Court of Federal Claims Rejects SBA Decision that Future Conditional Restriction on Stock Ownership Destroys “Unconditional Ownership”

by Morrison & Foerster LLP - Government Contracts Insights

Veteran-owned small businesses have long grappled with seemingly benign drafting inconsistencies between Small Business Administration (SBA) and Department of Veterans Affairs (VA) regulations that can leave a business qualified as a Service-Disabled Veteran-Owned Small Business (SDVOSB) by VA standards, but not at the SBA (or vice versa).  One such puzzler is the requirement for unconditional ownership by a service-disabled veteran, a requirement that is common to both SBA and the VA, but for which the VA provides a substantially more detailed definition.  Compare 13 C.F.R. § 125.12 (“A concern must be at least 51% unconditionally and directly owned by one or more service-disabled veterans.”) with 38 C.F.R. § 74.3(b) (adding that “[o]wnership must not be subject to conditions precedent, conditions subsequent, executory agreements, voting trusts, restrictions on assignments of voting rights, or other arrangements causing or potentially causing ownership benefits to go to another (other than after death or incapacity)”).  This additional detail has created some conflicting results, which is not helped by divergent interpretations of unconditional at SBA and the Court of Federal Claims, all of which has left many a veteran business owner (and more than a few legal practitioners) scratching their heads.

One context in which this issue comes up is when an SDVOSB seeks to diversify its ownership, either by providing ownership interest to key employees or by bringing in an outside investor.  In those instances, some of those parties may seek a right of first refusal on stock ownership in the company if the veteran chooses to sell.  After all, the minority owners have an interest in who holds the lion’s share of the company.  In the past, the Court of Federal Claims has found that the VA’s regulations allow for a right of first refusal.  See Miles Constr., LLC v. United States, 108 Fed. Cl. 792, 803 (2013) (holding that a right of first refusal did not affect a veteran’s unconditional ownership under VA regulations because the right was not presently executory, was a standard provision in normal commercial dealings, and did not burden the veteran owner’s interest unless he or she chose to sell).  SBA has taken the opposite position based on nuances in its own regulations.  Int’l Logistics Grp., LLC, SBA No. VET-162 (2009) (holding right of first refusal violated the unconditional ownership provision in the SBA regulations because the veteran’s right to sell her stake was conditional and encumbered).

Earlier this year, in Veterans Contracting Group, Inc. v. United States, 133 Fed. Cl. 613 (2017), the Court of Federal Claims rejected the SBA’s position, holding that SBA failed to provide a “coherent and reasonable” explanation for its decision that a shareholder agreement provision providing a company with the first opportunity to purchase any shareholder’s shares at death, incompetency, or insolvency destroyed the owner’s unconditional ownership.  The court chided SBA’s unyielding use of a dictionary to define unconditional as “unnecessary and inappropriate,” and instead adopted more flexible interpretations from SBA’s regulations for its 8(a) Business Development program, a business assistance program for small disadvantaged businesses, at 13 C.F.R. § 124.105, which the court said “expressly define unconditional ownership in the context of socially and economically disadvantaged individuals” and therefore provide insight into the scope of unconditional ownership for SDVOSB-eligibility.  133 Fed. Cl. at 622-623.  Within those 8(a) regulations, the court pointed to 13 C.F.R. § 124.105(e), which states “SBA will disregard any unexercised stock options or similar agreements held by disadvantaged individuals” in determining unconditional ownership, thus opening the door for a right of first refusal that is based on some future event.

In sum, the court in Veterans Contracting took a significant step toward harmonizing the VA and SBA regulations on rights of first refusal by added the many provisions of 13 C.F.R. § 124.105 to the practitioner’s playbook when looking to structure a successful and compliant SDVOSB.  What remains to be seen is whether the broader “commercially reasonable” rule of Miles will be fully imported into the SBA regulations beyond rights of first refusal.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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