New Defenses to the Ostensible Subcontractor Rule are Coming

You may have noticed that SBA issued a final rule last week that created sweeping changes to the SBA’s 8(a) Program regulations, but along with that, SBA made sure to slip in a change to the ostensible subcontractor rule that has been a sticking point for many contractors when facing affiliation concerns. With this final rule, SBA will update the regulations to provide contractors certain ways to defend against potential ostensible subcontractor rule affiliation, depending on the type of contract at issue. This represents a shift in thinking, related to how to combat allegations brought under this affiliation rule and could present some new wrinkles for contractors to consider when setting up subcontracting arrangements.

As avid readers of SmallGovCon know, we posted last week about some of the aspects of SBA’s recent final rule updating the 8(a) Program’s regulations. But it is important to point out, that within that final rule, is a change to the ostensible subcontractor rule that could affect a wide array of contractors, not only 8(a) Program participants.

First, it is important to quickly review what the ostensible subcontractor rule is. Last year, we posted one of our “Back to Basics” on affiliation and another one of the different affiliation types, both of which we highly recommend contractors review to get acquainted with the implications of affiliation, as we don’t have the time to dive into all its subtleties here. That being said, affiliation is basically when certain factors lead the SBA to see two contractors, for all intents and purposes, as one contractor, and thus their size is combined. One of the many ways to be found affiliated with another contractor is the ostensible subcontractor rule.

Currently, under 13 C.F.R. § 121.103(h)(2), to be found as a contractor’s “ostensible subcontractor”, and thus making both contractors affiliated, the following elements must be met:

  1. The subcontractor performs the “primary and vital requirements of a contract” OR
  2. The prime contractor is “unusually reliant” on the subcontractor AND
  3. The subcontractor cannot be a similarly situated entity as the prime contractor (which is defined by 13 C.F.R. § 125.1).

The SBA, when making affiliation determinations based on these elements, will take into account “all aspects of the relationship between the prime and subcontractor”. In determining whether the prime contractor is “unusually reliant” on the subcontractor, or whether the subcontractor is performing the “primary and vital requirements of a contract,” the journey taken by the SBA is a very fact-intensive one and consequently really depends on the contract at issue, as well as the nuances of the relationship between the two contractors.

We have previously talked here about some of the different analysis that occurs with ostensible subcontracting cases, but it really boils down to this: if the subcontractor is performing the work at the heart of the contract, or the prime contractor cannot perform without the subcontractor, then the ostensible subcontractor rule may be met. However, with the update recently released by SBA, this determination process is facing a change in which contractors may be able to take action to lessen risk of ostensible subcontractor affiliation.

In the final rule issued last week, SBA updates 13 C.F.R. § 121.103 to move the ostensible subcontractor rule to section (h)(3) and keep the elements discussed above, but update the “factors” that would be considered by SBA. The final rule articulates that, for general construction contracts, the SBA has added to the regulation that “the primary and vital requirements of the contract are the management, supervision and oversight of the project, including coordinating the work of various subcontractors, not the actual construction work performed.”

For general construction contractors, this provides a clear line to follow in order to help prevent ostensible subcontractor concerns centered around subcontractors performing the “primary and vital” requirements of a contract. The revisions to the rule, once effective, will clearly state to all, that as long as there aren’t any subcontractors performing the management, supervision, or oversight of the general construction project, then there is a low likelihood that the subcontractor is performing the primary and vital requirements of the contract. It will greatly reduce the risk that a subcontractor, on a general construction contract, will be seen as affiliated with the prime contractor under the ostensible subcontractor rule. However, it is important to note that this regulation language does not alleviate businesses of ensuring they are not unusually reliant on the subcontractor, and it only applies to general construction contracts.

That being said, general construction contracts are not the only types of contracts that the final rule provided with some new defenses to ostensible subcontracting. SBA is also updating the regulation to state, that for a “contract or order set-aside or reserved for small business for services, specialty trade construction or supplies” SBA will not find that the primary and vital requirements are being performed by the subcontractor, or that the prime contractor is unusually reliant on the subcontractor, if the prime contractor can “demonstrate that it, together with any subcontractors that qualify as small businesses, will meet the limitations on subcontracting” found in 13 C.F.R. § 125.6.

Therefore, contractors performing service, specialty trade construction, or supplies contracts, if set-aside for small businesses, can potentially avoid ostensible subcontractor concerns, by simply making sure to abide by the limitations on subcontracting. SBA case law used to be unclear on this, noting that for instance, compliance with limitations on subcontracting “is a matter of contractor responsibility, beyond OHA’s jurisdiction.” Shoreline Servs., Inc., SBA No. SIZ-5466 (May 28, 2013). OHA had also made clear that the two rules are separate, even though analysis of each may look at similar facts. Lynxnet, LLC, SBA No. SIZ-5612, 2014 (Nov. 7, 2014). Now, the two rules are closely intertwined, and SBA will have to look at limitations on subcontracting as part of ostensible subcontractor analysis.

We published a “Back to Basics” on limitations on subcontracting last year, that you can review to refresh your understanding of limitations on subcontracting, as we once again can’t go in-depth here on its nuances, but in general, the limitations on subcontracting rule sets limits on how much work assigned to a prime contractor may be subcontracted by the prime contractor to subcontractors that are not similarly situated. For service and supply contracts, only 50% of the contract work may be subcontracted, and for specialty construction, only 75% of the contract work may be subcontracted. So, under this final rule, if a prime contractor on a small business service, supply, or specialty trade construction contract, can show that they, along with any small business subcontractors (or other similarly situated subcontractors under SBA’s socioeconomic programs), have met the limitations on subcontracting requirements, it will be interpreted by the SBA that the subcontractors are not performing primary and vital elements of the contract. Also, that the prime contractor is not unusually reliant on the subcontractor, thus defeating the ostensible subcontractor rule.

Both of these changes represent some new, very clear ways for contractors to defend against ostensible subcontractor rule allegations, and if properly heeded may alleviate ostensible subcontractor affiliation concerns for many contractors. These options, likely can be easily met with careful planning and formation of a teaming agreement and/or proposal. While under the current rule, contractors must be very aware of the specific relationship and work done between them and their subcontractors. Once this rule becomes effective, it should provide some relief to contractors trying to navigate this oft-utilized affiliation rule, but it is important to keep in mind that this change is not effective until May 30, 2023. So until then, the old rules are still in effect.

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