Recent Changes in Human Capital and D+I for Public Companies

On August 26, 2020, the Securities and Exchange Commission (SEC) announced, as part of its ongoing initiative to modernize Regulation S-K disclosure, amendments that add human capital resources as a separate disclosure topic, including any human capital measures or objectives that issuers focus on in managing their business.[1]  This development follows years of mounting pressure from investors and other stakeholders calling for changes to disclosures, practices, and governance on a wide range of human capital and diversity and inclusion (D+I) topics affecting public companies, as well as the adoption by several states of new laws mandating diversity on boards of directors.

These rules changes could not be more timely. The COVID-19 pandemic has focused stakeholder attention on customer and employee safety and welfare. Companies are grappling with how to adapt to retain their workforce, provide a safe workplace, and respond to difficulties in supply chains or remote work environments. Further, social and racial inequality, spotlighted by the Black Lives Matter movement, has become not only a topic for public policy change but also an issue of corporate responsibility, as stakeholders look to companies for plans to respond to racial injustice and increase transparency in disclosing human capital matters.

In this client alert, we assess the changing seas of investor and stakeholder expectations and legal requirements related to key human capital and D+I topics.

Landscaping Human Capital and D+I Topics

Human capital management (HCM) covers a broad set of topics that are relevant to public companies. As a unifying theme, HCM views employees as assets that can be invested in and developed to enhance business value, differentiating it from prior approaches viewing employees generally as a cost to be managed. This shift in perspective drives the changes—sometimes subtle, sometimes significant—in disclosure, operations, and governance that stakeholders embracing HCM seek from public companies.

While the specific sub-topics applicable to any given company will vary, some examples of HCM initiatives, concerns, and metrics that a public company may choose to address, many of which overlap with D+I efforts, include:

• Human Resources: Talent acquisition and recruiting, professional development, training, internal promotion rate, leadership programs, turnover, employee feedback mechanisms (e.g., annual surveys, upward management feedback), data on employee satisfaction, employee recognition programs, and data on workforce composition (e.g., full-time, part-time, subcontracted) and diversity (e.g., race, ethnicity, gender).
• Compensation and Benefits: Employee health, safety, and well-being benefits (e.g., programs for physical, emotional, social, and financial health, such as paid family leave, childcare allowances, flexible work arrangements, 401(k) match), educational assistance, equitable pay practices for compensation of women and minority employees, internal minimum rate of pay for all employees, pay metrics of employees (e.g., ratios adjusted for job function between male and female employees and minorities and nonminority employees), chief executive officer pay ratio, bonuses and awards for rank-and-file employees, and leadership bonus pool allocations or individual compensation decisions based in whole or in part on performance on HCM initiatives.
• Risk Management: Culture, ethics and compliance, productivity (e.g., profit/revenue per full-time employee), labor relations, succession planning for the chief executive officer and other key executives and senior leaders, data privacy, supply chain labor practices, integration of HCM risks into risk management process, and employee training, management, and reporting.
• Governance: Board composition and board recruitment, board or committee oversight of HCM topics, engagement of employees (e.g., employee committees, affinity networks), evaluating the performance of executive officers and/or divisions or functions on diversity or other HCM initiatives, and internal reporting (e.g., board, senior leadership) and/or external reporting (e.g., in SEC filings, on investor relations page) on HCM metrics.

Diversity and inclusion, a topic with which many are more familiar, refers to goal of creating an equitable and welcoming workplace that is reflective of our heterogeneous society. Businesses are enacting policies to improve D+I in their organizations both to promote a better society and to bring benefits to the business, from enhancing the breadth of experiences and skills available to tackle problems to enabling the business to better understand the perspectives, needs, and preferences of its customers and other stakeholders. While the two elements of D+I frequently are grouped together, it is important to understand their distinction.

• Diversity: Representation in an organization by people of different backgrounds and identities, including people of different genders and sexual orientations, races and ethnicities, national origins and cultures, abilities and disabilities, as well as other important demographics like caregiver status, service as a veteran, being the first generation in the family to complete college, or socioeconomic background.
• Inclusion: Creating a fair, equal, and respectful environment that enables meaningful participation by diverse individuals in all layers of an organization’s workforce and management hierarchy and contribution by such individuals to an organization’s success.

