Following the market crash of 2008, decreasing opportunities and increased competition led many contractors, large and small, to turn to federal government contracting for the first time. These contractors sought a steady new stream of revenue and believed that performance of federal government contracts could provide just that.

Many of these contractors became interested in work “set aside” for small businesses. Each year, the federal government attempts to steer small businesses a certain portion of government contracts by reserving (i.e., setting aside) an ever-growing number of contracts exclusively for those companies considered to be small.

As part of this effort, some of these small-business contracts are set aside for particular types of small businesses, namely those participating in the Small Business Administration (SBA) development programs designed for: 8(a) (small, disadvantaged) businesses; HUBZones (small businesses located in historically underutilized business zones); SDVOSBs (service-disabled veteran-owned small businesses); and WOSB/EDWOSBs (woman-owned/economically disadvantaged woman-owned small businesses). Currently, the government aims toaward 23 percent of prime contracts per fiscal year to small businesses as a whole, including 3 percent each to SDVOSB and HUBZone businesses and 5 percent each to 8(a) and WOSB/EDWOSBs.

Given the substantial percentage of contracts set aside for these small businesses, contractors new to the federal contracting arena quickly realized how valuable eligibility for these small business programs could be. What they found, however, was that the statutory and regulatory structure that governed such eligibility was difficult to navigate. Not only does each program have its own distinct requirements for participant eligibility, but there are additional rules concerning the manner in which the participant must interact with other companies; interactions involving “affiliation” or a shift in “control” can render an otherwise-eligible company ineligible for participation in a small business program. Many contractors — and lawyers — found it hard to understand these rules and the nuances involved in size status determination. As a result, many contractors that were themselves large, or were affiliated with large companies, incorrectly portrayed themselves as small businesses and/or small 8(a) companies, HUBZone businesses, SDVOSBs, and WOSB/EDWOSBs. These contractors then competed for, and sometimes won, contracts they were not truly eligible to perform, often at the expense of eligible small businesses.

In fact, a recent analysis performed by the American Small Business League demonstrated that, last year alone, 72 of the 100 companies receiving the highest amount of federal small business contracts were not, in fact, small businesses. Moreover, the government General Accounting Office (GAO) has issued several reports in the last several years detailing the existence of actual fraud in the HUBZone, SDVOSB and 8(a) programs. This spring, the Department of Defense Office of Inspector General issued its own report, which concluded that the DOD had made hundreds of millions of dollars of SDVOSB set-aside awards to contractors that were ineligible and/or had misrepresented their SDVOSB status. The SBA published a report acknowledging that abuse of the small business programs was the agency’s biggest challenge. Specifically, the report stated that “procurement flaws allow large firms to obtain small business awards and agencies to count contracts performed by large firms towards their small business goals.” Prompted by the issuance of these and other similar studies, the abuse of small business programs (and the government’s failure to remedy such abuse) has become a hot-button issue in Washington. A resultant backlash against contracting fraud has ensued, bringing with it an uptick in investigations by inspectors general and the Department of Justice, and a push toward increased regulation of federal procurement activities.

Legislative Response

Most notably, on Sept. 21, 2011, the U.S. Senate passed the Small Business Contracting Fraud Prevention Act of 2011.This bill reflects the federal government’s interest in the protection and promotion of small businesses in federal contracting and seeks to deter fraud by increasing the penalties imposed on a business that falsely certifies its small business status. Specifically, the bill would allow the government to recover from the fraudulent contractor, under the government’s False Claims Act, damages equal to three times the total amount of the contract. In addition, because FCA suits can be brought by private individuals, as well as the government, the bill would likely result in a substantial increase in lawsuits against fraudulent contractors. A second bill, the 2013 National Defense Authorization Act, which was approved in early May by the House Committee on Armed Services, provides that a contractor’s misrepresentation of its small business size status is an independent basis for suspension or debarment of that contractor. In fact, if enacted in its current form, the bill would require agency officials to suspend or debar a contractor for misrepresenting itself as a small business.

These proposed changes reflect the growing pressure from Congress to crack down on small business procurement fraud and generally increase contractor suspensions and debarments. As the government continues to move in this direction, it is absolutely imperative that federal contractors, and the lawyers who represent them, understand the issues surrounding small business program eligibility, including ownership and control issues and affiliation, or risk suspension, debarment and enormous fines. Although the rules can be complicated, there are some basic guidelines that all federal contractors (or would-be federal contractors) should know.

