Pepper Hamilton, a multi-practice law firm with more than 500 lawyers nationally published an excellent article titled:
The SEC Is Scrutinizing Asset Valuations—Are You Ready?
By Jay A. Dubow,
Andrew J. Pinkston
Pepper Hamilton ClientAlert
January 9, 2013
The Securities and Exchange Commission (SEC) recently has set its sights on registered entities and their officers and directors for overvaluing the entities’ assets…
…On November 28, 2012, the SEC accepted Offers of Settlement from KCAP Financial, Inc. (KCAP), a closed-end business development company (BDC), and three of its officers…
Like KCAP, Medallion Financial (TAXI) is also a BDC.
TAXI’s five most senior officers are:
- Andrew Murstein, President
- Alvin Murstein, Chairman and Chief Executive Officer
- Larry Hall, Chief Financial Officer and Senior Vice President
- Michael Kowalsky, Executive Vice President
- Marc Adelson, Chief Operating Officer and Chief Credit Officer
…The SEC claimed that KCAP did not record and report the fair value of its assets in accordance with…[what]…is now Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820 (ASC Topic 820)…
These enforcement actions appear to be the start of a wave of such actions…the KCAP case is notable due to its allegation that ASC Topic 820 was not followed.
ASC Topic 820 defines “fair value,” establishes a framework for measuring fair value for purposes of generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements…ASC Topic 820, was designed to reduce confusion over the varying definitions of fair value and limited guidance for applying those definitions when applying GAAP.
While the FASB stated that ASC Topic 820 did not expand the use of fair value in any new circumstances, those subject to this accounting standard must be aware of how it may affect their valuation and disclosure policies.
Pursuant to ASC Topic 820 are requirements:
- defining “fair value” as an exit price, which reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. ASC Topic 820 is a market-based measurement, not an entity-specific measurement, and should be determined based on assumptions market participants would take into account when pricing the asset, such as credit worthiness and current market conditions.
- identifying three broad approaches to measure fair value: the market approach, the income approach, and/or the cost approach
- establishing a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels:
- Level One inputs: observable inputs, such as quoted prices in active markets for identical assets or liabilities
- Level Two inputs: observable inputs, such as quoted prices for identical or similar liabilities in markets that are not “active”; inputs other than quoted prices that are observable for the asset or liability; inputs that are derived principally from or corroborated by observable market data
- Level Three inputs: unobservable inputs, such as the use of the reporting entity’s management estimates of the assumptions that market participants would use in pricing the asset or liability, based on the best information available
- requiring disclosures about fair value measurements including a description of transfers between Level One and Level Two assets and the disclosure of inputs used in valuation.
According to the SEC, during the 2008 – 2009 financial crisis, KCAP did not account for certain market-based activity in determining the fair value of its debt securities. Moreover, KCAP issued materially misleading public filings related to its collateralized loan obligation investments.
The company claimed to incorporate market data into its financial valuations, but the assets in question were instead valued based on KCAP’s historical cost.
On May 28, 2010, KCAP restated its financial statements for all four fiscal quarters of 2008 and the first two quarters of 2009.
As a result of these restatements, it was determined that certain KCAP assets had been overvalued by as much as 300 percent. The SEC found that KCAP’s overvaluation and internal control failures violated the reporting, books and records, and internal control provisions of the federal securities laws…
…On October 17, 2012, the SEC charged Yorkville Advisors LLC (Yorkville), a $1 billion Jersey City, N.J. hedge fund firm, and two of its executives with scheming to overvalue assets and exaggerate reported returns in order to hide losses…the SEC alleged that
Yorkville and its executives:
- failed to adhere to its stated valuation policies
- ignored negative information about certain investments by
- withheld adverse information about fund investments from
the firm’s auditor, and
- misled investors about the liquidity of funds, collateral underlying investments, and the use of a third-party valuation firm.
…the SEC criticized the Directors for: delegating fair valuation responsibility to a valuation committee without providing guidance on how fair value determinations should be made; not reviewing the appropriateness of the methods used to value securities; not making meaningful efforts to determine the basis of fair value determinations; and not obtaining appropriate information explaining why particular fair values were assigned to portfolio securities.
This action is significant in holding directors responsible for valuation failures.
These cases should serve as a reminder… the SEC is focused on proper valuation, reporting, and oversight with regard to determining the fair value of assets. In particular, understanding ASC
Topic 820 and its standards will be important, especially when using Level Three inputs to value such assets.
In cases in which markets are inactive or where transactions in the market are forced or distressed, Level Three unobservable inputs, such as management estimates and assumptions about the market, may be all that are available…
…the SEC plans to look more closely at…investments and methodology for valuing assets. In response, such entities must strengthen internal controls and processes and increase disclosure of decision-making inputs.
This is all the more pressing for those entities that must value Level Three assets, since such Level Three asset valuation relies on unobservable inputs that are usually firm-supplied estimates.
There is a higher chance of misstatement or inaccurate assessments if a culture of accountability
and review has not been put in place.
We can expect an increase in SEC investigations and enforcement actions relating to asset valuation.
It is important to be prepared…
Lessons for the Big Taxi Twelve Lenders
All of you know the taxi medallion market since January 1, 2015 has been extremely illiquid due to the devastating impact of Uber competition. The market peaked in spring 2014 in New York, Chicago and Boston with a robust volume of medallion transfers.
However, during the past 14 months only a handful of medallions have been transferred in the three cities.
Your institutions have been parties in many of these foreclosures and other less than arm’s length transfers with your borrowers and hard money lenders you’ve worked with for decades.
You continue to use vastly outdated values in your filings with bank regulators and/or the SEC. For example, several of you claim carrying Boston medallions at $400,000 each on your balance sheets satisfies ASC 820 requirements. It is true that this value takes into account the tumble from the $700,000 peak price at the top of the spring 2014 Boston bubble.
Yet as you all know, there is currently a Boston medallion listed at $180,000 with no takers.
Calculating your loan to value ratios (LTVs) and mark to market values obviously makes no sense at $400,000.
As part of our Deferment Plan in Boston, we are currently seeking to hire an objective, third-party valuation firm to determine the impact of the handful of Boston transfers since January 1, 2015 on the value of a Boston medallion in February 2016.
ASC 820 VERY clearly requires defining “fair value” as an exit price, not an arbitrary value cooked up by management and approved by directors.
Together all of you Big Taxi Twelve lenders carry medallion loans on your balance sheet you value at a total of $5.7 billion.
With an anemically inactive medallion market riddled with less than arm’s length transfers, what EXACTLY is your methodology for defining an exit price?
Honest and accurate application of ASC 820 is not a suggestion by regulators.
It’s an increasingly enforced requirement.