The Council of Institutional Investors (CII) 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 set executive pay.
The influential investor advocate first made its request to the SEC in 2019 in a rulemaking petition. And in a March 11, 2024, letter to the SEC about its regulatory agenda, the CII once again urged the commission to start this project.
The 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 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.
CII represents employee benefit funds, foundations, and endowments with combined assets under management of about $4 trillion.
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 US 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.
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. 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,” wrote CII General Counsel Jeffrey Mahoney. “The result is that currently the ‘use of non-GAAP adjustments to determine incentive plan payouts is a common practice among companies of all sizes and industry sectors.’”
To better make his case, CII’s Mahoney pointed to a 2023 research paper highlighted by Harvard Law School Forum on Corporate Governance that indicates that “when non-GAAP earnings are large relative to GAAP earnings, CEO pay is abnormally high.”
A co-author of the paper is S.P. Kothari, a professor at MIT who served as the chief economist at the SEC from 2019 to 2021 when Jay Clayton was chair. Clayton pursued a business-friendly agenda as promised by then-President Donald Trump. Current SEC Chair Gary Gensler, appointed by President Joe Biden, has stressed the importance of protecting investors, and thus would likely be more receptive to the CII’s request than Clayton was.
Further, Mahoney cited a 2023 survey by Institutional Shareholder Services (ISS) that supports the CII’s petition for rulemaking in this area. ISS notes, among other things, the following:
- companies routinely use non-GAAP metrics in their incentive pay programs, and the performance results can be significantly affected by the non-GAAP adjustments approved by the board;
- many companies do not disclose in the proxy statement a line-item reconciliation of non-GAAP to GAAP for incentive program metrics; and
- a growing number of investors believe that disclosure of line-item reconciliation is needed to make an informed assessment of executives’ incentive pay.
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 says. Mahoney said CII agrees.
The organization “continues to believe it is imperative that the SEC promptly propose a rule to require, at a minimum, that companies include a hyperlink to a quantitative GAAP reconciliation for any non-GAAP financial measures contained in their CD&A,” he wrote.
This article originally appeared in the March 14, 2024, edition of Accounting & Compliance Alert, available on Checkpoint.
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