On December 29, 2014 and February 5, 2015, the U.S. Small Business Administration (“SBA”) proposed rules that, if adopted, will significantly change current regulations relating to a wide range of small business issues. The proposed rules implement significant portions of Congress’ National Defense Authorization Act of 2013 (“NDAA”) as well as other long-planned revisions to SBA rules. Comments in response to the December 29, 2014 changes are being review by SBA.  Comments in response to the February 5, 2015 changes are due May 6, 2015.

This bulletin focuses on the most important (and controversial) proposed changes, including:

1. Limitation on Subcontracting

2. Mentor-Protégé Program

3. Affiliation

4. Nonmanufacturer Rule

5. Post-Acquisition Recertification for Pending Offers

1.  Limitation on Subcontracting

The NDAA prescribed a new method of calculating limitations on subcontracting (“LoS”), and the proposed rule implements the NDAA.  Under the proposed rule, prime contractors on set-aside contracts may not expend on subcontracts more than 50% of the total amount paid to the prime by the Government.  Ostensibly, this means that prime contractors are no longer able to exclude the cost of materials, supplies, and other non-labor costs from the subcontracting limit calculation.  The percentage limit continues to be 50% for manufacturing and service contracts, 15% for construction contracts, and 25% for specialty trade contracts.  These limits apply to full or partial small business set-aside contracts, 8(a) contracts, SDVO SBC contracts, HUBZone contracts, and WOSB or EDWOSB contracts, where contract value exceeds $150,000.

The new rules also allow small business prime contractors to meet their LoS obligations by subcontracting to “similarly situated” entities.  This means that, for example, on a $10 million 8(a) set-aside contract, the 8(a) prime contractor and an 8(a) teaming partner, combined, could together retain only $5 million of the $10 million contract without violating the LoS rule.  The prime could count the performance of its similarly situated 8(a) subcontractor towards its performance requirement.  However, if a “similarly situated” entity subcontracts further to a non-similarly situated entity, those lower tier dollars would not count toward the prime’s LoS compliance.

Limitation on Subcontracting Compliance: Compliance is the responsibility of the prime contractor, who must certify compliance in its offer, and must identify any similarly situated teaming partners in its proposal (as well as the amount of the contract to be spent on each similarly situated teaming partner).  A written agreement between the prime contractor and each such entity is required, and the prime contractor must notify the contracting officer in writing of any change in its subcontracting if it falls out of compliance with the LoS.

Further, as the NDAA mandated, the penalty for violating the LoS is the greater of either $500,000 or the dollar amount spent in excess of the permitted levels for subcontracting.

Contracting Officer Responsibilities: If compliance is not apparent in the offer, then the contracting officer may seek a Certificate of Competency from SBA. The contracting officer must be satisfied that the small business will comply at time of award.

Period for Measuring Compliance: For a total or partial set-aside, prime contractors must comply with the LoS during the base period, and then during each option period.  Contractors are not allowed to fall out of compliance during the first years and then rebalance work share in the out years to achieve compliance by contract end.

Analysis: These new rules present a sea change for small business prime contractors, but the new rules require further refinement.  Below are two examples:

1.  Total amount paid v. “cost incurred”: The proposed rules tie LoS compliance to the total amount paid rather than the “cost incurred.”  This should make compliance simpler, at least mathematically.  But further guidance is needed on what, if any, costs can be excluded under this measurement.  For example, service contracts often include significant material costs that under the previous rule would have been clearly removed from the calculation.  The proposed rule suggests that when a procurement involves both services and supplies, whichever is the higher value component dictates the applicable LoS requirement, and the minority portion of the procurement appears to be wholly excluded from the LoS calculation.  See 79 Fed. Reg. 77967 (Dec. 29, 2014).  In other words, if there is a $3 million set-aside contract, $2.5 million of which is for supplies and $0.5 million is for services, the services portion is excluded from consideration.  The small business prime could retain 50% of only the $2.5 million paid for supplies, and could, ostensibly, subcontract 100% of the services component without impacting LoS compliance.  While this is a well-intentioned aspect of the proposed LoS requirements, SBA should explain more specifically how the new rules are intended to work, particularly in light of the new, draconian penalties for noncompliance.

 2.  Construction LoS Requirement: Previously, the rule required primes to perform 15% of the cost of the contract, not including the cost of materials.  The new rule would appear to require primes to retain no less than 85% of the contract value, with no apparent exclusion for material costs.  Some construction firms have expressed confusion over this, as the market reality often results in the prime (general contractor) retaining no more than 5% of total contract value.  Accordingly, for compliance to be feasible in present market conditions, it may be appropriate for SBA to clarify that material costs are excluded from this LoS calculation, or to amend the percentage limit applicable to construction contracts.

2.  Mentor-Protégé Expansion

SBA has proposed to expand its mentor-protégé program to all small business programs — establishing one uniform set of rules for SDVOSB, WOSB, HUBZone firms, 8(a) program participants, and small businesses. The new program is based on the existing 8(a) mentor-protégé program, but has actually relaxed some of the eligibility requirements that were unique to the 8(a) program (and thus inappropriate for universal application).

