1 THE COMPANY YOU KEEP Affiliation Implications For Federal Set-Aside Contracts May 2012 Presented by: Gerald Ormiston and Jamie Ziegler Liberty Mutual Surety

Presentation Goals & Disclaimer  Designed to provide information about the Federal Set-Aside contract programs and raise awareness of potential risks when large business enterprises work with small business enterprises on these programs.  Presentation is not legal advice or risk management advice for any individual or entity that is involved with or is contemplating becoming involved with these programs. 2

3 Topics for Discussion I.Why Understanding Risks in the Federal Set-Aside Arena has Become Necessary II.Overview of SBA Programs and Their Administration III.SBA Guidelines for Recognizing Improper Affiliations IV.Recognizing Improper Affiliations – You Be the Judge

Goals for Allocating Federal Dollars Source: SBA Website 77% Non-Qualified Prime Contracts 23% of Prime Contracts For Small Businesses 35.6% SB Set-Asides 21.7% W.O.S.B 13% HUBZone-SB 21.7% S.D.B. 13% S.D.V.O-SB

5 Congress Continues to Investigate Fraud and Abuse in the Small Business Set-Aside Arena

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What are the Risks?  Direct (to Surety) ■ Default termination on bonded set aside project  Indirect (to Account) ■Debarment ■Forfeiture of affirmative claims ■Civil/criminal penalties 7

8 Topics for Discussion I.Why Understanding Risks in the Federal Set-Aside Arena has Become Necessary II.Overview of SBA Programs and Their Administration III.SBA Guidelines for Recognizing Improper Affiliations IV.Recognizing Improper Affiliations – You Be the Judge

9 II. Overview of SBA Programs and Their Administration  8(a) Business Development – Minority Small Business Development (8(a) BD)  Historically Underutilized Business Zone Program (HUBZone)  Small Disadvantage Business (SDB)  Service-Disabled Veteran Owned Small Businesses (SDVOSB)  Women-Owned Small Business (WOSB)

10 8(a) BD Program Basics  Small Business unconditionally owned (51%) and controlled by one or more socially and economically disadvantaged individuals Subject to racial or ethnic prejudice due to circumstances beyond their control Ability to compete has been impaired due to diminished capital and credit opportunities compared to others in same or similar line of business  Good character  Citizens of the United States (residency added)  Demonstrate potential for success 13 CFR §§

11 8(a) BD Program Basics  Interested business files application with the SBA certifying that it is a small business under the applicable size standard  8(a) Program personnel will verify qualifications prior to award of a contract  SBA involvement in award of the contract May sign primary contract with procuring agency and subcontract with program participant Or may delegate authority to procuring agency to enter into contract directly with program participant 13 CFR §§

12 8(a) BD Program Basics  Status awarded for 9 years from initial designation  Primary NAICS code determines size  Economically Disadvantaged Spousal income & retirement income not included (*) AGI = $250,000 initial & $350,000 continuing Assets (FMV) = $4 MM initial & $6 MM continuing  Excessive Withdraws Officers salaries generally not included $250,000 if sales up to $1 MM $300,000 if sales $1 MM - $2 MM $400,000 if sales over $2 MM 13 CFR §§

13 HUBZone Program Basics  Principal office must be located within a designated historically underutilized business zone  35% of the business’ employees must reside in the HUBZone  Represent that the business will maintain 35% employee residence throughout the duration of the contract 13 CFR §§

14 HUBZone Program Basics  Apply to the SBA for certification  Must be small within the applicable size standard for the industry  Important subcontracting guidelines for the HUBZone participant Required to spend at least 50% of labor costs on its own employees May subcontract 35% of the cost of the contract to other HUBZone participants May not subcontract more than 50% to non-qualified HUBZone small businesses 13 CFR §§

15 Small Disadvantaged Business Basics  Participants in 8(a) BD Program automatically eligible  Receive certification from the procuring agency  8(a) criteria apply to determine whether a firm qualifies as a SDB except demonstrating the potential for success is not required Entity can be a part-time entity but qualifying individual must be full-time during part-time Removed the good character requirement 13 CFR §§

16 Service Disabled Veteran Owned Small Business (SDVO SB) Basics  At least 51% unconditionally and directly owned by one or more service-disabled veterans  Management and daily operations must be controlled by one or more service-disabled veterans  Contractor self-certification It is an SDVO SB It is small under the applicable size standard Will meet the percentage of work requirements VetBiz Verification Program 13 CFR §§

