On April 27, 2023, the Small Business Administration (SBA) issued a final rule, finalizing a September 9, 2022 proposed rule, and making a myriad of changes to the Small Business Regulations. Those changes are effective at the end of this month, on May 30, 2023. We will be covering a number of those changes in upcoming posts. But for now, we’re focusing on a change that will make some contractors very happy and other contractors very worried: real, negative consequences for small businesses that fail to comply with 13 CFR 125.6, which governs subcontracting limitations for small business set-aside contracts over the simplified acquisition threshold (presently defined in FAR 2.101 as $250,000).

For those of you who may need a refresher, 13 CFR 125.6 sets forth limits on the amount of work a small business prime contractor can subcontract on a set-aside contract. These limitations depend on the nature of the contract. For example, for general construction contracts, the small prime may not subcontract out more than 85 percent of the amount paid by the government to the small business prime; but in the case of other service contracts, the maximum amount permitted is 50 percent. Subcontracts to similarly situated entities (SSEs) (i.e., subcontractors that themselves would be eligible to compete as a prime for the set-aside contract at issue) do not count toward the limit. So, for example, if an 8(a) prime on an 8(a) set-aside subcontracts to another 8(a) company, that would be a subcontract to a SSE that would not count toward the limit. This can become a tricky issue, though, if the SSE/subcontractor itself enters into any subcontracts or if subcontracting NAICS codes are involved.  The purpose of the regulation is to stop excessive “pass-through” contracting. Given that the whole point of setting contracts aside for small or certain types of small businesses is to keep government payments flowing to small businesses, the government does not want small business primes to turn around and subcontract out the whole contract to large businesses. This would divert all those government dollars meant for small businesses to large businesses and negate the whole purpose of setting contracts aside in the first place. Enter 13 CFR 125.6.

As many contractors know, though, not all small business primes comply with this regulation. And the problem, until now, is that those rogue contractors suffered little to no negative consequences in connection with their flagrant violations. Compliance with 125.6 is not considered a matter of eligibility, so it generally has been deemed inappropriate to raise a competitor’s lack of compliance as a basis for a size or status protest. Moreover, unless it is clear on the face of a proposal that the small business prime cannot comply with this regulation (which, GAO finds, it almost never is absent verbiage tantamount to an explicit admission), bid protests based on prospective violations of 125.6 typically don’t succeed, either. Consequently, many compliant contractors—especially those with competitors prone to winning contracts out from under them while flagrantly violating this regulation—have been left wondering what the point of the regulation was at all.

Well, the SBA apparently agreed that something had to change. September’s proposed rule suggested “add[ing] a new 125.6(e) to provide consequences to a small business where a contracting officer determines at the conclusion of performance that the business did not meet the applicable limitation on subcontracting on any set-aside contract.” Specifically, in such a situation, the proposed rule actually prohibited a contracting officer from giving a satisfactory/positive past performance evaluation to a small business prime that failed to comply with 125.6. During the comment period, some commenters suggested that this was a tad harsh.  They recommended that there be some wiggle room for contractors that, through no fault of their own, might fail to meet the requirements. In response, the final rule is more lenient, but only just barely so.

Under the new regulation, if at the conclusion of performance on a set-aside contract the contracting officer determines that the prime did not meet the applicable limitation on subcontracting, he or she may not give a satisfactory or higher past performance rating for the appropriate factor or subfactor in accordance with FAR 42.1503, unless the contractor can establish mitigating circumstances or demonstrate that its failure to meet the applicable limitation on subcontracting requirement was beyond its control. The new regulation explains that “extenuating or mitigating circumstances” include things such as “unforeseen labor shortages, modifications to the contract’s scope of work which were requested or directed by the Government, emergency or rapid response requirements that demand immediate subcontracting actions by the prime small business concern, unexpected changes to a subcontractor’s designation as a similarly situated entity, differing site or environmental conditions which arose during the course of performance, force majeure events, and the contractor’s good faith reliance upon a similarly situated subcontractor’s representation of size or relevant socioeconomic status.” The regulation warns that in assessing extenuating or mitigating circumstances “[a]n agency cannot rely on any circumstances that were within the contractor’s control, or those which could have been mitigated without imposing an undue cost or burden on the contractor.” In other words, if at the end of contract performance a contracting officer finds that a small business prime has violated 125.6, that small business prime better be able to jump through some major hoops to prove that its noncompliance was in no way, shape, or form avoidable. Otherwise, the contracting officer will have no option but to assign a negative CPARS rating.

For those contractors that have spent years frustrated by competitors that ignore or make only performative attempts to comply with 125.6, this is great news! True, the new regulation still doesn’t provide contractors with a basis to protest a competitor that runs afoul of the subcontracting limitations (though you never know what other related protest basis you and your attorney might be able to find). Nonetheless, negative CPARS ratings will impact that competitor’s past performance in a way that hopefully knocks them out of the running for award in the first place. That is certainly an improvement and will be appreciated by those contractors that have remained steadfastly dedicated to compliance all along. On the other hand, for those contractors that have perhaps been a little more relaxed in their approach to compliance, this might not be welcome news.  If you fall into that camp, let this serve as your warning to change your ways now. And if you’re one of the contractors that have always tried hard to comply but still remain confused about how to calculate workshare percentages, how to identify SSEs, or how to determine once and for all if you are under the limitation thresholds, this is your wake-up call! It’s not just you – determining compliance with 125.6 can be a complicated issue that requires a detailed legal analysis. With the new regulation looming, now is the time to do a compliance deep-dive and ensure you are not exposed. Do it now, before your confusion impacts your next CPARS rating and limits your ability to get future work.