(Editor’s Note. As part of our continuing practice to provide “real life” case studies from our consulting practice, we thought we would recount a challenge we prepared to DCAA’s assertion that our client had paid its executives an excessive amount of compensation. Though not all issues described here are likely to be relevant to all contractors we thought we would still recount the arguments we put forth as an illustration of the types of arguments available to challenge assertions of excess compensation. As we have reported previously, excessive executive compensation is the number one issue that contractors and DCAA face. Though large contractors are normally covered by OMB executive compensation caps issued annually, all other organizations are subject to reasonableness standards where substantially lower amounts are considered appropriate.)
DCAA’s Position
The local DCAA office was auditing Contractor’s (we have disguised the name of our client – referred to as “Contractor” – as well as the period being audited, dollar amounts and names) 2007 incurred cost proposal and asked the DCAA Mid-Atlantic Region’s Compensation Team to audit the executive compensation for reasonableness. DCAA’s compensation team concluded that Contractor’s four top senior executives’ compensation for 2007 was unreasonable in the aggregate amount of $720,000. DCAA’s conclusion was based on comparing Contractor’s cash compensation paid to its senior executives with the data of four surveys, adjusted for a 10% “range of reasonableness” factor.
Our Response
In our response to DCAA’s draft audit report we respectfully disagreed with their position and put forth the following arguments to support our position that the amount of executive compensation paid was reasonable. We have significantly edited our response.
DCAA has failed to adjust its conclusions for Contractor’s exceptionally low fringe benefit costs. The Compensation Team’s assumption that the claimed cash compensation represents only base salary, bonus and deferred compensation is not correct. A significant amount of the cash compensation amount includes provision for fringe benefits such as holiday, vacation and sick leave as well as other normal fringe benefits. The cash compensation should be reduced to delete the fringe benefit amounts included in the executive compensation of the four senior executives.
DCAA is tasked with determining whether contractors’ executive compensation levels are reasonable. The approach taken is to identify “executive compensation” defined as salaries, wages, bonuses, deferred compensation and pension costs for defined contribution pension plans. Other forms of compensation commonly referred to as fringe benefits are defined by DCAA in DCAM Chapter 6-413.5 as legally required payments, pensions, life and health insurance, pay for time not worked (e.g. holidays, vacation sick leave, jury duty, grieving) and other benefits (e.g. severance pay, 401(k)s, ESOPs, deferred compensation).
The compensation of the four executives that was benchmarked was based on total compensation. The root of this problem is that in prior periods, including 2007, Contractor did not separately account for certain elements of compensation for their senior executives such as vacation pay, sick leave, holidays and as well as for imputed compensation for other normal fringe benefits such as insurance and 401(k) plans. Though Contractor has subsequently adopted practices to separately identify compensation and fringe benefits costs for executives, in 2007 and earlier periods they did not do so. Rather, all relevant fringe benefits were lumped into executive compensation and as a result, Contractor’s fringe benefit costs were zero.
In accordance with the Techplan Corporation (98-2 BCA) decision, an imputed fringe benefit rate should be computed and deducted (or in DCAA language, offset) from compensation. (We provided an exhibit where we computed a fringe benefit rate of 33% applicable to the four senior executives and adjusted their compensation downward to reflect the fringe benefit offset.) In addition, in prior audits DCAA took into account the fact Contractor does not distinguish between compensation and fringe benefits and adjusted the compensation and compared the result with one survey (the Wyatt survey).
Conclusion. DCAA needs to modify its conclusions by adjusting total compensation amounts for a reasonable fringe benefit rate. DCAA should take the same approach it has taken in the past, namely to adjust the cash compensation amount for low fringe benefits. We believe that if DCAA followed this approach it would reach the same conclusion it reached for the last ten years, i.e. Contractor’s executive compensation levels are reasonable.
We believe that there are serious flaws with two of the compensation surveys DCAA used.