SDVOSB Status Verification -  Veterans Administration (VA) requirement to bid VA SDVOSB set aside projects  Contractors must be approved by VA and listed in the VetBiz.gov Vendor Information Pages (VIP) database  Only applies to VA SDVOSB set aside projects  Program does NOT evaluate Teaming Agreements or other similar arrangements April 3,

18 Women-Owned Small Businesses Economically Disadvantaged Women-Owned Businesses (EDWOSB)  One or more women unconditionally and directly own at least 51% of the business  Management and daily operations controlled by one or more women  EDWOSB Economically disadvantaged plus limitation on net worth – 750K in assets (excluding ownership of the business and primary residence)  Contractor self-certification Verified by third-party entity 13 CFR §§

19 Self-Performance Requirements for SBA-Managed Programs - Construction  8(a) – perform 15% of the cost of the contract (excluding materials) with its own employees  SDVOSBC – spend 15% of labor costs on own employees or another SDVOSBC  HUBZone – spend 15% of labor costs with own employees  WOSB/EDWOSB – spend 15% of the cost of the contract (excluding materials) with its own employees 13 CFR § 125.6

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22 Calculating Average Annual Receipts for SBA Size Determination  Receipts = total income + cost of goods sold  Receipts do not include: Capital gains or losses Taxes collected or remitted Proceeds from transactions with affiliated entities  Period of measurement In business for more than 3 years – 3 most recent years divided by 3 In business for less than 3 years – total receipts during period of business divided by number of weeks in business, multiplied by CFR §

23 Topics for Discussion I.Why Understanding Risks in the Federal Set-Aside Arena has Become Necessary II.Overview of SBA Programs and Their Administration III.SBA Guidelines for Recognizing Improper Affiliations IV.Recognizing Improper Affiliations – You Be the Judge

Affiliation Determination  Affiliation Defined An affiliation exists when an entity controls or has the power to control the other, or a third party or parties controls or has the power to control both  Totality of the circumstances analysis (weighted averaging of several factors)  Particularly fact-intensive and may produce different results on a case-by-case basis April 3,

25 Affiliation Determination– Exceptions from an Affiliation Finding  Businesses will not be considered affiliated solely on the basis of the following characteristics: Businesses owned by investment / development companies qualified under the Small Business Investment Act Businesses owned and controlled by Indian tribes, Alaskan Native Corporations, Native Hawaiian Organizations Businesses which lease employees from a common organization Firms participating in the Federal Mentor / Protégé Program 13 CFR § (b)

26 Consequences of an Affiliation Finding  The combined size of the SBC and its affiliates determine whether the SBC falls within the size classification for a project Example: Project set-aside for businesses with $10 million or less in annual revenue SBC with $8 million in revenue for FY2009 = Eligible SBC with $8 million in revenue but affiliated with entity with $5 million in revenue for FY2009 = Ineligible

27 Consequences of an Affiliation Finding  At the time of bidding, contractors must represent their status as an eligible small business or a participant in an SBA program  Obtaining a small business set-aside by fraud or misrepresentation may result in Inspector General investigations, termination, debarment, suspension, criminal or civil penalties [See, e.g., 15 U.S.C § 645]

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29 Factors to Weigh When Making an Affiliation Finding  The SBA considers Ownership Interest Management Control Newly Organized Concern Rule Employee and Family Ties Contractual Agreements (i.e. Teaming Agreements, Joint Venture Agreements) Ostensible Subcontractor Rule

30 Ownership Interest / Management Control  Owning a majority of stock  Power to control a majority of voting stock  Own or control a combination of minority voting blocks  Owning future stock interests  Sharing officers, directors, managing members or partners  Profit-Sharing Agreements 13 CFR §§ (c)–(e)

31 Family Ties  Family Influence Identity of Interest Rule Rebuttable presumption that family members have identical interests and will be treated as affiliates –May be rebutted by evidence showing that the family members are estranged or that they have independent economic interests creating a clear line of fracture between the two entities. Key Point: The rebuttable presumption that family members have identical interests arises from the family relationship itself, not from the members involvement with each other’s business transactions. Gallagher Transfer & Storage Co., SBA No. SIZ-4295 (1998) 13 CFR § (f)

32 Employee Ties  Former Key Employee Influence Newly Organized Concern Rule – when former officers, directors, principal stockholders, managing members or other “key employees” form new business and receive assistance from former employer there is a rebuttable presumption that entities are affiliates May be rebutted by demonstrating “a clear line of fracture” between the two entities 13 CFR § (g) Key Point: Prevents large businesses from creating “spin off” firms which appear to be small and independent, but are, in fact, an extension of the large business [Field Support Services Inc., SBA No (1996)]

