Rulemaking Petition on Non-GAAP Financials in Proxy Statements

Ken Bertsch is Executive Director and Jeff Mahoney is General Counsel of the Council of Institutional Investors (CII). This post is based on a petition that CII submitted to the Securities and Exchange Commission on April 29, 2019. CII Deputy Director Amy Borrus and Research Director Glenn Davis contributed to this post.

The Council of Institutional Investors (CII) on April 29, 2019, petitioned the U.S. Securities and Exchange Commission (SEC) to require clear disclosure on use of non-GAAP financial metrics in the proxy statement Compensation Discussion & Analysis (CD&A). CII asked that the SEC apply the same rules and guidance in that document as it does for earnings releases and other filings. Non-GAAP financials should be explained and placed in appropriate context, and a reconciliation to GAAP should be provided or hyperlinked if the identical adjusted GAAP figures are reconciled in another filing. [1]

The use of non-GAAP or “adjusted” earnings in earnings reports is widespread and on the rise. Research by The Analyst’s Accounting Observer found that 386 companies in the S&P 500 index reported “adjusted” earnings in 2016, up from 264 in 2009. In both years, “adjusted earnings” were on average about one third higher than reported GAAP earnings. Exclusions included costs of equity grants, asset impairments, intangible amortization and restructurings.

These alternative measures of performance also are prevalent in executive compensation targets as presented in the proxy statement CD&A. In some cases, these measures may be useful for incentivizing prudent executive decisions benefitting long-term investors, and CII did not ask the SEC to prevent companies from using non-GAAP financial criteria for awarding compensation. But GAAP is the standard, and deviations need to be clear and put in context. This is as true for proxy statements as it is for 8-Ks, 10-Ks and earnings releases. Indeed, the need for clarity is especially appropriate in the CD&A context because shareholders cast advisory votes on executive compensation regularly—every year at most public companies.

The SEC’s Regulation G requirements provide an important investor protection against misleading information about performance. 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.

The Problem

Research shows that companies using adjusted earnings to depict substantially better pictures of performance relative to GAAP frequently incorporate adjusted earnings into executive compensation practices. In 2016, adjusted earnings of 28 companies in the S&P 500 showed substantial profits, even though their GAAP earnings were actually losses. Another 37 companies reported adjusted earnings that were more than 100% higher than their GAAP earnings. Of these 65 companies, 62 used adjusted earnings as compensation criteria in their CD&As, according to research by Robert Pozen at MIT’s Sloan School of Management. Pozen found that, while in most cases compensation committees used the same adjustments as did management in other filings that were subject to Regulation G, in some cases compensation committees used somewhat different definitions of adjusted earnings. [2]

These findings in 2016 continued patterns from prior years. 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 these companies, Pozen and co-author S.P. Kothari concluded in an article in the Harvard Business Review that “most compensation committees in firms with substantial differences between GAAP and non-GAAP numbers used the non-GAAP ones to set CEO pay.” At those companies, wrote Pozen and Kothari, “adjusted earnings or adjusted operating cash flow determined at least 40% of either annual cash bonuses or long-term stock awards, or both.” [3]

CII has not conducted a comprehensive study on 2018-19 proxy statements, but sees continuing shortfalls in disclosure, including some examples specified in footnote 7 of the CII petition. At the same time, some companies DO provide clear explanations of non-GAAP metrics used in compensation targets, and provide reconciliations to GAAP in the proxy statement. Some CII members (which include asset owners and asset managers) would disagree with the substance of certain adjusted metrics used by these latter companies. For example, many institutional are concerned on exclusion of stock-based employee compensation, which is a common adjustment to GAAP net income. But in the petition, CII only asked 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.

Rationale for Proposed Changes

CII does 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. The CD&A is the most important source used by investors in evaluating executive compensation, and in deciding how to vote on advisory votes on executive compensation. The CD&A also informs investor understanding of a corporation’s governance more generally, and in voting on election of directors.

CII has heard from its members increasing concerns about complexity in executive pay structures, and challenges in understanding compensation and its links to performance. It is imperative that the SEC require at least the level of transparency in proxy statement CD&As as in other corporate documents.

 * * *

The complete petition is available here.


1CII specifically petitioned the SEC to (1) initiate a rule change to amend Item 402(b) of Regulation S-K [17 CFR 229.402(b)] under the Securities Act of 1933 (Securities Act) to eliminate Instruction 5; and (2) revise the Division of Corporation Finance’s Compliance & Disclosure Interpretations on “Non-GAAP Financial Measures” consistent with the aforementioned amendment and to provide that all non-GAAP financial measures presented in the proxy statement Compensation Discussion & Analysis (CD&A) are subject to the requirements of Regulation G [17 CFR 244.101-102] and Item 10(e) of Regulation S-K [17 CFR 10(c)] and that the required reconciliation shall be included within the proxy statement or made accessible through a hyperlink in the CD&A.(go back)

2Unpublished data, on file with CII. See also Nicholas Guest, S.P. Kothari and Robert Pozen, “High Non-GAAP Earnings Predict Abnormally High CEO Pay,” January 2019, at back)

3Unpublished data, on file with CII. See also Nicholas Guest, S.P. Kothari and Robert Pozen, “High Non-GAAP Earnings Predict Abnormally High CEO Pay,” January 2019, at back)


Both comments and trackbacks are currently closed.