Each program has its own requirements for participant eligibility, but those relevant here all require a participant be a small business. To determine whether a contractor qualifies as small for the purposes of any given contract, one must ensure that the contractor’s size does not exceed the size standard — measured either in revenue or number of employees — associated with the North American Industry Classification System (NAICS) code assigned to that contract. Additionally, to participate in the SBA’s 8(a), SDVSB and WOSB/EDWOSB programs, an entity must be at least 51 percent unconditionally owned and controlled by an individual who is either economically disadvantaged in some way, historic or otherwise, a service-disabled veteran or a(n) (economically disadvantaged) woman, respectively. HUBZone eligibility requirements are a bit more complicated. To be eligible for participation in that program, a business must maintain its principal office in a HUBZone and ensure that 35 percent of its employees reside within a HUBZONE (or American Indian reservation), and that the company will attempt to maintain that percentage during the performance of any HUBZone contracts awarded to the concern.

Further complicating matters, both “ownership” and “control” are legal terms of art that implicate determinations concerning management experience, internal corporate structure and interaction with other companies. For example, in SDVOSB Appeal of Rush-Link One Joint Venture , SBA No. VET-228 (2012), the Small Business Administration Office of Hearings and Appeals (OHA) concluded that a company’s shareholders agreement rendered a corporation ineligible for participation in the SDVOSB program. Because the 55 percent majority owner, a service-disabled veteran, did not possess the power to independently overcome a 70 percent supermajority provision in the shareholders agreement, the OHA concluded the company was not controlled by the service-disabled veteran and was therefore ineligible for the program. In that same case, the OHA determined the service-disabled vet did not in fact own the company within the meaning of the SDVOSB program regulations, based on the existence of promissory notes that restricted his ownership rights, including ability to transfer his interest or receive dividends or distributions. In short, conclusions concerning the ownership and control of a business, and the effect of those conclusions on determinations of small-business status, can involve complicated and nuanced analyses.

Another area of concern is affiliation. Generally, affiliation exists when one business owns or controls another or when a third party owns or controls both businesses. Affiliation generally arises through common ownership, management or other relationships (including family ties) or interactions between two business concerns. Although SBA small business program contractors are not prohibited from having affiliates, affiliation can negatively impact a company’s small-business status because a business must add an affiliate’s revenue or employee count to its own when comparing its size to the applicable size standard. Moreover, affiliates can be found to own or control a company — if a company’s ties to its affiliate are found to be strong enough to impede the ownership or control of the individual who renders the company eligible for participation (i.e., the economically disadvantaged, service-disabled veteran or woman who owns 51 percent of the company), that company will lose its program eligibility.

At the same time, many small businesses lack the capability to perform large government contracts alone, and therefore must associate with other businesses through joint ventures or teaming agreements in order to obtain and/or perform these contracts. These joint-venture and teaming arrangements often implicate issues of ownership and control that can result in a finding of affiliation between the participating businesses. Therefore, it is important that lawyers advise their contractor clients about the potential consequences involved in forming a joint venture or entering into a teaming agreement and ensure that any joint-venture and teaming agreements are properly drafted to avoid affiliation issues, comply with the applicable regulations concerning contract performance and maintain small business program eligibility.

In conclusion, determinations concerning a contractor’s size status and eligibility for any of the various SBA small business development programs, and maintenance of such eligibility, involve complicated factual and legal analyses. As congressional pressure to root out fraud and penalize those companies misrepresenting their status grows, noncompliant contractors are increasingly susceptible to suspension, debarment and substantial fines. Potential problem areas that could lead to allegations of fraud can be difficult to identify. As such, it is necessary to seek legal advice on all matters that could impact small business program eligibility, including, but not limited to, size status, internal corporate structure issues affecting ownership and control and proper joint-venture and teaming arrangements. Because of the complexity of these issues, and because failure to properly identify any problems can lead to dire consequences, one must be sure to carefully review all applicable rules and regulations before advising a client in connection with any of the SBA’s small business programs. •

Edward T. DeLisle is a partner and Maria L. Panichelli is an associate with Cohen Seglias Pallas Greenhall & Furman. Both practice in the federal construction contracting group and can be reached at 215-564-1700, edelisle@cohenseglias or mpanichelli@cohenseglias.com.