Federal Circuit: Contractor's Change to its Operating Agreement Dooms SDVOSB Status
For many small businesses, doing business with the Federal government can be a complex and costly process. For example, small contractors not only must deal with fierce competition for set-aside contracts but also they must adhere to the maze of statutory and regulatory requirements governing Federal procurement.
Specifically, with respect to being eligible for, and receiving, government contracts that are set-aside for small business concerns, contractors must become familiar with portions of Title 13 of the Code of Federal Regulations ("Title 13"). Under Title 13, for example, contractors will find how the Small Business Administration ("SBA") calculates a small business concern's size and SBA's rules for being eligible for its socio-economic programs, including the service-disabled veteran-owned small business ("SDVOSB") program.
Given the particularized nature of SBA's regulations, contractors must pay careful attention because a small hiccup can have a significant impact on a contractor's ability to receive set-aside contracts. Unfortunately, that is exactly what happened in XOtech, LLC v. United States, Fed. Cir. No. 2019-1743 (Feb. 26, 2020), where a contractor amended its limited liability company ("LLC") operating agreement in a manner that ran afoul of the SDVOSB rules.
First, to be eligible as an SDVOSB under SBA's regulations, a small business is required to follow several rules, including for example, that:
it is directly owned by a SDV (13 C.F.R. § 125.12(a));
in the case of an LLC, at least 51% of each class of member interest must be unconditionally owned by one or more SDV's (13 C.F.R. § 125.12(c));
the management and daily business operations of the concern must be controlled by one or more SDV's (13 C.F.R. § 125.13(a));
a SDV must hold the highest officer position in the concern (usually President or CEO) and must have managerial experience of the extent and complexity needed to run the concern (13 C.F.R. § 125.13(b)); and
in the case of an LLC, one or more SDV's must serve as managing members, with control over all decisions of the LLC (13 C.F.R. § 125.13(d)).
At issue in this appeal is whether a SDV controlled all decisions of the SDVOSB as required under Section 125.13(d) of Title 13.
Here, XOtech was originally organized in 2000 under the Georgia LLC Act as a member-managed company, with an SDV as the only member. XOtech then transformed to a manager-managed company. Later, in 2012, XOtech's operating agreement was amended, whereby the SDV held over 90% interest in the LLC but its structure was changed such that the SDV's wife and son became managers of the company (the wife and son were non-SDV's).
The operating agreement provided that the LLC's managers "have full and complete authority, power and discretion to manage and control the business, affairs and properties of the Company, to make all decisions regarding such matters and to take all action necessary or convenient to carry out the business and affairs of the Company.”
In that regard, managers were permitted to hire employees, bind XOtech to contracts, borrow money, determine the amount and timing of distributions to the LLC members, and prosecute or defend any proceeding in XOtech’s name. Moreover, each manager had equal voting power, and a majority vote was required to make management decisions. Therefore, any management decision required the vote of either the wife or son, and the two non-SDV managers were allowed to make decisions without the vote of the SDV.
In 2017, XOtech was awarded a contract by the Army. An unsuccessful offeror challenged, among other things, XOtech's eligibility for SDVOSB contracts at the SBA. The initial protest was appealed to the SBA Office of Hearings and Appeals, which affirmed the Director's decision that XOtech was not an eligible SDVOSB on the basis that the SDV "lacked sufficient control over XOtech’s operations because he required the vote of at least one non-SDV to make management decisions." XOtech then filed a protest at the Court of Federal Claims, which arrived at the same conclusion: that XOtech was not an eligible SDVOSB.
The Federal Circuit appeal followed.
On appeal, XOtech made two principle arguments in support of its position that it was an eligible SDVOSB. First, it argued that the two non-SDV managers could not block a decision by the SDV. Second, it argued that the SDV's inability to prevent the two non-SDV managers from making decisions that he opposed does not render the SDVOB ineligible because "the ability of the non-SDV managers to bind XOtech is no different from that of an ordinary employee to whom decision-making authority has been delegated."
On the other hand, the Government argued that the company is not an eligible SDVOSB because at least one non-SDV was required to make management decisions. Moreover, it argued that the SDV's ability to remove managers at any time and for any reason was insufficient for the SDV to retain control over all of the management decisions of the company.
Ultimately, the Federal Circuit agreed with the Government that the SDVOSB was ineligible under SBA's rules. In support of its decision, the Court first noted that it looks at the terms of the entity's governing documents to determine whether it is an eligible SDVOSB. Because all decisions required the vote of at least one non-SDV, the Court concluded that if "any portion of an LLC’s decision-making authority requires the vote of a non-SDV, then SDVs cannot be said to control all decisions of the company." In other words, to establish management control over all decisions, one or more SDVs must be able to independently exercise control over all decisions, without the consent of any non-SDVs.
The Court was also not persuaded that the SDV retained control of the company because of its ability to remove the non-SDV managers at any time for any reason. In the Court's view, the SDV could not preempt the non-SDV managers from making decisions, and the SDV could not undo decisions that the non-SDV's made even after their removal.
At bottom, the Court noted that unless and until the SDV removes the non-SDV managers, all management decisions require the vote of at least one non-SDV. Because an SDV did not control “all decisions” of the company, XOtech was therefore ineligible for contracts set aside for SDVOSB's.
Takeaway
To receive set-aside contracts, small businesses must adhere to the numerous, particularized regulations under Title 13. A small business not only must be "small" under SBA's regulations but also must be formed in a manner that is consistent with SBA's various socio-economic regulations (this is also true for small business JV's).
As shown above, where a small business concern's operating agreement runs afoul of SBA's regulations––like the requirement that one or more SDV's have "control over all decisions" of the LLC––both the SBA and the Courts might conclude that the contractor is ineligible for set-aside contracts.
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