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OFFICERS: MICHAEL GIRONTA, President Gruntal & Co., Incorporated MICHAEL P. HELMICK, Vice President


Letter of Comment No: {P File Reference: 1082-154 Date Received: I /1~/t'(~

First Manhattan Co.

MAIL ADDRESS: GRACE B. VOGEL, Secretary J.P. Morgan Securities Inc. 60 Wall Street New York, NY 10260

MARK KNOTT, Treasurer Stifel, Nicolaus & Co., Inc.

January 15, 1996

Mr. Timothy S. Lucas Director of Research and Technical Activities Financial Accounting Standards Board 401 Merritt 7, P.O. Box 5116 Norwalk, CT 06856-5116

Re: File Reference 154-D Dear Mr. Lucas: The Financial Management Division of the Securities Industry Association ("FMD") appreciates the opportunity to comment on the Financial Accounting Standard Board's (Board) Proposed Statement "Consolidated Financial Statements: Policy and Procedures". FMD has followed this proposed Statement closely due to the significant impact it could have on many of our constituents' financial statements. As stated in our May 16, 1995 position paper "Accounting for Merchant Banking Investments by Brokers and Dealers in Securities" ("Position Paper" - attached), we strongly believe that consolidation of certain merchant banking activities by brokerdealers and their affiliates is very misleading to our financial statement users. This view is shared by our independent public accountants, our regulators, as well as industry analysts and rating agencies. Our Position Paper provides background information on broker-dealer merchant banking activities, current accounting, the unique characteristics of merchant banking investments compared to operating company investments, and the objectives of broker-dealer financial statement users. This letter expands on some of these issues, highlights additional issues raised by the proposed Statement, and recommends revisions to the proposed Statement.

Mr. Timothy Lucas Director of Research and Technical Activities Page 2

Overall, we believe that the scope exemption for consolidated entities that carry substantially all of their assets and liabilities at fair value and the definition of temporary control render the proposed Statement inoperable for our members. Our detailed comments on the Exposure Draft ("ED") as well as our recommendations for the Board's consideration follow.

We believe that the scope of the proposed Statement would encompass business activities that should not be reported on a consolidated basis. The Board addressed some of these activities by providing an exemption that excludes defined benefit pension plans, mutual funds and "certain other investment companies." Nevertheless, this exemption is too narrow, will result in inconsistent application within the securities industry, and provides for less meaningful financial statements. For example, the proposed Statement would result in some broker-dealers being exempt, while others are included. As stated below, we propose that an exemption be made for investments in controlled entities that are carried at fair value and held for purposes of sale rather than for their earnings on a going-concern basis. As discussed in our Position Paper, we would also support an added requirement to demonstrate management intent. Consistent with SFAS No. 115 "Accounting for Certain Debt and Equity Securities" the Board should not ignore management's objective to dispose of these assets as soon as possible.

Broker-dealers and investment companies engage in investment transactions that are identical. Moreover, current accounting, as required by the Investment Companies and the Broker-Dealer Audit Guides, require these transactions to be carried at fair value with changes in fair value reflected in current period earnings. The existing ED would require that these identical transactions be reported drastically different. Yet, the characteristics that distinguish these investments from operating company investments are the same. The ED's focus on excluding certain types of entities does not appear operational in today's business environment. Our proposal focuses on reporting similar transactions in a similar manner. We believe this is a preferable solution. Similar to other product areas, while the budget and funding of the investment banking division may be determined at the corporate level, specific merchant banking investment decisions are made by division employees. These decisions, while perhaps reviewed by a corporate committee, are rarely made by an entity's Board of Directors or governing body. The divisional decisions do not consider whether the investment fits in with the overall entity's strategic decisions, corporate culture, cash flow objectives, etc., but rather address capital gains and exit strategies. To require a broker-dealer to consolidate, a number of merchant banking investments, in which it holds a 1% general partnership interest, for example, would result in distortive information on revenue and expense line

