Compensation is not a Four-Letter Word

Compensation Is Not a Four-letter Word: Coping With a DCAA Executive Compensation Review

“[President Obama has] been very clear that he shares the outrage that most Americans feel about the spectacle of gaudy bonuses ... for executives at firms that are getting extraordinary assistance from American taxpayers. It’s not right.”[1]

Some might say that 2009 is precisely the wrong time to write an article that is even remotely critical of any Government efforts to prevent the reimbursement of “unreasonable” compensation of contractors’ executives. Some might think that the spirit of the times would automatically applaud the manner by which the Defense Contract Audit Agency (DCAA) conducts contractor executive compensation reviews (ECRs), the primary tool by which contracting officers make judgments regarding the allowability of the quantum paid by contractors to their top executives. But this article has nothing whatever to do with corporate jets, over-the-top corner office makeovers, or “gaudy bonuses” of any kind. It has everything to do with small and medium size businesses, struggling to turn a profit in a hyper-regulated marketplace, dealing with the vagaries of Federal cost allowability rules, and the DCAA ECR methodology. As a practical matter, in our experience,[2] the amount typically recommended for disallowance pursuant to an ECR ($100,000 to $300,000 in a given fiscal year) is large enough to be a significant “hit” to the contractor’s balance sheet, but also too small to make pursuing the matter through the “Disputes” clause[3] under the Contract Disputes Act (“the CDA”)[4] a good business decision. This is the DCAA’s “sweet spot” which perhaps explains why there have been so few fully-litigated ECR disputes and reported decisions in recent decades.

Yet the DCAA ECR method is fundamentally flawed from an objective or “scientific” standpoint, and too narrow in its consideration of subjective or judgmental considerations properly affecting the reasonableness of executive compensation. This commonly leads to situations in which contractors sense that they are being ill-used, but believe there is not much they can do about it except to push back with their own unassisted and unlearned efforts. In that posture, little headway can be gained in the face of the Government’s relatively unfettered ability to enforce collection of amounts determined to be unallowable, and seemingly inexhaustible capacity to resist contractor claims in the costly and time-consuming contract disputes process. Because the remedies available to many contractors facing an adverse ECR recommendation are so inadequate, it is critical that they understand the “rules of the game” as played by the DCAA and the contracting officer, and what they can do to put themselves in the best position to obtain a good result from the ECR process and, where necessary, to be in a strong position to pursue a dispute in the most cost-effective manner possible. The DCAA has every incentive, regardless of the merits of the underlying issue (i.e., whether executive compensation is reasonable), to pursue those companies who show a weak will or ability to resist. Knowledge is power in the ECR process, and active and continual engagement in the process of setting and defending executive compensation is the only way to even the odds.

This article is intended to convey such knowledge, and explain why early and active engagement in the ECR process is critical. It will have three major sections: (1) What is the legal basis for an executive compensation review? (2) How does the DCAA conduct ECRs; what are the principle flaws in the process; and, how can they be disputed? and (3) What should contractors do in order to head off trouble in the first place, and make disputes easier and quicker to resolve?

The FAR Standard. The ECR process focuses on whether executive compensation is reasonable as an element of allowability with respect to indirect costs incurred on cost reimbursement contracts. FAR Part 31 sets the general standards for assessing cost reasonableness, as follows:

(a) A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business. Reasonableness of specific costs must be examined with particular care in connection with firms or their separate divisions that may not be subject to effective competitive restraints. No presumption of reasonableness shall be attached to the incurrence of costs by a contractor. If an initial review of the facts results in a challenge of a specific cost by the contracting officer or the contracting officer’s representative, the burden of proof shall be upon the contractor to establish that such cost is reasonable.[5]

The FAR reasonableness standard, by concentrating on costs that “would be incurred by a prudent person in the conduct of a competitive business,” invites auditors, when conducting ECRs, to look at market forces, and what other businesses are incurring with respect to individual cost elements, such as executive compensation. In this context, the result has been that the ECR process has become very heavily, if not exclusively dependent upon commercially-available executive compensation surveys.[6] Moreover, the FAR gives the Government a significant advantage by imposing the burden on the contractor to prove reasonableness when an “initial review of the facts” causes the Government to challenge an incurred cost.

