An op-ed co-authored by SEC Commissioner Robert Jackson (who is reportedly planning to leave the SEC this fall, although he’s eligible to stay until the end of 2020) and MIT senior lecturer (and former president of Fidelity) Robert Pozen lambasts the use of non-GAAP targets in determining executive pay, absent more transparent disclosure. The pair argue that, although historically, performance targets were based on GAAP, in recent years, there has been a shift to using non-GAAP pay targets, sometimes involving significant adjustments that can “be used to justify outsize compensation for disappointing results.” What’s the bottom line? Where comp committees base comp on a different scorecard than GAAP, they argue, the committee should have to explain their decision by reconciling to GAAP in the CD&A. Will the SEC take heed?
The op-ed was premised on recent research co-authored by Pozen, which showed “that firms in the S&P 500 announced adjusted earnings that were, on average, 23% higher than GAAP earnings. At the same time, those firms reporting the largest differences between their adjusted and GAAP earnings awarded higher pay packages to their CEOs than predicted by the standard academic model of normal CEO compensation. Yet those firms with the largest differences, on average, experienced lower stock returns and subpar operating performance….” And, the difference between GAAP and non-GAAP adjusted measures can be significant: the op-ed pointed to 36 companies in the S&P 500 that, in 2015, announced non-GAAP earnings more than 100% higher than the GAAP equivalent, and 57 more companies that reported non-GAAP earnings that were 50% to 100% higher than GAAP. What’s more, the “compensation committees of almost all those companies used a non-GAAP measure as an important criterion for awarding executive pay.”
The authors recognized that sometimes it makes a lot of sense to use non-GAAP performance targets, such as “when one-time charges obscure the underlying health of a business.” But when a company issues a press release with non-GAAP numbers, to provide transparency, the company is required to follow a number of strict rules about the presentation (such as the not-more-prominent-than-GAAP rule) and to provide a reconciliation of the non-GAAP number to the comparable GAAP number. But those rules are generally not applicable to disclosure of pay targets in CD&A: “Unfortunately, those requirements do not apply to the reports that compensation committees of corporate boards disclose to investors each year. Thus, committees choosing to use adjustments when deciding on payouts need not explain why an adjusted version of earnings is the right way to determine incentive pay for the company’s top managers. This increases the risk that adjustments will be used to justify windfalls to underperforming managers.”
In light of the pervasiveness of the use of non-GAAP comp targets, the authors advocate changes in these rules and interpretations to aid investors to “easily distinguish between high pay based on good performance and bloated pay justified by accounting gimmicks. That’s why we’re calling on the SEC to require companies to explain why non-GAAP measures are driving compensation decisions—and quantify any differences between adjusted criteria and GAAP. A few public companies already provide investors with this kind of transparency. Others can too…. It’s time for the SEC to help investors understand exactly what performance they’re paying for.”