A recent bid protest appeal decision by the U.S. Court of Appeals for the Federal Circuit — XOtech, LLC v. United States — provides clear guidance on what it means to “control” a service-disabled veteran-owned small business (SDVOSB). In short, for a limited liability company (LLC) to qualify as an SDVOSB, at least one service-disabled veteran must control all decisions without the consent of someone who is not a service-disabled veteran.
Rules of the Game
Under the Small Business Administration (SBA) regulations, an SDVOSB must be both owned and controlled by one or more service-disabled veterans. Ownership generally means that “a concern must be at least 51% unconditionally and directly owned by one or more service-disabled veterans” (13 CFR § 125.12). For qualifying control, “the management and daily business operations of the concern must be controlled by one or more service-disabled veterans…” (§ 125.13(a)). Thus, “both the long-term decisions making and the day-to-day management and administration of the business operations must be conducted by one or more service-disabled veterans…” Accordingly, a “service-disabled veteran… must hold the highest officer position in the concern (usually President or Chief Executive Officer)…” (§ 125.13(b)). Also, for an LLC, “one or more service-disabled veterans… must serve as managing members, with control over all decisions of the limited liability company” (§ 125.13(d)). (emphasis added)
XOtech, LLC was originally organized as a member-managed LLC with the service-disabled veteran as the only member. Later, the LLC was converted into a manager-managed LLC, again with the service-disabled veteran as the only manager. XOtech then amended its operating agreement to change it from a single-manager LLC into a multiple-manager LLC with three managers and four members, the latter being the owners. None of the additional managers or members — all family members — were service-disabled veterans.
The operating agreement amendment added the service-disabled veteran’s wife, son, and another relative as members. The service-disabled veteran retained a 90% “senior member” ownership share, while the three other members split the remaining ownership interests. The senior member service-disabled veteran, thus, controlled all the decisions left to the LLC members, i.e., the major company decisions.
The three managers were the service-disabled veteran, his wife, and his son, the latter two of whom were not service-disabled veterans. Managers could make day-to-day management decisions that were not major company decisions, including hiring employees, borrowing money, or binding the company to contracts, among other powers. Each manager had an equal vote, and a majority was required for a decision. Thus, the two non-service-disabled veterans could make a management decision without the vote of the service-disabled veteran himself, or the service-disabled veteran would need the vote of at least one non-service-disabled veteran for a decision.
In 2018, XOtech won a logistics readiness support services contract for various U.S. Army Reserve locations. The procurement was set aside for SDVOSBs. A losing offeror filed a protest challenging XOtech’s SDVOSB status. The protest was forwarded to the SBA, which sustained it, determining that, while XOtech met the SDVOSB ownership requirements, XOtech was unable to show that the service-disabled veteran controlled the concern.
XOtech appealed the SBA decision three times, losing each: SBA’s Office of Hearings and Appeals, XOtech, LLC, SBA No. VET-277 (Sept. 14, 2018); the U.S. Court of Federal Claims (COFC), XOtech, LLC v. United States, 142 Fed. Cl. 313 (2019); and the Federal Circuit. The Federal Circuit affirmed the COFC decision that XOtech was not an SDVOSB. Under the operating agreement, the service-disabled veteran needed the vote of at least one non-service-disabled veteran for any management decision. Thus, the service-disabled veteran could not be said to control all decisions of the company. The Federal Circuit stated, “To establish [service-disabled veteran] control, one or more [service-disabled veterans] must be able to independently exercise control of all decisions, without the consent of any [non-service-disabled veterans].”
XOtech argued that the service-disabled veteran, as the super-majority, senior member had control because he could remove the non-service-disabled veteran managers at any time. XOtech also argued that the day-to-day management authority of the non-service-disabled veteran managers was like delegated authority in a company. Neither argument was persuasive. Removal of a manager would not have any retroactive effect on decisions properly taken by a manager before removal. Moreover, the source of any delegated authority was the majority of the managers, not the service-disabled veteran.
What is the takeaway?
When your SDVOSB is organized as an LLC — or as a partnership, which has similar rules —the service-disabled veteran must have independent control over all the concern’s decisions. (The rules are more complex for corporations.) Any changes to the operating agreement to include non-service-disabled veterans as members or managers are likely to be risky to the concern’s status. This case is a reminder that concerns enjoying small business status need to proceed with caution and the advice of experienced lawyers when changing their organizational structure.