In a previous post, we mentioned the April 27, 2023 Small Business Administration (SBA) Final Rule, which made a number of revisions to the Small Business Regulations. A few of those revisions relate to the Ostensible Subcontractor Rule, a topic that has confused contractors for years. The Final Rule seeks to clear up that confusion, or at least some of it. Specifically, the Final Rule revises 13 CFR 121.103(h) to (1) clarify how the Ostensible Subcontractor Rule applies to general construction contracts and (2) provide guidance on the utilization of the DoverStaffing factors in determining whether a subcontractor is an “ostensible subcontractor.”
Before getting into exactly what these latest changes say, let’s briefly recap what the Ostensible Subcontractor Rule is, and why it matters. Currently codified at 13 CFR 121.103(h)(2), the Ostensible Subcontractor Rule provides that the SBA will treat a small business prime contractor and an “ostensible subcontractor” as joint venturers for size determination purposes. In other words, the SBA will consider a prime to be affiliated with its subcontractor if that subcontractor is determined to be an “ostensible subcontractor” (more on how to define the term in just a moment). As many of you are surely aware, affiliation is generally a bad thing. When companies are considered affiliated, their combined size is compared to the applicable size standard. Oftentimes this pushes small businesses over the applicable size threshold, thereby nullifying small business eligibility. Accordingly, affiliation through the Ostensible Subcontractor Rule is something that contractors generally want to avoid. So how can a small business tell if its subcontractor is an ostensible subcontractor? It has to start with the regulatory definition.
The current regulation defines “ostensible subcontractor” as a subcontractor (1) that is not a similarly situated entity (as defined in 13 CFR 125.1) and (2) that performs primary and vital requirements of a contract or order, or upon which the prime contractor is unusually reliant. This “primary and vital” language routinely concerns small construction primes. Because it is common on general construction contracts for subcontractors to perform the majority of the actual construction work, there was always a question of whether the SBA would view such subcontracting as necessarily triggering the Ostensible Subcontractor Rule. In addition to this question, contractors both inside and outside the construction industry have long sought additional clarification on what constitutes “unusual reliance.” The Final Rule addresses both points.
Clarifications Concerning “Primary and Vital” Requirements of a General Construction Contract
The Final Rule clarifies that the “primary role of a prime contractor in a general construction project is to oversee and superintend, manage, and schedule the work, including coordinating the work of various subcontractors.” (Emphasis added.) As SBA explains, “[t]hose are the functions that are the primary and vital requirements of a general construction contract and ones that a prime contractor must perform.” Accordingly, going forward, the Ostensible Subcontractor Rule will be applied in general construction contracts to the management, supervision, and oversight of the project, including coordinating the work of various subcontractors, and not to the actual construction or specialty trade construction work performed, which the SBA now explicitly recognizes subcontractors often perform. Critically, “[t]he prime contractor must retain management of the contract but may delegate a large portion of the actual construction work to its subcontractors.”
Importantly, the Final Rule also offers guidance concerning the interplay between the new Ostensible Subcontractor Rule and 13 CFR 125.6 Subcontracting Limitations. Of course, all contractors must still comply with 13 CFR 125.6 (which was also revised by the Final Rule). But compliance now carries an additional bonus—it will, for the purposes of set-aside contracts for supplies, services, and specialty trade construction, now be considered sufficient proof in and of itself to overcome any ostensible subcontractor issue. In the context of general construction set-aside contracts, however, mere compliance with 13 CFR 125.6 will not be enough. In that context, the Ostensible Subcontractor Rule analysis above regarding oversight, management, and supervision must be performed.
Codification of (Some of) the DoverStaffing Factors (Sort of)
In addition to the construction-specific clarifications, SBA made some other revisions to the regulation, incorporating concepts from long-established case law. In a 2011 Size Appeals case, DoverStaffing, Inc., SBA’s Office of Hearings and Appeals articulated a four-factor test for determining when a prime contractor may be unusually reliant on a subcontractor (and therefore have an ostensible subcontractor problem):
- The proposed subcontractor is the incumbent contractor and ineligible to compete for the procurement.
- The prime contractor plans to hire the large majority of its workforce from the subcontractor.
- The prime contractor’s proposed management previously served with the subcontractor on the incumbent contract. And
- The prime contractor lacks relevant experience and must rely upon its more experienced subcontractor to win the contract.
The SBA’s September 9, 2022 Proposed Rule proposed to add two of the four DoverStaffing factors to the regulation (namely, the reliance on incumbent management and the reliance on the subcontractor’s experience).
During the comment period, commenters expressed concern about the mechanical application of these factors and worried that contractors would be prevented from leveraging subcontractor experience in ways that are currently quite common, especially as involving incumbents. In the Final Rule, the SBA acknowledged these comments but nonetheless concluded that the regulation would be more helpful to contractors if it contained a reference to the factors that might be considered. Accordingly, the new regulation adds the reference to the two DoverStaffing factors. However, taking into account the commenters’ suggestions, the SBA also added language clarifying that these factors would not be mechanically applied or create any sort of irrebuttable presumption of an ostensible subcontractor. As the SBA explained:
… no factor is determinative and…a prime contractor should be able to use the experience and past performance of its subcontractors to strengthen its offer, even where a subcontractor is the incumbent contractor. As with the existing rule, SBA intends to consider all aspects of the prime contractor’s relationship with the subcontractor and would not limit its inquiry to any enumerated factors. SBA continues to believe that the SBA Area Offices should be given discretion to consider and weigh all factors in rendering a formal size determination, and that unique circumstances could lead to a result that does not fully align with the DoverStaffing analysis…[a] prime contractor may use the experience and past performance of a subcontractor to enhance or strengthen its offer, including that of an incumbent contractor…it is only where that subcontractor will perform primary and vital requirements of a contract or order, or where the prime contractor is unusually reliant on the subcontractor, that SBA will find the subcontractor to be an ostensible subcontractor.
Taken together, these revisions should make it easier for contractors—especially construction contractors—to avoid ostensible subcontractor issues and related affiliation. The new version of the Ostensible Subcontractor Rule regulation will, going forward, be found at 13 CFR 121.106(h)(3) rather than 13 CFR 121.106(h)(2). A careful reading is recommended!