Non-Manufacturer Rule: SBA OHA OK’s Drop Shipments

The SBA’s non-manufacturer rule allows a drop shipper to qualify as a small business, so long as the drop shipper takes legal ownership of the items in question, according to the SBA Office of Hearings and Appeals.  In an important decision interpreting recent amendments to the non-manufacturer rule, SBA OHA rejected the argument that a company must take physical possession of the items in question in order to qualify as a non-manufacturer–which would have essentially prohibited drop shipments.

Before we discuss the SBA OHA decision in question, Size Appeal of Wear Mark, Inc. d/b/a All Seasons Apparel, SBA No. SIZ-5397 (2012), let’s back up and review the non-manufacturer rule.  When a manufacturing or supply contract is set-aside for small businesses, an offeror must either be the manufacturer of the end item, or fall within the exceptions described in the non-manufacturer rule, 13 C.F.R. 121.406(b).

The non-manufacturer rule states that a non-manufacturer may qualify as a small business if the firm: (1) does not exceed 500 employees; (2) is primarily engaged in the retail or wholesale trade and normally sells the type of item being supplied; (3) takes ownership or possession of the item(s) with its personnel, equipment or facilities in a manner consistent with industry practice, and (4) will supply the end item of a small business manufacturer or producer made in the United States, or obtain a waiver of this requirement.

The third factor, regarding ownership or possession, is a relatively new addition to the non-manufacturer rule.  The SBA adopted it in February 2011 after concluding that it was unfair to allow a small business to qualify as a non-manufacturer when the small business had never owned or possessed the items in question.

With that background, let’s examine the Wear Mark SBA OHA decision, which interpreted the “ownership or possession” requirement.  The Wear Mark case involved a VA SDVOSB set-aside contract for the purchase of interment flags.

A2Z Promo Group submitted an offer to the VA.  A2Z intended to place an order with Allied Materials & Equipment Company (a small business) for the flags.  Allied’s carriers would transport the flags to Allied’s loading dock.  At that point, A2Z was obligated to arrange for the product to be picked up at Allied’s loading dock, and the title and risk of loss passed to A2Z.  According to A2Z, this process was standard in the industry.

After evaluating proposals, the VA informed offerors that A2Z was the apparent awardee.  Two competitors subsequently protested the award, alleging, among other things, that A2Z did not qualify as a non-manufacturer because A2Z would never take physical possession of the flags, but instead would act as a drop shipper.  The SBA Area Office denied the size protest, finding that A2Z had taken legal ownership of the flags, and that in such a circumstance, physical possession was not required.

One of A2Z’s competitors filed a SBA size appeal with SBA OHA.  The competitor made two primary arguments.  First, it alleged that A2Z never took ownership because the flags were encumbered by a common carrier lien.  Second, it contended that even if A2Z had taken ownership, legal ownership alone did not suffice without physical possession.

SBA OHA rejected both arguments.  With respect to the lien, SBA OHA wrote, “the regulation only requires ownership, non unencumbered ownership.”  SBA OHA noted that common carrier liens arise as a matter of law under the Uniform Commercial Code and stated, “to hold otherwise would call into question the ownership of any item shipped by common carrier, and this cannot have been the intent of the regulation.”

SBA OHA also rejected the argument that A2Z was required to take physical possession of the items.  SBA OHA wrote that the non-manufacturer rule requires either ownership or physical possession, not both.  “Ownership is a question of law, and one need not take physical possession to take ownership of an item, if title to the item has passed under a contract,” SBA OHA stated.

SBA OHA also noted that to hold otherwise would essentially prohibit a drop shipper from qualifying under the non-manufacturer rule, writing that drop shipments are part of the “normal course of business” and that in adopting the 2011 revisions to the non-manufacturer rule, “SBA never intended to prohibit drop shipping.”  SBA OHA denied the size appeal.

Had the Wear Mark case gone the other way, it could have upended the business practices of drop shippers under the non-manufacturer rule.  Those companies can now breathe a sigh of relief, and continue doing business as usual.

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