Benefits of the new program are roughly the same as the current 8(a) program — mentors are obligated to provide assistance to protégés in exchange for being able to form mentor-protégé joint ventures that are eligible to bid on set-aside contracts, provided that the protégé is small for the procurement in question, but regardless of whether the mentor is large.  Besides expanding the program to all types of small businesses, the new program is largely the same as the current 8(a) mentor-protégé program.  Among other requirements:

• SBA has to approve the mentor-protégé relationship, which must be set forth in a written agreement.
• Mentors are typically able to have only one protégé, and vice versa, but SBA may approve additional relationships where a new agreement will not harm or compete with the prior agreement.
• SBA will annually review the relationship to ensure compliance with the agreement.
• A mentor may take up to a 40% equity interest in its protégé.

Analysis: The impact of this proposed expansion will be undoubtedly significant.   Expanding the program will be welcomed by many small businesses who have long sought to partner with large businesses but have been wary of affiliation pitfalls.  However, 8(a) program participants may be dismayed that they are no longer the exclusive beneficiaries of the program.  Further, the widespread availability of mentor-protégé agreements might result in a competitive landscape that virtually requires a mentor-protégé JV to win contracts.  Such a landscape could harm emerging small businesses that lack ties with potential large mentors.  As a result, the success of the program expansion — in terms of its ability to genuinely foster small business development — will depend on the effective exercise of SBA’s approval and oversight authority.

3.  Affiliation

Identity of Interest:  The proposed rule expands the presumption of affiliation due to an identity of interest to include firms who are owned or controlled by married couples, parties to a civil union, parents and children, or siblings.  The presumption of affiliation is rebuttable, and applies only where firms conduct business with each other, or provide loans, resources, equipment, locations or employees to each other.

Economic Dependence:  The proposed rule sets forth an explicit rebuttable presumption of affiliation where one firm derives 70% or more of its revenue from another firm during the previous fiscal year.

Analysis: These rules are not truly new; they codify prevailing case law to better provide warning to small businesses who may be flirting with affiliation without clear guidance from the SBA code.  With respect to the former change, regarding familial ties, the presumption will be more easily rebuttable where the two firms can show a clear line of fracture between their interests, perhaps because they are in different markets.  With respect to the latter change, this presumption may be more easily rebuttable for new entities that have only received a few contracts (i.e., start-up companies).  As the entity matures, however, it is likely that SBA will expect it to diversify the source of its revenue.

4.  Nonmanufacturer Rule

Based on existing rules and statutes, the nonmanufacturer rule requires small business prime contractors who obtain set-aside supply contracts to provide products manufactured in the United States by other small businesses, unless the rule has been waived by SBA.  This rule applies only to supply contracts to which a manufacturing NAICS code has been assigned.

Waivers:  Previously, it was often unclear whether a waiver applied to the class of products being supplied.  Under the proposed rule, however, contracting officers must notify potential offerors if a waiver applies to the procurement.

Software:  The proposed rule states that when the Government seeks modified or customized software under a set-aside procurement, the procurement must be assigned a services NAICS code.  Thus, the nonmanufacturer rule will not apply.  Where the Government seeks stock software that is readily available, this is a supply contract to which the nonmanufacturer rule applies (unless waived).

Analysis: The above change to nonmanufacturer rule waivers is significant because it may introduce a new basis for bid protests. Although the proposed rule is not explicit on this issue, the rule does create a new opportunity for contracting officers to exercise discretion by determining whether an available nonmanufacturer class waiver applies to the procurement at hand.  Where a prospective bidder disagrees with this determination, it may be subject to review through the bid protest process.

5.  Post-Acquisition Recertification for Pending Offers

The proposed rules require small businesses that are acquired or undergo a merger to recertify size status on pending offers prior to award.  Currently, the recertification rules are vague; the duty to recertify after an acquisition or merger comes from a contract clause — Post-Award Small Business Program Representation (FAR 52.219-28) — which does not become enforceable until a contract is awarded.  Accordingly, entities acquired during the pendency of a bid often choose to wait for a contract to be awarded before recertifying size.  And, after award, even if they recertify as large, they are usually able to keep the set-aside contract won prior to the recertification.

Analysis: The proposed change is controversial because it may affect company valuation or otherwise discourage investment in small businesses.  One obvious, yet unanswered, question is whether recertification as “large” prior to a set-aside award makes the offeror ineligible for the award.  Further, as written, the rule would be difficult to comply with because recertification must occur “prior to award,” but award timing is not under the control of the contractor.  SBA will hopefully clarify both issues in its final rule.

Conclusion

Significant changes have been proposed that will, if implemented, impact all small businesses contracting with the federal government.  As illustrated above, there are some key areas that could be clarified and improved.  Meanwhile, in anticipation of the new rules, small business contractors should review their internal compliance procedures and teaming strategies to ensure they are ready to comply with, or take advantage of, these new rules. 
 

Stephen P. Ramaley is a government contracts lawyer with experience prosecuting and defending bid protests before the U.S. Court of Federal Claims, executive branch agencies, and the GAO. Steve also assists public and private entities with regulatory compliance; government audits and fraud investigations; domestic preference rules (BAA/TAA) and export control laws; intellectual property rights and cyber-security; subcontractor and teaming agreements; and other matters relating to domestic and international commerce.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this post is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents.