Financial Reporting Alert 08-13, Accounting Considerations for Settlement Agreements Related to Auction Rate Securities
October 2, 2008
During August and September of 2008, several large financial institutions (hereafter referred to as broker-dealers) entered into settlement agreements with state and federal regulators regarding the marketing and selling of investments in auction rate securities (ARSs). The settlement agreements are in response to the intense scrutiny by regulators and investors in the wake of significantly deteriorating conditions in the ARS market.
As more fully discussed in Deloitte’s Financial Reporting Alert 08-2, 1 ARSs are unique investment products that have contractual maturities ranging from 20 to 30 years and that typically have been marketed to investors as cash equivalents. While ARSs have long-dated maturities, the rate-setting mechanism of these securities, accomplished through a “Dutch” auction process, is designed primarily to provide liquidity and economic characteristics similar to those of short-term investments. For these reasons, ARSs used to be among the most popular investments for excess cash. While ARSs were designed to behave similarly to short-term investments, when demand for ARSs decreases and there is insufficient interest in the Dutch auction, a failed auction occurs and current investors are unable to liquidate their positions through the auction process. In such situations, current investors are forced to continue holding their ARSs until there is sufficient demand and a successful auction occurs, unless they are able and willing to sell the ARSs at potentially depressed prices in the secondary market.
In February 2008, demand for ARSs significantly decreased as the deterioration in the global credit markets continued and investor confidence in these investment products greatly diminished. The lack of demand resulted in numerous auction failures. Because investors were no longer able to liquidate their ARS positions through the auction process, investors and regulators began criticizing broker-dealers that marketed or sold these investment products as cash equivalents. In response to the scrutiny, many broker-dealers recently entered into various forms of settlement agreements to indemnify certain investors for losses on their ARS portfolios. 2
While the terms of each settlement agreement vary by broker-dealer, the most common feature is an agreement to repurchase the ARS for cash equal to the par value of the ARS on a specified future date (or range of dates). 3 In this case, the purchase agreement is effectively a put option written by the broker-dealer to certain eligible investors.
The remainder of this Alert discusses accounting considerations related to the written put option from the perspective of both broker-dealers and investors.
Accounting Considerations for Broker-Dealers
The broker-dealer’s accounting depends on whether it has entered into a legally enforceable settlement agreement that meets the definition of a firm commitment 4 (“enforceable settlement agreement”). 5
Accounting Before a Settlement Agreement
Before entering into an enforceable settlement agreement, a broker-dealer should determine whether the potential for litigation or a pending settlement agreement represents a contingent liability that requires recognition or disclosure pursuant to Statement 5. 6 Statement 5 defines a contingency as “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.” Therefore, before an enforceable settlement agreement or the resolution of any associated litigation, the potential that a broker-dealer has incurred a loss in connection with its past selling or marketing of ARSs is a contingency within the scope of Statement 5.
Under paragraph 8 of Statement 5, if information is available before the issuance of financial statements that indicates it is probable that a loss has been incurred in connection with the broker-dealer’s past selling or marketing of ARSs and that the amount of the loss is reasonably estimable, the broker-dealer should accrue a liability for the contingency and recognize a related charge in current-period income. Paragraph 10 of Statement 5 specifies that if it is only reasonably possible that a contingent loss has been incurred or the loss amount is not reasonably estimable, the broker-dealer should disclose the nature of the contingency and an estimate of the “possible loss or range of loss.”
Accounting Once a Settlement Agreement Becomes Legally Enforceable
On the date the broker-dealer enters into an enforceable settlement agreement, the uncertainty regarding whether a loss has been incurred is resolved and an obligation must be recognized for issuing the written put option. The accounting for the written put option depends on whether it meets the definition of a derivative instrument under Statement 133 7 or is considered a financial guarantee contract within the scope of Interpretation 45. 8
Typically, the written put option has the first two characteristics of a derivative instrument in paragraphs 6(a) and 6(b) of Statement 133 because it has an underlying (i.e., the ARS) and a notional amount (i.e., the par value of the ARS that is subject to the written put option) and requires no initial net investment by either the broker-dealer or the investor. However, the written put option typically does not have the third characteristic of a derivative instrument in paragraphs 6(c) and 9 of Statement 133 (i.e., a net settlement requirement). The written put option does not meet the third characteristic of a derivative if it requires physical settlement of the ARS (i.e., the investor must physically deliver the ARS to the broker-dealer upon exercise in exchange for cash), there is not a market mechanism that facilitates net settlement, 9 and the ARS is not considered readily convertible to cash. 10
While the written put option typically does not meet the definition of a derivative instrument under paragraph 6 of Statement 133, it is considered a financial guarantee contract within the scope of Interpretation 45. 11 The Interpretation provides guidance on the disclosure and initial recognition of obligations undertaken in issuing guarantees.
