Acquiring Small Business Government Contractors and the New FAR Small Business Subcontracting Rules

[Former Counsel Joan Ochs was a contributing author on this Advisory.]
On July 14, 2016, the Federal Acquisition Regulation Council issued a final rule implementing changes to the Federal Acquisition Regulation (FAR) small business subcontracting regulations.¹ These changes -- which will become effective on November 1, 2016 -- are consistent with the 2013 regulatory changes to small business subcontracting made by the U.S. Small Business Administration (SBA) to implement the Small Business Jobs Act of 2010 (Pub. L. 111-240). In addition to existing recertification requirements for small businesses following a merger or acquisition, the new rules add requirements for new subcontracting plans, notification, and reporting; create new compliance obligations; and have implications for past performance evaluations in future procurements. Acquirers of a company that identifies itself as a “small business” under the SBA regulations should consider the potential impact of the new regulations under the key FAR provisions amended by the Final Rule: FAR Subpart 19.7 (The Small Business Subcontracting Program) and the contract clauses at FAR 52.219-8 (Utilization of Small Business Concerns) and FAR 52.219-9 (Small Business Subcontracting Plan). Acquirers, including private equity firms and strategic buyers, should evaluate the impact that the acquisition and the new small business subcontracting rules may have on the sustainability of the target company’s government business.

The Transaction May Limit the Target’s Business Opportunities

A company bidding on a government procurement reserved for small businesses must certify in its proposal its qualification for small business status. Such companies may face additional certification requirements after contract award. Specifically, if a company is awarded a government contract based on its small business status, and if that company is later acquired by or merges with another entity, the contract awardee must recertify its size status within 30 days following the merger or acquisition.² The new SBA regulations impose additional recertification requirements on a small business concern if a merger or acquisition occurs after the small business concern submits its proposal but prior to contract award.³

To determine a government contractor’s size status, the SBA looks at both the entity itself and the contractor’s affiliates. Affiliates are entities under common control with the contractor, based on ownership, management, previous relationships, and contractual relationships.⁴ In determining whether affiliation exists, the SBA considers the totality of the circumstances and may find affiliation even in circumstances where no single factor alone may be sufficient to constitute affiliation. If the SBA determines that affiliation does exist, it will count the receipts or number of employees of the contractor whose size is at issue, combined with the receipts or number of employees for all of the contractor’s domestic and foreign affiliates to determine if the contractor still qualifies as a small business under the specified North America Industry Classification System (NAICS) code and corresponding size standard following the merger or acquisition. ⁵

The acquirer may try to structure the transaction with the small business government contractor in a manner to avoid affiliation, such as by having the target retain majority ownership and management control of itself. Often, however, the target and the acquirer will be deemed to be affiliates, and the target will no longer qualify as a small business under the SBA’s regulations.

Following a merger or acquisition resulting in a change in size status, the small business must notify all contracting officers for its outstanding bids and proposals and existing contracts and make updated representations regarding its size status. Generally, the target will retain its status as a small business for the life of its existing government contracts, and the change in size status will not change the terms and conditions of the contracts. The target will be permitted to complete its performance on its existing small business set-aside contracts. However, once the target recertifies that it is no longer a small business, the contracting agencies will no longer be permitted to count additional orders placed with, contract options exercised with, or modifications issued to that contractor towards the fulfillment of the agencies’ small business procurement goals. In other words, the agencies will not be entitled to receive small business credit for such orders or contracts.

As a result, agencies may be less motivated to award future business -- including exercising options or placing orders under existing contracts -- to the contractor. The contractor also will no longer be eligible for participation in future procurements reserved for small businesses. Similarly, prime contractor customers will no longer be able to consider contract extensions or modifications of the target’s subcontracts towards meeting their goals under their small business subcontracting plans, and may be less motivated to continue doing business with the target company following the loss of the target company’s status as a small business. Thus, the value of a small business target and the overall sustainability of its government contracts business could decrease dramatically after size recertification and loss of small business size status.

The Transaction May Create a New Obligation to Submit Subcontracting Plans

The changes to the FAR small business subcontracting requirements under the Final Rule will, under certain circumstances, impose additional subcontracting obligations on acquirers.

As noted, a contractor must recertify its size status after a merger or acquisition. Under FAR 19.301-2(e) as revised by the Final Rule, contracting officers may require a contractor -- and its new parent entity -- to submit a subcontracting plan for each contract, if the contractor no longer certifies as a small business. While recognizing that the contractor’s change in size status does not change the terms and conditions of the contract, revised FAR 19.301-2(e) will provide that “the contracting officer may require a subcontracting plan for a contract containing 52.219-9, Small Business Subcontracting Plan, if a prime contractor’s size status changes from small to other than small as a result of a size rerepresentation (see 19.705-2(b)(3)).” The Final Rule also supplements the existing guidance to determine if a subcontracting plan is necessary. It revises FAR 19.705-2 to direct contracting officers to consider -- in addition to the factors already included in the FAR -- the total contract dollars, and whether the contractor may acquire any portion of work from potential subcontractors with minimal or no disruption to performance and at a fair market value.

As revised, FAR 19.702(a)(3) will mandate that contracting officers require subcontracting plans under certain circumstances (unlike with recertification, where contracting officers have discretion regarding whether or not to require subcontracting plans, see FAR 19.301-2(e)). If a contract modification causes the value of a contract without an existing subcontracting plan to exceed $700,000 -- or $1.5 million for a construction contract -- the contracting officer must

require the contractor to submit a subcontracting plan for the contract, if the contracting officer determines that subcontracting opportunities exist. In addition, FAR 19.705-1(b)(1) as revised will require that, unless the contractor has a commercial plan,⁶ the contracting officer

must require a subcontracting plan for each indefinite-delivery, indefinite-quantity contract -- including task order delivery order contracts, Federal Supply Schedules, Government-wide Acquisition Contracts, and Multiple Award Contracts -- if the estimated value of the contract meets the subcontracting plan thresholds at FAR 19.702(a)(1), and the contracting officer determines that small business subcontracting opportunities exist.

