As many service-disabled veteran-owned small businesses have discovered, the VA CVE believes that so-called “right of first refusal” provisions prevent veterans from freely selling or transferring their ownership interests.  Because such transfer restrictions are commonplace in standard corporate bylaws and operating agreements, countless SDVOSBs have been denied VA CVE verification for including them.

Those days may be over.

In a decision released to the public late last week, the U.S. Court of Federal Claims held that the VA OSDBU had erred by sustaining a SDVOSB eligibility protest on the basis of the company’s right of first refusal provision.  That decision, Miles Construction, LLC v. United States, No. 12-597C (2013), also includes other important rulings on the scope of “unconditional” ownership and the VA OSDBU’s evaluation of SDVOSB eligibility protests.

The Miles Construction decision involved a SDVOSB set-aside for the repair of a storm sewer at a VA Medical Center.  Miles Construction, LLC, which had been verified as a SDVOSB in March 2012, was the lowest bidder.

After the VA announced that Miles was the apparent low bidder, a competitor filed a SDVOSB eligibility protest with the VA OSDBU.  The protester alleged that Miles and another company had common ownership and control, rendering Miles ineligible for SDVOSB status.

The VA OSDBU notified Miles of the protest and gave it one week to respond.  Miles timely responded to the allegations contained in the protest.

The VA OSDBU subsequently informed Miles that it had rejected the common ownership and control claims raised by the protester.  However, the VA OSDBU stated that it had nevertheless found that Miles’ veteran owner, Morgan Slizofski, did not unconditionally control the company, because three articles of the company’s operating agreement supposedly contained restrictions on Mr. Slizofski’s ability to transfer his ownership.  The VA OSDBU stated that this lack of unconditional control rendered Miles ineligible for the solicitation and that Miles would be removed from the VetBiz database.

The operating agreement articles in question were Articles X, XI, and XII.  Article X stated that owners could not transfer their ownership interests in contravention of the agreement.  Article XII addressed the transfer of ownership in the event of incapacity or death.  Article XI was essentially a right of first refusal clause.  It provided that if an owner decided to sell his or her shares, the company, or the remaining members of the company, would have the first opportunity to purchase the shares.

After receiving the VA OSDBU’s decision, Miles filed a pre-award bid protest with the Court of Federal Claims.  Miles alleged that the VA OSDBU’s decision was arbitrary, capricious and contrary to law.  Miles sought an injunction reinstating it as a verified SDVOSB and awarding it the VA Medical Center Contract.

The court agreed with Miles.  The court first held that Article X was “beside the point” because it merely referred to the remainder of the operating agreement.  Thus, the court held, the VA OSDBU could not rely on Article X to reject Miles as a SDVOSB.

The court reached a similar conclusion with respect to Article XII, which addressed transfers in the event of incapacity or death.  The court wrote that “VA’s regulation itself contain provisions specifically allowing transfer upon the death or incapacity of a veteran without contravening the unconditional ownership requirement.”  The court held that Article XII provided no basis to deny Miles’ SDVOSB status.

The court then focused on the sole remaining reason for the denial: the right of first refusal provision in Article XI.

The VA argued that the provision defeated unconditional control “because it prevents an owner from acting upon his ownership interest in instances such as a sale [that depends] upon future approval by the other members of the company.”  The VA cited two decisions of the SBA Office of Hearings and Appeals, in which SBA OHA interpreted “unconditional control” within the SBA’s SDVOSB program to bar restrictions on ownership transfers.  However, the court distinguished the SBA OHA cases, writing that “a different regulation, 38 C.F.R. § 74.3, is at issue.”

The court then wrote that in adopting the “unconditional ownership” restriction, the VA was “attempting to prevent ‘ownership benefits,’ such as voting rights or the distribution of profits or losses, from falling into the hands of non-veterans, even as the company appeared to operate under the auspices of the veteran majority owner.”  The court continued, “inclusion of a standard right of first refusal is a ‘normal commercial practice’ that does not hinder the veteran-owner’s interest unless the veteran receives a bona fide offer and chooses to sell.”

The court concluded that the right of first refusal provision “does not affect the veteran’s unconditional ownership” and that the VA OSDBU’s decision to the contrary “was arbitrary and capricious and contrary to law.”

After hitting the VA over the head with this ruling, the court was not quite done.  It also held that the VA OSDBU had violated the law by expanding its review of the SDVOSB eligibility protest to encompass “general compliance with the verification requirements” without affording Miles the opportunity to respond to the expanded investigation.

“An agency should not act without affording the entity whose award or projected award is protested with notice of an alleged defect and an opportunity to respond,” wrote the court.  An interpretation of the regulations “that does not allows this basic procedural due process is plainly erroneous and cannot be upheld.”

After ruling in Miles’ favor, the court issued an order setting aside the VA OSDBU’s decision on the protest.  The court also ordered that Miles be restored to the roster of eligible SDVOSB companies and that the VA consider’ Miles’ apparent low bid in response to the VA Medical Center solicitation.

As its most basic, the Miles Construction case is a victory for common sense.  Many service-disabled veterans have complained that restrictions on commonplace right of first refusal provisions should not impact SDVOSB eligibility.  At least in the context of the specific provision at issue in Miles Construction, the court agreed.

The question then becomes, “now what?”  Will the VA CVE revise its position on ownership restrictions in response to the decision?  If so, what happens when an ownership transfer restriction is stricter than the one at issue in Miles Construction–such as a “tag along” or “drag along” provision, or a requirement that the veteran owner sell at a specified price?  Much remains to be seen.

Also unclear is what effect, if any, Miles Construction will have on the SBA’s review of right of first refusal provisions in the context of the non-VA “self-certification” SDVOSB program, which the SBA currently polices.  After all, the court was careful to distinguish the SBA and VA regulations, meaning that SBA is under no obligation to follow Miles Construction.

Although the right of first refusal question is important, SDVOSBs should also not lose sight of the fact that Miles Construction also stands for two other principles: first, that the VA’s SDVOSB regulations allow transfer restrictions in the event of death and incapacity; and second, that the VA OSDBU must allow a protested SDVOSB to respond to particular alleged defects in its eligibility.

It’s only February, but my guess is that Miles Construction will appear in any year-end review of cases affecting small government contractors.  It will be interesting to see what happens next.