Your U.S. Government Contract: The Small Business Set-Aside Prime, the Large Business Subcontractor, and the Deadly Ostensible Subcontractor Rule

Your U.S. Government Contract: The Small Business Set-Aside Prime, the Large Business Subcontractor, and the Deadly Ostensible Subcontractor RuleAuthor:  Cheryl Adams, Esq.

How could this possibly go wrong?  You cannot believe your good fortune:  a large-business incumbent government contractor is not eligible for award of the agency’s follow-on procurement.  The follow-on is a set-aside, the incumbent is too big to be eligible to compete for the contract.  The incumbent wants to team with you so they can be in on the procurement!  You will be the prime, they’ll be the sub.  The prospective procurement could be set aside under any of the array of socioeconomic set-aside programs the federal government has to choose from, including:

  • Small Disadvantaged Business (SDB or 8(a))
  • Historically Underutilized Business Zone (HUBZone)
  • Service-Disabled Veteran-Owned Small Business (SDVOSB)
  • Women-Owned Small Business (WOSB)

For simplicity’s sake, we will say that you are the prime contractor, planning to compete for an 8(a) set-aside procurement.  You can’t believe your good fortune.  Your 8(a) business is eligible, eager for business, and being courted by:  The Best!  Large Business Sub!  Ever!

The Potentially Poisonous Perfect Subcontractor

This incumbent large business subcontractor has everything that you don’t, including in-house expertise to perform work under the right NAICs code.  In fact, you couldn’t even hope to perform this contract without the prime’s stellar past performance record and management team.

You’d like to learn, but it’s not as if your firm has ever done this kind of work before – so, no time like the present to get on board and learn the ropes from the experts, right?  They have thundering herds of trained employees, key personnel, and management who are intimately familiar with the ins and outs of dealing with this particular government program office’s requirements.  You’re already picking out the champagne glasses you and your subcontractor will use to celebrate contract award.

But wait.  Could the Ostensible Subcontractor Rule ruin everything?

Be the Prime Who Does Primary and Vital Work

The ostensible subcontractor rule can’t hurt you if you know and apply this simple principle:  You, as 8(a) prime, must self-perform, and show in your proposal that you will self-perform, the “primary and vital” work under the contract.

Don’t Be “Unusually Reliant” on Your Large Business Subcontractors

The ostensible subcontractor rule can’t hurt you if you are not in the weak position of relying too much on your large business subcontractor to provide contract performance.  You should be able to show that you could perform the contract without the sub’s help, if you had to.

The Not So Clever Shell Game

What is a large business to do when the firm’s long and lucrative contracting relationship with the federal government appears it may be ended by a set-aside follow-on procurement?  Unfortunately, there is a long history of various tricks and games that large contractors have attempted in order to transmogrify themselves into entities that can compete in the set-aside arena.  One of the games is:  find a willing 8(a) firm to be prime, and the large business is the sub — for purposes of winning the contract.

The 8(a) prime is essentially an empty shell, while the large business sub performs most of the substantive work.  Of course, that’s not how these socioeconomic set-aside programs are supposed to function, and the courts are wise to that shell game.  Your other 8(a) competitors are wise to the shell game, too, and there is plenty of case law indicating that they will not hesitate to challenge your eligibility if you and your prime try it.

The Rule:  No Ostensible Subcontractors Need Apply

The “ostensible subcontractor” rule provides that when a subcontractor is actually performing the primary and vital requirements of the contract, or when the prime contractor is unusually reliant upon the subcontractor, the two firms are affiliated for purposes of the procurement at issue. 13 C.F.R. § 121.103(h)(4). The rule “asks, in essence, whether a large subcontractor is performing or managing the contract in lieu of a small business [prime] contractor.” Size Appeal of Colamette Constr. Co., SBA No. SIZ-5151, at 7 (2010)

The ostensible subcontractor rule was invented to address gamesmanship and misuse of the set-aside system.  As more cases are decided, the boundaries of the rule morph and change while furthering a more or less consistent underlying goal or principle.

How bizarre is that?  Last time you checked, you had a prime / sub relationship in place – after all, that’s what you and your sub agreed this business relationship would be.  Suddenly, like Alice in Wonderland stepping into the rabbit hole, by operation of a quirk of law, you’re in a joint venture and you have this new unwanted “affiliation” with your sub.

Ok, so now you’re in a Joint Venture with your sub, even though you and your sub agreed you would be in a sub / prime relationship.

Why Would You Care If You’re In A Joint Venture (JV)?

