Navigating Murky Executive Compensation Rules
By Richard L. Moorhouse and Sean M. Connolly
President Obama appointed Kenneth Feinberg as the administration’s so-called “compensation czar” in June and gave him the authority to set pay for high-level corporate executives of federal bailout funding recipients under the Troubled Asset Relief Program. In October, Feinberg announced executive compensation cuts averaging 50 percent for firms that still owe on their federal debts.
In addition, the American Recovery and Reinvestment Act requires certain government contractor stimulus funding recipients to report names and total compensation of their top five highest paid officers.
While the administration’s focus on executive compensation has been center stage, it’s worth remembering that defense contractors have long been subject to compensation review by the Defense Department’s own “czar,” the Defense Contract Audit Agency. Indeed, some commentators say that DCAA has stepped up its compensation scrutiny in the last several years.
Department policy as enforced by DCAA requires a contractor’s calculated year-end compensation costs to be allowable, reasonable and within the office of federal procurement policy’s statutorily set executive compensation ceilings. Otherwise, contractors may face DCAA disallowances of executive compensation costs and sizable repayments. Thus, allowable and reasonable compensation should be set in advance by management to allow adjustments at the beginning of the year, or alternatively, informed decisions to accept some part of compensation as unallowable.
DCAA auditors conducting compensation audits must first verify that the executive pay at issue includes only allowable elements, compensates only allowable activities and is reasonable. Generally, pay must be for current year work, and certain costs are unallowable even when the company includes them as part of an executive’s compensation. For example, executive pay for lobbying, advertising, or organization/reorganization activities is unallowable.
Also, certain compensation elements are unallowable, including stock options, phantom stock, and stock appreciation rights based on corporate security price changes. Nor are profit distributions allowable costs if made to an executive who is contractually obligated to buy a substantial interest in the company.
After determining the allowable compensation elements and activities, DCAA auditors then determine total compensation reasonableness. FAR 31.205-6(b)(2) deems compensation reasonable “if the aggregate of each measurable and allowable element sums to a reasonable total.” What is a “reasonable total” that DCAA will accept?
The DCAA Contract Audit Manual includes the following factors in establishing an adequate compensation system: organizational structure; lines of authority, duties, and responsibilities; internal controls and managerial reviews; compensation consistency, both internally and externally; pay structures; periodic internal reviews of policy compliance; adequate documentation; definitive flow of authority; and written policies and procedures describing the compensation package.
Compensation reasonableness also includes “benchmarking” with relevant external pay surveys based on the company’s size, industry, geographic area and type of work. Contractors must justify compensation that exceeds the average executive compensation paid by comparable firms for similar duties. Executives who serve in several roles do not automatically justify more compensation if similarly situated executives are often dual-hatted as well. DCAA requires contractors before “benchmarking” to remove unallowable elements and pay, and it often relies on its own national compensation surveys to benchmark executive pay.
After deducting all unallowables, DCAA auditors then apply the office of federal procurement policy’s compensation ceiling, based on the median compensation accrued over 12 months for the top five compensated executives of those publicly traded companies with more than $50 million in annual sales. In May 2009, the office set the new ceiling amount at $684,181, which applies to compensation costs incurred after Jan. 1, 2009.
The case law on compensation disputes is limited, so navigating executive pay issues can become murky, and DCAA auditors have broad discretion on the question of reasonableness. This often becomes a battle of the market surveys, so contractors that plan ahead and come fully prepared, engage a compensation expert, and have a well-documented compensation system, are far better off when DCAA comes knocking on the door for internal audit.
Richard L. Moorhouse (firstname.lastname@example.org) is a shareholder and Sean M. Connolly (email@example.com) is a senior associate with the government contracts practice group and the defense and homeland security practice group in the international law firm of Greenberg Traurig, LLP. The views expressed are solely those of the authors.