On August 26, 2020, the United States Securities and Exchange Commission (SEC) adopted final amendments under Regulation S-K as part of a Disclosure Effectiveness Initiative to modernize and improve corporate disclosures which will become effective on November 9, 2020. One of the key revisions is the addition of a new disclosure topic that will require SEC reporting companies to provide a description of their human capital resources to the extent such disclosures would be material to an understanding of the company’s business. This topic is required disclosure in annual reports on Form 10-K and certain registration statements. The final rules should be addressed with a carefully planned disclosure strategy for upcoming annual reports.
HCM and broader ESG proposals have continued to gain increased stakeholder attention in the past several years and concerns around oversight of these issues have only been amplified by COVID-19, making HCM a priority among corporate boards. We expect this trend to continue as companies develop their HCM disclosure strategies.
Institutional investor demand for attention
For the past several years, there has been heightened scrutiny by investors, proxy advisory firms, and other stakeholders calling for enhanced disclosures by companies of their HCM practices. Large institutional investors have been at the forefront of the trend in their communication, voting guidelines and stewardship principles.
- BlackRock: Ray Cameron, head of BlackRock’s investment stewardship team in the Americas, noted that the “current crisis has brought human capital management strategies to the fore” and companies are “understanding that how they treat employees today will have a direct impact on their social license to operate in the future.” BlackRock’s Engagement Priorities for 2020 further provide: “Given most companies identify their employees as their greatest asset, we expect boards to oversee human capital management strategies. Absent disclosure about the board’s role in overseeing the company’s human capital practices, including an explanation of the type of information reviewed and how frequently, [BlackRock] will hold members of the relevant committee, or the most senior non-executive director, accountable.” BlackRock engaged 640 companies on human capital management issues and another 125 on social issues in 2020 and expects to scrutinize company societal impact and commitment to stakeholders in the upcoming disclosure season.
- State Street: In August 2020, State Street sent an open letter to board chairs stating their expectations with respect to racial and ethnic diversity. Starting in 2021, State Street will ask (and expect) its portfolio companies to disclose their “risks, goals and strategy related to racial and ethnic diversity and make relevant disclosure available to shareholders,” but companies should be prepared to discuss these topics in off-cycle engagement with State Street as well, which may occur as early as this fall. Among other things, the letter seeks disclosure on current measures of diversity of the board and the global employee base and how the board intends to execute its oversight of diversity and inclusion.
- Vanguard: Vanguard’s 2020 Investment Stewardship report provides: “Ultimately, boards should work to prevent risks from becoming governance failures. We’ve seen increasing evidence that nontraditional but material risks related to environmental and social topics (such as climate change, cybersecurity, and human capital management) can damage a company’s long-term value. If a company’s practices, organizational culture, or products put people’s health, safety, or dignity at risk, they can pose a financial risk to investors too. Strong oversight practices enable a board to steer a company through unpredictable crises.”
Final rule on human capital management disclosure
Historically, the only specific business disclosure requirement directly related to human capital has been a rule that companies disclose the number of people they employ. The new regime calls for an expanded, in-depth evaluation of human capital as a source of sustainable value for the business by expanding the business disclosures under Item 101(c) of Regulation S-K. Companies will be required to disclose their human capital resources, including any human capital measures or objectives that they focus on in managing their business, to the extent material to an understanding of the company’s business taken as a whole. The rules identify potential measures or objectives that address the attraction, development, and retention of personnel as non-exclusive examples of subjects that may be material, depending on the nature of the company’s business and workforce.
Similar to other changes made in the final amendments, the HCM rules use a principles-based approach. In its announcement of the final rules, the SEC acknowledged that it did not adopt a definition of the term “human capital” because the concept, while generally understood, is often tailored to the circumstances and objectives of individual companies. Consistent with this view, the SEC noted the expectation that the exact measures and objectives included in HCM disclosures may evolve over time and may vary across industry, regions, strategic posture and macro-economic conditions.
Other than requiring specific disclosure of the number of persons employed by the Company, the HCM rules do not specifically require disclosure of additional metrics. However, the release notes that, under the principles-based approach, to the extent that a measure, for example, of a company’s part-time employees, full-time employees, independent contractors and contingent workers, and employee turnover, is material to an understanding of the company’s business, this information should be disclosed.
Practical guidance for framing the new required disclosure
- identify human capital objectives that are strategic drivers of their performance and long-term value creation;
- determine how to measure progress consistently over time; and
- decide how collected information will be utilized within the organization (e.g., to drive specific strategy or guide resource allocation).
Companies will also need to determine the respective roles and qualifications of the board, compensation committee or other committees in oversight of HCM, and, ultimately, the manner in which HCM efforts will be communicated both through public disclosures and shareholder engagement efforts. This public disclosure may be in the annual report on Form 10-K in response to the new disclosure line item, but companies should also be mindful that there has been a push for broader disclosure of HCM information more generally in proxy statements, sustainability reports and company websites.
