The Advisors' Blog

– Bob Hayward and Ted Peto, Kirkland & Ellis

Just as the Sarbanes-Oxley Act of 2002 reduced the ability of a private fund’s representative to serve on the audit committee of a U.S. public company (a “public portfolio company”), it appears that the Dodd-Frank Act will have a similar impact on the service of a private fund’s representative on a compensation committee.

The Act requires the SEC to adopt rules no later than July 16, 2011, directing NYSE and Nasdaq to prohibit listing any company not complying with enhanced independence requirements for compensation committee members. In determining compensation committee “independence,” the Dodd-Frank Act requires public companies to consider at least the following factors:

– the source of compensation received by a compensation committee member, including consulting, advisory, or other compensatory fees (apparently including management fees paid by the public portfolio company to the private fund), and
– whether the compensation committee member is an affiliate of the public portfolio company or any of its subsidiaries.

Although subject to SEC rulemaking, the SEC will likely base “affiliate” status on the SEC’s traditional definition, i.e., a person that directly or indirectly controls, or is controlled by, or is under common control with, the issuer, with a presumption that more than 10% direct or indirect ownership of a an issuer creates affiliate status. If so, a representative of a private fund owning more than 10% (or of a group of private funds acting in concert and owning in the aggregate more than 10%) of a public portfolio company would be precluded from serving on the company’s compensation committee, subject to the “controlled company” exception described below.

While the Dodd-Frank Act exempts a “controlled company”–i.e., a company with more than 50% of its voting power held by an individual, a group or another issuer–from this compensation committee independence test, the Act does not exempt a public portfolio company if the private fund owns between 10% and 50% of its stock.

This compensation committee independence provision is apparently inconsistent with other provisions of the Dodd-Frank Act. On the one hand, the Act seeks to expand stockholder powers by giving stockholders (including a private fund stockholder) both a “say on pay” and access to the company’s proxy statement for the election of directors. On the other hand, however, as discussed above, it would apparently deny a stockholder owning between 10% and 50% of the company’s stock (including a private fund) the right to have its representatives serve on the company’s compensation committee. Furthermore, the Act fails to address why is it acceptable for a private fund that owns more than 50% of the public portfolio company’s stock to serve on the compensation committee but not acceptable for one that owns between 10% and 50%.

It is particularly noteworthy that, in contrast to the Sarbanes-Oxley Act, the Dodd-Frank Act does not impose an absolute and inflexible definition of “independence” and thus leaves discretion to the SEC, NYSE and Nasdaq in this regard. The SEC should carefully consider this provision of the Dodd-Frank Act–especially the “affiliate” requirement–before implementing rules that potentially disenfranchise those stockholders with the greatest interest in ensuring that executive compensation is appropriate and properly balanced.