The big problem with being a JV is affiliation.  The basic rule is:  “A contractor and its ostensible subcontractor are treated as joint venturers, and therefore affiliates, for size determination purposes.”  13 C.F.R. § 121.103(h)(4)

Unless the JV meets the requirements for approval under SBA rules for participation under the Mentor-Protégé program, or the JV falls under one of the other narrow exceptions in the SBA rules, two or more entities forming a JV are treated as one entity for purposes of meeting set-aside size standards.  It doesn’t matter if the individual firms are small.  All of the composite entities, added together into one JV, can be too large to meet size eligibility requirements for a set-aside.  Separately, each one of the entities might be able to win the contract.  Put together into one JV, maybe now they’re too big to compete for the contract.

If you, as prime, team up with a subcontractor that is “large” under the relevant NAICs code, you might not be eligible to compete for a set-aside government contract if suddenly you and your prime, together, are a JV.

The Similarly Situated Entity Escape Pod: 

Some cases include “not similarly situated entity” language in the statement of the ostensible subcontractor rule.  For example, the rule may be stated as,

“The ‘ostensible subcontractor’ rule provides that a subcontractor which is not a similarly situated entity to the prime contractor challenged concern, and which either is actually performing the primary and vital requirements of a contract, or upon which the prime contractor is unusually reliant, is treated as a joint venturer, and thus an affiliate, of the challenged concern.” Size Appeal of Elevator Service, Inc., SIZ-5949, Aug 10, 2018. 

The cases where “not a similarly situated entity” is mentioned in the ostensible subcontractor rule are bringing in 13 C.F.R. § 121.103(h)(3).   13 C.F.R. § 121.103(h)(3) provides an exception for a joint venture of two or more business concerns so long as each concern is small under the size standard for the NAICS code assigned to the contract.  This means both concerns are small under the same NAICs code.  There are additional requirements:  the procurement either needs to be “bundled” at any dollar value, or the procurement falls under various dollar thresholds.  This also means that you cannot use the “similarly situated” escape pod if your subcontractor is a large business under the relevant NAICS code.  This exception only helps you escape the ostensible subcontractor rule if your subcontractor is another small business, and the two of you put together would add up to comprise (an otherwise ineligible) large business.

If there are multiple subcontractors, some of them are “similarly situated entities” (SSEs) and some are not, then the affiliation analysis becomes more complex.  “[W]here an area office cannot exempt all subcontractors from the ostensible subcontractor analysis as SSEs, the area office must still determine whether the other non-SSE subcontractors violate the ostensible subcontractor rule. In these instances of multiple subcontractors with mixed status, the initial step [is]… ‘to determine whether the prime contractor will self-perform the contract’s primary and vital requirements,’ with one caveat…. [T]he area office must determine whether the prime contractor and any SSEs will perform the contract’s primary and vital requirements.”

Because “the purpose of the ostensible subcontractor rule is to prevent an other-than-small firm from evading SBA’s regulations (e.g. size or status restrictions) and, thereby, usurp federal contracting opportunities from small contractors,” OHA does not have a problem with small business SSEs teaming together and allocating the work among themselves as they see fit.  Essentially, as long as one or more SSEs performs the “primary and vital” work of the contract, it doesn’t matter whether the SSE firm is a prime or a sub.  Size Appeal of Synaptek Corp., SIZ-5954, August 24, 2018

 

Procedural Background:  The Usual Path of SBA Size Determination Challenges: 

The SBA’s Area Offices issue size determinations.  Typically, when a size determination is challenged, or protested, the challenge is submitted to the agency Contracting Officer, who forwards the challenge to the SBA’s Area Office.  The Area Office then makes a decision about the size.  Your firm is either too big to be eligible for the contract or it’s not. If you don’t agree with the SBA Area Office decision, you can appeal.

The U.S. Small Business Administration Office of Hearings and Appeals (OHA) decides most of the appeals.  OHA decides whether the SBA Area Office’s size determination was based on a clear error of fact or law.  The party appealing the size determination bears the burden of proof.

These ostensible subcontractor cases are “intensely fact-specific.”  The area office must examine “all aspects of the relationship, including the terms of the proposal and any agreements between the firms.” Size Appeal of Jacob’s Eye, LLC, SIZ-5895, April 5, 2018.  The games go on from there, and “may the odds be ever in your favor.”  Oh, wait, that quote is from the Hunger Games, by Suzanne Collins, not government contracting law.  I digress.

Ostensible Subcontractor Rule: Lessons Learned from the U.S. Small Business Administration Office of Hearings and Appeals (OHA) Recent Cases

Lesson Learned:  The Small Business Prime should fully support, in its proposal, what portions of work it plans to perform; and it should provide all the information the SBA Area Office needs to issue a fully supported size determination.

Size Appeal of Jacob’s Eye, LLC, SIZ-5895, April 5, 2018

If there is not enough documentation in the record for OHA to figure out whether there was clear error, OHA will not decide the case.  Instead, the OHA Administrative Judge may vacate the size determination and remand (send the case back) to the Area Office for further review and investigation.

