The SEC Just Mandated Human Capital Disclosure: What Does This Mean for You?

Add bookmark

Dave Vance
11/30/2020

Although most don't yet realize it, the world of L&D and HR just changed dramatically for the better—and there will be no going back.

The change is coming first to publicly traded companies, but it won't stop there. Within a few years, the change will permeate all organizations, even privately held companies and nonprofits. The long-awaited age of transparency for both investors and employees is finally here.

What is this momentous change? On August 26, the U.S. Securities and Exchange Commission mandated human capital disclosure by all companies selling securities in the United States. The rule is effective Nov. 9 and there is no grace period, so publicly traded companies will need to disclose material human capital information starting with their Nov. 30, Dec. 31 or Jan. 31 quarterly or annual public financial release.

I know at this point you may be thinking, “So what?” or “What does that have to do with me?” But be patient with me for a few minutes and it will become clear.

Let’s start with a little history so you can appreciate what the SEC has done.

History of Human Capital Disclosure

The SEC was founded in 1934 during the depths of the Great Depression to bring order to largely unregulated securities markets controlled by each state. (Note: A security is a stock, bond or derivative.)

The SEC told companies that if they wanted to sell securities to the public, they would have to provide some basic information to investors—such as what the company sells—and they would have to share financial statements—such as the income statement and balance sheet. Believe it or not, some companies at the time were selling stock without providing any information to investors!

The rules evolved over the years with the last major update in 1977 (things move slowly at the SEC). With this rule-making more than 40 years ago, the SEC published a list of 12 items that companies needed to disclose along with their financial statements. The list included items such as the product or service offered, seasonality of the business, source of raw materials and competitive conditions, but only one item related to human capital: the number of employees.

In 2015 the SEC undertook a once-every-other-generation review of the rules with the understanding that the world had changed significantly since 1977. Three things in particular had their attention.

First, the pace of change had increased to the point where any new prescriptive list of items to disclose (a replacement for the 12 items from 1977) would be outdated within a few years.

Second, the nature of companies had changed dramatically. Most companies were no longer engaged in manufacturing and a list of prescribed items that worked for manufacturing would not work for services.

Third, and this is really important, the primary driver of value was now human capital—not physical capital.

Back in 1975, 83 percent of the value (stock price x number of outstanding shares) of the S&P 500 companies could be explained by the value of the physical assets on their balance sheets. This was not much different from 1934 where nearly 100 percent of the value could have been explained by tangible or physical assets.

However, and this is the truly amazing part, by 2015, only 16 percent of the value of the S&P 500 companies could be explained by the physical assets on their balance sheet. The remaining 84 percent (the exact opposite from 1975!) was now explained by human capital.

So, human capital today is the primary driver of stock price and the value of a company. Yet, financial statements don't include any entries for human capital, and the balance sheet continues to be about physical capital. And, according to the 1977 SEC rules, companies have to disclose only one item about their primary driver of value, and that is the number of employees—not exactly a robust measure of human capital.

You can see the problem, and so did the SEC. Time had passed their old approach by. They needed a new, modern approach that would reflect the importance of human capital as well as the fast-changing landscape. They solicited comments over a three-year period and then on August 8, 2019, published draft rules laying out a brand-new approach.

Once again, they solicited comments, and on August 26, 2020, published the final rule called Modernization of Regulation S-K, which is what governs public disclosure by companies for their initial security offerings (S-1 reports) as well as quarterly (10-Q reports) and annual (10-K) financial releases.

The SEC’s new approach adopts a material rather than prescriptive approach as a way to address the fast-changing landscape. Under this new approach, companies must disclose all material information about their business, which will differ significantly by type of company and industry.

The concept of materiality simply means anything that an investor would want to know before buying or selling a security. In other words, if it's important, you had better disclose it publicly. If you don’t, the SEC can take administrative action against you, but even more worrisome from a risk-mitigation view point, a shareowner can sue you for failure to disclose material information, which caused them harm. Your risk officer, CFO and CEO are not going to be keen to be exposed to this type of risk.

To address the new role of human capital as the primary driver of value, the SEC also mandated disclosure of all material human capital information. If an investor would want to know about it, then you need to disclose it.

Just to send a clear signal to companies, the chair of the SEC, Jay Clayton, commented that he has never encountered a company where human capital was not material. Although the SEC decided against a prescriptive approach for human capital, it has stated that it expects to see human capital disclosure around employee attraction, development and retention, at a minimum. So, no specific metrics are offered, but the SEC has provided pretty clear direction.

Of course, more than just HR measures will need to be disclosed. The quarterly and annual financial release will need to provide explanation, context and forward guidance just as the commentary does today that accompanies the financial statements and discussion of material items.

Examples of and Metrics for Human Capital Disclosure

Suppose you're sharing your employee engagement score or leadership trust index and the scores drop. You're going to have to explain that and tell the reader what you plan to do about it. You'll also need to share and comment on material HR initiatives like new software systems, new total compensation approaches and new performance management processes.

