Ostensible Subcontractor Rule: Primary and Vital Contract Requirements

Ostensible Subcontractor Rule:  Primary and Vital Contract Requirements

By Theodore P. Watson, Esq. and Cheryl E. Adams, Esq.

Prime’s Management of the Project is Critical

When your company bids on a federal government contract as a small business, prime contractor management of the project under the ostensible agreement is essential to avoid violating the Ostensible Subcontractor Rule.  If you are the prime contractor, and you want to avoid an SBA (U.S. Small Business Administration) size standard decision that you are “other than small,” when looking at your prime contractor subcontractor relationship.  You must demonstrate that (a) you are handling the primary and vital parts of the contract, and also (b) you are managing the overall project.  Both are very important.

The Ostensible Agreement & SBA Ostensible Definition

Under the government’s Ostensible Subcontractor Rule, the subcontractor is defined as “ostensible” when the subcontractor (instead of the prime) is actually performing the primary and vital requirements of the contract under the ostensible agreement, or when the prime contractor is unusually reliant upon the subcontractor. The gist of any size determination will rest on the details of the prime subcontractor relationship. If SBA determines that either of these situations is occurring, then the two firms, the prime and the subcontractor, are affiliated for purposes of the procurement at issue.  13 CFR 121.103(h)(4).

Ostensibility and Intent of the Ostensible Subcontractor Rule

The famous SBA ostensibility rule is intended to prevent “other than small” firms (large businesses) from forming types of relationships with small firms that evade SBA’s size requirements.  To oversee compliance with the rule, the SBA Area Office examines all aspects of the relationship, including the terms of the proposal, prime management of the project, and any agreements between the firms to see whether the relationship between a prime contractor and its subcontractor violates the Ostensible Subcontractor Rule.

The Problem with Affiliation:  When Prime + Sub = Large Business

If SBA deems that two firms are affiliated, for purposes of a small business set-aside procurement, then generally SBA will add the sub’s size to the prime’s size, and treat them as one offeror, for purposes of determining whether the offeror is “small” under the applicable NAICS code.  This can be a serious problem, because if SBA determines that the prime and the sub do happen to be affiliated, that means the offeror now could be too big to be eligible for award of the small business set-aside contract.  A prime contractor / subcontractor team could lose the opportunity to win a contract if they are too big under the applicable NAICS code because they are affiliated under the Ostensible Subcontractor Rule.  The idea is to avoid being affiliated, if there is a risk that Prime + Sub = Large Business.

Similarly Situated Small Businesses:  A Key Exception to the Ostensible Subcontractor Rule

Tip:  One way that some of the more sophisticated small business prime contractors avoid being “not small” under the Ostensible Subcontractor Rule’s affiliation requirements is to seek out “similarly situated” small businesses to fulfill their subcontracting needs.   In general, a small business is “similarly situated” if it is also small under the same NAICs code as the prime, and, of course, also “small” under the NAICs code assigned to the procurement by the government Contracting Officer.

Under this exception to the affiliation rules, there may no need for offerors to be concerned about whether Prime + Sub = Large Business, for purposes of the Ostensible Subcontractor Rule. 

Prime Contractor Subcontractor Relationship and Primary and Vital Contract Requirements

When submitting proposals to the government, keep in mind that the primary and vital contract requirements are those associated with the principal purpose of the acquisition.  Applying the affiliation rule, the prime should always ask whether it can perform the work, as a prime contractor, without the help of the subcontractor.  If the answer is no, then the prime may want to rearrange its plan of action to better demonstrate prime management as the bidder of record.

Tip:  Do not make the mistake of thinking that oversight and quality assurance will be conclusive proof that the prime is performing the primary and vital requirements.  This can be attacked in a small business size protest.  Instead, the prime should make sure that in addition to providing oversight and quality assurance, the prime is also performing the substantive requirement of the Performance Work Statement (PWS).

Best practice:  To avoid potential violations of the Ostensible Subcontractor Rule, a best practice is to follow the requirements of the Limitation on Subcontracting rule.

Details and Facts are Important:

The Ostensible Subcontractor Rule can be a very tricky statute.  Court rulings often catch small businesses and large contractors off guard because even where there was no actual intent to violate the rule.  Intent does not matter, the SBA can still rule adversely against a prime contractor / subcontractor business arrangement that it finds violates the Ostensible Subcontractor Rule.

– SBA’s ostensible subcontractor inquiries are very fact specific, given that each SBA decision is based on the specific solicitation, and the specific offeror’s proposal, at issue.

