On April 27^th, the U.S. Small Business Administration (“SBA”) published a final rule making changes to the regulations governing the 8(a) program. This final rule is SBA’s implementation of the proposed rules issued by the SBA on September 9, 2022 and we summarized the changes adopted by the final rule here.

While many of the SBA’s regulatory changes are intended to document existing SBA policies and practices, the SBA did implement a number of substantive changes. Accordingly, over the next several weeks, we will be going through various parts of the final rule and conducting an in-depth discussion and analysis of the changes. We anticipate addressing the following areas in this series:

• Bona Fide Place of Business Requirements (published May 5, 2023)
• Joint Ventures
• Size Determinations in Connection with Multiple Award Contracts
• Ostensible Subcontractor Rule (published May 30, 2023)
• Limitations on Subcontracting
• 8(a) Business Activity Targets (published June 2, 2023)
• Follow-On Contracts
• Size Protests
• All Small Mentor-Protégé Program

Limitations on Subcontracting (§ 125.6)

In this update, we are addressing the changes to the rules governing limitations on subcontracting.

The goal of the 8(a) program is to “assist eligible small disadvantaged business concerns compete in the American economy through business development.” The federal government, however, does not want 8(a) entities to obtain 8(a) awards, and then subcontract away a majority of the work to larger businesses, thereby subverting the goal of the 8(a) program. While the ostensible subcontractor rule limits the ability of an 8(a) entity to subcontract away performance of the primary and vital requirements of a contract, the limitations on subcontracting rules focus on revenue from government contracts, and require 8(a) entities, and other small businesses performing small business set-aside contracts, to receive specific percentages of the contract revenue from their small business set aside prime contracts:

• For service contracts, the small business must receive 50% of the revenue from the prime contract;
• For contracts for supplies or products (other than from a non-manufacturer of such supplies), the small business must receive 50% of the revenue from the prime contract;
• For contracts for supplies from a non-manufacturer, the small business must supply the product of a domestic small business manufacturer or processor, unless a waiver is granted;
• For general construction contracts, the small business must receive 85% of the revenue from the prime contract; and
• For specialty trade construction contracts, the small business must receive 75% of the revenue from the prime contract.

Subcontracts to similarly situated entities (i.e., entities that have the same socio-economic status, such as two 8(a) entities) do not count when calculating compliance with the SBA’s limitations on subcontracting. However, any further subcontractor by those similarly situated entities do count when determining compliance with the SBA’s limitations on subcontracting.

This means that a prime contractor, who is an 8(a) entity and has received an 8(a) services contract award, can subcontract 49% of the contract revenue to a non-8(a) entity and an additional 10% of the contract revenue to an 8(a) entity. Even though the 8(a) prime contractor is only retaining 41% of the contract revenue, the prime contractor is treated as having retained 51% of the contract revenue because the 8(a) subcontractor is a similarly situated entity. However, if that 8(a) subcontractor then subcontracted 5% of its work to a non-8(a) entity, the prime contractor will have violated the limitations on subcontracting rules because a total of 54% of the contract revenue will be going to non-8(a) entities. Therefore, 8(a) entities (and small business entities in general) should be careful both in regards to how much they are subcontracting out to first-tier subcontractors and, when subcontracting with similarly situated entities, whether (and how much) those similarly situated entities are subcontracting work out to second-tier subcontractors.

Generally, compliance with any applicable limitations on a subcontractor will be determined based on a contract year—compliance will be measured during the base term of the contract and then during each subsequent option period.

However, there may be multiple awards during a single contract year for multiple award contracts. As part of the updates to the 8(a) program regulations, the SBA adopted language providing that, on multi-agency set-aside contracts, where more than one agency can issue orders under the contract, compliance with the applicable limitations on subcontracting will be measured order by order by each ordering agency. This means that if an 8(a) entity (or small business) has a MAC that has been set aside for small businesses (8(a), HUBZone, etc.), and different agencies issue orders under that set aside contract, the 8(a) entity must comply with the applicable limitations on the subcontract with respect to each individual order, and not a contract year basis.

