On February 11, 2011, the U.S. Small Business Administration (SBA) issued a final rule making significant changes to its 8(a) business development program, and to size regulation.

The proposed rule, which was issued on October 28, 2009, purported to codify many of SBA’s existing policies and practices, proposed significant changes to SBA’s current regulations and implicitly overruled certain decisions of SBA’s Office of Hearings and Appeals (OHA). (For a discussion of the proposed rule, see Holland & Knight’s November 2, 2009 Alert on that topic.)

The final rule adopts most, but not all, of the changes from the proposed rule, including significant changes to SBA’s mentor-protégé program and regulations applicable to joint ventures, including those between mentors and protégés, for both 8(a) and non-8(a) small business set-aside contracts. In particular, the final rule provides welcome clarification on the distinction between a “populated” and an “unpopulated” joint venture. This alert updates our previous discussion and provides a summary of the most significant changes in the final rule related to mentor-protégé relationships and joint ventures.

Number of Offers/Contracts Per Joint Venture

SBA’s current regulations limit a specific joint venture to submitting no more than three offers over a two-year period.

The proposed rule would have changed the limit from three offers to three contract awards under one joint venture agreement within a two-year period. The proposed rule also confirmed that the same members to a joint venture could form additional joint ventures and be awarded three additional contracts for each. The proposed rule, however, made clear that at some point, too many joint ventures between the same parties could lead to a finding of general affiliation (codifying SBA’s existing policy).

The final rule adopts all of the above changes from the proposed rule. As a result, a joint venture may now be awarded three contracts within a two-year period under the same joint venture agreement. After the three-contract limit has been reached, the same joint venture members may form a new joint venture to pursue and perform three additional contracts.

“Populated” Versus “Unpopulated” Joint Ventures

Over the past few years, there has been increasing uncertainty on whether SBA required joint venturers to “populate” a joint venture with its own employees or simply use the employees of the individual joint venturers to perform the contract. The existing regulations provided almost no guidance for joint venturers on this important distinction.

The proposed rule purported to “clarify” SBA’s current policy that if a joint venture was formed as a separate legal entity, then it must have its own employees. If, however, the joint venture was not a separate legal entity, then it need not have its own separate employees and employees of each of the individual business entities may perform work for the joint venture.

SBA received several comments on this aspect of the proposed rule. Several commenters opposed this policy and the proposed rule. SBA was persuaded by these comments and, thus, the final rule does not adopt this aspect of the proposed rule. Rather, the final rule states that a joint venture that is a separate legal entity, may be, but is not required to be, populated with employees.

SBA Approval of 8(a) Joint Venture Agreements

SBA’s current regulations require SBA approval of joint venture agreements for 8(a) contracts prior to award, but do not require approval of joint venture agreements for non-8(a) contracts (i.e., small business set-aside contracts).

The proposed rule allowed the parties to a previously approved joint venture to obtain SBA approval for a second and third 8(a) contact by merely providing SBA an addendum to the original agreement outlining the scope of work for the new contract. The final rule adopts the proposed change without modification and retained the current rule of not requiring approval for joint venture agreements for non-8(a) contracts.

Joint Ventures for Non-8(a) Contracts

SBA’s current regulations permit a joint venture between a mentor and a protégé to qualify for both non-8(a) small business set-aside contracts and 8(a) contracts. The current SBA regulations at 13 C.F.R. § 124.513 set forth specific requirements for 8(a) joint ventures, including the requirement that: (1) the joint venture agreement be approved by SBA prior to award; (2) the project manager for the contract be an employee of the 8(a) firm; and (3) the 8(a) firm receive at least 51 percent of the joint venture’s profits (but please see the change discussed in the next section, on distribution of profits).

In Size Appeal of: SES-Tech Global Solutions, OHA ruled that joint venture agreements for non-8(a) contracts do not need to meet the requirements of § 124.513. OHA held that as long as the protégé firm qualifies as a small business under the applicable size standard, the joint venture members are exempt from affiliation and thus the joint venture itself qualifies as a small business. Thus, conceivably, the large business mentor in such a joint venture could hold a majority interest and employ the project manager, and the joint venture could still qualify for the exemption from affiliation.

