I. Introduction
Imagine you are a government contractor and you pick up the phone after hearing it ring.
Salesperson: “Hey! Acme, Inc., a small business, just called and they want to partner on a new small business set-aside. They need us to perform a big part of the work, and we can’t bid directly because it’s a set-aside. I’m going to send you the solicitation now.”
You: “We need to consider the Ostensible Subcontractor Rule before we commit to anything.”
Salesperson: “The what!? This is a huge contract. We want to win!”
It is common for conversations that involve the “Ostensible Subcontractor Rule” to begin like this. The Ostensible Subcontractor Rule is one of many rules designed to prevent large businesses from reaping the benefits of contracts reserved for small businesses. The Ostensible Subcontractor Rule has an admirable purpose in reserving certain benefits for small businesses, but it is nuanced, confusing, and difficult to apply. These roadblocks are exacerbated when agencies outside of the Small Business Administration (SBA) solicit for set-asides. In the author’s experience, contractor personnel and government contracting professionals frequently do not understand the Ostensible Subcontractor Rule. Further, they lack the same objectives as the SBA. Because the SBA has ultimate authority to make determinations regarding the Ostensible Subcontractor Rule, small and large businesses may be totally transparent about their relationships and may even be performing the contract with the blessing of the SBA (which just wants the contract to be performed). However, the SBA can swoop in, find the Ostensible Subcontractor Rule applies, and leave the contract with no one to perform the work (as it was improperly awarded). This also creates liability concerns for the contractor.
While the Ostensible Subcontractor Rule only applies to contracts for “other than manufactured products,” contractors must comply with the Limitations on Subcontracting clause in all contracts in addition to being cautious about the Non-Manufacturer exception to this rule. The Limitations on Subcontracting clause and its exception apply in addition to, not instead of, the Ostensible Subcontractor Rule in the case of contracts for other than manufactured products. This rule states that a small business prime “will not pay more than [fifty percent] of the amount paid by the government to it to firms that are not similarly situated.” In other words, if the contract is for supplies, the prime may not subcontract more than fifty percent of the cost to manufacture the product (excluding the cost of materials) to non-similarly situated entities. Contractors must consider both rules when dealing with small business set-asides. Finally, these rules have gone through several recent changes, complicating how to apply these rules.
This article begins with a brief synopsis of relevant small business contracting concepts. Then, it provides an in-depth analysis of the Ostensible Subcontractor Rule, the Limitations on Subcontracting clause, and the information contractors need to navigate these rules.
II. In the Beginning: Small Business Contracting
When contracting with the federal government, businesses must identify themselves as either other than small (i.e., large) or small. The SBA explains the purpose of this identification:
To help provide a level playing field for small businesses, the government limits competition for certain contracts to small businesses. Those contracts are called ‘small business set-asides,’ and they help small businesses compete for and win federal contracts. There are two kinds of set-aside contracts: competitive set-asides and sole-source set-asides.
In addition, small businesses may further certify that they fit into certain socio-economic categories, including disadvantaged, HUBZone, woman-owned, veteran-owned, and service-disabled veteran owned. The FAR does not prescribe how to determine size or socio-economic status, as the rules for such determinations are in 13 C.F.R. Part 121. To be “small,” a contractor must satisfy the size standard for the North American Industry Classification System (NAICS) code selected for the contract. For each NAICS code, size is determined by measuring either a company’s annual receipts (i.e., revenue) or number of employees.
A. Affiliation
As part of the size determination process, the SBA aggregates the employees or annual receipts of the offeror and its affiliates. This “affiliation rule” aims to prevent large businesses from buying or creating a subsidiary—no matter the number of employees or revenue of the subsidiary—that would qualify as a small business. The SBA wants true small businesses competing for set-asides. SBA regulations define an “affiliate” as an entity that “controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists.” The SBA weighs “factors such as ownership, management, previous relationships with or ties to another concern, and contractual relationships.” “Control may be affirmative or negative.” In making a size determination, the SBA assesses the “totality of the circumstances.” The procedures the SBA considers in making this determination can be found in 13 C.F.R. Part 121.
B. Joint Ventures
A “joint venture” (JV) of two or more businesses may also compete for government contracts, including set-asides. A JV is a separate entity for the purposes of government contracting and must have its own name, a Commercial And Government Entity (CAGE) code, and SAM registration. All parties to a JV must be small to qualify for a set-aside, and the affiliation rule applies in this context as well. However, there is an exception to this rule that allows JVs comprised of large and small businesses to qualify for a set-aside if they have a mentor-protégé agreement (MPA). This article discusses MPAs in greater detail in III.C.vi below.
