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On December 29, 2014, the Small Business Administration issued long overdue proposed amendments to its regulations (with 60 days for comments) to implement many of the provisions of the National Defense Authorization Act of 2013 relevant to small business contracting.

Most notable is the complete overhaul of the calculation of the limitations on subcontracting requirement. The amendment proposes a major shift in the way the calculation is performed. The current method requires the prime contractor to be responsible for the specified percentage of cost of performing the contract (with variations depending on whether it is a contract for services, supplies, construction, or specialty trade construction). The amendment proposes shifting the calculation from this cost-based approach to the amount paid to the prime, which must be more than the specified percentage paid to other than “similarly situated” subcontractors. The proposed revision is intended to be easier to calculate, but complexities remain.

The applicable limitation (for supplies, services, etc.) is to be determined by the NAICS code selected by the contracting officer. The biggest exclusion from this calculation is amounts paid to “similarly situated entities,” which is a subcontractor, at any tier, that would qualify for the same status as required by the set-aside requirement (e.g., small business, 8(a), etc.). The proposed rule also adds a requirement that the prime contractor certify compliance with the applicable limitation on subcontracting. (Although, the SBA has requested comments on whether prime contractors should have to report to the contracting officer on compliance with this requirement as well as the frequency and method of reporting.) New penalties would include a fine the greater of either $500,000 or the amount spent on other than similarly situated subcontractors in excess of the limitation on subcontracting.

Although the proposed amendments track the changes prescribed by the NDAA generally, there are some notable changes. The most important difference is that the proposed calculation would look at all tiers of subcontractors, in a manner more akin to the subcontracting calculations used by the U.S. Department of Transportation in its disadvantaged business enterprise program. This is intended to prevent small business subcontractors acting as pass throughs for large businesses. The SBA has not proposed a definition for a “subcontractor,” so, for example, it is an open question whether independent contractors (1099s) could be considered subcontractors and how they would count in a limitation on subcontracting calculation. Additionally, the proposed rule would also exclude “similarly situated” subcontractors from consideration in the application of the “ostensible subcontractor” affiliation rule.

Also of note are several proposed changes to the nonmanufacturer rule. Contracting officers would be required to notify potential offerors if any waivers (class or contract specific) of the nonmanufacturer rule apply to a procurement. It proposes to treat certain software items as supplies (so that the nonmanufacturer rule would apply) but provides that some software could be eligible for waivers if the applicable criteria is met. (Under the proposed rule, software will still be considered a service if the procurement is for creation or modification of custom design software.) This is an area where there will be continued confusion about the applicability of the nonmanufacturer rule, particularly due to the uncertainty generated by the Court of Federal Claims’ recent decision in Rotech v. United States, 118 Fed. Cl. 408 (2014). In this decision, which we have previously reported on, the Court held that the nonmanufacturer rule applies to any supplies even if the NAICS code assigned to the procurement is one for services. This decision is contrary to unambiguous SBA regulations, and will require Federal Circuit reversal or a statutory amendment to rectify.

Additional proposed revisions include:

• A broader exclusion from affiliation to allow a joint venture to qualify as small for any government procurement as long as each joint venture partner qualifies individually as small under the size standard corresponding to the NAICS code assigned in the solicitation.

• Revision to the standard for affiliation based on identity of interest to provide more specificity by establishing: (1) a rebuttable presumption of affiliation if firms do business together and are owned/controlled by a married couple, parties to a civil union, parents and children, or siblings; and (2) a presumption of affiliation based on economic dependence if one firm derives 70% of its revenue from another firm over the previous fiscal year.

• A new recertification requirement so that if a merger or acquisition occurs after offer/proposal submission but prior to award, the offeror must recertify its size to the contracting officer prior to award. The creation of a staggered timing requirement is likely to add confusion and complexity to transactions. And, while it appears to be SBA’s intent that all originally eligible contractors who have to recertify during a procurement will remain eligible for award regardless of their size at the time of the recertification, the proposed regulation, as drafted, is not completely clear on this point.

• Revisions to the regulations on subcontracting plans focused largely on compliance and sanctions. Under a new notification provision, prime contractors would have to notify small businesses in advance of including them in a proposal, offer, bid, or subcontracting plan. The proposed rule would establish a reporting mechanism that allows subcontractors to report fraudulent activity or bad faith behavior by a prime contractor with respect to a subcontracting plan. It would also expand the range of sanctions that can be imposed for the failure to implement corrective action following a compliance review or failure to demonstrate good faith. In addition to liquidated damages already provided for, the failure could be a material breach and may also be considered in any past performance evaluation of the contractor.

Comments on this rule are due on or before February 27, 2015 and we anticipate lengthy comments will be submitted. Be on the lookout for more changes on the horizon because:

• The 2013 NDAA also included provisions to expand the scope of SBA’s Mentor-Protégé program beyond the 8(a) Program. Proposed regulations tied to those much anticipated changes are still forthcoming.

• The FAR will have to be amended to track the revisions to the SBA regulations. Any lag in time in matching the FAR to the SBA regulations may introduce uncertainty as to which regulations apply to procurements and contracts incorporating the different FAR versions of the requirements.