NAICS Code Appeals: One Size Does Not Fit All

by Morrison & Foerster LLP - Government Contracts Insights

The federal government sets aside many contracts for small businesses, but not all small business set-asides are created equal.  Instead, different size standards define small business status for different procurements.  The size standards vary from industry to industry, so a given firm may be a small business for one procurement at the same time it may be other-than-small for a different procurement for seemingly similar goods or services.

To keep order, the Small Business Administration (SBA) maintains a manual of industrial codes – called North American Industry Classification System (NAICS) codes – that are assigned to particular classes of manufacturing and service industries.  Each NAICS code is associated with a particular size standard that changes over time.  Some size standards are based on a firm’s revenues and are expressed as dollar values – a firm is small if its average annual receipts do not exceed the specified number of dollars.  Others are based on the size of a firm’s workforce – a firm is small if its average number of employees does not exceed the figure associated with the particular NAICS code in question.

For each procurement in excess of the micro-purchase threshold (currently $3,500 for most acquisitions), the contracting officer must designate within the solicitation a single NAICS code that best corresponds to the goods or services the agency is soliciting.  FAR 19.303.  The chosen NAICS code establishes the size standard for that procurement.  If the procurement is a small business set-aside, the size standard can determine (in large part) whether a particular offeror is eligible for award.

As one might expect, an agency’s choice of NAICS code is often more art than science, and reasonable minds may disagree what the best NAICS code may be for a given procurement.  Because different NAICS codes may correspond to different size standards, the agency’s code choice in a set-aside procurement may result in a particular firm being eligible or ineligible to compete for award.  Exclusion from a competition is a powerful incentive for firms to challenge an unfavorable NAICS code selection.

Unlike normal pre-award solicitation challenges, a challenge to a NAICS code is not a bid protest that can be filed with the Government Accountability Office (GAO), Court of Federal Claims, or the procuring agency.  Instead, an aggrieved potential offeror must file a NAICS Appeal with the SBA Office of Hearings and Appeals (OHA), within 10 calendar days after issuance of the solicitation containing the objectionable NAICS code.  See 13 C.F.R. § 121.1103.  OHA does not require the agency’s selected NAICS code to be perfect.  Rather, an appellant has the burden of proving that the chosen code is based upon a clear error of fact or law and does not best describe the principal purpose of the product or service being acquired.  If OHA issues an adverse decision, a party with standing may then appeal OHA’s decision to the Court of Federal Claims.

Illustrative Case:  American West Laundry, Inc.

A recent decision from OHA illustrates how a NAICS code appeal proceeds, and what remedies are available.  American West Laundry, Inc., SBA No. NAICS-5842 (2017), involved an Army solicitation for a contractor to perform bulk laundry services, including picking up dirty laundry from an Army hospital, cleaning and drying it at the contractor’s facility, and returning the laundry to the Army within 24 hours.  The Army set the procurement aside for small businesses, and assigned NAICS code 812331 (Linen Supply), with a size standard of $32.5 million in average annual receipts.

Within 10 days after issuance of the solicitation, American West filed a timely NAICS appeal with OHA, arguing that the Army should have assigned NAICS code 812320 (Drycleaning and Laundry Services (except Coin-Operated)), with a much smaller size standard of $5.5 million in average annual receipts.  Reading between the lines, American West had less than $5.5 million in average receipts (and thus would meet the stricter size standard), but believed a number of its potential competitors (which might have less than $32.5 million in annual receipts under the more generous size standard) exceeded the stricter standard.  Reducing the size standard to $5.5 million would thus clear out a portion of the appellant’s competition.

A second offeror, Division Laundry & Cleaners, intervened in the appeal to defend the agency’s choice of NAICS codes.  Reading between the lines, this firm likely was one of the companies that was small under the $32.5 million standard, but would have been other-than-small under the $5.5 million standard.  Division Laundry argued that the Army’s chosen code was correct because it included “businesses that provide laundered items, such as bed linens, towels, and hospital gowns,” which are the items this solicitation required to be laundered.  Division Laundry also argued that this is the code the agency had used in the past for similar procurements.

