Change Ahead SignEarlier this week, we blogged about a final rule issued on May 31 by the Small Business Administration (“SBA”), which made several major changes to the small business regulations. This new rule implements changes mandated by the 2013 National Defense Authorization Act, (“NDAA”) and finalizes the proposed rule issued by the SBA back in December of 2014.
As we explained in our earlier blog, one of the new rule’s most important changes relates to the self-performance requirements and limitations on subcontracting contained at 13 C.F.R. § 125.6. Below is a more detailed look at the numerous changes to that regulation, which go into effect on June 30, 2016.

Background and Purpose

As many of you know, 13 C.F.R. § 125.6 establishes minimum self-performance requirements for small business prime contractors performing various types of set-aside contracts. The intent of this regulation was to avoid “pass-through” situations (where small businesses awarded set-aside contracts subcontracted virtually their entire contracts to large businesses), which would divert government dollars from the intended small business beneficiaries, and thereby negate the purpose of the agency’s small business programs. To avoid this problem, SBA enacted 13 C.F.R. § 125.6, requiring small business prime contractors to self-perform a certain percentage of the work on its set-aside contracts.

Shift in Conceptual Framework

Under the old version of the regulation, compliance with the performance of work requirements differed based on the type of small business program set-aside at issue (i.e. small as compared to 8(a), WOSB/EDWOSB, SDVOSB, or HUBZone). Moreover, the method for calculating compliance not only varied by program set-aside type, but also based on whether the acquisition was for services, supplies, general construction, or specialty trade construction. For example, a prime contractor on a general construction contract set-aside for HUBZone companies had to spend “at least 15% of the cost of contract performance incurred for personnel on the concern’s employees.” In comparison, an 8(a) prime contractor performing a set-aside contract for supplies or products had to “perform at least 50 percent of the cost of manufacturing the supplies or products (not including the costs of materials).” In other words, compliance was determined using a percentage threshold, which the prime contractor had to meet.
The rule shakes this up a bit. The overall goal remains the same: Keep a minimum of small business dollars in small business pockets. However, as the SBA explains, the revised regulation “creates a shift from the concept of a required percentage of work to be performed by a prime contractor to the concept of limiting a percentage of the award amount to be spent on subcontractors.” For instance, using the example above, rather than requiring a contractor to self-perform 15%, the revised 13 C.F.R. § 125.6 mandates that the prime contractor cannot subcontract more than 85%. It’s a slightly different, but important, change in perspective.

Similarly Situated Entities

One of the most talked about elements of the new rule is the fact that subcontracts made to “similarly situated entities” are not counted towards the applicable subcontracting limit. The NDAA defined a similarly situated entity as “a small business subcontractor that is a participant of the same small business program that the prime contractor is a certified participant and which qualifies the prime contractor to receive the award.”  In other words, a HUBZone could subcontract to another HUBZone, or an 8(a) could subcontract to another 8(a), without counting those subcontracts towards the applicable limit.
In its 2014 proposed rule, the SBA proposed that a subcontractor had to be “small” for purposes of the NAICS code assigned to the prime contract in order to fall within the definition of “similarly situated entity.”  In the final rule, however, the SBA has departed from that idea; under the new regulation, a subcontractor may qualify as a “similarly situated entity” so long as it is “small” under the NAICS code assigned to the subcontract, regardless of whether the subcontractor is “small” for purposes of the prime contract’s NAICS code. Because prime contractors – and not the government – are responsible for assigning NAICS codes to their own subcontracts, this provides a lot more flexibility. (Of course, primes will have to remember to assign NAICS codes to their subcontract, something they often forget to do currently.)
The NAICS code shift is not the only change regarding “similarly situated entities” that occurred between the proposed rule and final rule. Under the proposed rule, the SBA required the prime contractor and any “similarly situated” subcontractors to execute written “teaming” agreements containing certain mandatory provisions. However, because the written agreement requirement was heavily criticized during the comment period, it was removed from the final rule. The new rule does not require written agreements between primes and their “similarly situated” subcontractors.
During the comment period, questions were raised about how these concepts would be applied to lower tier subcontractors. More specifically, people were concerned that if compliance was determined by looking at first tier subcontractors only, a first tier “similarly situated” subcontractor could in turn pass all of its performance on to a large or otherwise not similarly situated entity through a second subcontract, thus circumventing the regulation entirely. To address these concerns, the SBA explained in the final rule that:
SBA will apply the limitations on subcontracting collectively to the prime and any similarly situated first tier subcontractor. . . any work performed by a similarly situated first tier subcontractor will count toward compliance with the applicable limitation on subcontracting. Any work that a similarly situated first tier subcontractor subcontracts, to any entity, will count as subcontracted to a non-similarly situated entity for purposes of determining whether the prime/sub team performed the required amount of work. In other words, work that is not performed by the employees of the prime contractor or employees of first tier similarly situated subcontractors will count as subcontracts performed by non-similarly situated concerns.

