On April 27th, the U.S. Small Business Administration (SBA) published a final rule making changes to the regulations governing its 8(a) program. This final rule is SBA’s implementation of the proposed rules issued by the SBA on September 9, 2022. We summarized the changes adopted by the final rule here.
While the SBA intended many of its regulatory changes to document existing SBA policies and practices, it did implement a number of substantive changes. Accordingly, over the next several weeks, we will be going through various parts of the final rule and conducting an in-depth discussion and analysis of the changes. We anticipate addressing the following areas in this series:
- Bona fide place of business requirements;
- Joint ventures;
- Size determinations in connection with multiple award contracts;
- Ostensible subcontractor rule;
- Limitations on subcontracting;
- 8(A) business activity targets;
- Follow-on contracts;
- Size protests; and
- All small mentor-protégé programs.
Ostensible Subcontractor Rule
In this update, we are addressing the changes to the ostensible subcontractor rule.
As part of the eligibility requirements to enter the 8(a) program and other SBA small business programs (i.e., small business set-aside, 8(a), women-owned small business (WOSB), HUBZone, and service-disabled veteran-owned small business (SDVOB) contracts), or to receive a small business set-aside contract, a business entity must not exceed the SBA’s applicable size standard based on North American Industry Classification System (NAICS) code—size standards are typically described in terms of number of employees or annual receipts. When calculating a particular entity’s size, the SBA counts both the revenue and employees of that particular entity, and the revenue and employees of any affiliate.
While affiliation is typically found due to common ownership and management (except for Alaska Native Corporations, Tribes, and Native Hawaiian Organizations, which are exempt from affiliation based on common ownership or control), aggregation of the revenue and employees of two distinct entities for purposes of a size determination can also occur between a prime contractor and their subcontractor, based on the ostensible subcontractor rule, which treats the prime contractor and its ostensible subcontractor as joint ventures for size determination purposes. As a joint venture, the revenue and employees of the prime contractor and the subcontractor are combined for purposes of determining if the prime contractor is small for the applicable NAICS code.
An “ostensible subcontractor” is a subcontractor that is (1) not a “similarly situated” entity performing the “primary and vital requirements” of the contract; and (2) unusually relied on by the prime contractor. A subcontracting entity is similarly situated only if it holds the same socio-economic status as the prime contractor; e.g. both the prime contractor and subcontractor are certified 8(a) small businesses. In this case, the subcontractor is not considered an “ostensible subcontractor.” Otherwise, the prime contractor must perform the primary and vital requirements of the contract and must demonstrate that it possesses the ability to perform the contract with a sufficient level of independence from its subcontractor.
Primary and Vital Requirements
The phrase “primary and vital requirements of the contract” is not specifically defined in the regulations, but generally means those requirements associated with the principal purpose of the acquisition (i.e., the solicitation’s principal purpose(s)). This requires 8(a) entities (and other small businesses) to carefully examine the solicitation in order to identify the solicitation’s primary requirements before entering into any subcontracting arrangement. Subsequently, the small business prime contractor must actually perform those identified requirements.
As an example, in Size Appeal of High Desert Aviation, SBA No. SIZ-6179, the SBA’s Office of Hearing and Appeals held that where a government solicitation for the “spraying of herbicide” provides that the purpose of the contract is to “secure services for the spraying,” the actual application of the herbicide is the primary and vital requirement that the prime contractor must perform. The requirements to procure herbicide and to plan and manage the herbicide application are important but ancillary requirements of that contract.
In adopting the final rule, the SBA added language clarifying that, for construction contracts, the prime contractor’s primary and vital requirements of the contract are to supervise, oversee, manage, and schedule the work on a contract, including coordinating the work of various subcontractors. The prime contractor is not required to perform the majority of the actual construction or specialty trade construction work. The SBA noted in adopting its final rule that some stakeholders suggested the SBA should include more specificity around the meaning of “manage the contract,” but the SBA rejected that suggestion to avoid potential misinterpretations:
SBA believes that a general requirement to supervise, oversee, manage, and schedule the work on a contract, including coordinating the work of various subcontractors, is sufficient. SBA is concerned that adding any specificity beyond that or highlighting one or two specific items of managing a contract might be read as SBA believing those one or two items are more important in the analysis than any others. That is not SBA’s intent, and SBA believes that an SBA Size Specialist should have the discretion to analyze all the facts in determining whether an arrangement rises to the level of an ostensible subcontractor.