Under the Final Rule, a subcontracting plan must include fourteen different types of information and assurances. Among other requirements, a subcontracting plan must include:

1. separate goals, expressed in terms of total dollars subcontracted, and as a percentage of total planned subcontracting dollars, for the use of small business, veteran-owned small business, service-disabled veteran-owned small business (SDVOSB), HUBZone small business, small disadvantaged business, and women-owned small business concerns as subcontractors;

2. a statement of total dollars that the contractor plans to subcontract for an individual subcontracting plan; or the contractor's total projected sales, expressed in dollars, and the total value of projected subcontracts to support the sales for a commercial plan;

3. a description of the principal types of supplies and services that the contractor will subcontract, and an identification of the types planned for subcontracting;

4. an assurance that the contractor will cooperate with certain studies or surveys and will submit certain periodic reports;

5. assurances that the contractor will make a good faith effort to acquire supplies, services, or construction work from the small business concerns listed;

6. assurances that the contractor will provide the contracting officer with a written explanation if the contractor fails to meet its described subcontracting goals; and

7. assurances that the contractor will not prohibit any of its subcontractors from discussing with the contracting officer any material matter pertaining to payment to or utilization of a subcontractor.⁷

The Final Rule specifies that, if the contractor adds a subcontracting plan as a result of a size re-classification -- or a modification to the dollar value of the contract -- then the subcontracting goals will apply from the date of incorporation of the subcontracting plan into the contract.⁸ The contractor’s subcontract reporting obligations, including submission of an Individual Subcontracting Report (ISR), will be triggered on a cumulative basis from the date that the subcontracting plan is incorporated into the contract.⁹

The New Rule Attempts to Reduce Instances of “Bait And Switch” Involving Proposed Subcontractors

In addition to creating new small business subcontracting obligations, the Final Rule will revise the FAR to make it more difficult for contractors to propose the use of small business subcontractors for a government contract and then fail to follow through with those proposed subcontractors during contract performance. Specifically, the Final Rule will add paragraph (a)(12) to FAR 19.704 to require that each offeror’s subcontracting plan include assurances that the offeror will make a “good faith effort” to acquire supplies, services, or construction work from the small business concerns that the offeror included in its bid or proposal, and in the same or greater scope, amount, and quality as used in preparing and submitting the bid or proposal.¹⁰ The Final Rule will also add paragraph (a)(13) to FAR 19.704 to require a prime contractor to submit a written explanation to the contracting officer within 30 days of contract completion if the contractor fails to utilize its small business subcontractors in the manner proposed in its bid or proposal.

Under the Final Rule, contractors may be subject to additional consequences for failing to implement their subcontracting plans. Under the current FAR provisions, if a contractor does not comply in good faith with its approved subcontracting plan, the contractor may be found to have materially breached its contract.¹¹ Beginning November 1, 2016, a contractor’s failure to comply in good faith with its small business subcontracting plan also “may be considered in any past performance evaluation of the contractor.”¹²

On a related point, the FAR as revised will require a prime contractor to allow its subcontractors to communicate directly with the contracting officer concerning “any material matter pertaining to payment to or utilization of a subcontractor.”¹³ While this change will not create privity between the subcontractor and the Government, it could alert a contracting officer to instances where a prime contractor may not be utilizing proposed small business subcontractors post-award or is otherwise failing to abide by its small business subcontracting plan.

The New Rule Adds Additional Obligations vis-à-vis Subcontractors

The Final Rule will amend the FAR to impose an additional notification requirement on prime contractors for competitive subcontracts over the simplified acquisition threshold in which a small business concern received a small business preference. In such instances, the prime contractor must, prior to award of the subcontract, inform each unsuccessful small business subcontract offeror, in writing, of the name and location of the apparent successful offeror and if the successful subcontract offeror is a small business, veteran-owned small business, SDVOSB, HUBZone small business, small disadvantaged business, or women-owned small business concern.¹⁴

Under the revised FAR, prime contractors also will need to assign to each subcontract the NAICS code and corresponding size standard that the prime contractor determines best describes the principal type of supplies or services to be subcontracted.¹⁵ Prime contractors will no longer be permitted to simply flow down the NAICS code selected by the contracting officer for the prime contract.

The New Rule Adds Liability Protection for the Prime Contractor

The Final Rule includes one change that prime contractors may welcome. Under FAR 19.703, as revised by the Final Rule, prime contractors will not be held liable for a subcontractor’s misrepresentation about its size or socioeconomic status, assuming the prime contractor acted in good faith.¹⁶ The Final Rule further provides that a prime contractor may accept size and socioeconomic representations from a potential subcontractor either from the subcontractor’s self-certifications included in its System for Award Management registration or by direct written representation. There is no order of preference for either method of representation by a small business subcontractor, but SBA regulations require that, for subcontracting purposes, a concern must qualify as small as of the date that it certifies its size status for the subcontract.¹⁷

Conclusion

Acquirers and their advisors should be mindful of the revisions to the FAR small business subcontracting regulations during the due diligence process, particularly where the acquisition involves a target company identifying itself as a “small business.” The transaction may expose the target company and its parent company to new subcontracting plan requirements, along with additional notification, reporting and compliance obligations. More broadly, the new FAR small business subcontracting rules may impact the value and sustainability of the target company’s government business.