Go small or go home: Understanding affiliation rules for set-aside contracts

Although small businesses are, by definition, small, federal government procurements set-aside for small business contractors are significant. Small business contracting has gained attention in recent years, particularly with the rollout of the Small Business Administration’s “all small” mentor-protégé program, which allows a large business to form a joint venture with a small business to compete for and perform set-aside contracts. At the same time, many small businesses — as well as their teaming partners — do not understand how SBA determines whether a company is small or the various ways in which a small business can unintentionally lose its status as a small business. Understanding these concepts is critical to remaining eligible to bid and receive set-aside contracts.

How is size determined?

If you have a basic familiarity with small business contracting, you may be thinking, “How complicated can this be? There is a size standard assigned to each procurement, and if my company qualifies as small under the applicable size standard, we are eligible for award.” The complexity arises when one considers whether the small business contractor in question has any affiliates.

A size standard represents the largest size that a business (including its subsidiaries and affiliates) may be to be considered a small business for federal contracting programs. Size standards are based on either the firm’s average annual receipts or the firm’s average number of employees. When SBA determines a company’s size under either a receipts-based sized standard or an employee-based size standard, SBA includes the revenues or employees of the company and the revenues or employees of any affiliates.

If a solicitation requires offerors to certify their size, the disappointed offerors have the opportunity to file a size protest, alleging that the apparent successful offeror is ineligible for award. In the vast majority of size protests, the protester argues the apparent successful offeror is other-than-small because it is affiliated with one or more other concerns and exceeds the applicable size standard. A size protest triggers a size determination by SBA. SBA will request extensive documentation and information from the protested company, including information about potential affiliates. If SBA determines that the protested company is not small under the applicable standard, SBA’s regulations provide that the contracting officer shall either not select the protested firm for award or terminate the award if award has been made. Put another way, a finding of affiliation may result in the loss of a contract.

What is affiliation?

Broadly, affiliation occurs when one business has the ability to control another business, or when a third party has the power to control both businesses. Control may arise through common ownership, management or other relationships or interactions, including familial connections, between two or more companies. Importantly, it does not matter if the ability to control is exercised — the key consideration is whether the power to control exists. There are multiple scenarios that can give rise to affiliation, and some of the most common are discussed below.

Common ownership

Common ownership occurs when an owner of a firm holds an ownership interest in one or more other firms. In some situations, the nature of the common ownership is clear. Common ownership can also be complex and less apparent, particularly when a company is owned by multiple shareholders.

Size Appeal of Government Contracting Resources, Inc., SBA No. SIZ-706 (2016), demonstrates the complexities that may arise in this area. The protested firm, Government Contracting Resources, Inc. (GCR), and 20 other companies held equal minority ownership interests in Valley Indemnity, Ltd. (Valley). SBA found that because there was no majority shareholder and there were multiple shareholders with equal ownership interests, GCR was presumed to control Valley. At SBA’s Office of Hearings and Appeals (OHA), GCR argued that it had rebutted the presumption that all of the minority owners controlled Valley because GCR’s 4.16% ownership interest was not large enough to facilitate control, and GCR’s appointed director was one of 26 directors. OHA rejected this argument, stating: “If appellant’s interests are too small to control Valley, the same could also be said for each of Valley’s other owners, with the result being that no party would control Valley. OHA, though, will not accept an argument that a firm is not controlled by any party.” OHA affirmed the initial size determination, and GCR was ineligible for award.

Importantly, control may be affirmative or negative. For example, if an owner holds a minority ownership interest in a company (i.e., less than 50%), but that minority owner has the ability under the company’s bylaws, operating agreement or shareholders’ agreement to prevent the company from taking an action, that minority owner may have negative control.

Ostensible subcontractor

Affiliation can also arise because of the relationship between the firms themselves, and in such situations, the finding of affiliation is often based on the ostensible subcontractor rule. The ostensible subcontractor rule provides that a prime contractor and subcontractor are affiliated if 1) the subcontractor is performing the primary and vital requirements of the contract or 2) the prime contractor is unusually reliant upon the subcontractor. Notably, either circumstance can give rise to affiliation. When assessing an allegation of affiliation under the ostensible subcontractor rule, SBA examines all aspects of the prime contractor-subcontractor relationship, including the proposal for the procurement and any related agreements.

OHA has identified the following four factors to determine whether a prime contractor is unusually reliant on a subcontractor: 1) the subcontractor (or proposed subcontractor) is the incumbent on the contract and is ineligible to compete for the instant procurement; 2) the prime contractor plans to hire the large majority of its workforce from the subcontractor; 3) the prime contractor’s proposed management served with the subcontractor on the incumbent contract; and 4) the prime contractor lacks relevant experience and as a result must rely on the more experienced subcontractor to win the contract.

If SBA makes a finding of affiliation under the ostensible subcontractor rule, the affiliation finding is limited to the procurement at issue, which means the companies may still be eligible for award of other small business contracts.

Why should contractors of all sizes be aware of affiliation?

The rules governing affiliation are complicated and nuanced, and a company often has an affiliate and does not realize it until after a size protest is filed and the protested award is in jeopardy. Importantly, for a given procurement, SBA determines the size of a concern as of the date the firm submits “its initial offer or response which includes price.” In other words, if a size protest is filed, it is too late to address the problems raised in the size protest for the purposes of the challenged award.

An adverse size determination will result in the loss of a contract and can also affect the firm’s ability to compete for future set-aside contracts. With the exception of adverse size determinations based on a violation of the ostensible subcontractor rule, the small business will be deemed ineligible for award of set-aside contracts until the firm is recertified as small. And, if the protested firm is a protégé in a mentor-protégé joint venture, the joint venture will be ineligible for award of set-aside contracts until the protégé is recertified.

How can a company avoid affiliation?

All of this begs the question: What can a small business do to avoid affiliation? The types of affiliation discussed above are preventable. However, taking the proactive steps needed to avoid affiliation requires a thorough understanding of affiliation and the circumstances that may give rise to a finding of affiliation. For example, the firm’s corporate documents should be reviewed to have a full understanding of who controls the company – even if what is on paper differs from the day-to-day reality of the firm’s operations.

Companies teaming with a small business contractor for a set-aside contract should exercise due diligence when entering a teaming relationship. Companies teaming with small businesses should also ensure that teaming agreements, subcontracts and other agreements include representations concerning the prime contractor’s small business status.

Affiliation is a complex and dynamic subject with potentially significant consequences for small businesses and their teaming partners. If small businesses and their teaming partners gain an understanding of the circumstances that may result in affiliation, they may be able to prevent an affiliation finding and a resulting adverse size determination—preserving the small business’s ability to compete for prized set-aside contracts.

Michelle Litteken is Of Counsel with the Government Contracts Practice Group in Morris, Manning & Martin LLP’s Washington, D.C. office. She focuses on helping clients understand and successfully navigate all aspects of government contracts by using creative and practical measures.

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