|August 12, 2008|
Previously published on August 1, 2008
A recent decision by the Office of Hearings and Appeals (OHA) of the U.S. Small Business Administration (SBA) confirms that the SBA affiliation rules do not prohibit all forms of “negative control” by minority shareholders, such as supermajority approval requirements for certain fundamental corporate transactions. In Size Appeal of EA Engineering, Science and Technology, Inc., SBA No. SIZ-4973 (2008), OHA held that supermajority approval requirements for transactions unrelated to the daily operations of the business do not de facto create affiliation between the business and its minority shareholder. In so holding, OHA appears to have relaxed its position from previous decisions, wherein OHA implied that any and all forms of negative control would result in a finding of affiliation.
The EA Engineering decision should make it easier for small business government contractors to obtain equity capital investments to help grow their businesses. This is a welcome development, especially since SBA’s new re-certification rule, which became effective on June 30, 2007, has had the effect of drying up many sources of equity capital for small business government contractors.
The Negative Control Affiliation Rule
Any government contractor seeking to qualify as a small business should be well versed in SBA’s affiliation rules, including the “negative control” affiliation rule at issue in the EA Engineering case. In determining whether a business concern is considered small and, thus, eligible for procurement programs set aside for small businesses, SBA counts the employees or revenues (depending upon the applicable size standard) of the concern itself and all of the concern’s “affiliates.” 13 C.F.R. § 121.103(a)(6). SBA considers concerns to be affiliated when one controls or has the power to control the other, or a third party controls or has the power to control both entities, regardless of whether that control is actually exercised. 13 C.F.R. § 121.103(a). SBA affiliation rules provide that control can be either affirmative or negative. Negative control “includes, but is not limited to, instances where a minority shareholder has the ability, under the concern’s charter, by-laws, or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.” 13 C.F.R. § 121.103(a)(3).
Investors who acquire less than a majority of the stock of a business concern, i.e., minority shareholders, commonly seek to protect their investments by imposing restrictions on the ability of the majority shareholders to take certain actions without the minority’s consent. These are known as “negative controls” because they permit the minority shareholder to block corporate actions. Examples of such negative controls include restrictions on incurring debt, encumbering assets or paying bonuses to corporate officers and employees without the minority shareholder’s consent. A more fundamental and more common form of negative control is a restriction on selling the business or issuing new stock (which would have the effect of diluting the minority shareholder’s interests) without the minority’s consent. Negative controls are especially popular among venture capital companies, who often acquire only a minority interest and leave the founders in control to continue managing the business.
When acquiring a minority interest in a government contractor, negative controls can result in a finding of affiliation between the investor and the business under SBA’s above-quoted negative control affiliation rule. Depending on the size of the investor, this could render the small business ineligible to compete. Unfortunately, SBA’s negative control rule does not indicate whether any and all forms of negative control would lead to affiliation in SBA’s view. Read literally, the rule suggests that a supermajority voting requirement for even the most basic and corporate transaction would create affiliation. The effect of the rule, therefore, has been to dissuade investments in small business government contactors of less than a controlling share.
EA Engineering sheds light on the extent to which a minority shareholder may insist upon negative controls to protect its investment without running afoul of SBA affiliation regulations. The case involved a small business government contractor that was 49.5 percent owned by a large company known as LBG. While LBG held two of the five seats on EA’s board of directors, it did not otherwise place restrictions on the small business’ ability to establish compensation levels, make employment decisions for the corporate officers, incur debt, dispose of assets, or otherwise pursue related contracts. However, a stockholders agreement between LBG and EA contained a supermajority voting requirement for certain fundamental corporate transactions. Specifically, at least 67 percent of the outstanding shares (which is effectively a unanimous consent requirement in this case) were required to consent before EA could make changes to the charter or bylaws, issue additional shares of capital stock or enter into any business substantially different from the type of business engaged in by the company at the time of the agreement. These are typical restrictions that any prudent investor would require to protect its investment.
SBA’s area office determined that, under the stockholders’ agreement, LBG was able to assert negative control over EA via the supermajority requirement and therefore the two companies were affiliated. Due to SBA’s finding of affiliation, EA was considered other than small and ineligible for award.
On appeal to OHA, EA Engineering argued that the supermajority voting requirement did not amount to negative control because it affected only fundamental corporate changes and did not limit the small business’ ability to manage and control the day-to day operations. Agreeing with EA, OHA held that because the minority shareholder consent requirements did not affect EA’s operations, the supermajority requirements were not the type of negative controls contemplated by the negative control affiliation rule. OHA declared that any other ruling would create "a de facto prohibition on supermajority voting requirements, regardless of the degree of control they entail" and could "create a chilling effect on a small concern’s access to capital."
In coming to its decision, OHA reviewed its previous size determination decisions involving the negative control rule. In one prior case, the challenged small business could not make any of the following decisions without the minority shareholder’s approval:
- transfer or encumber its assets
- amend or terminate existing lease agreements
- purchase equipment
- increase employee compensation
- incur debts or obligations
In that case, OHA held that, due to the negative controls, the investor and the challenged small business were affiliated because the majority shareholder could not manage the business as it wished. In EA Engineering, OHA determined that such a scenario was not present as the negative controls did not affect any management decisions related to daily operations.
The Effect of EA Engineering
OHA’s analysis in EA Engineering is instructive to anyone considering an investment in a small business government contractor. OHA has now made clear that SBA’s affiliation regulations do not place a de facto prohibition on negative controls commonly used by investors who purchase a minority interest in a small business. Instead, SBA will consider the nature and extent of the controls in determining whether affiliation exists. Negative controls relating to day-to-day operations are likely to result in affiliation, while controls relating to fundamental corporate actions such as issuance of new stock or sale of the business will not result in affiliation.
The EA Engineering decision is encouraging for another reason. As noted, in his decision, Judge Pender stated that a de facto prohibition on all negative controls “would create a chilling effect on a small business concern’s access to capital.” In this regard, OHA displayed a sound understanding of the capital needs of small business government contractors and the harmful effect a narrow interpretation of the negative control rule would have on small business contractors’ access to capital. Unfortunately, as many commentators have argued, it appears the drafters of SBA’s recent re-certification rule did fully appreciate or understand the effect that rule would have on small business contractors’ access to equity capital. The re-certification rule has yet to be litigated before OHA (although one case is pending). EA Engineering would suggest that, in future decisions, OHA will interpret the re-certification rule with due regard to the capital needs of small business government contractors.