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.”

In the study, the authors noted that, most often, regulators have been concerned that non-GAAP metrics might mislead investors, resulting in mispriced securities. And companies, the study authors observed, typically justify the use of non-GAAP earnings as “(i) a better indicator of economic reality and (ii) better reflective of the factors under their control than GAAP earnings.” However, the study found that the evidence supported neither view: the study did not find mispricing as a result of the use of non-GAAP numbers nor did the authors “find non-GAAP earnings to be more informative or permanent than GAAP earnings post-2010 [when the study period commenced]. In summary, intuition and evidence both suggest non-GAAP earnings would neither impede nor facilitate investors’ ability to grasp firms’ actual financial performance.” Overall, the evidence from the study suggested that “large non-GAAP earnings adjustments influence some boards of directors in approving a level of CEO pay that is otherwise not supported by the firm’s stock price or GAAP earnings performance.” With regard to recommended reforms to address these issues, the study suggested that “the SEC may want to require that compensation committee reports give GAAP metrics ‘equal prominence’ with non-GAAP metrics, as in earnings press releases. In particular, the SEC might consider requiring compensation committee reports of all public companies to (i) prominently disclose the amount of difference between the non-GAAP criteria used by the committee and the relevant GAAP numbers; and (ii) provide a justification for why the committee chose to use non-GAAP criteria in setting executive compensation.”

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.”

The relevant SEC Compliance and Disclosure Interpretation related to non-GAAP financial measures seems to go a bit further in the direction advocated by the authors than does the actual instruction to the CD&A rule:

“Question 108.01 Instruction 5 to Item 402(b) provides that ‘[d]isclosure of target levels that are non-GAAP financial measures will not be subject to Regulation G and Item 10(e); however, disclosure must be provided as to how the number is calculated from the registrant’s audited financial statements.’ Does this instruction extend to non-GAAP financial information that does not relate to the disclosure of target levels, but is nevertheless included in Compensation Discussion & Analysis (‘CD&A’) or other parts of the proxy statement—for example, to explain the relationship between pay and performance?

Answer: No. Instruction 5 to Item 402(b) is limited to CD&A disclosure of target levels that are non-GAAP financial measures. If non-GAAP financial measures are presented in CD&A or in any other part of the proxy statement for any other purpose, such as to explain the relationship between pay and performance or to justify certain levels or amounts of pay, then those non-GAAP financial measures are subject to the requirements of Regulation G and Item 10(e) of Regulation S-K.

In these pay-related circumstances only, the staff will not object if a registrant includes the required GAAP reconciliation and other information in an annex to the proxy statement, provided the registrant includes a prominent cross-reference to such annex. Or, if the non-GAAP financial measures are the same as those included in the Form 10-K that is incorporating by reference the proxy statement’s Item 402 disclosure as part of its Part III information, the staff will not object if the registrant complies with Regulation G and Item 10(e) by providing a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation and other information. [July 8, 2011]”

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.”