33 Subcontracts  An affiliation is found under the ostensible subcontractor doctrine when a small business is in essence, performing as a subcontractor to a large business that is nominally a subcontractor on the project  The small business general contractor is therefore “unusually reliant” on the large subcontractor 13 CFR § (h)(4)

34 Subcontracts  The large subcontractor performs “primary and vital” requirements of the contract Contract management Control of Project Funds Technical responsibilities Large percentage of actual labor Teaming Agreements Financial and bonding assistance Large subcontractor is the incumbent contractor 13 CFR § (h)(4)

35 Subcontracts  An Ostensible Subcontractor affiliation may be found during contract performance  A new regulation closed a “loophole” in which a small business contractor could submit an offer proposing that it will perform primary and vital portions of the contract and then subcontract the entire contract after award  Now, a contractor no longer may annually certify it is a small business when a subcontractor assumes primary and vital tasks during contract performance 13 CFR § (g)(4)

36 Teaming Agreements  Defined in the Federal Acquisition Regulations (FAR) as a potential prime contractor agreeing with one or more other companies for them to act as a subcontractor under a Government contract  The FAR recognizes teaming arrangements may offer the best combination of performance, cost and delivery  The Government will accept the validity of teaming arrangements provided they are fully and timely disclosed FAR – 9.603

37 Teaming Agreements  Teaming Agreements will be reviewed to determine whether it creates an affiliation under the ostensible subcontractor rule  Issues Considered in the Affiliation Review Delineation of the proposed division of work and compliance with the performance thresholds The proportion of skills, knowledge and experience brought to the contract by each team partner Who will manage the day-to-day functions

38 Teaming Agreements  Issues Considered in the Affiliation Review (continued) Whether terminology is used in the agreement that would indicate the parties have entered into an impermissible joint venture (i.e., “we”, the “Team”) The extent to which the subcontractor was involved in the contract proposal If, and how, profit is distributed (profit sharing is red flag for an affiliation)

39 Joint Venture Agreements  Parties to a Joint Venture are considered affiliated with each other  Three exceptions: Each entity is “small” and the contract is greater than half the assigned size standard A Joint Venture of at least one 8(a) participant and one or more other small businesses A Joint Venture consisting of a mentor and protégé 13 C.F.R (h)

40 Joint Venture Agreements  Temporary and Limited Purpose, Not on a Continuing or Permanent Basis Three Contracts over two-year span (SBA tracks) The number of contracts is determined at the time of offer Example - if a JV has had two contracts in two years and then submits three offers, the JV will not violate the rule even if it receives all three contracts for a total of 5 contracts  Permissible to Create More Than One Joint Venture The same two (or more) entries may create additional joint ventures, and each new JV may be awarded three contracts A long-standing inter-relationship between the same JV partners increases the chances of an affiliation finding 13 C.F.R (h)

41 8(a) Joint Ventures  An 8(a) may partner with one or more other small businesses to perform an 8(a) contract  JV Agreement must be approved by the SBA before contract award  An 8(a) / SBC Joint Venture is permissible only: When the 8(a) participant lacks the capacity to perform the contract on its own The agreement is fair and equitable The 8(a) participant will substantially benefit from the Joint Venture 13 C.F.R

42 8(a) Joint Ventures  The JV Agreement must state: The purpose of the Joint Venture The 8(a) is the managing partner The project manager is an employee of the 8(a) The 8(a) must own at least 51% of the JV if it is a separate legal entity 8(a) must receive proportionate share of profits Performance responsibilities The equipment, facilities and resources contributed by each partner

43 8(a) Joint Ventures  Size Requirements: At least one 8(a) in the JV must be less than one-half the size standard assigned to the contract, and For a contract with a revenue-based size standard, the contract exceeds one-half the size standard; or For a contract with an employee-based size standard, the contract exceeds $10 million

44 8(a) Joint Ventures  New Performance of the Work Requirements as of February 2011 The prior regulation required an 8(a) to perform “a significant portion of the contract” Current regulations require the 8(a) to perform 40% of the work performed by the JV: The 8(a) must do more than administrative functions Unpopulated Joint Venturers - when both the 8(a) and non-8(a) partners are technically subcontractors, the amount of work performed by the partners will be aggregated and the work by the 8(a) must be at least 40% of the work done by all partners Populated Joint Venturers - the non-8(a) JV partner, or any affiliates, may not be a subcontractor to the JV, unless approved by the SBA 13 C.F.R (d) (i)

