The Council of Institutional Investors (CII) once again pressed the Securities and Exchange Commission (SEC) to add a rulemaking project to its agenda to close a loophole in regulation governing a public company’s use of financial measures based on something other than GAAP to determine executive compensation.
The influential investor group wants the commission to write a rule that would improve the non-GAAP measure presentation in the proxy statement’s Compensation Discussion and Analysis (CD&A). Performance metrics can be wide-ranging and are often based on non-GAAP adjusted measures that are not reconciled to GAAP, which can be misleading.
There are rules on the use of non-GAAP measures, but they do not apply to the target measures for compensation in CD&A, which is an important source of information for investors when evaluating executive pay.
Thus, the investor organization believes the SEC should require companies to reconcile the non-GAAAP measures used to determine executive pay to GAAP and also provide a narrative description of why the non-GAAP financial measures are better for determining compensation than GAAP numbers.
The CII’s September 19, 2024, letter was in response to the SEC’s request for comment on its so-called reg flex agenda, which is updated twice a year. It reflects the regulatory priorities of the chair of the agency—this case Gary Gensler.
The council first made its request to the SEC in 2019 in a rulemaking petition.
“Many U.S. companies routinely use non-GAAP metrics in their incentive pay programs,” CII General Counsel Jeffrey Mahoney told Thomson Reuters on October 2. “And many investors believe requiring a line-item quantitative reconciliation of those metrics to GAAP is needed to make an informed assessment of executives’ incentive pay for proxy voting purposes.”
The CII represents employee benefit funds, foundations, and endowments with combined assets of more than $4 trillion under management.
In particular, in his letter to the SEC, Mahoney cited research showing that non-GAAP has been one of the most problematic reporting areas, but almost all large public companies use non-GAAP measures because they tend to paint a more positive picture of their financial performance than would under comparable official GAAP written by the FASB.
To support his request, Mahoney also cited research that showed that companies are engaging in an opportunistic use of non-GAAP earnings to justify higher executive pay. This research was co-authored by a former SEC chief economist.
Further, a survey by proxy advisory firm Institutional Shareholder Services found that many companies do not disclose a line-item reconciliation of non-GAAP to GAAP for incentive program, something that would be easy to fix if the SEC were to step in and write a rule.
A survey by another proxy advisory firm, Glass Lewis, found that 81% of investors want non-GAAP to GAAP reconciliation in the proxy statement. This was in response to whether “the absence of explanatory disclosure should be a factor when forming Say on Pay vote recommendations in situations where incentive outcomes are materially impacted by the use of adjusted Non-GAAP results.”
In a 2024 proxy season briefing, Glass Lewis said that of the four failed say-on-pay proposals at S&P 500 companies had to do with “concerns around controversial non-GAAP adjustments to incentive plan performance results” at railway company Norfolk Southern.
And CII found that Norfolk Southern’s proxy statement had no quantitative reconciliation of its “ROAIC” non-GAAP financial measures for determining executive compensation. ROAIC is return on average invested capital.
In addition, Mahoney cited a 2024 report by Intelligize that discussed the SEC’s Pay Versus Performance rule adopted in 2022 and the CII’s 2019 petition on non-GAAP.
As “shareholders’ understanding of executive compensation and related performance measures rises, there will be increased scrutiny of the relationship between non-GAAP financial performance measurers and executive compensation,” Intelligize concludes.
Thus, at a minimum, CII’s Mahoney wrote that the SEC should “promptly” propose a rule to require companies to “include a hyperlink to a quantitative GAAP reconciliation for any non-GAAP” measures in their proxy statements.
The rules that cover non-GAAP measures are in Regulation G and Item 10(e) of Regulation S-K.
Reg G requires companies to present with equal or greater prominence the most directly comparable financial measure from U.S. GAAP. Companies must reconcile the differences between the non-GAAP financial measure with the most directly comparable financial measurement from GAAP. Companies must also disclose why they believe the non-GAAP measures provide useful information to investors about their financial conditions and results of operations.
In the meantime, no other comment letters were submitted in response to the invitation to comment on the reg flex agenda.
This article originally appeared in the October 3, 2024, edition of Accounting & Compliance Alert, available on Checkpoint.
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