Understanding the Ostensible Subcontractor Rule
Federal regulations limit the percentage of a set-aside contract that a prime contractor may subcontract to other concerns. Compliance with these limitations on subcontracting, however, does not necessarily make a small business concern safe from a finding of affiliation by the SBA. Small government contractors or 8(a) concerns that rely too heavily on another business for subcontracting may trigger affiliation under the Ostensible Subcontractor Rule. The Ostensible Subcontractor Rule holds that a small business which “is unusually reliant” on a subcontractor may be deemed affiliated for size determination purposes. Small businesses and 8(a) concerns must therefore understand the requirements and potential risks under this rule when hiring subcontractors or entering into teaming agreements with respect to government contracts.
The ostensible subcontractor rule treats a prime contractor and its subcontractor “as joint venturers, and therefore affiliates, for size determination purposes” when the subcontractor “performs primary and vital requirements of a contract,” or the prime contractor is “unusually reliant” upon the subcontractor. 13 C.F.R. § 121.103(h)(4). The rule, which applies equally to all set-aside contracts — including small business, 8(a), and HUBZone contracts — aims to “‘prevent other than small firms from forming relationships with small firms to evade SBA’s size requirements.’” Size Appeal of Iron Sword Enters., LLC, SBA No. SIZ-5503, 2013 SBA LEXIS 113, *13 (2013) (quoting Size Appeal of Fischer Bus. Solutions, LLC, SBA No. SIZ-5075, at 4 (2009)).
To determine whether the relationship between a prime contractor and a subcontractor violates the rule, SBA considers “[a]ll aspects of the relationship,” including: 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.
13 C.F.R. § 121.103(h)(4). Unfortunately, beyond this non-exclusive list, SBA regulations do not provide any additional guidance as to what constitutes the “primary and vital” contract requirements or when the prime contractor is “unusually reliant” upon a subcontractor. SBA’s Office of Hearings and Appeals (“OHA”), however, has developed a substantial body of case law interpreting the ostensible subcontractor rule.
The relevant case law identifies several factors that OHA deems indicative of ostensible subcontractor affiliation. The presence of one or more 1 of these factors does not necessarily mean that the relationship between the prime contractor and the subcontractor violates the rule; rather, SBA evaluates ostensible subcontractor affiliation on a case-by-case basis.2 The most pertinent factors with respect to evaluating the potential application of the ostensible subcontractor rule are discussed below.
1. Division of Work
The ostensible subcontractor rule identifies “the percentage of subcontracted work” as an important consideration. 13 C.F.R. § §121.103(h)(4). The larger the subcontractor’s share of the work, the greater the risk of affiliation. Indeed, since the “primary and vital requirements of a contract” account for only a fraction of the total cost of the contract, ostensible subcontractor affiliation can occur even if the subcontractor performs substantially less than the regulatory limitations on subcontracting allow. See, e.g., Shoreline Servs., 2013 SBA LEXIS 63, *23 (citing Size Appeal of Santa Fe Prot. Servs., Inc., SBA No. SIZ-5312, at 10 (2012)) (“Not all the requirements identified in a solicitation can be primary and vital, and the mere fact that a requirement is a substantial part of the solicitation does not make it primary and vital.”); Size Appeal of Greenleaf Constr. Co., Inc., SBA No. SIZ-4663, 2006 SBA LEXIS 14, *18 (2006) (fact that challenged firm complied with the Limitations on Subcontracting Clause does not preclude a finding of unusual reliance).
In the context of construction contracts, however, compliance with the ostensible subcontractor rule is analyzed somewhat differently:
For services, OHA has held ‘the prime contractor must perform the contract’s primary and vital requirements, not merely manage the subcontractor’s performance of these tasks.’ In construction contracting, however, OHA has recognized that subcontractors often perform a majority of the actual construction work, because the prime contractor frequently must engage multiple subcontractors specializing in a variety of trades and disciplines. Accordingly, ‘[t]he primary role of a prime contractor in a construction project is to superintend, manage, and schedule the work, including coordinating the work of the various subcontractors.’ Stated differently, a small business prime contractor on a construction contract may delegate a large portion of the construction work to its subcontractors without contravening the ostensible subcontractor rule, provided that the prime contractor retains management of the contract.
Iron Sword, 2013 SBA LEXIS 113, *14-15 (emphasis added); see also Size Appeal of J.R. Conkey & Assocs., Inc., SBA No. SIZ-5326, at 8 (2012); Size Appeal of Roundhouse PBN, LLC, SBA No. SIZ-5383, at n.6 (2012). Thus, in Iron Sword, OHA held that “the mere fact that [the prime contractor] proposed to self-perform a comparatively small portion of the actual construction work is not sufficient to establish a violation of the ostensible subcontractor rule.” Id. at *15. Because OHA regards the management of a construction contract to be the prime contractor’s primary role, it focuses less on the amount of work that the subcontractor is performing and more on other factors that tend to show that the prime contractor would be unusually reliant upon the subcontractor. See, e.g., Garbutt Constr., 2009 SBA LEXIS 94, *15-18.
