On Thursday last week, the SEC’s Investor Advisory Committee voted to approve, with two abstentions, a subcommittee recommendation regarding human capital management disclosure. You probably remember that, in 2020, during the tenure of then-SEC Chair Jay Clayton, the SEC adopted a new requirement to discuss human capital as part of an overhaul of Reg S-K that applied a “principles-based” approach. The new rule limited the requirement to a “description of the registrant’s human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the development, attraction and retention of personnel).” (See this PubCo post.) With workforce having grown in importance as a value driver, many viewed the amendment as a step in the right direction, but one that fell short. Subsequent reporting suggested that companies “capitalized on the fact that the new rule does not call for specific metrics,” as “[r]elatively few issuers provided meaningful numbers about their human capital, even when they had those numbers at hand” (although more recent studies have shown some expansion of disclosure). (See this PubCo post.) As you know, Corp Fin is currently working on a proposal to mandate enhanced company disclosures regarding HCM, and, according to the most recent Reg-Flex agenda, October is the target for issuance of the proposal. (See this PubCo post.) Recommendations from SEC advisory committees often hold some sway with the staff and the commissioners. Will the IAC recommendations have any impact?
The IAC has discussed the issue of HCM disclosure in the past. In March 2019, the IAC recommended that the SEC pursue rulemaking to improve human capital disclosures for investors. That was followed by the principles-based 2020 amendments. More recently, the IAC met twice to discuss the issue of HCM disclosure, first in June 2022, to discuss human capital as non-traditional financial information (see this PubCo post) and, just a few months later in September, expanding the discussion to consideration of other labor-related performance data metrics that might be appropriate for disclosure (see this PubCo post). At the first meeting in 2022, the IAC member moderating the panels observed that investors rely on decision-useful disclosures to “understand and assess a company’s business, risks and prospects, to make critical decisions about how and where to direct capital. It is thus critical that this information remain both relevant and reliable. As the sources of value and risk have shifted over the past several decades, investors’ informational needs have necessarily evolved.” In 1973, when issuers were first required to disclose headcount, 83% of the market cap of the S&P 500 was in physical assets—property, plant and equipment. In the midst of this “fourth industrial revolution,” more value resides in intangible assets, such as knowledge-based assets. In 2020, 90% of the market cap of the S&P 500 is in intangible assets, such as human capital. In light of this shift, do we need to rethink whether investors getting the information they need? What types of financial information, she asked, are now relevant for investors?
At the IAC meeting
At the meeting, SEC Chair Gary Gensler said that the staff had been “evaluating how disclosures under [the 2020 rule amendments] have been informing investors and possible recommendations for any enhancements, including considering the Committee’s prior recommendations regarding the total dollars spent on the workforce as well as turnover.” Commissioner Jaime Lizárraga said that “[w]e can build on the 2020 foundation with quantitative metrics that will give investors the standardized, comparable information needed to properly evaluate companies’ market value.” Commissioner Hester Peirce, typically not a fan of prescriptive regulation, asked a number of questions:
- “Are investors the only audience of the disclosures being recommended? If not, which specific disclosures are tied to financial materiality, the touchstone for investor-oriented disclosures? Will other constituencies benefit from these disclosures at the cost of investors?
- Principles-based standards are designed to accommodate a varied issuer population. Would it even be possible for the Commission to draft uniform, prescriptive human capital disclosure requirements that would elicit material information regardless of a company’s size, industry, location, and any other distinct human capital challenges?
- Would the recommended disclosures risk giving investors false confidence in the accuracy, consistency, and comparability of human capital information?
- Why do we need a new rule just three years after the Commission’s adoption of human capital disclosures and before FASB issues its final disaggregation rule? [See SideBar below.] If anything additional is needed, would guidance regarding the existing rule be better than a new rule?
- Do we risk requiring disclosures that only larger companies could afford, perhaps because they already make similar disclosures? How should the Commission scale these disclosures for smaller companies? What kind of human capital information is most costly for companies to track?
- The draft recommendation expresses an interest in disclosures related to ‘gender, race/ethnicity, age, disability, and/or other [important] categories.’ Are there constitutional or other legal concerns with requiring such information to be disclosed publicly? How would this information be financially material?
- How can the Commission avoid drafting rules that would have the effect of micromanaging public companies’ human capital decisions, rather than simply eliciting disclosure?”
The IAC Recommendation
According to the recommendation, a “growing body of work provides evidence that companies with effective human capital management perform better than those that manage their human capital poorly,” including, for example, better returns and better productivity. In addition, the modernization of the economy, with the “overwhelming percentage of company valuation now held in intangibles,” underscores the need for better workforce information. Accordingly, investors have been looking for data on the workforce. But the available data is often unreliable, forcing analysts “to rely on crude workarounds to fill the human capital reporting gap,” with the result that human capital may not be “fully priced into the market.”
