Defending Executive Compensation Successfully

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1 Defending Executive Compensation Successfully Presented by CohnReznick s Government Contracting Industry Practice Kristen Soles, Partner

2 PLEASE READ This presentation has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. This presentation and its content are the property of CohnReznick LLP and are protected by applicable copyright laws. Any unauthorized use of the information herein will be considered a violation of CohnReznick LLP s intellectual property rights. Unless stated otherwise herein, no part of this presentation may be copied, distributed, or published, in whole or in part, without the prior written agreement of CohnReznick LLP. 1

3 AGENDA Executive Compensation Rules and History FAR and Statutory Requirements DCAA Guidance and Procedures DCAA Actual Practice The J. F. Taylor Case The Metron Case Techniques for an Affirmative Defense 2

4 Rules and History

5 THE STATUTORY CEILING Allowability for GovCon senior executives is capped by statute (10 U.S.C. 2324(e)(1)(p) and 41 U.S.C. 256(e)(1)(p)) at a benchmark Does not limit pay, only allowability Benchmark is median of total comp paid top five employees at each home office and segment of U.S. public companies over $50 million 4

6 HISTORY OF THE STATUTORY CEILING 5

7 RECENT DEVELOPMENTS 2012 NDAA extended applicability of statutory Exec Comp cap from top five Exec s to all GovCon employees 2011 Benchmark set 4/23/2012 at $763,029 an increase of $69,078 over 2010 Applies to contracts awarded on/after 1/1/2011 6

8 MORE DEVELOPMENTS 5/18/2012, House rejected an amendment to HR 4310, the 2013 NDAA, that would have limited allowable (GovCon employee) compensation to $400,000 (President s salary) 6/29/2012, Senate Armed Services Committee released its markup of S 2467, the 2013 NDAA, with GovCon employee pay cap of $230,700 Election year posturing or real possibility? 7

9 THE LANGUAGE Currently, 10 USC 2324(e)(1)(P) makes unallowable any contractor employee compensation in excess of the benchmark compensation amount determined applicable for the fiscal year by the Administrator for Federal Procurement Policy under section 1127 of title 41 (currently $763,029) Section 842 of the SASC version of the 2013 NDAA would change that to read the annual amount payable under the aggregate limitation on pay as established by the Office of Management and Budget (currently $230,700) (Emphasis added) 8

10 STATUTORY CEILING TREND 9

11 FAR and Statutory Requirements

12 FAR REQUIREMENTS AND CITES GENERAL FAR Compensation for Personal Services (a) General. Compensation for personal services is allowable subject to the following general criteria and additional requirements contained in other parts of this cost principle. (1) Compensation for personal services must be for work performed by the employee in the current year (2) The total compensation for individual employees or job classes of employees must be reasonable for the work performed 11

13 FAR REQUIREMENTS AND CITES-EXEC COMP FAR Compensation for Personal Services (p) Limitation on allowability of compensation for certain contractor personnel (1) Costs incurred after January 1, 1998, for compensation of a senior executive in excess of the benchmark compensation amount determined applicable for the contractor fiscal year by the Administrator, Office of Federal Procurement Policy (OFPP), under Section 39 of the OFPP Act (41 U.S.C. 435) are unallowable [under] (10 U.S.C. 2324(e)(1)(P) and 41 U.S.C. 256(e)(1)(P)). FAR not yet modified for 2012 NDAA change 12

14 DCAA Guidance and Procedures

15 DCAA GUIDANCE AND PROCEDURES Primary Exec Comp review is during audit of the Incurred Cost Submission for the applicable FY DCAA s sample notification letter to the ACO of ICS planned start includes During the audit, we plan on evaluating the following: labor and material cost transfers material requirements indirect expenses with focus on executive compensation, depreciation, public relations and advertising, and employee morale interdivisional cost transfers 14

16 DCAA PROCEDURAL BASICS If the company under audit is public DCAM 3-1S1 - Supplement-Contractor Securities and Exchange Commission Reports states [Incurred Cost Submission] Schedule T, "Compensation of Officers," discloses executive compensation. This compensation may be reviewed for reasonableness and may be compared to SEC filing (Form 10-K) for any differences. 15

17 DCAA PROCEDURAL BASICS DCAM Audit of Executive Compensation Para (a) cautions auditors that Exec Comp should be evaluated separately Para (b) states that Execs should include those with a title of VP or above and those responsible for managing executive office, controller-accounting, legal counsel, engineering, manufacturing, purchasing, contracts, and individuals responsible for major programs or product lines. 16

