By Soyoung Ho
A senior official signaled last week that the SEC will not write a rule requiring public companies to clearly explain why and how they use adjusted or non-GAAP financial metrics in the Compensation Discussion and Analysis (CD&A) section of the proxy statement.
This comes as the Council of Institutional Investors (CII) in April 2019 petitioned the SEC 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.
The influential investor group represents pension funds, endowments, and foundations that collectively manage more than $4 trillion in assets. CII wants the SEC to amend Item 402 of Regulation S-K, which lays out the reporting requirements for various filings with the commission. In particular, the group wants 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.
The group 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 on December 10 at the AICPA’s 2019 Conference on Current SEC and PCAOB Developments 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 Jeffrey Mahoney 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.
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.
SEC Commissioner Robert Jackson has publicly said that he was concerned with the effect of buybacks at a time when companies are enjoying lower tax rates under the American Jobs Creation Act passed into law in December 2017. The tax law allows U.S. companies to repatriate cash at reduced rates for a limited time. The repatriation tax rates could be as low as 8 percent, compared to the 35 percent companies traditionally paid.
While the pace of buyback is said to be slowing down, Goldman Sachs estimated that the largest 500 public companies were on track to buy back another $940 billion of their own stocks this year.
Reform groups and some Democrats on the Hill believe the practice promotes a short-term mindset at the expense of long-term growth. The short-term focus is worsened when a large portion of executive compensation is based on stock. Executives are motivated to promote spending that lifts the share price but undercuts capital investments in product development or market share gains. Jackson has said there is evidence that a substantial number of executives use buybacks as a chance to cash out the shares they received for compensation.
However, Hinman said companies are being more thoughtful.
“In terms of disclosure that we sort of have seen—some but not everyone do, but I think many more people are doing this than are necessarily writing about it—is how the comp committee takes into account the impact of buybacks on the targets that they are establishing,” he said. “I think there’s been a lot of criticisms [that] buybacks tend to make it easier to achieve certain targets in the comp system that may be set. 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. 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.”
Commissioner Jackson did not immediately respond to a request for comment.