The proposed rule sought to overrule SES-Tech by requiring any joint venture claiming an exception to affiliation to meet the requirements of § 124.513(c) and (d), whether the contract being pursued by the joint venture was an 8(a) contract or a non-8(a) small business set-aside.

The final rule adopts the proposed rule. Thus, under the final rule, any mentor-protégé joint venture that seeks an exception to affiliation on a non-8(a) contract (i.e., a small business contract) must follow the requirements of § 124.513(c) and (d). According to SBA, it was contrary to the underlying purposes of the mentor-protégé program to permit an exclusion from affiliation for non-8(a) contracts without requiring the joint venture agreement to comply with the specific requirements imposed on 8(a) joint ventures.

Distribution of Profits

SBA’s current regulations require the 8(a) firm to receive at least 51 percent of the net profits of an 8(a) joint venture. The proposed rule sought to impose a requirement that the 8(a) firm receive “profits from the joint venture commensurate with the work performed by the 8(a) Participant(s).”

Many commenters supported the proposed rule and the final rule adopts the proposed rule without modification. Coupled with the new 8(a) performance of work percentage discussed in more detail below, this new rule means that the 8(a) member firm must receive no less than 40 percent of the profit earned by the joint venture.

Restriction on Joint Venturers as Subcontractors to the Joint Venture

Under current SBA regulations, tribally owned and Alaska Native Corporation (ANC)-owned 8(a) firms are permitted to receive sole source contracts above the dollar thresholds applicable to other 8(a) firms ($3.5 and $5.5 million for services and supply contracts, respectively).1 This exemption has permitted large businesses to form mentor-protégé joint ventures with tribal and ANC-owned concerns and receive large contracts on a sole source basis. Under current SBA regulations, such a joint venture could then subcontract as much as 50 percent of the work back to the mentor, which could effectively permit a large business to receive as much as 70-80 percent of the contract revenue.

The proposed rule provided that in a joint venture where the 8(a) member was a tribally-owned or ANC-owned firm, the non-8(a) joint venture member could not also be a subcontractor to the joint venture on an 8(a) sole source contract.

The final rule substantially increases the scope of this restriction. The final rule now applies to all 8(a) joint ventures, not only joint ventures involving tribally-owned and ANC-owned 8(a) firms or sole source contracts. Under the final rule, a non-8(a) joint venturer may not act as a subcontractor, at any level, to the joint venture on any 8(a) contract unless the SBA grants a waiver. This means that mentors are no longer permitted to act as both joint venture member and subcontractor to a populated joint venture performing an 8(a) contract. For unpopulated joint ventures, the rule does take into consideration the fact that the members effectively act as subcontractors to the unpopulated entity. The prohibition on subcontracting applies only to populated joint ventures, but to address the situation mentioned above, where the large business receives as much as 70-80 percent of the contract revenue, SBA amended the 8(a) performance of work requirements, discussed further below.

The 8(a) Firm’s Performance of Work Requirement

Under current SBA regulations, the 8(a) member in a joint venture seeking to qualify for an 8(a) must perform a “significant portion” of the work done by the joint venture. The current regulations do not define “significant portion” as a fixed percentage or otherwise, although SBA has permitted some agencies to use 25 percent as an informal threshold.

The proposed rule sought to revise § 124.513(c) to eliminate the soft “significant portion” requirement and replace with a hard requirement that the 8(a) member of a joint venture perform at least 40 percent of the work done by the joint venture.

The final rule adopts the proposed rule, but only for certain types of joint ventures. Specifically, if the joint venture is unpopulated, or populated only with administrative personnel, the 8(a) member must provide the project manager and perform 40 percent of the work with its own employees. To calculate compliance with the 40 percent requirement for unpopulated joint ventures, the total amount of work performed by the joint venturers (at any level) will be aggregated and at least 40 percent of that effort must be done by the 8(a) member and any of its affiliates.

SBA, however, recognizes that in a populated joint venture, the employees of the joint venture itself, not the employees of the individual members, perform the work. Thus, it is difficult if not impossible to determine the percentage of work performed by each individual member. Accordingly, for populated joint ventures, the final rule requires the 8(a) member merely to demonstrate “what it will gain from performance of the contract and how such performance will assist in its business development.” For joint ventures that are populated, the joint venture must demonstrate that performance of the contract is controlled by the 8(a) member.

