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| Executive Pay Memo North America

Companies must assess materiality of human capital under final SEC rules

Governance Advisory Services |Executive Compensation
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By Steve Seelig and William (Bill) Kalten | September 3, 2020

If they are material to an understanding of the company’s business, disclosures about human capital resources will be required.

Publicly listed U.S. companies and their human capital professionals will need to focus quickly on sweeping changes made by the Securities and Exchange Commission (SEC) to the periodic disclosure rules for Form 10-Q quarterly and Form 10-K annual reports and registration statements. Although the SEC’s action reflected a move to a “principles-based” approach tailored to each individual company, rather than a mandated set of disclosures, the final rules notably added a new requirement that a company disclose, when material to an understanding of the business, a description of its 1) human capital resources, and 2) any human capital measures or objectives that are a focus of managing the business.

The SEC changes are not limited to human capital resources disclosures in Form 10-K and other filings; they also require a rethinking of how companies will describe their business as a whole, broaden the regulatory compliance discussion beyond just environmental laws, beef up the discussion of legal proceedings and hone the disclosure of risk factors. This will mean the human capital disclosure will be part of a larger reassessment of how these disclosures should be crafted. The new disclosure rules are effective 30 days from the date they are published in the Federal Register. So for calendar-year companies, it is possible that the rules will apply to the third-quarter 10-Q disclosure, and they will certainly apply to the 2020 10-K disclosure.

Focus on the human capital disclosure

It is noteworthy that the SEC final rules do not require companies to focus on any particular aspect of human resources (companies must decide which elements are material to them), nor does it mandate specific disclosures regarding climate change or diversity (an issue the two Democratic commissioners cite as their reason for dissenting from the three-person majority). This is consistent with the other changes made that, generally, require companies to assess whether an issue meets the standard of being material to an understanding of the business.

Similar to the rules for Compensation Discussion and Analysis (CD&A), the determination of whether and how to assess the need for disclosure is “principles-based,” so that particular human capital disclosure items, or metrics employed to assess human capital, are to be based on a company’s particular facts and circumstances. Per the preamble:

Furthermore, we note that while the final amendments do not require registrants to use a disclosure standard or framework to provide human capital disclosure, as recommended by some commenters, a principles based approach affords registrants the flexibility to tailor their disclosures to their unique circumstances, including by providing disclosure in accordance with some or all of the components of any current or future standard or framework that facilitates human capital resource disclosure that is material to an understanding of the registrant’s business taken as a whole.

While not mandating any particular disclosures, this language recognizes that many companies already measure their human capital resources under an evolving array of standards or frameworks from the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB), to name just a few. The strong implication from the rules is that companies will determine that a human capital disclosure is required, albeit tailored to the unique business, workforce, and facts and circumstances. This was echoed in SEC Chairman Jay Clayton’s statement in support of the rules:

[U]nder the principles-based approach, I do expect to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs.

The regulation itself is not a directive that any particular human capital disclosure is required and makes reference only to very limited, “non-exclusive” examples of what might be disclosed, including the number of employees as well as measures or objectives that address the development, attraction and retention of personnel. The economic analysis section of the preamble suggests that companies would also consider disclosing “other human capital characteristics, including education, experience, and training, that have positive effects on firm performance.”

During the open meeting, the SEC Staff noted that many companies have already begun offering human capital-related discussions in 2020 quarterly filings about COVID-19’s impact on their human resources, in response to encouragement from the SEC back in April for companies to do so in their forward-looking statements.

Issues companies and human resources functions must now confront:

Some companies already include disclosures on these issues that meet the regulatory standard, while others make scant mention of human capital in their 10-K business descriptions; some companies have robust frameworks for performing their human capital analyses, while others have not yet begun the process. Regardless of where your company falls on these continua, you should start addressing the following questions:

  • What is the principal objective behind these disclosures?
  • How would the disclosed information benefit shareholders, ecosystem partners and broader stakeholders?
  • What are the appropriate methods for measuring the value of human capital for your company?
  • What existing methods are in place for measuring the value of human capital?
  • Are these methods set forth as corporate objectives, either for the human resources function, a segment of the business or the business as a whole?
  • How will materiality of human capital metrics be assessed?
  • What, if any, overlaps are expected with a company’s sustainability reporting?
  • To the extent human capital issues are not measured, does this indicate they are not material and would not need to be disclosed?
  • These changes focus on disclosure for many different facets of the organization. Who is heading the effort and how will the process work?
  • What part of your organization will make the determination of whether the need to disclose human capital issues meets the materiality standard?
  • What might the disclosure look like if the company has not quantified the impact of human capital but intends to measure it for next year?
  • How might a company describe in its current disclosure that it believes a human capital measure is material but that it has not yet compiled the data sufficient for it to be disclosed?
  • To what extent might a company take the position an issue is material for one year’s disclosure but then omit references to it in later years?
  • How would the company’s employees assess the prominence and materiality of different human capital measures?

Our perspective

By adopting the final rules, the SEC sends a strong signal to companies that human capital management needs to be a regular item on their board’s agenda, with similar prominence already given to financial, technology, operational and risk issues. Our view is that addressing the questions raised by the rules ought not to be just a disclosure exercise as companies move forward; it should also reflect detailed data assembly and analyses under any number of possible frameworks.

As with any principles-based requirement, it will be important for companies to adhere to the spirit of the disclosures while avoiding any unintended consequences. Subsequent articles will focus on suggested approaches that may be appropriate for your company, including a potential list of human capital metrics, frameworks for assessing their prominence and materiality, and examples of progressive disclosures.

Authors

Senior Director, Executive Compensation (Arlington)

Senior Director, Retirement and Executive Compensation

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