If Appellant (in this case Appellant = Prime) fails to produce information requested by the Area Office, the Area Office may then assume that the missing information would have shown that the prime is not a small business.  The prime needs to fully support, in its proposal, what portions of the work it will perform.

Lesson Learned:  How to tell if a solicitation requirement is “Primary and Vital”

Size Appeal of Residential Enhancements, Inc., SIZ-5931, June 11, 2018

“[T]he initial step in an ostensible subcontractor analysis is to determine whether the prime contractor will self-perform the contract’s primary and vital requirements.” Not everything in a solicitation is a “primary and vital” requirement.  This case sheds light on indicators of “primary and vital” requirements:

– those associated with the principal purpose of the acquisition;

– the bulk of the effort;

– the bulk of the contract dollar value;

– qualitative factors, such as relative complexity and importance of the requirements;

– “it is the goods or services which the procuring agency actually seeks to acquire, and not those goods or services which the contractor must perform or provide in order to deliver those goods or services, which determine what the primary and vital tasks of the contract are.”

– in this case, where the sub had no operational role, and only performed quality control, the sub was not performing “ancillary,” not primary and vital services.  OHA noted that the solicitation specifically allowed for subcontracting the quality control function.

Lesson Learned:  The NAICs code that the Contracting Officer (CO) chooses can indicate which work is “primary and vital.”

Size Appeal of Kûpono Government Services, LLC, SIZ-5967, October 23, 2018

In a procurement for highly specialized technical training, the CO chose NAICs code 611430, Professional and Management Development Training, for the set-aside procurement.

“The proposal stated that [the prime] selected ARES as a subcontractor due to ARES’s ‘in-depth understanding of DOE nuclear facility operations, subject matter expertise in nuclear safety, safeguards and security, and protective force disciplines, and demonstrated experience in developing and delivering training in these disciplines,’ whereas Appellant’s own ‘capabilities and expertise [are] in IT systems, site operations, and facilities management.’”

OHA found that the “proposal suggests that Appellant lacks the subject matter expertise to perform the training without engaging ARES as a subcontractor.”  The sub was performing all of the work under the relevant NAICs code (e.g. the “primary and vital” work), whereas the prime’s performance of management and other functions such as IT, site operations, and facilities management were only incidental.  Therefore, the ostensible subcontractor rule was violated.

Lesson Learned:  How to tell if there is “Unusual Reliance.” The Four Key Factors

Size Appeal of Residential Enhancements, Inc., SIZ-5931, June 11, 2018

There are “four key factors” that are routinely applied in these cases.  They 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.

Lesson Learned:  The source of  supervision and control matters

Where a prime is hiring key personnel, as long as the key personnel remain under the supervision and control of the prime, the ostensible subcontractor rule is not violated.  Size Appeal of Residential Enhancements, Inc., SIZ-5931, June 11, 2018

Overall management and control by the prime are especially important for construction contracts. In this industry, “the subcontractors often perform a majority of the actual construction work, because the prime contractor frequently must engage multiple subcontractors specializing in a variety of trades and disciplines.”

“In cases involving construction work, OHA has repeatedly 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.” …Further, “a small business prime contractor on a construction contract may delegate a large portion of the construction work to its subcontractors without contravening the ostensible subcontractor rule, provided that the prime contractor retains management of the contract.” Size Appeal of Martin Bros. Construction, Inc., SIZ-5945, July 31, 2018

Lesson Learned:  Affiliation through identity of interest can be a problem.

Size Appeal of Martin Bros. Construction, Inc., SIZ-5945, July 31, 2018

Affiliation through “identity of interest” is an issue that often arises in size standard challenges, in the same cases along with ostensible subcontractor arguments.  Under SBA regulations, “Affiliation may arise among two or more persons with an identity of interest. Individuals or firms that have identical or substantially identical business or economic interests (such as family members, individuals or firms with common investments, or firms that are economically dependent through contractual or other relationships) may be treated as one party with such interests aggregated.”

Identity of interest tends to be raised as a potential issue in challenges to size standards.  Therefore, we often find this argument made along with ostensible subcontractor arguments.  These are usually two separate and distinct legal arguments:  (1) affiliation found through identity of interest; and (2) ostensible subcontractor rule applications.  In Martin Bros, “identity of interest” is treated as a separate issue.  However, because an “ostensible subcontractor” analysis involves looking at all the facts and circumstances, one can’t be sure that “identity of interest” facts won’t slide in as part of the “ostensible subcontractor” analysis.

