SBA Provides Welcome Clarity and Perhaps Some Additional Leeway on the Ostensible Subcontractor Rule

The Small Business Administration (SBA) issued a final rule, effective May 30, 2023, that revises various SBA regulations relating to the agency’s small business contracting programs. The final rule focuses primarily on regulations governing the 8(a) Business Development Program, which we discussed in a prior Advisory, but it also includes many important changes that extend beyond that program. This Advisory discusses the rule’s changes to the ostensible subcontractor rule, which include: (1) codifying factors for determining whether a subcontractor is an ostensible subcontractor that must be deemed affiliated with the prime offeror; (2) potentially precluding affiliation under the ostensible subcontractor rule where the prime offeror can show that it intends to comply with limitations on subcontracting; (3) limiting the ostensible subcontractor rule to acquisitions expected to exceed the simplified acquisition threshold, which is currently set at $250,000 with some exceptions; and (4) clarifying the ostensible subcontractor rule’s application to general construction contracts. As discussed below, the most important aspect of these changes for many contractors is likely to be the possibility of avoiding affiliation under the ostensible subcontractor rule by showing compliance, or an intention to comply, with contractual limitations on subcontracting.

A. The Importance of Affiliation and the Ostensible Subcontractor Rule

Affiliation is a critical consideration when determining a firm’s size status. If a prime offeror is determined to be affiliated with one or more other firms and the affiliated firms’ aggregated average annual receipts or employee headcount exceed the size standard under an applicable North American Industry Classification System (NAICS) code, the prime offeror will be considered a large business and ineligible for award.

Two or more firms can be affiliated under a variety of tests, including the ostensible subcontractor rule.¹ That rule provides that "[a] contractor and its ostensible subcontractor are treated as joint ventures for size determination purposes" and are, therefore, affiliated for determining size status in a particular procurement.² SBA’s rules define an "ostensible subcontractor" as "a subcontractor that is not a similarly situated entity … and performs primary and vital requirements of a contract, or of an order, or is a subcontractor upon which the prime contractor is unusually reliant."³ SBA’s rules also continue to state that the agency considers “[a]ll aspects of the relationship between the prime and subcontractor … [and] [n]o one factor is determinative” when determining whether the relationship between a prime offeror and a subcontractor triggers affiliation.⁴

A prime offeror faces a variety of negative repercussions for failing to account for affiliation, including through misapplication of the ostensible subcontractor rule. If a prime offeror represents itself as small but is later considered to have been large, the offeror may face allegations that it misrepresented its size status, which could result in a range of penalties for both the prime offeror and its subcontractor. Perhaps the most extreme risk is the potential for liability under the False Claims Act (FCA) for misrepresenting small business size status and significant financial liability under SBA’s so-called presumed loss rule, which establishes a presumption that the damages to the government from a size or socioeconomic status misrepresentation is the total value of the contract regardless of the value actually received. Predicating an allegation of fraud on the misapplication (or misunderstanding) of the ostensible subcontractor rule would be aggressive, and the Department of Justice (DOJ) or a relator would face hurdles in pursuing such a theory. However, both DOJ and relators have shown a willingness to pursue novel FCA theories, and contractors and subcontractors should, therefore, expect that an alleged failure to account for the ostensible subcontractor rule could be treated as fraud. Separate from the often draconian remedies under the FCA, even the most innocent failure to account for the ostensible subcontractor rule could result in a finding that the prime offeror is ineligible for award and contract termination. On a positive note, as discussed below, the final rule appears to provide some clarity that could make it easier for contractors to prove affiliation is not present under the ostensible subcontractor rule.

B. Key Updates to the Ostensible Subcontractor Rule

1. Codifying Certain DoverStaffing Factors

The final rule codifies some, but not all, factors from DoverStaffing Inc., SBA No. SIZ-5300 (2011), which is the seminal SBA Office of Hearings and Appeals (OHA) decision interpreting and applying the ostensible subcontractor rule. In that case, OHA identified four primary factors to consider:

• Whether the proposed subcontractor is the incumbent contractor and ineligible to compete for the procurement
• Whether the prime contractor plans to hire a large majority of its workforce from the subcontractor
• Whether the prime contractor's proposed management previously served with the subcontractor on the incumbent contract
• Whether the prime contractor lacks any relevant experience and must rely solely upon its more experienced subcontractor to win the contract

OHA has stated that no factor is dispositive and OHA is more likely to find an ostensible subcontractor relationship when the subcontractor at issue performs 40% or more of the work on the contract.⁵

The final rule directly codifies the first, third, and fourth factors from DoverStaffing, though SBA will continue to consider all facts and circumstances.⁶ SBA specifically declined to adopt the second factor regarding the incumbent workforce, recognizing "a successful concern is often required to offer to qualified employees of a predecessor contract the right of first refusal on a subsequent contract, and must hire such individuals if they so opt."⁷ This is consistent with OHA’s post-DoverStaffing decisions, which have also recognized that an awardee may be required to hire incumbent personnel.⁸ Importantly, the final rule provides that a prime offeror can leverage experience and past performance of a subcontractor that is not a similarly situated entity to enhance its proposal so long as the subcontractor will not perform “primary and vital” contract requirements.

