On April 27, the Small Business Administration (SBA) issued a final rule which, effective May 30, will make a number of changes to the SBA regulations impacting small businesses. The regulations, finalizing the proposed rule issued on September 9, 2022, provide new penalties for noncompliance with the limitations on subcontracting rule, updated joint venture (JV) and size requirements, and changes to the ostensible subcontractor rule. This post dissects the regulations and highlights a few noteworthy changes below.
Penalties for Noncompliance with Subcontracting Limitations for Small Businesses
13 CFR 125.6 places certain limitations on how much work small business set aside contracts over the simplified acquisition level can be subcontracted to third parties. The percentage of “subcontract-able” work depends on the type of prime contract. For example, most small business prime contractors (or similarly situated contractors) must perform 50% of supply and service contracts, but prime contractors performing on general construction contracts are only required to self-perform 25%. The limitations effectuate the intent of the small business set aside program requiring work to be done by small businesses ensuring the viability of the small business contracting community.
Unfortunately, the regulations are frequently ignored or exploited due to the limited consequences associated with failure to comply. First, it has been largely inappropriate to raise noncompliance under a size protest because it is not an eligibility issue. Further, bid protests are normally similarly doomed unless noncompliance is clear on the face of the proposal. The September proposed rule recommended prohibiting contracting officers (COs) from giving noncompliant small business prime contractors satisfactory past performance ratings. The final rule found a middle ground.
Specifically, the final rule gives COs the option to decline to give small prime contractors who have not met the applicable limitation on subcontracting requirements a satisfactory or higher past performance rating unless the contractor can demonstrate extenuating or mitigating circumstances. The final rule includes a non-exhaustive list of “extenuating or mitigating circumstances” including: “unforeseen labor shortages, modifications to the contract’s scope of work which were requested or directed by the Government, emergency or rapid response requirements that demand immediate subcontracting actions by the prime small business concern, unexpected changes to a subcontractor’s designation as a similarly situated entity (as defined in § 125.1), differing site or environmental conditions which arose during the course of performance, force majeure events, and the contractor’s good faith reliance upon a similarly situated subcontractor’s representation of size or relevant socioeconomic status.” This “middle ground” will provide some much-needed teeth to the subcontracting limitation requirement.
JVs and Size Regulations
Under current SBA regulations, a specific JV would be considered affiliated for contracts awarded beyond two years from the award of the first contract. The final rule clarifies the SBA’s position, differentiating between orders and contracts. The new language under 12 CFR 121.103(h) will state, “a joint venture may be issued an order under a previously awarded contract beyond the two-year period.”
Populated vs. Unpopulated JVs
The final rule also clarifies how the SBA should treat populated JVs – allowing their use in certain situations. Current SBA regulations prohibit JVs that exist as separate legal entities from being “populated” with “individuals intend[ing] to perform the contracts awarded to the joint venture.” The final rule clarifies that “a populated joint venture could be awarded a contract set aside or reserved for small business[es] where each of the partners to the joint venture were similarly situated.” This means a JV comprised of two small businesses of the same socioeconomic designation may use a populated JV.
For size purposes, populated JVs will be judged by “aggregate[ing] the revenues or employees of all partners to the joint venture.” “Where two or more parties form a separate business entity (e.g., a limited liability company or partnership) and populate that entity with employees intended to perform work on behalf of that entity, SBA similarly views that as an ongoing business entity and will aggregate the receipts/employees of the parties that formed the separate business entity in determining size.”
Ostensible Subcontractor Rule
The final rule also clarifies how the ostensible subcontractor rule applies to general construction contracts and prime contractors performing on services, specialty trade construction and supplies contracts. It also added two risk factors for COs to “consider in determining whether a specific subcontractor should be considered an ostensible subcontractor.”
First, the SBA acknowledged that “the primary role of a prime contractor in a general construction project is to superintend, manage, and schedule the work, including coordinating the work of various subcontractors. Those are the functions that are the primary and vital requirements of a general construction contract and ones that a prime contractor must perform…” Therefore, the ostensible subcontractor rule “should be applied to the management and oversight of the project, not to the actual construction or specialty trade construction work performed.”
In addition, the final rule will add two factors to consider when determining whether a subcontractor is an ostensible subcontractor. The factors come from an SBA Office of Hearings and Appeals (OHA) decision in Size Appeal of DoverStaffing, Inc., SBA No. SIZ-5300 (2011): “the prime contractor’s proposed management previously served with the subcontractor on the incumbent” and “the prime contractor lacks relevant experience and must rely upon its more experienced subcontractor to win the contract.”
Lastly, the final rule will also update the regulations to reflect that the “SBA will find that a small business prime contractor is performing the primary and vital requirements of the contract or order” when performing on a “contract or order set-aside or reserved for small business for services, specialty trade construction or supplies” if “the prime contractor can demonstrate that it, together with any subcontractors that qualify as small businesses, will meet the limitations on subcontracting provisions set forth in § 125.6.” The updated language gives those contractors performing services, specialty trade construction or supplies contracts a potential defense to the ostensible contractor rule.
Recertification Following Sale or Merger
Lastly, the final rule clarifies that recertification of a business’ size must be completed following a sale or merger. “However, recertification in connection with a ‘sale’ or ‘acquisition’ is required only where the sale or acquisition results in a change in control or negative control of the concern.” The SBA never intended for non-controlling stock sales to trigger the mandatory recertification process.
The final rule makes several clarifications to the SBA’s regulations. Some of those changes, including the changes to 13 CFR 125.6, could have a measurable impact on contractors. These changes are only a portion of the broad rule primarily focused on clarifications and revisions to the SBA’s 8(a) regulations. This blog will detail these new 8(a) changes in an upcoming post.