Diversity can be measured by simple point-in-time metrics, like how many diverse individuals of a given category did an organization employ during a set period or as of a set date, as compared to the total number of individuals employed in or at that time. Inclusion can be inferred from more nuanced metrics, like how many diverse individuals serve on a company’s board of directors and in senior management, and what is the average promotion rate and turnover rate for diverse individuals compared to the overall company averages. If an organization seeking D+I has a high number of diverse individuals, but few are in management, few are promoted, and those diverse individuals don’t last long, the organization may be succeeding on the recruiting front, but have a fundamental issue with inclusion that is affecting penetration of diverse individuals into management ranks and retention.

Current Disclosure Practices and Recent Changes to Regulation S-K

Public companies provide information about these HCM and D+I topics either as part of their disclosures to investors required by the SEC’s reporting framework, typically in their proxy statement or Annual Report on Form 10-K, or through their investor relations page or a stand-alone environmental, social, and governance (ESG) report or HCM report.

Up until this month, required SEC disclosure related to HCM was relatively sparse, and none were required with respect to D+I. Item 402 of Regulation S-K called only for narrative and quantitative disclosure about compensation, benefits, and the ratio of a company’s median pay compared to that of the chief executive officer, and focused its attention on only a small number of senior executives. With regards to other employees, Regulation S-K otherwise reflected a historical approach of focusing on the costs of compensation and benefits, and its only line-item requirement with respect to disclosure about human capital resources was, under Item 101(c)(1)(xiii), to state the number of persons employed by the company.

However, as of August 26, 2020, the SEC announced final amendments to Item 101(c) to refocus requirements regarding human capital resources disclosures. The SEC has expanded the past requirement to disclose the number of employees with an additional new requirement to provide information regarding the public company’s “human capital resources,” including in such description any human capital measures or objectives that management focuses on in managing its business, to the extent such disclosures would be material to an understanding of the company’s business as a whole. The rule provides a non-exclusive list of examples of human capital measures and objectives that may be material, depending on the nature of the company’s business and workforce, including measures or objectives that address the attraction, development, and retention of personnel. Consistent with other disclosure obligations, materiality of any individual factors will still be determined by the disclosing company. However, in the current environment, where intangible assets and human services are often greater drivers of growth than a company’s tangible assets, and where across the country we are seeing walkouts and lawsuits related to discrimination hurting companies’ brands and reputations, it is hard to imagine a company for which no information regarding HCM or D+I should be disclosed.

Notably, the SEC’s new rules represent not only an expansion of the coverage of HCM topics but also a move towards principles-based disclosure, which will require companies to exercise judgment regarding materiality. This principles-based approach reflects an expectation that disclosure will vary based on a company’s industry, and may evolve over time. Ultimately, such disclosure will allow investors to see through the eyes of management and understand and evaluate how the company looks at this intangible resource. The inherent flexibility of the SEC’s new rules means that the HCM initiatives, concerns, and metrics already being discussed by public companies, investors, and other stakeholders and disclosed by public companies within or outside the SEC’s disclosure framework will be important precedents for companies evaluating the materiality of HCM and D+I to their operations.

Finally, it should be noted that these new requirements were adopted in response to a broader movement for increased disclosure of ESG factors from institutional investors. Shareholders, and not just those with a primary focus on impact, are asking for more disclosure related to these matters as material factors in their investing decisions.[2] Proxy advisory firms like ISS are also leveraging their influence over institutional shareholder votes to pressure companies to enhance these disclosures. Compliance with the SEC’s new disclosure requirements may just be a baseline in public companies’ response to pressure from shareholders.

State Legislatures Require That D+I Be Addressed in Board Composition

Boards themselves are under greater scrutiny to reflect the D+I policies being implemented within the company. Investors, customers, and employees have often led the push for greater diversity within both a company and its leadership and board, and some states have turned these requests into requirements through legislation. States that have enacted board gender or racial and ethnic diversity requirements or disclosure laws include California, New York, Illinois, Colorado, Washington and Maryland, with several more currently considering such legislation.

