February 10, 2017

Key Reminders for Financial Institutions for 2016 10-Ks and the 2017 Proxy Season


As reporting companies are in the midst of preparing 10-Ks for 2016 and gearing up for the upcoming proxy season, we believe it is important to keep in mind guidance issued by the staff of the Securities and Exchange Commission (SEC) in the past year. This advisory includes (i) an overview of certain trends in the areas of focus by the SEC in its comment letters to financial institution registrants in connection with their annual, quarterly and current report filings and (ii) a brief review of required items and issues for 2017 proxy statements.

SEC Comment Letter Trends

Based on our review of over sixty comment letters to financial institutions during 2016, the following two topics appeared to be the subject of the SEC’s increased focus: (1) Non-GAAP Financial Measures; and (2) material trend and risk disclosure in the Management Discussion & Analysis (MD&A).

Non-GAAP Financial Measures. The SEC’s Division of Corporate Finance (DCF) issued several comment letters to financial institutions that addressed non-GAAP disclosures following the release of the Non-GAAP Financial Measures Compliance and Disclosure Interpretations (C&DIs) in May 2016. The updated C&DIs provide additional guidance regarding (i) the types of adjustments and non-GAAP measures that are potentially misleading, (ii) the proper presentation for non-GAAP measures like per-share “funds from operations” or other per-share performance measures, (iii) the adjustment or elimination of non-GAAP financial performance measures for items that are non-recurring, infrequent or unusual, and (iv) the types of non-GAAP disclosures that would be considered more prominent than the most directly comparable GAAP measure. The guidance and the comment letters consistently indicate that the evaluation of a particular registrant’s non-GAAP disclosure is largely dependent on the facts and circumstances under which the disclosures were made.

DCF’s comments relating to non-GAAP financial measures focused on: (1) the removal of non-GAAP adjustments from earnings reports in light of the May 2016 C&DIs; (2) the greater prominence of non-GAAP measures in comparison to information prepared in accordance with GAAP; (3) absence of, incorrect or inadequate disclosure of calculation of non-GAAP metrics; and (4) absence of reconciliations from non-GAAP measures to the most directly comparable GAAP measure.

Removal of Non-GAAP Measures

Item 10(e) of Regulation S-K prohibits the use of a non-GAAP financial measure to eliminate or “smooth” items that have been identified as non-recurring, infrequent or unusual when the nature of the charge or gain at issue indicates that it is reasonably likely to recur within the next two years. For example, on several occasions DCF observed that registrants’ prior activities suggested that future acquisitions of other financial companies or their assets and liabilities would continue to be an ongoing strategy for facilitating internal growth. According to DCF, adjustments to remove acquisition- or merger-related expenses from net or operating income would be potentially inconsistent with the revised C&DIs in cases where registrants are likely to engage in additional acquisitions or mergers in the near future.

Prominence of Non-GAAP Measures over GAAP measures

On several occasions, DCF also commented on the prominence of non-GAAP disclosures over directly comparable GAAP disclosures. Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure, it must present the most directly comparable GAAP measure with equal or greater prominence. According to the revised C&DIs, a determination as to whether a non-GAAP measure is more prominent than a directly comparable GAAP measure depends on the facts and circumstances under which the disclosure is made. The C&DIs, however, provide several examples of non-GAAP disclosures that the SEC would consider inconsistent with Item 10(e)(1)(i)(A) of Regulation S-K, including the presentation of a full income statement of non-GAAP financial measures and the disclosure of a non-GAAP financial measure before or without disclosing the most directly comparable GAAP financial measures.

MD&A - Results of Operations. DCF continues to emphasize disclosure by registrants that will enable investors to better understand the operations of their companies, along with any attendant risks associated with their operations. The range of SEC comments in 2016 to the MD&A section of registrants’ annual reports on From 10-K was fairly broad and often issuer specific; however, DCF comments on the MD&A tended to focus on:

(1) the disclosure of material known trends and risks, along with an analysis of key factors that affect a registrant’s results of operations; and

(2) quantifying the relevant components of the overall changes in financial statement line items.

Disclosure of Material Known Trends and Risks

DCF’s comments emphasized providing investors with more complete information regarding the financial health of a company. With that in mind, DCF’s comments relating to the disclosure of material known trends and risks were targeted at ensuring that registrants provide clearer disclosure for any material changes in revenue for certain products or services. DCF requested, among other things, additional disclosure related to:

  • heightened risk exposure for certain loan portfolios that could be affected by changes in oil prices;
  • trends in provisions for loan losses;
  • significant changes in revenue or operating income; and
  • the impact on the financial statements of troubled debt restructurings. In addition, some comment letters addressed to larger registrants sought disclosure of the potential impact of external events (i.e., events in Syria and the Sudan) on the registrants’ operations.