III. Ostensible Subcontractor Rule
A. Introduction to the Ostensible Subcontractor Rule
When a small business decides to pursue a set-aside as the prime contractor and anticipates engaging subcontractors, it must carefully consider the size of its subcontractors and the type of work they will be performing. In set-aside contracts for other than manufactured products, the small business prime contractor could be deemed to be a JV and, thus, affiliated with any of its subcontractors that are determined to be ostensible subcontractors. Such affiliation could cause the small business prime contractor to lose its small business size status and become ineligible for contract award. Specifically:
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. 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.
The key factors for evaluating whether a subcontractor is an ostensible subcontractor include (i) whether the prime contractor and subcontractor are “similarly situated,” (ii) whether the subcontractor is performing the “primary and vital” requirements of the contract or order, and (iii) whether the prime contractor is “unusually reliant” upon its subcontractor for performance.
1. Similarly Situated
A subcontractor is “similarly situated” when it “has the same small business program status as the prime contractor.” In other words, the subcontractor must be (i) small under the applicable NAICS and(ii) have the same status as that which qualified the prime contractor for the award (HUBZone, veteran-owned, etc.). Regarding factor (ii), the Department of Defense (DoD), General Services Administration (GSA), and National Aeronautics and Space Administration (NASA) recently updated this definition to clarify that if a contract is simply a small-business set-aside (i.e., no socioeconomic status associated with the award), then any small business concern qualifies, without regard to socioeconomic status.
2. Contracts vs. Orders
The Ostensible Subcontractor Rule applies to both the contract and specific orders. The rule states, “An ostensible subcontractor is a subcontractor that is not a similarly situated entity . . . and performs primary and vital requirements of a contract, or of an order . . . .” Therefore, the Ostensible Subcontractor Rule is relevant to each order within a contract, and performance of a single order can violate the Ostensible Subcontractor Rule.
3. Manufacturing and Supply Contracts
The Ostensible Subcontractor Rule does not apply to contracts classified as manufacturing or supply contracts. In these types of contracts, only the Limitations on Subcontracting clause and Nonmanufacturer Rule apply. The reason for this is:
In classifying the procurement as a manufacturing/supply procurement, the procuring agency must have determined that the “principal nature” of the procurement was supplies. As a result, any work done by a subcontractor on the services portion of the contract cannot rise to the level of being “primary and vital” requirements of the procurement, and therefore cannot be the basis o[f] affiliation as an ostensible subcontractor.
4. Primary and Vital vs. Unusually Reliant
Sections III.B and III.C contain a detailed analysis of both the primary and vital and unusually reliant tests, respectively. From the author’s experience, some contractors conduct a single analysis of these tests because contractors use the same facts for both. However, it is important to know that “primary and vital” and “unusually reliant” are two separate, independent tests. The rule is written in the disjunctive rather than conjunctive, and violating either causes a violation of the Ostensible Subcontractor Rule. As stated by the SBA, “the ‘[O]stensible [S]ubcontractor R]ule’ may be violated when either the prime contractor does not perform the ‘primary and vital requirements of the contract,’ or the prime contractor is ‘unusually reliant’ on subcontractors.”
Importantly, contractors must do these analyses must before responding to a solicitation, as analysis of the relevant factors may impact how a prime and subcontractor can work together, and how the proposal will be drafted.
Lastly, the tests to make these determinations are “intensely fact specific,” so there is no bright-line rule. One must analyze “the specific requirements of each solicitation and an individual offeror’s response to those requirements.” The factors discussed below will help guide contractors through each unique solicitation and identify potential concerns.
B. Primary and Vital
The SBA defines “primary and vital” as those requirements “associated with the principal purpose of the acquisition.” In determining the principal purpose, case law and SBA Office of Hearing & Appeals (OHA) rulings have identified two straightforward factors to review. First, contractors should examine the requirements associated with the “bulk of the effort, or contract dollar value.” This involves, for example, analyzing the percentage of employees, labor costs, and labor hours (i.e., time) associated with each portion of the contract. Sensibly, the portion of the contract that costs the most or takes the most time to complete is associated with the primary and vital requirement. Second, contractors should use the NAICS code assigned to the solicitation. FAR 19.102(b)(1) states, “The contracting officer [(CO)] shall determine the appropriate NAICS code by classifying the product or service being acquired in the one industry that best describes the principal purpose of the supply or service being acquired.”
