At a meeting today of the SEC’s Investor Advisory Committee, the Committee voted—14 to 6—to recommend that the SEC consider imposing human capital management disclosure requirements as a part of its Disclosure Effectiveness Review and disclosure modernization project. As the vote count suggests, with a significant bloc of votes against, the debate about the recommendation was quite contentious. Now that the recommendation moves to the SEC, the question is: whose views will prevail?

In his opening remarks, SEC Chair Jay Clayton stressed once again his framework for analyzing disclosure rules, which is “rooted in the principles of: (1) materiality; (2) comparability; (3) flexibility; (4) efficiency; and (5) responsibility.” He also emphasized that, consistent with that framework, disclosure requirements must evolve over time to reflect changes in markets and industry, which is especially apparent with regard to human capital. Increasingly, he said, human capital is the source of economic strength and, for some companies,

“human capital is a mission-critical asset. Disclosure should focus on the material information that a reasonable investor needs to make informed investment and voting decisions; yet, applying this and the other principles I mentioned to human capital in the way businesses assess and disclose, and investors evaluate, for example, revenue or costs of goods sold, is not a simple task. That said, the historical approach of disclosing only the costs of compensation and benefits often is not enough to fully understand the value and impact of human capital on the performance and future prospects of an organization. With that as context, my view is that to move our framework forward we should not attempt to impose rigid standards or metrics for human capital on all public companies. Rather, I think investors would be better served by understanding the lens through which each company looks at its human capital. In this regard, I ask: what questions do boards ask their management teams about human capital and what questions do investors—those who are making investment decisions—ask about human capital? For example, how do investors use human capital information to make relative capital allocations among similar organizations? Armed with general and sector-specific answers to these questions, we can better craft rules and guidance.”

In his prior comments to the Committee on this topic (see this PubCo post), Clayton observed that Items 101 and 102 of Reg S-K, which address, to a limited extent, people and properties, were adopted back when companies’ most valuable assets were plant, property and equipment, and human capital was primarily a cost. But now, human capital and intellectual property often represent “an essential resource and driver of performance for many companies. This is a shift from human capital being viewed, at least from an income statement perspective, as a cost.” However, it will not be easy to develop standardized disclosure requirements for “human capital.” Given that disclosure requirements should elicit information that is material to making investment decisions, Clayton observed, those requirements may need to differ significantly, depending on the industry and even the company. It may not be possible, Clayton observed, to identify metrics that offer market-wide comparability and perhaps not even industry-wide comparability:

“Each industry, and even each company within a specific industry, has its own human capital circumstances. For example, I would expect that the material human capital information for a manufacturing company will be different from that of a biotech startup, and different from that of a large healthcare provider. Further, the human capital considerations for a car manufacturer will be different from that of a home manufacturer. Because of those differences and the principles of materiality, comparability, and efficiency, I am wary of jumping in with rules or guidance that would mandate rigid standards or metrics for all public companies.”

Commissioner Robert Jackson also noted that the economy is changing to be more of a “human-centric model,” and that the role of workers is likewise changing, as more companies look to “contingent workers.” Disclosure should reflect these changes.

Committee member Professor John Coates, who drafted the recommendation, presented it to the room, observing that the recommendation satisfied all five of the tenets of Clayton’s disclosure framework. The recommendation first describes, as background, an economy transitioning from one “based almost entirely on industrial production to one that is becoming increasingly based on technology and services.” As a result, the disclosure system should

“evolve to include disclosure regarding intangible assets, such as intellectual property and human capital. Human capital is increasingly conceptualized as an investable asset. Modernizing the Commission’s framework for corporate reporting generally should reflect these facts, subject to the standard of materiality. More specifically,… a 2015 study of the components of S&P market value data found that the implied intangible asset value of the S&P 500 grew to an average 84% by 2015 from the 1970s, when it was less than 20%. The shift is ongoing, and reflects a growth in the importance of intangibles, such as human capital, of four percentage points over ten years.”

Reflecting that trend, the Human Capital Management Coalition, which includes a number of large institutional investors, previously submitted a rulemaking petition to the SEC asking for new rules requiring human capital disclosure. In addition, institutional and retail investors have expressed interest in “clear and comparable information about how firms approach HCM.” (See this PubCo post.) The intensity of interest in HCM is also reflected in projects from SASB (see this PubCo post), as well as academic research, which “has found that high quality HCM practices correlate with lower employee turnover, higher productivity, and better corporate financial performance, producing a considerable and sustained alpha over time.”

In a 2017 petition for rulemaking, the Human Capital Management Coalition, a group of 25 institutional investors with more than $2.8 trillion in assets under management, asked the SEC to adopt rules requiring “issuers to disclose information about their human capital management policies, practices and performance.” The proponents contended that disclosures regarding human capital management would benefit investors and the public, as well as promote capital formation. The petition, however, was not explicit with regard to the details of any proposed regulation, identifying only the broad categories of information that the proponents viewed as “fundamental to human capital analysis.” (See this PubCo post.) The SASB sustainability accounting standards also tackle HCM among a broad range of sustainability topics, although they generally tend not to take a deep a dive into HCM issues. (See this PubCo post.) In addition, the International Organization for Standardization (ISO) has developed a new ISO standard, ISO 30414 Human resource management — Guidelines for internal and external human capital reporting, which may allow investors and others to benchmark companies’ performance on HCM. The new ISO standard calls for companies to publicly report on 23 specific metrics and to report internally on an additional 36 measurements. (See this PubCo post.)