The SBA also adopted language clarifying that small businesses must comply with both the limitations on subcontracting rules and the ostensible subcontractor rule. The SBA’s intent was to clarify that, for general construction contracts, a small business could not perform a small portion of the contract (i.e., in compliance with the limitations on subcontracting requirement that the prime contractor perform 15% of the work on a construction contract), but subcontract out supervision and oversight responsibilities to another business entity. The SBA stated, “if that business entity is not a similarly situated entity, that subcontracting could render the prime contractor ineligible due to the ostensible subcontractor rule.”
The primary and vital requirements are those associated with and necessary to achieve the principal purpose of acquisition. They are not dependent on the percentage of work performed by the subcontractor. However, the determination and performance of the primary and vital requirements is only half the battle with the ostensible subcontractor rule, as an 8(a) entity prime contractor must also not be “unusually reliant” on the subcontractor.
Unusually Reliant: The SBA’s Factor-Based Analysis
In addition to performing the primary and vital requirements of a contract, an 8(a) prime contractor must also not be “unusually reliant” on its subcontractor, in that it must possess the requisite capabilities to perform the contract. In determining whether a subcontractor is an ostensible subcontractor, the SBA considers “[a]ll aspects of the relationship between the prime and subcontractor,” applying a factor-based analysis. In adopting the final rule, the SBA added new language addressing the factors used for that analysis. Specifically, the SBA adopted two of the four factors considered in a test created by the SBA’s Office of Hearings and Appeals in the case Size Appeal of Dover Staffing, Inc., SBA No. SIZ-5300 (2011). The four factors from that case are:
(i) the proposed subcontractor is the incumbent contractor and ineligible to compete for the procurement,
(ii) the prime contractor plans to hire the large majority of its workforce from the subcontractor,
(iii) the prime contractor’s proposed management previously served with the subcontractor on the incumbent contract, and
(iv) the prime contractor lacks relevant experience and must rely on its more experienced subcontractor to win the contract.
The two factors from this test that the SBA expressly adopted are (1) whether the prime contractor’s proposed management previously served with the subcontractor on the incumbent contract, and (2) whether the prime contractor lacks relevant experience and must rely on its more experienced subcontractor to win the contract.
The SBA also made it clear that these are only factors to consider, and that no single factor is determinative:
SBA agrees that the ultimate determination in every case depends upon who is performing the primary and vital requirements of a contract or order and whether a prime contractor is unusually reliant on a subcontractor. SBA also agrees that no factor is determinative and that a prime contractor should be able to use the experience and past performance of its subcontractors to strengthen its offer, even where a subcontractor is the incumbent contractor. As with the existing rule, SBA intends to consider all aspects of the prime contractor’s relationship with the subcontractor and would not limit its inquiry to any enumerated factors. SBA continues to believe that the SBA Area Offices should be given discretion to consider and weigh all factors in rendering a formal size determination, and that unique circumstances could lead to a result that does not fully align with the Dover Staffing analysis. That being said, SBA believes that identifying factors that can be considered is helpful to contractors. As such, the final rule retains factors that SBA may consider but adds a provision identifying that no single factor is determinative. The final rules also specifically clarifies that a prime contractor may use the experience and past performance of a subcontractor to enhance or strengthen its offer, including that of an incumbent contractor. It also re-enforces that it is only where that subcontractor will perform primary and vital requirements of a contract or order, or where the prime contractor is unusually reliant on the subcontractor, that SBA will find the subcontractor to be an ostensible subcontractor.
A finding by the SBA that a subcontractor is an “ostensible contractor” creates the risk of being deemed “other than small” and, thus, ineligible for the contract. To avoid such a result, 8(a) entities should consider the following:
- The prime contractor should lead preparation of the proposal.
- A team agreement should be on the prime contractor’s letterhead (not the subcontractor’s) and should detail each party’s role and scope of work.
- The prime contractor should participate in the project or site walkthrough.
- The prime contractor should not lease or obtain all necessary equipment or facilities from the subcontractor.
- The prime contractor should possess the same or more performance experience as the subcontractor.
- The prime contractor should ensure it would otherwise be eligible to receive the contract award without a subcontractor.
- The prime contractor should ensure the amount of work to be performed by the subcontractor is 40% or less.
- The prime contractor should not refer to the prime-subcontractor relationship as a “team.”
- The prime contractor performs the “primary and vital requirements” by:
- Identifying the principal purpose of the solicitation.
- Conducting onsite management.
- Ensuring that the subcontracts do not preclude management and supervision of the subcontractor’s work.
- The prime contractor should avoid “unusual reliance” on a subcontract by:
- Hiring personnel from alternative sources in addition to the incumbent subcontractor.
