As many of our readers know, the ostensible subcontractor rule is one way in which the Small Business Administration (SBA) can find affiliation between a small business and one of its subcontractors, potentially resulting in the small business’s disqualification from a procurement. The rule is designed to ensure that small businesses perform the primary and vital requirements of a set-aside contract and are not unduly reliant on an entity that is not similarly situated to perform the contract. Allegations of affiliation based on this doctrine are frequently made in size protests, putting at risk awards that small businesses have expended significant time and resources to secure.
For that reason, it is important that small business both understand the ostensible subcontractor rule as well as the very broad exception to the rule applicable to set-aside contracts for supplies, services, and specialty trade construction contracts. We explore both below.
Understanding the Ostensible Subcontractor Rule
The ostensible subcontractor affiliation rule set forth at 13 C.F.R. §121.103(h)(3) explains that a small business prime contractor and its subcontractor will be deemed affiliated for size determination purposes when the subcontractor is not a similarly situated entity, meaning it is a first-tier subcontractor that does not have the same small business program status as the prime contractor and meets one of the following criteria:
- Performs the primary and vital requirements of a contract.
- Is a subcontractor upon which the prime contractor is unusually reliant.
Additional ostensible subcontractor provisions for specific types of small businesses are also set forth in other sections of 13 C.F.R. – WOSB at 127.504(g), VOSB and SDVOSB at 128.401(g), HUBZone at 126.601(d).
As noted above, disappointed offerors in competitions for small business set-aside contracts often assert in SBA size protests that the apparent awardee is ineligible for the award due to affiliation with a subcontractor because of a violation of the ostensible subcontractor rule. When this occurs, the SBA reviews the solicitation’s Statement of Work to identify the primary and vital contract requirements. It then compares the tasks assigned to the subcontractor with those requirements.
In addition, the SBA typically considers these four factors as indicative of unusual reliance:
- The proposed subcontractor is the incumbent that is ineligible to compete for the procurement.
- The prime contractor intends to hire most of its workforce from the subcontractor.
- The prime contractor’s proposed management was previously with the subcontractor on the incumbent contract.
- The prime contractor lacks relevant experience and must rely on its subcontractor to win the contract.
Size Appeal of Charitar Realty, SBA No. SIZ-5806 (2017).
If affiliation is found because a subcontractor that is not similarly situated is performing the primary and vital functions of the prime contract or the prime contractor is unusually reliant on the subcontractor, the revenue of the two entities (or the employees for employee-based NAICS codes) are combined to determine whether the small business awardee is eligible under the applicable size standard. This often results in the small business’s apparent awardee being excluded from the competition.
Exception to the Ostensible Subcontractor Rule
The ostensible subcontractor rule presents a significant challenge to small businesses that often, by their nature, are just developing the capabilities and capacity to take on complex government contract work. This presents even more of a challenge in the service sector in light of the key indicia of unusual reliance because incoming contractors often “rebadge” incumbent employees and managers, and sometimes retain the incumbent as a subcontractor to ensure a smooth transition and service continuity for the government customer.
Likely for this reason, in a final rule issued in 2023, the small business regulations were amended to include a broad exception to the ostensible subcontractor rule at 13 C.F.R. §121.103(h)(3)(iii) that allows a small business to retain an award even if it is not performing the primary and vital function of a contract or is unusually reliant on a non-similarly situated subcontractor:
In the case of a contract or order set-aside or reserved for small business for services, specialty trade construction or supplies, SBA will find that a small business prime contractor is performing the primary and vital requirements of the contract or order, and is not unduly reliant on one or more subcontractors that are not small businesses, where the prime contractor can demonstrate that it, together with any subcontractors that qualify as small businesses, will meet the limitations on subcontracting provisions set forth in § 125.6 of this chapter.
This means that in a set-aside contract for services, supplies, or specialty trade construction, if a small business, together with similarly situated subcontractors, can demonstrate that it meets the applicable “limitation on subcontracting” rule at 13 C.F.R. §125.6 the SBA is required to find that the small business is performing the primary and vital requirements of the contract and is not unduly reliant on one or more subcontractor. The limitation on subcontracting rules requires, in brief:
- Supplies and Services – the prime contractor may not pay more than 50% of the amount paid by the government to subcontractors that are not similarly situated entities.
- Specialty Trade Construction – the prime contractor may not pay more than 75% of the amount paid by the government to subcontractors that are not similarly situated entities (excluding the cost of materials).
This, in essence, guts the ostensible subcontractor rule, at least for the categories of set-asides covered by the exception. For example, if a small business awardee has shown in its response to a size protest that non-similarly situation subcontractors that would otherwise be affiliated because of the ostensible subcontractor rule will receive less than 75% of the funding, excluding the cost of materials, the SBA will not find affiliation.
And while set-asides for general construction contracts are not covered by the sweeping exception, the 2023 amendment included a new provision that explicitly defines the primary and vital requirements of such contactors, under which the applicable limitation on subcontracting rule permits a small business to pay up to 85% of the among paid by the government to subcontractors that are not similarly situated. 13 C.F.R. §121.103(h)(3)(iv) states:
In a general construction contract, 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.
Strategies for Compliance and Going Forward
While all entities competing for small business set-asides should endeavor to comply with the ostensible subcontractor rule, if contractors competing for services, specialty trade construction, or supply set-asides have any concerns about whether they will perform the primary and vital requirements or are unusually reliant on non-similarly situated subcontractors, they should pay careful attention to compliance with the applicable limitation on subcontracting thresholds.
Even if a small business size protest results in a finding of affiliation due to an ostensible subcontractor violation, the SBA will, in essence, overlook that affiliation if the small business can demonstrate compliance with the limitation on subcontracting. And for small businesses competing for construction set-asides, pay careful attention to the way in which the primary and vital requirements are defined, particularly when negotiating the division of work with subcontractors and drafting related agreements.