In addition, COs shall consider “qualitative factors, such as the relative complexity and importance of requirements.” Kupono serves as a good example of evaluating qualitative factors. In Kupono, the Department of Energy’s National Training Center (NTC) issued a solicitation containing four contract line item numbers (CLINS). In determining the principal purpose, OHA paid particular attention to the language used in the solicitation. In finding a training CLIN was the primary and vital requirement of the contract, OHA first noted most “of the RFP is devoted to discussing [training].” In other words, if a particular requirement takes up the bulk of discussion in a solicitation, that weighs in favor of it being the primary and vital requirement. Second, the solicitation stated the procurement’s “overall objective [is] to acquire a contactor to support the mission of the [NTC].” OHA then referred to the mission statement of the NTC, which was to conduct training. OHA reasoned that if NTC’s mission was to conduct training, and the solicitation stated its objective was to support the mission of NTC, it weighed in favor of the primary and vital requirement being that most closely associated with training.
One drawback of using these qualitative factors is that they cannot be relied upon without considering the entirety of the solicitation. OHA has stated, “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.”
For example, in Tinton Falls Lodging Realty, the solicitation called for offerors to arrange and manage lodging for personnel attending training at a particular location. The scope of work required the successful contractor to ensure all personnel had lodging in the local area, to arrange for transportation to and from the training, and handle all related administrative tasks. No training dates or lodging occupancy rates were guaranteed, so the contractor had to be on call to make or cancel reservations. The awardee ultimately intended to subcontract eighty percent of the lodging to a large business, and a disappointed offeror filed a size protest. The cost for lodging was by far the most expensive part of the contract, meaning most funds would ultimately flow to a large business. However, on review, the SBA said the primary and vital aspect of the contract was logistics (e.g., arranging the lodging and transportation), despite the fact the NAICS code for the contract was “721110 (‘Hotels (except Casino Hotels)’).” In other words, the NAICS code and the largest and most expensive part of the contract were for hotel rooms, but the SBA determined the primary and vital requirements of the contract were for logistics. The Court’s rationale was that the lodging and transportation needs of the government could change frequently and with little notice, and the contractor had to respond appropriately and ensure lodging and transportation were provided. Therefore, “even though no management and coordination tasks are expressly identified, there is no question that the solicitation requires management and coordination . . . .” The Court, agreeing with and citing the Area Office’s determination, stated the “contract requires the contractor to monitor, control, record[,] and report the changing needs of [the government] for lodging and transportation. [Therefore], the primary and vital element of the solicitation was the coordination of lodging, transportation, and other services . . . .”
1. Recommendations Regarding Analyzing the Primary and Vital Factors
The lesson from Tinton Falls is that no single factor is determinative. Rather, each factor must be analyzed. There are four important questions to ask: (1) What is the NAICS code?; (2) Where are the majority of labor hours spent?; (3) What comprises the majority of the solicitation?; and (4) What comprises the majority of our response?
Warren Buffet once said, “There is nothing like writing to force you to think and get your thoughts straight.” Just as one might do a risk assessment, contractors should put these factors on paper and analyze each one. Not only does this help the team think through the issues but it also records the company’s thought process if an issue arises in the future. Between employee turnover and the simple passage of time, it is important to ensure those working on the contract in the future understand why a decision was made.
In addition to analyzing each factor, ask the government. During the question and answer portion of the solicitation response, ask: “What is the primary and vital aspect of the contract per 13 C.F.R. § 121.103(h)(2)?”
Lastly, contractors often state assumptions they have made in their solicitation response. For set-asides, state what the company believes is the primary and vital requirement and make that an assumption of the response.
C. Unusually Reliant
The Ostensible Subcontractor Rule also considers if the prime is “unusually reliant” on its subcontractors. To determine whether the prime contractor is unusually reliant, there are four “key factors” identified by the seminal SBA ruling on the subject, DoverStaffing. The four factors are: (1) the proposed subcontractor is the incumbent contractor and is ineligible to compete for the procurement; (2) the prime contractor plans to hire the large majority of its workforce from the subcontractor; (3) the prime contractor’s proposed management previously served with the subcontractor on the incumbent contract; and (4) the prime contractor lacks relevant experience and must rely upon its more experienced subcontractor to win the contract. Each factor is discussed below.
