SEC Provides MD&A Guidance for Issuers With Illiquid Securities, Including Many Auction-Rate Securities
 
April 7, 2008
 

The Division of Corporation Finance sent a letter recently to public companies holding significant amounts of asset-backed securities, loans carried at fair value or the lower of cost or market, or derivative assets and liabilities in their recent financial statements. The letter identified a number of disclosure issues that public companies may want to consider relating to the valuation of securities and other financial assets and liabilities affected by the current liquidity problems in drafting their Management Discussion and Analysis (MD&A) section of their periodic reports.

Issuers must apply the principles contained in SFAS 157, Fair Value Measurements, when valuing assets and liabilities at fair value, for their financial statements for fiscal years ending after November 15, 2007, and all interim periods within such fiscal years. SFAS 157 allows issuers to depart from actual market prices or other third-party pricing information only when the available information does not reflect the prices that would be obtained in orderly transactions between market participants. Transactions that do not allow for customary marketing activities are not considered orderly transactions. Assets or liabilities for which no orderly transaction pricing is available must be identified as “level 3” assets and liabilities which may be valued using the issuer’s own assumptions concerning the assumptions that market participants would make when valuing the same assets or liabilities. Based on the number of failed auctions affecting many auction-rate securities, companies holding auction-rate securities in their investment portfolios need to consider the possibility that these securities need to be identified as level 3 assets.

In view of the current illiquidity of certain assets and liabilities covered by SFAS 157, the Division of Corporation Finance urges issuers having material fair valuation issues to consider and, when appropriate, discuss the following in their MD&A section of their periodic reports:

• the amount of level 3 assets and liabilities as a percentage of total assets and liabilities priced at fair value
• any material increase or decrease in level 3 assets and liabilities and the reasons for such variation
• if there is a material transfer of assets and liabilities into level 3, the reasons why a level 1 or 2 valuation is no longer justified, any material gain or loss recognized during the period and any amount excluded from the realized/unrealized gain or loss line item in the level 3 reconciliation
• the extent to which realized and unrealized gains or losses recognized on level 3 assets or liabilities affected results of operations, liquidity or capital resources, the reasons for material variations in values and whether (and if so why) these values differ materially from amounts expected to be realized on settlement or maturity
• details about the type of assets underlying asset-backed securities and their credit ratings

In addition, the Division advises issuers, that have not already done so in their 10-Ks, to consider providing in upcoming periodic filings, a general discussion of their valuation models in their MD&A, and, to the extent material, information regarding:

• changes to such models and the impact that such changes may have on the financial statements
• use of relevant market indices in valuation models and material adjustments
• model validation and testing procedures
• sensitivity of fair valuations to significant inputs used in models (range of values)
• impact of changes in the aggregate fair value of assets and liabilities on overall liquidity and capital resources

http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm