THE ILLUSION OF SMALL BUSINESS SET-ASIDES IN INFORMATION TECHNOLOGY PROCUREMENT

Transcription

1 26 Contract Management August 2014

2 Contract Management August

3 or the past 60 years, Congress has encouraged the viability of small (and other disadvantaged) businesses through federal procurement policy. 1 Congress establishes governmentwide goals regarding the percentage of money spent on small businesses products and services and the Small Business Administration (SBA) tracks agency performance against these standards and reports the results to Congress and the president. For example, the Rule of Two requires a contracting officer to reserve exclusively for small businesses all acquisitions within certain dollar thresholds unless the contracting officer determines there is no reasonable expectation of receiving offers from two or more responsible small businesses that are competitive in terms of price, quality, and delivery. 2 To further protect small business participation and ensure U.S. federal government dollars ultimately find their way to the intended recipients, the government has established various rules and regulations governing this matter. 3 In the IT sector, however, the application of many of these rules is contradictory or ignored, and dollars intended for small businesses flow, instead, to large manufacturers or systems integrators. Instead of assisting and promoting small business, the current 28 Contract Management August 2014

4 rules make it very difficult for small business prime contractors to provide the IT products requested by the government without violating the same rules that were enacted to help and protect them. NAICS Codes and Size Standards Determinations (and contractor representations) of size depend largely on the nature of the items being acquired (e.g., supplies vs. services) and, specifically, the North American Industry Classification System (NAICS) code selected to describe them. In issuing small business set-aside contracts, the government uses NAICS codes to establish size standards governing which entities qualify as small businesses for preferences or eligibility under government programs and procurements. 4 SBA regulations require procuring agencies to designate a proper NAICS code for all procurement programs for which status as a small business is required or advantageous. 5 Indeed, the failure to assign a NAICS code can render a solicitation defective. 6 In designating a NAICS code, the procuring agency is required to select the NAICS code which best describes the principal purpose of the product or service being acquired. 7 Where both products and services are being acquired, acquisitions must be classified according to the component that accounts for the greatest percentage of contract value. 8 Thus, when determining the applicable NAICS code, the procuring agency must identify whether the contract is primarily for the acquisition of services or supplies. 9 Likewise, relevant case law holds that this is achieved by identifying where the greater portion of a contract s value is allocated, with services or goods. 10 Under a contract requiring the performance of a combination of work, a contracting officer must identify whether the contract is one for services, construction, or supplies for purposes of applying the performance of work requirements identified in the Federal Acquisition Regulation (FAR) Limitations on Subcontracting clause. 11 Once properly assigned, the NAICS code has a corresponding size standard, which is represented by either a dollar figure (i.e., annual revenue amount) or number of employees (i.e., headcount). 12 The contractor must represent its current size under the standard set forth under the particular NAICS code assigned to the contract. For example, NAICS code , Electronic Computer Manufacturing, carries with it a 1,000-employee size standard. A prospective offeror with less than 1,000 employees would be considered small for the purposes of that procurement. 13 In a procurement set-aside for small business, however, accurately representing size against the standard applicable to the NAICS code identified in the solicitation is only the first step. Once the contractor s size status is appropriately determined and certified as small, the contractor (and the government) Contract Management August

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6 still must comply with other applicable SBA regulations, such as performance of work requirements, the ostensible subcontractor rule, and, in many cases, the non-manufacturer rule to ensure the small business (prime) contractor is the actual beneficiary of the government funds. Performance of Work Requirements (Limitations on Subcontracting) In acquisitions restricted to small business, there are limitations placed on an awardee s subcontracting. The rationale for this is clear: Because the dollars are set-aside for small business, the government has an interest in ensuring the ultimate recipient of that money is a small business and a small business prime contractor is not simply being used as a front to pass through the bulk of those dollars to a large business. To accomplish this, solicitations reserved for small businesses where the contract amount is expected to exceed $150,000 must include the Limitations on Subcontracting contract clause at FAR Thus, in an acquisition for services, it is required that at least 50 percent of the cost of performance incurred for personnel shall be expended for the contractor s own employees. 15 Likewise, in an acquisition for supplies, the contractor must perform at least 50 percent of the cost of manufacturing the supplies, excluding the cost of materials. 16 However, there is an exception to the forgoing manufacturing requirement for supplies called the nonmanufacturer rule (NMR). The Non- Manufacturer Rule The NMR sets out the requirements for resellers to provide supplies under a small business set-aside. The NMR applies only when the procurement is set-aside for small business, and the procurement has been assigned a manufacturing or supply NAICS code. 17 In such cases, the reseller must, among other things, have less than 500 employees and, in the absence of a waiver under 13 C.F.R (b)(5), furnish the end item of a small business. 18 The NMR does not apply to acquisitions that have been assigned a services, construction, or trade association NAICS code. 19 Further, in a mixed procurement (i.e., a procurement that contains both supplies and services), the NMR does not apply to the supply portion Contract Management August

