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What's Next for DCAA Executive Compensation Audits? What to Do in the Wake of the J.F. Taylor, Inc. Decision

Winter 2012

The Armed Services Board of Contract Appeals recently ruled that the Defense Contract Audit Agency (DCAA) method for analyzing the reasonableness of a contractor's executive compensation under FAR Part 31 is inadequate to support unallowability determinations. The appeals challenged a series of executive compensation audit/reviews (ECRs) over a four-year period and the government's disallowance of over $800,000 in executive compensation. The core of the appeals, litigated by Wiley Rein, was an attack on the lack of statistical method and rigor by the DCAA in its use of compensation survey data to derive a level of compensation for the company's executives that it deems "reasonable." After a full hearing in 2009, the Board ruled on January 18, 2012 that J.F. Taylor, Inc. (JFT) had discredited the DCAA ECR methodology, which it described as "fatally flawed statistically and therefore unreasonable." J.F. Taylor, Inc., ASBCA No. 56105, 2012 WL 261272 (A.S.B.C.A.), *__.

Potential Federal Circuit appeal aside, what intelligence may contractors derive from the decision as it stands now, and what, if anything, can they do to address past, present and future ECRs performed using the current, now discredited, DCAA method? JFT challenged the DCAA's method on several grounds, but the central focus of the appeals was the statistical validity of the results DCAA derived from its use of compensation surveys. Among other critiques, JFT alleged that the DCAA method: ignored compensation survey data dispersion and employed an arbitrary 10% "range of reasonableness" allowance; ignored differences in survey sizes; and, failed to consider the company's financial performance and other relevant factors that may explain compensation variations. At bottom, the Government lost the appeals because it did not appreciate that the survey data upon which it relies are statistical data and, therefore, failed to engage JFT on the critical issues raised regarding the statistical underpinnings of its judgments regarding the reasonableness of JFT's executive compensation.

DCAA's method, described in Defense Contract Audit Manual Sections 6-413.4 and 6-414, is patterned on a process that was used in the ECR involved in the TechplanCorp. appeals, 96-2 BCA ¶ 28426, ASBCA Nos. 45388, 41470, 45387, 1996 WL 391461 (A.S.B.C.A.), a case successfully prosecuted in 1996 by William A. Roberts, III, co-chair of Wiley Rein's Government Contracts practice group. The Taylor decision did not repudiate the method employed by DCAA, a compensation survey-centric, statistical approach. In fact, it recited the 8-step procedure from the Techplan decision verbatim. Although the basic Techplan­-sanctioned ECR method remains intact, the Board in Taylor clearly rejected the DCAA's use of an invariable 10% "range of reasonableness" (ROR), not required by Techplan. Moreover, because the Government did not defend against JFT's other statistical critiques, the way that DCAA uses statistics to derive "reasonable" compensation from survey data has been found to be "fatally flawed."

JFT challenged other aspects of the DCAA method, arguing that the ECRs could not be sustained because the method "market priced" JFT' s executive compensation at the median without adequate consideration of the company's superior performance; because the method used did not yield auditable and reliable results; and, because DCAA failed to evaluate the compensation of the JFT vice presidents based on the revenues of the whole company even though each vice president had company-wide responsibilities for the success of the company. In regard to this last argument, the amount of revenue is a material factor in computing reasonable compensation; in essence, the more company revenue attributed to an executive, the higher the reasonable compensation. DCAA argued that three of the four vice presidents were responsible for only a portion of total company revenue, and thus the compensation deemed reasonable for these three executives was lower than it would have been had they been credited with total JFT revenue. On this issue the Board sided with DCAA, finding that, on the facts of these appeals, the DCAA approach to revenue attribution was correct. But overall, the DCAA method, from a statistical standpoint, was left in ruins by the Board's JFT decision.

Now What?

