Caution: Violations of the Ostensible Contractor Rule Result in Lost Contracts

SBA Affiliation Rules - Ostensibly Affiliated Under New SBA Subcontractor RulesGiven the new SBA subcontractor rules and regulations, subcontractors should pay special attention to whether or not they still can be ostensibly affiliated. Although the new SBA affiliation rules relax the possibility of becoming affiliated, the Ostensible Subcontractor Rule is still alive and well.  

The new rules are not intended for the prime contractor to now become unusually reliant on the subcontractor. Instead, the new rules allow the prime to subcontract out work to small businesses that are similarly situated.

Fraud Concerns

Affiliation based on the Ostensible Subcontractor rule is not just about the present and future contracts.  It can result in liability from past contracts.

The Department of Justice and the SBA will join forces to evaluate small business and findings, particularly of ongoing relationships in violation of this rule, have resulted in criminal charges including fines and jail time.  This is not a matter to be taken lightly.=

What Does Affiliation Mean?

Affiliation occurs when a prime and subcontractor are treated as a joint venture and consequently have their sizes combined – dependent upon whether the NAICS code is based on employees or a monetary limitation on revenue.

Combining the sizes of a large business with a small business result in the small business exceeding the size standard and the loss of a contract, if not small business size status for future contracts.

How Small Business Subcontractors become Ostensibly Affiliated

Incumbent contractors: As newly organized businesses, prime contractors should be cautious when hiring incumbent employees. When all of the employees involved in performing the contract will be current or former employees of the incumbent, then the prime can still be ostensibly affiliated when it is bringing on a substantial amount of employees from the incumbent contractor.

Case Examples:

This was the case in Size Appeal of Modus Operandi, Inc., SBA No. SIZ-5716 (2016). Prime contractors should focus on bringing in their own employees to some level and usually rely on the subcontractor’s personnel.

  • The test is not that the prime is employing the employees. Instead, it is whether the employees ultimately come from the subcontractor.
  • When using a teaming agreement, minimize hiring management type employees from the incumbent subcontractor (en masse).

The SBA will more than likely decide that by hiring your management team from a large incumbent contractor, then you will be unduly reliant on subcontractor for the performance of the procurement and that you would be bringing nothing more than your small business status to the table.

Meeting limitation on subcontracting requirements: Under the new SBA affiliation rules, small business prime contractors will receive credit for subbing out work to other small businesses. However, you still have to comply with the limitation on subcontracting regulations and must still meet the similarly situated requirement.

Violation of the Ostensible Subcontractor Rules and Regulations: In addition, the SBA’s legal analysis in a size protest is still whether or not you are unduly relying on your subcontractor to perform the work.

  • If the subcontractor / incumbent contractor is ineligible to bid on the project, the SBA will look further.
  • If as the prime contractor you plan on hiring a large majority of your workforce from the subcontractor, then you will be ostensibly prohibited from keeping the award.
  • You can become ostensibly in violation of affiliation rules if the prime contractor’s proposed management previously served with the subcontractor on the incumbent contract.
  • If as the prime contractor, you lack relevant experience and was obliged to rely upon your more experienced subcontractor to win the contract, then the SBA could also find that you are ostensibly affiliated.

SBA OHA has previously ruled that  “when a prime contractor proposes the incumbent contractor as its subcontractor, relies heavily upon its subcontractor for both managerial and non-managerial personnel, and has little or no corporate experience, the prime contractor is [ ] at risk of violating the ostensible subcontractor rule.” Wichita Tribal Enterprises, SBA No. SIZ-5390 at 11 (citing DoverStaffing and SM Resources).

SBA Affiliation Rules – Subcontractor Rules for Similarly Situated Businesses

Under the new SBA affiliation rules and regulations, a contractor that is a small business does not have to include the amounts subcontracted to a “similarly situated” subcontractor.

Similarly, situated subcontractors included other small businesses that can be the same size or socioeconomic category for purposes of set-aside contracts. In other words, if the procurement is an 8(a) set-aside, then the similarly situated small business subcontractor would also be an 8(a) certified company. See additional information about government relationship with subcontractors.

The prime’s subcontracted work to a similarly situated small business would legally count as work done by the prime contractor under the limitation on subcontracting rules. The exception for similarly situated subcontractors applies to all four types of contracts described in FAR 52.219-14 (services, supplies, construction and specialty trade).

The exception will also apply to any analysis under the ostensible subcontractor affiliation rule so long as there is no undue reliance.

Serious Concerns for Primes Subcontracting to Small Businesses: As a prime contractor that will identify a new small business, you must notify those subcontractors in writing before submitting a government bid.

This rule focuses on prime contractors who don’t intend to use a subcontractor but only does so to get the contract. As you can see, the affiliation and ostensible subcontractor rule is only one aspect of the SBA’s focus.  Government contractors in general, have to seriously look at their subcontracting relationships and must avoid the possibility of a false statement even at the bidding stage.  

  • Not only is your competition open to submitting a size protest based upon affiliation but it may also allege that you had no intention of using the proposed subcontractor, to begin with.

Bad faith and breach of contract: Even if after the contract is issued and subcontractor agreements are not upheld, you could be found as acting in bad faith and be stuck with a material breach of contract claim from the government contracting agency. This could even lead to liquidated damages.

For help to become compliant with new SBA affiliation subcontractor rules and to avoid becoming ostensibly affiliated, call our government contract law attorneys at  1-866-601-5518. FREE INITIAL CONSULTATION

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