SBA is likely to find a prime contractor affiliated with a subcontractor if the prime relies on the subcontractor to provide key personnel. See, e.g., ACCESS, 2007 SBA LEXIS 22, *36 (“Appellant does not propose to its own current personnel for any of the key positions”). As stated by OHA: “If a concern cannot manage a contract without the presence of a key subcontractor employee, this gives a large measure of control to that subcontractor.” Size Appeal of TKC Tech. Solutions, LLC, SBA No. SIZ-4783, 2006 SBA LEXIS 32, *23 (2006). In TKC, the prime contractor had proposed the subcontractor’s employee as project manager. OHA held that this arrangement fully justified “the Area Office’s determination that the prime contractor was unduly reliant upon the subcontractor,” stating that the use of the subcontractor’s employee as the program manager was “an admission that [the prime contractor] lacked the ability to perform the contract without him.” Id. at *24.
Similarly, in Garbutt, OHA held that the prime contractor’s selection of the subcontractor’s employee as on-site superintendent (combined with the subcontractor’s agreement to indemnify the surety) showed that that prime was unusually reliant upon the subcontractor. OHA observed that “the provision of the on-site superintendent is a primary and vital function for a construction contract,” and the fact that the subcontractor’s employee would perform that role gave the subcontractor “an important measure of control or power.” 2009 SBA LEXIS 94, *17; see also Iron Sword, 2013 SBA LEXIS 113, *15-16 (use of subcontractor’s employee as on-site project manager showed that the subcontractor, not the prime contractor, “primarily controls management of the contract”).
3. Relative Experience
The relative inexperience of the prime contractor also increases the likelihood of a finding of ostensible subcontractor affiliation. As OHA said in Smart Data, “a prime contractor must bring something to the table beyond its small business size status and . . . that something must be, at a minimum, the ability to perform primary and vital contract requirements.” 2009 SBA LEXIS 78, *49. Thus, where a “neophyte prime” teams with an experienced subcontractor, SBA will probably find that the prime could not qualify for the contract award without unusual reliance upon the qualifications or other assistance from the subcontractor. See Size Appeal of Ahuska Int’l Sec. Corp., SBA No. SIZ_4752, 2005 SBA LEXIS 76, *21 (2005); Smart Data, 2009 SBA LEXIS 78, *49.
For example, in Garbutt, OHA observed that the small prime contractor did not have “any experience in performing contracts near the size of its current $12,297,800 bid.” 2009 SBA LEXIS 94, *16. The largest contract the prime contractor had performed was only $3,118,078. Id. The administrative judge stated that “[h]ence the facts undeniably suggest that [the prime contractor] and [the subcontractor] are really proposing to share the management of a project much larger than those performed by [the prime contractor] in the past and for which [the prime contractor] could not obtain the statutorily required payment and performance bonds on its own.” Id. Finding the record “entirely too suggestive of a pass-through,” the judge concluded that “it appears Appellant’s only material contribution to this procurement is its size and its HUBZone status.” Id. at *17-18.
4. Bonding, Financing, and Equipment
“SBA may find affiliation if the subcontractor supplies critical bonding, financing, or equipment, particularly if the prime could not obtain these things from other sources.” Koprince, supra note 1, at 22. Indeed, 13 C.F.R. § 121.103(h)(4) specifically mentions “bonding assistance” as an important consideration. Thus, in Garbutt, OHA found that the prime contractor was affiliated with the subcontractor in part because the subcontractor had agreed to indemnify the surety for the statutorily required performance and payment bonds. 2009 SBA LEXIS 94, *15-16. See also Iron Sword, 2013 SBA LEXIS 113, *18 (teaming agreement contemplated bonding assistance); Size Appeal of H. R. Allen, Inc., SBA No. 2830, 1988 SBA LEXIS 197, *10 (1988) (although “bonding assistance alone does not prove a joint venture, the provision of such assistance in the presence of other relevant indicia of affiliation (such as incapacity to perform the contract) has been held probative of a joint venture”); Size Appeal of Emergency Beacon Corp., SBA No. SIZ-4813, 2006 SBA LEXIS 67, *42 (impossible for prime contractor to perform the contract without the subcontractor’s equipment).
5. Terms of the Teaming Agreement
13 C.F.R. § 121.103(h)(4) also directs the SBA to consider the parties’ “teaming agreement.” For example, the agreement in ACCESS was found to support an ostensible subcontractor finding since it was prepared on the subcontractor’s letterhead. ACCESS, 2007 SBA LEXIS 22, *10. Furthermore, the agreement’s provisions raised doubts as to whether the prime contractor would perform the primary and vital contract requirements, as the subcontractor had reserved for itself the hardware and software components of a computer-related services contract. Id. at *39-40.
