Human Capital

Investor Group Petitions for Better Exec Comp Disclosure

The investors want companies to better explain in proxies their use of non-GAAP metrics for determining executive compensation.
David McCannMay 7, 2019

As CFO has reported, the Securities and Exchange Commission has grown vigilant in recent years about enforcing rules governing companies’ public use of non-GAAP financial metrics such as “adjusted earnings.”

The SEC’s concern is that deviating from the official GAAP definition of earnings — such as in earnings calls and press releases — can mislead investors as to a company’s true performance and value. That’s why, where companies report non-GAAP numbers, they’re required under Regulation G to reconcile them to the most closely comparable GAAP numbers.

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Regulation G does not, however, require companies to provide such reconciliation in the Compensation Discussion & Analysis (CD&A) section of companies’ annual proxy statements, which is supposed to provide the rationale for executive compensation plans.

Now, the Council of Institutional Investors (CII), whose members collectively manage some $4 trillion in assets, is pushing the SEC to require additional disclosure from companies that base executive compensation at least partly on non-GAAP performance measures.

In an April 29 petition, CII told the commission that “[e]xcluding 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.”

The SEC “should fix this anomaly in its guidance on the use of non-GAAP financials,” CII urged.

Robert Pozen

The petition cited research by Robert Pozen, a senior lecturer at the MIT Sloan School of Management, finding that in 2016, 28 companies in the S&P 500 reported non-GAAP metrics showing substantial profits, “even though their GAAP earnings were actually losses.”

Pozen also found that 37 other companies reported adjusted earnings that were more than 100% higher than their GAAP earnings.

Those findings from 2016 “continued patterns from prior years,” the petition noted. In 2015, for example, two-thirds of the companies in the S&P 500 index reported adjusted earnings exceeding their GAAP income.

After analyzing the proxy statements of those companies, Pozen and co-author S.P. Kothari concluded in a Harvard Business Review article that with respect to CEO pay, “adjusted earnings or adjusted operating cash flow determined at least 40% of either annual cash bonuses or long-term stock awards, or both.”

CII noted that while it has not conducted a comprehensive study of 2018-19 proxy statements, “[w]e see continuing opportunities for better disclosures about the use of non-GAAP measures related to performance targets.”

The petition named Abbott Laboratories, Advanced Micro Devices, Altice USA, Cisco Systems, Cogent Communications, Oracle, and Revlon as examples of companies with potentially misleading CD&As in either 2018 or 2019.

On the same day the petition was sent, CII held a press conference in which executive director Ken Bertsch and Pozen provided additional perspectives and took questions.

“If you try to read compensation committee reports [in proxy statements], you’ll see how challenging it is,” said Pozen, who also was chairman of MFS Investment Management, vice chair of Fidelity Investments, and chair of an SEC committee in 2008 aimed at improving financial reporting.

“I’ve surveyed a number of asset managers,” he said, “and people are really confused. Unless [the proxy] gives a quantitative reconciliation, it’s hard to tell what phrases like ‘adjusted earnings’ and ‘adjusted revenue’ mean.”

He added, “So, we’re asking companies to explain what they mean by ‘adjusted earnings’ in a quantitative way, and secondly to explain why they think these are the appropriate metrics for the compensation of their top executives. The SEC has the authority to make this the uniform practice, and that’s what we’re hoping they will do.”

Some challenges presented by non-GAAP metrics are tougher than others, Bertsch noted.

For example, in the case of Advanced Micro Devices, which based 2018 executive bonuses on non-GAAP metrics, “the only explanation we could see in the proxy statement said that ‘our adjusted non-GAAP income was calculated by adjusting our fiscal 2018 GAAP net income for non-GAAP financial adjustments.’ So it restates the question three times without providing an answer.”

According to Bertsch, AMD “probably was thinking that you know they use non-GAAP income in their earnings release, and there’s a reconciliation there. But that’s not clear at all from the text.”

Altice USA actually did use two different adjusted EBITDA calculations outside the proxy statement, “but it’s not clear if what’s in the proxy conforms with either of those,” Bertsch said.

Asked what was the most egregious practice related to the use of non-GAAP measures for compensation calculation, Pozen pointed to the frequent exclusion from income all expenses for stock options and restricted shares. Doing so, of course, helps executives reach their performance targets.

“As is well known, there was a debate in the accounting profession 15 years ago as to whether companies, particularly technology companies, should exclude stock-related compensation expense from their GAAP net income,” said Pozen.

“In the end, the accounting authorities determined that companies needed to include that expense. So, therefore, when companies now decide to [exclude it], they’re saying they don’t agree with the accounting authorities.”