1. Factor 1: The Proposed Subcontractor Is the Incumbent Contractor and Is Ineligible to Compete for the Procurement
This factor is self-explanatory: the SBA reviews proposed subcontractors to see if they were the incumbent on the previous contract. This factor is simply a “red flag,” alerting the government that the incumbent may be using a small business as a subterfuge to continue performing a previously held contract. This can occur when an incumbent contract holder grows out of its small business status and is no longer eligible for award when the contract is recompeted.
As it is only a “red flag,” the presence of this factor alone is insufficient to cause a violation of the Ostensible Subcontractor Rule. It alerts the SBA that the remaining factors need to be analyzed. For example, if a contractor hires employees from the incumbent or plans to subcontract a large percentage of the work to the incumbent, it begins to look as if the prime is simply passing through the work. This occurred in Modus Operandi, in which a prime contractor (Modus Operandi) intended to use a single subcontractor (the incumbent contract holder). There, ten of the twenty employees assigned to the contract would be employees of the prime, and the remaining ten employees would be hired from the incumbent. OHA ultimately found Modus Operandi was unusually reliant on its subcontractor, not because the prime was using the incumbent as a subcontractor, but because of the extent to which it relied on the incumbent for its workforce.
2. Factor 2: The Prime Contractor Plans to Hire the Large Majority of Its Workforce from the Subcontractor
Factor 2 is focused on determining whether the prime can perform the contract. The logic behind the rule is that if the prime cannot show it is providing employees for the contract, it cannot be performing primary and vital functions. In other words, the prime is considered reliant on a subcontractor if it must hire most of the personnel to perform the contract. From the SBA’s perspective, it is indicative of an attempt to sidestep the rule. Essentially, the prime is saying, “We can’t subcontract the work, so let’s just ‘hire’ the subcontractor’s employees.”
Executive Order (EO) 14,055, “Nondisplacement of Qualified Workers Under Service Contracts” requires successor contractors in service contracts to hire the predecessor contractor’s employees. Upon implementation, this rule and its predecessor further complicated the unusually reliant analysis and led to SBA OHA rulings that made a distinction between hiring managerial and non-managerial personnel.
SBA rulings break down hiring of subcontractor personnel into three categories of hiring: (1) non-managerial, (2) managerial, and (3) en masse. First, hiring non-managerial personnel from a subcontractor is not viewed as strong evidence of being unusually reliant. For example, in Elevator Service Inc., the Department of Veteran’s Affairs (VA) solicited a contract to maintain elevators. The winning contractor intended to use six to eight elevator maintenance personnel to perform the physical work. The prime contractor intended to hire six (all or almost all) of the elevator maintainers from a subcontractor. These maintainers would report to a manager from the prime. The OHA found this was not indicative of unusual reliance, stating, “[t]he hiring of an incumbent subcontractor’s employees does not in itself establish unusual reliance, particularly when the managerial personnel remain under the supervision and control of the prime contractor.” Second, hiring managerial personnel alone is insufficient to establish unusual reliance where the prime has sufficient experience on its own to win. Thus, hiring managerial personnel is viewed as a factor of being unusually reliant, but it is weighed against the prime’s experience. Third, a prime may still run afoul of unusually reliant when it proposes to rely on a subcontractor for virtually all staffing, including both managerial and non-managerial employees, and without contributing the prime contractor’s own employees or other value to the project beyond its small business status. In other words, the prime is viewed as unqualified to perform if it must hire en masse and otherwise contribute little skill or knowledge to performance. This is what occurred in Modus Operandi,discussed above, where the prime intended to hire fifty percent of its workforce from a subcontractor.
An exception to this rule occurs when there is “a limited pool of eligible employees that could be utilized,” and the prime must hire employees from an incumbent or other subcontractor. This occurred in Montech, in which a small business proposed to hire a majority of its workforce for a contract from the incumbent. Despite this, the OHA found the contractor was required to hire personnel with high-level security clearances—something necessary to perform the contract—and comply with a collective bargaining agreement. Therefore, “[i]n light of these restrictions, [the prime] had a limited pool of eligible employees that could be utilized . . . and more extensive reliance upon [the] incumbent workforce would not have been improper.”
