July 5, 2012

ASBCA Rejects DCAA's Methodology for Determining Reasonableness of Executive Compensation

Holland & Knight Government Contracts Blog
Gregory R. Hallmark

A defense contractor recently won a rare victory over the Defense Contract Audit Agency (“DCAA”) in the highly contentious struggle over the allowability of executive compensation costs. In Metron, Inc., ASBCA Nos. 55624, 56751, 56752 (Jun. 4, 2012), the Armed Services Board of Contract Appeals held that there were fatal flaws in DCAA's methodology for determining the "reasonable" amount of executive compensation and that, contrary to DCAA’s determination, all the costs in dispute were allowable. The ASBCA's opinion provides a framework for the successful defense of a firm's executive compensation practices, as well as precedent for attacking DCAA's determination of the "reasonable" level of compensation. Contractors that value executive talent would be wise to carefully study the case.

I. Background on DCAA's Audits of Executive Compensation

As many contractors know, DCAA has made a practice of closely scrutinizing executive compensation. The amount of executive compensation that is allowable for reimbursement under cost-reimbursement contracts is capped by statute at a benchmark amount (currently $763,029). See FAR 31.205-6(p). But even if an executive is paid less than that maximum amount, to be allowable, the compensation still must be reasonable for the work performed. In Metron, no executive was compensated above the cap, but DCAA deemed the compensation the contractor paid to ten executives to be unreasonable.

In evaluating executive compensation, DCAA's practice has been to independently determine the reasonable level of compensation for the executive in question and disallow any compensation that is more than 10% greater than the "reasonable" amount. In theory, DCAA bases its determination of the reasonable level of compensation on market surveys of compensation paid to individuals in similar positions by firms with similar revenues and in the same industry and geographic location as the contractor. This requires to DCAA determine which of the positions analyzed in the surveys best matches the executive's duties. Also, because the surveys display a spectrum of compensation levels for each position, DCAA must select a point on the spectrum that it deems appropriate for the contractor and the executive—it could, for instance, be the median compensation, the 25th percentile, or 75th percentile. In some cases, and indeed in Metron's case, DCAA will even manipulate the data presented in the surveys if it feels the survey authors used improper methodologies.

II. The Metron Case

Using this process, DCAA independently arrived at figures that it deemed reasonable for Metron's ten executives. DCAA's figures for the two-year period of 2004-2005 were collectively $1.3 million less than the contractor actually paid the ten executives. DCAA questioned this amount as unreasonable compensation. DCMA demanded repayment of about $700,000, the portion of the total amount that was attributable to DCMA-administered contracts.

Rather than accept DCAA's analysis, Metron opted to appeal to the ASBCA. The Board agreed with Metron, taking issue with many aspects of DCAA's methodology and finding that all of the compensation paid was, in fact, reasonable. The Board's decision teaches several important lessons about how to deal with DCAA's scrutiny of executive compensation.

A. Choice of Surveys

One critical question the Board faced in evaluating DCAA's disallowance of executive compensation was whether DCAA has used appropriate surveys. In this case, Metron based its compensation levels on a single market survey, the Radford Executive Survey. But DCAA used an average of the Radford Survey and three other surveys, which, not surprisingly, resulted in lower comparables than using the Radford Survey alone.
Metron persuaded the ASBCA that use of the Radford Survey alone was appropriate because it was by far the most relevant to Metron's high-technology industry. The Board found that the other three surveys "were not sufficiently comprehensive, reliable, relevant to Metron's industry, and/or the job matches were not sufficiently similar and representative to warrant material reduction of the results obtained from use of the Radford Survey data alone."

Contractors should closely scrutinize the surveys that DCAA uses to determine reasonable compensation; they may be diluting the best and most relevant survey data with less relevant data, to the contractor's detriment.

B. DCAA's Adjustments to Survey Results

The ASBCA's opinion cast serious doubt on DCAA's practice of manipulating survey results that it deems inadequate. In assessing Metron's claimed compensation costs, DCAA opined that the Radford Survey improperly inflated its total compensation data by counting only executives who were reported as having been paid incentive bonuses and ignoring those for whom no incentive bonus information was reported. DCAA recalculated the survey's median bonus, which had the effect of reducing the median bonus by a large percentage. DCAA then reduced the survey's total compensation results by a corresponding amount.

The Board held that DCAA's recalculation was inappropriate, as it assumed facts that were not reported in the survey. The survey provided only the results of the survey authors' analyses of raw data, not the underlying raw data. There were many reasons why a firm might not report incentive bonus information that would be consistent with the survey's actual results. Because the survey did not provide the underlying data, there was no reason for DCAA to believe that the survey's findings were inaccurate or that DCAA's method was more accurate.
Given the dim view that the ASBCA took of DCAA's adjustments, any manipulation of survey data by an auditor should immediately raise a red flag.

