OHA: Provisions in Operating Agreements for SBA Set-Aside Program Participants can Sink Eligibility

The organizational documents for a business seeking certification under a SBA socio-economic program can play an important part in a company demonstrating its eligibility under the SBA’s requirement for control by the company’s owners, such as a service-disabled veteran or disadvantaged owner. Unlike some of the SBA’s requirements for eligibility, the manner in which a program applicant or participant might run afoul of this requirement are not always obvious. Typical provisions in the organizational documents that, under “non-SBA” circumstances may seem innocuous, may unintentionally undermine the disadvantaged owner’s requirement of showing of unconditional ownership and control. 

In a recent OHA decision regarding Service-Disabled Veteran-Owned Small Business (SDVOSB) eligibility, (CVE Protest of: Randy Kinder Excavating, Inc.  d/b/a RKE Contractors, Protester Re: E&L Construction Group, LLC), an unsuccessful bidder filed a protest of a set-aside contract award, alleging that the company was not unconditionally controlled by the disadvantaged owner. After considering a variety of arguments, OHA issued a decision based on a handful of provisions in the respondent’s operating agreement.

The salient facts of the case are as follows. The VA’s Center for Verification and Evaluation (CVE) initially verified E & L Construction Group, LLC (E&L)  as a Service-Disabled Veteran-Owned Small Business (SDVOSB). The CVE found E&L in compliance with applicable regulations and included the company in the Vendor Information Pages database of eligible firms, effective for three years.

On March 10, 2021, the VA issued a solicitation for a construction project at Fort Sill National Cemetery in Elgin, Oklahoma (Solicitation). The Contracting Officer (CO) set aside the procurement entirely for SDVOSBs. E&L was the lowest bidder and apparent awardee. On April 29, 2021, Randy Kinder Excavating, Inc. d/b/a RKE Contractors (RKE), an unsuccessful bidder, filed a protest challenging E&L’s SDVOSB status. In the protest, RKE alleged that E&L’s Service-Disabled Veteran and majority owner, Christopher Esponge, did not fully control E&L and the company was substantially dependent on a non-veteran, and could not exercise independent business judgment without great economic risk, and was therefore ineligible for the contract award.

Specifically, RKE alleged that E&L was co-located with another company, Patriot Construction and Industrial, LLC (Patriot); that E & L rented space to a division of Patriot; and that E&L and Patriot were in the same line of business and presumably share resources and office space. Patriot’s owner and Chief Executive Officer Ben LeBlanc was also the 49% owner of E&L and Mr. Leblanc provided significant financial assistance to E&L. RKE argued that because of these business relationship’s, E&L was dependent upon Mr. LeBlanc for survival, which RKE believed indicated Mr. Esponge’s lack of unconditional control of E&L. E&L responded to RKE’s protest and asserted that that the company was not affiliated or economically dependent on Patriot or Mr. LeBlanc and sought to make it clear that Mr. Esponge was the founder, manager, and majority owner of E&L.

RKE submitted a supplemental protest and noted specific examples in operating agreements that support its contention that E&L did not satisfy the requirement of having unconditional ownership. The relevant issue RKE raised were in regard to provisions in E&L’s 2020 amendment to the operating agreement (2020 Operating Agreement). In particular, E&L identified several sections in the 2020 Operating Agreement that impermissibly restricted Mr. Esponge’s ability to dispose of his ownership. These sections included 1) a provision requiring Mr. Esponge to provide a right of first refusal if he decided to sell his ownership interest, 2) a section that precluded Mr. Esponge from retiring or withdrawing from E&L without written approval from the other members, 3) a section requiring Mr. Esponge to dispose of his ownership interest in certain situations, such as when filing a petition for voluntary bankruptcy, and 4) other impermissible limitations on Mr. Esponge’s ownership reflected in a section that called for a “involuntary transfer events” or “forced sale” events.

RKE also argued that additional provision in the 2020 Operating Agreement limited Mr. Esponge’s ability to control the company by giving Mr. LeBlanc impermissible negative control of E&L. These provisions included a section requiring a unanimous vote of the members to amend the operating agreement, and another other provision requiring a supermajority vote to elect a successor manager.

E&L disputed the specific allegations in the RKE’s supplemental response and stated that “Mr. Esponge has full control and full ownership rights and direct ownership of his 51% share of E&L pursuant to the 2020 Operating Agreement.” E&L’s supplemental response also referenced OHA precedent upon which it relied to justify granting Mr. LeBlanc apparent negative control that concluded that “situations where a minority owner may have the power to block certain extraordinary actions, do not endow the minority owner with negative control if those provisions are crafted to protect the investment of the minority shareholders and not to impede the majority’s ability to control the business.” E&L reasserted its position that Mr. Esponge was the sole manager and the principal executive officer of the company, in charge of day-to-day operations and Mr. LeBlanc, had no ability to perform duties affecting the overall operations of E&L and his say in any activities that required his vote were allowed under the regulations.

OHA sustained RKE’s protest, concluding that E&L’s business conditions did not support a finding that the company was unconditionally owned and controlled by one or more Service-Disabled Veterans, and therefore was not an eligible SDVOSB. In support of its opinion OHA explained that:

Unconditional ownership means ownership that is not subject to conditions precedent, conditions subsequent, executory agreements, voting trusts, restrictions on or assignments of voting rights, or other arrangements causing or potentially causing ownership benefits to go to another (other than after death or incapacity).

SBA regulations require that SDVO’s have unlimited, unrestricted ownership and must have the ability to dispose of their ownership in any way the SDVO owner chooses with few exceptions.

In this case, OHA found that E&L’s 2020 Operating Agreement placed significant limitations on Mr. Esponge’s ownership of the company. OHA referenced the sections in the 2020 Agreement that limited Mr. Esponge’s ability to sell his ownership interest by requiring a right of first refusal to E&L; the provision restricting his ability to retire or withdraw from the company, without written approval from other members; certain “involuntary transfer events” in the agreement which required Mr. Esponge’s  to transfer his interest to E&L . Accordingly, OHA found that E&L is not at least 51% unconditionally owned by a Service-Disabled Veteran.

Generally, the basic purpose of the operating agreement is to give its members protection from personal liability and to structure its members’ financial and working relationship. Limited liability companies are formed under state law and the rules regarding specific requirements of an operating agreement are controlled by state law. Adequately demonstrating the SBA’s requirements for unconditional ownership often requires special attention in drafting or modifying the standard terms found in operating agreements. Also, even operating agreements drafted by experienced practitioners may run afoul of SBA’s requirements. Provisions that may be beneficial for tax, estate planning or for protecting minority ownership interests may cause issues in gaining or retaining eligibility for SBA socio-economic programs.

This case is an example as to why it’s often best that applicants seeking certification through an SBA socioeconomic program be formed as simply as possible with their organizational documents reflecting the same. The owners of such applicants might also consider consulting an attorney familiar with the specific SBA requirements for the particular program to assist in preparing organizational documents for their business.

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