Identifying an active market – just as unclear as you thought it was

We’ve looked several times already (here and here) at the concept of an active market as defined in IFRS 13, in particular through a couple of instances where European regulators took issue with an issuer’s contention that a particular shareholding wasn’t traded in such a market.

CPA Canada’s IFRS Discussion Group recently considered the same issue, noting: “Sometimes whether a market is active or not is self-evident. For example, an entity with shares quoted on an exchange (for example, the Toronto Stock Exchange) may have regular trading frequency and volume to provide pricing information on an ongoing basis. However, for entities in a start-up phase or a specific industry, their shares may have low frequency of trading and, in some cases, there could be no daily or monthly trading. Even if trading took place, the volume of shares traded could be low.”

The group went on to consider a fact pattern of an entity for which the shares have traded only four times during a given year, with a total volume amounting to less than 5% of the total float, and where no shares have been issued during the year by private placements or by other means. Here’s some of the discussion that flowed from that:

  • “Group members made various observations regarding other characteristics that entities can look at in assessing whether the investment is traded in an active market. For example, an entity could look at the bid-ask spread because generally if there are multiple participants in the market, the differential should be small. Also, an entity could consider economic indicators (for example, the price of oil) that could be correlated with the price of the security.
  • One Group member observed that entities could start with the presumption that an investment traded on an exchange is an active market, but then consider whether evidence exists to rebut that presumption….
  • One representative from the Canadian Securities Administrators (CSA) noted that National Policy 12-203, Cease Trade Orders for Continuous Disclosure Defaults, also considers the concept of an active liquid market. Although this policy is in a different context from IFRS 13, the regulators have concluded that there is not an active liquid market for securities traded a few times in small volumes over a period of a month or two. Another CSA representative commented that generally they start with looking at the security and understanding the trading pattern, including when the last trade occurred, and the type of trade (for example, whether it is a forced trade or a related party trade)…”

The group then asked: if the investment in question isn’t considered to have a quoted price in an active market, then what are the implications for applying the fair value hierarchy – in particular, does the entity measure the fair value using a valuation technique, or is it permitted to use the last quoted price, regardless that the price isn’t obtained from an active market? Among other things, “proponents note that adjustments to the last quoted price would require significant assumptions and estimates. Hence, the last quoted price (even when the instrument is trading thinly or not at all) would be more indicative of the share’s fair value than any other Level 2 or 3 valuation, especially when the equity instrument being valued is that of a start-up or similar type of entity.”

On this, some members of the group “thought it would be difficult to accept, or default to, the last quoted price if the entity reached the conclusion that the instrument is traded in an inactive market. An old value cannot be presumed to represent fair value, and thus, other valuation techniques should be used to derive a more reasonable estimate.” A member pointed out that as IFRS 13 requires measuring fair value from a market participant’s perspective, further work would be needed to understand how a market participant would view the most recently quoted price. A representative from the CSA observed “that the inactive trade could be a useful reference point. Also, consideration should be given as to how long ago the last trade occurred relative to the measurement date, and whether using that price will produce a misleading result for investors. Valuation techniques produce estimates as well. Therefore, it is important to assess the reasonableness of the valuation techniques and the inputs used.”

So where does this leave us? Mainly with confirmation, for those who’ve struggled with issues in this area, that they likely weren’t missing anything obvious. The point about accepting the last traded price as being better than anything else only seems, at bottom, to imply that any fair value measurement not derived from a level 1 measurement is essentially useless to users anyway, so one might at least select one that can be tied to something. But in countering that, many of the points made by the group are subjective at best – for instance, in a thinly traded situation there may be no way of knowing how a theoretical market participant would look at things, or of assessing whether a particular price provides a “misleading result.” It may be tempting to conclude that a higher price will often be more misleading than a lower one, but regulators may not agree (if, for instance, they regard that approach as a way to avoid the later recognition of an impairment loss, based on clear subsequent deterioration in prospects).

Likewise on the first question, the points made provide little to hang on to. The course of considering economic indicators that could be correlated with the price of the security seems unlikely to bear solid fruit on too many occasions. And while identifying a particular trade as being forced or as the result of a related party relationship may help in concluding the price in that trade doesn’t carry much information about what anyone else would do, the same is often true for any trade in a super-slow-moving security – the data set just isn’t big enough to say anything about what the wider world would think if it ever focused on the issuer (which, of course, it never will). So in many cases, it may not come down to much more than management’s ability to craft an eloquent, suitably wide-angle argument for its preferred position. Still, as I mentioned, the group’s discussion is valuable for confirming that, yes, things in this area really are as unclear as they seemed to be…

The opinions expressed are solely those of the author

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