8(a) Joint Ventures  New Annual Reporting Requirement The 8(a) partner must report annually to the SBA how the performance of the work threshold is being met for each contract

46 8(a) Mentor/Protégé Joint Ventures  A Feature of the 8(a) Program  Purpose Enhance the capabilities of the protégé and improve its ability to compete  No affiliation due to the mentor / protégé agreement or assistance provided Must enter into written agreement subject to SBA review Relationship will be annually reviewed by the SBA 13 CFR §

47 8(a) Mentor/Protégé Joint Ventures  Mentors Can be a non-profit or an 8(a) BD graduate Generally only one protégé at a time, need SBA approval & never more than three Demonstrate favorable financial health  Protégés Developmental stage OR never received 8(a) contract OR ½ applicable NAICS code (not during last 6 mos.) Generally one mentor at a time (different NAICS code)  Approved written agreement, one point of contact, support for at least one year & significant consequences 13 CFR §

8(a) Mentor/Protégé Joint Ventures  New annual reporting requirements Protégé must report to the SBA on the mentor’s assistance each program year Annual certification whether any changes to the agreement  New consequences of the mentor not providing the stated plan of assistance Termination of the mentor / protégé relationship Firm will be ineligible to mentor for two years SBA may recommend the procuring agency issue stop work order for each mentor / protégé JV contract SBA may consider failure to be a basis for debarment 13 CFR § (H)

49 Contractual Relationships– Other Consequences  Will the rights and obligations of the “small business” entity be enforceable if the entity was actually ineligible for the set-aside contract? Recent decision held that an affiliated large subcontractor could not enforce provisions of its agreement with a small business who obtained a set- aside contract in violation of the SBA Regulations Morris-Griffin Corp. v. C&L Serv. Corp., 731 F.Supp. 2d 488 (E.D. Va. 2010) order vacated (Dec. 7, 2011).  Potential implications for sureties

50 Weighing the Risks  Has there been a SBA certification approval?  Has the small business entity provided the Government with documentation defining its relationship with the larger entity?  Is the relationship between the small business entity and the larger entity an approved relationship, i.e. Mentor/Protégé?

51 Topics for Discussion I.Why Understanding Risks in the Federal Set-Aside Arena has Become Necessary II.Overview of SBA Programs and Their Administration III.SBA Guidelines for Recognizing Improper Affiliations IV.Recognizing Improper Affiliations – You Be the Judge

52 IV. Recognizing Improper Affiliations You be the Judge  Case 1 U.S. Air Force contract for mission hardware and software training, support and logistics management. The contract was set aside for SDVO SBC’s. Company A, the low bidder, was a subcontractor on the predecessor contract. Company A is a SDVO SBC. Company B, a large business, is the incumbent prime contractor for the predecessor contract.

53 IV. Recognizing Improper Affiliations You be the Judge  Case 1 Company A submits a proposal, self-certifying as an SDVO SBC, identifying itself as the prime contractor, and Company B, the large contractor, as a subcontractor and teaming partner. Company A’s proposal refers to A and B as a “team” that offers a low-risk option because Company B’s knowledge and personnel retention will offer a seamless transition. The logos of both companies appear on almost every page of the proposal.

54 IV. Recognizing Improper Affiliations You be the Judge  Case 1 Company A will adopt techniques and approaches developed by Company B during the predecessor contract. Company A plans to retain Company B’s incumbent workforce, its facility lease, and Government furnished equipment. The Teaming Agreement provides that Company B must consent to Company A soliciting employees. Company A’s program manager will be primarily responsible for managing the contract. Company A will not receive financial assistance from Company B. Company B has the option to terminate the Teaming Agreement to bid for the contract if the set-aside requirement is removed.

55 IV. Recognizing Improper Affiliations You be the Judge  Case 1 Holding Company A is not affiliated with Company B Company A will be performing primary and vital contract requirements and will be primarily responsible for managing the work. Although Company A is adopting certain techniques and approaches from Company B, Company A was already acquainted with them from being the incumbent subcontractor. Company A is not usually reliant on Company B for its workforce because Company A will be independently retaining and managing the employees. Spiral Solutions & Tech., Inc., SBA No (Sept. 15, 2011).