Number of Mentors/Protégés

Under current SBA regulations, a protégé may have only one mentor but, in limited circumstances, a mentor may have multiple protégés, subject to SBA approval.

The proposed rule sought to provide an absolute limit of three protégés per mentor and allowed SBA to approve a second mentor for a protégé in limited circumstances. The final rule adopts the proposed rule, but clarifies that the absolute limit of three protégés is not a lifetime limit, only a prohibition on the number of protégés a mentors may have at one time. In addition, the final rule allows protégés to have an additional mentor in some circumstances. The second mentor must be in an unrelated NAICS code, and the protégé must show that the additional mentor provides specific expertise that is otherwise unavailable from the first mentor. The protégé must also show that the addition of a second mentor will not conflict with the assistance provided under the first mentor-protégé arrangement.

Mentor-Protégé Joint Ventures for Subcontracts

Some in SBA have taken the position that, under current SBA regulations, a mentor-protégé joint venture can qualify as a small business only for federal prime contracts.

The proposed rule permitted mentor-protégé joint ventures to qualify as small for federal subcontracts as well as prime contracts. The final rule adopts the proposed rule without change.

Mentor’s Failure to Provide Assistance

To receive SBA approval, a mentor-protégé agreement must specify the developmental assistance that the mentor will be providing to the protégé. According to the narrative explanation accompanying the proposed rule, SBA made clear that it was concerned that many mentors enter into such relationships solely to obtain contracts and do not provide the promised level of developmental assistance. The proposed rule would have permitted SBA, in such circumstances, to recommend to a procuring agency that it issue a stop-work order for each federal contract the mentor and protégé are performing as a small business. The stop-work order could be withdrawn if SBA eventually becomes satisfied that the developmental assistance has been or will be provided to the protégé. The rule also permitted SBA to initiate proceedings to debar the mentor from federal contracting if SBA determines that the mentor entered into the mentor/protégé relationship solely to obtain one or more federal contracts.

Despite significant opposition to the proposed rule, the final rule adopts the proposed rule without change. In addition to the stop-work order, the final rule permits the SBA to authorize the substitution of the 8(a) member in lieu of the mentor-protégé joint venture entity where it is shown that the 8(a) member can complete performance without the mentor’s assistance. Mentors will be provided an opportunity to respond to the allegation that it has failed to provide the requisite developmental assistance. If the mentor fails to respond or its response is inadequate, the SBA may terminate the mentor-protégé relationship, bar the mentor from participating in the mentor-protégé program for two years and/or seek the stop-work order and substitution remedies discussed above.

Other Proposed Changes

The final rule also changes the application of SBA’s “ostensible subcontractor rule.” Under the ostensible subcontractor regulation, if a proposal indicates that a large business subcontractor will perform the primary and vital requirements of the contract, the subcontractor will be treated as a joint venturer with the small business prime contractor. This results in an aggregation of revenue and employees between the entities for purposes of determining the prime contractor’s size status. The final rule clarifies that in addition to reviewing compliance with the ostensible subcontractor rule at the time of initial award, a review must also be made at the time of option exercise by the government. If it is clear based on performance of the contract to date that the subcontractor was performing the primary and vital requirements of the contract, then the prime and subcontractor will henceforth be treated as joint venturers and any options exercised under the contract will not count as an award to a small business if the aggregate of the entities renders them other than small.

The final rule also adopts the proposed rule’s provision that allows contracting agencies to receive 8(a) credit for orders placed with 8(a) concerns under multiple award IDIQ contracts even if the underlying contracts were not set-aside exclusively for 8(a) contractors, as long as the competition for the order is restricted to 8(a) concerns, the awardee must comply with the limitations on subcontracting and nonmanufacturer rules, and the selected contractor is an 8(a) participant as of the date specified for receipt of task or delivery order proposals.

The final rule also made significant changes to the qualification requirements for 8(a) contractors, including gross income, net worth and asset limitations for the individual claiming disadvantaged status (although these changes are not examined here).

A copy of the final rule can be found here. Its effective date is March 14, 2011.