3. Factor 3: The Prime Contractor’s Proposed Management Previously Served with the Subcontractor on the Incumbent Contract
This factor may seem duplicative of Factor 2, but the analysis here is about who has ultimate management responsibility. The focus is on ensuring the prime contractoris overseeing and managing the contract and has not given this authority to a subcontractor. For example, in National Sourcing, a prime contractor proposed to have the incumbent contractor provide “mid-level leaders,” who would report to a program manager from the prime. OHA found this arrangement “cannot support the conclusion that [the subcontractor] could control the contract when [the prime] itself will employ the program manager, who will have complete control over contract performance.” In other words, the SBA wants to ensure the prime has ultimate control over performance.
Furthermore, hiring employees from a subcontractor (Factor 2) is often weighed against this factor. In Elevator Service Inc., while almost all the physical work would be performed by individuals hired from the incumbent subcontractor, OHA found this was not indicative of unusual reliance, stating, “The proposed project managers are all [prime] employees, who will have ultimate control over the contract, not [subcontractor employees].” The fact that the prime was hiring multiple employees from the subcontractor was weighed against the fact that control was maintained by the prime.
4. Factor 4: The Prime Contractor Lacks Relevant Experience and Must Rely upon Its More Experienced Subcontractor to Win the Contract
This factor is used “in evaluating all aspects of the relationship” between the prime and subcontractor. Like the other factors, the SBA is simply using this factor to judge a prime’s reliance on its subcontractors. If experience is totally lacking or minimal, the obvious question is, “How can the prime be performing this contract without relying on a subcontractor?” Stated directly, “[w]hen a prime contractor relies almost totally upon the experience of other firms to establish its relevant experience, that is probative evidence it is unusually reliant upon its subcontractor to perform the contract in question.”
There is no bright-line rule to determine what level of experience is enough, but it is clear that the contractor must have some experience relevant to the solicitation, and that experience needs to be clearly stated in the proposal. OHA easily finds a violation of the Ostensible Subcontractor rule when the prime has no experience. “In B&M Construction, Inc., OHA upheld a determination that the contractor violated the ostensible subcontractor rule because its proposal did not present any relevant past experience.” “In Bama Company, OHA upheld a determination the contractor was other than small because its proposal failed to state any of its own relevant past experience and instead cited only to its subcontractor’s experience.”
When it comes to what level of experience is sufficient, the determination is made on a “sliding scale” corresponding to the complexity of the solicitation. For example, in a commercial item procurement, it is easier to find that previous commercial item experience is similar to a new commercial item acquisition. This occurred in J.W. Mills Management, LLC, where the OHA overruled an area office’s determination of unusual reliance. The solicitation asked the contractor to “provide information about three projects within the preceding five years that were similar in scope and magnitude to the instant procurement.” The prime submitted information about two projects it had completed, but it also submitted information of three relevant experiences of its subcontractor. The OHA found that this was sufficient, stating, “[t]he procurement in question, however, is a relatively straightforward “commercial items” acquisition . . . [and] [i]t is thus not apparent why [assistance from the sub] would be necessary to enable [the prime] to perform this contract.” In other words, OHA’s rationale was that for less complex contracts (e.g., commercial item procurements), a prime is less likely to need to rely on a subcontractor.
On the other side of the spectrum is Warrior Serv. Co, LLC. In this case, the VA solicited for home oxygen delivery services, including “all supplies, materials, equipment, transportation of equipment, equipment services, labor, supervision, patient education, safety management, and infection control . . . [and] new patient set-ups and initial set-ups for oxygen systems; follow up visits; set-ups for CPAP and BiPap; equipment monitoring, maintenance, and repair; and patient education.” The solicitation required ten years of home oxygen delivery services. A small business that had approximately six years of experience in durable medical equipment delivery—but no experience in home oxygen medical equipment—responded to the solicitation. The small business intended to subcontract with a large company that had extensive home oxygen experience. Both the area office and OHA found a violation of the Ostensible Subcontractor Rule, specifically the reliance of the prime on its subcontractor. At the U.S. Court of Federal Claims, the small business argued it had demonstrated experience in delivery of various types of medical equipment, including complicated medical equipment. The prime contractor argued that:
[A]bsent the government [being] able to show some sort of reason why oxygen tanks are so terribly special that they need to be treated completely differently than everything else that the government is buying within the durable medical goods spectrum, the government’s position is not justifiable even on the lack of experience issue . . . [because the prime is] working on much more complicated issues . . . .