Though we believe using one centralized, specially trained group of auditors is a significant improvement over using less trained, local DCAA auditors inclined to use a variety of approaches, use of a single team does have certain disadvantages where they are inclined to take a “one size fits all” (i.e. consider all surveys equally valid) approach that does not accurately benchmark individual companies’ executive compensation. Our consultant, who participated in compensation reviews in the Mid-Atlantic region when he was a DCAA auditor, informs us the team sometimes selects surveys that may not be entirely representative in order to be able to compute an average cost of several surveys. This seems to be the case here. Though taking an average is theoretically attractive, the accuracy of such an approach is dependent on how representative the surveys are with the company being analyzed – if they are not representative, they should not be used. The four surveys used here have varying levels of accurate comparables with the characteristics of Contractor and in our opinion, two should be eliminated, Jaffe and Mercer.
In our written response, which is too detailed to reproduce here, we provided a detailed analysis of the four surveys used, identifying strengths and weaknesses of each in attempting to benchmark Contractor’s characteristics with the purported characteristics of the four surveys. We concluded that two of the surveys used identified compensation levels that were 50% lower than the other two surveys (comparable survey results should not differ significantly). Our analysis indicated that the reason for the large disparity in results from the four surveys used were a result of two factors:
(1) Contractor’s location in a particularly expensive area in California where senior technical management is in short supply could not be adequately benchmarked to one survey that measured only nation-wide averages while another measured only Mid-Atlantic companies
(2) one of the surveys we asked to be discarded examined “all industries” rather than the high tech professional labor services offered by the Contractor. We requested that two of the surveys used to benchmark Contractor’s executive compensation should be discarded and that two additional surveys that Contractor used should be substituted.
In our response we introduced two surveys we claimed were more appropriately benchmarked to Contractor. One of the surveys – Aspen Survey – though no longer published in 2007 was used by Contractor for many years while another we introduced – Radford Survey – more closely benchmarked high tech professional services. Though again too detailed to recount here we presented an analysis of why the two surveys were more closely representative of Contractor not in hopes that DCAA would substitute ours with theirs (unrealistic hope) but that they would include the findings of the two in computing average survey results.
DCAA stated that in spite of use of the Aspen survey in prior years it could not recognize the results of the Aspen survey in 2007 because the last year it was published – 2005 – represents data that was more than two years old and hence not appropriate for evaluating compensation in 2007. We had never heard of this “more than two year old” prohibition (in fact older surveys are fine if the results are properly escalated and the conditions are similar) and could find no discussion of it in either the FAR or DCAM so we asked DCAA for the basis of excluding a two year old survey. DCAA indicated two cases - ISN and Techplan ASBCA cases addressed the prohibition. We reread the two cases and found no mention of the two year prohibition. The only possible reference to survey data being too old is in the ISN case where 1992 survey data was referenced and the Board stated more current 1994 data from the same survey should have been used.
DCAA has inaccurately identified three of four titles associated with Contractor’s senior executives and then inappropriately benchmarked those incorrect job titles with its surveys.
In benchmarking the Contractor executives, DCAA used the same titles that Contractor had assigned to the four individuals many years prior to 2007 – CEO, Chief Operations Officer, Chief Marketing Officer and VP of Operations. After reading the job descriptions of each of the four executives and inquiring into the nature of their jobs, it was clear to us that Contractor years ago, without a lot of thought and unaware of any adverse consequences, assigned job titles to its senior executives. In spite of significant changes in subsequent years, those job titles were not updated and DCAA used those old, now inaccurate job titles to benchmark Contractor’s compensation.
We provided the auditors printed job descriptions and detailed accounting of the nature of the four executives’ jobs. The two top executives were a husband and wife team who founded the company 30 years earlier where each shared CEO duties. In addition, the wife also assumed duties of a CFO so we asserted that either they should both be benchmarked as co-CEOs or the wife as a part CEO and part CFO. The person designated as VP of Operations was really a Chief Operations Officer (whom a VP of Ops commonly reports to) and we asserted his position should be considered COO not a significantly lower VP of Ops (where we said no such position existed in 2007). As for the person designed as Chief Marketing Officer his position had radically changed by 2007 to be President of a new subsidiary company where remarkable success was achieved (discussed below).
Conclusion. The job titles DCAA assigned to the four executives and then benchmarked, though understandable since those were the titles designated, were erroneous. More accurate job titles would be: Co- CEO and Board Chairman (some surveys allow for greater compensation for senior board members), co-CEO, Board Secretary and CFO, COO and President or CEO of subsidiary company.