Manner of Calculating Percentage

As explained above, under the old rule, compliance differed based on the type of set-aside at issue, and varied based on whether the acquisition was for services, supplies, general construction, or specialty trade construction. Some self-performance requirements were calculated using “the cost of the contract incurred for personnel.” Others used “the cost of the contract (not including the costs of materials)” or “the cost of manufacturing the supplies or products (not including the costs of materials).” These small differences between the manner of calculation could cause much confusion. It often proved very difficult for contractors to figure out exactly what, exactly, they had to do, or what work they had to perform, in order to be compliant. Self-performance calculation questions were the some of the most common questions posed by our small business clients.
The revised regulation is much simpler. First of all, it eliminates the differences between the different small business programs: the same rules apply to small business, 8(a), WOSB/EDWOSB, SDVOSB and HUBZone set-asides. Second, regardless of whether the contract is one for services, supplies, or construction (general or specialty), the subcontracting limitations are described in terms of “the amount paid by the government to [the prime contractor]” That said, construction contractors will still have to exclude costs of materials from their calculations. Even so, this revision will make it much, much simpler to determine exactly how much you can subcontract and still be compliant.
The final rule also provides some clarification regarding “mixed contracts” – i.e. those contracts that contain elements of both supply and service contracts, to which several different subcontracting limitations could therefore apply. The rule explains that “the CO must first determine which category, services or supplies, has the greatest percentage of the contract value, and then assign the appropriate NAICS code.” The corresponding limitations on subcontracting will then apply “only to that portion of the requirement identified as the primary purpose of the contract.” The SBA further explained:
Therefore, where a procurement combines supplies and services, the limitations on subcontracting apply only to subcontracts that correspond to the principal purpose of the prime contract. For a contract principally for services, but which also requires supplies, this means that the prime contractor or its similarly situated subcontractors cannot subcontract more than 50 percent of the services to other than small concerns. However, the prime contractor can subcontract all of the supply components to any size business.

Exemption for Small Contracts

Another important change with regard to subcontracting limitations is the addition of a carve-out for certain small dollar contracts. Set-aside contracts under $150,000 will no longer be subject to the limitations on contracting set forth at 13 C.F.R. § 125.6, so long as they are small business set-asides. For 8(a), WOSB/EDWOSB, SDVOSB and HUBZones set-aside contracts, these subcontracting limitations will still apply regardless of contract dollar amount.

Conclusion

As discussed above, under the new regulation, contractors should find it much easier to figure out what work, exactly, they have to perform to be compliant. Moreover, the “similarly situated entity” change should give contractors more flexibility in terms of subcontracting. The changes nonetheless stay true to the purpose of the small business programs (the economic development of small businesses through performance of government contracts), and create a more intuitive framework without (for the most part) creating unnecessary confusion or red tape.
Overall, we see these changes as very positive. This faithful implementation of the NDAA 2013 mandates was, for the most part, worth the wait. Here’s to hoping the mentor-protégé program works out just as well.
Please stay tuned for our continued coverage of the other changes from the SBA’s May 31, 2016 proposed rule, and check our website for news about our webinar on the same topic.
Michael H. Payne is the Chairman of the firm’s Federal Contracting Practice Group and, together with other experienced members of the group, frequently advises contractors on federal contracting matters including bid protests, claims and appeals, procurement issues, small business issues, and dispute resolution.
Maria L. Panichelli is an Associate in the firm’s Federal Contracting Practice Group. Her practice includes a wide variety of federal contracting and construction matters, as well as all aspects of small business procurement.