SBA’s Office of General Counsel filed its own response in the appeal, arguing that both the Army and the appellant got the NAICS code wrong.  According to the SBA, the code should have been 812332 (Industrial Launderers), with an associated size standard of $38.5 million – higher even than the initially chosen NAICS code.  The SBA argued that this code included work related to hospital laundry services (such as the services required by this procurement) and, moreover, corresponded to a superseded code definition that (like the current procurement) included services where a contractor was responsible for replacing or repairing Government-owned items to be laundered if those items were no longer serviceable.

Which of the three codes was correct?  Citing its own precedent, OHA found that the Army’s preferred code was incorrect because it described services where the contractor owns the laundered items and rents them to the Government – i.e., supplying linens to the Government.  Here, the Government owned the linens, and the contractor was only going to launder them.  OHA also found the SBA’s preferred code was incorrect.  Like the Army’s code, the SBA’s preferred code also applied only to launderers that “supply[], on a rental or contract basis,” the laundered items, but here the contractor was to provide laundry services for Government-owned items.  OHA did not find that slightly different definitions in the obsolete code manual cited by the SBA shed any light on the applicability of current NAICS codes.  Thus, the appellant’s preferred code (with its $5.5 million size standard) was the correct one, as only it applied to laundry services performed on Government-owned items and reasonably encompassed the solicited services.

So, the appellant won.  That victory, however, had no effect on the solicitation at issue:  although the appeal was timely filed within 10 days after release of the solicitation, the date set for receipt of quotations was only two weeks after the solicitation’s issuance.  Because OHA issued its decision after the due date for quotations, the decision had no effect on the pending procurement, although regulations allow the decision to be applied to future solicitations for the same services.  13 C.F.R. § 134.318(b); FAR 19.303(c)(8).

When to Appeal a NAICS Code

When and why would a company appeal a NAICS code?  As American West demonstrates, a desire for accurate taxonomy is not the primary motivation behind NAICS code appeals.  In general, we recommend that prospective offerors provide preferred NAICS codes to an agency as early in the acquisition process as possible, including in pre-solicitation responses or in questions and answers on draft solicitations.  If the solicitation is issued with a disadvantageous code, here are a few scenarios where an appeal may make good business sense:

  • The chosen NAICS code has an unfavorably high size standard. This was the issue in American West.  The choice between NAICS code 812331 (Linen Supply) and NAICS code 812320 (Drycleaning and Laundry Services (except Coin-Operated)) determined whether a very small firm like the appellant would have to compete only against other firms with annual revenues below $5.5 million, or against firms with revenues as high as $32.5 million.  A lower cutoff can knock a number of rivals out of set-aside competition altogether.
  • The chosen NAICS code has an unfavorably low size standard. This is the other side of the coin.  If the agency’s chosen NAICS code has a size standard that your otherwise small business exceeds, you should consider whether a different NAICS code (with a higher size standard) better describes the set-aside procurement.
  • A different NAICS code may drive a different Rule of Two analysis. Under the so-called Rule of Two, an agency must set aside for small businesses all acquisitions between $3,500 and $150,000, unless “there is not a reasonable expectation of obtaining offers from two or more responsible small business concerns that are competitive in terms of market prices, quality, and delivery.”  FAR 19.502-2(a).  Similarly, an agency must set aside for small businesses any procurement in excess of $150,000 if there is a reasonable expectation that offers will be obtained from at least two responsible small business concerns, offering the products of different small business concerns, at fair and reasonable prices.  FAR 19.502-2(b).  If a procurement’s selected size standard is low enough, there may not be a reasonable expectation of receiving two small business offers – causing the solicitation to be issued on an unrestricted basis, and thus open to large businesses.  Where the choice of NAICS code might be expected to alter the Rule of Two analysis and a procurement status as a set-aside or non-set-aside, it may be advantageous to appeal the selected code so that the procurement will – or will not – be set aside for small businesses.
  • It may make sense to intervene in someone else’s NAICS code appeal. Interested parties may participate in another party’s NAICS code appeal.  An intervention clearly makes sense when you are not happy with the assigned NAICS code, but it also may be advisable to participate in an appeal when you agree with the assigned code.  If you do not intervene in the appeal, and OHA renders a decision imposing a NAICS code that is unfavorable to you, you likely will be foreclosed from filing an appeal of the new NAICS code or from seeking judicial review.  See Palladian Partners, Inc. v. United States, 783 F.3d 1243 (Fed. Cir. 2015).

[View source.]

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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