In a recent decision, the Small Business Administration’s (SBA) Office of Hearing and Appeals (OHA) allowed a large concern, the dominant minority stockholder, to impose a limited form of negative control over a small business concern without treating the two concerns as “affiliates” for size determination purposes. In Size Appeal of EA Engineering, Science, and Technology, Inc., OHA held that EA Engineering, Science, and Technology, Inc., a small concern, was not affiliated with its minority stockholder, a much larger concern, despite EA Engineering’s stockholder agreement, which effectively permitted the large concern to block EA Engineering from changing its organic documents, issuing additional shares of capital stock, and entering into a substantially different line of business.

Prior to this decision, SBA had offered limited guidance as to what, if any, form of negative control a large concern could impose and/or exercise over a small concern without resulting in affiliation. SBA’s uncertain treatment of negative controls has undoubtedly impeded small businesses’ access to capital, because large concerns interested in investing in small concerns could not be assured that the small concerns would remain eligible for government contracts under small business setaside standards and procedures. Thus, OHA’s approval of the use of a supermajority shareholder voting requirement intended to protect the minority stockholder’s investment from fundamental changes in the small concern’s businesses or capital structure should have the effect of encouraging some large businesses to invest in small businesses.

Case Summary

In 2007, the Air Force Center for Environmental Excellence issued a request for proposal for about 20 environmental remediation services contracts, several of which were set-aside for small businesses. The Air Force selected, under the small business set-aside, EA Engineering for negotiations of one of the contracts. However, an unsuccessful competing offeror, FPM Group, Ltd., filed a size protest with the SBA, claiming that EA Engineering failed to meet the required 500 employee size standard because of EA Engineering’s alleged affiliation with the Louis Berger Group (LBG), a minority stockholder of EA Engineering and a much larger concern.

FPM Group primarily argued that LBG, a minority stockholder in EA Engineering, could exercise negative control over EA Engineering, and, therefore, the two firms were affiliated for purposes of the employee size standard. The SBA affiliation regulations, 13 C.F.R. § 121.103, equate negative control with a minority shareholder’s ability to prevent a quorum or otherwise block action by the board of directors or shareholders of the small concern. EA Engineering’s stockholder agreement requires a supermajority of shareholder votes to execute three specific actions: changes to the certificate of incorporation or bylaws, issuance of additional shares of capital stock, and entrance into a substantially different line of business. Although LBG’s 49.5 percent ownership stake in EA Engineering cannot prevent the board from reaching a quorum, it does result in shareholder blocking power if EA Engineering sought to pursue one of the above three enumerated actions.

OHA, reversing the SBA Area Office’s determination, held that EA Engineering and LBG were not affiliated because LBG’s negative control did not interfere with the daily business operations of EA Engineering. After analyzing its precedent on negative controls, OHA concluded that negative control results in affiliation only when the control affects the management of the small concern’s daily operations. In EA Engineering’s case, the negative control did not affect the EA Engineering board’s ability to reach a quorum, nor EA Engineering’s management of its daily operations. Rather, the negative control only extended to three extraordinary situations that were intended to protect LBG’s investment in EA Engineering. Accordingly, OHA held that SBA’s size regulations did not intend for this type of “protective” negative control to result in size affiliation.

Practical Impact

This decision provides some guidance to large businesses interested in investing in small concerns. Now, large businesses can structure stockholder agreements to protect their investments by using a supermajority shareholder voting approval requirement so long as it applies only to welldefined events likely to fundamentally change the nature of the investment—i.e., changes in the small concern’s line of business, capital structure, and organic documents. By contrast, if the approval requirement covers events capable of interfering with the ordinary daily management of the small concern, it will likely result in affiliation, jeopardizing the small concern’s ability to compete for government contracts set-aside for small businesses.

While this decision provides some clarity into the kinds of negative controls likely to result in affiliation, grey areas remain. For example, it remains uncertain whether a mechanism other than a supermajority shareholder voting approval requirement would result in affiliation regardless of the actions subject to approval, or whether minority shareholder blocking power over a large expenditure by the small concern would result in affiliation. At the very least, this decision approves the use of a supermajority shareholder voting approval requirement for changes to a small concern’s organic documents, issuances of additional capital stock, and entrances into a new line of business.