SBA Proposes Anticipated Small Business Subcontracting Rule

Justin A. Chiarodo and Philip E. Beshara

Justin A. ChiarodoPhilip E. BesharaA recent proposed rule issued by the Small Business Administration (SBA) previews long-awaited changes to SBA’s regulations governing small business government contracting programs. These changes will impact both large and small government contractors alike and warrant close attention. This alert highlights key elements in the proposed rule, including major changes to subcontracting limitations for small business set-asides that first arose in the FY 2013 National Defense Authorization Act (NDAA). Given the explosive growth in enforcement for small business program violations, and draconian new penalties for such violations, all contractors should take steps to ensure they comply with the upcoming rule changes.

Changed Method for Calculating Subcontracting Limitations

The FY 2013 NDAA implemented a number of changes to small business programs in federal procurements (we recently covered these changes here). The primary reform in the NDAA—now addressed in the SBA’s proposed rule—is a significant shift in the method of limiting subcontracting under set-aside procurements. The SBA and FAR currently require prime small business concerns on set-aside contracts to incur set percentages of costs incurred under the contract based on the contract type (e.g., at least 50 percent of the personnel or manufacturing costs incurred under service and supply contracts). The challenges in monitoring this cost-based method led Congress to amend the Small Business Act. That statute now limits the percentage of the total contract price a prime awardee can subcontract out. Consistent with the statute, the proposed rule would amend 13 CFR § 125.6 to require small business primes to perform 50 percent of the total contract price for service and supply contracts, 15 percent for general construction, and 25 percent for specialty trade construction.

However, Congress exempted “similarly situated entities” from the limitations. As presented in the proposed rule, a prime contractor may subcontract any amount to “a participant of the same SBA program that qualified the prime contractor as an eligible offeror and awardee of the contract.” This exemption does not exempt all small businesses—only those of the same program as the prime. For example, while a HUBZone prime contractor could subcontract any amount to another HUBZone entity, the HUBZone prime would still be limited in the amount it could subcontract to an 8(a) entity, or any other non-HUBZone firm.

There is an important aspect of the “similarly situated entity” exception. SBA expressed its concern that the limitations could be circumvented where a prime contractor subcontracts all the work to a similarly situated subcontractor, who might then further subcontract the work to a large business. To address this, the proposed rule contains language limiting subcontracting “at any tier” to entities “not similarly situated.”

For example, though the proposed rule would allow an 8(a) prime contractor to subcontract $800,000 of a $1 million service contract to a similarly situated 8(a) subcontractor, the prime would violate the limitations if that 8(a) subcontractor then subcontracted $500,001 to any business not under the 8(a) program.

The proposed rule also includes the FY 2013 NDAA’s harsh penalties for violations of the subcontracting limitations (a minimum $500,000 fine or the dollar amount spent on subcontractors in excess of the limitations, whichever is greater) and a provision that “SBA may consider any party’s failure to comply with the spirit and intent of [a similarly situated entity subcontract] as a basis for debarment.”

Given these high stakes, the proposed rule calls for close attention in all aspects of contract and subcontract administration. Because it may be several more months before a rule is finalized, and even longer before the FAR Council takes up an amendment to the subcontracting limitations clause at FAR 52.219-14, contractors should carefully review proposals, contracts, and modifications mindful of this evolving landscape and monitor any changes to the SBA and FAR regulations in light of the FY 2013 NDAA reforms.

Other Provisions

The proposed rule also deals with affiliation. It would create a rebuttable presumption that two firms are affiliated if one firm derives 70% or more of its revenue from the other over the prior fiscal year or if the two firms are owned and controlled by family members, including “married couples, parties to a civil union, parents and children, and siblings.” The proposed rule would also exclude similarly situated subcontractors from being deemed affiliated under the ostensible subcontractor rule.

Finally, the proposed rule amends recertification requirements following a merger or acquisition, requiring affected offerors to recertify any time prior to contract award, and includes modifications to the nonmanufacturer rule, size protests, joint ventures, NAICS code appeals, and more.

The SBA proposed rule can be found at 79 Fed. Reg. 77,955 (Dec. 29, 2014). Given these changes and enhanced penalties for non-compliance, we expect a continued focus on enforcement of the subcontracting limitations and other small business compliance matters. We will continue to monitor changes in these important regulations.