Government Contracting Client Alert (February 2014)

DAVID, BRODY & DONDERSHINE, LLP

Government Contracting Client Alert (February, 2014)

NEW LIMITATIONS ON SUBCONTRACTING RULES STILL AWAITING FINAL REGULATORY IMPLEMENTATION

The National Defense Authorization Act (NDAA) of 2013, which was signed into law by President Obama over a year ago in January 2013, made numerous important changes to the limitation on subcontracting rules applicable to small business set-aside contracts. Pub. L. No. 112-239, Section 1651. According to the statute, the NDAA's changes, as they apply to service and supply contracts, appear to have gone into effect at the time of enactment without any express requirement for regulatory implementation, ostensibly overruling existing Federal Acquisition Regulation (FAR) requirements, e.g., FAR 52.219-14, Limitations on Subcontracting (DEC 1996) and SBA regulation 13 CFR 125.6. Hopefully, the government will clarify the effective date of the new requirements, when it finally issues proposed regulations based on the changes set forth in the NDAA. However, at this time, it is not clear when the new rules will be implemented under the FAR and SBA regulations.

The limitation on subcontracting rule has often been referred to as the "50 percent rule", as it precludes prime contractor small business service contractors from farming out more than half of the "cost of performance incurred for personnel" to subcontractors. The limitations on subcontracting were originally imposed on 8(a) companies in 1986 and were subsequently extended to other set-asides in 1987 under the Small Business Act. The Small Business Act also imposed limitations on subcontracting on supply prime contractors requiring them to perform at least 50% of the cost of manufacturing the supplies or products (not including the cost of materials), and on general construction contractors, requiring firms to perform at least 15% of the cost (excluding materials) of general construction with its own employees. The statutory and regulatory provisions implementing these rules remained unchanged through 2012 despite concerns that the rules were being violated, leading to pass-through contracts.

The NDAA significantly revises how the limitations on subcontracting will now be calculated for service contracts from the "cost of performance incurred for personnel" to the "amount paid" to the prime contractor. This change is designed to ensure that the bulk of the services are performed by the prime contractor. Thus, under the new legislation, small businesses service contractors may subcontract no more that 50% of the "amount paid under the contract". The statute also states that in the case of a contract for supplies, other than from a regular dealer in such supplies, the small business may not expend more than 50% of the amount, less the cost of materials, paid to the concern under the contract. The statute also authorizes SBA to implement by regulation similar limitations for construction contracts (presumably based on 15% of the amount paid). By basing the calculations the prime contractor has to make in order to determine compliance on the "amount paid", the government hopes to simplify the calculations that the prime needs to perform to determine whether or not it is in compliance with the rules.

Under the current SBA regulations, which still apply the old rule, the "cost of contract performance" means "[a]ll allowable direct and indirect costs allocable to the contract, excluding profit or fees". Therefore, under the current regulations, the prime contractor under a services contract has to engage in a potentially tedious calculation based on excluding non- labor costs and profit from its overall calculation of the "cost of contract performance incurred for personnel" to determine compliance. On the surface, the rule appears to have simplified what a prime contractor has to do to establish compliance. However, if the prime contractor has high profit and non-labor costs, subcontracting 50% of the total "amount paid" might result in having the subcontractor do more than 50% of the cost of personnel. On the other hand, under the new provision, if the subcontractor's non-labor costs and profit exceeds the prime's rates, then the subcontractor would have to perform significantly less than 50% of the cost of performance incurred for personnel.

The NDAA also provides a significant change for small businesses that are unable or unwilling to do more than 50% of the work. These businesses may now meet their set-aside performance obligations by subcontracting to a "similarly situated entity". This means that for small business set-asides, the prime contractor can count its small business subcontractor awards toward its own compliance, or in the case of an 8(a) set-aside, count the 8(a) subcontractor awards towards compliance. In other words, a small business or small disadvantaged business prime contractor may comply with the new requirement by subcontracting with another small business or small disadvantaged business that is similarly situated. It should be noted that for the HUBZone and SDVOSB programs, "similarly situated entities" that are subcontractors already count toward the prime contractor's performance for purposes of the calculation under the current limitation on subcontracting rule. The expansion of the "similarly situated" entity rule under the NDAA should be embraced by small businesses as a significant shift in policy that will afford small businesses with limited resources, who wish to prime a set-aside contract, the ability to create teams with other similarly situated small businesses to meet the 50 per cent requirement.

The new regulation contains harsh penalties for firms who violate the limitation on subcontracting rules. The legislation provides that if a contractor exceeds the limitations on subcontracting, it may be fined the greater of $500,000.00 or the amount expended, in excess of the permitted levels, on subcontractors. The potentially heavy penalties imposed by this new provision is a significant departure the government's past failures to aggressively enforce the old limitations on subcontracting rule .

Finally, it should be noted that the GAO has just recently issued a decision, Sealift, Inc., B-409001, January 6, 2014, in which it dismissed a protest challenging an award made after the enactment of the NDAA based on the protestor's claim that the awardee submitted a proposal that violated the limitation on subcontracting FAR clause (FAR 52. 219-14) included in the solicitation, which is still based on the analyzing the cost of performance incurred for personnel. In rejecting this argument, the GAO observed that the awardee was also in compliance with the new NDAA requirement and suggested that small businesses might not have to wait for regulatory implementation to benefit from the changes under the NDAA for awards made after the enactment of the NDAA in January, 2013.

We will continue to monitor the implementation of the new rule. We anticipate that the government will seek comments from the public before it proceeds to issue implementing regulations. If you need any additional information concerning the limitation on subcontracting rules, or other issues relating to government contracting, you can contact Ken Brody of David, Brody & Dondershine, LLP, 12355 Sunrise Valley Drive, Suite 650, Reston, Va. 20191, at 703-264-2220 or [email protected]. You can also visit our website at www.dbd-law.com for additional information about our firm.

David, Brody & Dondershine, LLP is a law firm that concentrates on providing services to businesses, including representing businesses that do work for federal, state and local governments. This client alert is intended to provide general information about significant legal developments and should not be construed as legal advice on any specific facts and circumstances.

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