18 DCAA PROCEDURAL BASICS DCAM Audit of Executive Compensation Para (c) cautions that Execs are Executives are not a class of employees Para (d) tells auditors that Executives may be rewarded not only for their contribution to the organization, but also on the profitability of their functional unit, as well as the overall profitability of the company. 17

19 DCAA PROCEDURAL BASICS DCAM Audit of Executive Compensation Para (g) specifically acknowledges that pay exceeding 110% of the amount established as reasonable by a Comp Survey may be justified by clearly superior performance when the executive has responsibility for overall management of a segment or firm But, apparently, nobody believes it! 18

20 COMMON MISSTEPS OF GOVERNMENT CONTRACTORS Making sure their executive compensation is below the OFPP cap and calling it a day 110% in excess is not being substantiated by metrics Policies and procedures may not be in place Trying to figure out/defend this stuff 6 years after the fact Is there materiality in executive compensation? 19

21 HIGHER RISK COMPENSATION Compensation to Owners of closely held corporation is called out as having higher risk as Owners have the ability to influence their own compensation Owner compensation must be reasonable and not a distribution of profits (however, not automatically unallowable if a distribution of profits on the accounting records as a result of accounting methodology) 20

22 DCAA Actual Practice

23 DCAA PROCEDURAL SPECIFICS DCAM Review for Unreasonable Compensation Para (g) cites the Techplan ASBCA Case No , 96-2, BCA and establishes these steps for evaluation of Exec Comp Determine position Identify surveys considering revenues, industry, geographic location, and/or other relevant factors Update data to common point with escalation factors Array data from survey(s) for relevant compensation elements at various levels and develop a composite number for each Determine which numbers to use. In most cases, use average or median data Apply a range of reasonableness to the numbers selected. DCAA policy is to use 10 percent as the range of reasonableness. Adjust cash compensation for lower than normal fringe benefits Compare the adjusted compensation to range of reasonableness and question differences 22

24 DCAA PROCEDURAL SPECIFICS Unfortunately, the very detailed and specific procedures of DCAM (g) are not compatible with the policy set forth in DCAM (g) And, DCAA runs on PROCEDURES 23

25 The J.F. Taylor Case

26 THE J. F. TAYLOR CASE* J.F. Taylor challenged the results of Executive Compensation Reviews (as a part of ICS audits) for four FYs and final decisions appealed in 2007, and heard at the ASBCA in 2009 J. F. Taylor challenged DCAA s methodology on multiple grounds, but statistical validity of the results was the central focus of the appeals *Appeals of J.F. Taylor, Inc., ASBCA Nos , J. F. Taylor was represented by Richard B. O'Keeffe, Jr. and Nicole J. Owren- Wiest of Wiley Rein LLP 25

27 THE J. F. TAYLOR CASE The company alleged that the DCAA method: Ignored survey data dispersion and employed an arbitrary 10% "range of reasonableness" Ignored differences in survey sizes Failed to consider the company's financial performance Failed to consider other relevant factors that may explain compensation variations 26

28 THE J. F. TAYLOR CASE In its January 18, 2012, ruling, the Board observed that the Government "made no effort to respond to statistical arguments." The Board then ruled for J. F. Taylor and described the DCAA methodology as fatally flawed statistically and therefore unreasonable. 27

29 THE J. F. TAYLOR CASE DCMA requested the ASBCA reconsider its ruling in J. F. Taylor DCMA did NOT Appeal the ruling(s) as has often been reported (that would have been to the Federal Circuit Court, not the ASBCA and the May 17 deadline for that has passed) Present any new data or arguments in its request for reconsideration The ASBCA has not ruled on the request for reconsideration 28

30 THE J. F. TAYLOR CASE WHAT S IT MEAN? Because the case (successfully) challenged DCAA s basic statistical methodology, far-reaching impacts are likely DCAA will probably have to revise process of evaluating reasonableness Validity of past/ongoing exec comp audits, carried out using the fatally-flawed method, and resulting in disallowances, could be called into question 29

31 The Metron Case

32 THE METRON CASE* Metron challenged Exec Comp Reviews conducted during ICS audits of FYs 2004/2005 DCAA questioned more than $1M of Exec Comp claimed in 2004/2005 for $16.5M/$18.3M firm In its analyses, DCAA used data from four (4) different surveys, adjusted in various ways *Appeals of Metron, Inc., ASBCA Nos , 56751, Metron was represented by Stephen D. Knight, Esq. of Smith Pachter McWhorter PLC 31