The court disagreed, stating: “The Solicitation, however, require[s] . . . [i]ndividuals who are duly recognized as credentialed/licensed Registered Respiratory Therapist (RRT) or Certified Respiratory Therapist (CRT) . . . These requirements imply that home oxygen delivery services are ‘so terribly special’ . . . .” This shows that the more complex or specialized a contract, the more directly related experience must be to qualify as “relevant experience” necessary to substantiate the prime is not unusually reliant.
5. Bringing the Factors Together (and a Surprise Factor 5).
In making a size determination, the SBA considers the “totality of the circumstances.” As a result, the four factors are simply guidelines, not exhaustive. The SBA is required to make findings regarding “[a]ll aspects of the relationship between the prime and subcontractor,” and two or more firms may be affiliated “even though no single factor is sufficient to constitute affiliation.” As a result, the SBA can still find unusual reliance even if none of the four factors alone is sufficient.
Like primary and vital, this makes it impossible to provide a bright-line rule for contractors to use when they contemplate prime/subcontractor relationships. Nevertheless, there is a common theme: prior to the solicitation, the prime must have the capability to substantially perform the material aspects of the contract (i.e., it must be qualified). Some hiring may occur to sharpen skills or increase the workforce. However, significant hiring, in either scale or in setting up a new capability, will be scrutinized. Contractors should review the Contractor Performance Assessment Reporting System (CPARS) and build a record that shows capability prior to the solicitation. Ultimately, “the determination of what capabilities are necessary to perform a contract, or whether the awardee has such capabilities, are matters of contractor responsibility, and thus are the province of the [CO].” This means the contractor must prove its experience to the CO in its solicitation response.
Lastly, contractors may consider one other factor when attempting to determine if it will run afoul of the unusually reliant criterion: “‘[W]hen these [four] factors are present, violation of the ostensible subcontractor rule is more likely to be found if the proposed subcontractor will perform 40% or more of the contract.’” While not named a factor, it is a tangible consideration that may be used to guide determinations.
However, merely limiting the subcontractor to performing only forty percent of the work is not enough. Consider the scenario in DoverStaffing, in which DoverStaffing submitted a response stating that it would perform fifty-one percent of the work, Subcontractor One (the incumbent) would perform forty percent, and Subcontractor Two would perform nine percent. In other words, DoverStaffing tried to contract around the Ostensible Subcontractor Rule by having a subcontractor perform forty percent of the work. Despite this, the OHA found DoverStaffing was unusually reliant on Subcontractor One based on an analysis of the four factors. This shows that there are limits on contractor’s ability to use contract language to defeat an Ostensible Subcontractor Rule violation, and that the forty percent rule is not dispositive.
To avoid violating the Ostensible Subcontractor Rule, contractors should scrutinize relationships between a small-business prime and large-business subcontractors. Further, contractors should apply the factors discussed above. While the factors are not dispositive, they will help identify potential issues.
6. Mentor-Protégé Joint Ventures
There is no “silver bullet” that magically resolves all Ostensible Subcontractor Rule issues. However, the closest solution is forming a JV with a mentor-protégé agreement. Only small businesses are eligible for award of a small business set-aside. This rule applies to JVs as all parties to a JV must be small to qualify for a set-aside. However, the SBA rules allow large and small businesses with a mentor-protégé agreement (MPA) to qualify for a set-aside if they are a JV. This arrangement would eliminate most Ostensible Subcontractor Rule concerns.
The SBA’s Mentor-Protégé program helps eligible small businesses (protégés) partner with more experienced contractors (mentors) to gain experience and capacity in government contracting. To participate, the small business and large business must have an MPA which spells out the assistance to be provided by the large business to the small business, including, for example, financial assistance or assistance in developing compliance protocols.
While a full discussion of the requirements for an MPA is beyond the scope of this article, there are a few important considerations. First, MPAs must be submitted to and approved by the SBA. Additionally, a large business may only have up to three protégés. Further, the agreement may have a term of up to six years. If the initial term is for less than six years, it may be extended by mutual agreement for an additional amount of time that would total no more than six years from inception. Finally, the parties must submit a report every year to the SBA showing how the mentor is actually assisting the protégé. The SBA will not approve an MPA if it “determines that the assistance to be provided is not sufficient to promote any real developmental gains to the protégé, or if SBA determines that the agreement is merely a vehicle to enable the mentor to receive small business contracts.” This is just another confirmation that the large business must actually help the small business develop, not just use it to obtain small business contracts.