2. Compliance With Limitations on Subcontracting is a Defense to the Ostensible Subcontractor Rule

SBA’s final rule precludes affiliation under the ostensible subcontractor rule if the small business prime offeror can show it will meet limitations on subcontracting requirements.⁹ Limitations on subcontracting prevent the prime offeror from subcontracting more than a maximum amount of work to subcontractors that are not similarly situated. (The specifics of limitations on subcontracting vary depending on the nature of the contract. We have discussed them in a past Advisory.) The tests for applying limitations on subcontracting focus on dollars spent, or to be spent, for broad types of work, like all services, versus the more granular analysis required to assess which entity is (or entities are) performing the “primary and vital” contractual requirements for purposes of applying the ostensible subcontractor rule.¹⁰ The final rule states "SBA will find that a small business prime contractor is performing the primary and vital requirements of the contract or order, and is not unduly reliant on one or more subcontractors that are not small businesses, where the prime contractor can demonstrate that it, together with any subcontractors that qualify as small businesses, will meet the limitations on subcontracting provisions set forth in § 125.6 of this chapter."¹¹ In the preamble, SBA confirmed that it "believes that meeting the applicable limitation on subcontracting requirement is sufficient to overcome any claim of the existence of an ostensible subcontractor."¹²

It is not clear how, or even if, OHA will assess compliance with limitations on subcontracting under the new rule. Historically, OHA has declined to consider whether an offeror intends to comply with limitations on subcontracting because OHA views that issue as a matter of contractor responsibility outside OHA’s jurisdiction. SBA’s rule would seem to require OHA to either start assessing whether compliance with the limitations on subcontracting is expected or disregard the de facto safe harbor that the rule provides for companies that comply with limitations on subcontracting. If OHA chooses the former, as we expect, that would present new territory for OHA.

At least until OHA has interpreted the new regulations, contractors should be cautious in relying on compliance with limitations on subcontracting to avoid affiliation under the ostensible subcontractor rule in size protests. In such a protest, the challenged firm bears the burden of proving it qualifies as small.¹³ Demonstrating compliance with limitations on subcontracting in a size protest could prove difficult unless the proposal contains clear statements about how work will be allocated among the prime offeror, subcontractors that qualify as similarly situated entities, and other subcontractors. Proposals often lack this level of detail absent an express solicitation requirement. Under Government Accountability Office (GAO) and Court of Federal Claims (COFC) precedent, compliance with limitations on subcontracting is considered a matter of contractor responsibility or contract administration outside GAO’s and COFC’s respective bid protest purviews except where a proposal is clear on its face that the offeror will not comply with limitations on subcontracting. But under SBA’s revised regulation, a protested concern might need clear statements in the proposal to carry its burden of proof in defending against a size protest where it plans to rely on compliance with limitations on subcontracting to refute anticipated allegations related to compliance with the ostensible subcontractor rule. In other words, there may now be an onus on prospective contractors to proactively demonstrate a commitment to comply with limitations on subcontracting.

3. Applicability

The final rule clarifies that the ostensible subcontractor rule applies only to contracts that exceed the simplified acquisition threshold (currently $250,000, with certain exceptions). As discussed above, under the final rule, compliance with limitations on subcontracting is now (at least conceptually) a defense against affiliation under the ostensible subcontractor rule. Limitations on subcontracting apply only to small business set-aside contracts expected to exceed the simplified acquisition threshold.¹⁴ SBA therefore noted that if limitations on subcontracting do not apply, then the ostensible subcontractor rule should not apply.¹⁵

4. General Construction Contracts

General construction contracts are different from standard procurement contracts because of how performance responsibilities are allocated. In many procurement contracts, particularly those for services, the prime contractor provides program management while also performing the fundamental contract requirements. In construction, subcontractors, including those specializing in specific trades and disciplines, often perform the majority of the construction work, while the prime contractor provides management, oversight, and supervision. The final rule accounts for these differences by specifying that for general construction contracts, the “primary and vital” requirements are supervising, overseeing, managing, and scheduling the construction work.¹⁶

*Bryan R. Williamson contributed to this Advisory. Bryan is a graduate of the University of Oregon School of Law and is employed at Arnold & Porter's Washington, D.C. office. Bryan is admitted only in Washington. Bryan is not admitted to the practice of law in Washington, D.C.

© Arnold & Porter Kaye Scholer LLP 2023 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.