Mr. Timothy Lucas Director of Research and Technical Activities Page 3

items as well as assets and liabilities. The resulting consolidated financial statements would be much less meaningful than presenting these investments at fair value. The reader of a broker-dealer financial statement is concerned with fair value, and the income statement effects of these investments, not the historical cost consolidation of an amorphous reporting entity. Another point to be considered is that the recent proposal for hedge accounting currently being deliberated by the Board would enable entities to report all financial instruments at fair value. For broker-dealers, financial instruments constitute substantially all of their assets and liabilities. In effect, the proposed consolidation Statement would require consolidation of these investments in 1997, whereas once the Statement on hedge accounting is effective and all financial instruments can be fair valued, broker-dealers would become exempt. It seems illogical to require broker-dealers to consolidate these investments simply because current GAAP requires long-term debt and other financing transactions to be reported at historical cost. This is especially true since most repos, resales and securities lending transactions are recorded at amounts which approximate (99%) fair value and most broker-dealer long-term borrowings (which finance inventory positions and customers' floating- rate margin loans) are hedged to obtain floating rates. If the Board chooses to continue to direct the scope exemption to defined entities, we suggest the following modification: Reference to "fair value" in Paragraph 4 should be expanded to include assets and liabilities reported at fair value or amounts approximating fair value. This provision would allow all entities which follow the BrokerDealer Audit Guide to be accounted for in a consistent manner.

Temporary Control We agree that consolidation is not appropriate for entities that are subject to temporary control. The issuance of financial statements of a vastly different consolidated group from period to period would not only add to the cost of compliance with the proposed Statement, it would also confuse financial statement users. This is particularly true in the case of securities industry companies that engage in merchant banking and similar activities. Merchant bankers view the acquisition of a controlling interest in an entity as an investment banking activity. Realization of the earnings process is accomplished with the ultimate sale of the investee. Legal, tax, credit, and other practical issues often dictate that a controlling interest is taken. Nevertheless, it is the valuation of the investee's potential, rather than its current ability to generate operating income and cash flow, that is of primary concern. Accordingly, the investee is managed differently than an operating subsidiary. This issue is discussed in more detail in the attached position paper.

Mr. Timothy Lucas Director of Research and Technical Activities Page 4

In addition, the accounting information required from the investee entity is focused on managerial issues and is generally less comprehensive than the financial accounting information required from operating subsidiaries. The additional effort to consolidate and deconsolidate a steady stream (inlout) of merchant banking investees would add significantly to the current burden of financial reporting by the securities industry. For example, application of purchase accounting requires a revaluation of recorded assets and liabilities, goodwill valuation and amortization, adjusting future depreciation, interest income and expense, and accounting for deferred tax consequences of the acquisition. In addition to accounting for the book-tax differences that consolidation accounting would require for these activities, there would be significant regulatory reporting differences for companies in our industry. These differences would give rise to an additional reconciliation effort. All of this would add to the cost of completing the transactions, resulting in a dimunition of the business. We believe that these costs would exceed any benefits that could arguably be derived by financial statement users. Presenting the operations of merchant banking investees along with broker-dealer recurring operations will only cloud the reported financial results. Just as discontinued operations are segregated from continuing operations, the ever- changing composition of merchant banking investees requires different reporting. As proposed by the ED, consolidation of these investments under current GAAP would result in quarterly changes in segment reporting and discontinued operations. Due to the volume of merchant banking activity, as a practical matter, annual reports will lose comparability between periods. We believe that fair value accounting is the most appropriate model for merchant banking activities. The one-year rule contained in paragraph 16 of the ED is too restrictive to exclude merchant banking activities. The proposed statement does not consider the operating cycle for this product. Accounting Research Bulletin No. 43 defines the operating cycle as the average time intervening between the acquisition of materials or services and the final cash realization from the sale of products or services. From the outset, the objective of merchant banking is to exit the transaction with a capital gain. Nevertheless, the strategy to achieve this objective evolves over time as the deal develops. As a result, the time from initial acquisition to ultimate realization through disposition typically runs from three to seven years. Based on its prior history, a merchant banking firm would be able to define its operating cycle for these activities. We propose that the one-year rule be extended to include the operating cycle for an entity's merchant banking activities. Investments that are expected to be disposed of within the defined operating cycle would be considered "temporary".