The SBA explained that it made this change to insure that agencies can track compliance with the limitations on subcontracting rules:

Section 125.6(d) provides that the period of time used to determine compliance for a total or partial set-aside contract will generally be the base term and then each subsequent option period. This makes sense when one agency oversees and monitors a contract. However, on a multi-agency set-aside contract, where more than one agency can issue orders under the contract, no one agency can practically monitor and track compliance. In order to ensure that this statutory requirement is met for the contract, SBA believes that compliance should be measured order by order by each ordering agency.

The SBA also added language to the limitations on subcontracting rules stating that a contracting officer cannot give a satisfactory/positive past performance evaluation for the appropriate evaluation factor or subfactor to a contractor on any set-aside contract (small business set-aside; 8(a); WOSB; HUBZone; or SDVOSB) that the contracting officer determined did not meet the applicable limitation on subcontracting requirement at the conclusion of contract performance.

The SBA explained that:

The current rules provide discretion to contracting officers to require contractors to demonstrate compliance with the limitations on subcontracting at any time during performance and upon completion of a contract. SBA’s current rules do not, however, address what happens if a contracting officer determines that a firm fails to meet the statutorily required limitation on subcontracting requirement at the conclusion of contract performance. SBA’s proposed rule provided that a contracting officer could not give a satisfactory/positive past performance evaluation for the appropriate evaluation factor or subfactor to a contractor that the contracting officer determined did not meet the applicable limitation on subcontracting requirement at the conclusion of contract performance. The final rule, however, also gives the small business contractor the opportunity to explain and demonstrate that the failure to meet the limitations on subcontracting requirements was outside of the contractor’s control.

The SBA included in the final rule examples of factors that a small business could point to when justifying their failure to meet the limitations on subcontractor rules:

• unforeseen labor shortages,
• modifications to the contract’s scope of work which were requested or directed by the Government,
• emergency or rapid response requirements that demand immediate subcontracting actions by the small business,
• unexpected changes to a subcontractor’s designation as a similarly situated entity,
• differing site or environmental conditions which arose during the course of performance,
• force majeure events, and
• the contractor’s good faith reliance upon a similarly situated subcontractor’s representation of size or relevant socioeconomic status

The SBA did note, however, that “[t]he contracting officer could not rely on any circumstances that were within the contractor’s control, or those which could have been mitigated without imposing an undue cost or burden on the contractor.”

Comparison of Prior Rule to New Rule

§ 125.6125.6 What are the prime contractor’s limitations on subcontracting?

. . .

(c)  Subcontracts to similarly situated entities. A small business concern prime contractor that receives a contract listed in paragraph (a) of this section and spends contract amounts on a subcontractor that is a similarly situated entity shall not consider those subcontracted amounts as subcontracted for purposes of determining whether the small business concern prime contractor has violated paragraph (a) of this section, to the extent the subcontractor performs the work with its own employees. Any work that the similarly situated subcontractor does not perform with its own employees shall be considered subcontracted. SBA will also exclude a subcontract to a similarly situated entity from consideration under the ostensible subcontractor rule (§ 121.103(h)(4) § 121.103(h)(3)). 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.

…

(d) Determining compliance with applicable limitation on subcontracting. The period of time used to determine compliance for a total or partial set-aside contract will generally be the base term and then each subsequent option period. For an order set aside under a full and open contract or a full and open contract with reserve, the agency will use the period of performance for each order to determine compliance unless the order is competed among small and other-than-small businesses (in which case the subcontracting limitations will not apply). However, for a multi-agency set aside contract where more than one agency can issue orders under the contract, the ordering agency must use the period of performance for each order to determine compliance.

[examples omitted]

(e) Past Performance Evaluation. Where an agency determines that a contractor has not met the applicable limitation on subcontracting requirement at the conclusion of contract performance, the agency must notify the business concern and give it the opportunity to explain any extenuating or mitigating circumstances that negatively impacted its ability to do so.

(1) Where a small business does not provide any extenuating or mitigating circumstances or the agency determines that the concern’s failure to meet the applicable limitation on subcontracting requirement was not beyond the concern’s control, the agency may not give a satisfactory or higher past performance rating for the appropriate factor or subfactor in accordance with FAR 42.1503.

