• On Dec. 29, 2014, the Small Business Administration issued a proposed rule to implement certain provisions of the National Defense Authorization Act of 2013, including a provision which changes the methodology for determining compliance with the Limitations on Subcontracting rule.
  • The changes suggest an effort to replace murky standards for determining compliance in the area of small business teaming for government contracts with some bright-line tests and procedural checkpoints.

On Dec. 29, 2014, the Small Business Administration (SBA) issued a long-awaited rule to implement certain provisions of the National Defense Authorization Act of 2013 (NDAA). A summary of the NDAA's small business provisions can be found in our blog post about the NDAA itself.

The key provision in the NDAA and SBA's Dec. 29 proposed rule changes the methodology for determining compliance with the Limitations on Subcontracting rule. The proposed rule generally shifts the analysis from the costs incurred by the small business prime contractor to a limitation of the percentage of the total contract revenue that may be paid to subcontractors that are not in the prime contract's socioeconomic category. As explained in our blog post, the new methodology can – depending on the circumstances – fundamentally expand or constrict a small business prime contractor's ability to outsource work to subcontractors as compared to the existing rule.

Additional changes in the proposed rule come in the topics of affiliation, joint ventures, certification and penalties for noncompliance. When considered together, all the changes suggest an effort to insert some bright-line tests and procedural checkpoints into the process of small businesses teaming up for government contracts where previously a murkier analysis ruled the question of compliance.

The Dec. 29 proposed rule is notable for not only the intended procedural changes but also the absence of some NDAA-mandated regulations. Perhaps the most significant of these is the silence on the expansion of the mentor-protégé program. It appears that the SBA intends to address this in another proposed rule to be issued in the near future. The Dec. 29 rule is also notable in that it is merely a proposed rule. The NDAA was signed into law on Jan. 3, 2013, and directed that the SBA issue its regulations within 270 days from the date of enactment. The proposed rule instead arrives almost two years later. In short, there may be ambiguity as to what law actually governs these small business issues from the date of the NDAA's enactment until the SBA issues a final rule. This is occurring because the NDAA actually amended portions of the Small Business Act itself. Until the proposed rule becomes final, the NDAA and the impending SBA regulations are not totally consistent.

Comments to the SBA on the proposed rule must be submitted by Feb. 27, 2015. As is typically the case with SBA regulatory changes, the Federal Acquisition Regulation (FAR) provisions and clauses that implement the SBA rules will need to be updated after the SBA rules are adopted in final form. Therefore, it could still be awhile before government contractors see the effects of the NDAA-mandated revisions reflected in their contracts.

Below is a more in-depth discussion of the change to the limitations on subcontracting, followed by an overview of some of the other highlights of the proposed rule.

Limitation on Subcontracting

The SBA proposes to revise the Limitations on Subcontracting rule, found in 13 C.F.R. 125.6, to implement the changes required by Section 1651 of the NDAA. As revised, compliance with the Limitations on Subcontracting rule will be determined by a percentage cap on the total amount of the prime contract that may be paid to subcontractors by a small business prime contractor. For service and supply contracts, small business prime contractors must agree that no more than 50 percent of the total amount paid under the prime contract will be paid to subcontractors. For general construction contracts the percentage is 85 percent and for specialty trade construction the percentage is 75 percent. In contrast, the existing rule calculates compliance for services and supply contracts based on the percentage of the performance cost incurred by the prime contractor. The proposed rule does not modify the prime/subprime ratio (50/50 for service and supply, 15/85 for construction and 25/75 for specialty trade) but rather alters the value basis for calculation.

The proposed provision provides an exception to the limitation for "similarly situated entities." That is, a small business prime contractor will not need to include the amounts subcontracted to a similarly situated entity (i.e., another business concern that falls into the same size or socioeconomic category for purposes of set-aside contracts) in determining the subcontracted percentage allowed. For example, in a prime contract that is set-aside for 8(a) firms, amounts paid to subcontractors that are also 8(a) firms need not be considered as subcontracted amounts for the purposes of the limitation. This exception will also apply to any analysis under the Ostensible Subcontractor affiliation rule.