Mr. Timothy Lucas Director of Research and Technical Activities PageS

In addition, we believe that the exception to the one-year rule for "circumstances beyond management's control" should be expanded to include situations in which there would be significant negative consequences associated with a sale within one year. An example would be a loss that would not give rise to a tax benefit if the sale occurred within a year. Conforming Accounting Policies We believe that a requirement to conform accounting policies of entities that use specialized accounting principles of their respective industries is not operational or beneficial to financial statement users. Specialized accounting principles have been developed to address unique transactions and reflect the substance of those transactions. For example, a holding company that enters into an interest rate swap contract to hedge its long-term debt will account for the contract on an accrual basis and disclose information about the financial instrument. On the other hand, its subsidiary swap dealer will mark-to-market its trading position. These two . accounting methods for the same contract properly reflect the nature of the transaction for each of the respective entities. To eliminate either accounting result in the consolidated financial statements would be distortive. The ED refers to the accepted practice of the reporting entity. This raises a question as to the definition of the "accepted practice" when a holding company consolidates entities in a number of specialized industries such as banks, insurance companies, public utilities and broker-dealers. Assume that a consolidated group is primarily a manufacturing entity, but it also includes a broker-dealer. The proposed consolidation procedures would require investments carried at fair value by the broker-dealer to be adjusted to the accounting model in SFAS 115. It is our opinion that the accounting policies of specialized industries should be retained in consolidation in order to provide for comparable and meaningful financial reporting.

Mr. Timothy Lucas Director of Research and Technical Activities Page 6

******** We look forward to presenting our views on the ED at the public hearing in February. If you have any questions or require additional information, please call either William Torpey at 212-449-9928 or Charles Vadala at 212-296-2267.

Yours truly,

(!bJu~ Charles Vadala Co-Chairman Accounting Committee Financial Management Division Securities Industry Association

Committee: Peter Desmond, Ernst & Young, LLP Michael Gironta, Gruntal & Co., Incorporated Marshall Levinson, Bear, Stearns & Co., Inc. Thomas Lockbumer, Deloitte & Touche, LLP Julie Oliver, Salomon Brothers Inc. William P. Torpey, Merrill Lynch & Co., Inc. Charles Vadala, Morgan Stanley & Co.

William P. Torpey Co-Chairman Accounting Committee Financial Management Division Securities Industry Association

Accounting Issues Memorandum Accounting for Merchant Banking Investments by Brokers and Dealers in Securities

Prepared by tile

Financial Management Division of the Securities Industry Association with assistance from members, acting in an individual capacity, of the Stockbrokerage and Investment Banking Committee of the American Institute of Certified Public Accountants

May 16, 1995

Introduction This paper has been prepared by the Financial Management Division of the Securities Industry Association, with assistance from members, acting in an individual capacity, of the Stockbrokerage and Investment Banking Committee of the American Institute of Certified Public Accountants ("AICP A"), to respond to a request from the Financial Accounting Standards Board ("F ASB") to explain why merchant banking investment activities of broker-dealers should be exempted from the F ASB' s Preliminary Views on Major Issues Related to Consolidation Policy ("Preliminary Views"). The exemption would apply to broker-dealers and their affiliates ("broker-dealers") that follow the accounting requirements prescribed by the AICPA's Industry Audit and Accounting Guide, Audits of Brokers and Dealers in Securities ("Audit Guide"), which requires companies to report both trading assets and investment securities at fair value. The accounting issue involves whether or not certain investments made in connection with broker-dealer's merchant banking activities should be consolidated. Specifically, current accounting practice, as stipulated by the Audit Guide, requires these investments to be carried at fair value. This paper recommends that this specialized industry practice continue. Fair value accounting for these temporary investments, as compared to consolidation, results in a more appropriate and meaningful financial statement presentation because it enables users of financial statements the ability to assess a broker-dealer's underlying liquidity, revenues, costs, operating margins, and cash flows. Current accounting for broker-dealer investments is consistent with the industry's practice of carrying all trading assets and liabilities at fair value. This presentation provides financial statement users with consistent fair value information for trading assets and investments and is required by the Proposed Audit and Accounting Guide "Audits of Brokers and Dealers In Securities" ("Proposed Audit Guide") in Section 7.39 "Leveraged Buyouts and Bridge Loans".

