As PilieroMazza noted recently here, the Small Business Administration (SBA) released a proposed rulemaking that will impact government contractors. This client alert discusses a major proposed change that would significantly impact any small business that has a minority shareholder or investor. While the proposed rule also aims to create uniformity across SBA’s socioeconomic programs—including the 8(a) Business Development, Women-Owned Small Business (WOSB), and Service-Disabled Veteran-Owned Small Business (SDVOSB)—the proposed rule looks to undo years of case law and seriously impacts what it means to control a company and qualify as a small business for purposes of doing business with the federal government.
What is Negative Control?
It is important to first understand that under SBA’s affiliation regulation, it is not simply enough to ask who has the ability to make day-to-day and long-term decisions, but you also must consider whether someone (a person or a company) has the ability to block an action, such as through a quorum requirement or unanimous consent requirement. If someone has the ability to block an action, then that person or company could be deemed to have negative control over the company. Depending on what the particular action is, that could result in an affiliation and/or the company not qualifying as 8(a), WOSB, SDVOSB, or small business.
Over a number of years, SBA’s Office of Hearings and Appeals (OHA) issued numerous decisions on what may be permissible negative control items. There is not an exhaustive list and what may be permissible differs on the type of set-aside and type of entity (i.e., stand-alone company or joint venture).
While the proposed rule would put an end to the multi-million dollar question of what may or may not be permissible as a negative control right for a minority owner, it would significantly limit the rights of a minority owner and could severely hinder a small business from obtaining any sort of equity investment.
What Are “Extraordinary Circumstances”?
Currently, the only socioeconomic program with an exhaustive list of what actions are permissible for a minority shareholder to have a controlling say over is the SDVOSB program. There are only five permissible extraordinary circumstances where SBA will not find that a lack of control exists, including:
- adding a new equity stakeholder;
- dissolution of the company;
- sale of the company or all assets of the company;
- merger of the company; and
- the company declaring bankruptcy.
The proposed rule would add a sixth item for amending the company’s governing documents to remove a shareholder’s authority to block items (1) through (5).
Why These Changes Matter
Not only is SBA seeking to apply this standard across the socioeconomic programs that have strict ownership and control requirements (SDVOSB, 8(a), and WOSB), but SBA proposed to revise its definition of negative control that applies to all small businesses generally to include these extraordinary circumstances as the only permissible items that a minority shareholder may have a “veto right” over.
While SBA explained that this change would permit all small businesses to seek equity funding without becoming affiliated with investors because of a broad interpretation of the negative control rule, this could have the impact of significantly limiting the available investor pool for small businesses, as many investors and minority shareholders may want more protections for their investment.
To that end, SBA is seeking comments as to whether the six identified exceptions are sufficient or whether one or more additional exceptions should also be included.
Other Uniformity Across Socioeconomic Programs
While the proposed changes to negative control would impact any small business, individual, or company seeking to invest in a small business government contractor, SBA included other proposed changes to create uniformity for what it means to be unconditionally owned and controlled by a qualifying individual for 8(a), WOSB, and SDVOSB purposes, as well as other technical revisions. These include:
- Permit a right of first refusal granting a non-qualifying owner the contractual right to purchase the ownership interests of the qualifying owner without affecting the unconditional nature of ownership, if the terms follow normal commercial practices. This right currently exists in the VetCert (SDVOSB) program, but the proposed rule would add this right for the 8(a) and WOSB Programs.
- Harmonize the ownership requirements across the programs pertaining to partnerships.
- Align the language regarding distribution of profits.
- Currently, both the 8(a) and SDVOSB regulations require the qualifying owner to be the highest compensated individual, with certain limited exceptions. If he or she is not, then that indicates a lack of control. The proposed rule would add a similar provision for the WOSB Program.
- Both the 8(a) and VetCert (SDVOSB) Programs provide that a small business is ineligible for certification if the concern or any of its principals failed to pay significant financial obligations owed to the federal government. The proposed rule would add this restriction to the WOSB and Historically Underutilized Business Zone (HUBZone) Programs as well.
- The proposed rule would add a new provision for all socioeconomic programs (8(a), SDVOSB, WOSB, and HUBZone) providing that a firm that is decertified or terminated from one SBA certification program due to submission of false or misleading information, may be removed from SBA’s other small business contracting programs.
- As we further detailed here, the proposed rule would delete the program-specific recertification requirements and move them to a new section that would cover all size and status recertification requirements
If your firm is affected by these proposed changes and would like to submit public comments to SBA, please make sure to do so before the deadline on October 7, 2024.
If you have questions about SBA’s proposed changes, please contact the author of this client alert, Meghan Leemon, or another member of PilieroMazza’s Government Contracts, Mergers & Acquisitions, and Private Equity & Venture Capital practice groups. Special thanks to Nathan Jahnigen for his assistance with this client alert.
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