Hiring Incumbent Personnel Can Violate the Ostensible Subcontractor Rule:

If a prime hires former employees of its subcontractor this, by itself, is not improper or indicative of unusual reliance.  Nonetheless, companies must still be aware of the specific laws and court rulings addressing this often-overlooked matter.  Executive Order (EO) 13495 has been repealed, before it was repealed it required service providers who win follow-on contracts to offer jobs to non-managerial employees at the previous company. 

The appeals court has recognized the hiring of incumbent personnel should no longer be considered strong evidence of reliance under the Ostensible Subcontractor Rule.  This ruling was issued in light of EO 13495, and widespread industry practice.

Tip:  Make sure the prime/subcontractor teaming agreement is clear that any incumbent employees previously employed by the subcontractor will now report to the prime contractor’s program manager.  This makes a better case that the prime is in control, and is not unduly reliant on the subcontractor.

The appeals court also found that EO 13495 “does not apply to managerial personnel, and does not mandate that a successor contractor will rely upon the incumbent for its entire workforce.”  This leads to legal analysis of the prime’s management of the project.  In the case of Wichita Tribal Enterprises, SBA No. SIZ-5390 at 3. SBA OHA, on appeal, agreed with SBA that the prime contractor was unusually reliant upon its subcontractor, based on four key factors:

– The proposed subcontractor was the incumbent contractor and was not itself eligible to compete for the procurement.

– The prime contractor planned to hire the large majority of its workforce from the subcontractor.

– The prime contractor’s proposed program manager previously served as program manager for the subcontractor on the incumbent contract.

– The prime contractor was a relatively new firm with modest revenues and scant experience.

OHA concluded 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.”

Common But Avoidable Mistakes:

In a recent construction contracting case, OHA found that a subcontractor, not the prime, will perform the primary and vital contract requirements.  In construction contracts, “OHA has long held that ‘[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… As a result… on-site management of the contract is of paramount importance in a government construction procurement.  OHA noted that the offeror’s proposal did not indicate that the prime contractor will manage the contract, and observed that all of the onsite managers – including the Project Manager and the Site Superintendent – were identified in the proposal as subcontractor employees rather than the prime contractor employees.  While the proposal did state that the prime contractor’s President would oversee the contract as Program Manager, the proposal also made clear that she would not be site-based.  Unfortunately, that was not enough prime contractor control and management to avoid problems with the ostensible subcontractor rule.

            The prime attempted to solve the problems by hiring the sub’s on-site project manager after proposals were submitted, and after the first size appeal was decided against this offeror.  However, this was done too late.  The on-site Program Manager’s change in employer from prime to sub did not matter, as “changes of approach occurring after the date to determine size do not affect a firm’s compliance with the ostensible subcontractor rule.” Find out about SBA Affiliation Meaning Common Management & Identity of Interest.

            Tips: 

– If you are a prime is bidding on a small business set-aside construction contract, be aware that the work of superintending, managing and scheduling the work, including coordinating the work of the various subcontractors, may be viewed by SBA and OHA as “primary and vital work” under the contract. 

– Focus on having the right team in place when you submit your initial proposal, as you cannot wait until after there is a size protest to fix problems that cause your subcontractor to fall under the ostensible subcontractor definition. 

– Also, it can help to show in your proposal that (a) the people managing the construction project are on-site, not offsite, and (b) that the people managing the construction project are employees of the prime contractor, not the subcontractor.

Show Prime Contractor Control Through Buying or Leasing Facilities and Equipment.

It can be a fatal mistake to leave the government to make guesses or assume, which entity is doing the primary and vital work.  “In evaluating whether the nonmanufacturer or ostensible subcontractor rules apply, it is the proposal which is the most important evidence.”  Size Appeal of OSG, Inc., SBA No. SIZ-5718, at 12 (2016); Size Appeal of CWU, Inc., SBA No. SIZ-5118, at 12 (2010). 

Recently, a prime contractor successfully defended against a size protest because its proposal explicitly stated that it was the prime that will be manufacturing the eyeglasses. The proposal did not refer to any subcontractors. Therefore, OHA found the proposal makes it clear that the prime will perform the contract itself, without a subcontractor. This was supported by the fact that the prime purchased the sub’s leases and equipment, so it could directly perform the contract with what is now its own equipment and on its own premises. Thus, OHA found allegations ostensible subcontractor rules were violated to be “completely meritless.”  Size Appeal of:  Superior Optical Labs, Inc., RE: PDS Consultants Inc., SBA No. SIZ-6068, 2020 (Aug. 27, 2020)

Read about Contract Disputes Act of 1978 — General Contractor and Subcontractor Pass-Through Rights & Contract Claims.