Recommendation The Securities Industry Association ("SIA"), therefore, recommends that broker-dealer investments be exempted from the consolidation requirements contained in the Preliminary Views. We believe that a similar exemption would also apply to investment companies. Similar to the language contained in paragraph 4 of Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities", the following exemption would apply: "This Statement does not apply to enterprises whose specialized accounting practices include accounting for substantially all investments in debt and equity securities at market value or fair value, with changes in value recognized in earnings (income) or in the change in net assets. Examples of those enterprises are brokers and dealers in securities, defined benefit pension plans, and investment companies". In addition to an industry exemption, we would also support a requirement that specific criteria be established requiring companies to demonstrate through historical experience management's intent to dispose of these investments. Investments acquired as part of exempted enterprises' activities are always considered temporary and should not become part of the normal operating activities of the investor. The proposed statement could require consolidation of investments

absorbed into the operating activities of the investor. A pattern of such activity would taint management's intention to dispose of remaining investments and require consolidation of applicable investments. This criteria would help differentiate broker-dealer and other exempted enterprises' activities from those of an "operating company".

Background Investment acquisitions occur for specific reasons. The buyer will be either (1) an operating company; (2) a group of managers; (3) a group of financial investors; or (4) a combination of the three. The most common acquisition occurs when an operating company, motivated by strategic objectives, acquires a company to expand existing business, reduce costs, or extend into a new line of business. Management groups, in contrast, typically acquire companies they know well to concentrate on the benefits of improved financial performance in the hands of those who bring about improvement. Financial investors, including merchant bankers, acquire equity and/or debt interests in specific companies because they identify opportunities to earn superior financial returns through the ultimate sale of these investments. Simply stated, merchant banking investments are bought to be sold. The securities industry views merchant banking as another investment banking product. Merchant banking activities generally include investments made by broker-dealers to provide growth and expansion financing to companies that require additional capital but do not yet have access to sufficient public or private institutional funding. Similar to trading investments, these investments are perceived by broker-dealers to be undervalued. Also similar to other merger and advisory services offered by broker-dealers, these products provide advisory, commitment, partnership management and underwriting fees, as well as gains or losses from sales of investments. A typical merchant banking operating cycle involves investing in an entity during its middle stage of business development. These investments include partnership interests in leveraged buyout funds as well as direct investment. Entities engaged in merchant banking provide financing for: • • •

leverage buyouts, which are purchases by investor groups, often including key incumbent managers, of all or part of the assets or stock of a company acquisitions of one company by another, and turnarounds, in which companies that have been unprofitable are restructured or reorganized in an attempt to make them profitable.

While specific exit strategies may not be in place at acquisition and the operating cycle for these inventories of investments exceed one year, merchant bankers dispose of portfolio investments as soon as practical. Dispositions of investments include public offerings, including SEC Rule 144A offerings; sales to management based on the terms of the original investment; private placements; or distributions of shares to investors in partnerships.


Characteristics of Merchant Banking Investments Compared to Operating Company Investments The following list differentiates the unique characteristics of broker-dealer merchant banking investments compared to operating companies' investments. • • •

• • • • • • • •

Existing industry guidance requires fair value accounting for broker-dealer merchant banking investments. Merchant banks have a short-term investment horizon during which time they pursue an exit strategy to realize gains. Merchant bank principals or representatives may serve on the board of directors of investee companies and, while providing financial or strategic advice, look to management for the operating expertise to run the business. Business operating decisions are made by the company, not the investor. The cash flows, employee compensation and benefit plans, financial, legal, and tax reporting structures are not combined with those of the sponsor or other investees. Individual investments within a portfolio are not combined. Broker-dealers normally do not guarantee the financial obligations of their investees. Management of investee companies are not combined with management of the brokerdealer. Managements of other investee companies are also not integrated. Sponsors or investors typically receive unregistered or restricted securities for which they have the right to demand registration when specified events occur. Separate-banking and analysts relationships are maintained. Unlike an operating company, broker-dealers normally don't acquire all of the voting common stock of a company. Unlike operating companies, acquisitions are made to generate gains on sales. Operating companies acquire entities for synergies to reduce costs, expand product lines, grow businesses, etc.

