Federal Circuit Affirms Strict Application of SDVOSB Ownership and Control Standards

The Federal Circuit's decision in XOtech, LLC v. United States¹provides a stark reminder that companies relying on Service Disabled Veteran Owned Small Business (SDVOSB) status must be vigilant in ensuring their governing organizational documents satisfy the requirements for such status. As shown in XOtech, standard provisions in governing documents may condition a service-disabled veteran's (SDV) control of the company in a way that precludes SDVOSB status.

Context for SDVOSB Ownership & Control Requirement

Congress provides significant benefits to SDVOSBs, including the ability to have certain procurements set aside for SDVOSBs alone. As the Federal Circuit recognized, SDVOSB status "is thus highly beneficial in competing for government contracts because it permits designated contractors to compete for government business against fewer competitors."²

Congress requires, however, that in order to qualify as an SDVOSB, a business must be "owned and controlled" by an SDV.³ Regulations promulgated by the Small Business Administration (SBA) establish criteria for assessing whether the required degree of control in fact exists, including the requirement that an SDV must have "control over all decisions of the limited liability company."⁴ In XOtech, the Federal Circuit confirms that if a company's internal governance structure dilutes the authority of the SDV to control the business, that company may be found ineligible for SDVOSB preference.⁵

XOtech's Management Structure

XOtech LLC, organized under the Georgia Limited Liability Company Act, was structured as a "manager-managed company" where "management of the company is vested in one or more managers who have authority to manage the company as provided in the operating agreement."⁶

Under the relevant Operating Agreement, XOtech was owned by four members with voting rights corresponding to their ownership interests. Only one of the four members was an SDV, and he owned 90.28% of XOtech. The Operating Agreement identified certain "significant and transformative" decisions as "Member decisions," and the SDV's majority interest meant that he controlled all such decisions.⁷ The Operating Agreement did not, however, provide for unqualified SDV control.

While the SDV's majority ownership interest ensured his control over member decisions, the Operating Agreement granted the company's managers broad authority over important operational decisions, including: "'full and complete authority, power and discretion to . . . to take all action necessary or convenient to carry out the business and affairs of the Company.'"⁸ More specifically, the managers had authority to hire employees, bind XOtech to contracts, and borrow money on behalf of the company, among other things.

Instead of centralizing these management functions under the unqualified control of the SDV, XOtech's Operating Agreement designated three of the four members as having manager status and divided the management authority among them. Specifically, the Federal Circuit explained that the Operating Agreement provided that "[e]ach Manager has equal voting power, and a majority vote of Managers is required to make a management decision."⁹ Therefore, any management decision "require[d] the vote of at least one non-SDV" and the two non-SDV could make unilateral management decisions.¹⁰

Prior Proceedings

XOtech received a contract award set aside for SDVOSBs, but the award was protested to the SBA on the basis that, among other things, XOtech was not eligible for SDVOSB status.¹¹ The SBA area office held that XOtech could not qualify as an SDVOSB because the SDV-manager "lacked sufficient control over XOtech's operations because he required the vote of at least one non-SDV to make management decisions."¹² The SBA Office of Hearings and Appeals affirmed.¹³ XOtech elevated the protest to the Court of Federal Claims, but the court "determined that not all decisions of XOtech are controlled by SDVs because its Operating Agreement requires . . . the vote of at least one non-SDV to make management decisions."¹⁴

The Federal Circuit's Decision

XOtech appealed to the Federal Circuit, raising two principal arguments. First, XOtech argued that notwithstanding the terms of the Operating Agreement, the non-SDV managers could not block any management decision because the SDV had authority to remove any non-SDV managers that took an action with which he disagreed. Second, XOtech argued that the SDV manager's "inability to prevent non-SDV Managers from making decisions that he opposes does not preclude [SDVOSB] status because the ability of the SDV Managers to bind XOtech is no different from that of an ordinary employee to whom decision-making authority is delegated."¹⁵

The Federal Circuit rejected XOtech's arguments and affirmed the Court of Federal Claims in a unanimous opinion authored by Judge Lourie and joined by Judges Taranto and Stoll. The Federal Circuit confirmed, in plain language sure to be quoted in countless future size and status protests, that issues of "control" relating to SDVOSB status will be based on review of a company's governing organizational documents. Moreover, control will be found lacking where "any portion of an LLC's decision-making authority requires the vote of a non-SDV:"

We agree with the government and the Claims Court that XOtech is not an SDVO business. To determine who controls the decisions of a company, we will look to the terms of its governing documents. . . . If any portion of an LLC's decision-making authority requires the vote of a non-SDV, then SDVs cannot be said to control all decisions of the company. To establish SDV control, one or more SDVs must be able to independently exercise control of all decisions, without the consent of any non-SDVs. That is not the case here.¹⁶

The Federal Circuit included broad language regarding supermajority voting requirements, agreeing with the assertion that "where a governing document requires a supermajority for certain decisions and SDVs do not control a supermajority of votes, SDVs lack the requisite control for SDVO status under 13 C.F.R. § 125.13."¹⁷

The Federal Circuit found that the SDV's authority to fire managers that made decisions with which he disagreed did not change the fact that they could make those decisions to begin with. According to the court: "Until [the SDV] actually removes the non-SDV Managers, all management decisions require the vote of at least one non-SDV" and he "cannot preempt the non-SDV managers from making decisions, and he cannot undo decisions that they have made even after their removal."¹⁸

The Federal Circuit also rejected XOtech's argument that the non-SDV managers possessed authority analogous to employees of any company that were granted delegated decision-making authority:

The ability of employees to make decisions during day-to-day operations results from a delegation of management authority, and the source of that authority is XOtech's management structure, which [the SDV] does not independently control. Ultimately, the hiring, firing, and delegation of authority to employees are decisions reserved to managers who are not controlled by SDVs.¹⁹

Conclusion

The bottom-line message of the court in XOtech is that: "The government has established a program to benefit firms owned by SDVs, and if a firm wishes to obtain the benefits of that designation, then it must comply with the rules and structure its business accordingly."²⁰

Governing document terms in broad use in the commercial market (or even the non-SDVOSB government contracting market) might not comply with rules governing SDVOSB preferences. Even small delegations or limitations on the authority of the managing SDV may endanger a company's SDVOSB status. XOtech is therefore a strong reminder that any company relying on SDVOSB eligibility (even a company like XOtech that is substantially controlled by an SDV) should carefully review their governing organizational documents to ensure that the company's SDV leadership meets all statutory and regulatory ownership and control requirements.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.