FAR 31.205-6 focuses more specifically on compensation for personal services. Executive compensation typically falls under the section that addresses compensation not covered by labor-management agreements, as follows:

(2) Compensation not covered by labor-management agreements. Compensation for each employee or job class of employees must be reasonable for the work performed. Compensation is reasonable if the aggregate of each measurable and allowable element sums to a reasonable total. In determining the reasonableness of total compensation, consider only allowable individual elements of compensation. In addition to the provisions of 31.201-3, in testing the reasonableness of compensation for particular employees or job classes of employees, consider factors determined to be relevant by the contracting officer. Factors that may be relevant include, but are not limited to, conformity with compensation practices of other firms—

This guidance is sparse, but does at least indicate to contracting officers the sorts of comparisons that are appropriate. FAR 51.205-6, moreover, also draws a distinction between companies that are subject to market forces such as closely-held firms, and those that are not, as follows:

(6)(i) Compensation costs for certain individuals give rise to the need for special consideration. Such individuals include:

(A) Owners of closely held corporations, members of limited liability companies, partners, sole proprietors, or members of their immediate families; and

(B) Persons who are contractually committed to acquire a substantial financial interest in the contractor’s enterprise.

(iii) For owners of closely held companies, compensation in excess of the costs that are deductible as compensation under the Internal Revenue Code (26 U.S.C.) and regulations under it is unallowable.[8]

These firms are deemed worthy of “special consideration,” although the nature of such consideration is not spelled out.

Case Law. There are few reported decisions concerning the reasonableness of executive compensation. As noted above, the amounts in issue appear to fall typically in the contractor’s “dead zone,” somewhere between a nuisance, and enough to make the costs of litigation a necessity. However inasmuch as it has had the biggest influence over DCAA ECR policy and practice, the leading case in this area is the Armed Services Board of Contract Appeals decision in Techplan Corp.[9] In Techplan, the contractor was a high technology services company with revenues of between $10.5 and $13.8 million for a three years period (1986-88). At issue was the reasonableness of the total compensation of the company’s chief executive officer (“CEO”), who was also the company’s chief operating officer, chief financial officer, controlling shareholder and chairman of the board of directors. After a full hearing, the Board ruled heavily in favor of the company, sustaining the appeals in part, and remanding the case to the parties for quantum settlement.[10]

At the hearing the parties each presented expert witnesses who advanced their own views on the reasonableness of the Techplan CEO’s compensation package. While the parties positions differed dramatically, they generally agreed, and the Board found, that

The Board generally favored the Appellant’s expert testimony. In addition, at the hearing, Techplan also put on two fact witnesses, including the CEO, who gave unrebutted evidence that the company’s performance during the years in issue was superior. This was done to support the company’s contention that it was entitled to pay executives at the upper end of the scale, that is, at the 75th percentile. This testimony established the qualifications of the CEO, the company’s standing in its industry, and its long-term financial success. The Board ruled that Techplan was justified in paying above average salaries as argued.

The other leading executive compensation decision was published a year after Techplan, in the Information Systems and Networks appeal.[12] The decision in this appeal went largely against the Appellant, and little of significant precedential value came from the Board’s opinion. However, as discussed below, the DCAA has misread the decision in a way that continues to skew ECRs to this day.

DCAA Construction and Use of the Techplan and Information Systems and Networks Decisions. Despite the fact that the Techplan decision went against the Government, the DCAA evidently viewed it, in one narrow sense, as the template for all future ECRs. However, while the DCAA incorporated much of what was done to evaluate the reasonableness of executive compensation in the Techplan case into its ECR method, it also misinterpreted what it took from the decision on one fundamental point, and entirely ignored a major element of the Board’s holding. Because of this, the DCAA ECR method is flawed, and should be challenged where the method is used as the basis for a disallowance recommendation.

The DCAA Contract Audit Manual (“CAM”) sets forth policy and procedure for auditors to follow. The CAM section entitled “Review for Unreasonable Compensation” sets forth the blueprint for ECRs and makes explicit reference to the Techplan, as follows:

g. The Techplan ASBCA Case No. 41470, 96-2, BCA 28426, cited the steps to be taken to evaluate the reasonableness of executive compensation. The following process was the ASBCA’s interpretation of how compensation experts would market price executive compensation. This process should be followed to the extent practical. The auditor should rely on the contractor’s market pricing when available, unless the contractor used free internet surveys to develop labor costs as these surveys are not independent or objective. The auditor should ascertain that the contractor’s market pricing is compliant with FAR 31.205-6 and the process cited in the Techplan Corporation ASBCA Decision.

(2) Identify survey(s) of compensation for the position to be evaluated that match the company in terms of revenues, industry, geographic location and/or other relevant factors.

(3) Update the surveys to a common data point for each year through the use of escalation factors.

(4) Array the data from the surveys for the relevant compensation elements at various levels of compensation, such as the average (mean) or selected percentiles, and develop a composite number for each. Note: Use of other percentiles is necessary only if the contractor’s performance (see 6-414.4h below) is quantitatively and measurably above or below average. The Information Systems & Networks Corporation ASBCA Decision clarified that for companies with performance that was below average, below average levels of compensation could be utilized as the reasonable level of compensation for market pricing.