Another factor expressly mentioned by 13 C.F.R. § 121.103(h)(4) is “whether the subcontractor is the incumbent contractor and is ineligible to submit a proposal because it exceeds the applicable size standard for that solicitation.” “[E]ngaging the incumbent as a subcontractor leads to heightened scrutiny of the arrangement, but is not a per se violation.” Size Appeal of InGenesis, Inc., SBA No. SIZ-5436, 2013 SBA LEXIS 5, *41-42 (citing Size Appeal of HX5, LLC, SBA No. SIZ-5331, at 11). For example, in CWU, SBA No. SIZ-5118, the incumbent contractor’s receipts exceeded the $7 million size standard. It subsequently entered into a subcontract with a small business for the follow-on contract. Observing that “incumbency can be probative of unusual reliance,” OHA held that the subcontractor’s incumbency, combined with other factors, demonstrated ostensible subcontractor affiliation.
7. Proximity to the Jobsite
The parties’ relative distance from the jobsite is another factor, especially where the work requires onsite supervision, such as construction. The construction project in Garbutt was in Grand Rapids, Michigan, but only the subcontractor had an office in Grand Rapids. The prime contractor’s office was in Georgia, and the contractor’s prior experience was concentrated there as well. The administrative judge observed, “Superintending and managing construction cannot be accomplished without presence at the construction site, and Appellant’s headquarters is more than 900 miles from Grand Rapids, Michigan.” Garbutt, 2009 SBA LEXIS 94, *15. Thus, the prime contractor’s distance from the jobsite was viewed as evidence of affiliation.
8. Proposal Preparation
“If the subcontractor drafts the proposal or otherwise plays a large role in determining the content of the proposal, it is indicative of ostensible subcontractor affiliation.” Koprince, supra note 1, at 20. In Garbutt, the subcontractor “took the lead and responsibility for submitting the bid and locating the required subcontractors who [were] going to perform the work required by the [contract].” 2009 SBA LEXIS 94, *15. In fact, the prime contractor did not even attend the pre-bid walk-thru or request plans and specifications, whereas the subcontractor did. Id. OHA regarded these facts as indicative of unusual reliance. See also Size Appeal of ePerience, Inc., SBA No. SIZ-4668, 2004 SBA LEXIS 83, *13 (2004) (collaboration in drafting the proposal, and prime contractor’s reliance on subcontractor’s in-depth knowledge of the solicitation was “another strong indicia” of affiliation).
9. Proposal Terminology
Using the word “team” to describe the relationship between the prime and the subcontractor does not necessarily lead to a finding of undue reliance. See Size Appeal of Greenleaf Constr. Co., Inc., SBA No. SIZ-4663, 2004 SBA LEXIS 58, *22 (2004) (“Under any circumstances, the mention of ‘team’ and ‘partnering’ does not equate with a mandatory finding of an ostensible subcontractor relationship.”). “However, persistent identification of the “team” over the prime contractor is one factor that can be used to support a finding of undue reliance. This is especially true when the proposal emphasizes the experience of the subcontractor over the experience of the prime contractor.” CWU, SBA No. SIZ-5118 (citations omitted). Thus, in ACCESS, the administrative judge observed, “Appellant’s proposal makes no differentiation between itself and [its subcontractor]. Instead, it constantly refers to the [prime contractorsubcontractor] team, to ‘we’ to describe effort or plans to ‘our’ this or that. Given the pervasive nature of these references, I find these references are probative evidence of unusual reliance.” 2007 SBA LEXIS 22, *37. See also Size Appeal of J. W. Mills Mgmt., LLC, SBA No. SIZ-5416, 2012 SBA LEXIS 113 (“Appellant’s proposal makes consistent reference to its anticipated teaming arrangement with BCI and emphasize the experience of the team, including placing BCI logo along with Appellant’s logo on various pages of its proposal, which is probative of a joint effort in submitting the proposal.”).
10. Profit Sharing
Under OHA precedent, a profit sharing arrangement does not automatically create affiliation but is “‘one aspect of the totality of the circumstances” that should be considered.’” Size Appeal of J. W. Mills Mgmt., LLC, SBA No. SIZ-5416, 2012 SBA LEXIS 113, *23-24 (2012) (quoting Size Appeal of Infotech Enterprises, Inc., SBA No. SIZ-4346, at 15 (1999)). In J.W. Mills, OHA accepted the prime contractor’s “reasonable” explanation that it had advocated the profit-sharing approach in order to ensure that it would not lose money on the contract, and concluded that “under the circumstances presented here, the profit sharing arrangement is not indicative of a joint venture.” In Size Appeal of Am. Guard Servs., SBA No. SIZ-4397 (2000), on the other hand, OHA found the prime and subcontractor affiliated based in large part on the companies’ agreement to split profits on a 60/40 percent basis.