Quantifying Relevant Components of Overall Changes in Line Items

The comment letters often requested a more fulsome analysis of changes in revenue at the most plausible granular level. For example, DCF requested additional disclosure to (i) understand a registrant’s increase in operating income from non-mortgage products; (ii) explain valuation allowances against deferred tax assets; and (iii) understand the components and period-over-period changes in a registrant’s fees and other revenues in identified operating segments. On a few occasions, DCF asked registrants to address the materiality of the investment risk related to significant external events in quantitative terms.

Other Important Comment Letter Topics. While the following topics did not appear in the comment letters with the same frequency as those discussed above, the SEC has also sought enhanced disclosure relating to

(1) various operating segments;

(2) revenue recognition policies;

(3) methods for calculation of the fair value of assets; and

(4) income tax reporting, particularly with respect to the calculation of effective tax rates.

Among these additional topics, those relating to segment reporting and revenue recognition policies appeared to garner the most attention from the DCF. Comments relating to segment reporting were primarily concerned with: (i) the identification of product and service revenue for each of the operating segments; and (ii) information relating to each reportable segment if it is included in the measure of profit or loss reviewed by the chief operating decision maker as required under ASC 280-10-50-22. With respect to revenue recognition policies, the DCF comments often targeted disclosures relating to the facts and circumstances surrounding recognition of income or allowances for various losses.

Proxy Statement Issues for 2017

“Say When on Pay” Votes. Under the Dodd-Frank Wall Street Reform and Customer Protection Act (Dodd-Frank), a public company is required to have a nonbinding vote to determine the frequency of “say on pay” votes not less often than once every six years. Public companies that initially held their “frequency of say on pay” votes during the 2011 proxy season are required to include a “frequency of say on pay” agenda item in their proxy statements for their 2017 annual meetings. Stockholders have the option of selecting between annual, biannual or triannual votes, with the overwhelming majority of companies currently using the annual option, based on the 2011 proxy season results.

CEO Pay Ratio Disclosures. On August 5, 2015, the SEC adopted a final rule requiring public companies to disclose the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees. The new rule requires public companies to begin making these disclosure in proxy statements for the first fiscal year beginning on or after January 1, 2017. The SEC clarifies in the preamble to the final rule that a registrant’s initial pay ratio disclosure would be included in its first annual report on Form 10-K or proxy or information statement for its annual meeting of shareholders following the end of such year. For calendar year/fiscal year registrant’s, this would mean the proxy statement for the 2018 annual meeting. In October 2016, the SEC issued several C&DIs that provide some guidance with respect to the Pay Disclosure Ratios.

The new rule requires registrants to identify a median employee from an appropriate population of employees and compare the compensation of such median employee to the compensation of the registrant’s CEO. To determine the employee population, the registrant must select a date within three months from the end of its fiscal year, and the median employee will be selected from this population using annual total compensation, as calculated under Item 402(u) of Regulation S-K. Item 402(u) requires registrants to identify their median employee using annual total compensation or another consistently applied compensation measure (CACM), which could include information from the registrant’s tax or payroll records. According to the SEC, a CACM must reasonably reflect annual compensation, but it is not required that a CACM select the same median employee that a registrant would select if it were to use annual total compensation. For purposes of this rule, registrants’ employees include workers whose compensation the registrant (or one of its consolidated subsidiaries) determines, regardless of how those same workers would be classified for tax or employment law purposes.

On February 6, 2017, the Acting Chairman of the SEC issued a public statement noting that some issuers have encountered unanticipated compliance difficulties that may hinder compliance with the pay ratio disclosure rule in the 2017 proxy season. He sought public comment regarding the rule and asked the staff to reconsider its implementation, both of which are extraordinary in that the rule is final and is currently in effect. Absent further guidance from the SEC, registrants should continue to prepare for compliance with the rule with 2017 as the reporting period and 2018 as the first year of disclosure for calendar year reporting companies.

*Peter Torstensen contributed to this article. He is a University of Notre Dame Law School graduate employed at Arnold & Porter Kaye Scholer LLP. He is not admitted to the bar.

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