Once a small business has an approved MPA, it may create a JV with its large business mentor. This requires an agreement that complies with 13 CFR 125.8(b). There is one major caveat to this arrangement: The small business protégé must perform “at least [forty percent] of the work performed by the [JV].”
A non-small business that is interested in helping a small business grow should start the process early. It takes time to identify a partner and have the process approved by the SBA. The SBA states that it takes 105 days to approve a mentor-protégé agreement. This must be approved before applying to become a JV. Waiting until a solicitation is issued may not allow enough time to start the process. Even if it is not interested in formalizing the relationship today, a large company can identify small business partners, educate them on the opportunity, and prepare the paperwork in an effort to expedite the process with the SBA.
IV. Limitations on Subcontracting
In addition to the Ostensible Subcontractor Rule, contractors must also consider the Limitations on Subcontracting clause. Confusingly and frustratingly, when the Ostensible Subcontractor Rule applies, the Limitations on Subcontracting clause is in addition to the Ostensible Subcontractor Rule. The Ostensible Subcontractor Rule determines size, while Limitations on Subcontracting clause sets the value of work the prime must perform. A common misconception—both in government and industry—is that if a prime satisfies this fifty percent requirement from the Limitations on Subcontracting clause, then it meets the required standard without any issues. This is wrong. Affiliation and the Ostensible Subcontractor Rule are not determined solely by the value of work performed. Thus, a Prime could satisfy the Limitations on Subcontracting clause requirement but fail the Ostensible Subcontractor Rule. As a caveat, the Ostensible Subcontractor Rule does not apply to manufacturing or supply contracts, but the Limitations on Subcontracting clause applies to manufacturing, supply, and services contracts.
The Limitations on Subcontracting clause is provided in FAR 52.219-14. It states that a small business prime may “not pay more than 50% of the amount paid by the government to it to firms that are not similarly situated.” While not stated in the FAR, 13 C.F.R.125.6(a)(2)(i) states certain direct costs may be excluded from this calculation, including “[o]ther direct costs . . . to the extent they are not the principal purpose of the acquisition and small business concerns do not provide the service, such as airline travel . . . cloud computing services, or mass media purchases.” As always, the rules for construction are different, and FAR 19.505(b)(iii)–(iv) sets the thresholds at eighty-five percent (general construction) and seventy-five percent (special trade), respectively.
Payments to a similarly situated subcontractor count towards the fifty percent requirement (i.e., it is counted the same as if the prime had performed the work). “Similarly situated” has the same definition as discussed in III.A.i.
The Limitations on Subcontracting clause applies to all small business set-asides above the Simplified Acquisition Threshold (SAT), and to contracts below the SAT for 8(a), HUBZone, Service-Disabled Veteran-Owned, and Woman-Owned small business set-asides. The rule does not apply to a HUBZone contractor if it waives the price evaluation preference. When a contract combines services and suppliers, “the contracting officer shall select the appropriate NAICS code” that best describes the principal purpose of the product or service being acquired. That NAICS decision determines the portion of the contract to which the Limitations on Subcontracting clause applies. For example, when a NAICS code for services is assigned, the fifty percent limitation applies only to the services portion of the contract. When a contract is assigned a NAICS code for supplies, the fifty percent limitation applies only to the supply portion of the contract.
The applicable period to make these calculations is either the base term, and each subsequent option year, or by order. The CO is required to select which period will be used.
A. Non-Manufacturer Rule
For acquisitions of supplies, there is an exception to the Limitations on Subcontracting clause called the Nonmanufacturer Rule (NMR). The NMR addresses situations when a small business prime is awarded a contract for the acquisition of supplies, but it does not manufacture some or all the supplies. The NMR only applies to procurements with “a manufacturing or supply NAICS code, or the Information Technology Value Added Resellers (ITVAR) exception to NAICS code 541519.” It does not apply to a services contract or the supply portion of a services contract.
