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DCAA and Executive Compensation after Taylor/Metron

By: John Ford, Senior Consultant, Government Contractor Services Group

Within a period of approximately six months at the beginning of 2012, the Armed Services Board of Contract Appeals (“ASBCA”; “the Board”) issued two significant decisions concerning the process for determining reasonable compensation under Federal Acquisition Regulation (FAR) 31.205-6(b)(2). These decisions were J.F. Taylor, Inc., ASBCA Nos. 56105 and 56322 (Jan. 18, 2012) and Metron, Inc., ASBCA Nos. 56624, 56751 and 56752 (June 4, 2012). In both cases, the Defense Contract Audit Agency (“DCAA”) had questioned substantial amounts of compensation as being unreasonable. This conclusion was reached by following the standard procedure DCAA had used for years. Essentially, this procedure is to determine the average of the median of two or more compensation surveys and then to add a 10 percent range of reasonableness. Any amount of compensation above the amount computed in this fashion is considered unreasonable. DCAA calls this process “market pricing.” In both cases, the ASBCA substantially rejected DCAA’s conclusion that the questioned compensation was unreasonable. In doing so, the Board called into question DCAA’s “market pricing” technique.

In Taylor, the contractor presented evidence by a statistician that DCAA committed nine separate errors in reviewing Taylor’s compensation. The primary error was that DCAA did not consider the effect data dispersion (e.g., the spread between the 25th percentile and 75th percentile in the surveys) had on the validity of the compensation amounts found reasonable. Second, DCAA did not consider differences in the number of respondents in each survey in order to determine the weight to be accorded each survey. Other flaws were that DCAA assumed that revenue was the determinant of reasonable compensation and did not consider other factors.

After describing the errors committed by DCAA, the expert calculated an upper limit of reasonable compensation (ULRC) for Taylor. In doing so, he assumed a normal distribution of compensation between the 50th and 75th percentiles in the surveys. In the expert’s opinion, anything below the ULRC would be reasonable while anything above it would be unreasonable. This ULRC exceeded the 75th percentile in the surveys used by DCAA.

In Metron, the contractor based its compensation on one survey and other factors relating to its specific type of work. DCAA used other surveys and questioned compensation based upon the use of those surveys. The Board found that the “survey data relied on by the government 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” single survey.

In sustaining Metron’s appeals in the most part, the Board stated that “[d]etermination of the reasonableness of executive compensation is a fact-specific inquiry, requiring examination, inter alia, of the specific tasks, responsibilities, education/training and work experience of the executives in question.” Thus, the Board indicated that factors other than those suggested in 31.205-6(b)(2) should be considered in evaluating the reasonableness of compensation. In this regard, the Board supported its sustention of the appeals by stating “[r]ecruitment and retention of the requisite PhD-educated executives capable of obtaining the necessary security clearances for the highly sophisticated sensitive and technical work performed by Metron also support our conclusion that the executive compensation in dispute here was reasonable.” Thus, the Board clearly based its decision on factors other than those in 31.205-6(b)(2) and company financial performance as DCAA did.

Subsequent to these decisions, DCAA has not significantly changed its procedures for evaluating executive compensation. In this regard, DCAA has prepared an unpublished talking paper justifying its continued use of the procedures that were stated to be “fatally flawed” in Taylor and to be used in rebutting arguments raised by contractors citing Taylor or Metron. This talking paper clearly indicates that DCAA did not grasp the significance of these decisions and that it does not understand the FAR test for reasonableness found in FAR 31.201-3.

DCAA devotes most of its discussion to the ULRC computed in Taylor, making several mistakes in this regard. First, is the assumption that Taylor indicates that companies should set their pay targets at the ULRC. This is not true. What Taylor’s expert simply did by the use of the ULRC was show that DCAA’s use of the average of the median compensation in the surveys used was “clearly incorrect” from a statistical “as well as from a common sense standpoint” because this process resulted in almost 40 percent of companies in DCAA’s surveys being deemed to pay unreasonable compensation.

Second, the level at which the ULRC was set in Taylor was based upon the surveys used by DCAA. Thus, that level would not be appropriate in all circumstances because other surveys might have more statistical validity than those used by DCAA in Taylor. Further, the computation of the ULRC was simply a statistically valid means of determining the upper limit on reasonable compensation. Using this same procedure with other surveys could lead to different results.

Third, DCAA asserts that the use of the ULRC is inconsistent with the reasonableness factors from 31.205-6(b)(2). However, DCAA fails to recognize that the four factors it cites are only suggestions (i.e., factors that “may” be considered in determining reasonableness). As demonstrated in Metron, other factors can be considered.

Fourth, DCAA evidences a lack of understanding of 31.201-3, which states in relevant part 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.” DCAA contends that a prudent person would not set the majority of executive pay at amounts that exceed the highest reported survey amounts in the surveys (i.e., the 75th percentile). However, in the three studies DCAA cites to support this contention, 6, 12, and 21 percent of the companies surveyed did just that. Further, DCAA’s position demonstrates a lack of understanding regarding 31.201-3. Under the test enunciated there, to be unreasonable, no prudent business person would incur the cost. DCAA’s interpretation is that a cost is unreasonable if most or a substantial number of prudent business people would not incur it.

While not stated in the paper, DCAA’s fixation on the 75th percentile may be a reflection of a misstatement in the Contract Audit Manual (CAM) concerning the ASBCA’s decision in an earlier compensation case, Information Systems and Networks (ISN), Corp. ASBCA No. 47849 (July 7, 1997) (ISN). CAM 6-414 states that the ISN decision “’capped’ executive compensation

at the 75th percentile when justified by performance”. However, nothing in the ISN decision can be interpreted as imposing a cap on the amount of compensation that is reasonable.

In its paper, DCAA continues to cling to the notion that company performance is the key factor in driving compensation and that other factors, such as those cited as justification for the compensation paid by Metron, should not be considered. The paper ignores the basis for the decision in Metron and asserts that the case was decided DCAA clings to this position despite the fact that the Board clearly based its decision on factors not mentioned in the FAR, but the facts of the case. In this regard, DCAA is ignoring the fact that what constitutes reasonable compensation is a “fact specific” inquiry. In other words, there is no strict mathematical formula that can be used to determine reasonable compensation.

All in all, the DCAA talking paper confirms what has been widely suspected, that is, DCAA has not learned the lessons from Taylor and Metron. Instead, DCAA believes that Taylor was decided the way it was simply because the government did not call a witness to rebut the statistical evidence presented by Taylor. In this regard, DCAA denigrates Taylor’s expert witness by stating “he admittedly is not an expert on executive compensation.” Based on this talking paper, we can expect DCAA to continue its same practices in regard to executive compensation. How much appetite, the Administrative Contracting Officer will have to support DCAA remains to be seen. More importantly, it should be asked how much appetite the Defense Contract Management Agency (DCMA) trial attorneys will have to continue to litigate cases where DCAA has used its “fatally flawed” process to question compensation costs.

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