On May 31, 2016, SBA released its long anticipated final rule on the limitations on subcontracting. The final rule becomes effective on June 30, 2016. In order to help you understand how the final rule changes the existing regulations, we have prepared a chart of the major regulatory changes announced in the new rule which accompanies this letter  

In the final rulemaking, SBA adopted most of the changes announced almost a year and half ago in its proposed rule (released on December 29, 2014. You can find a chart we prepared comparing the proposed rule to the existing rule and our comments on the proposed changes here). However, the final rule contains several significant departures from the proposed rule that should be noted.  

In our comments on the proposed rule, we noted that additional guidance was needed regarding the definition of “cost of materials” for services contracts. The final rule includes clarification that all costs associated with providing services, including any overhead or indirect costs associated with those services, must be included in determining compliance with the limitations on subcontracting.  

Our comments also focused on how, for “mixed” contracts of supplies and services, the proposed rule needed to provide additional clarification regarding whether or not the cost of supplies are excluded prior to determining compliance with the limitations on subcontracting for the services portion of the contract, if the primary purpose of the contract is services.  In the final rule, SBA provides this additional clarity, explaining that the limitations on subcontracting apply only to that portion of the requirement identified as the primary purpose of the contract. For a contract principally for services, but which also requires supplies, this means that compliance with the limitations on subcontracting will only apply to the portion of the contract allocated for services; however, the prime contractor would be able to subcontract all of the supply components to any size business.

In our comments, we also suggested that SBA amend the definition of “cost of materials” to include any service or product that cannot be procured from small businesses. For example, we see this issue come up often in the environmental remediation industry for procurements that require rail transportation – there are no small business rail carriers. However, SBA has left in place the current “cost of materials” definition, which does not provide for such an exception. 

Importantly, the final rule provides a departure regarding the proposed definition of a “similarly situated entity.” The proposed rule defined such an entity as one that meets the same socioeconomic classification as the prime contractor in addition to being small under the NAICS code assigned to the prime contractor’s procurement. In the final rule, SBA revised the definition to allow a subcontractor to qualify as a similarly situated entity if it is small for the NAICS code that the prime contractor assigns to the subcontract. The final rule is also consistent with SBA’s requirement that prime contractors assign a NAICS code to the subcontract which describes the principal purpose of the subcontract.  

SBA has also clarified that performance by an independent contractor is considered a subcontract, and may qualify as a similarly situated entity if the contractor meets the relevant criteria.  

The final rule clarifies that SBA will apply the limitations on subcontracting collectively to the prime and any similarly situated first tier subcontractor, and any work performed by a similarly situated first tier subcontractor will count toward compliance with the applicable limitation on subcontracting. 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 entities.  

The proposed rule required prime contractors to enter into written agreements with their proposed similarly situated subcontractors, and that these written agreements would be required to be submitted to the contracting officer with the prime’s offer at the time of proposal submission in order for the similarly situated entities to count towards meeting the limitations on subcontracting requirements. Due to the many comments SBA received on this issue pointing out the impracticality of such a requirement, especially for indefinite-delivery, indefinite-quantity contracts, SBA eliminated this requirement in the final rule. Prime contractors will maintain the discretion to change subcontractors mid-stream during contract performance and have any similarly situated subcontractors count towards meeting the applicable performance goals. Written agreements will no longer be required.

The final rule eliminates the requirement for small businesses to submit compliance reports regarding their reliance on similarly situated entities to meet their performance obligations under set-aside contracts. However, SBA intends to issue a proposed rule requesting public comment on the issue of whether all small businesses – not only those utilizing similarly situated entities – should be required to report on compliance with the limitations on subcontracting on set-aside contracts. Additionally, the proposed rule required prime contractors to certify their compliance with the limitations on subcontracting when utilizing similarly stated entities; the final rule has been revised to eliminate this certification requirement.  

When determining affiliation based on economic dependence, the final rule adopted a three-year measurement timeframe as suggested in our comments. SBA also revised the final rule that the presumption of affiliation based on economic dependence may be rebutted by a showing that, despite the contractual relations with another concern, the concern at issue is not solely dependent on the other concern.  The final rule also contains examples to clarify when economic dependence affiliation should and should not be found. SBA then clarified that it will not find affiliation between two concerns owned by an Indian Tribe, Alaska Native Corporation, Native Hawaiian Organization, or Community Development Corporation based solely on the contractual relations of the two concerns.    

We understand that the final rule creates significant changes to the regulatory landscape, and will directly impact the ability for companies to stay in compliance with their contractual obligations. We recommend that all of our clients carefully review the text of the final rule, 81 Fed. Reg. 34243, so that they fully understand the full implications on their federal contracting obligations. Please let us know if you have any questions regarding the final rule.
On July 12, 2016, we are hosting a seminar in Tyson’s Corner, VA to provide an in-depth discussion of the final rules. We are excited to be joined by John Klein, SBA’s Associate General Counsel for Procurement Law, who played a major role in drafting the final rules for this session. Click here if you would like more information or to register for the seminar