Well, first, it remains to be seen whether the agency appeals the decision to the Court of Appeals for the Federal Circuit (CAFC). The agency has until May 17, 2012 to make that decision. Moreover, because the Board found the DCAA's ECR methodology unreasonable, the J.F. Taylor decision is likely to have an impact that extends well beyond these appeals. At a minimum, DCAA will need to revise the process by which it evaluates the reasonableness of executive compensation, thereby affecting future reviews. In addition, the validity of past and ongoing executive compensation audits, carried out using the fatally-flawed method, and which resulted in substantial disallowances, could potentially be called into question through the disputes process or otherwise. However, past ECRs that have been merged into global settlements of annual incurred cost submission audits, and final indirect rate determinations that have, in turn, been embodied in executed bilateral modifications, may be difficult to reopen. Moreover, even if such an final rate agreement could be reopened, it could be risky for a contractor to seek to do so without careful consideration of the consequences. If an agreement were set aside on the basis of a "Taylor­-made" challenge, the Government might assert that other aspects of the settlement, such as unrelated concessions granted during negotiations, were likewise again in play. Thus, any contractor contemplating such an effort should give serious thought to the potential impact on the total settlement and bottom line.

Beyond possible reopening of completed ECRs, there are several best practices that contractors can adopt in order to take advantage of the lessons of the Taylordecision:

JFT strongly attacked the disarray and incompleteness of the DCAA ECR working papers that formed the basis for the disallowance. Although the Board did not rule on this issue, contractors should strive to create and maintain detailed contemporaneous records and rationales for key compensation decisions. Such documentation will be compelling evidence if a dispute arises. Moreover, until the DCAA enforces greater discipline in the creation and maintenance of complete ECR working papers, a contractor with good documentation on its side will look better by comparison, as did JFT.

If executives have company-wide responsibilities which may qualify them to have total company revenue attributed to them, these responsibilities should be fully documented in position descriptions, organizational charts and the like, and these documents should be updated often to reflect any changes over time. By doing so, a company will be in a position to avoid segmenting of company revenue, and thereby driving down the level of compensation deemed reasonable and thus allowable.

Engage the DCAA auditors during their review. Request the survey data being used and seek, in real time, explanations of key issues and DCAA decisions. Where possible, companies should perform their own statistical analyses of survey data alongside the DCAA auditors. As JFT's expert, Mr. Jimmy J. Jackson, testified at the hearing, "[a]ny person with a freshman statistics course can do the calculation." While it may not be quite that simple, the point is that the technique used by JFT, and accepted by the Board, is not the sole province of advanced mathematicians.

Using the Taylor decision for support, carry the fight to the Contracting Officer, if direct engagement with DCAA is unavailing. In view of the Board's unambiguous rejection of the DCAA's implementation of the Techplan 8-step process, contracting officers may be less willing to risk dispute and litigation and, at a minimum, should be more willing to push back against DCAA conclusions.

It is too early to discern the Government's response to the Taylor decision. Nevertheless, certain conclusions can be drawn. First, if there is no immediate ECR stand down, all in-process or new ECRs are subject to legal challenge. Affected contractors should subject any resulting disallowances to close scrutiny, and consider using the Disputes process in cases reflecting flaws in the execution of the reviews similar to those described in Taylor. Second, if the DCAA does change its methodology, the new approach must itself be carefully analyzed to determine whether it adequately addresses not only the statistical flaws enumerated in the Taylor decision, but also the non-statistical critiques asserted by JFT, but not ruled upon by the Board. These may themselves serve as free-standing legal bases for challenge to the results, or they can add weight to statistically-based arguments. Finally, contractors should review their own policies and processes for determining executive compensation, and their approaches to dealing with ECRs, to ensure that they have maximized their ability to avoid improper and unjustified disallowances based on a fatally-flawed DCAA method.

Wiley Rein attorneys Richard B. O'Keeffe, Jr. and Nicole J. Owren-Wiest represented J.F. Taylor, Inc. in these appeals. As appellate counsel, Mr. O'Keeffe and Ms. Owren-Wiest have a very detailed appreciation for the various issues raised in regard to the DCAA method, and are prepared to advise contractors in need of advice in regard to executive compensation issues raised by DCAA-conducted ECRs, and the most cost-effective options for addressing them.