Virginia Federal Court Refuses to Enforce Federal Subcontract That Violates SBA’s Fifty Percent and Ostensible Subcontractor Rules

A recent federal court decision creates a new risk for subcontractors to small business or 8(a) prime contractors on federal set-aside contracts whose subcontracts do not comply with the rules of the U.S. Small Business Administration (SBA). The U.S. District Court for the Eastern District of Virginia held that an 8(a) set-aside prime contract violated SBA’s “ostensible subcontractor” and “fifty percent” rules and, therefore, a subcontract between the 8(a) prime contractor and a non-8(a) subcontractor was unenforceable. Morris-Griffin Corp. v. C&L Service Corp., Civ. No. 2:10cv298, 2010 WL 3221975 (E.D. Va. Aug, 16, 2010).

The Morris-Griffin decision is required reading for all government prime contractors and subcontractors involved in SBA set-aside programs. Because the case was decided by the federal court sitting in Norfolk, Virginia, the decision could have serious consequences for the government contractor community in the Washington, D.C. area, as many government subcontracts specify courts in Virginia as the mandatory forum for resolution of disputes.

Background

The Morris-Griffin case involved a somewhat familiar scenario. The plaintiff, Morris-Griffin Corporation (MGC), was the incumbent prime contractor on an 8(a) set-aside contract with the Department of Housing and Urban Development (HUD) for mortgage loan servicing. MGC no longer qualified as a socially and economically disadvantaged small business concern when the contract came up for re-compete as an 8(a) set-aside, and thus MGC was ineligible to compete as prime. MGC did what many contractors in this position do – it sought out a current 8(a) firm to team with in a prime-subcontractor relationship for the re-compete. Unfortunately, the 8(a) firm that MGC teamed with, C&L Service Corporation (CLS), was a janitorial service company with no experience in loan servicing. MGC, the subcontractor, proposed to take a leading role on the HUD contract, providing most of the labor and capital, signing several important third-party subcontracts, and paying for various assets needed to perform the HUD contract. SBA initially questioned the relationship, but under pressure from HUD, ultimately approved it, and CLS was awarded the HUD prime contract.

After award, CLS gradually took steps to assume control of the relationship with HUD and in an effort to “drive MGC out.” When CLS refused to pay the entire amount MGC invoiced for its expenses on the subcontract, MGC invoked the subcontract’s arbitration clause. MGC also filed a motion for preliminary injunction and temporary restraining order in the U.S. District Court for the Eastern District of Virginia, purportedly to maintain the status quo pending arbitration. MGC sought an order enjoining CLS from withholding funds and from making any unilateral decisions with respect to the HUD contract. The court denied the motion, holding that the HUD contract was awarded in violation of SBA regulations and, therefore, that the subcontract was unenforceable.

On its own initiative, the court – apparently familiar with the federal small business contracting regulations – questioned the legality of the subcontract. First, the court held that the parties were “affiliates” for size-determination purposes because the small-business prime contractor was “unusually reliant” on MGC, making MGC an “ostensible subcontractor” under the SBA regulation at 13 C.F.R. § 121.103(h). The court employed SBA’s “seven-factor test” to determine whether a small business is “unusually reliant” on its subcontractor and found that six of seven factors weighed in favor of a finding of unusual reliance: (1) the parties jointly split management of the contract, with the subcontractor employing most of the key management and supervisory personnel; (2) the subcontractor had the background and expertise to perform the HUD contract; (3) the subcontractor “chased the contract” by seeking out CLS (choosing CLS specifically because it “would not be a competitor to [MGC] in the loan servicing field”); (4) CLS had “very little” role in preparing the proposal in response to HUD’s solicitation; (5) the parties contemplated that the subcontractor would perform a relatively large share of the contract, and the subcontractor actually incurred 60 percent of the labor costs; and (6) the subcontractor was to (and did) perform the more complex and costly contract functions, such as providing administrative staff, supervisors and IT staff.