So, don’t just imagine one page of numbers and pretty graphics. Instead, imagine multiple pages of numbers and visuals accompanied by multiple pages of commentary.

Are you beginning to appreciate where this is going? Let’s take it to the next level.

While the SEC has not provided any specific metrics they expect to see, the International Organization for Standardization has some in their December 2018 Guidelines for Internal and External Reporting.

In fact, they suggest a total of 59 metrics for organizations to share from both an employee and investor point of view. Understanding that the reporting burden is greater for smaller organizations, ISO recommends 10 metrics for public reporting by small/medium organizations and an additional 13 for public reporting by large organizations.

The 10 for all-sized organizations include total workforce cost, human capital ROI, EBIT per employee, turnover rate, total development and training cost, and percentage of employees who have completed compliance training, among others.

The 13 additional metrics for larger organizations include diversity by age, gender and disability, leadership diversity, leadership trust, time to fill vacant positions and time to fill critical vacant positions, and percentage of positions filled internally and percentage of critical positions filled internally.

ISO also recommends other metrics for L&D which could be disclosed publicly, such as percentage of employees who receive training, percentage of leaders who receive training, percentage of leaders who receive leadership development and average hours of training per year.

A number of us believe that the ISO recommended metrics will serve as a starting point for companies as they begin to create their human capital reporting strategy to meet the new SEC rule.

The ISO standards should also provide a safe haven upon which companies may rely to meet the SEC rule. In other words, since the SEC is not being prescriptive, a company may say that they relied on the ISO recommendations, which should afford some protection as long as the company has disclosed all other material human capital information. Plus, ISO provides definitions for each metric and guidance on how to use them.

A Suggested Short List of Measures Your Organization Should Consider Disclosing Publicly to Meet the SEC Rule

To help you better understand what this entails, below are measures grouped by SEC focus area, followed by additional metrics:

  • Attraction: Time to fill critical positions, percentage of positions filled internally and percentage of critical positions filled internally.
  • Development: Total cost of training and development, percentage of employees who receive training in compliance and ethics, percentage of employees who receive any training, average hours of formal training per year, percentage of leaders who receive training and percentage of leaders who receive leadership development.
  • Retention: Turnover and turnover for critical positions.
  • Additional recommended metrics: Employee engagement score, leadership trust score, diversity by gender, age, disability, race or national origin, leadership diversity, pay equity, human capital ROI, total workforce cost, number of FTEs and contingent/contract and temporary workers.

How many of these are you ready to disclose today? Do you currently generate all of them internally? How do you believe you will compare with other organizations when you share them?

The SEC rule will force publicly traded companies in the U.S. to begin to disclose starting this quarter, but it won’t be long before all companies will be compelled to share as well.

Think about it this way: In the future, what employee will want to go to work for an organization that refuses to share its important human capital metrics, such as diversity, pay equity, employee engagement or leadership trust? Why would an employee go to work for a company that refuses to share how much it invests in employees, how many hours of training it provides or what kind of promotional opportunities exist?

There'll be only one reason for a company to refuse to share this information and that is because they're embarrassed by their human capital metrics. So, even if you aren't forced to share by the SEC, the competitive marketplace will force you to share.

The same applies to investors. What investor in the future will invest their own funds or recommend a client invest in a company with no human capital transparency?

We all know that human capital is the primary driver of stock price, so can you imagine investing in a company where there is no visibility to the primary driver of value? That would be like returning to 1934 when companies expected you to invest without sharing any relevant information.

The new age of transparency for both employees and investors is now upon us. Make sure leaders in your organization know about it. And make sure that someone is beginning to craft your public reporting strategy.

In fact, why not volunteer to lead the effort? And this is a great opportunity to argue for more resources because now your L&D and HR metrics are going to be made public, so your investor relations head, SVPHR, CFO and CEO are going to be commenting on these.

Trust me, they will start caring about data accuracy like never before because the last thing they want is to have to make a public retraction or apology for incorrect data. Going forward, your L&D and HR data will be reviewed in detail by multiple people and teams in preparation for disclosure, so now is the time to get the resources you've been wanting!

This is a really exciting new world where the SVPHR or CHRO is going to become much more of an equal to the CFO, and where L&D and HR metrics become just as important as financial measures. Moving forward, quarterly and annual financial releases will spend more and more time sharing, describing and commenting on human capital metrics.

Benchmarking organizations will be close behind to gather all this public information and compare companies, putting incredible pressure on poor performers from a human capital point of view.

In 10 years, people will look back and wonder why we didn’t always have this level of transparency, just like we look back at the 1930s and wonder how it was possible for companies not to share product or financial information.

Welcome to the future!

 


This article originally appeared on Chief Learning Officer. You can view the post here

RECOMMENDED