(5) Determine which of the numbers to use for comparative purposes. In most cases average or median data will be utilized as an initial position prior to performing a detailed financial performance analysis.

(6) Apply a range of reasonableness, such as 10 percent, to the number or numbers selected. It is DCAA policy to use 10 percent as the range of reasonableness. A 10 percent range of reasonableness (ROR) was also supported by the ASBCA in the Information Systems & Networks Corporation ASBCA Decision.

(7) Adjust the actual total cash compensation for lower than normal fringe benefits. (Calculate an offset.)

(8) Compare the adjusted compensation to the range of reasonableness. Differences should be questioned as unreasonable.[13]*

DCAA misinterpreted and misused the Techplan decision by converting the Board’s mere approbation of the method used in that case into mandates for all future ECRs. As evidenced by this CAM section, there are two major problems with what the DCAA did with the Techplan decision. First, it incorrectly asserts that the Board in Techplan held that these steps were “to be taken” – i.e., they are mandatory. The Board, however, did not go that far. Rather, the Board simply ruled, after listening to the parties’ experts, that “experts in the compensation field would generally accept taking” the eight steps listed.[14] The Board in no way indicated that these eight steps, with their “survey-centric” focus, constituted the only permissible method for evaluating the reasonableness of executive compensation, or that these eight steps were all that needed to be done in an ECR.[15]

Second, the Techplan decision merely accepted the parties’ apparent agreement that a 10% “range of reasonableness” (“ROR”) was adequate, in that case, to account for the variability of the data in the compensation surveys proffered by the parties. The Board stated only that compensation experts applied a ROR, “such as 10%.” It did not rule that, regardless of the quality of the survey data used in the ECR, 10% was the appropriate ROR for all cases,. However, the CAM added its own policy gloss to Techplan Step 6, stating that “[i]t is DCAA policy to use 10 percent as the range of reasonableness. A 10 percent range of reasonableness (ROR) was also supported by the ASBCA in the Information Systems & Networks Corporation ASBCA Decision.”[16] There is no legal basis for the adoption of an invariable 10% ROR, and the Techplan decision is no basis to do so. Certainly the FAR, in the 13 years since the publication of the Techplan decision, has not adopted any such rule. Moreover, the Information Systems and Networks decision, cited by the CAM, provides no meaningful support for an inflexible 10% ROR.[17] In the Information Systems and Networks case, the Government’s expert used a 10% ROR, and the Board found his presentation more persuasive than that of the Appellant’s. However, there is nothing in the decision which amounts to a ruling that a 10% ROR is to be applied in every ECR case. Moreover, the DCAA “policy” fails to account for a prior Board decision in which a 30% ROR was used advanced by an appellant in an ECR appeal. Because the 30% ROR was “unrebutted” by the Government, the Board, in sustaining the appeal, approved it.[18] In addition, as discussed below, the use of an invariable 10% ROR is flawed as a matter of statistics.

Beyond these misconstructions of the Techplan decision, the CAM also promulgates bad policy and bad law with respect to the way in which compensation is correlated with company performance. Use of compensation survey data in ECRs typically leads to a range of salaries in relation to company performance based on the (not unreasonable) assumption that better performing companies can reasonably pay their employees higher compensation. This range typically uses the quartiles 25%, 50% and 75%. For many firms, the difference between a “clean” ECR and one with disallowances recommended is whether the company is “market priced” (i.e., authorized to be reimbursed) at the 75^th rather than the 50^thpercentile. Thus, a prime source of disputes in ECRs is over the company’s performance. The CAM addresses this issue as follows:

h. Often contractors will propose that their executives should be paid more than 110 percent of the reasonable compensation based on the average compensation paid by comparable firms for executives with similar duties. Above average levels of compensation are usually identified by percentiles, such as the 75th percentile. For an executive with responsibility for overall management of a segment or firm, such a proposal may be justified by clearly superior performance as documented by financial performance that significantly exceeds the particular industry's average. The ASBCA, in their decision on Information Systems & Networks Corporation ASBCA No. 47849, “capped” executive compensation at the 75th percentile when justified by performance.

(2) The contractor must show that the measure chosen is representative of the executive’s performance. Consideration should be given to the competitive environment in which the contractor operates. There should be no extra compensation awarded because of high performance measured by a standard which is not affected by the executive’s performance, and certainly there should be no extra compensation due to performance which results primarily from the contractor’s status as a Government contractor. Performance is typically measured using more than one criterion of performance. For example, a contractor may have significant sales growth through acquisitions and mergers while operating at a loss. In this situation, the contractor would not be considered to have superior performance based on the lone measure of sales growth.

