March 21, 2008

Is Fair-Value Accounting the Problem?

In the search for causes of the recent market turmoil, it was inevitable that a finger would eventually be pointed at fair-value accounting. FASB’s Statement No. 157, Fair Value Measurements, which defines fair value and establishes the framework for measuring fair value under GAAP, is under attack as financial institutions take enormous write-downs of the fair values of their financial assets. The developing debate was noted in this recent article:

In recent weeks, financial services firms have blamed their financial troubles on the use of fair value. Perhaps the most vocal has been Martin Sullivan, CEO of American International Group. The insurer recently reported $11 billion in write-downs, and has called for changes in the accounting rules.

“We are trying, as are many others, to value very complex instruments,” Sullivan told investors during a conference call in February. “These valuations are not mechanical. They involve difficult estimates and judgments. I can tell you that we have, at all times, brought our best judgment to bear in making these valuations.”

To be sure, critics of fair value say that it can distort market realities by giving management too much discretion and room for abuse. But the proponents say it actually creates transparency by reflecting the up-to-date reality of an asset’s or liability’s worth.

Corporations that have made poor decisions lately are using fair value as a “scapegoat,” according to the CFA Institute Centre for Financial Market Integrity, a research and policy organization. “Fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition,” says Georgene Palacky, director of the CFA’s financial reporting group.

Indeed, Tweedie [David Tweedie, chairman of the International Accounting Standards Board] deflects the current fair-value criticisms as ignoring the true roots of the current problems in the financial marketplace. “The real problem in the current crisis is a lack of trust and lack of transparency,” he says.

The IASB further defends the use of fair value in a discussion paper about reducing complexity in reporting financial instruments, released on Wednesday. The 98-page document was in the works long before the credit crisis hit; however it comes at an opportune time for the supporters of mark-to-market accounting.

In it, the IASB says fair value “seems to be the only measure that is appropriate for all types of financial instruments.” Still, the board acknowledges that “there are issues and concerns that have to be addressed before [rule-makers] can require general fair value measurement.”

It seems to me that it is highly unlikely the SEC or Congress would bow to this pressure and seek to suspend FAS 157 at a time when up-to-date financial information is more important than ever to investors. The days of book value accounting for financial instruments are long gone – and probably for the best.

Some Legislative Developments

Congress has left town for its Spring recess (which I hope to do next week as well), but before it left town some members dropped a couple of securities-related bills that are worth noting.

Earlier this month, Senator Elizabeth Dole (R-NC) introduced the “Regulatory Relief and Fairness Act” (S. 2703), a bill seeking to exempt certain financial institutions from the requirement to provide SOX Section 302 certifications and Section 404 internal control assessments. Recall that when adopting the internal control and certification requirements in the Sarbanes-Oxley Act, Congress (and the SEC when adopting the rules) considered the example of similar requirements that were already in place for banks and similar financial institutions.

In February, Representative Jeb Hensarling (R-TX) and Representative Ed Royce (R-CA) introduced the “Securities Litigation Attorney Accountability and Transparency Act” (H.R. 5463). The bill seeks to amend the federal securities laws to target frivolous securities suits by awarding reasonable fees and expenses to a defendant in the event the suit is adjudicated in the defendant’s favor based on a motion to dismiss, a motion for summary judgment or a trial on the merits and, among other conditions, “the position of the plaintiff was not substantially justified.” The bill would also attempt to get at some of the “Milberg Weiss” problems by requiring sworn certifications from plaintiffs and their counsel concerning payments, the nature of their legal representation, political contributions and other conflicts of interest. The bill would also provide for a competitive bidding process in the selection of lead counsel in securities class action litigation.

Yesterday, Representative Barney Frank (D-MA) gave a speech in Boston where he called for either the Federal Reserve or a new regulator to oversee systemic risks in the financial system posed by banks, securities firms or hedge funds. As noted in the NY Times article, this concept – if enacted – could change the landscape for the financial regulators, given that the oversight duties are currently spread across the Treasury, the Fed and the SEC.

Developing Future Securities Lawyers?

Last week I spoke at “Career Day” at my kids’ school, and my rather daunting challenge was how to make securities law fun and exciting for second and fourth graders. It is always tough as a lawyer to compete with the firemen, policemen, air force pilots, etc. in terms of capturing the kids’ imagination.

In my presentation, the students went to an abbreviated version of law school where they learned about the securities laws. I boiled them down as follows:

– Always tell the truth – and don’t lie or make stuff up
– Don’t trick anybody
– Tell the whole story
– Tell people all of the risks involved.

The kids then counseled me in raising capital for my “big idea” – turning their school into an amusement park. They nixed me saying things like “this amusement park will be so big you can see it from the moon” and reviewed this prospectus with some critical comments. With regard to the statement in the prospectus – “This is our roller coaster. We think that it will be the best roller coaster around” – one of the second graders said “I think you should say that it is ‘one of the best’ roller coasters around.” I think that young man has a future as an examiner in Corp Fin!

I hope that I got through to the kids with some good investing tips and a positive take on lawyers. One wrote to me in a thank you note: “I learned that you have to be careful with money and not just give it to someone.” Another kid said “Your job sounds more like a hobby to me than a job – you are lucky to do that all day!” Perhaps I was guilty of not telling the whole story…

– Dave Lynn