September 30, the SEC Office of the Chief Accountant and the FASB staff provided guidance on fair value under FAS 157, addressing when internal assumptions can be used to measure fair value, when to use broker quotes, and when transactions in disorderly or inactive markets represent fair value. FAS 157, which became effective in November 2007, defines fair value as the price that would be obtained in an orderly transaction between market participants in the principal or most advantageous market.
The SEC’s guidance came in response to banking industry complaints that the emphasis under FAS 157 on such market valuations for financial assets was forcing banks to write down performing assets to “fire sale” or distressed prices, compelling them to sell more assets to raise capital and thereby depressing prices further in a downward spiral. Many supporters of FAS 157, including investors’ groups, expressed the view that market values gave a more accurate picture of the health of financial institutions than values based on cost or cash flow models.
The SEC rarely involves itself in FASB policy making, and its action is clearly an attempt to reach a compromise between the two positions: the SEC relaxed the interpretation of some of FAS 157’s market valuation provisions but did not suspend market valuation, as some have requested.
Some of the key elements of the SEC/FASB guidance are:
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Distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered when weighing the available evidence. Unfortunately, the only further guidance that the SEC and the FASB give is that “determining whether a particular transaction is forced or disorderly requires judgment.” However, by placing this determination in the realm of judgment, the SEC can still second-guess the firm that follows in good faith a strong, well-documented, consistent and independent process.
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FAS 157 sets forth a three-tier framework for disclosure of fair values, where Level 1 prices derive from trades in an active market, Level 2 prices derive from observable inputs, or prices in related markets, and Level 3 prices derive in part or whole from unobservable inputs such as models. The SEC’s guidance states that, in some cases, using internal assumptions and unobservable inputs (e.g., an internal discounted cash flow model) may be more appropriate than using observable inputs (e.g., prices in markets for similar but not identical securities). For instance, if the observable inputs (say, prices in related markets) require too many adjustments and the internal model is more accurate, under the guidance the Level 3 price would be more appropriate. Before the SEC’s guidance, many market participants interpreted this disclosure hierarchy as implying that Level 3 prices were less appropriate than Level 2 prices.
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Broker quotes are not necessarily fair value if there is no active market in the security, defined as a market in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
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A significant increase in the bid-ask spread or the existence of a relatively small number of bidders are indicators that may suggest that a market is inactive.
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Broker quotes based on models warrant less weight than those based on market transactions.
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Whether a broker is giving an “accommodation” quote (i.e., one not binding on the broker) “should be considered”, which probably means that such quotes deserve less weight in pricing judgments.