(3) Use of a particular measure to justify higher than average compensation should be applied consistently over a period of years, with both increases and decreases in the performance measures reflected in the changes to compensation claimed as reasonable.[19]

There are several flaws with the way in which the CAM addresses “market pricing” in the context of an ECR, and the way in which ECRs are conducted. First, the CAM asserts that the ASBCA, in the Information Systems and Networks decision “capped” executive compensation at the 75th percentile when justified by performance.”[20] The Board did nothing of the kind. Rather it merely found, on the basis of the specific facts adduced in the appeal, that the Government’s compensation expert had capped Appellant’s executive compensation at the 75^th percentile, stating as follows:

27. Mr. Keuch [the Government’s expert] next measured ISN's annual performance and the performance of the companies in the proxy sample, determining 25th, 50th, and 75th percentiles for performance, and drew a comparison between ISN and peer companies (R4, tab 50; tr. 3/64-65). Where ISN was ranked at or above the 75th percentile among its peers for annual performance, Mr. Keuch recommended executive pay for ISN in the 75th percentile, which formed the “cap” for pay (R4, tab 50).[21]

The Board subsequently found that “Mr. Keuch used an appropriate data base, applied the FAR properly, and used a consistent and logical methodology. We find his report and testimony persuasive.”[22] As can be discerned from the Board’s opinion, the correctness of the 75^th percentile “cap” as an invariable standard was not disputed in the Information Systems and Networks appeal, and we have no way of knowing how or why the Government’s expert arrived at that recommended “cap” based on the unique facts in that case. Under the circumstances, therefore, the CAM is not justified in its assertion that the Board, in Information Systems and Networks, “capped” reimbursement for executive compensation at the 75^th percentile. Nevertheless, based on this misreading of the Information Systems and Networks case, the 75^th percentile “cap” is now a fixture of the DCAA ECR method. As a matter of pure mathematical logic, the 75^th percentile cap cannot withstand scrutiny. It is undeniable that precisely 25% of all firms in a given class of businesses are in the top quartile. Thus, to “cap” reasonable compensation at the 75^th percentile is arbitrary. While this “cap” may make the DCAA’s job easier, it does not make the practice reasonable.

In our experience, DCAA practice is to market price a company at the 50^th percentile, and only to undertake a performance analysis if the company objects to a recommended disallowance.[23] Further, even when such an analysis is undertaken, any one-year downturn in financial performance can be deemed a justification for market pricing at a lower level. This practice is in conflict even with the CAM, which states that “[u]se of a particular measure to justify higher than average compensation should be applied consistently over a period of years, with both increases and decreases in the performance measures reflected in the changes to compensation claimed as reasonable.”[24] There is no reason to quarrel with the assertion that measures of performance should be applied consistently from year to year, and certainly it is reasonable to take into account longer term trends in financial performance when assessing the reasonableness of executive compensation in a given year. However in our experience, the DCAA justifies this approach by reference to FAR guidance which states that “[c]ompensation for personal services must be for work performed by the employee in the current year and must not represent a retroactive adjustment of prior years’ salary or wages.”[25] This provision, on its face, does not support the DCAA’s position, and should be challenged.

Moreover, the DCAA takes this approach without consideration of factors that may affect financial performance metrics in ways that do not reflect adversely on the performance of executives whose compensation is under review. Thus, for example, if a company was uniquely affected by a major event, such as the 9/11 attacks, its financial performance, when compared to companies whose business was not so sensitive to the catastrophe, will suffer. But that is not a compelling reason to downgrade the value of the services performed by the company’s executives. Consider, for example, two management consulting companies, one of which serves the travel industry; the other, the airport security screening industry. Both might be peers in a financial performance survey used by the DCAA in an ECR, and the financial performance of both would be affected by the 9/11 attacks. However, the impacts would be roughly reciprocal, with the travel consultant taking a dramatic bottom line hit for FY 2002, while the security company’s financial performance would be expected to shoot up. Using potentially skewed financial performance metrics from a single year or two as the basis for an increase or decrease in reasonable executive compensation, ignores the reality of the market for scarce high-performing executives. As a practical matter, short of a company-killing, long-term catastrophe, companies are forced to pay what the market demands for top executive talent, and cannot make executive compensation decisions the basis of short-term financial performance. Thus, not only is the DCAA’s approach unreasonable and contrary to the CAM, it is also contrary to the FAR cost principle that “[a] cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business.”[26] In addition, it is contrary to the Board’s holding in Techplan. In that appeal, at hearing, the company’s CEO testified, among other things, in regard to the company’s long-term profitability as a factor in advocating for 75^th percentile market pricing, as follows,

The company has been profitable every year that I have led it, which is all the years of its existence; both companies (Techplan and TDS), and has [sic] grown significantly during the period that I have led it from zero. I can state unequivocally that I believe the growth rate on average through 1990 was 23 1/2, 24 percent. The company has been essentially debt free since 1981.[27]