DCAA’s customary use of a default median percentile is inappropriate here. By just about any financial measurement prescribed in the Techplan ASBCA case and the DCAM, Chapter 6-414-4, Contractor’s operations and financial performance were superior. As a result, any survey used should be measured at a minimum of the 75th percentile, not the 50th percentile that DCAA has used.
DCAA normally uses the median percentile in benchmarking salary levels, leaving the burden of proof for using a higher percentile to the contractor. The FAR, Techplan and ISN ASBCA decisions as well as the DCAM provide for using higher (and lower) percentiles based on financial performance of the company being evaluated. The DCAM identifies examples of financial performance and we have selected a sample to demonstrate Contractor’s superior financial performance where we provided an exhibit demonstrating a broad range of superior performance (e.g. sales and profit increases, return on equity, return on assets, etc.).
Contractor was awarded a contract in 2008 valued at over $100,000,000 over five years, a very large increase for a $7 Million a year company. This exceptional financial performance is the result of “seeds sown” in the 2007 time period (e.g. justifying a bundling of services into one contract, demonstration of expanded technical capabilities, excellent past performance reviews, etc.). Accordingly, this exceptional financial performance should be associated with 2007 performance which provides further credence to the appropriateness of applying a higher percentile when benchmarking Contractor’s compensation.
Selection of percentiles to use is also based on operations performance in addition to financial achievements. Contractor’s performance ratings were consistently superior which provided the basis for being awarded its huge contract a short time later.
Conclusion. Contractor’s superior technical and financial performance, reflected in both its 2007 financial statements and award of a major contract that was a result of work performed in 2007, clearly justifies use of the 75th percentile in any survey used.
The amount of costs benchmarked for the President of the subsidiary, $300,000, includes a one-time incentive payment of $130,000 to relocate to Washington DC and run the new operations there. So, the total compensation that should have been benchmarked is $170,000 whereas the incentive payment should be evaluated on separate reasonableness grounds.
The courts and boards will not permit retroactive disallowances of cost when the contractor can reasonably show that the contractor relied on the government’s prior conduct. This principle is known as “equitable estoppel” or “estoppel” and it applies when the contractor can show a history of acquiescence or approval of a particular cost which as we have seen, was clearly approved in the past.
To prove estoppel four conditions must be present which was the case here:
(1) The government must have actual notice of all the relevant facts – DCAA was provided complete cost submissions in prior years that clearly identified executive compensation.
(2) The contractor must have reasonably relied upon the government’s action or inaction - in developing its indirect expense rates for forward pricing Contractor relied on DCAA’s prior unequivocal action and had it reason to believe it would be questioned, Contractor would have sought an Advance Agreement with the ACO per FAR 31.109.
(3) The government must have realized, or should have realized, the contractor’s reliance - it is self evident that the government realized Contractor’s reliance because contracts were closed out using indirect rates audited and approved by DCAA.
(4) The contractor would be prejudiced or suffer a loss as a consequence of the retroactive application – DCAA’s proposed reduction would result in a 50% decrease of executive compensation causing a significant loss in 2007.
Some of Contractor’s employees would earn more or slightly less than some of the executive salaries that DCAA asserts would be reasonable.
If DCAA’s position was sustained, compensation for several employees would be higher than amounts allowed for the four executives. We provided an Exhibit that showed five employees’ salaries in 2007 exceeded the amount the survey allows for the bottom executive level while nine employees are within 10 percent of that benchmarked amount. One employee’s salary exceeds the second benchmarked amount while three employees’ salaries are within 10 percent of the benchmarked amount. The government has been very satisfied with the education and experience level of employees working on its projects, the high level of achievement and the reasonable cost. Why else would Contractor have been awarded so many contracts in the last few years.
Conclusion. It does not make sense to have non-executive employees making close to or more than executives having more than 25 years seniority with the company.
Contractor is proposing indirect rates that are significantly lower than other contractors. Accordingly, the government is receiving a significantly lower price than comparable companies are offering. To insist that Contractor pay back an additional amount representing questioned costs of excess compensation would result in severe financial harm to Contractor, which could impair performance on current contracts.
Contractor’s proposed indirect cost rates are significantly lower than comparable companies doing business with the federal government. Its proposed incurred cost rates for 2007 is 65 percent for overhead and 11 percent for G&A. (We provided an exhibit comparing quite favorably Contractor’s indirect rates with those of other professional services companies.)
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