The Council of Institutional Investors (CII) reiterated its request asking the Securities and Exchange 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 the rules 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.
“Investors often struggle to make sense of how companies assess performance in approving large compensation packages,” according to CII membership approved corporate governance policies.
The rules that cover non-GAAP measures are in Regulation G and Item 10(e) of Regulation S-K. Reg G, which became effective in 2003, require 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 particular, CII wants the SEC to write a rule that would require companies to include an explanation of why non-GAAP measures are better than official GAAP to determine executive compensation and to include a quantitative reconciliation of the two sets of figures. A hyperlink to reconciliation in another SEC filing would also work.
CII, an influential group representing benefit plans, foundations and endowments with combined assets under management of about $4 trillion, first petitioned the SEC over four years ago when Jay Clayton was chairman. The head of the agency sets the rulemaking agenda. Now, Gary Gensler heads up the commission.
The group’s request also comes as analysts say that non-GAAP financial measures may be useful to understand a company’s financial performance, but such figures may also be opportunistically misused to report more profits. Almost all large public companies customize earning figures that do not follow GAAP—some estimates say 95 to 97 percent of S&P companies use non-GAAP measures, depending on the reporting year. Companies often exclude costs such as stock option expenses, write-offs of acquired intangibles and restructuring charges.
“And many of these same companies use non-GAAP earnings as a key criterion in setting executive compensation,” CII General Counsel Jeffrey Mahoney wrote to the SEC in his latest request on Aug. 28, 2023.
He cited a 2023 research paper that provides empirical evidence that companies are opportunistically using non-GAAP earnings to justify higher executive pay.
“Some might argue that the 2019 Petition is unnecessary because companies will voluntarily improve their proxy disclosures to include a quantitative reconciliation or a hyperlink to a quantitative reconciliation in another SEC filing,” Mahoney wrote.
In anticipation of that argument, he said that CII reviewed the 2020, 2021, 2022 and 2023 proxy statements of the seven companies that were highlighted in the 2019 petition as examples of companies that need to provide better non-GAAP disclosure, including Abbott Laboratories and Revlon.
“Based on our review, it does not appear that any of the companies have to-date provided a quantitative non-GAAP to GAAP reconciliation or even a hyperlink to a quantitative reconciliation in their 2020, 2021, 2022 or 2023 CD&As,” Mahoney wrote. “CII continues to believe it is imperative that the SEC propose a rule to require, at a minimum, that companies include a hyperlink to a GAAP reconciliation for any Non-GAAP Financial Measures contained in their CD&A.”
Will SEC Finally Put on Rulemaking Agenda?
Since the April 2019 petition, CII has repeatedly urged the SEC to undertake the rulemaking. So far, Gensler has not put it on the agenda, which currently has over 50 rulemaking items with 30 to be finalized in the near-term. It is unclear whether Gensler will add it to the agenda when it is updated in the fall.
But an expert on GAAP and non-GAAP believes the SEC ought to start rulemaking.
“I think it’s a great idea that they include a reconciliation of the GAAP-to-non-GAAP measures used to award compensation based on such targets,” said Jack Ciesielski, who has done extensive research on companies’ use of non-GAAP.
“It’s only fair to let the owners of the company see the targets that managements have decided should determine their own pay. It’s almost like giving them a blank check,” said Ciesielski, president of investment research firm R.G. Associates, Inc. who serves as a member of the Financial Accounting Standards Board’s Emerging Issues Task Force. “If the SEC doesn’t pick this for their agenda, I’d like to see CII recommend to their membership that all of them should adopt a policy to vote against compensation packages until the investee companies provide such a reconciliation.”
Misleading Disclosures Continue
In the meantime, for several years, the SEC staff has continued to observe abusive practices by some companies on non-GAAP measures because they tend to give a rosier view of their financials than the most comparable official U.S. GAAP would.
The SEC staff issued Non-GAAP Financial Measures C&DIs in 2016 and has since updated it a few times, most recently in December 2022, to correct the bad practices.
Moreover, the SEC in 2020 issued Release No. 33-10751, Commission Guidance on Management’s Discussion and Analysis of Financial Condition and Results of Operations, which also touch upon some non-GAAP measures.
Today, senior officials at financial reporting conferences say that this is still a frequently cited topic of staff comment letters to companies. The staff routinely reviews filings, and when they see insufficient or misleading disclosures, letters are sent to companies to fix them.
This article originally appeared in the August 31, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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