In ruling on the proper level to market price the company, the Board in Techplan, specifically relied on this long-term trend in finding that above average compensation was justified, stating that,

After eliminating the Government expert's analysis, we are left with the unrebutted, credible testimony of appellant's CEO and vice president, the financial data about appellant set forth under the first heading of this opinion, which shows average growth in revenues of 14% and continued, although declining, net income, and the personal information about the CEO set forth under the second heading. This evidence supports the contention that the company could reasonably elect to set its CEO's compensation at an above average level. We conclude, therefore, that the CEO's compensation may properly be compared with the data for the 75th percentile rather than for the average.[28]

Thus, the short-sighted DCAA is subject to legitimate criticism and should be challenged when the company’s long-term performance is inconsistent with a short-term downturn cited as the basis for a DCAA demand for drop in executive compensation. A further flaw in the DCAA approach to market pricing is its exclusive reliance on financial performance. The CAM appears to ignore all non-financial performance evidence in the market price question and, in our experience, ECR practice is that auditors also ignore factors such as the company’s standing in the industry. In Techplan however, such evidence was proffered to and considered by the Board, and was critical to the Board’s decision that Techplan was entitled to pay at an above-average level. The CEO testified as follows:

Obviously, I do think we are an above average company. We are a small business competing in a large group of small businesses. Many of them have similar skills ... . 99.9 percent of our work is competitively awarded, which requires then that my company have stature in this community from a technical standpoint, and from a financial standpoint and from a cost effectiveness standpoint.

We always had one overriding consideration, however; and that is a small company cannot survive absent a significant level of credibility with its customer in terms of

Second, ... we have name recognition in our customer community as a high quality provider of the types of services that we provide ... . We also have name recognition in our marketplace of competitor contractors ... . And on that basis, we are invited to join them in teaming where we will fill a nitch [sic] that they do not have covered in proposals that they are making to the Government.[30]

Thus, the Board considered not only financial performance data, but also testimony concerning the company’s “standing” and “credibility” in the industry as reflected by technical expertise, the ability to capture business in a competitive marketplace, and the excellence of its senior management. In our experience, the DCAA considers none of these factors in determining whether a company is entitled to pay (and be reimbursed) above average compensation to its executives. This unduly cramped approach is not only illogical, but also it runs counter to FAR 31.201-3(a) and the Techplan decision.

The DCAA Mid-Atlantic Compensation Team. The DCAA’s ECR program is executed by the “Mid-Atlantic Compensation Team,” (“MACT”) which is considered by DCAA to be an “Agency-wide Center of Excellence.[32] Organized under the DCAA Technical Programs division, the MACT was composed of two “technical specialists” and four accountants as of November 2007. The stated goal of the MACT is to provide “team continuity and consistency in audit approach” through “team members trained and certified in the compensation area.”[33] MACT members are trained by the “World at Work” organization (“WAW”), formerly known as the American Compensation Association, which provides certification in several specialties, including the designation, “Certified Compensation Professional” (“CCP”).[34] In our experience, despite the geographically-limited team designation, the MACT provides ECR support to contracting officers agency-wide.

Various idiosyncratic DCAA ECR policies and practices are justified on the basis that they are supported by “generally-accepted compensation principles” (“GACP”). These principles, even the DCAA has admitted (in depositions), are not independently compiled, peer-reviewed and updated on any kind of systematic or regular basis, but rather are drawn by DCAA auditors conducting ECRs from WAW teaching materials and from other random sources on an “as needed” basis. At a recent deposition, a DCAA auditor in an executive compensation appeal testified as follows:

Q: And is that something you get from generally accepted compensation practices?

A: Well, that might be in a compensation answer book, a reference book. They might discuss it there, and then it's -- it's, you know, probably taught at WorldatWork courses.

For example, DCAA auditors have testified that, according to GACP, executive compensation should be analyzed on a national basis, without taking local conditions into account. In other words, the reasonableness of an executive compensation for someone working in Waycross, Georgia is a fair comparator for an executive located in Boston, Massachusetts. The auditor testified as follows:

A: There's -- there's probably indus -- you know, articles in industry, compensation articles on that topic.

Q: But as opposed to the GAAP, generally accepted accounting principles, there's nothing like that that says for executives it’s – it’s national?

In view of the amorphous nature of the GACP, which as been embraced by the MACT, companies facing adverse ECR recommendations should probe for and challenge the use of GACP.