The SIA appreciates the challenge the F ASB faces in carving out and exempting certain companies from the consolidation requirements of the Preliminary Views. AJthough specific industry exemptions from the Preliminary Views should be sufficient, we acknowledge that certain companies might want to avoid consolidation, for example, of a research and development subsidiary by categorizing this entity in a particular manner. For this reason we would support a requirement that tangible criteria also be established to confirm the appropriateness of fair value accounting. A pattern of violations of these criteria would represent clear evidence of management's intention and require consolidation of all applicable investments. Some of the characteristics identified above could be considered in developing this criteria.


Present Accounting Practices As required by the Audit Guide, merchant banking investments are carried at fair value or amounts which approximate fair value. This method is consistent with the accounting for other equity securities included in broker-dealer trading accounts. While the method used to calculate fair value for these investments may differ due to their illiquid nature, the underlying concept is the same. The main difference is that for one product, publicly traded listed equity securities, real-time pricing is available; while many merchant banking investments require different valuation techniques. The ultimate objective for both products, however, remains the same; that is, to generate a gain on appreciation of the underlying assets. Both assets are reported at fair value and are always intended to be sold. Sections 7.2 through 7.16 of the Proposed Audit Guide document the appropriate fair value accounting required for trading and investment securities. These valuation methods are summarized below: Financial Instruments Listed on a Recognized Exchange Valuing securities listed or traded on one or more securities exchanges is ordinarily not difficult, because quotations of completed transactions are published daily. A security traded on the valuation date is generally valued at the last quoted sales price. A security listed on more than one national securities exchange is valued at the last quoted sales price at the time of valuation on the exchange where the security is principally traded. Securities not traded on the valuation date with published closing bid and asked prices available, are valued within the range of the closing bid and asked prices. As a general policy, some companies use the bid price, some the mean of the bid and asked prices, and some a valuation within the range considered to best represent fair value in the circumstances. In accordance with the Proposed Audit Guide, consideration is also given to using a discount to value thinly traded or large blocks of restricted securities. Financial Instruments Not Traded on a Recognized Exchange but Having a Readily Available Market Price For most unlisted secuntIes traded regularly in the over-the-counter market, quotations are available from various sources. These sources include the financial press, various quotation publications and financial reporting services, individual broker-dealers, and the NASD. For unlisted securities not traded on the valuation date, a company may adopt a policy of using the average of the bid prices, the average of the bid and asked prices, the average of the price quotations of a representative selection of broker-dealers, or a valuation within the range of bid and asked prices considered to best represent value in the circumstances. Each of those policies is acceptable if consistently applied.


Quotations for over-the-counter securities are normally obtained from more than one brokerdealer, unless they are available from an established market maker. Quotations are obtained from unaffiliated entities, and quotations for several days are reviewed. NASDAQ is one of the most convenient sources of such quotations. If a security is traded infrequently or if the market in the security is thin, the reliability of market quotations is considered. If market quotations for the security are deemed not reliable, an estimate of value, determined in good faith by management and corroborated by finance personnel, is used. Often, market values are obtained by analyzing subsequent sales. Financial Instruments Not Having a Readily Available Market Price Under certain circumstances, it may be necessary to estimate the fair value of securities if market quotations are not available. The objective of the estimating process is to present the asset at the amount the investor could reasonably expect to receive in an orderly sale, over a reasonable period of time. As noted in the Proposed Audit Guide, the SEC's Codification of Financial Reporting Policies provides the best available guidance on the factors to be considered, the responsibilities for, and methods used to value securities for which market quotations are not readily available. Valuation methods that are acceptable include, for example, a multiple of earnings, discounted cash flow analysis and acquisition multiples for similar companies. These analyses take into consideration specific company, industry, and other appropriate economic factors given the underlying facts and circumstances. The overall objective in present accounting practices is to determine the most appropriate fair value, given the facts and circumstances. While the SIA acknowledges that valuing less liquid and non-traded securities requires a greater degree of judgment, we believe that this method still provides the most helpful and relevant understanding of merchant banking investments in brokerdealer financial statements.

