Welcome to a special edition of the Legal Landscape a series designed to provide government contractors with a quick, but thorough, summary of important legal developments and regulations in government contracting, as well as a plain-English explanation of how these developments may affect state & local contractors. In this special edition we’ll discuss significant changes recently rolled out by the Small Business Administration (SBA) regarding federal small business procurement regulations. Government contractors should keep in mind that state & local agencies often look toward changes in federal regulations as a guideline. SBA Implements Significant Rules Changes to Federal Small Business Procurement Regulations The Small Business Administration (“SBA”) recently rolled out some major changes to the federal small business procurement regulations. The first was a May 31, 2016 final rule, which finalized the agency’s earlier December 2015 proposed rule, and implemented numerous mandates by the National Defense Authorization Act (“NDAA”) of 2015. This rule, which went into effect June 30, 2016, made (among others) the following changes to the SBA regulations: Expansion of JV Exception to Affiliation Where Each Individual JV Partner is Small (13 C.F.R. § 121.103(h)); Changes to Subcontracting Limitations and “Similarly Situated Entity” Rules (13 C.F.R. § 125.6); Clarification regarding what types of familial relationships will result in a rebuttable presumption of “identify of interest” affiliation pursuant to 13 C.F.R. § 121.103(f) (for more information see our previous blog); Addition of a rebuttable presumption of “identify of interest” affiliation pursuant to 13 C.F.R. § 121.103(f) based on 70% economic dependence between companies (for more information see our previous blog). In addition to this rule, the SBA recently issued a “Statement Of General Policy” relating to the interaffiliate sales exclusion. We discuss each of these changes in more detail below: Expansion of JV Exception to Affiliation Where Each Individual JV Partner is Small Prior to these recent revisions, the regulation dealing with affiliation (13 C.F.R. § 121.103) contained a narrow exception applying to certain joint ventures. Specifically, there was no “affiliation” between two or more joint venture members if the procurement was: (1) bundled, or (2) “large” - large meaning, in this context, that either: (a) in a revenue-based size standard, the value of the procurement was greater than half the size standard corresponding to the NAICS code assigned to the contract; or (b) in an employee-based size standard, the value of the procurement was over $10 million. Under the new regulations, a joint venture will be considered a “small” business for federal procurement purposes as long as each individual joint venture partner individually qualifies as a “small” business under the relevant contract. Essentially, this rule expands the exception to affiliation for all joint ventures where both concerns making up the joint venture are individually “small.” Of course, each small business must not otherwise be affiliated. Takeaways for Contractors This revision to the regulations will make it much easier to enter into JVs in connection with set-aside contracts. Now, as long as both JV partners are individually “small”, the JV is considered “small” as well! Changes to Subcontracting Limitations and “Similarly Situated Entity” Rules When the federal small business set-aside programs were created, there was some concern about “pass-through” situations – i.e. situations in which a small business, awarded a set-aside contract, would subcontract almost all the contract work to a large business. This kind of set-up would divert government dollars from the intended small business beneficiaries, and thereby negate the purpose of the agency’s small business programs. To avoid this problem, SBA enacted 13 C.F.R. § 125.6, which establishes minimum self-performance requirements for small business prime contractors performing various types of set-aside contracts. Under the old version of the regulation, compliance with the performance of work requirements was determined using a percentage threshold, which the prime contractor had to meet. That percentage varied based on whether the acquisition was for services, supplies, general construction, or specialty trade construction. The revised regulation approaches the situation a little differently. The overall goal remains the same: Keep a minimum of small business dollars in small business pockets. However, as the SBA explains, the revised regulation “creates a shift from the concept of a required percentage of work to be performed by a prime contractor to the concept of limiting a percentage of the award amount to be spent on subcontractors.” For instance, rather than requiring a contractor to self-perform 15% of the contract work, the revised regulation mandates that the prime contractor cannot subcontract more than 85%. While the old rule created a threshold, the new rule uses a sort of cap and that’s a slightly different way of looking at things. Another important change concerns subcontracts to “similarly situated entities.” Under the revised subcontracting limitation regulations, such subcontracts will not count to the above-mentioned cap. A similarly situated entity is defined as “a small business subcontractor that is a participant of the same small business program that the prime contractor is a certified participant and which qualifies the prime contractor to receive the award.” In other words, a HUBZone could subcontract to another HUBZone, or a 8(a) could subcontract to another 8(a), without counting those subcontracts towards the applicable limit. A common question is how to calculate compliance when subcontractors themselves enter into subcontracts. When drafting the revised regulations, the SBA was concerned that if compliance was determined by looking at first tier subcontractors only, a first tier “similarly situated” subcontractor could, in turn, pass its subcontract through to a large or otherwise not similarly situated entity through a second subcontract. In doing so, they could circumvent the purpose of the regulation entirely. To address these concerns, the SBA explained in the final rule that work that is not performed by the employees of the prime contractor or employees of first tier similarly situated subcontractors will count towards the subcontracting cap. An additional change under the revised regulation relates to how the percentage of work is calculated. Under the old rule, some self performance requirements were calculated using “the cost of the contract incurred for personnel” while others used “the cost of the contract (not including the costs of materials)” or “the cost of manufacturing the supplies or products (not including the costs of materials).” These small differences between the manner of calculation caused a lot of confusion. It often proved very difficult for contractors to figure out what, exactly, they had to do, or what work they had to perform, in order to be compliant. The revised regulation is much simpler. Regardless of whether the contract is one for services, supplies, or construction (general or specialty), the subcontracting limitations are described in terms of “the amount paid by the government to [the prime contractor].” That said, construction contractors will still have to exclude costs of materials from their calculations. Even so, this revision will make it easier to determine exactly how much you can subcontract and still be