7 Restricted Limits competition and participation by small businesses (excludes otherwise applicable small businesses) Higher government prices Agencies and small business primes violate SBA regulations (e.g., NMR, limitations on subcontracting, ostensible subcontractor rule) Eliminates the domestic preference protections of both the Trade Agreements Act and Buy American Act Illusory and deceptive Dollars flow to large business even though expressly reserved for small business of the acquisition where the procurement is classified as a service contract (i.e., assigned a service NAICS code). 20 Like the performance of work requirements, the rationale behind the NMR is to prevent a large business from using a small business as a front that simply passes through the majority of the government s contracting dollars to a large business manufacturer. Frequently, however (and especially in the IT industry), the items desired by the government are manufactured only by large businesses. Unrestricted Increases competition and participation by small business (includes all small businesses) Lower government prices Agencies and small business primes comply with applicable laws and regulations Domestic preference protections of the Trade Agreements Act do apply Open and transparent Dollars may flow to large business The expectation (and requirement) that the majority of contract dollars flow to small business when an acquisition for IT goods and services is reserved is purely illusory. In both cases above, the majority of dollars flow through to large businesses. However, the unrestricted acquisition strategy is currently the only path where both the agency and small business prime can be open and transparent and do not run afoul of federal procurement regulations. FIGURE 1. THE SMALL BUSINESS SET-ASIDE ILLUSION IN IT PROCUREMENT The Ostensible Subcontractor Rule The ostensible subcontractor rule is an extension of the small business affiliation rules used for determining a contractor s size. Under the ostensible subcontractor rule, if the subcontractor performs too great a role under a contract, the prime contractor and its subcontractor are treated as affiliates for the purposes of calculating size against the applicable NAICS code. 21 Specifically, an ostensible subcontractor is a subcontractor that performs primary and vital requirements of a contract or a subcontractor upon which the prime contractor is unusually reliant. 22 SBA considers all aspects of the prime-sub relationship and, if it is determined that a prime contractor is merely superficial, SBA will deem the two entities as joint venturers (i.e., affiliates) and combine both parties revenue or headcount for the purposes of determining whether the prime contractor meets (or exceeds) the size standard for the applicable solicitation. Recently, SBA used the ostensible subcontractor rule to intervene in an acquisition for Cisco hardware and software maintenance services by the U.S. Department of the Army. 23 Here, the contracting officer set aside the procurement entirely for small business under NAICS code , Footnote 18 a services NAICS code with a size standard of 150 employees. 24 The contract was ultimately awarded to Red River Computer Co., Inc., a business with less than 150 employees. However, six months after performance had begun under the contract, the director of SBA s Office of Government Contracting filed a size protest arguing that Red River did not qualify as a small business, citing the ostensible subcontractor rule. Specifically, SBA alleged that Red River was affiliated with its subcontractor, Cisco, because Cisco personnel would be performing the primary and vital elements of the contract and because Red River would be unusually reliant upon Cisco for performance. Red River and its government customer asked SBA s area office to dismiss the protest, arguing, in part, that the real problem was that the acquisition should not have been reserved exclusively for small business in the first place. They claimed that if Red River was found to be large, then any (and every) other prime contractor would also be large because only Cisco personnel could provide the services called for in the contract. In other words, no small business would be able to perform the contract without violating the ostensible subcontractor rule. Red River asked the area office to dismiss the protest, but instead it held that Red River was affiliated with Cisco under the ostensible subcontractor rule and, therefore, not a small business for the procurement. In so finding, the SBA area office distinguished this case from an acquisition for supplies. Here, the procurement involved services, not goods or equipment. And, unlike products, SBA found a small business could acquire the requisite skills to perform the contracted-for services. Red River subsequently appealed to the SBA Office of Hearings and Appeals, which ultimately upheld the area office s findings Contract Management August 2014

8 The Illusion SBA s findings in Red River suggest that the outcome would have been different if the acquisition was for supplies instead of services. In other words, had the acquisition been for Cisco equipment, SBA would have agreed that the procurement was flawed as a set-aside because no small business could have performed the requirements of the contract without violating the ostensible contractor rule (and perhaps also the NMR). Herein lies the problem: Where an IT procurement (and especially one for IT products) is reserved for small business, it is virtually impossible for a small business prime to perform the requirements of the contract without violating the ostensible subcontractor rule, the NMR, or both. 26 Yet, agencies frequently set aside these procurements (in some cases using the Rule of Two) and count and report the dollars spent under these circumstances as having gone to small business. The same also happens frequently in small business set-asides for IT services. The deliverables desired by the government are such that the large system integrator subcontractor ends up performing the majority of the effort, thereby violating the performance of work requirements, the ostensible subcontractor rule, or both. Again, the dollars are reported as having gone to small business when, in fact, the bulk of the funds have flowed through to large subcontractors. The illusion that the government s money ends up with small business primes in IT set-asides (and the silliness of the current system) becomes even more obvious when comparing these set-asides with the results in an acquisition for identical items that is unrestricted. In both cases, the majority of the money flows through the small business prime to a large original equipment manufacturer subcontractor. In both cases, the government agency counts the spending toward its small business utilization goals. However, in the set-aside context, the aforementioned procurement rules are violated, the flow of money is illusory and deceptive, competition is restricted, and the government pays higher prices. On the other hand, where the competition is unrestricted, small business participation (i.e., competition) is increased, agencies do not violate current regulations, the money flow is open and transparent, and the government pays lower prices. (See FIGURE 1 on page 32.) It defies logic that restricting a procurement exclusively for small business renders a solicitation defective (or at the very least makes contractor performance impossible without violating SBA regulations), but conducting the same acquisition unrestricted allows the agency to follow the rules and properly take small business credit against its utilization goals for its spending, even though the majority of the money ends up with a large subcontractor in both instances. Other Problems Further, restricting acquisitions for IT products to small businesses eliminates the country of origin requirements of both the Trade Agreements Act and Buy American The FACt is... We Have All the FACs Management Concepts offers a holistic FAC curriculum to ensure that your workforce is up-to-date with training to comply with all certification requirements for FAC-C, FAC-COR, and FAC-P/PM. Visit: Contract Management August

