By Kimi Murakami

What may be standard in the corporate world can severely disrupt set-aside status in the highly-regulated government contract space. Take the recently-decided case of Precise Systems.

This decision presents another cautionary tale of why it is so critical for contractors to understand the SBA rules–or to talk to lawyers who do–before entering into corporate restructuring transactions.

In the final decision issued by Chief Judge Patricia Campbell-Smith in the case of Precise Systems, Inc. v. U.S., No. 14-1174C (Fed. Cl., July 28, 2015), the Court of Federal Claims upheld the U.S. Small Business Administration (SBA)’s decision, which had been affirmed by the Office of Hearings & Appeals (OHA), that Precise was not an eligible service-disabled, veteran owned small business (SDVOSB) for a Department of State (DOS) procurement set aside for SDVOSBs. The contractor’s status as an SDVOSB failed because the service-disabled veteran on whom Precise’s SDVOSB status was based did not have sufficient ownership of the company.

There are two prongs that must be met for a small business to be eligible to qualify as an SDVOSB. According to the SBA’s regulations, the SDVOSB concern must be at least 51 percent unconditionally and directly owned and controlled by one or more service-disabled veterans. These requirements of ownership and control are separate and distinct. And SBA has promulgated separate regulations pertaining to each requirement. See 13 C.F.R. § 125.9; 13 C.F.R. § 125.10.

In the case of Precise, the DOS selected Precise as the awardee from among fifteen other SDVOSB offerors. The awardee’s eligibility as an SDVOSB was challenged by four protestors on the ground that the service-disabled veteran did not meet the ownership requirement of the SBA rules. To satisfy the prong requiring direct and unconditional ownership, the SBA’s SDVOSB regulations provide that “in the case of a concern which is a corporation, at least 51 percent of the aggregate of all stock outstanding and at least 51% of each class of voting stock outstanding must be unconditionally owned by one or more service-disabled veterans.” 13 C.F.R. § 125.9 (emphasis added). The SBA regulations are silent as to what constitutes a class or a series of stock or how to distinguish between them.

The service-disabled veteran in the Precise case owned a majority of the company’s “Series A” common stock but he did not own at least 51 percent of the company’s “Series B” preferred stock. A majority of the Series B stock was owned by the company’s employees under an employee stock option plan (ESOP). Precise argued that because both series of stock had similar voting rights and the ESOP’s majority ownership of the second series in no way diminished the service-disabled veteran’s control over the company, OHA should not treat the two “series” as separate “classes” for eligibility as an SDVOSB requirements. SBA rejected Precise’s argument and concluded, with OHA affirming, that the two series of shares were separate classes of voting stock and, therefore, the service-disabled veteran had to own at least 51 percent of each class of stock in order to satisfy the ownership requirement for SDVOSB status. Because he did not, the company’s eligibility as an SDVOSB failed.

In reaching her decision, Judge Campbell-Smith found OHA’s rationale for determining that the two series were separate classes of voting stock was rational and adequately reasoned. She decided, therefore, to agree with OHA’s conclusions. Even if the differences between the two series of stock enhanced the service-disabled veteran’s interest, she found this fact to be irrelevant. Further, the Court of Federal Claims was not persuaded by Precise’s argument that the service-disabled veteran had control over decisions of the concern notwithstanding the fact that it did not own a majority of the Series B stock. OHA was within its discretion, Judge Campbell-Smith concluded, to adopt a hardline approach and to signal that it will not engage in a case-by-case analysis as to whether differences in rights, privileges, and limitations of stock would inure to the benefit of the of the service-disabled veteran or someone else. 

The fact that the other series of stock was owned by an ESOP also did not affect the decision. Regardless of what type of owner held a majority of the Series B shares, the problem for Precise in this case was having two separate series of stock that were not majority owned by the service-disabled veteran. The regulations clearly state that the service-disabled veteran must own at least 51 percent of both series of outstanding voting stock. The establishment of a stock option plan by the employees could have been accomplished without creation of a second series of shares–and should have been–if the company and its lawyers were keeping in mind the regulatory requirements of participating in the SBA’s SDVOSB program. By not remaining compliant with the regulations the company lost its eligibility for SDVOSB status which prevents Precise from qualification, award, and performance of an important federal government contract.

Government contractors participating in the SBA’s other set-aside programs such as the 8(a) Business Development and woman-owned small business programs–not just SDVOSBs–should keep the Precise case in mind. The language of the SBA’s regulations relating to ownership for these other set-aside programs is virtually identical to the SDVOSB regulation at issue in the Precise case. As Judge Campbell-Smith pointed out: “There can be no serious dispute that the ownership criteria of the SBA’s 8(a) BD program, 13 C.F.R. § 124.105, and the SBA’ SDVO SBC program, 13 C.F.R. § 125.9, is comparable–or that the two programs have consonant mandates and goals–such that precedent interpreting one is likely controlling in the other…Indeed, the OHA has acknowledged that that the ‘corresponding [ownership criteria] for the 8(a) BD program, 13 C.F.R. § 124.105(d), is worded very similarly to 13 C.F.R. § 125.9(d).” Precise at p. 12.

In other words, contractors be warned when creating or restructuring ownership of a company hoping to participate in a federal set-aside procurement.

About the Author:  Kimi Murakami is counsel with PilieroMazza and focuses her practice on corporate transactions with an emphasis on mergers and acquisitions of government contractor.  She also has experience advising on intellectual property matters including trademarks and trade secrets.  She can be reached at [email protected]