compliant. Takeaways for Contractors The revised subcontracting limitation regulations have been streamlined, which should make it much easier to analyze whether or not you are in compliance. In addition, the new “similarly situated entity” subcontracting exception should make it much easier to subcontract work while remaining compliant. That said, self-performance is always a complicated issue, and you should check with a legal expert if you have any questions about your compliance with the revised regulation. Clarifications for “Identity of Interest” Affiliations 13 C.F.R. § 121.103(f) discusses the circumstances where an “identity of interest” between two or more persons or entities leads to a finding of “affiliation” among those persons/entities, and, consequently the “aggregation” of their respective assets for purposes of determining size. “Identity of interest” affiliation encompasses two different kinds of affiliation. Identity of Interest Affiliation Based on a Familial Relationship: The first type of identity of interest affiliation is based on a familial relationship. The SBA has interpreted 13 CFR 121.103(f) as creating a rebuttable presumption that family members with identical or similar interests must be treated as one person (with their individual ownership interests aggregated), unless the family members are estranged or not involved with each other's business transactions. However, decisions analyzing familial relationship-based identify of interest affiliation have been inconsistent and hard to interpret. For that reason, the SBA proposed to add additional guidance on how to analyze this issue, narrowing the types of familial relationships that result in a presumption of affiliation. The final rule explains that the presumption of “identify of interst” affiliation based on familial relationships applies to firms that conduct business with each other and are owned or controlled by married couples, parties to a civil union, parents, children and siblings. This presumption may be rebutted by showing a clear line of fracture between the firms. It is notable that the rule suggests that affiliation is presumed only if the firms conduct business with each other. This appears to allow family members who own firms to escape the presumption of affiliation so long as the companies are not engaged in any business transactions with each other. Takeaways for Contractors Contractors must make sure to be extra careful when doing business with other companies owned, run by or employing spouses, parents, children and siblings of the contractor’s owners, executives, or employees. Failure to observe proper formalities could result in a finding of affiliation. Identity of Interest Affiliation Based on Economic Dependence: The second type of an “identity of interest” affiliation is based on economic dependence. Under the new rule, if the firm in question “derived 70% or more of its receipts from another concern over the previous three fiscal years,” there is a presumption of affiliation. Under the old rule, there was no such fixed percentage, however, the 70% figure was regularly used by SBA’s Office of Hearings and Appeals in its decisions. The presumption may be overcome by a showing that the firm in question is not solely dependent upon the other firm. The final rule suggests that this presumption may be rebutted by, for example, a showing that a concern has only been in business for a short period of time, and therefore has only been able to secure a limited number of contracts. Takeaways for Contractors As many of you already know, Federal contractors should be very careful when doing business with the same businesses over and over. Constant subcontracting to/from the same company, or any other interactions leading to 70% dependence on another company, could result in a finding of affiliation. Exclusion of All Types of Affiliates from “Interaffiliate Transaction” Exception 13 C.F.R. § 121.104(a) explains how the SBA should calculate a company’s “receipts” for purposes of determining that company’s size. That regulation provides that a company’s “total receipts” should not include “proceeds from transactions between a concern and its domestic or foreign affiliates.” The purpose of this interaffiliate transactions rule is to prevent “double counting of income” during the size determination process. Based on that stated purpose, most contractors (and legal experts) believed that the interaffiliate transactions exception operated to exclude, when calculating a company’s receipts, all transactions between a company and any of its affiliates. However, last year, in Size Appeals of G&C Fab-Con, LLC (a case in which Cohen Seglias represented the appellant), OHA reached a different conclusion. Specifically, OHA concluded that the “the interaffiliate transaction exclusion applies only if the concerns in question have a parent-subsidiary relationship and are eligible to file a consolidated tax return.” Many contractors, attorneys, and federal contracting experts felt that this was an improper interpretation of 13 C.F.R. § 121.104(a). SBA also disagreed with OHA’s conclusion. And so it issued its SBA Size Policy Statement No. 3 to express that disagreement. It stated that: Recent SBA size determinations and decisions of the Office of Hearings and Appeals have limited the exclusion by applying it only to transactions between affiliates that are eligible to file a consolidated tax return . . . The regulation does not include a limitation on the types of affiliates for which interaffiliate transactions can be excluded, and in no way ties the exclusion to a concern’s ability to file a consolidated tax return with the identified affiliate. SBA believes that the current regulatory language is clear on its face. It specifically excludes all proceeds from transactions between a concern and its affiliates, without limitation. Therefore, the SBA concluded that, going forward, when calculating a company’s receipts, it would not restrict the exclusion for interaffiliate transactions to transactions between a concern and a firm with which it could file a consolidated tax return. Rather, the exclusion for interaffiliate transactions may be applied to all interaffiliate transactions between a concern and a firm with which it is affiliated under the principles in 13 CFR 121.103. However, the SBA noted that contractors seeking to exclude certain transactions under this exception must specifically identify and explain the transactions they seek to exclude, and must also properly document the transactions. Takeaways for Contractors If you have been found affiliated with another company, there might still be hope that you are “small”. Your size standard will be calculated using the sum total of you and your affiliates’ revenue, or employees. But in a revenue-based size standard context, you will now be able to exclude ALL interafilliate transactions, which just might make the difference between falling under or over the “small” business threshold. If you have questions about how to calculate your size, consult a legal or accounting expert familiar with Federal small business procurement. Conclusion These changes are all very positive developments. They clarify the regulations, and improve efficiency without circumventing the purpose of the SBA’s small business programs (i.e. the economic development of small businesses through performance of government contracts). It will be interesting to see what further tweaks are needed as these new regulations are used. We will keep you posted in future editions of the Legal Landscape.