Between new regulations from the Small Business Administration (SBA) and decisions from the SBA's Office of Hearings and Appeals (OHA), the limits of acceptable actions by small business owners set on maintaining their small business size status continues to change. Most recently, OHA issued a noteworthy decision that clarifies restrictions on negative control of small businesses, including what actions it considers "extraordinary actions" and what actions are ordinary actions related to the daily control of a company. OHA's decision in Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018) is helpful in understanding the parameters of permissible negative control since OHA provided its clearest list to date of "extraordinary actions" and "ordinary" actions essential to the daily operation of the company. However, it is important to note that the impact of the ruling, as far as service-disabled veteran-owned small businesses (SDVOSBs), will be limited in light of the new SBA and VA regulations.

Brief Summary of the Size Protest

In January 2018, the Navy issued a set-aside SDVOSB solicitation for a single Indefinite Delivery/Indefinite Quantity contract, with a corresponding $38.5 million annual receipts size standard. In April 2018, the Navy notified unsuccessful offerors that the apparent awardee was Southern Contracting Solutions III, LLC (SCS), a joint venture (JV) comprised of Electronic Metrology Laboratory, LLC (EML) and Emerald Resource, LLC (Emerald), an SDVOSB.

In response to the Navy's notification, Government Contracting Resources, Inc. (GCR), filed a size protest alleging that SCS is not a small business. In its protest, GCR made several allegations, including that (i) EML's average annual receipts for the period of measurement exceeded the $38.5 million annual receipts size standard for the procurement; (ii) EML is a member of at least five other JVs; (iii) EML and Emerald were affiliated due to a history of pervious JVs; and (iv) Emerald is dependent on EML because "a significant share" of Emerald's receipts are attributed to its JVs with EML. In sum, GCR alleged that EML and Emerald were affiliated and therefore ineligible for the instant award.

In June 2018, the SBA Area Office issued a size determination finding SCS to be an other than small business for the $38.5 million size standard. The Area Office found the exception to affiliation among JV partners did not apply because EML was found to be affiliated with two companies due to common ownership. In its decision, the Area Office analyzed EML's Operating Agreement, including Section 3.5 titled "Major Decisions." In reviewing the actions listed under Section 3.5 of the Operating Agreement, the Area Office determined that EML's President had impermissible negative control over EML because the actions relate to the daily operations of the business.

Negative control exists when a minority owner can block ordinary actions of a concern that are essential to the operating the company daily operations. However, prior case law has allowed minority owners to having the ability to block certain extraordinary actions of the concern have not been provided negative control if those provisions are crafted to protect the investment of the minority shareholders, and not to impede the majority's ability to control the operations or to conduct business as it chooses. Extraordinary actions are actions that are not essential to the daily operation of the concern, but are actions which could have a severe impact upon the company.

OHA Appeal and OHA's Analysis

SCS appealed the decision to OHA, arguing the Area Office erred as a matter of fact and law in determining that EML's President had impermissible negative control over EML's daily operations. SCS argued that the Area Office engaged in a flawed analysis of EML's Operating Agreement, incorrectly applied OHA precedent, and clearly erred in not providing SCS due process regarding issues of negative control.

OHA ultimately determined that based on the facts in Southern Contracting, the Area Office had erred in finding that the President of EML had negative control over EML and vacated the size determination. What is particularly noteworthy about this decision is the discussion of extraordinary and ordinary actions.

OHA began its analysis by determining that the issue on appeal concerned whether joint venture partner EML was a small business, and that this determination rested on whether the minority member of EML had negative control over EML. If the minority member of EML had control over EML, OHA reasoned that EML was affiliated with other firms the minority member has the power to control through common ownership. If EML was found affiliated, it would no longer be small and would, in turn, make the joint venture ineligible.

While OHA has analyzed issues of negative control in several decisions, the Southern Contracting decision provides the clearest list yet of what constitutes "ordinary actions" and what constitutes "extraordinary actions." OHA listed the following as extraordinary actions, which a minority member may be given the power to block, or which may require a minority member's input, without resulting in a finding of negative control:

  • Amending the Bylaws/Operating Agreement/Articles of Incorporation;
  • Issuing additional capital stock;
  • Entering into any substantially different business;
  • Approving the addition of any new members or the withdrawal of any old members;
  • The sale of all or substantially all of the assets of the company;
  • Approving an increase or decrease the size of the Board;
  • Disposal of the company's goodwill;
  • Approving an increase or decrease the number of authorized interests;
  • Correcting a false statement in the Articles of Incorporation.
  • The submission of a claim to arbitration
  • Confessing of a judgment
  • Selling all or substantially all of a firm's assets;
  • Mortgaging or encumber all or substantially all of a concern's assets;
  • Committing any act that could result in a change in the amount or character of the concern's contribution to capital;
  • Causing a change in the character or business of the concern;
  • Committing any act that would make it impossible to carry on ordinary business;
  • Approving the reclassification of interests designed to protect a minority owner's investment;
  • Amending the operating agreement in any manner that materially alters the rights of existing members;
  • Filing for bankruptcy; or
  • Taking an action in contravention of the Operating Agreement.

Additionally, OHA listed the following as ordinary actions, which demonstrate a minority member having control over the daily operations of a concern, and thus do constitute negative control:

  • Control over the budget;
  • Power to hire and fire officers;
  • Control over employee compensation;
  • Ability to borrow money;
  • Purchasing equipment;
  • Making changes to a budget;
  • Bringing or defending a lawsuit;
  • Creation of debt;
  • Payment of dividends;
  • Amending or terminating leases;
  • Encumbering assets; or
  • Requiring that all actions taken to manage the company require a vote of 75 percent of the members.

The above clarifications, however, will have a limited impact on SDVOSBs This is because for offers submitted after Oct. 1, 2018, SDVOSBs will be subject to the new SDVOSB regulations, which list only the following five exclusively recognized extraordinary actions:

  • Adding a new equity stakeholder;
  • Dissolution of the company;
  • Sale of the company;
  • The merger of the company; and
  • The company declaring bankruptcy.

This list is notable as lacking the ability to have a negative control on amending the operating agreement itself, which in turn could be used to remove the five protections permitted.

The Southern Contracting decision helps to clarify what actions OHA will treat as extraordinary actions and which it will treat as ordinary actions that part of daily operational control. Even though the SDVOSB regulations on negative control changed for proposals submitted as of Oct. 1, 2018, the guidance is still helpful in interpreting requirements for other socioeconomic programs.