Earlier this week, we covered the U.S. Department of Veterans Affairs's (VA) publication of a final rule amending its Veteran-Owned Small Business (VOSB) and Service-Disabled Veteran-Owned Small Business (SDVOSB) Guidelines. We anticipated that the U.S. Small Business Administration (SBA) would publish a corresponding final rule this week so that there was one set of consolidated rules governing VOSBs and SDVOSBs by the VA and SBA. As predicted, the SBA published its final rules amending its SDVOSB Guidelines with an effective date of Oct. 1, 2018. Notably, this gives contractors only the weekend to read and digest the substantive changes made by the SBA’s final rule, which go into effect this Monday, Oct. 1, 2018.
The SBA's final rule does not stray significantly from the proposed rules. Pursuant to the SBA's final rule, the VA will continue to be responsible for verifying whether the individuals under which a contractor can apply for VOSB or SDVOSB status are, in fact, veterans or service-disabled veterans. Likewise, challenges to a contractor’s status as a VOSB or SDVOSB based on issues of ownership or control will be decided by the SBA’s Office of Hearings and Appeals (OHA).
However, the SBA's final rule also amends its own regulations outside of the consolidation that will essentially overturn prior OHA case law related to extraordinary circumstances that allow for negative control and whether there is a physical presence requirement to maintain control. The final regulations also do not fully address all of the comments to the proposed rules received by the SBA, and fail to provide clarity on certain regulations, such as the application of the reasonable commute regulation. The result will be continued uncertainty in the areas until OHA has an opportunity to analyze and apply the new rules.
Below are some of the most significant changes to regulations applicable to SDVOSBs resulting from the SBA’s final rule for which contractors need to be aware:
Adding Surviving Spouse/Employee Stock Ownership Plans
- The final rule adds new definitions and regulations relating to certain circumstances under which a surviving spouse can control a SDVOSB without losing the contractor’s SDVOSB eligibility.
- The final rule also exempts employee stock ownership plan ownership from the calculation of ownership for SDVOSBs.
- The final rule results in much needed consolidation and consistency between the SBA and VA’s rules, as these regulations existed in one form or another for VA procurements, but not for SBA procurements.
- The final rule creates a rebuttable presumption that non-service-disabled veterans control the firm where:
- The non-service-disabled veteran is involved in the management or ownership of the firm and is a current or former employer or a principal of a current or former employer of any service-disabled veteran;
- The non-service-disabled veteran receives compensation that exceeds that received by the highest-ranking officer (usually the Chief Executive Officer or President);
- The SDVOSB is co-located or shares equipment, employees, or resources with another firm in the same or similar line of business, and an owner, officer, or director (or any of their direct relatives) has an equity interest in the SDVOSB;
- The non-service-disabled veteran provides critical financing, bonding support, or a critical license to the SDVOSB; and
- A business relationship exists that causes such dependence that the SDVOSB cannot exercise independent judgment without great economic risk.
- The final rule creates a new rebuttable presumption that a service-disabled veteran not working for a contractor during regular, normal working hours does not control the firm.
- The final rule creates a new rebuttable presumption that a service-disabled veteran does not control a SDVOSB if that individual is not located within a "reasonable commute" to the firm’s headquarters and/or job-sites locations. Despite requests for clarification as to what constitutes a "reasonable commute" during the notice and comment period, the SBA provided no clarification. Instead, the regulations only provide that telework and other technology options cannot provide a reasonable rebuttal. Additionally, the SBA claims its final rule is consistent with OHA’s case law. However, the final rule appears to be intended to overrule OHA's decision in Matter of Minority Temporary Agency, Inc., SBA No. SDBA-166 (2006), under which OHA declined to follow the SBA’s position. In Minority Temporary Agency, Inc., the SBA argued that "full-time devotion has a physical presence requirement and Ms. Leboeuf has failed to meet it. "In response, OHA disagreed with the SBA and stated that: "There is no case which holds that the individual did not control the firm based solely on their managing it from a location other than the firm’s main office.""
- The final rule rejects comments that requested the SBA expand its proposed (and limited) "extraordinary circumstances" definition, under which a minority investor may have a veto power over a firm’s decision-making process but which would not render the firm ineligible. Instead, the SBA's final rule will only allow for five "extraordinary circumstances:"
- adding a new equity stakeholder;
- dissolution of the company;
- sale of the company;
- the merger of the company; and
- the company declaring bankruptcy.