Initial Recognition of the Put Option
At initial recognition of the written put option, the broker-dealer should apply the recognition guidance in paragraph 10 of Interpretation 45. Paragraph 10 states that the amount initially recognized related to the written put option should “be the greater of
(a) the amount that satisfies the fair value objective as discussed in paragraph 9
[of Interpretation 45] or (b) the contingent liability amount required to be recognized
at inception of the guarantee by paragraph 8 of Statement 5.”
Subsequent Measurement of the Put Option
While Interpretation 45 provides guidance on the initial recognition of the written put option, it does not address subsequent measurement. However, because the guarantee is a written put option, it is expected that the broker-dealer will subsequently measure the put option in a manner consistent with the SEC staff’s long-standing position that written options should be marked to fair value through current-period earnings. 12
Accounting Considerations for Investors
The investor’s accounting depends on whether it can benefit from an enforceable settlement agreement that meets the definition of a firm commitment and relates to an ARS held by the investor.
Accounting Before a Settlement Agreement
Before an enforceable settlement agreement exists, a pending settlement agreement or the potential for litigation represents a gain contingency that is within the scope of Statement 5. Paragraph 17(a) of Statement 5 states that “[c]ontingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization.” Therefore, the investor should not recognize the gain contingency in its financial statements before the broker-dealer enters into an enforceable settlement agreement. 13
Accounting Once a Settlement Agreement Becomes Legally Enforceable
Once the investor is entitled to receive benefits from an enforceable settlement agreement that meets the definition of a firm commitment (see footnote 4 of this Alert), it should recognize its rights associated with the put option as an asset. At that point, the investor has obtained these rights and the gain is no longer contingent. The put option meets the definition of an asset in Concepts Statement 6 14 because it is a probable future economic benefit that is obtained by the investor as a result of past transactions or events. 15 The put option also meets the definition of a financial asset because it provides the investor with a right to exchange its ARS with the broker-dealer for cash at potentially favorable terms. 16 Therefore, as of the date the settlement agreement becomes a legally enforceable firm commitment, the put option should be recognized at fair value, with an offsetting gain recognized in current-period earnings.
The put option between the investor and the broker-dealer relates to the ARS held by the investor but is not embedded in or attached to the ARS. Rather, it is a freestanding instrument that must be accounted for separately from the ARS. 17
Subsequent Measurement of the ARS
Because the put option is a separate freestanding instrument, it does not alter the maturity or price of the ARS and should not be considered in the measurement of the ARS. 18 Instead, the ARS should continue to be accounted for separately from the put option in accordance with Statement 115. 19
If an investor has avoided recognizing an other-than-temporary impairment on its ARS by asserting that it has the intent and ability to continuing holding the ARS until forecasted recovery, the investor should carefully consider whether that assertion continues to hold after the broker-dealer enters into the enforceable settlement agreement. Generally, for the investor to conclude that it has the positive intent and ability to hold the available-for-sale security until recovery, it would also have to conclude that it does not intend to exercise its put option. If the investor expects to exercise the put option, an assertion that it has the intent and ability to continue holding the security until forecasted recovery is called into question and any unrealized loss deferred in other comprehensive income should be immediately recognized in current-period earnings as an other-than-temporary impairment.
Subsequent Measurement of the Put Option
As discussed above, the put option typically does not meet the definition of a derivative instrument under paragraph 6 of Statement 133. While applicable to written options, the SEC staff’s long-standing position does not apply to purchased options. Therefore, the initial cost basis of the put option is not subsequently adjusted for changes in its fair value unless the investor elects to measure the put option at fair value under paragraph 7(a) of Statement 159, 20 which permits an entity to elect the fair value option for recognized financial assets. Because the put option meets the definition of a financial asset, the investor may elect to apply the fair value option to the put option when it is initially recognized. If the investor elects to measure the put option at fair value, period changes in fair value must be recognized in current-period earnings.
Accounting Mismatch Between ARS and the Put Option
Depending on whether the investor elects to measure the put option at fair value (with changes in fair value recognized in current-period earnings) and whether the ARS is classified as an available-for-sale security (with changes in fair value recognized in other comprehensive income to the extent that the security is not considered other-than-temporarily impaired), an accounting mismatch most likely exists between the put option and the ARS. To resolve this accounting mismatch, the investor may elect to transfer its ARS from an available-for-sale classification to a trading classification pursuant to Statement 115. While paragraph 15 of Statement 115 states that “transfers into or from the trading category . . . should be rare,” because of the unique nature of current ARS settlements, such “rare” reclassifications are permitted. 21 The ARS settlements are one-time events that have broad market impact. The transfer of ARS to a trading classification allows fluctuations in the fair value of the ARS to be recorded in current-period earnings to offset a portion of the change in the fair value of the put option. This accounting leads to greater symmetry in the accounting between the ARS and the put option and more faithfully represents the economics of the two transactions. Such accounting will also prevent a gain or loss from being accumulated in other comprehensive income and from being recognized only once the option is exercised.
