By Soyoung Ho
An investor advocate group last year petitioned the SEC to write a rule requiring public companies to clearly explain why and how they use adjusted financial metrics in the Compensation Discussion and Analysis (CD&A) section of the proxy statement. And departing SEC Commissioner Robert Jackson believes the commission should seriously consider it.
The Council of Institutional Investors (CII), a powerful investor group that represents pension funds, endowments, and foundations that collectively manage more than $4 trillion in assets, in April 2019 asked the market regulator to revise its rules so companies will be compelled to follow the requirements that govern non-GAAP measures when they determine CEO pay to make sure that the metrics are not misleading.
“I think CII’s petition is very interesting, and I hope that my colleagues will take a close look at that,” Jackson said in a recent interview with Thomson Reuters . He announced he will leave the agency in mid-February 2020.
The investor group wants the SEC to revise Item 402 of Regulation S-K. Reg S-K lays out the reporting requirements for various filings with the commission. In particular, the group asked the SEC to require companies in their proxy statements to explain why they are using metrics other than GAAP in their CD&A for setting executive compensation and provide a quantitative reconciliation of such metrics to their GAAP financials, or hyperlink to the reconciliation in another document.
However, a senior official signaled in December 2019 that the SEC will not work on such a rule. Both CII and Commissioner Jackson believe that the inaction is a missed opportunity to better protect investors.
The organization is worried that non-GAAP metrics used to be the exception in compensation committee reports, but now they have become the rule. In general, companies will often use non-GAAP metrics because they make their financial outlook better. In egregious instances, Audit Analytics observed that some companies double-adjusted executive compensation metrics by labeling the metrics in both earnings releases and executive pay in the same way but calculating the metrics differently.
William Hinman, director of the SEC’s Division of Corporation Finance (CorpFin) did not directly address the rulemaking petition but indicated that updating the rule may not be necessary. The item is also missing in the SEC’s rulemaking agenda.
“The CD&A is excluded from having to reconcile non-GAAP numbers, but we do in the rule ask people to show how you get to that number if it’s a non-GAAP number,” Hinman said in December at an AICPA conference in Washington. “You don’t have to do the full reconciliation; many times, people will sort of cross-reference the reconciliation. But we do see on occasion people not providing how you get to that number in a clear way.”
His division at the SEC would be in charge of drafting any rulemaking in the area, but he indicated that agency staff pressure might be sufficient to address unclear disclosures.
“I think also that would help people understand the comp disclosure better and give more confidence to investors on that process,” he explained. “So, we would encourage people to, you know, when they are using [non-GAAP]… to provide at least how they got there. The method of calculation is it’s what the rule says. It’s not reconciliation, but it’s pretty close.”
Regulation G and Item 10(e) of Reg S-K provide rules on the use of non-GAAP measures. Reg G says that companies cannot present their non-GAAP numbers more prominently than their audited GAAP numbers. The rule requires companies to reconcile the differences between the non-GAAP financial measure with the most directly comparable financial measurement from GAAP. The regulation also requires a statement about why management believes that presenting non-GAAP financial measures provides useful information to investors regarding the company’s financial condition and results of operations, among other requirements.
“We welcome SEC staff comments on registrant’s non-GAAP measures in the CD&A which we believe will lead to improved disclosures that will help investors in better understanding and voting on executive pay plans,” CII General Counsel Jeffrey Mahoney previously said. “However, in our view, the relevant SEC rules must also be improved.”
“Application of Regulation G and Item 10(a) to CD&A is critical because it would require a quantitative reconciliation of non-GAAP measures to the most directly comparable financial measure presented in accordance with GAAP, and a statement disclosing the reasons why the registrant’s management believes that presentation of the non-GAAP financial measure provides useful information to investors,” Mahoney said.
“We write rules for all the companies, and what’s so troubling to me about our failure to deal with Non-GAAP compensation practices is that what we hear from our friends at cocktail parties isn’t necessarily what’s happening across Corporate America,” said Jackson. “The problem is we don’t write rules at the SEC only for the best counseled companies who are doing the right thing.”
Stock buybacks and CD&A
Hinman’s remarks on non-GAAP and CD&A at the conference started out with discussions on another controversial topic: the significant increases in stock buybacks in recent years.
Jackson has been concerned by the massive amount of corporate stock buybacks in the past two years as a result of the Trump tax cuts. He believes it negatively affects long-term investors. In particular, he said executives are motivated to promote spending that lifts the share price but undercuts capital investments in product development or market share gains.
However, Hinman said companies are being more thoughtful with buybacks and compensation targets.
“Almost every company that we meet with in this area says that the comp committee is very thoughtful about that and takes it in to account,” Hinman said. “Not every CD&A actually discloses that. And so, people on the outside sometimes have the impression that by doing the buyback you are making it easier for execs to reach their goals. But what we have seen in practice is a lot more companies are actually taking into account, factoring out the impacts of the buyback either on the EPS [earnings per share] calculation or however it may affect the target.”
In Jackson’s view, the SEC should not speculate about what boards are doing.
“A big problem with just guessing what boards are talking about is we tend to be biased by our own experience. So, it may be that some of the boards that we know best as individuals are talking about it,” Jackson said. “We need to be able to write a rule that forces all boards to disclose to investors what they are talking about. And that’s why I pushed for that.”
This article originally appeared in the January 22, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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