Statistical Flaws in the DCAA/MACT ECR Method. The MACT approach to ECRs centers on the use of compensation surveys. A survey is, fundamentally, an attempt to produce an educated guess regarding the characteristics of a selected population on the basis of a sample of less than 100% of the population’s members. “Statistics” is “[t]he mathematics of the collection, organization and interpretation of numerical data.”[35] The use of surveys thus is a statistical exercise. The DCAA recognizes this fact through the use of a range of reasonableness and regression analysis to account for the inherent variability of survey data.[36] The DCAA’s recognition that surveys are all about statistics is made clear by the NDIA presentation, which asks the question, “[w]hat are compensation surveys?” and answers that question in part by stating that they are “statistical data presented (percentiles, regression analysis, buckets, etc.).”[37]

Yet despite the fact that statistical analysis is the core competency required to collect, organize and interpret compensation survey data, our experience has been that DCAA auditors are completely untrained in statistical analysis. As a result, ECR results and recommendations are inherently unreliable and subject to attack.

We have found through review of DCAA work papers and through discovery conducted in a contract appeal, that MACT members are untrained in statistics at anything approaching the level required to use compensation and financial performance survey data in a reasonable and reliable manner. For example, in a deposition taken in a contract appeal in which ECRs are the basis for the contracting officer’s final decisions, the DCAA auditor testified as follows:

Q: Okay. So -- and I just want to be complete here regarding regression analysis and the training courses. Are you familiar with the term “nonlinear regression analysis”?

A: I -- I'm not 100 percent sure, but I think it's the comparison between your -- your sales and your -- your pay, the relationship between sales and compensation.[38]

The deponent in this appeal testified that he was responsible for conducting hundreds of ECRs as a member of the MACT. Survey data is not uniformly helpful in decision-making. Surveys can be skewed in many ways, and the number of observations, or sample size, dramatically affects the quality of survey data (i.e., generally, the greater the number of observations, the more useful are the survey results). The DCAA ECR method presumes that there is a direct relationship between corporate revenue and executive compensation (i.e. that, as revenue increases, reasonable executive compensation increases proportionately). The terms with which the auditor was not familiar are standard statistical concepts used to collect, organize and interpret survey data. The term, “coefficient of determination,” by the way, is R², and it is the proportion of variability in a data set that is accounted for by the statistical model. This same auditor viewed survey data in which the R²was only .20 or better was acceptable for use in an ECR. In other words, a compensation datum for corporate revenue explained, for such a survey, only 20% of the differences in executive compensation, leaving 80% of the variation unexplained. Despite this weak correlation between revenue and executive compensation, the auditor nevertheless considered the survey to be adequate for ECR usage. Moreover, there appears to be no uniformity among auditors regarding the reliability of survey data for ECRs. Another MACT member being deposed in the same appeal stated that any R² that was over zero was acceptable.

Not surprisingly, the lack of training and expertise in statistics by DCAA auditors introduces error into the statistics-driven ECR process. Beyond the use of data showing weak or no correlation between revenue and executive compensation, the MACT also commits a fundamental statistical error by treating all survey data equally, regardless of quality. Thus, a survey datum which is based on 5 observations (N=5) is considered equal to a datum based on 100 (N=100) observations. DCAA makes no effort to weight the surveys used in ECRs to account for such differences, with significant skewing of results. There are other statistical and logical flaws in the DCAA ECR process which are beyond the scope of this article. Suffice to say however, that the lack of statistical analytical expertise by the MACT, as it engages in a fundamentally statistical exercise, coupled with the fact that the MACT ignores all other evidence that has a bearing on reasonableness of executive compensation, leaves the DCAA ECR process wide open to attack and dispute.

ECR Working Papers. In our experience, we have also found that the MACT does not typically document its ECR process in a transparent way or in a manner that permits easy defense of disputed judgments, actions and decisions by the auditor. Among other guidance, auditors are required to adequately document decisions in regard to controversial issues. The CAM states as follows:

In reports that question contractor proposed costs, explanatory notes should contain detailed information such that the contracting officer is able to understand clearly the basis for each element of cost, how the cost was evaluated, and the conclusions made on the basis of that evaluation.[39]

CAM Secs. 4-401 and 4-403 contain similar exhortations to auditors. These appear to be honored only in the breach by ECR auditors. This is both a blessing and a curse. It is a disadvantage to the contractor in terms of being able to understand what the DCAA did in any given case, but on the other hand, when the disputes process is invoked, it can increase the challenge to the Government in defending executive compensation disallowances. In any event, the adequacy of the ECR working papers should be an important consideration in assessing the relative litigation risks of the parties.

Incurred cost audits are unpleasant. Under the best of circumstances, they are no better than a painful way for a company to hold its own. And of course, everyone is busy running the company and coping with the myriad demands of their customers. However, ECRs can be a trap for the unwary, and the worst thing a company can do is to ignore the ECR process. Executive compensation in the context of an ECR is just like a tooth with a cavity in it – if you leave it alone, it will go away. Prudent planning and attention to the company’s executive compensation practices in general, and to ECRs as they occur in particular, can reduce the pain of an ECR to a minor, ephemeral ache. Here are some ideas on how to accomplish this.