This article primarily addresses the ostensible subcontractor rule, so we will not discuss “identity of interest” in depth.  However, it is good to be aware that if your firm’s size standard is challenged, you and your attorney may need to look beyond the usual ostensible subcontractor rule issues and try to avoid situations where there are overly close ties between the prime and the subcontractor with respect to family relationships, common investments, or other types of economic interdependence.

Lesson Learned:  Hiring of incumbent-contractor personnel is not very strong evidence of undue reliance.  Size Appeal of Elevator Service, Inc., SIZ-5949, Aug 10, 2018

Regarding the 2nd factor of the “unusual reliance” analysis:  Whether the prime contractor plans to hire the large majority of its workforce from the subcontractor, management and control by the prime are more important than where the employees came from.

“In light of widespread industry practice and … Executive Order [13,495, 74 Fed. Reg. 6103 (Feb. 4, 2009)], OHA has opined that the hiring of incumbent non-managerial personnel cannot be considered strong evidence of unusual reliance… The 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…”   The wholesale hiring of all six positions from the subcontractor, in Elevator Service, was justified because the contract “requires union employees that are experienced, trained, and licensed through NEIEP (or equivalent) and the State of California. Thus, the employees on the job site are from a specific pool of eligible employees…”

The Executive Order mentioned above encourages the hiring of incumbent employees.  It has the effect of making the hiring of incumbent contractor personnel less significant in determining undue or unusual reliance.

Lesson Learned:  A prime’s strong past performance record can show that the prime is not overly reliant on the sub.

Regarding the 4th factor of the “unusual reliance” analysis:  Whether the prime contractor lacks relevant experience and must rely upon its more experienced subcontractor to win the contract, solid past performance evidence can be very helpful.

“[P]ast performance is ‘only one among other factors in the ostensible subcontractor analysis” and one that will not suffice absent other strong indicia of a violation.’ “  In Synaptek Corp, two references showing relevant past performance experience were enough for OHA to find no unusual reliance, where there were no other indicators of unusual reliance.  Size Appeal of Synaptek Corp., SIZ-5954, August 24, 2018

In Elevator Service, the prime was able to point to three previous contracts of its own that it performed for the same type of work.  Based on that past performance record, OHA found that the prime had significant relevant experience and did not need to rely on the incumbent to win the contract. Size Appeal of Elevator Service, Inc., SIZ-5949, Aug 10, 2018 

Lesson Learned:  If you’re the prime, your proposal must show you have a meaningful role:  supervising subcontractors is not always enough.

Size Appeal of Jacob’s Eye, LLC, SIZ-5955, August 29, 2018

Here, a violation of the ostensible subcontractor rule was found because the prime did not include in its proposal any meaningful role for itself.  OHA stated, “It is well-settled that ‘[t]he ostensible subcontractor rule is violated when a prime contractor will have no meaningful role in performing the contract’s primary and vital requirements.’”  The proposal did not identify any significant portion of the R&R services that would be self-performed by Appellant, and, other than two managerial employees who were not currently employed by Appellant, Appellant did not propose any of its own personnel to perform work on the contract.

Supervision of subcontractor employees is not necessarily enough.  “[A] prime contractor does not perform the primary and vital requirements of a contract merely by supervising its subcontractors in their performance of work.”  In this case, the management services were not a primary and vital part of the contract.  Instead, management was only a small fraction of the dollar value of the contract, and was only incidental to the primary goods and services the government agency sought to acquire.

           Best Practices:

In summary, some best practices for a prime contractor, when choosing subs for set-aside contracting partners are:

  • Understand the Ostensible Subcontractor rule, and how under 13 C.F.R. § 121.103(h)(4), you and your sub can become one Joint Venture entity, and affiliated for purposes of size standards, if you are not careful
  • Before you submit your proposal, make sure you are clear on which work in the solicitation the CO considers to be “primary and vital.”  If you’re not sure which parts of the solicitation the CO views as “primary and vital,” just ask the CO.
  • Make sure that you, as prime, manage and control the “primary and vital” work.
  • Avoid “undue reliance” on your subs by ensuring that you, as prime, can handle performance of the contract without your sub.
  • Know the Four Key Factors that can lead to a finding of undue reliance on your subs – these factors are routinely applied in ostensible subcontractor rule analyses:

(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.

  • Provide a past performance record that shows you have some relevant experience in the “primary and vital” work called for in the solicitation.
  • Last, but not least, do not be afraid to find other, similarly situated entity (SSE) small businesses to add to your team. Other SSE’s can give you a lot of flexibility in how you allocate the work, while avoiding ostensible subcontractor rule limitations.

Following these best practices can go a long way toward avoiding successful challenges to your size status when competing for set-aside government contracts.

For a free and confidential consultation with government contracts attorney Cheryl Adams call Watson & Associates, LLC on 1-800-601-5518 or 720-941-7200.