Under the SBA’s affiliation rules, one of the many ways a small business can be deemed affiliated with another is through the economic dependence rule: where a small business derives 70% or more of its revenues from another entity, the SBA ordinarily considers it to be economically dependent upon—and thus subject to the control of—that other entity.
So it was in a recent decision from the SBA’s Office of Hearings and Appeals (“OHA”), which confirmed the so-called “70% rule” for economic dependence.
In Size Appeal of Core Recoveries, LLC, SBA No. SIZ-5723 (Mar. 21, 2016), the SBA Area Office, “acting on an anonymous complaint,” challenged Core Recoveries’ size under NAICS code 561440 (Collection Agencies), which carries a $15 million size standard. The Area Office alleged that Core Recoveries was affiliated with a large business, West Asset Management.
Core denied the Area Office’s allegations, and explained that, as of the date of the SBA’s November 19, 2015 inquiry, “West maintained only 1,616 accounts with [Core Recoveries], which represented only 1.1% of [Core’s] total account volume on that date.” Additionally, Core said that it no longer had an active contract with West.
Nonetheless, the Area Office found Core to be affiliated with West through economic dependence. Under OHA precedent, a small business is automatically deemed affiliated with another entity where the small business derives more than 70% of its revenue from that other entity. (There is a limited exception for new businesses, which didn’t apply here).
Analyzing Core’s receipts for the operative fiscal years, the Area Office determined that Core earned 99.6% (in 2012), 99.8% (in 2013), and 94.16% (in 2014) of its annual receipts from West. Because Core derived more than 70% of its revenues from West during the operative period, it was deemed economically dependent on—and thus affiliated with—West.
Core appealed to the OHA, challenging the Area Office’s “mechanical application” of the 70% economic dependence rule. In addition, Core argued that the Area Office failed to consider the fact that Core’s active relationship with West ended in February 2015; as a result, Core said that only 1.1% of its account volume came from its business with West. Thus, Core argued that it was no longer affiliated with West as of November 19, 2015—the specific date on which Core said its size was to be determined.
Though the OHA agreed that Core’s size should be determined as of November 19, 2015, it nonetheless held that the Area Office correctly found Core to have been affiliated with West. The OHA noted that “the Area Office appropriately considered the fact that [Core] derived more than 90% of its receipts from West during the years before November 19, 2015.” In the face of such heavy dependence on another entity for its revenues, the OHA noted that “the challenged firm must persuasively demonstrate it is no longer economically dependent on its alleged affiliate, and the alleged affiliate does not have the ability to control the challenged firm.”
Core’s appeal failed to satisfy this burden. In fact, Core admitted to the Area Office that more than 70% of its revenues in 2015 came from West. Moreover, Core did not explain how its contract with West—which, again, apparently was terminated in February 2015—might account for such a large proportion of Core’s 2015 receipts. Because Core failed to adequately explain its continuing relationship with West, “the Area Office could properly conclude that [Core] remained economically dependent upon West as of November 19, 2015.”
Core thus failed to demonstrate that the Area Office’s size determination was clearly erroneous, so the OHA denied Core’s appeal. As a result, Core was considered affiliated with West by virtue of its economic dependence.
Core Recoveries serves as an important reminder: where 70% or more of a small business’s revenues are derived from another entity, the SBA ordinarily will deem the small business affiliated with that entity through the economic dependence rule. And where a small business appears to be economically dependent on another entity, it is the small business’s burden to “persuasively demonstrate” that such dependence no longer exists.