Objectives of Financial Statement Users Users of broker-dealer financial statements include shareholders, investors, analysts, rating agencies, customers, and employees. Financial statements of broker-dealers are unique in that the majority of assets and liabilities are carried at fair value or amounts which approximate fair value (i.e., repurchase agreements, margin loans, and securities borrowed). Assets and liabilities not carried at fair values or amounts which approximate fair value are limited principally to fixed assets and long-term borrowings. This accounting results in substantially all unrealized gains and losses already included in stockholders equity. As such, for public traded broker-dealers, equity analysts often use book value per share as a gauge to determine a firm's stock price trading range. The securities industry has long advocated fair value accounting for all financial instruments. The industry believes this approach provides the most meaningful information to financial statement users. Users of broker-dealer financial statements agree that a fair value presentation for merchant banking investments provides the best analytical tool to measure management's performance in addition to isolating these available-for-sale assets to one financial statement


category. This presentation is also consistent with the way broker-dealer management monitors product performance. Consolidation of merchant banking investments would cloud the true financial performance of broker-dealers. In many instances, a firm may have effective control of an investment but retain a small ownership percentage. In this instance, consolidation of the assets, liabilities, earnings, and cash flow amounts would be distortive, particularly since the cash flows are generally not available to the broker-dealer due to separate investee debt covenants. The SIA believes that elimination of fair value carrying amounts in favor of consolidation of assets and liabilities at historical cost provides less meaningful data. Rating agency representatives and equity analysts have indicated it will be more difficult to perform comparative analysis and monitor these investments across firms. Consolidation of merchant banking investments would provide inconsistent year-to-year financial information for each firm and non-comparability within the industry. One broker-dealer may have, for example, twenty merchant banking investments, all carried at fair value. If "effective control," as defined in the Preliminary Views, exists in ten instances, half of these assets would be carried at fair value and the other half be required to be consolidated. Both types of investments, however, were acquired in a similar manner, will be disposed of through sale, IPO, or writen-off within the same time frame. Both assets are also managed as investment opportunities, not strategic businesses. Consolidation of purchased and sold merchant banking investments each year will change the underlying consistency and comparability of financial statements such that: (1) every year will produce results not consistent with prior years (i.e. For example, one year a company might consolidate a defense contractor, clothing store, supermarket, and an oil company; while the following year's financial statements might include, a drug store, a furniture manufacturer, a leasing company, and a paper manufacturer.), (2) financial statements and footnotes between broker-dealers, having similar merchant banking products would be completely different as specialized industry disclosures for temporary investees would continue to be added and deleted, and (3) financial statements would always include results from discontinued operations. From a practical standpoint, consolidation of broker-dealer merchant banking investments would be very difficult and costly due to inconsistent accounting policies and different fiscal year-ends across consolidated entities. Amounts recorded in a broker-dealers income statement representing changes in fair values would need to be reversed and historical cost balances established. In addition, auditors may be required to perform substantial additional procedures, particularly for companies with different year-ends, as well as obtain consents to opine on brokerdealer financial statements. This is in addition to specific SEC regulations that require fiscal yearends for subsidiaries to be no greater than 93 days from the reporting entities year-end. Comparability of financial performance between broker-dealers would also be distorted. Industry and analysts ratios would become less meaningful as consistent measures used to track firm performance would be compromised. From a securities analysts' perspective, for example, consolidation of investee's debt obligations, with ratings different than the broker-dealers, would be confusing and misleading in terms of broker-dealer liquidity.


Conclusion In summary, to report financial condition, results of operations, and cash flows, the SIA believes that a fair value presentation for these investments continues to be most appropriate. Consolidation of historical cost information for temporary merchant banking investments provides less meaningful data to financial statement users. We recommend that the FASB include an exemption for brokers and dealers in securities (who account for investments in accordance with the Broker-Dealer Industry Audit Guide) from the consolidation requirements expressed in the Preliminary Views. We would also support, if considered necessary, additional restrictions based on specific criteria addressing management's intent in relation to investments carried at fair value. We believe these criteria would assist the FASB in limiting and clarifying the scope of specific industry exemptions.