New small business subcontracting rule means headaches for everyone

Watch out, a new small business subcontracting rule took effect Tuesday. It brings new limits on subcontracting on set-aside contracts. It harmonizes a confusing situation of a mismatch between Small Business Administration rules and the Federal Acquisition Regulation. For the details, Federal Drive with Tom Temin spoke with Haynes Boone procurement attorney Dan Ramish.

Interview Transcript: 

Tom Temin What this new rule does then is match what Congress said it wanted for subcontracting under set asides. And now the FAR and the SBA rules match?

Dan Ramish These new SBA rules are part of a series of changes that SBA has made to clarify protections for small business set aside awards to make sure that small businesses aren’t just acting as a front for large businesses and that the small businesses themselves are benefiting from set aside work. These new rules, they’re refinements of long standing rules. One of them is the limitations on subcontracting, which provides a specific limit as to the percentage of work that a small business prime contractor that receives a set aside award can subcontract to businesses that are not small or that don’t have the applicable socioeconomic status. Right.

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Tom Temin And that’s always been under 50%, right?

Dan Ramish Yeah. So the maximum is 50% of the amount paid by the government can be subcontracted to large businesses or businesses that are not as the term is similarly situated. So if it’s a woman-owned small business set aside, the woman-owned small business prime contractor can’t have a non woman owned business as a subcontractor performing more than that 50%.

Tom Temin I mean, the basic idea here is that Lockheed and IBM and or you name the company can’t hang a little sign on the front that says 8A Company. But really once you lift the sign, pass the nos. The camel is the large company.

Dan Ramish That’s right. I mean, the governmentwide goals are 23% for small businesses of prime contract value. And there are goals for all these other statuses. Right. And it’s hard for agencies to meet those. And so the concern of SBA is, well, exactly as you say, large businesses will find ways to get around that. And so limitations on subcontracting are one of those ways. And it’s a requirement that small business prime contractors have. Now, there is going to be a new, more certain penalty for small businesses. There are already monetary penalties and there’s a mention of debarment in the existing rules. But those are hard for agencies to enforce. The new penalties relate to past performance ratings. And so they say specifically that a contracting officer can’t generally now give a satisfactory positive past performance evaluation. If at the end of a contract, they determine that the prime contractor didn’t comply with the limitations on subcontracting.

Tom Temin Does that mean they can give a negative rating?

Dan Ramish It means they must give a negative rating. Unless there are special circumstances. But they make it difficult for the contracting officer to use those exceptions. So not only do they have to find that there was something outside of the contractors control that resulted in their inability to to meet this requirement, and that has to be something like force majeure or unexpected changes in their supply chain, things that are that they couldn’t have anticipated, unforeseen labor shortages, those kinds of things. So there has to be those those extenuating circumstances. And then the rules also say it has to be approved at a level above the contracting officer. So SBA is really telling agencies you have to give a negative performance rating unless you jump through all these hoops. And there’s really a good reason not to. The offshoot of this is it’s been hard for agencies to enforce these rules first, because the formulas are complicated. But then SBA has found that agencies haven’t been providing adequate oversight. And so they’re trying to raise the stakes for noncompliance and deter prime contractors from ignoring these rules by making it clear that there are going to be consequences to past performance and their ability to win new work if they ignore the rules.

Tom Temin We’re speaking with Dan Ramish. He’s a procurement attorney with Haynes Boone. And I wanted to ask you about one provision in here that’s a little bit complicated. That’s the ostensible subcontractor rule, which is sort of a complication and a watch here. What is that all about?