Potential HCM areas of focus and disclosure in response to the new Regulation S-K requirement, subject to each company’s materiality assessment, include the following:
- Diversity and inclusion: Programs or initiatives related to recruitment and retention of diverse candidates and other corporate partners, programs or initiatives to mentor and ensure equal opportunities at the company for diverse employees, unconscious bias trainings, and community involvement. For instance, if a company has adopted the Rooney Rule for directors or other positions, it could be helpful to provide that disclosure.
- Workforce compensation and pay equity: Company-wide compensation program design and implementation more generally, including incentive structures, internal minimum rates of pay, as well as efforts to promote gender and diversity pay equity. This may include involvement of outside compensation advisors or use of benchmarking data. This coming year, we expect to see disclosures around changes made to compensation programs in response to COVID-19 and the considerations that were involved. In the case of companies that had to reduce compensation or furlough employees, we expect to see disclosure of actions taken to ease departures or reduced wages that demonstrate a commitment to the workforce. For example, many companies provided severance packages, extended health insurance to part-time employees or furloughed employees, offered paid sick leave, or established wellness initiatives and mental health services.
- Talent acquisition and retention: Competitive trends affecting recruitment and retention of employees (including, if material, voluntary and involuntary turnover rates), trends in overall workforce composition and talent needs, and succession planning for senior leadership roles.
- Employee engagement and wellness: The use of employee satisfaction and engagement surveys, implementation of health and safety measures (particularly in light of the COVID-19 pandemic) and employee wellness programs.
- Development and training: Investments in employee training (including, if material, average hours of training), performance reviews, professional and leadership development, and educational assistance.
- Company culture: Internal controls relating to compliance with codes of conduct and appropriate escalation of misconduct or whistleblower concerns, as well as overall integration of HCM risks into the company’s broader risk management process. Initiatives to promote overall alignment with the company’s mission, values and strategy such as employee town halls, upward feedback, and team building programming.
- Oversight and governance: How the company manages its human capital, including the role of management as well as board or board committee oversight over HCM generally or specific areas under HCM.
As has been the case among companies providing voluntary HCM disclosures prior to the final amendments, HCM objectives utilized and disclosed are expected to vary based on the unique circumstances of each particular company. Compliance with principles-based disclosure is not new to SEC reporting companies. The executive compensation disclosure rules governing the Compensation Discussion and Analysis (CD&A) section of SEC filings adopted in 2006 are principles-based and the approach has successfully resulted in expanded and meaningful disclosures that have evolved since the adoption of the rules. CD&As today largely provide thorough explanations of a company’s executive compensation programs, including executive compensation objectives, elements of pay and significant compensation decisions made by the company’s board of directors. Similar to the CD&A disclosures, we expect the principles-based approach the SEC has used for human capital measures and objectives will result in disclosures that will also evolve and be enhanced over time, as companies continue to focus and engage with their stakeholders on this issue. This principles-based approach will allow each company to tell its story by explaining to investors the aspects of HCM that are critical to its operations, industry and the regions in which it operates, and how the company is managing those aspects.
While the HCM rule has been criticized by some commentators for not requiring metrics on, among other things, part-time vs. full-time workers, workforce expenses, turnover and diversity, it does not preclude such disclosure either, and leaves it to the company to determine what disclosure is material to investors. Companies will need to make a materiality assessment and industry practice will need to set precedent. Part of the push to provide more meaningful disclosure in the CD&A has been due to investor and proxy advisory firm pressures. Similar pressures are likely to result in evolving and meaningful disclosures with respect to HCM.
Thinking towards the future
Review of HCM disclosure for the annual reports on Form 10-K is an opportunity for companies to assess different aspects of their HCM efforts. While not all information or efforts will be material to the understanding of a business as a whole, there may be information that is nonetheless compelling to various stakeholders. This information may be better suited as disclosure in the proxy statement, sustainability reports and company websites. However, it will be more difficult to conduct that review piecemeal, and advanced consideration and planning may be beneficial.
Potential for litigation on HCM disclosures
Like all SEC filings and other public communications, HCM disclosures should present a balanced view and be thoroughly reviewed to avoid potential litigation. This summer, shareholder derivative suits were filed against several high-profile companies alleging, among other matters, that the companies' annual proxy statements contained false or misleading claims by espousing a commitment to diversity that was not reflected in the composition of the board or management. While these suits rely on narrow theories that may not ultimately be successful, companies should keep in mind the potential for similar litigation to arise out of HCM disclosures. As a result, companies should approach HCM disclosure, including any quantitative metrics they decide to provide, with the same controls as applied to other regulated disclosures. Companies should also be prepared for increased scrutiny if they are unable to deliver on disclosed HCM objectives or are perceived to have failed to disclose material HCM challenges.