SBA Adds to Compliance Rules for Limitations on Subcontracting

Recently, the SBA released a final rule that clarifies some of the mysteries surrounding the limitation on subcontracting rules. The new rule, which goes into effect on December 30, 2019, provides clearer guidelines for contractors, while also creating some new requirements and definitions as discussed below.

I’ve highlighted four areas where the new rule will alter some aspects of compliance with the limitations on subcontracting.

Limitations on Subcontracting Compliance Monitoring by the Contracting Officer

SBA’s rules now provide that contracting officer can request information from contractors to demonstrate compliance with the limitation on subcontracting. This is not really a change, as contracting officers have always been responsible for subcontracting limit compliance, but it reflects new emphasis on what the contracting officer should look for when enforcing the limits.

In the commentary on the final rule, SBA recognized that, while contracting officers monitor compliance with the limitations on subcontracting, SBA’s rules could do a better job defining how to measure compliance. The changes to these rules could result in an uptick in enforcement actions by contracting officers.

One thing that has been added–clear language that “contracting officers have the discretion to request information from contractors to demonstrate compliance with limitations on subcontracting clauses.” The new rule states that contracting officers, “may, at their discretion, require the contractor to demonstrate its compliance with the limitations on subcontracting at any time during performance and upon completion of a contract . . . . Evidence of compliance includes, but is not limited to, invoices, copies of subcontracts, or a list of the value of tasks performed.”

It’s a good idea to keep track of all these items going forward to be able to show compliance. Alas, this change does not clear up an area of confusion for many contractors, whether compliance is measured the change does not clear up an area of confusion as to the timeline for compliance–is it based on the entire contract, base year, and the base or options for each order?

Independent Contractor Versus Employee?

SBA has stated in the past that if an individual counts as an “employee” for size determination purposes, then SBA will also consider that person an employee for limitations on subcontracting purposes. From a policy perspective, SBA found it unfair “to say that a given individual counts against a firm in determining size (because he/she is considered an ’employee’ of the firm) and then to say that that same individual also counts against the firm for the limitations on subcontracting requirements (because he/she is not considered an ’employee’ of the firm).”

SBA’s existing rule at 13 C.F.R. § 125.6(e)(3) had caused confusion. It stated that “[w]ork performed by an independent contractor shall be considered a subcontract, and may count toward meeting the applicable limitations on subcontracting where the independent contractor qualifies as a similarly situated entity.” The goal of this rule was to avoid companies subcontracting out work when it should have been performed by the contractor who got the award. For instance, on a “WOSB service contract, SBA did not want a WOSB prime contractor to pass performance of the contract to one or more independent contractors that would not themselves qualify as WOSBs.”

SBA had proposed a rule that would treat independent contractors differently for contracts assigned an employee-based size standard versus those assigned a receipts-based size standard. But based on negative comments that this dichotomy in treatment would add complexity for small businesses, SBA changed course. SBA revised the rule to more simply provide that “contractors should apply the analysis in § 121.106(a) to determine whether independent contractors are employees or subcontractors, and that in situations where the independent contractor is a subcontractor, their work may be counted toward the applicable limitation on subcontracting if they are a similarly situated entity.”

The revised language for 13 C.F.R. § 125.6(e)(3) will state:

For contracts where an independent contractor is not otherwise treated as an employee of the concern for which he/she is performing work for size purposes under § 121.106(a) of this chapter, work performed by the independent contractor shall be considered a subcontract. Such work will count toward meeting the applicable limitation on subcontracting where the independent contractor qualifies as a similarly situated entity.

This change should help contractors who often use 1099 employees.

Change in Status for Similarly Situated Entities

The new rule also makes clear that, once a subcontractor loses its size or socioeconomic status, the prime contractor can no longer count that subcontractor as similarly situated. A new sentence in § 125.6(c) states: “A prime contractor may no longer count a similarly situated entity towards compliance with the limitations on subcontracting where the subcontractor ceases to qualify as small or under the relevant socioeconomic status.”

SBA provides no commentary on this change. But it may have some significant ramifications.

At the point when the subcontractor loses its size or status, the prime contractor might have to replace the subcontractor or perform the work on its own in order to meet the limitations on subcontracting. This seems to impose a monitoring requirement on prime contracts–should subcontracts include a requirement that subcontractors inform a prime contractor immediately of any change in size or status? At the very least, this new provision should remind small business prime contractors to include provisions allowing them to reallocate work share of a subcontractor due to the limitations on subcontracting.

Finally, this new gloss on the similarly situated entity rule will mean that subcontractors are treated more harshly than prime contractors. After all, prime contractors are generally allowed to keep their size or status throughout the life of a multiple award contract as long as they were small or had the proper status at time of initial offer. But subcontractors will not enjoy the same benefit because they could lose their subcontract immediately even if they were qualified as of the date of the prime contractor’s initial offer.

This change could have a big impact on small business subcontractors and make them less likely to subcontract to similarly situated entities. There is a risk that a subcontractor could lose status during the middle of performance. This provision also raises questions of how a prime contractor monitors its subcontractor’s size or status and the precise timing for when the subcontractor loses its size or status.

Exclusions From the Limitations on Subcontracting

SBA will exclude certain costs from the calculation of whether a company has complied with the limitations on subcontracting for a services contract. This would not change the rules for supply and construction contracts.

First, “any work required to be done by local foreign contractors should be excluded from any limitations on subcontracting determination (i.e., should be excluded from the ‘total value of the contract’ in determining whether a small business did not subcontract more than the limitations on subcontracting percentage) . . . .”

More wide ranging, the direct costs of four specified industries can be excluded from limitations on subcontracting compliance calculations if the costs “are not the principal purpose of the acquisition and small business concerns do not provide the service.”

These four industries are airline travel, work performed by a transportation or disposal entity under a contract assigned the environmental remediation NAICS code (562910), cloud computing services, or mass media purchases. But the rule will also allow “small business in another industry in a similar situation to the four identified to also demonstrate that certain direct costs should be excluded because they are not the principal purpose of the acquisition and small business concerns do not provide the service.”

Presumably, a small business should make clear to the contracting officer that it will be excluding any of the enumerated costs from its calculation or if it seeks to exclude any other similar costs. Ultimately, the decision to allow exclusion of costs would be up to the contracting officer.

* * *

Prime contractors and subcontractors alike should take careful note of the changes to the limitations on subcontracting. The rules add some clarity and may make compliance easier in some respects, while also complicating other aspects of limitations on subcontracting compliance.

Questions about this post? Email us or give us a call at 785-200-8919.

Looking for the latest government contracting legal news? Sign up for our free monthly newsletter, and follow us on LinkedIn, Twitter and Facebook.