On September 30, 2008 the Office of the Chief Accountant of the U.S. Securities and Exchange Commission and the Financial Accounting Standards Board (the "FASB") jointly released an interpretive memorandum regarding "mark-to-market" accounting.  The interpretation comes in the wake of concerns that excessive accounting write-downs have brought many financial institutions close to insolvency.  Under the interpretation, sales of securities that are made in "disorderly transactions" are not determinative of the value of similar securities.  Thus, where forced or distressed sales of mortgage securities have taken place in the market, other institutions are not necessarily required to mark the securities in their own portfolios to the fire sale price. Instead they may rely on other information, such as management's internal assumptions as to expected cash flows and risk, to determine the value of the mortgage securities in their own portfolios.

FASB Statement 157 (Fair Value Measurements) in essence requires companies to employ a hierarchy of techniques when valuing assets under U.S. generally accepted accounting principles.  The most representative valuation exists where there has been a quoted market price in an active market for an identical asset (this is known as Level 1).  Where a Level 1 valuation is present, it must be used.  Level 2 occurs under similar circumstances except that the asset being valued is not identical but similar to the asset sold in the market.  Finally, Level 3 applies in cases where an active market for the security does not exist and the company must use other inputs as to value.

An exception under Statement 157 states that Level 3 may be used instead of Level 2 in situations where a distressed sale has taken place.  Many auditors have argued that, with the frequency and consistency of sales that have taken place in the mortgage securities market, these sales cannot be classified as "distressed sales."  The September 30th interpretation makes it clear that, in certain circumstances, Level 3 is actually a more accurate valuation than Level 2 and should therefore be used.  The interpretation dictates that only "orderly transactions" should be viewed as determinative of fair market value.  Orderly transactions involve willing market participants and allow for adequate exposure to the markets.  Conversely, the interpretation states that disorderly transactions are distressed or forced liquidation sales, which should be perceived as taking place in an inactive market; these sales "are not determinative when measuring fair value."  Factors that should be considered in determining whether the market is inactive include whether there is a large spread in the market between the asking price and the bidding price, as well as whether there are relatively few bidders in the market.

The interpretation makes it clear that the value of an investment must be written-down in cases where impairment is not temporary.  Factors in determining whether a security is "other-than-temporarily impaired" are the decline in value, the period of time until anticipated recovery, and the period of time that the decline has existed.  In each case, the greater the number, the greater the chance that the security should not be viewed as temporarily impaired.

The interpretation states that the FASB is preparing to propose additional interpretive guidance on fair value measurement under U.S. GAAP later this week.

If you have any questions concerning the foregoing, please contact Bonnie Roe, Gerald Shepherd or Scott Tayne in our New York office at 212.588.5500.

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practices nationally and internationally from offices in Toronto, Montréal, New York and an affiliate in Paris and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstance.  For particular applications of the law to specific situations, the reader should seek professional advice.