C. Selection of Appropriate Percentile

The Metron case gives contractors precedent to argue that factors other than revenue should determine the appropriate compensation level. The ASBCA squarely called into question

DCAA's practice of selecting a particular point along the compensation spectrum purely on the basis of the firm's revenues.

In Metron, DCAA determined that the executives' compensation should be at the 66th and 41st percentiles of its peer group for 2004 and 2005, respectively, on the basis of the firm's revenues in comparison to that of other firms in its peer group.

The Board found two faults with this determination. First, the Radford survey only provided data at the 25th, 50th, and 75th percentiles—it did not provide figures for the 66th and 41st percentiles, and calculating figures for those percentiles required DCAA to use unsupported assumptions regarding the raw survey data that was not actually provided in the survey. As the Board stated, "[g]reater scientific, statistical or analytical certitude is not possible given this lack of data."

Second, the Board rejected the very concept of assigning contractors a point on the spectrum based on revenues. The survey compared firms within various "revenue bins"—Metron's was the $0-$50 million bin—and there was no correlation between revenue and compensation within a given revenue bin. Rather, the Board agreed with Metron that its executives could reasonably be paid above-average compensation, compared to firms in the relevant revenue bin, because Metron's sophisticated technical work required its executives to be highly educated in mathematics or science and to possess high-level security clearances and because the firm outperformed its financial goals.

Similarly, the Board rejected DCAA's placement of Metron's division executives at the 25th percentile of the survey data for division executives, on the basis that Metron's divisions were smaller in revenue than the average survey participant's divisions. Again, the Board held that DCAA made an unwarranted assumption about the underlying survey data—revenue size could not be ascertained at any particular percentile of compensation.

D. Selection of Peer Group

Metron also teaches that contractors should make sure that DCAA compares them with an appropriate peer group of firms. Metron is a small, privately held company with a relatively flat organizational structure. Yet DCAA compared Metron with a peer group that included very large publicly-traded companies with materially different organizational and financial structures. The Board rejected DCAA's selected peer group, which included "publicly-traded, Fortune 500 companies such as IBM," calling DCAA's approach "misleading and unfair."

E. Selection of Comparable Survey Positions

Careful attention should be paid to whether DCAA has selected survey positions that best match the duties of the executives in question. In Metron, DCAA declined to treat Metron personnel with the title "Senior Engineer" as executives, comparing them instead with mid-level management positions. DCAA based this determination, in part, on the fact that the Senior Engineers did not have "Vice President" in their titles and allegedly were not in charge of units or responsible for a distinct product line or service.

The ASBCA evaluated the duties of Metron's Senior Engineers and found that they had substantial senior level management and business development responsibilities—they were, functionally, the equivalents of Vice Presidents. The Board agreed with Metron that the compensation of Senior Engineers should be based on a higher-compensated survey position than DCAA had used.

F. The Importance of Good Executive Compensation Plans

Finally, the Metron case shows the value of developing a strong executive compensation plan and then strictly adhering to that plan. A contractor holds the burden of proving that its executive compensation costs are reasonable, so it cannot succeed merely by pointing out flaws in DCAA's determination of what is reasonable. Metron's rigorous and carefully crafted executive compensation plan went a long way toward persuading the Board that its compensation costs were reasonable.

Starting in the mid-1990's, Metron established an executive compensation plan based on the Radford Survey. The plan included a comprehensive analysis of why Metron selected that particular survey—the company went so far as to poll its employees to determine who were its competitors for talent and business, then compared its competitors to the firms surveyed and determined there was a good demographic match. The company established the executives' base salaries as the average base salary from the Radford Survey for comparable positions. It also provided for incentive bonuses based on the amount of revenue and profit earned by the company or particular divisions in which executives worked. If the company or the relevant division met its revenue and profit goals, the executive would earn bonuses bringing their total compensation to the average total compensation from the survey for comparable positions. If revenue and profit goals were not met, their total compensation would be less than the survey's average; if the goals were exceeded, their total compensation would be greater than the survey's average.

Even though Metron almost universally paid its executives above-average compensation in 2004 and 2005, it persuaded the ASBCA that its compensation costs were reasonable. It was able to do so, in large part, because its executive compensation plan, in the Board's words, "set reasonable compensation levels depending on achievement of pre-established management goals and internal metrics and there is no evidence that the plan was not consistently followed by Metron." By establishing and following a comprehensive and expertly developed executive compensation plan, a contractor can make its executive compensation costs as close to bullet-proof as possible.

According to the Grant Thornton annual surveys, year after year, government contractors report that executive compensation is the most frequent issue raised in DCAA audits. The Metron case may give contractors more confidence in disputing DCAA disallowances of executive compensation costs.

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