On August 23rd the Second Circuit affirmed a lower court’s dismissal of a suit alleging securities fraud in Fait v. Regions Financial. The plaintiffs, securities holders of Regions, asserted that Regions violated Section 11 and 12 of the Securities Act of 1933 by making material misstatements with regard to goodwill and loan loss reserves in its 2007 10k and 2008 10Q. However the Second Circuit held that the plaintiffs failed to plead a claim under Sections 11 and 12 because calculations of goodwill and loan loss reserves were issues of opinion, not fact, and the plaintiffs did not plead any facts that demonstrated that the officers of Regions knew, at the time the filings were made, that the calculations were incorrect.
In the years prior to 2008, Regions had acquired several businesses that derived a substantial portion of their profits from mortgage-backed securities. In February 2006, Regions reported goodwill (calculated as the difference between the purchase price and the net fair value of a target’s assets) as $11.5 billion and declared its loan loss reserves were $555 million. These amounts remained relatively constant through the first three quarters of 2008. In January 2009, when the company released its fourth quarter 10Q, goodwill decreased by roughly 50% to $5.5 billion and its loan loss reserves doubled to $1.15 billion. For perspective, Lehman Brothers, Bear Sterns, and Washington Mutual had all gone under, and Congress had initiated the Toxic Asset Relief Program (“TARP”) more than three months before Regions recognized any impairment to its goodwill or declared any increase in loan loss reserves.
Oddly enough, the Second Circuit implicitly recognized that the calculations of goodwill and loan loss reserves need to be rooted in factual observations when it cited Henry v. Champlain Enterprises (“There may be a range of prices with reasonable claims to being fair market value”). Nonetheless the court focused almost entirely on whether or not the plaintiffs pleaded facts that demonstrated that directors of Regions knew their calculations were wrong, an issue that would only be relevant if the statements were entirely based on their opinion. This focus was to the exclusion of an obvious, potentially determinative issue: whether the estimates of goodwill and loan loss reserves were within the range of reasonable values given market conditions at the time.
Less than a month after Fait was decided, the Financial Accounting Standards Board (FASB) released revised guidelines governing the impairment of goodwill. Beginning December 15, 2011 companies will be allowed to forego the yearly fair value analysis of goodwill if they come to the conclusion that it is more likely than not that goodwill remains unimpaired. This determination is entirely “qualitative” and inherently involves the exercise of “significant judgment” on the part of reporting companies. While the guidelines do provide greater guidance regarding factors that should be considered when deciding whether or not the carrying value of a reporting unit is likely to be larger than its fair value (which would indicate that goodwill may be impaired), the guidelines also specify that no individual or group of factors can be considered determinative on the issue.
Given the adverse incentives for companies to report an impairment to goodwill or increase in loan loss reserves, particularly in difficult times (when such action may be most appropriate), one can expect that impairment to goodwill and increase in loan loss reserves will be a perpetually lagging indicator for market analysts attempting to assess the financial strength of companies.