After the sale or acquisition of a business or its assets, there are often one or more post-closing requirements that business owners must complete. In deals involving government contractors, two of these requirements are especially important: contract novation and size recertification. Below, PilieroMazza attorneys provide a post-closing guide for government contractors on meeting novation and recertification requirements to avoid costly penalties such as loss of contract award or criminal liability.
Overview
Parties preparing to acquire a small business government contractor, or its assets, often wonder how the transaction will affect government contracts and size certifications held by the entity being acquired. Before the acquiring party takes over a government contract, it is important for buyers and sellers to understand the government’s process for approving the acquisition, which is governed by complex Small Business Administration (SBA) rules and regulations. In this blog post, we explain key concepts of contract novation and size recertification, and what steps to take to ensure a smooth transition and compliance with government regulations.
Contract Novation and Why It Is Important
A novation can take a variety of forms in standard commercial contracts. It can be a new agreement to replace an existing contract, or it can be an agreement between new parties to substitute one or more of the parties in an existing contract. In the case of federal contracting, the latter generally applies. For example, if a business has a government contract and sells that contract to another entity, a novation replaces the contract between the selling entity and the government with a contract between the buyer and the government.
A common misconception is that novation is the same as the assignment of a contract; it is not. While assignment only transfers the rights and benefits of a contract, novation effectively cancels the contract with the original awardee, and transfers the entirety of that contract to the new party, including the rights and benefits along with the obligations and liabilities. This is why the government has such broad discretion when evaluating whether or not to approve a novation.
Following the closing of a deal, a contract novation is often necessary when one party is assuming the other party’s duties under a government contract. Contract novation is important for several reasons:
- Assignment of almost all government contracts is prohibited by law.[1] Consequently, a novation is usually required.
- A novation allows the buyer to legally perform the contract and receive payment from the government. It also releases the novating party from any future obligations and liabilities under the contract.
- Novation preserves the continuity and quality of service to a government agency that may not want to deal with finding a different contractor or renegotiate the terms of the contract.
Steps for Novation
Novating a government contract can be a complex process, and strict adherence to the proper procedures[2] is crucial to gaining government approval of the novation and maintaining continuity in the contract. The government requires a variety of documents to complete the novation process, and some of the requirements are vague. Not knowing the applicable regulations makes it easy to get caught in the weeds. Several key steps in the novation process are:
- Review the existing contract to check whether there is any clause that prohibits or restricts novation. Some contracts may require prior written consent from the government or the other party for a novation to be valid.
- Draft a novation agreement that clearly states the intention of the parties to extinguish the existing contract and replace it with a new one, among other provisions.
- Obtain signatures of all parties to the novation agreement.
- Notify any other parties that may be affected by the novation, such as subcontractors, suppliers, regulators, or lenders. Copies of the novation agreement are often provided to these parties.
- Update all records or systems to reflect the change of contractor, such as invoices, receipts, reports, or databases.
- Create and submit a novation package for the government’s approval.
Government Approval of a Novation
After the novation documents are submitted to the government, the cognizant Contracting Officer (CO), or the Administrative Contracting Officer (if the seller is assigned one), will review the documents and determine whether the novation is in the best interests of the government. This review and approval process can take a significant amount of time, usually three to six months or longer. One of the factors that may affect the length of time it takes a CO to approve a novation is the complexity of the transaction and the number of contracts involved, as well as whether or not the assets necessary to perform the work were transferred in full.
In the past the COs rarely denied any novations (say 15 years ago); however, in more recent history and with the uptick in M&A activity with federal contractors, many government contracts expressly address novations and provide strict guidelines about what needs to be included, or when the contracting agency will even entertain a novation. It is still very common to have an assignment approved (i.e., “novated”), but can be more difficult than it was in the past, and every CO treats the situation differently. Indeed, some COs demand “wet” signatures, some want “audited” balance sheets, some want raised corporate seals on the originals, or other items identified in the FAR while most COs see those requirements as antiquated and superfluous (which we certainly agree with). As such, it can all come down to the personal decision of each individual CO.
Further, the CO will also look for other issues such as significant organizational conflicts of interest that need to be resolved or waived, or whether the company can recertify as a small business. If the CO determines that the novation is in the best interests of the government, the CO will then execute the novation agreement with all parties, distribute copies of the executed agreement to all affected contracting offices, and update any records or systems to reflect the change of contractor.
SBA Size Standards and Recertification
The government sets different size standards for different industries and types of contracts based on factors such as number of employees, annual revenue, or net worth. Small businesses must meet these size standards to qualify for various benefits and preferences, such as set-aside contracts, mentor-protégé programs, subcontracting opportunities, or small business innovation research grants.
Size status is not static; it can change over time due to various events such as growth, decline, merger, acquisition, or affiliation. Under certain circumstances, small businesses must recertify their size status to ensure they are still eligible for the contracts and programs they participate in or bid for. The size recertification process allows the government to verify eligibility of small businesses for certain contracts and programs.
Recertification Regulations
Generally, size certification is based on the business’ status at the time it bids on a government contract, and subsequent recertification is not a requirement absent specific circumstances. For example, small businesses with long-term contracts (more than five years) must recertify their size status no later than 120 days before the end of the contract’s fifth year and no later than 120 days prior to exercising any future option year. The recertification must indicate whether the company continues to qualify as a small business under the size standard for the specific contract. Also, the government has the option to demand recertification at any time.
Important in the context of M&A, another circumstance that requires recertification is when a contract is novated by the government. Under SBA regulations, a contractor must recertify its size status within 30 days of an approved contract novation. Other instances requiring recertification include after a merger, sale, or acquisition where there is a change in controlling interest and no contract novation is required, including when a business has pending bids and proposals for government contracts at the time of a sale or acquisition. This is because SBA considers changes in ownership or control as factors that may affect small business eligibility. Therefore, during preliminary negotiations, it is important for all sides of a transaction to understand that an acquisition will most likely trigger a recertification that would not have occurred otherwise.
These regulations aim to ensure that only eligible small businesses receive the benefits and preferences intended for them by the government. They also aim to provide more clarity and consistency for small businesses and contracting officers regarding when and how to recertify size status.
Impact on the Transaction
These requirements can directly impact the acquisition of businesses holding government contracts. Many parties carefully plan for pre-closing requirements but do not consider the potential post-closing issues. For example, mutual cooperation on the novation steps should be a requirement of the purchase agreement, and parties should clearly delineate responsibilities for accomplishing each step. Further, the government’s approval of novation is not guaranteed, and the SBA recertification process may impact the viability of an acquired contract.
These possibilities should be a part of negotiations, and the purchase agreement should include appropriate compensation in the event of any roadblocks. Retaining qualified counsel early in the M&A process will ensure that these considerations are incorporated into any preliminary agreements (e.g., Letters of Intent) and that SBA regulations are thoroughly addressed in purchase agreements.
Key Takeaways
Contract novation and size recertification are critical post-closing steps for small businesses operating in the government contracting space. Failure to recertify size status after a sale or acquisition may result in penalties such as cancellation of contract award, termination of contract performance, suspension or debarment from government contracting, or civil or criminal liability. Therefore, in the context of a sale or acquisition, government contractors should be aware of their obligations to novate existing contracts and recertify size status for pending bids and proposals.
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[1] 42 U.S.C. § 6305.
[2] FAR Subpart 42.12.