33 THE METRON CASE Metron alleged that the DCAA Method(s): Used data from inappropriate surveys for comparison Inappropriately adjusted survey data to compensate for missing data Inappropriately adjusted survey data to account for revenue accountability of individuals Inappropriately concluded that individuals without VP title were not (therefore) in charge of units or responsible for a distinct product line Failed to recognize in any meaningful way the superior performance of the firm 32

34 THE METRON CASE In its June 5, 2012, ruling, the Board concluded Metron had met the burden of proof that the costs in dispute were reasonable, stating that Payments at the 50th to 75th percentiles were reasonable because of accomplishments and performance of the firm and its Executives Use of multiple surveys to average was inappropriate when one of the surveys fit Gov t extrapolations, adjustments, and regressions of the survey data were statistically flawed 33

35 THE METRON CASE This is the second severe blow to DCAA s Exec Comp methodologies and the reputation of the Team Will we see a request for reconsideration of Metron (as in J. F. Taylor)? Will DCMA appeal to the Circuit Court (as it did NOT in Taylor)? 34

36 THE METRON CASE MEAN? WHAT S IT Should be a warning to firms to document the basis for all Exec Comp Should also encourage firms to challenge DCAA s questioned costs when they are arbitrary or ill-considered The Board has effectively established a precedent for using data at other than the median based on firm performance and THEN drawing a 10% box around that! 35

37 Techniques for an Affirmative Defense

38 TYPICAL DCAA MISSTEPS It often uses whatever survey data is at hand regardless of fit It sometimes picks survey data for its fit to its positions rather than the firm It sticks with the 10% range of reasonableness NO MATTER WHAT! It almost NEVER considers ANY of the factors that might support higher comp levels 37

39 BEST PRACTICES AND A PROACTIVE DEFENSE JFT attacked the disarray of the DCAA working papers on which the disallowance was based Create and maintain detailed contemporaneous records and rationales for compensation decisions If Execs have broad responsibilities, document them File dated position descriptions (yes, even for Execs) and Org Charts with the ICS for the year particularly if it supports responsibilities for companywide activities 38

40 BEST PRACTICES AND A PROACTIVE DEFENSE Engage DCAA auditors during the review Request survey data used and request explanations of key issues and DCAA decisions Where possible, perform your own statistical analyses of survey data alongside the DCAA auditors From testimony of one of the J. F. Taylor experts "[a]ny person with a freshman statistics course can do the calculation." 39

41 BEST PRACTICES AND A PROACTIVE DEFENSE Ensure the survey data used is appropriate for your company In a recent client case, DCAA used survey data for generic business services to establish reasonableness for exec comp For the last five years, the firm under audit received 99.6% of all federal prime contract obligations in the NAICS code for R&D in the Physical and Life Sciences 40

42 BEST PRACTICES AND A PROACTIVE DEFENSE If direct engagement with DCAA isn t working, take it to the ACO In light of the ASBCA's rejection of DCAA's current 8-step methodology, ACOs may be less willing to risk dispute and litigation and more willing to push back against DCAA Until J. F. Taylor is final, if you haven t settled, DON T If DCAA or the ACO is pushing you to settle, STALL 41

43 BEST PRACTICES AND A PROACTIVE DEFENSE Pull data on your own company from and analyze for NAICS codes used by the Government Compile and present performance data for your firm relative to similar firms Use data from Deltek, Grant Thornton, PSC, and similar surveys 42

44 BEST PRACTICES AND A PROACTIVE DEFENSE If DCAA digs in, dispute its results Make sure your rebuttal gets into the audit report to the ACO NEGOTIATE, NEGOTIATE, NEGOTIATE! 43

45 QUESTIONS/COMMENTS 44

46 RESOURCES Kristen Soles, Partner (703) GovCon360 keeps you abreast of the ever-changing regulatory environment that is Government contracting. From reference materials, like searchable pdf copies of the FAR and DCAM, to our past Lunch and Learn seminar slide decks and thought pieces on industry matters, we ve got it covered. Subscribe to our RSS feed to receive short alerts on recent industry changes. It s always been our job to help our clients maintain a competitive advantage by staying ahead of the curve. This website is an extension of the services we ve been providing for over 35 years by putting useful resources and up-to-date information at your fingertips. 45

Defending Executive Compensation Successfully. Rich Wilkinson, Director Watkins Meegan LLC

Defending Executive Compensation Successfully Rich Wilkinson, Director Watkins Meegan LLC Agenda Executive Compensation Rules and History FAR and Statutory Requirements DCAA Guidance and Procedures DCAA