1 Financial Reporting Alert 08-2, Auction Rate Securities Warrant Scrutiny for Impairment.
2 As of September 29, 2008, the financial institutions that have entered into settlement agreements include Goldman Sachs Group Inc., HSBC, JPMorgan Chase & Co., Morgan Stanley, Merrill Lynch & Co. Inc., Citigroup Inc., Deutsche Bank Inc., Commerce Bancshares Inc., UBS AG, and Wachovia.
3 While the agreement to repurchase the ARS at par as of a future date is the most common component of the various settlement agreements, certain settlement agreements also include offers to (1) provide liquidity to the investor at no cost before the exercise date of the put option, (2) reimburse investors for losses incurred on the sale of its ARS before the announcement of the settlement agreement, and (3) pay consequential damages to investors through an arbitration process. In addition, most settlement agreements include monetary fines paid to various state and federal regulatory agencies. This Financial Reporting Alert discusses only the accounting considerations related to the repurchase agreement. It is recommended that preparers discuss accounting considerations related to the other components of the settlement agreements with their accounting advisers.
4 Paragraph 540 of Statement 133 defines a firm commitment as follows:
An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.
5 Note that the determination of when a settlement agreement becomes legally enforceable depends on careful consideration of the settlement terms. For example, a settlement agreement may become legally enforceable when the settlement terms are final and accepted by the regulators and communicated to the public such that an individual investor can determine whether the terms are within the scope of the settlement, when the broker-dealer informs the investor of his or her rights under the settlement, or when the investor has a commitment to put the ARS to the broker-dealer and release the broker-dealer from further recourse. It may be necessary for an entity to consult with its legal advisers when making this determination.
6 FASB Statement No. 5, Accounting for Contingencies.
7 FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended and interpreted).
8 FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others — an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34.
9 Paragraph 9(b) of Statement 133 provides that a contract that requires one party to physically deliver the underlying asset may still be considered net-settleable if there is a market mechanism that facilitates net settlement. For example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract is a market mechanism that facilitates net settlement.
10 Paragraph 9(c) of Statement 133 stipulates that a contract requiring physical settlement may still be considered net-settleable under paragraph 6(c) if one party to the contract is required to deliver an asset that is considered “readily convertible to cash.” Footnote 5 of Statement 133 indicates that an asset is considered readily convertible to cash if it has (1) interchangeable (fungible) units and (2) a quoted price in an active market. Currently, most ARSs are not trading in an active market and therefore are not considered readily convertible to cash. However, this conclusion must be continually reassessed. If the ARS market subsequently becomes active, the written put option may meet the definition of a derivative instrument in a future period.
11 Paragraph 3(a) of Interpretation 45 states that the Interpretation applies to “[c]ontracts that contingently require the guarantor to make payments (either in cash, financial instruments, other assets, shares of its stock, [footnote omitted] or provision of services) to the guaranteed party based on changes in an underlying [footnote omitted] that is related to an asset . . . .” The written put option is a contract that requires the broker-dealer to pay the investor in cash on the basis of changes in the value of the ARS.
12 The SEC staff’s long-standing position that written options must be marked to fair value through current-period earnings is referred to in paragraph 8(d) of EITF Issue No. 00-6, “Accounting for Freestanding Derivative Financial Instruments Indexed to, and Potentially Settled in, the Stock of a Consolidated Subsidiary,” as well as in speeches of several SEC staff members at the AICPA Conference on Current SEC Developments, including Stephen M. Swad (1994), Russell B. Mallett (1996), and Pascal Deroches [ sic] (1998 and 1999).
13 While Statement 5 indicates that a gain contingency should not be recognized in the financial statements, paragraph 17(b) of Statement 5 states, “Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization.”
14 FASB Concepts Statement No. 6, Elements of Financial Statements — a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2).
15 Paragraph 25 of Concepts Statement 6 defines assets as “probable [footnote omitted] future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”
16 Paragraph 6 of FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, defines a financial asset as “[c]ash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right (1) to receive cash or another financial instrument from a second entity or (2) to exchange other financial instruments on potentially favorable terms with the second entity.”
17 Appendix D (the glossary) of Statement 150 defines a freestanding financial instrument as a “financial instrument that is entered into separately and apart from any of the entity’s other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction that is legally detachable and separately exercisable.” The put option (1) is a contractual arrangement that is entered into between the broker-dealer and the investor (i.e., it is not an agreement between the investor and the issuer of the ARS), (2) is legally separate from the ARS (i.e., the ARS can be transferred to a third party without a transfer of the put option), and (3) can be exercised independently of any other instrument or event.
18 Because of its nontransferability and detached nature, the put option generally does not create a “secondary market” in which the ARS could be sold. In addition, paragraph 8 of FASB Staff Position No. FAS 115-1/124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” states, “An investor shall not combine separate contracts (a debt security and a guarantee or other credit enhancement) for purposes of determining whether a debt security is impaired or can contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its cost.”
19 FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.
20 FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115.
21 Note that this accounting treatment is narrowly applicable to ARS settlement agreements but not to other fact patterns.