The Small Business Administration (“SBA”) is changing its views on small business prime contractors who propose to hire “key personnel” from their subcontractors when looking at the “ostensible subcontractor” rule. The ostensible subcontractor rule states that when a prime contractor is unusually reliant on the subcontractor, SBA will consider the prime contractor affiliated with its subcontractor in performing the contract.
This new flexibility is quite a bit different from OHA’s decision in DoverStaffing Inc., SBA No. SIZ-5300 (2011), a pivotal case on the ostensible subcontractor rule. In that case, OHA noted that although Executive Order 13495 encourages the hiring of incumbent non-managerial personnel, it does not apply to the hiring of incumbent managerial personnel. OHA held that the prime contractor’s proposal to hire all of the key personnel from its subcontractor, the incumbent contractor, indicated the prime contractor was unusually reliant upon the subcontractor for performance of the contract.
To understand how this could potentially affect you, you need to understand affiliation rules. When you calculate the size of your business to determine if you are a small business, you must include the annual receipts and employees of your affiliates. Affiliation is determined by the ability to control.
Generally, affiliation exists when one business controls or has the power to control another or when a third party (or parties) controls or has the power to control both businesses. Control may arise through ownership, management, or other relationships or interactions between the parties. Control may be affirmative or negative. Negative control includes 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.
When the ability to control exists, even if it is not exercised, affiliation exists. So if you have to consider the subcontractor employees and annual revenue along with your own, this could prohibit you from being considered a small business under certain NAICS codes. To fully understand affiliation rules, which are extremely complex, read the Small Business Compliance Guide on Size and Affiliation.
The SBA OHA has recently found that there is no violation of the ostensible subcontractor rule if the key personnel remain subordinate to the prime contractor’s employees. So if the prime contractor’s proposed project manager is currently an employee of the proposed subcontractor but will be hired by the prime contractor upon award, OHA would not find unusual reliance on the subcontractor if that project manager will be under the control of the prime contractor.
OHA uses the following indicators for violation of the rule (note that these indicators remain unchanged; it’s their interpretation that has evolved):
Proposed subcontractor was the incumbent;
Incumbent subcontractor was not eligible to compete for the acquisition;
Prime contractor planned to hire the majority of its workforce from the subcontractor;
Prime’s proposed program mgr. was the subcontractor’s program mgr. on the incumbent contract;
The prime contractor was a comparatively new firm with low revenues and little experience.
If these indicators are true in your case, then beware. OHA has 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.”
This change in the interpretation of the ostensible subcontractor rule impacts all small business government contractors. A more flexible interpretation on hiring key personnel from a proposed subcontractor could allow more small businesses to obtain prime contracts when they do not have experienced managerial personnel.
On the other hand, if you are an offeror seeking a small business set-aside, it could be more difficult to challenge the small business size of an awardee who is dependent on a subcontractor to staff their contract.
Bottom line is that OHA is changing its position in some cases on the ostensible subcontractor rule and whichever side you fall on this argument, it’s important to understand the potential impact.