Dan Ramish This is another mechanism that SBA regulations have for making sure that large businesses aren’t trying to get around the rules and take advantage of small businesses to get set aside dollars. This rule has been around a long time. It’s typically litigated in size protests at SBA area offices, and then at the Office of Hearing and Appeals of the SBA, which has administrative judges that hear appeals of size protests. And so this rule, basically there are two different prongs of this. The SBA Office of Hearings and Appeals will look at whether the prime contractor on a set aside contract is subcontracting the primary and vital requirements of the contract. So if a small business wins this award. And then gives the core part of the work defined in the case law as the principal purpose of the acquisition. They just have a large business do the main work and they just do a little side piece. Then that’s a violation and results in affiliation. Or the other prong is if if the prime contractor is unusually reliant on a subcontractor and that has its own separate test, where again, SBA looks at it and says this is really a large business acting through a small business. And so there are new rules here on the ostensible subcontractor rule that provide a safe harbor. And it actually relates to the other rule that we mentioned, the limitations on subcontracting. So now moving forward, if there is a challenge regarding the ostensible subcontractor rule and competitors saying you small business have violated the rule, the small business can point to the limitations on subcontracting, if they can demonstrate that they are satisfying that limitation, that they’re not for service and supply contracts subcontracting more than 50% of the dollars they get from the government, then that’s a defense. And SBA won’t find them in violation of the ostensible subcontractor rule.

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Tom Temin Well, here’s a twist that I’ll throw at you. Suppose that the dollars going to the sub, which is the large business, are 45% or 35%, and therefore you’re well below that limitation on how much you can subcontract out of the dollar value. What if that 35% or nevertheless is paying for the main work and the 65% of the dollars are paying for the ancillary? What’s the situation then?

Dan Ramish Sure. So the safe harbor says SBA is not even going to get into that for their purposes as as long as the small business is doing at least the 50% of the work on a service or supply contract, they’re not going to let a competitor argue that the primary and vital functions are being subcontracted to a large business. If they’re doing that much of the work, the purpose of the set aside is satisfied the small business is getting the benefit of it. Now there is one exception to this safe harbor, and that’s for construction services, because and this is based on the nature of the construction industry. So the limitations on subcontracting rule actually has a different threshold for construction and says a general construction contractor can actually subcontract 85% of the dollars that it gets from the government. And so the safe harbor doesn’t extend to the construction industry if there is a general construction contract. But the rule does provide additional clarity for those contractors because it defines what is considered the primary and vital functions on a general construction contract. And it says the management supervision and oversight of the project, including the coordinating of work of various subcontractors and not the actual construction work that’s performed, is the primary and vital functions. So if you’re a general contractor on a construction project and you’re a small business on a set aside, if you are doing the oversight and management and supervision, which is the traditional rule, that’s the key function on those contracts, this provides clarity. So you don’t have to worry about interpreting what what the primary and vital functions of those contracts are.

Tom Temin Right? Because if you’re building a parking structure, say, and you’re overseeing that as a small business, you’re going to have to buy the steel from likely a large company or a fabricator. And those tend to be bulky companies. And so the biggest cost element might be the steel components, but you’re still safe because you’re overseeing it and managing it.

Dan Ramish That’s right. You wouldn’t be subcontracting the primary and vital functions. There’s an acknowledgment that in those circumstances you’re using a whole bunch of different trade contractors. The management is the key thing.

Tom Temin All right. So this rule is in place. What do you think agencies need to do and what do companies need to do? We know what what small businesses need to do is mind their P’s and Q’s on how they subcontract anything else the agencies ought to be doing to to make sure it doesn’t happen in the first place?

Dan Ramish Well, contracting officers will certainly be paying more attention to the limitations on subcontracting to follow this new past performance requirement for contractors. The limitations on subcontracting. There should be a renewed focus to make sure that they’re going to be able to comply by the end of the contract with those requirements or they’re going to be more certain consequences. And then on the ostensible subcontractor piece, it’ll be helpful for prime contractors to have some kind of contemporaneous documentation that they’re going to meet the limitations on subcontracting rule so that if they get challenged on this ostensible subcontractor role, they’ll be able to say, hey, look, we’re complying with the limitations on subcontracting. It’s not always the case when you’re submitting a proposal or entering into teaming arrangements that you document exactly how much of the work you’re going to perform. But now there’s an additional benefit to doing that so that you can use it as a defense against this.

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