- If hiring personnel from an incumbent subcontractor, individually review each personnel—that is, do not hire en masse unless the pool of eligible employees is clearly limited (e.g., a specific security clearance or type of experience is required).
- If hiring a large pool of personnel from an incumbent subcontractor, have a contingency plan for finding and hiring alternative personnel.
Comparison of Prior Rule with New Rule
The following demonstrates the changes made to the ostensible subcontractor regulations. Strikethroughs indicate language that has been removed. Bolded and underling indicates language that has been added. Hyperlinks connect to the regulations without tracked changes.
(h) Affiliation based on joint ventures. * * *
(2) (3) Ostensible subcontractors. A contractor and its ostensible subcontractor are treated as joint venturers for size determination purposes. An ostensible subcontractor is a subcontractor that is not a similarly situated entity, as that term is defined in § 125.1 of this chapter, and performs primary and vital requirements of a contract, or of an order, or is a subcontractor upon which the prime contractor is unusually reliant. As long as each concern is small under the size standard corresponding to the NAICS code assigned to the contract (or the prime contractor is small if the subcontractor is the SBA-approved mentor to the prime contractor), the arrangement will qualify as a small business. [renumbered from 13 C.F.R. 121.103(h)(2) with change]
(i) All aspects of the relationship between the prime and subcontractor are considered, including, but not limited to, the terms of the proposal (such as contract management, technical responsibilities, and the percentage of subcontracted work), agreements between the prime and subcontractor (such as bonding assistance or the teaming agreement), and whether the subcontractor is the incumbent contractor and is ineligible to submit a proposal because it exceeds the applicable size standard for that solicitation, and whether the prime contractor relies solely on the subcontractors’s experience because it lacks any relevant experience of its own. No one factor is determinative.
(ii) A prime contractor may use the experience and past performance of a subcontractor to enhance or strengthen its offer, including that of an incumbent contractor. It is only where that subcontractor will perform primary and vital requirements of a contract or order, or the prime contractor is unusually reliant on the subcontractor, that SBA will find the subcontractor to be an ostensible subcontractor.
(iii) In the case of a contract or order set-aside or reserved for small business for services, specialty trade construction or supplies, SBA will find that a small business prime contractor is performing the primary and vital requirements of the contract or order, and is not unduly reliant on one or more subcontractors that are not small businesses, where the prime contractor can demonstrate that it, together with any subcontractors that qualify as small businesses, will meet the limitations on subcontracting provisions set forth in § 125.6 of this chapter.
(iv) In a general construction contract, the primary and vital requirements of the contract are the management, supervision and oversight of the project, including coordinating the work of various subcontractors, not the actual construction work performed.
(c) The performance requirements (limitations on subcontracting) limitations on subcontracting (performance of work) requirements, the ostensible subcontracting rule, and the nonmanufacturer rule do not apply to small business set-aside acquisitions with an estimated value between the micro-purchase threshold and the simplified acquisition threshold (as both terms are defined in the FAR at 48 CFR 2.101).
(c) * * *
(7) Affiliation based on the ostensible subcontractor rule. A concern and its ostensible subcontractor are treated as joint venturers, and therefore affiliates, for size determination purposes. As such, they are affiliates for size determination purposes and must meet the ownership and control requirements applicable to joint ventures. An ostensible subcontractor is a subcontractor or subgrantee that performs primary and vital requirements of a funding agreement (i.e., those requirements associated with the principal purpose of the funding agreement), or a subcontractor or subgrantee upon which the concern is unusually reliant. All aspects of the relationship between the concern and subcontractor are considered, including, but not limited to, the terms of the proposal (such as management, technical responsibilities, and the percentage of subcontracted work) and agreements between the concern and subcontractor or subgrantee (such as bonding assistance or the teaming agreement). To determine whether a subcontractor performs primary and vital requirements of a funding agreement, SBA will consider whether the concern’s proposal complies with the performance requirements of the SBIR or STTR program.
(a) General. A certified HUBZone small business concern may enter into a joint venture agreement with one or more other small business concerns, or with an SBA-approved mentor authorized by § 125.9 of this chapter, for the purpose of submitting an offer for a HUBZone contract. The joint venture itself need not be a certified HUBZone small business concern.
(1) The joint venture itself need not be a certified HUBZone small business concern, but the joint venture should be designated as a HUBZone joint venture in SAM (or successor system) with the HUBZone-certified joint venture partner identified.
(2) A certified HUBZone small business concern cannot be a joint venture partner on more than one joint venture that submits an offer for a specific contract or order set-aside or reserved for certified HUBZone small business concerns.
This article summarizes aspects of the law and does not constitute legal advice. For legal advice for your situation, you should contact an attorney.
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