Historically, however, the recommendation continues, the SEC—and GAAP—have viewed human capital only as a cost, not as a primary source of value. (By comparison, acquired R&D can be shown on the balance sheet.) What’s more, the SEC’s disclosure requirements have not kept pace with the shift in views on the value of human capital; current disclosure “is not consistent, verified, or comparable across companies. Differences in HCM make existing disclosure requirements, such as the 10-K requirement to disclose the number of employees, difficult for investors to interpret or use. Yet HCM metrics such as those outlined below are a routine part of financial due diligence, such as in M&A transactions, including for basic valuation models.”

Accordingly, the recommendation advised the SEC to consider mandating human capital disclosure as part of its Disclosure Effectiveness Initiative, after conducting its usual processes “to learn more from investors, issuers and the academic community through… roundtables, concept releases, and proposed rules for public comment, including information about what kinds of HCM disclosures are already required under other regulatory regimes, with a view to minimizing marginal costs of compliance while achieving the benefits of improved disclosure.” These disclosure requirements might be limited to the most basic, purely principles-based disclosure, asking companies to “detail their HCM policies and strategies for competitive advantage and comment on their progress in meeting their corporate objectives.” Alternatively, the requirements could be more prescriptive, mandating use of specific metrics, some of which companies already use to measure

“the success of their HCM strategies and investments. Development of specific metrics should depend on the outcome of standard regulatory processes, and should be adopted only after due consideration for how they might have unintended consequences, such as ‘managing to the metric.’ Any requirements should be crafted so as to reflect the varied circumstances of different businesses, and to eschew simple ‘one-size-fits-all’ approaches that obscure more than they add. For example, workplace safety metrics may be crucial for mining companies, but immaterial for software companies. Nonetheless, the fact that board and managers routinely rely on a number of similar metrics suggests that they can add value for investors, at least within a given sector, similar to the ‘view from management’ approach to MD&A disclosure.”

Based on research, the recommendation then offers some examples of specific metrics that “could be considered in rule-making or as part of routine disclosure reviews by Commission staff. At a minimum, application of existing SEC guidance on non-GAAP accounting, including efforts to prevent issuers from providing inconsistent or otherwise misleading HCM disclosures over time, could be specifically applied to HCM metrics.”

For example, the recommendation suggests that Reg S-K, Item 101, could be expanded to require more information about the breakdown of workers into full-time, part-time and contingent categories, as well as key performance indicators, such as rates of turnover, internal hire and promotion, safety, training, diversity and standard survey measures of worker satisfaction. Discussion of applicable company policies on these topics might be included. Item 101 also requests information about competitive conditions, which could be interpreted to apply to “productivity and competitive advantages of the issuer’s employee population, relative to competitors and available pools of labor.” Through the SEC comment process, the staff could seek to elicit data about the education, experience and training of the workforce. In addition, proxy disclosure could address how human capital is being “incentivized and managed” by augmenting executive comp disclosure with summaries of material information about broader workforce compensation and incentives, such as factors considered in pay and promotion decisions and organizational structures related to HCM. The recommendation suggests that the SEC work with FASB “to consider the evolving role of HCM in value creation and update Generally Accepted Accounting Principles accordingly.”

As noted above, a number of Committee members voiced their dissents, objecting to, among other things, these aspects of the recommendation:

  • While there was not much significant objection to the initial general discussion in the recommendation, the most oft-cited objection related to the identification of specific metrics at the end of recommendation; even if intended merely as suggestions for consideration, the identification of these metrics, dissenters contended, could be interpreted as an endorsement, creating a default standard and de facto expectation for management to disclose accordingly.
  • If the specific metrics became mandatory, they could lead companies to “mark to the metric” and engage in the identified practices even if inappropriate for the business, just for purposes of disclosure, giving investors a false sense of confidence.
  • The movement toward mandating these disclosures is part of an increasing politicization of regulation, much like pay-ratio disclosure, dissenters argued, and, while this proposal is more moderate, it could be the proverbial “camel’s nose under the tent.”
  • There are already a number of incentives for voluntary disclosure, as well as frameworks like SASB, that offer standardization and harmonization and would be preferable to a regulatory mandate.
  • The recommendation has a bias toward viewing human capital as an asset, but human capital can also be a liability, as in the context of pension liabilities; current GAAP treatment is more neutral.
  • Additional disclosure requirements in this area could make it tougher for companies to do business in the US and deter companies from going public.
  • Prescriptive requirements, if adopted, could soon become outdated. What if workers were replaced by robots?

Supporters of the recommendation countered that:

  • HCM certainly impacts corporate decision-making, and the relevance of this information for investors is inarguable. For example, in some industries, high turnover rates may dissuade investment.
  • Investors are currently pressing for information on HCM.
  • The recommendation is actually quite modest and just advocates commencement of a process, urging the SEC to consider what it might do on the issue and only after conducting its typical learning and engagement process.
  • The recommendation does not suggest a final rule for the SEC to adopt; rather, it just identifies issues for the SEC to consider. Moreover, the supporters argued, the dissenters are overestimating the extent of deference the SEC will give to the recommendation.
  • The metrics identified are well-known and largely derived from issuer disclosures and various widely accepted standards.
  • With regard to politicization, the Committee’s influence is more modest than suggested; even if the identification of metrics were eliminated, the debate about mandating specific metrics would occur anyway.
  • HCM is the “elephant in the room,” and it would be a mistake not to move forward.