The Council of Institutional Investors (CII) has filed a petition with the SEC urging the agency to fix what it says is a regulatory loophole allowing companies to use potentially inflated earnings data in assessing executives’ pay without explanation.
CII is concerned that companies using executive compensation targets based on non-Gaap financial measures are not required to adequately disclose how those measures relate to Gaap. The group wants this information to be presented in a ‘proper context’ within the CD&A that appears in a company’s proxy statement – something CII says is not being done by many companies using non-Gaap, or adjusted, earnings and other non-Gaap measures to help determine how executives are paid.
According to the investor group, research indicates that companies using adjusted earnings to depict substantially better performance relative to Gaap often incorporate these adjusted earnings into executive compensation analysis.
In 2016, adjusted earnings of 28 companies in the S&P 500 showed significant profits despite their Gaap earnings in fact being losses, according to CII’s petition. Another 37 companies reported adjusted earnings that were more than 100 percent higher than their Gaap earnings, it states. CII cites research by Robert Pozen at MIT’s Sloan School of Management as finding that of these 65 companies, 62 used adjusted earnings as compensation criteria in their CD&As.
Pozen found that, although in most cases compensation committees used the same adjustments as management used in other filings subject to Regulation G, in some cases compensation committees used somewhat different definitions of adjusted earnings, CII states.
Regulation G requires public companies that disclose or release non-Gaap financial measures to include, at the same time, ‘a presentation of the most directly comparable Gaap financial measure and a reconciliation of the disclosed non-Gaap financial measure to the most directly comparable Gaap financial measure.’
The regulation was adopted under the Sarbanes-Oxley Act to address public companies' disclosure or release of certain financial information that is calculated and presented on the basis of methodologies other than in accordance with Gaap.
‘CII has not conducted a comprehensive study on 2018-19 proxy statements, but we see continuing opportunities for better disclosures about use of non-Gaap measures related to performance targets,’ CII executive director Ken Bertsch and general counsel Jeffrey Mahoney write in the petition. They add that, on the other hand, some companies using non-Gaap metrics related to compensation targets define such metrics in their CD&As and explain how they differ from Gaap.
‘We would emphasize that some CII members would argue with the substance of certain adjusted metrics used by these latter companies (for example, the exclusion of stock-based employee compensation),’ Bertsch and Mahoney write. ‘But all we seek with this petition is a requirement for clear explanations and Gaap reconciliations that would permit a shareholder to understand the company’s approach and factor that into its say-on-pay vote and/or buy/sell decision, and potentially engage board members on the shareholder’s concern.’
Regulation G offers an important investor protection against misleading information about performance, Bertsch and Mahoney say. ‘Excluding the CD&A disclosures on compensation targets from the Regulation G requirements results in CD&A references to non-Gaap financials that are not always clear, and may mislead investors. We believe the SEC should fix this anomaly in its guidance on use of non-Gaap financials.’
Specifically, the CII petition asks the SEC to:
- Amend Item 402(b) of Regulation SK to eliminate instruction 5
- Revise the division of corporation finance’s guidance to provide that all non-Gaap financial measures presented in a proxy statement’s CD&A are subject to the requirements of Regulation G and Item 10(e) of Regulation SK.
‘We do not believe there is a reasonable basis for excluding executive pay targets as disclosed in the CD&A from what the SEC deems elsewhere to be necessary disclosures on adjusted financial measures,’ Bertsch and Mahoney write.
‘Textual and quantitative reconciliation of the differences between adjusted earnings and Gaap is clearly feasible in the CD&A, since such information was included in the proxy statements of roughly half of the 62 companies with large differences that used adjusted earnings as compensation criteria in 2016, and we see this in more recent proxy statements as well.’