Set Executive Compensation by Committee. Although most decisions are best when not made by committee, executive compensation may be an exception. A chartered compensation committee, typically reporting to the board of directors, should perform a rigorous study of all relevant market data and circumstances bearing on compensation decisions, if possible, with the assistance of independent external compensation consultants. Compensation committee meetings should have detailed minutes, and compensation decisions should be based on written criteria. Small, closely-held companies often forego such infrastructure; however, lack of documentation and rationale for questionable compensation decisions can be a red flag for the DCAA, especially in view of FAR guidance that calls for “special consideration” for such companies.[40] Moreover, contemporaneous explanations for seemingly anomalous decisions are more persuasive than those that are made after costs have been challenged as unreasonable.

Maintain Accurate Position Descriptions. Based on GACP, the DCAA will, as a default approach, evaluate top division executives using divisional rather than company-wide revenue. Because compensation survey data have a rough direct relationship with compensation (i.e., the higher the revenue, the higher the reasonable compensation), so reasonable compensation will generally be deemed lower for executives with only parochial divisional responsibilities. However, if top division executives do have substantial company-wide responsibilities, these should be clearly documented so that when an ECR is performed, these executives will be evaluated using the more advantageous company-wide revenue amount. Consider the example in the table below:

The executive vice president may have the same background, qualification level and tenure in position as the top divisional executive, but if the company cannot demonstrate that the latter has company-wide responsibilities, the DCAA will evaluate the Top Division Executive's compensation using the revenue for the division rather than the company as a whole. Where such an evaluation does not reflect the reality of the situation, the company should ensure that it can document any broader responsibilities, and these should be brought to the ECR reviewer's attention early in the process.

Compile Complete and Accurate Data on Company Performance. The DCAA may, if requested, analyze a company's financial performance to determine whether the company should be “marketed” at higher than the median or 50th percentile compensation level. In most cases, as in the example in Table 1, there is a substantial difference in compensation level between companies at the 50th and 75th percentiles. Thus, companies should:

Be a Member of the ECR Team. The easiest way to get a bad ECR report is to treat the event as a nuisance and simply hope that it will be over soon. Thus, companies should engage with the DCAA as early as possible in the ECR process, before the auditor begins to form firm impressions. Be aware of any areas of weakness in compensation practices or company performance, and be ready with explanations and supporting documentation to minimize the impact. Make sure that you give a complete in-briefing to the reviewer concerning the company overall, and any unique circumstances that might affect the ECR. Introduce the reviewer to the executives whose compensation is to be evaluated, and provide complete information regarding the executives' background, experience and accomplishments. With the assistance of legal counsel as appropriate, be responsive and timely with regard to all requests for information and documents. Insist on an out-briefing, and follow-up to correct any misunderstandings or inaccuracies on the reviewer's part before he or she puts pen to paper on the ECR. Submit a complete and timely rebuttal to any preliminary findings that are inadequate or legally insufficient.

Engage the Contracting Officer. Ideally, the contracting officer can serve as a firewall between a bad ECR and a disallowance. However, recent DCAA guidance authorizes auditors to refer contracting officer “mismanagement” to the DoD Inspector General without first elevating such concerns through the contracting officer’s management chain.[41] This means, we believe, that contracting officers will be less likely to resist DCAA ECR recommendations. Although the contracting officer is, by law, the decision-maker on disallowance decisions, in practice, contracting officers will rarely even be aware of an ECR until it is over and the report is on his or her desk. However, By then, it is often too late to sway the contracting officer with the facts and the most compelling analysis. As soon as an ECR is started, the company should be talking to the ACO in much the same way as it is engaging with the ECR reviewer. Where the DCAA's analysis is off track, this should be immediately (and diplomatically) brought to the ACO's attention, and any mistakes or misunderstandings corrected. That way, when the ECR comes in, he or she may be predisposed to question the DCAA's views if a dispute comes up.

Executive compensation reviews are with us to stay and, in view of recent events which have give executive compensation a bad name, contractors cannot reasonably hope that ECRs will get any easier to cope with. However, there are a multitude of steps that any company, even without an enormous investment in disputes litigation, can take to put itself in the best possible position in an ECR. Start with understanding the underlying legal principles, as well as the DCAA process and the flaws in it, and push back when necessary; know what is needed to maximize the company’s performance profile and do not by shy about sharing with the auditor; implement sound compensation practices and then live up to them; and become a part of the ECR team and stay in touch with the auditor and the contracting officer every step of the way. Executive compensation is not a four-letter word – do not let the ECR process cause you to use any four-letter words of your own.

* Except as otherwise indicated herein, all emphasis is added.