The court also found that the parties failed to comply with the “fifty percent rule” of 13 C.F.R. § 125.6(a),¹ which provides that the small business contractor on an 8(a) set-aside contract “must perform at least 50 percent of the cost of the contract incurred for personnel costs with its own employees.” The parties’ expense reports showed that the subcontractor incurred roughly 60 percent of the labor costs.

Because the parties were “affiliates” under SBA regulations, the court held that MGC fraudulently represented in its proposal for the HUD contract that it, including its affiliates, qualified as a small business concern. Therefore, according to the court, the HUD contract was illegal. The court then held that the subcontract was unenforceable because it violated SBA’s regulations and the public policy underlying the small business program. The court also held that MGC’s claim for equitable relief was barred by the doctrine of “unclean hands” because MGC acted in bad faith by orchestrating the submission of an unlawful bid to HUD and incurring labor expenses in excess of amounts permitted under federal regulations and the subcontract.

Significantly, according to the court, the fact that neither the SBA nor HUD rejected the parties’ bid was no defense because neither had the authority to waive the applicable regulations. Indeed, at the conclusion of the opinion, the court implies that SBA and HUD intentionally turned a blind eye to the illegal subcontracting relationship because they both stood to benefit from it:

It has come to the Court’s attention that government set-aside contracts are susceptible to finagling. … An individual SBA officer has little incentive, if any, to question a particular small business’ certification. After all, the percentage of federal contracting dollars set aside for small business concerns is publicly reported. The Department of Housing and Urban Development, in particular, has a reputation as being the “friendliest” cabinet-level agency to small business. … In 2005, HUD awarded nearly three-quarters of its contracting budget to small business concerns.

The incentives that this system creates are perverse. Small business concerns enter into teaming agreements where their primary contribution is one thing and one thing only: eligibility for § 8(a) contracts. This practice is amply demonstrated by the facts of the current case, where a janitorial firm nominally secured a multi-million dollar contract to perform mortgage loan servicing, despite a complete lack of any prior experience in the industry. Does this truly benefit small businesses? Certainly their owners can profit from this arrangement. But in terms of actually allocating work to the small businesses that are so vital to our nation’s economy, the system is hardly ideal.

The court directed that a copy of its opinion be sent to a HUD official, even though HUD was not a party to the case.

Risks and How to Avoid Them

The Morris-Griffin case illustrates yet another risk for contractors who run afoul of SBA’s affiliation regulations or the Limitations on Subcontracting clause, namely, nullification of their subcontracts. Ordinarily, the SBA “ostensible subcontractor” rule is enforced by SBA through the size protest process. SBA’s fifty percent rule/Limitations on Subcontract clause is sometimes enforced by the U.S. Government Accountability Office (GAO) or U.S. Court of Federal Claims through the bid protest process. In addition, failure to comply with these rules may also be the subject of investigations by agency Offices of Inspector General, GAO or other federal investigators. Indeed, GAO recently issued several reports alleging fraud and abuse in SBA set-aside programs for small, 8(a), service-disabled veteran-owned (SDVO) and Historically Underutilized Business Zone (HUBZone) contractors, and SBA’s Inspector General has been aggressively investigating alleged fraud and abuse by contractors in these programs.

The Morris-Griffin decision is the first published court decision where these SBA rules were invoked to nullify a subcontract in a private dispute between a prime and subcontractor. Again, because the case was decided by the federal court for the Eastern District of Virginia, where many government prime contractors and subcontractors are located, its precedential effect may be significant.

The bottom line is that government prime contractors and subcontractors competing for or performing contracts set- aside for small, 8(a), SDVO or HUBZone firms should closely examine their relationships to ensure they comply with SBA regulations and thereby avoid the issues raised in, and potentially disastrous consequences of, the Morris-Griffin decision.

¹ SBA’s “fifty percent rule” is implemented by the “Limitations on Subcontracting” contract clause at Federal Acquisition Regulation 52.219-14.