The NMR allows the prime to meet the fifty percent requirement from the Limitations on Subcontracting clause by obtaining products from other small business manufacturers. In other words, the prime need not manufacture fifty percent of the value of the supplies, but it must buy items it does not manufacture from small business manufacturers in order to meet the fifty percent threshold. The rule is designed to prevent a small business prime from subcontracting all the work to large businesses. To utilize the NMR, the small business prime must:
(1) be small under the applicable NAICS; (2) not exceed 500 employees; (3) be primarily engaged in the retail or wholesale trade and normally sell the type of item being supplied; (4) take ownership or possession of the items with its personnel, equipment, or facilities in a manner consistent with industry practice; and (5) supply the end item of a small business manufacturer, processor or producer made in the United States.
While each element is important, the last element deserves particular attention. It must be broken down into two sub-requirements: “small business manufacturer, processor or producer,” and “made in the United States.”
For products, “there can be only one manufacturer of the end item being acquired. The manufacturer is the concern which, with its own facilities, performs the primary activities in transforming inorganic or organic substances, including the assembly of parts and components, into the end item being acquired . . . .” The rule focuses on the size of the manufacturer, not the supplier to the prime. As such, the prime could reasonably buy the product from a business of any size, so long as the actual manufacturer of the product is small. Conversely, buying product from a small business is not sufficient; the manufacturer must also be small.
This rule often comes into play in the acquisition of name-brand-only or National Stock Number-specific procurements (NSN). This is a requirement that agencies rarely know about, but it has dire consequences. It means a small business prime could dutifully perform a contract with the government fully aware of the product’s source (e.g., name brand only), but violate the NMR. Without a waiver, the SBA could find a violation of the NMR and Limitations on Subcontracting. This could result in contract termination, leave the government without a source of supply, and the contractor potentially owing damages. This emphasizes the tension between the SBA and agencies, and the importance of understating SBA rules.
1. Multiple Item Acquisitions
For “multiple item acquisitions” (MIA), the end product that the prime supplies is a kit or other combination of items. This rule clarifies that the fifty percent requirement is the value of items that comprise the deliverable, and there is no requirement that the entire deliverable be manufactured by a small business. In other words, a non-manufacturer is compliant with the Limitations on Subcontracting clause and NMR if fifty percent of the value of items that make up an MIA comes from small business manufacturers. For example, in a contract for a $100,000 kit, if $50,000 of the items in that kit come from small business manufacturers, the prime is compliant. If more than fifty percent of the estimated contract value is comprised of items manufactured by other than small concerns, a waiver is required from the SBA.
This rule is distinguished from NMR because clarifies that contractors do not have to evaluate each item in an MIA for compliance with the NMR. For example, if a solicitation is for a kit comprised of ten items, compliance with NMR is analyzed at the kit level, not the component level.
2. Waiver
The second exception to the NMR is a class or individual waiver. When a waiver exists, the item(s) may come from a large business. When a waiver is present in an MEIA, the fifty percent requirement still exists, but the calculation is reduced by the amount of the waiver. For example, suppose a procurement is for ten items that cost ten dollars each (i.e., a $100 procurement) and a waiver exists for one of the ten dollar items. The method to apply the waiver is to first calculate the fifty percent value, and second, apply the waiver amount. Under this example, the fifty percent value is fifty percent. Apply the waiver amount at this stage (the dollar), and now only forty dollars of items must come from small business manufacturers (i.e., fifty dollars minus a ten dollar waiver equals forty dollars).
B. Enforcement
The SBA updated the Limitations on Subcontracting clause in a way that suggests greater enforcement is on the way. In a rule effective December 30, 2019, “contracting officers [now] have the discretion to request information from contractors to demonstrate compliance with limitations on subcontracting clauses . . . [including] invoices, copies of subcontracts, or a list of the value of tasks performed.” Possible increased enforcement is buttressed by audit findings issued by the Department of Defense Inspector General in 2022 that specifically called out deficiencies regarding the Limitations on Subcontracting clause. Therefore, contractors should review the Limitations on Subcontracting clause, scrutinize existing contracts for compliance, and implement procedures to ensure ongoing compliance in the future.
V. Conclusion
The Ostensible Subcontractor Rule and Limitations on Subcontracting clause are important rules designed to ensure small businesses benefit from set-aside contracts. If a violation of either rule is discovered during contract performance, it could have significant consequences, including, for example, contract termination. As a result, in all set-aside solicitations, an evaluation of all factors must be conducted before issuing submitting a bid or proposal. Due to the nuanced nature of these rules, attention to detail and analysis of multiple factors is required. This article seeks to guide contractors through that process, so both the government and contractor can have a successful and mutually beneficial relationship.