For example, on August 30, 2020, AB 979 was passed in the California state legislature, and will be sent to Governor Gavin Newsom to be signed (or vetoed). AB 979 will require publicly held companies with headquarters in California to have a minimum ratio of members from underrepresented communities. The legislation defines “director from an underrepresented community” as “an individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self‑identifies as gay, lesbian, bisexual, or transgender.” AB 979 will require boards to have a minimum of one director from an underrepresented community no later than December 31, 2021, and by December 31, 2022, the requirement will increase to two or three such directors, depending on total board size.

These recent developments show that states are pressuring companies at an increased rate over D+I matters, especially as they relate to board diversity. States want to see significant changes and often, once legislation is adopted, companies don’t have much time to comply given the typical lead-time required for board refreshment and director recruitment. Accordingly, nominating committees of many public companies whose boards are or may be subject to these requirements are already taking efforts to focus new director searches to comply with these requirements as quickly as possible. Whether states begin enforcing these statutes through penalties and fines, and whether these statutes withstand potential legal challenges, remains to be seen. But even absent legislative requirements, companies must be mindful of investor and stakeholder focus on board composition in light of D+I trends. Indeed, companies without a diverse board may be hard-pressed to represent themselves as having an inclusive workplace.

Preparing for HCM and D+I Engagement

Investors and stakeholders view HCM and D+I policies and practices as a way for companies to mitigate risks in the short term and create stability and growth in the long term. A focus on HCM and diversity issues aligns with investors’ view of talent as a source of long-term value for today’s public companies and a way to build brand loyalty with customers and employees. A focus on HCM and inclusion issues can mitigate the risk of turnover and dissatisfied employees and can help ensure that a company sees the productivity returns of investment in its intangible human capital resources. Companies taking a holistic view of their business strategy on human capital and D+I topics will be best positioned to take advantage of the opportunities, and to avoid possible risks, arising out of this new environment—and to engage with large institutional investors increasingly focused on these topics.

Most companies already have an overall D+I strategy, and some may already track HCM metrics. However, a public company starting to prepare an HCM approach to comply with the SEC’s new rules should consider and address the following topics:

• Consider what HCM metrics will be tracked and how they will be used. HCM metrics can be used to measure the efficiency, productivity, stability, and overall health of a company’s human resources. Plan how such data will be used, not only as a communication and disclosure tool but also at the operational level, such as in reviews of hiring, promotion, compensation, and attrition trends, or in comparisons within the company by region, segment, or division. Identify which groups within the company will be responsible for HCM strategy and which aspects of the company’s operations should incorporate HCM goals.
• Ensure the quality of metrics and disclosures. Whether provided in the company’s SEC filings or through other mediums such as investor relations pages, stand-alone reports, or investor outreach, treat HCM and D+I disclosures and metrics with the same rigor as the company’s other SEC disclosures. Companies must ensure that any metrics being used internally or disclosed externally are reliable and comparable over time. Consider whether new procedures or software tools will be needed to track and monitor relevant information, such as voluntarily disclosed diversity data, and how to manage such data while complying with applicable privacy regulations. Keep in mind that misrepresentations or misleading disclosure, whether in SEC filings or other communications, can create liability for a company and lead to risk of litigation. Consider limiting overly aspirational statements and including forward-looking statement disclaimers and other appropriate cautionary language.
• Prepare for questions about metrics and disclosures. For investors and other stakeholders, disclosure alone is not the end goal. Companies will need to be ready to explain what they are doing to improve human capital and D+I matters when reporting less than ideal HCM and D+I disclosures to shareholders. Companies will also need to respond to trends in those disclosures, as investors have often called for three years of reporting on relevant metrics.
• Address HCM and D+I at the board level. Ultimately, HCM and D+I are both board and management issues. Boards should review their oversight role of HCM and D+I topics as part of their typical, ongoing review of the company’s governance practices. Boards should also consider proactively addressing board composition. This can be an opportunity not only to review and refresh the board’s diversity profile, but also to consider recruiting directors with human capital expertise.

[1] See Release Nos. 22-10825, 34-89670, Modernization of Regulation S-K Items 101, 103, and 105 (Aug. 26, 2020), available at: https://www.sec.gov/rules/final/2020/33-10825.pdf.  The rules will go effective thirty days after being published in the federal register.

[2] See our client alert titled: What Public Companies Should Be Considering Now for ESG Disclosures, available at: https://www.mofo.com/resources/insights/200811-sasb-gri-esg-reporting.html.