SBA Affiliation Rules: Beware Supermajority Voting Requirements

Under the SBA’s affiliation rules, a minority owner may “control” a company where the company’s governing documents impose supermajority voting requirements that require the minority owner’s consent for the company to make ordinary business decisions.

In a recent size appeal decision, the SBA Office of Hearings and Appeals confirmed that supermajority voting requirements may establish control (and affiliation), even where the minority owner does not actually exercise its control.

OHA’s decision in Size Appeal of Potomac River Group, LLC, SBA No. SIZ-5689 (2015) involved a DoD solicitation for assistance in performing security interviews and polygraph examinations.  The solicitation was issued as a small business set-aide under NAICS code 561611 (Investigation Services).

After evaluating competitive proposals, the agency identified Potomac River Group, LLC as the apparent successful offeror.  An unsuccessful competitor subsequently filed a size protest challenging PRG’s small business eligibility.

The SBA Area Office determined that PRG was owned 48.54% by Frank Frysiek, 48.54% by Intelligent Decisions, Inc. (“ID”), and 2.92% by Jacqueline Von Wodke.  Mr. Frysiek served as PRG’s President, Manager, and CEO.  Ms. Von Wodke was also an officer of the company.

In the course of evaluating the size protest, the SBA area office examined PRG’s operating agreement.  The operating agreement provided, in relevant part, that “all determinations, discussions, approvals and actions affecting the Company and its business and affairs shall be determined, made, approved or authorized only by the affirmative vote of Members holding at least 75% of all Voting Units . . ..”

Because Mr. Frysiek and ID owned equal shares of PRG, the SBA Area Office applied the “equal or approximately equal” presumption under 13 C.F.R. 121.103(c)(2), in which control is presumed among minority owners with equal or approximately equal interests that are large as compared with other interests.  The SBA Area Office also found that the 75% supermajority requirement prevented Mr. Frysiek from taking any action without ID’s consent.  Accordingly, the SBA Area Office determined that PRG was affiliated with ID–and because ID was a large business, PRG did not qualify for the DoD contract.

PRG filed a size appeal with OHA.  In its size appeal, PRG pointed out that it had provided the SBA Area Office with sworn declarations stating that, in practice, ID played no role in PRG’s management.  According to the sworn declarations, all of PRG’s decisions were made by Mr. Frysiek.  PRG stated that ID and its principals had never taken action on PRG’s behalf; in fact, ID’s principals had never even visited PRG’s offices.  And while the operating agreement called for ID’s consent for action to be taken at membership meetings, PRG “has never had any membership meetings, and ID has never voted on any action taken . . ..”  PRG argued that, in determining that ID had control, the SBA Area Office had “elevated form over substance.”

OHA wrote that “[a]n Operating Agreement is a Limited Liability Company’s equivalent of Corporate By-laws; it governs the LLC’s business and lays out the Members’ rights and duties.”  In PRG’s case, “[i]t is clear that the Agreement requires that all actions taken to manage [PRG] require a vote of 75% of the Members’ voting units.”  OHA continued:

As noted above, it is the Agreement that legally governs this company.  The declarations [PRG] submitted may reflect [PRG’s] practice in running the corporation, but that is not the issue here.  The regulation makes clear that power of one firm to control another supports a finding of affiliation, and it does not matter whether the control is exercised, so long as the power to control exists.  ID has a 48.54% interest in [PRG], which means its assent is necessary to command a 75% vote.  ID has the ability to block any “determinations, discussions, approvals and actions affecting the company and its business and affairs,” and any act of [PRG’s] Members requires its approval.

OHA wrote that ID “has this power under the Agreement, whether it has chosen to exercise it or not.”  Reaching this conclusion “is not an elevation of form over substance.”  Rather, “it is a recognition of the actual, legal power given to ID by the Agreement, based upon the plain language of the Agreement itself.”  ID “may choose to be a passive, even supine, investor, but the fact is that under the Agreement its consent is required for [PRG’s] every decision.”  OHA concluded: “[u]nder SBA’s regulations, this degree of negative control mandates a finding that ID is affiliated with [PRG].”

OHA denied PRG’s size appeal and affirmed the SBA Area Office’s size determination.

It is not unusual for a minority owner to believe that it does not really “control” a small business because the minority owner is not actively involved in the business’s management.  But as the Potomac River Group size appeal demonstrates, even where a minority owner has chosen not to exercise its management rights, supermajority voting provisions can create legal negative control in the minority owner.  And, as OHA makes clear, legal negative control is all that is required to establish affiliation.

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