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Market Ticker: SEC “Urges” Banks to Follow the Law… Sure, Why Not?

30 Oct

What a novel idea – banks following the law…

Well, the SEC must be feeling quite proud of itself, to be so bold as to suggest that banks might want to follow the rules… sheesh.

The SEC “Urges” Banks To Follow GAAP And The Law

You have to love this….

Oct. 29 (Bloomberg) — The U.S. Securities and Exchange Commission urged banks to disclose their expected losses from flawed foreclosure documents, as mortgage-bond investors demand refunds on billions of dollars of securities.

“Expected” = required to disclose.  If the amount is “material” then the law demands that an 8-K be filed as a material event. Essentially anything that could have an impact on the value of the firm’s stock must be disclosed.

Lenders must disclose circumstances that they “reasonably expect” to have an “unfavorable impact” on financial results, the SEC said in a letter posted on the agency’s website today. The letter was sent because of “concerns about potential risks and costs associated with mortgage and foreclosure-related activities,” the SEC said.

This is not just a matter of SEC regulations (although those are important) this also goes to SFAS 5, which is the FASB standards related to accounting.

Specifically, there are three “points of order” with regard to contingent losses:

  • Probable.  That is, likely to occur.

  • Reasonably possible. More than remote, but less than likely.

  • Remote. Unlikely or slight.

Now let’s go down the “decision ladder” a bit.

8. An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income 3 if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.4 It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

b. The amount of loss can be reasonably estimated.

Ok, that’s pretty clear.  If you have a probable loss and can reasonably estimate it, you shall book it against income.

Now what if you can’t?

9. Disclosure of the nature of an accrual 5 made pursuant to the provisions of paragraph 8, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading.

You must disclose if in the absence of that disclosure your accounting statements would be misleading.

10. If no accrual is made for a loss contingency because one or both of the conditions in paragraph 8 are not met, or if an exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 8, disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred.6 The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. Disclosure is not required of a loss contingency involving an unasserted claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable.

Let’s parse Paragraph 10.

If you have not booked the charge against income because you can’t ascertain with reasonable certainty the amount, or the loss is not “probable”, then you are still required to disclose the potential contingency when there is a reasonable possibility that the loss (or an addition to an existing loss) will occur.

That disclosure must include the nature of what happened and an estimate of the possible loss (e.g. expected minimum and maximum losses) or a statement that no estimate is currently possible.

Your “out” is that you’re not required to disclose something you know about a possibility of unless someone has asserted a claim – but you are required to do so if the claim is probable and you have a reasonable possibility of an adverse outcome.

Complicated?  Not really.

See, we have known repurchase and coverage demands from various constituencies – including monoline insurers – who made those demands known before the issuance of the latest quarter’s financial statements.  This makes the claims probable, which means that only a reasonable possibility of an adverse outcome was necessary to trigger disclosure requirements.

So where was disclosure of the potential range of losses, given that the claims were asserted?

Statements like “we’re going to aggressively fight each putback claim” aren’t enough.  You’re required to state the range of possible outcomes if there is a reasonable possibility you will not prevail.

Note that the SEC’s rules (e.g. securities “laws”, such as they are rarely enforced) operate to require disclosure when you become aware of a “reasonably possible” event.  Accounting rules under FASB only require action when accounting statements are prepared (e.g. quarterly for public companies, typically, and if a private concern when prepared for other business purposes such as the annual financial statements used for the annual meeting and/or tax preparation.)

Sarbanes-Oxley also interfaces with this in that the executives of the corporation are now required to know if such impairments exist (e.g. “I didn’t know about that” won’t save you any more – as it used to) and they cannot lie in any official communication. This is certainly true for the financial statements produced for filing as 10-Qs and I’m willing to bet that any reasonable interpretation extends this to the quarterly conference call.  Note that “lies by omission” are the same as lies by statement under SarbOx since positive knowledge is required for corporate officers.

Where are the statements in these quarterly filings with the range of possible harm and where are the auditors?  While an official audit opinion is only given annually with the 10-K, the fact remains that the quarterly filings, while unaudited, are still subject to both SEC and SarbOx requirements for disclosure.

 

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