56 IV. Recognizing Improper Affiliations You be the Judge  Case 2 Solicitation issued by the Department of the Army for a contractor to perform public works services at Fort Hood, Texas. The contract was set-aside for SDVO SBC’s. Company A and Company B formed a joint venture to bid on the project. Company A is a SDVO SBC, Company B is not. The Joint Venture Agreement indicates that Company A and Company B will each appoint one managing director and the two will make all decisions by mutual agreement.

57 IV. Recognizing Improper Affiliations You be the Judge  Case 2 The JV Agreement provides for an employee of Company A to serve as project manager, but did not state the name of that employee. The JV Agreement also indicates that Company A will share 51% of the net operating income and net operating losses of the joint venture. Lastly, the JV Agreement contains a statement that the parties will comply with the SBA Regulations, rather than delineating each party’s responsibilities.

58 IV. Recognizing Improper Affiliations You be the Judge  Case 2 Holding The bidding Joint venture is ineligible for the project because the JV Agreement did not meet the requirements of the SBA Regulations in the following ways: 1)Company A is not designated as the managing venturer, and in fact, splits the decision-making between the venturers; 2)A specific project manager for Company A was not named; 3)While the JV Agreement addressed net operating income losses, it did not establish Company A would receive 51% of net profits, as required; 4)The agreement did not specifically define the responsibilities of each venture partner. Hana-JV, SBA No. VET-227 (February 22, 2012).

59 IV. Recognizing Improper Affiliations You be the Judge  Case 3 Invitation for bids issued for the production of marine deck cranes set aside for small businesses. This procurement is the third in a series of prior purchases of identical cranes. Company A was previously awarded the second procurement. Company B was a subcontractor of Company A on the second procurement and performed approximately 55% of that contract’s value.

60 IV. Recognizing Improper Affiliations You be the Judge  Case 3 Company A has been in the same line of business for 28 years. It has its own shop and engineering personnel. Company A prepared its own bid. Company A will be manufacturing cranes with Company B’s design. Company A and Company B have a licensing agreement which allows Company A to utilize and manufacturer the cranes and provides for Company B to lend Company A its personnel to assist with the manufacturing and installation.

61 IV. Recognizing Improper Affiliations You be the Judge  Case 3 The licensing agreement also provides Company B with first preference to sell components to Company A which Company A chooses to purchase rather than manufacturer itself. Company A and Company B will not be sharing profits and do not have a teaming agreement. Company B agreed to indemnify the bond for Company A for a fee. In the event of liability, Company A and Company B will contribute in proportion to their respective manufacturing levels.

62 IV. Recognizing Improper Affiliations You be the Judge  Case 3 Holding: Company A and Company B are NOT affiliated. Company A and Company B have a legitimate contractor- subcontractor relationship. Company A is capable of controlling the contract and performing the work with its own resources. The companies will not be sharing profits. Company A had the autonomy to either create its own design or deal with and obtain the design of any firm it so chose. With respect to the bonding assistance, Company A is using its own financial resources to obtain the bond and entered into an arms-length transaction to obtain assistance from Company B. Lake Shore, Inc., SBA No. 2632, 1987 WL (S.B.A. 1987).

63 IV. Recognizing Improper Affiliations You be the Judge  Case 4 Army Corps of Engineers small business set-aside contract for dredging. Company A, a small business, was the successful bidder. Company B is owned and controlled by the brother and adult son of Company A’s majority shareholder. Company A leases office space from Company B at fair market value in an arm’s length transaction.

64 IV. Recognizing Improper Affiliations You be the Judge  Case 4 The two companies do business together. For example, Company B accounted for about 10% of Company A’s gross receipts in the previous year. Both companies use the same NAICS codes, which encompasses civil engineering construction, dredging, and surface cleanup. However, each company works in a different subset of that code and each has a different specialty. Company A works mainly in marine contracting and mechanical dredging, while Company B largely performs tunneling and underground work.

65 IV. Recognizing Improper Affiliations You be the Judge  Case 4 The two companies do not share common management or common directors and are distinct corporate entities. The family members are not officers or directors of each others’ companies. The majority shareholder of Company A is the sole indemnitor for the company’s bonds. Company A owns all of its own equipment. None of the family members live in the same household.

66 IV. Recognizing Improper Affiliations You be the Judge  Case 4 Holding: The two companies are affiliated under the identity of interest rule. Company A did not present evidence that sufficiently rebuts the presumption of identical interests from the familial relationship between owners of Company A and Company B. Company A was also heavily dependent on Company B for work, which is also an indicia of affiliation. L&S Industrial & Marine, Inc., SBA No. SIZ-4978, 2008 WL (S.B.A. 2008).

Questions?