FSP 157-E: Two New FSP’s

On March 17, 2009, the FASB issued two proposed FSPs: one on fair value measurements and the other on impairments of securities. Proposed FSP FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed (“FSP 157-e”), gives clarity on how to determine whether a market is active or inactive, and whether a transaction is distressed. Proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments (the 2nd FSP”), deals with other-than-temporary impairment (“OTTI”) losses on debt and equity securities. It calls for clarity surrounding the credit and noncredit components of an OTTI event, as well as better communication as to when an OTTI event has occurred. It also requires separate display on the income statement of losses related to credit deterioration versus losses related to other market factors. Market-related losses would be recorded in OCI if it is not likely that the investor will have to sell the security prior to recovery. If approved, both FSPs will be effective for most public companies as of March 31, 2009, beginning with the first quarter’s 10-Q. Below is a summary of 157-e. The 2nd FSP will be discussed in a separate alert. SUMMARY OF FSP 157-E There are concerns about how to measure fair value in inactive markets in which quoted prices may reflect the effects of distressed transactions. The SEC and the Valuation Resource Group have questioned the relevance of market data in performing certain valuations in such markets. As proposed, FSP 157-e will require companies to use a two-step test to assess whether the market is active or inactive by evaluating the situation as follows: Step 1: Is the market active? Step 2: If the market is NOT active, there is a rebuttable presumption that the quoted price is associated with a distressed transaction, in which case the entity should NOT use quoted prices but should instead use a valuation technique (i.e. DCF). The FSP does not specify the appropriate discount rate to use. If the market IS active, or if the quoted price is NOT associated with a distressed transaction, its business as usual, except there is new emphasis on making sure no additional adjustments to fair value are appropriate (is the quoted price current? is the quoted price the consequence of a trade with an insignificant volume compared with the total market for that asset?). To evaluate whether the market is active, the following factors should be considered:

1. Few recent transactions (based on volume and level of activity). Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.
2. Price quotations are not based on current information.
3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
4. Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.
5. Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class.
6. Abnormally wide bid-ask spread or significant increases in the bid-ask spread.
7. Little information is released publicly (for example, a principal-to-principal market).

If the market is deemed inactive, in order to rebut the presumption that a quoted market price is associated with a distressed transaction, there must be evidence that:

1. There was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset, and
2. There were multiple bidders for the asset.

The first item means it is not a fire sale. We believe that true fire sales occur on a relatively infrequent basis. The FASB has been asked to provide clarity on the second item. IMPACT OF 157-E The FSP has a significant impact on the valuation of many securities that meet the criteria above. It reflects a significant departure from the mark-to-market principles set forth in Statement 157, particularly for Level 2 inputs. For example, the FSP might be viewed as being in conflict with ¶28b of Statement 157: “Quoted prices for identical or similar assets or liabilities in markets that are not active, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (for example, some brokered markets), or in which little information is released publicly (for example, a principal-to-principal market)”. By reducing the number of price inputs, the proposed rule may move us away from current market values, one of the basic tenets of Statement 157. Quoted prices in inactive markets are obviously relevant to investors and should, at a minimum, be disclosed side-by-side with other valuation methodologies. In addition, applying theoretical valuation techniques may unnecessarily cause the valuation process to become more burdensome to companies. Pluris is participating in the FASB comment letter process. Hereis the link to comment letters for this FSP on the FASB’s website: http://www.fasb.org/ocl/fasb-getletters.php?project=FSPFAS157E