(2) Where a contracting officer determines that extenuating circumstances warrant a satisfactory/positive past performance evaluation for the appropriate evaluation factor or subfactor and the individual at least one level above the contracting officer concurs with that determination, a satisfactory or higher past performance rating may be given.

(i) Extenuating or mitigating circumstances that could lead to a satisfactory/positive rating include, but are not limited to, unforeseen labor shortages, modifications to the contract’s scope of work which were requested or directed by the Government, emergency or rapid response requirements that demand immediate subcontracting actions by the prime small business concern, unexpected changes to a subcontractor’s designation as a similarly situated entity (as defined in § 125.1), differing site or environmental conditions which arose during the course of performance, force majeure events, and the contractor’s good faith reliance upon a similarly situated subcontractor’s representation of size or relevant socioeconomic status.

(ii) An agency cannot rely on any circumstances that were within the contractor’s control, or those which could have been mitigated without imposing an undue cost or burden on the contractor.

(e)(f) Inapplicability of limitations on subcontracting. The limitations on subcontracting do not apply to:

(1) Small business set-aside contracts with a value that is greater than the micro-purchase threshold but less than or equal to the simplified acquisition threshold (as both terms are defined in the FAR at 48 CFR 2.101); or

(2) Subcontracts (except where a prime is relying on a similarly situated entity to meet the applicable limitations on subcontracting).

(3) 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.

(4) 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 if the information regarding such compliance is not already available to the contracting officer. Evidence of compliance includes, but is not limited to, invoices, copies of subcontracts, or a list of the value of tasks performed.

(f)(g) Request to change applicable limitation on subcontracting. SBA may use different percentages if the Administrator determines that such action is necessary to reflect conventional industry practices among small business concerns that are below the numerical size standard for businesses in that industry group. Representatives of a national trade or industry group or any interested SBC may request a change in subcontracting percentage requirements for the categories defined by six digit industry codes in the North American Industry Classification System (NAICS) pursuant to the following procedures:

(1) Format of request. Requests from representatives of a trade or industry group and interested SBCs should be in writing and sent or delivered to the Director, Office of Government Contracting, U.S. Small Business Administration, 409 3rd Street SW., Washington, DC 20416. The requester must demonstrate to SBA that a change in percentage is necessary to reflect conventional industry practices among small business concerns that are below the numerical size standard for businesses in that industry category, and must support its request with information including, but not limited to:

(i) Information relative to the economic conditions and structure of the entire national industry;

(ii) Market data, technical changes in the industry and industry trends;

(iii) Specific reasons and justifications for the change in the subcontracting percentage;

(iv) The effect such a change would have on the Federal procurement process; and

(v) Information demonstrating how the proposed change would promote the purposes of the small business, 8(a), SDVOSB, VOSB, HUBZone, WOSB, or EDWOSB programs.

(2) Notice to public. Upon an adequate preliminary showing to SBA, SBA will publish in the Federal Register a notice of its receipt of a request that it considers a change in the subcontracting percentage requirements for a particular industry. The notice will identify the group making the request, and give the public an opportunity to submit information and arguments in both support and opposition.

(3) Comments. SBA will provide a period of not less than 30 days for public comment in response to the Federal Register notice.

(4) Decision. SBA will render its decision after the close of the comment period. If SBA decides against a change, SBA will publish notice of its decision in the Federal Register. Concurrent with the notice, SBA will advise the requester of its decision in writing. If SBA decides in favor of a change, SBA will propose an appropriate change to this part.

(g)(h) Penalties. Whoever violates the requirements set forth in paragraph (a) of this section shall be subject to the penalties prescribed in 15 U.S.C. 645(d), except that the fine shall be treated as the greater of $500,000 or the dollar amount spent, in excess of permitted levels, by the entity on subcontractors. A party’s failure to comply with the spirit and intent of a subcontract with a similarly situated entity may be considered a basis for debarment on the grounds, including but not limited to, that the parties have violated the terms of a Government contract or subcontract pursuant to FAR 9.406–2(b)(1)(i) (48 CFR 9.406–2(b)(1)(i)).

This article summarizes aspects of the law and does not constitute legal advice. For legal advice for your situation, you should contact an attorney.