[1] Comments made by White House advisor David Axelrod, interviewed in February 2009 on Fox News Sunday, discounting concerns that new stimulus-plan limits on executive compensation would cause a “brain drain,” http://www.cqpolitics.com/wmspage.cfm?docID=news-000003052604 (last visited April 1, 2009, copy on file with author).

[2] Our “experience” as referenced in this article is derived from ECRs conducted since 2001 for four separate client companies, one of which has resulted in a contract appeal that will be the subject of a hearing before the Armed Services Board of Contract Appeals in the Spring of 2009.

[3] Federal Acquisition Regulation (“FAR”) 52.233-1, DISPUTES (JULY 2002) .

[4] The Contract Disputes Act of 1978, as amended, 41 U.S.C. §§ 601-613.

[5] FAR 31.201-3(a).

[6] David Durante, DCAA MACT Supervisor, Executive Compensation on Government Contracts: An Audit Perspective, a slide-show presentation given to the November 14, 2007, National Defense Industrial Association (hereafter “NDIA Presentation,” on file with author), at 18-25.

[7] FAR 31.205-6(b)(2).

[8] FAR 31.205-6(a)(6).

[9] ASBCA No. 45387, 96-2 BCA ¶ 28426, 1996 WL 391461 (July 2, 1996.).

[10] 96-2 BCA ¶ 28426 , at 13-14.__.

[11] Id. at 6.

[12] ASBCA No. 47849, 97-2 BCA ¶ 29132, 1997 WL 381263 (July 7, 1997.).

[13] CAM, Sec. 6-414.4(g).

[14] 96-2 BCA ¶ 28426, at 6._

[15] This DCAA position persists. See NDIA Presentation at 32, “Key Points, Techplan ... Steps for evaluating reasonableness were established ... .”

[16] CAM, Sec. 6-414.4(g)(6). Mr. Durante’s NDIA Presentation establishes that this misreading of Techplan persists. In rehearsing the key points of the Board’s decision, Mr. Durante asserted that the Board found that a “10% ROR is acceptable.” NDIA Presentation at 32.

[17] ASBCA No. 47849, 97-2 BCA ¶ 29132, 1997 WL 381263 (July 7, 1997.).

[18] Lulejian & Associates, Inc., ASBCA No. 20094,, 76-1 BCA P 11880, 1976 WL 1917 (Apr. 27, 1976.).

[19] CAM, Sec. 6-414(h).

[20] Id.

[21] ASBCA No. 47849, 97-2 BCA ¶ 29132, 1997 WL 381263 (July 7, 1997.)..

[22] Id.

[23] These empirical observations are supported by the DCAA which, in its NDIA Presentation, only mentions evaluation of financial performance for the purpose of allowing higher than average compensation after the contractor has submitted a rebuttal. NDIA Presentation, at 16.

[24] CAM, Sec. 6-414(h)(3).

[25] FAR 31.205-6(a)(1).

[26] FAR 31.201-3(a).

[27] 96-2 BCA P 28426, at 9. The Techplan vice president also testified on this point as follows:

I have many things that I would point to that I believe indicate that we are above average in our business. Number one, there are very few companies of our size that have been in business and been successful for the twenty or so odd years that we have been in business ... .

Also, we have had sustained sales growth for many years, and there are not very many companies that I'm familiar with in our market area who can make the same pronouncement. We've also had sustained profitability. There are not very many companies that you can point to in our business that have a long history of consistent profitability.

Id. at 10.

[28] Id. at 11..

[29] Id. at 9-10..

[30] Id at 10..

[31] Id. at 11..

[32] NDIA Presentation at 4.

[33] Id.

[34] NDIA Presentation at 6-7.

[35] Webster’s II New College Dictionary (2001), at 1078.

[36] NDIA Presentation, at 12-13.

[37] NDIA Presentation, at 12-13 and 18.

[38] Deposition transcript on file with author.

[39] CAM 10-210.6(b).

[40] FAR 31.205-6(a)(6)(i).

[41] DCAA Action Guidance Memo PAS 730.4.A.4, dated March 13, 2009, states as follows:

Certain unsatisfactory conditions related to actions of Government officials will be reported to the Department of Defense Inspector General (DoDIG) in lieu of reporting the conditions to a higher level of management. The unsatisfactory conditions reported to the DoDIG will be those cases where DCAA determines an independent assessment and related actions are necessary due to the significance and/or sensitivity of the matter.

Unsatisfactory conditions include actions by Government officials that appear to reflect mismanagement, a failure to comply with specific regulatory requirements or gross negligence in fulfilling his or her responsibility that result in substantial harm to the Government or taxpayers, or that frustrate public policy.

See http://www.dcaa.mil/mmr/09-PAS-004.pdf (last visited April 10, 2009).

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