Does Your SBA Operating Agreement Comply With the Rules? If Not, You Can Lose Your Contract.
When making size determinations and affiliation under the negative control definition for small businesses, the SBA not only looks at finding actual control over the protested business but also whether a non-disadvantaged person or entity has the ability to control the company. Companies should make sure that their operating agreements do not leave them exposed and ultimately have millions of government contract revenues taken away due to a violation of SBA business control rules.
The negative control definition and positive control legal analysis can be confusing to small businesses. However, waiting until the small business size protest is filed can be too late.
Negative Contol Definition Under 13 CFR 121.103(a)(3)?
When the SBA reviews a company for what is negative control under its regulations, negative control typically refers to whether an individual or company has the power to affirmatively take action to amend, alter or modify company documents or business operations. Oftentimes, mistakes are detected when reading SBA operating agreement contracts for purposes of affiliation, partnership agreements or some level of business contracts.
However, SBA OHA has also found that “amending or changing aspects of a business’s certification of incorporation or bylaws, issuing additional shares of capital stock, and entering a substantially
different line of business” are extraordinary events for which negative control does not give rise
Negative control generally would not arise under 13 CFR 121.103(a)(3). solely with actions that include: (i) disposal of a company’s assets; (ii) receiving capital contributions from a member; (iii) admitting new
members; (iv) materially altering the rights of existing shareholders; (v) filing for bankruptcy or
receivership; and (vi) admitting that the firm is insolvent. See Size Appeal of DooleyMack Government Contracting, LLC, SBA No. SIZ-5086, at 7 (2009).)
Despite the above, OHA has also indicated that a single indication of negative control is not, by itself, sufficient to find affiliation. Size Appeal of Q Integrated Companies, LLC, SBA No. SIZ-5778 (2016).
Examples of Negative Control
- When your operating agreement requires approval from a third party, there is a chance that negative control and affiliation can be found.
- Negative control can exist if a minority shareholder can block ordinary actions essential to operating the company. Size Appeal of Eagle Pharmaceuticals, Inc., SBA No. SIZ-5023, at 10 (2009)
- The creation of debt and the payment of dividends are among such “ordinary actions,” as these matters are fundamental to the daily operation of a business. Eagle Pharmaceuticals.
- The ability to hire and fire executive officers and the setting of compensation are ordinary actions essential to operating a company. Size Appeal of DHS Systems, LLC, SBA No. SIZ-5211.
- Operating agreements where contested managerial decisions require approval of others besides the person who is supposed to be in control of the company since those other persons can refuse to consent. See Size Appeal of CarntribeClement 8AJV #1, LLC, SBA No. SIZ-5357
Small businesses should be aware that when the company is approved for a specific program, the SBA will continuously monitor the company to make sure that it is still controlled by disadvantaged individuals.
- If there is a change in management or control of the company, the change must be submitted and approved by SBA before the firm can change control.
- A firm can be terminated from an SBA program by not getting the SBA’s approval before any change in control.
Terms such as the identity of interest become part of the negative control definition and analysis when the SBA makes its decision. 13 CFR 121.103(a)(3) governs the SBA’s analysis.
When appealing an SBA size determination and adverse affiliation decision, many protestors base their arguments on the fact that the SBA Area Office did not address if one party could exert negative control over the other, and that the SBA did not consider the totality of the circumstances. This approach can be a slippery slope because the SBA can look at various issues that relevant to affiliation decisions.
- No one fact wins the case.
- SBA decisions only have to be reasonable.
Under 13 CFR 121.103, control may be affirmative or negative. Negative control includes, but is not limited to, instances where a minority shareholder has the ability, under the concern’s charter, by-laws, or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.
13 CFR 121.103 SBA Operating Agreements Can Impact How SBA Evaluates Negative vs Positive Control
When applying the SBA definition of negative control, the wording in your business operating agreements can still create legal problems. For example, when an operating agreement only has specific reasons why the business owner can terminate them, SBAOHA has also looked to see whether a company owner can remove employees for merely disagreeing with him.
To establish control and avoid potential affiliation in a small business size protest, business owners must have absolute decision making when by the express language of through the entity’s voting mechanisms. Size Appeal of Envtl. Quality Mgmt., Inc., SBA No. SIZ-5429 (2012) (appearance of negative control was illusory because majority owner could unilaterally remove directors without cause).
- Having negative and positive control between two companies can lead to affiliation
- 13 CFR 124.106(c) provides that, for a limited liability company (LLC) to be eligible for the 8(a) BD program, one or more disadvantaged individuals must control “all decisions” of the LLC.
Another problem when assessing negative vs positive control is when appeal courts see that your operating agreement states that “disagreements among the managers will be resolved by “vote of a majority of Managers.” When applying the legal definition of negative control, this argument does not show that the business owner has total control over company business decisions.
A minority shareholder can be seen as having control over the majority shareholder under 13 CFR 121.103 if he can somehow block actions that are critical to the daily operations of the business. See Size Appeal of Carntribe Clement 8AJV #1, LLC, SBA No. SIZ-5357, at 13 (2012) (“Negative control exists if a minority owner can block ordinary actions essential to operating the company.”).
Negative Control Landmines Impact 8a Certification
A common problem exists when applicants seek to get 8a certified. The issue does not only arise in a small business size protest. When the SBA reviews 8a applications, they will also look at corporate documents to see if a third party violates the negative control definition. Simply put, you must fully understand the legal principles of positive control and definition of negative control when applying SBA affiliation rules.
Can the Area Office Make Determinations as to Whether Your Company is in Compliance with 8(a) BD Requirements?
SBA OHA has made the longstanding legal decision that when it comes to compliance with substantive 8(a) BD requirements, under 13 C.F.R. Part 124, such issues are beyond the scope of an area office’s subject matter jurisdiction. If there are concerns, then the area office must seek resolution by referring the question to the Office of Business Development for further review and investigation.
For additional questions or help with affiliation in your SBA operating agreement and decisions about the negative vs positive control definition under 13 CFR 121.103, call our small business size protest lawyers at 1-866-601-5518. FREE INITIAL CONSULTATION.