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10 Act and thereby grants China and other nondesignated counties an avenue to supply products directly to the U.S. government. First, FAR Subpart 25.4, Trade Agreements, is expressly exempted from acquisitions setaside for small business. 27 Further, commercial item IT is specifically exempted from the Buy American Act. 28 Therefore, setting aside contracts for small business for IT products eliminates the country of origin protections of both the Trade Agreements Act and Buy American Act. As a result, even high-profile and multibillion-dollar set-aside indefinite delivery/indefinite quantity procurements may allow products from China to be sold and provided to U.S. government customers. Conclusion The belief that U.S. government dollars flow to small business prime contractors in IT set-asides is illusory. When applied to acquisitions for IT products, the current rules governing small business set-asides are irrational, if not completely broken. Current SBA regulations make it nearly impossible for a small business prime to bid on or perform such contracts without violating the exact same regulations that were put in place to protect them. In short, setting aside acquisitions for IT products (and services in some instances) causes real compliance challenges and often insurmountable hurdles for agencies and potential contractors alike. When considering whether to restrict IT acquisitions to small business, agencies should take great care to determine whether a small business prime can actually deliver the products and services desired without violating applicable SBA regulations. CM ABOUT THE AUTHOR JEFFREY M. ELLINPORT is a senior director and deputy general counsel at immixgroup. He specializes in government contract law, software licensing, IP transfer, and litigation. Send comments about this article to cm@ncmahq.org. ENDNOTES 1. See The Small Business Act of 1953, 15 U.S.C. 631 et seq. 2. As per Federal Acquisition Regulation (FAR) See, e.g., FAR Part 19; 13 C.F.R. 121 et seq. 4. Rotech Healthcare, Inc. v. United States, 71 Fed. Cl. 393, 407 (2006) C.F.R See King s Thrones, LLC, SBA No. NAICS-4845 (2007) (finding that [a]bsent a NAICS code designation the procurement is materially and continuously defective. ) C.F.R (b). 8. Ibid. 9. See 13 C.F.R (b) ( Primary consideration is given to the relative value and importance of the components of the procurement making up the end item being procured. ). 10. See Size Appeal of Arizona Medical Supply Co., SBA No (1979) (examining the greatest proportion of the contract s value, comparing the amount of the contract that was for services versus the amount that was for supplies); and Rotech Healthcare, 71 Fed. Cl. at (citing Arizona Medical Supply) (finding that the request for proposals, despite the inclusion of ancillary services, was a contract for supplies, concluding, the services portions of the contracts are slight in comparison to the supply portions. For that reason, the court cannot conclude that these solicitations truly offer mixed-purpose contracts which would disqualify the disputed procurements from being classified as supply contracts. ). 11. Ibid. 12. See 13 C.F.R See 13 C.F.R for affiliation rules and how to calculate the number of employees; see also 13 C.F.R (b)2, FAR (a), and FAR (a)(3) for 500-employee small business size standard for resellers. 14. See FAR (e). 15. FAR (c)(1). 16. Ibid., at (2) C.F.R (b). 18. Ibid. See also files/nmr%20class%20waiver%20 LIST-AS%20OF% VERSION%2010. pdf for the SBA NMR Class Waiver List as of December 31, C.F.R (b)(3); see also Rotech Healthcare, 71 Fed. Cl C.F.R (b)(4) C.F.R (h)(4). 22. Ibid. 23. See Size Appeal of Red River Computer Co., Inc., SBA No. SIZ-5512 (2013). 24. See 13 C.F.R , n Size Appeal of Red River Computer Co., Inc., SBA No. SIZ-5512 (2013) (It should be noted that on appeal, Red River did not attempt to challenge the merits of the ostensible subcontractor findings (i.e., that Red River was unusually reliant on Cisco), but rather challenged the area office s findings on procedural grounds.) 26. In the case of the NMR, even if a waiver has been granted for the products sought and, thus, compliant, the majority of dollars still flow through to a large original equipment manufacturer. 27. FAR (a)(1). 28. FAR (e). Contract Management August