Timing Matters:  The Ostensible Subcontractor Rule Applies as of the Date of Final Proposals.

“The size status of a concern, including its affiliates, is generally determined as of the date the concern submits a written self-certification that it is small to the procuring activity as part of its initial offer (or other formal response to a solicitation) which includes price. 13 CFR 121.404(a). However, for purposes of compliance with the nonmanufacturer rule (13 CFR 121.406(b)(1)) and the ostensible subcontractor rule (13 CFR 121.103(h)(4)), size status is determined as of the date of the final proposal revisions. 13 CFR. 121.404(d). Because [the prime] submitted its proposal on October 29, 2019, and there were no final proposal revisions, [the prime’s] size must be determined as of that date.”  Size Appeal of Superior Optical Labs, Inc., SBA No. SIZ-6068, (Aug. 27 2020)

            Tip:  Initial Proposals:  Ensure that your prime/sub relationships or affiliations do not make you too large, as of the date of your initial proposal.

            Be aware that government might decide to award contracts based on initial proposals.  The government may not ask for proposal revisions, especially if the solicitation has language indicating that the government intends to award without discussions, or otherwise reserves the right to award based on initial offers.

            Tip:  Proposal Revisions:  After initial proposals, avoid making changes to your prime/sub affiliations in ways that might bring your proposal into non-compliance with the ostensible subcontractor rule.  Any proposal you submit to the government could be the proposal the government accepts, and therefore could be the “final proposal” the government uses to determine size status, for purposes of the ostensible subcontractor rule. 

            Tip:  Solve Ostensible Subcontractor Problems Before Final Proposals Are Due:  In some types of procurements, during negotiations, or in the course of the pre-award process, you may become become aware of potential issues with the prime not performing work the government considers to be primary and vital, or other possible problems with violating the ostensible subcontractor rule.  If so, there may be opportunities to solve these problems by changing your prime/subcontractor business arrangements before final proposals are submitted to the government.

  SBA Makes Mistakes When Making Size Determinations – Be Aware of Them

Find out the Difference Between Teaming Agreement vs Joint Ventures.

If the Primary and Vital Work is Manufacturing, the Ostensible Subcontractor Rule May Not Apply:

The ostensible subcontractor rule does not apply to procurements for manufactured products.   “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.”  Size Appeal of Superior Optical Labs, Inc., SBA No. SIZ-6068, (Aug. 27 2020). [emphasis supplied]

There can be questions regarding whether the work qualifies as “manufacturing.”  The primary and vital work of manufacturing is transforming raw materials into end items.  For example, cutting and sewing are integral to all types of apparel manufacturing.  Size Appeal of:  HWI Gear, Inc. RE: Mechanix Wear, LLC, SBA No. SIZ-6072 (Sept 16, 2020)

A number of activities are sometimes mistaken for manufacturing but do not count as “manufacturing” for purposes of escaping the ostensible subcontractor rule.  For example, OHA has stated that the essential design, material acquisition, and production coordination, are not manufacturing.  Also, “contributions to the design and engineering of the [end item] are not relevant” in determining whether it is the manufacturer,” Size Appeal of Camp Noble, Inc., SBA No. SIZ-5644 (2015). Performance of testing and quality control, again, do not constitute manufacturing. 13 C.F.R. § 121.406(b)(2)(i)(A). Again, the central question would be whether the “manufacturer” will perform the primary activities of transforming raw materials into the end items. 

Prime Contractors’ Experience and Actual Management Under the Rule

Small business size determinations often prove fatal when there is little past performance information available regarding the small business offeror.  Although the FAR allows for a neutral rating for lack of experience, both the SBA and OHA have ruled that “it is appropriate to consider a prime contractor’s experience as part of an ‘ostensible subcontractor rule’ analysis, because such matters are relevant to whether the prime contractor can perform independently from the subcontractor.”  See Size Appeal of Assessment & Training Solutions Consulting Corp., SBA No. SIZ-5228, at 7 (2011). 

Get help filing or defending allegations of violating the Ostensible Subcontractor definition.  Call our SBA size standards protest and ostensible subcontractor lawyers at 1-866-601-5518 for a FREE Initial Consultation.