Notably, the SBA's final rule does not include other situations that have been recognized by OHA as "extraordinary circumstances." These include OHA's previously recognized extraordinary circumstances of:
- amending the operating agreement or by-laws;
- the issuance of additional stock or equity; and
- 3. entry into a substantially different line of business.
Instead of being consistent with OHA, the SBA's final rule effectively overturns long-standing prior case law for SDVOSBs. See, e.g., Size Appeal of Carntribe-Clement 8AJV # 1, LLC, SBA No. SIZ-5357 (2012) ([A] minority shareholder’s power to veto extraordinary actions outside the ordinary course of business—such as the issuance of additional stock, amendment of the concern's charter or bylaws, or entry into a substantially different line of business—does not necessarily constitute 'negative control.) (citing Size Appeal of EA Engineering Science, and Technology, Inc., SBA No. SIZ4973, at 9-10 (2008)).
Accordingly, the SBA's final rule will result in an inconsistent application of regulations between SDVOSBs and other socioeconomic categories. Additionally, the inability of a minority investor to prevent the amendment of the operating agreement or by-laws will also render any term of that agreement ineffective and will provide no protection for minority investors. For example, while the regulations recognize the addition of a new equity stakeholder as an extraordinary event, the service-disabled veteran may simply remove such a restriction after the agreement has been signed because that individual has unlimited power to change any and all terms of the agreement.
As such, if you are a VOSB or SDVOSB, you should immediately review your by-laws or operating agreement, because what was a previously acceptable term may render the company ineligible, starting on Monday, Oct. 1, 2018.
Finally, it is currently unclear if this new provision and the restrictions on negative control in the final rule apply will also equally to SDVOSB joint ventures. For the first time, SBA has articulated in the final rule that "SBA does not find that the [SDVOSB] regulation needs to be consistent with the joint venture regulations, which address an entirely different situation. A joint venture is not itself an [SDVOSB] and is therefore treated differently." (emphasis added). However, the control requirements relate to SDVOSBs. See 13 CFR § 125.13. Thus, given the final rule, it is unclear if the broader control rules in 13 CFR § 125.13 apply to 13 CFR § 125.18(b), which only require that the SDVOSBs be the managing venturers and that one of its employees be responsible for performance of the contract. In addition, the joint venture regulations, on their face, would also violate the new extraordinary action restrictions as they require a special bank account be established, which requires the signature of all parties to the joint venture for withdrawal purposes, yet this is not one of the five enumerated "extraordinary actions."
- The SBA's final rule replaces the definitions of "permanent caregiver," "service-disabled veteran," and "surviving spouse."
- The final rule also adds a new definition of "daily business operation." The SBA adopted a comment deleting a reference to "setting the strategic direction of the firm" and made clear that "daily business operations" does not include setting the strategic direction of the company.
Changes to Requirements for Business Forms
- The final rule changes ownership requirements for a partnership. The SBA's prior regulation required service-disabled veterans to own at least 51% of each type of partnership interest. Therefore, if a partnership had general partners and limited partners, it required the service disabled veteran to be both a general and limited partner. In the final rule, the SBA changes the requirement. Now, service-disabled veterans must own at least 51% of the aggregate voting interest in the partnership.
- The final rule also updates and explains dividend/distribution requirements. In general, 'an individual’s right to receive benefits, compensation, and the ultimate value of 'an individual’s equity should be consistent with the purported amount of equity. For example, consistent with SBA's regulations, a contractor cannot state that a service-disabled veteran owns 60 percent of the equity, but records show that he or she is entitled to only a smaller amount of the firm's profit, or that the residual value of that equity is less than 60 percent if the firm is sold.
- Additionally, the final rule makes clear that ownership will be decided without regard to state community property laws.
Ambiguity as to the Incorporation of 8(a) Regulations
- The SBA's final rule maintains that even though the SBA did not incorporate all of the 8(a) regulations, the "SBA will continue to rely on the 8(a) program rules in part 124 for guidance in interpreting these control requirements.” This position is confusing because the SBA differentiates unfavorable OHA case law on "extraordinary circumstances" on the basis that it involved the 8(a) program participants and not SDVOSBs.
The publication of the SBA’s final rule creates consistent rules for ownership and control that will be applied by the VA and SBA. However, the benefits resulting from the final rules' consistency comes at a price, and also includes changes that were not set forth in direction from Congress or the Small Business Act and which appear to be intended to overturn OHA decisions that were unfavorable to the SBA. This may create traps for the unwary.