The proposed rule also would impose new procedures and notice requirements not expressly mandated by the NDAA. A small business submitting an offer for a prime contract must certify that it will meet the limitation on subcontracting. If it is not apparent from the offer that the applicable limitation will be met, the contracting officer may refer the matter to the appropriate SBA area office for a certificate of competency. In addition, if a small business prime contractor intends to use any similarly situated entities as subcontractors, it must identify each entity in its offer along with the intended percentage subcontracted. Moreover, the prime contractor must enter into a signed, written agreement with every similarly situated entity detailing the percentage of work forecasted, and these agreements must be attached to the prime contractor's offer. If a prime contractor modifies a subcontractor's award after the award of the prime contract, the prime contractor must notify the contracting officer in writing of the change and how it will affect compliance.

These new hardline procedures are accompanied by stiff penalties where previously none were included in the regulations for violations of the subcontracting limitations. Now, the penalty for a violation shall be the greater of $500,000 or the dollar amount expended, in excess of permitted levels, on subcontractors.

Another feature in the proposal is that the Limitations on Subcontracting rule that would be used for each type of socioeconomic set-aside contract. This represents a change from the SBA's existing regulations, which have slightly different rules for small business, 8(a), HUBZone, service-disabled veteran-owned, and woman-owned set-aside contracts.

Lastly, the proposed rule would exempt contracts below $150,000 from the Limitations on Subcontracting rule.

Additional Changes Under the Proposed Rules

  • Affiliation: The SBA proposes to include additional guidance in determining affiliation based upon identity of interest. These provisions create some bright-line tests for analysis, but they are rebuttable presumptions. As before, affiliation would be presumed between firms owned and controlled by married couples, parties to a civil union, parents and children, and siblings. Affiliation would also now be presumed upon economic dependence if the qualifying small business concern derived 70 percent or more of its receipts from another concern in the previously completed fiscal year.
  • Joint Ventures: The SBA proposes to remove the contract size requirement from the exclusion from affiliation for small businesses seeking to perform as a joint venture. Currently, small businesses may avoid affiliation for size determination purposes only where contracts are bundled or meet certain dollar thresholds set forth in the regulations. The proposed provision allows small business to create a joint venture for any size contract without being affiliated. The SBA has indicated that this change is meant to work in tandem with the changes to the limitations on subcontracting. If individual small business concerns are allowed to subcontract to as many similarly situated entities as desired, then joint ventures of such business concerns should be afforded the same treatment.
  • Calculation of Annual Receipts: The SBA proposes to amend the definition of "annual receipts" to make clear that this calculation includes passive income. The SBA has indicated that this clarification is not a change in policy but rather a correction of the previous misreading that some small business concerns had made in excluding passive income.
  • Recertification: The SBA proposes to insert a strict rule for when recertification of size is required by a small business concern after a merger or its acquisition. If a merger or acquisition of a firm that submitted an offer as a small business occurs after the offer but prior to the award, then the firm must recertify its size to the contracting officer prior to award. Existing SBA regulations require recertification of contracts after a merger or acquisition but do not expressly address recertification of pending offers.
  • Nonmanufacturer Rule: The nonmanufacturer rule requires that, for small business set-aside contracts for manufactured items, the prime contractor must either manufacture the items itself or acquire its supply from another small business. The Dec. 29 proposed rule clarifies that the nonmanufacturer rule does not apply to contracts valued between $3,000 and $150,000.
  • Waivers After Solicitations: The SBA proposes to authorize a waiver of the nonmanufacturer rule for an individual contract award after a solicitation has been issued as long as all potential offerors are provided additional time to respond.
  • Waivers for Purchase of Software: The SBA proposes to classify commercially readily available software as a product or item of supply for purposes of assigning a NAICS code and corresponding size standard. As such, a prime contract for this type of software would require compliance with the nonmanufacturer rule or be eligible for a waiver. This rule would not apply to customized software, as this type of procurement is classified as a service contract.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.

Georgina C. Shepard