Uncertainty over the future of applying “blockage discounts” when valuing thinly traded securities needs to be resolved urgently if firms are to meet the deadline for compliance with the Financial Accounting Standards Board’s Statement (SFAS) 157, industry observers say.

SFAS 157, which lays out guidelines for fair-value measurements and comes into force in November, is expected to eliminate blockage discounts, though market participants remain unclear about whether they may still be used in the valuation process under certain circumstances.

Regulators have discouraged the use of block discounts because the methods for deriving the discounts – which estimate how much the market would drop if a large block of securities was to hit the market all at once – are diverse and largely subjective.

“Blockage discounts are based in the assumption that since you hold such a large holding relative to the normal trading volume you would never be able to receive the current market price if you dumped all of your securities at once,” says Brian Gallagher, partner at Deloitte & Touche.  Gallagher says his firm tells clients they cannot use block discounts.

However, Espen Robak, president of New York-based Pluris Valuation Advisors, a provider of restricted securities and warrants valuations, says that while SFAS 157 seems aimed at abolishing blockage discounts, there need to be exceptions for “securities that are so thinly traded as to cast doubt on the market’s ability to truly reflect fair value.” For example, SFAS 157 mandates the use of price-times-quantity valuation for securities that trade in an active market, but does not define what constitutes an inactive market, Robak says.

Block discounts may be needed when, for example, a holder has 10 million shares of a particular stock that only typically trades 1,000 shares per day.  In the past, the holder may have applied a block discount of 20 to 30 percent to the value of the stock to reflect the difficulty of selling the block in such a thin market, Robak says. However, he says it is still not clear whether block discounts will still be allowed in those circumstances under SFAS 157.

According to a FASB staff member, SFAS 157 does not directly address the usage of block discounts in inactive markets, though this is an issue reported by firms implementing the standard.  The staff member says that FASB is in the process of setting up a resource group on valuation issues which could help provide implementation guidance on issues including block discounts.