Further, the IAC contends, the “growth of net loss firms highlights the need for updated human capital reporting.” Valuation of these companies is especially difficult, requiring that investors “understand the firms’ margins and the degree to which these firms report negative net income because they are engaging in the type of investment, such as research and development or investment in human capital, that GAAP commonly treats as an expense that reduces net income.” Even FASB’s disaggregation proposal would not “provide sufficient visibility into labor costs.”
The IAC recommendation recognized that both the 2020 amendments and the FASB disaggregation proposal were useful first steps, “but both fall short of giving investors the full information needed for accurate valuation of human capital. For example, the 2020 rule offers virtually no guidance or prescription about what information should be disclosed, and it explicitly declines to define ‘human capital.’” As a result of the lack of specificity, the IAC contends, issuers have provided disclosures that are not consistent or comparable. In terms of costs to issuers, the IAC recognized that the recommendation would involve increased costs, but indicated that “technological advancement has significantly decreased the cost of collecting—and, ostensibly, reporting— basic human capital data.” Balancing the costs to issuers against the benefits, including the benefit of elimination of the costs to investors in hunting for data, the IAC concludes that it “would be more efficient for issuers to provide human capital information directly.”
The IAC recommendation has two basic components: enhancements to the human resources disclosure in the business description under Reg S-K Item 101(c) and enhancements to the narrative disclosure in MD&A.
Business Description. With regard to Item 101(c), the IAC recommends that the SEC add requirements for disclosure of
“1. The number of people employed by the issuer, broken down by whether those people are full-time, part-time, or contingent workers;
2. Turnover or comparable workforce stability metrics;
3. The total cost of the issuer’s workforce, broken down into major components of compensation; and
4. Workforce demographic data sufficient to allow investors to understand the company’s efforts to access and develop new sources of talent, and to evaluate the effectiveness of these efforts.”
Headcount breakdown. With regard to headcount disclosure, the IAC contends that current disclosures are inconsistent, with some excluding international workers and many excluding contingent labor “despite 2008 SEC staff guidance stating that industries typically reliant on independent contractors should disclose these numbers as well.” The IAC notes that the measure of contingent workers “would include reporting on all similarly situated persons whose work contributes to a material level of revenue or income.” Investors find these breakdowns of headcount to be telling: for example, the IAC suggests, a move of many employees to part-time “could indicate a downward shift in operations, and the volume of independent contractors provides insight into management’s assessment of the stability of current operations.”
Turnover metrics. Disclosure of turnover metrics was considered important because studies have shown that “turnover is meaningfully related to financial performance.” For example, better employee retention is “associated with higher stock returns.” Replacement costs can be high, and “high rates of undesired turnover can be costly for companies due to loss of knowledge and social capital, lower productivity, and reduced product and/or service quality.” In addition, turnover is a quantitative metric that can be compared across companies.
Compensation cost components. According to the recommendation, the cost of labor is “likely the most significant operating cost that companies incur,” yet it is rarely disclosed (about 15% of S&P 500 firms), making it more difficult to understand why certain line items, such as COGS, increased or decreased. “Disclosure of workforce costs,” the recommendation contends, “would allow investors to understand these costs—and to evaluate the efficiency of each dollar invested in human capital through various productivity measures.” As with executive comp, breaking compensation down into its components would allow investors to understand employees’ incentives, “how a company invests in its workforce, and whether any of that investment should be capitalized in the investors’ own financial models.”
Workforce demographic data. The IAC recommends that the SEC require better data on the demographic composition of the workforce, including diversity at senior levels. Diversity data, the IAC suggests, provides insight into “companies’ efforts to identify and develop new sources of talent,” allowing “investors to evaluate a firm’s talent pipeline and effectiveness of DE&I efforts.” The IAC observes that empirical research has demonstrated the value of diversity, and research has shown that “diversity-related disclosures have emerged as one of the most common human capital disclosures.” Former Chair Clayton “acknowledged that D&I are ‘value-enhancing’ and that he ‘expects’ public companies that deem D&I to be material to the business and a driver of performance to include this in disclosures.” However, the IAC contends, company disclosures on diversity are often “generic, qualitative, varied with respect to the level of detail, and lack specific metrics”—missing the “decision-useful information that investors seek.”
MD&A. With regard to MD&A, the IAC recommends that the SEC require additional narrative about how the company’s “labor practices, compensation incentives, and staffing fit within the broader firm strategy. Such a discussion would address what portion of labor costs management views as an investment and why, including how labor is allocated across areas designed to promote firm growth (e.g., R&D) and those necessary to maintain current operations rather than increase sales revenue (e.g., compliance).” The IAC notes that its “recommendation here is consistent with the recommendation put forward in a June 2022 rulemaking petition submitted by former SEC commissioners and senior officials as well as professors of accounting and securities law.”