11. Hiring Subcontractor’s Rank and File Employees
SBA may find the prime and subcontractor affiliated where the prime relies upon the subcontractor for essentially all of its workforce. See, e.g., Size Appeal of DoverStaffing, Inc., SBA No. SIZ-5300, 2011 SBA LEXIS 106, *18-19 (2011) (“The critical point, which Appellant does not dispute, is that not only will Appellant be subcontracting to [Subcontractor One] for 40% of the work on this contract, but Appellant will be hiring the [Subcontractor One]’s incumbent employees en masse to perform Appellant’s 51% of the work.”). In InGenesis, however, OHA held that a prime contractor’s plan to hire much of its non-managerial workforce from the subcontractor, after evaluating and negotiating with those employees individually, did not establish unusual reliance. OHA explained that “although Appellant’s proposal did indicate that Appellant planned to hire incumbent employees if practicable, the proposal nevertheless makes plain that Appellant will utilize a detailed vetting process to evaluate, and negotiate, with employees individually.” 3 InGenesis, 2013 SBA LEXIS 5, at *38-39.
Small government contractors or 8(a) concerns must take care to understand and avoid affiliation under the Ostensible Subcontractor Rule, which can be a frequent obstacle in government contracting. Whenever possible, avoiding potential indicia of affiliation is always the best practice. But when ostensible subcontractor risk factors do exist, structuring the relationship carefully may help the parties avoid a successful size protest. As long as contractors are careful in the structuring of their teaming agreements and follow the standards practices established, they should be able to avoid the pitfalls of affiliation and the Ostensible Subcontractor Rule. Attorneys at Jackson Rosenfield LLP are available if you need assistance in designing or reviewing a teaming agreement, or in evaluating whether a subcontractor would likely be deemed affiliated under the Ostensible Subcontractor Rule for size determination purposes.
1OHA precedent originally identified seven factors to be considered when determining 1 whether affiliation exists under the ostensible subcontractor rule, as follows:
1. which party will manage the contract;
2. which party possesses the requisite background and expertise to carry out the contract;
3. which party chased the contract;
4. the degree of collaboration on the bid or proposal;
5. whether there are discrete tasks to be performed by each party, or, rather, a commingling of personnel and material;
6. the amount of work to be performed by each party; and
7. which party performs the more complex and costly contract functions.
See D.P. Associates, Inc., SBA No. SIZ-2719, 1987 WL 93680, at *2 (Aug. 7, 1987). The seven factors test is now defunct because of the current rule’s requirement that SBA consider “all aspects of the relationship between the prime and subcontractor.” See e.g., Microwave Monolithics, Inc., SBA No. SIZ-4820, 2006 WL 3519106, at *7 (Nov. 16, 2006) (explaining that the seven factors test is an earlier way of encapsulating what has since been codified in the ostensible subcontractor rule). Nevertheless, even though OHA is no longer supposed to use the seven-factor test, the aspects that currently receive the greatest attention overlap to a great extent with the old factors. See Size Appeal of C&C Int’l Computers & Consultants, Inc., SBA No. SIZ-5082, 2009 SBA LEXIS 93, *30 (2009) (“Even though these factors do not apply the correct legal standard (all aspects of the relationship), OHA has tolerated their use because the seven factors test covers matters that may be indicative of affiliation and thus beneficial.”).
2“Ostensible subcontractor inquiries are intensely fact-specific given that they are based upon the specific solicitation and specific proposal at issue.” Iron Sword, 2013 SBA LEXIS 113, *13. “As a result, prior cases have very little precedential value, aside from certain general principles, and OHA has acknowledged this reality.” Size Appeal of C.E. Garbutt Const. Co., SBA No. SIZ-5083, 2009 SBA LEXIS 94, *12 (2009).
3“OHA also noted that Executive Order 13,495, “Nondisplacement of 3 Qualified Workers under Service Contracts,” encourages the hiring of incumbent non-managerial personnel. Id. at *39. The order states:
It is the policy of the Federal Government that service contracts and solicitations for such contracts shall include a clause that requires the contractor, and its subcontractors, under a contract that succeeds a contract for performance of the same or similar services at the same location to offer those employees (other than managerial and supervisory employees) employed under the predecessor contract whose employment will be terminated as a result of the award of the successor contract, a right of first refusal of employment under the contract in positions for which they are qualified.
In light of Executive Order 13,495, “OHA has found that it is not problematic for a prime contractor to hire a subcontractor’s non-managerial workforce, provided that personnel are reviewed individually rather than unilaterally transferred or hired en masse. InGenesis, 2013 SBA LEXIS 5, *36.