April 4, 2022
COURT OF FEDERAL CLAIMS PASSES ON CLARIFYING SDVOSB UNCONDITIONAL OWNERSHIP . . . FOR NOW
From time to time, the U.S. Court of Federal Claims will, as courts do, issue a decision that may leave heads scratching. Such it is with the Court’s decision in E&L Construction Group, LLC v. U.S.
On March 25, 2022, the Court examined an appeal by a federal government contractor (E&L Construction Group, LLC) of a decision by the U.S. Small Business Administration’s (SBA’s) Office of Hearings and Appeals (OHA) that found the contractor was not an eligible Service-Disabled Veteran-Owned Small Business (SDVOSB) because it was not unconditionally owned by a service-disabled veteran.
The SBA’s regulations at 13 C.F.R. 125.12 (which had previously been numbered 13 C.F.R. 125.9) require an SDVOSB to be at least 51% unconditionally and directly owned by a service-disabled veteran. In 2018, the SBA amended its SDVOSB regulations to include, at 13 CFR 125.11, a definition of “unconditional ownership:”
Unconditional ownership means ownership that is not subject to conditions precedent, conditions subsequent, executory agreements, voting trusts, restrictions on or assignments of voting rights, or other arrangements causing or potentially causing ownership benefits to go to another (other than after death [or] incapacity). The pledge or encumbrance of stock or other ownership interest as collateral, including seller-financed transactions, does not affect the unconditional nature of ownership if the terms follow normal commercial practices and the owner retains control absent violations of the terms.
(13 CFR 125.11.)
As it turns out, this definition largely mirrors a similar definition of unconditional ownership under regulations that the SBA issued in 2010 covering Women-Owned Small Businesses (WOSB’s) and in 1998 regulations covering small businesses in the SBA's 8(a) Business Development program, except that the definition in the WOSB regulation omits language excepting transfers on account of death or incapacity. (See 13 CFR 124.3, 13 CFR 127.201(b).) The definitions in the WOSB and 8(a) regulations, in turn, also mirror the definition of unconditional ownership that was once found in the U.S. Veteran Administration's (VA's) regulation at 38 CFR 74.3(b) covering SDVOSB's in the VA's programs. That VA regulation, like the SBA's 8(a) program regulation, does include language excepting transfers on account of death or incapacity.
As we discussed in a prior GovCon Bulletin™ article, NDAA 2017 streamlined the rules covering SDVOSB's under both VA programs and the SBA program by giving the SBA exclusive responsibility for formulating eligibility requirements under either programs. Consequently, in 2018, the VA regulation at 38 CFR 74.3 was changed to refer back to the SBA’s regulations under 13 CFR Part 125 for guidance on SDVOSB ownership requirements. Nevertheless, as we discuss below, the Court of Federal Claims jurisprudence addressing the definition of unconditional ownership under the prior version of 38 CFR 74.3(b) may be instructive since the language in that superseded VA regulation is nearly identical to the language in the current SBA regulation at 13 CFR 125.11 that now covers both the VA's and the SBA's SDVOSB programs.
Getting back to that SBA regulation, under a straightforward reading of the definition of unconditional ownership in 13 CFR 125.11, any condition or arrangement that may cause the transfer of ownership to another person or entity would seemingly violate the unconditional ownership requirement except in three circumstances: if the triggering event causing the transfer is death, if the triggering event causing the transfer is incapacity, or if the condition or arrangement is a pledge/encumbrance of ownership interest as collateral under “normal commercial” terms.
It would seem easy enough to apply this regulation then, but in E&L Construction, the Court ultimately declined to rule either in favor or against OHA on whether the unconditional ownership requirement under the SBA's regulation was met. The Court chose, instead, to remand the case back to OHA for further explanation. The Court’s review of OHA’s ruling is peculiar for a number of reasons.
In the first place, other than making a passing reference to an argument raised in the OHA proceedings about the contractor’s operating agreement, the Court never actually addressed the issues that were in contention in the case. Indeed, the Court did not even mention what it was about the contractor or its operating agreement that caused OHA to determine that the contractor was not unconditionally owned by a service-disabled veteran.
Only a reading of the OHA decision in the proceedings below (In re E&L Construction Group, LLC, SBA No. CVE-198-P (2021)) reveals that the contractor’s operating agreement that was in effect during the relevant time period contained several restrictions on the transfer of ownership by a service-disabled veteran owner.
In particular, the OHA’s decision pointed out a provision in the contractor's operating agreement that generally required transfers of an owner member’s interest in the company to be subject to the approval of a manager who could be replaced. Other provisions of the operating agreement that anticipated ownership transfers without the manager's approval, in turn, imposed other restrictions. For example, an owner member could sell his or her interest to a third party but only if the member first followed “right of first refusal” procedures that provided the company, and then other owner members, a right to acquire the owner’s interest. Another provision mandated involuntary transfers of an owner’s interest to the company upon the occurrence of certain events such as felony indictments or convictions. Lastly, another provision in the operating agreement permitted an owner member to retire or “withdraw from the company” but only with prior written approval of other members. OHA ultimately concluded that this provision, along with the right of first refusal and involuntary transfer provisions, placed significant restrictions on the service-disabled veteran owner’s ownership in the company.
Under a straightforward reading of the SBA’s regulation, the outcome in E&L Construction might have seemed obvious. But rather than review the issue of whether the contractor’s ownership interest, as documented in the relevant operating agreement, met the unconditional ownership requirements under the SBA’s regulations, the Court in E&L Construction fixated instead on OHA’s discussion of a pre-2018 OHA decision in In the Matter of Wexford Group International, Inc., SBA No. SDV-105 (2006).
The Wexford Standard
OHA decided Wexford in 2006, and thus, before the SBA amended its SDVOSB regulations to include a definition of unconditional ownership. Consequently, without any regulatory guidance, OHA in Wexford went straight to Webster’s dictionary for a plain meaning of “unconditional” and formulated the following standard:
[U]nconditional necessarily means there are no conditions or limitations upon an individual's present or immediate right to exercise full control and ownership of the concern. Nor can there be any impediment to the exercise of the full range of ownership rights. Thus, a service-disabled veteran: (1) Must immediately and fully own the company (or stock) without having to wait for future events; (2) Must be able to convey or transfer interest in his ownership interest or stock whenever and to whomever they choose; and (3) Upon departure, resignation, retirement, or death, still own their stock and do with it as they choose. In sum, service-disabled veterans must immediately have an absolute right to do anything they want with their ownership interest or stock, whenever they want.
(Wexford, SBA No. SDV-105 (2006).)
Applying this formulation, OHA decided in Wexford that ownership of shares held in an ESOP on behalf of owners was neither direct nor unconditional because the ESOP imposed right of first refusal requirements on the transfer of those shares.
To be clear, in the aftermath of Wexford, OHA and the SBA have repeatedly taken the position that unconditional ownership requirements leave little room for any kind of restriction on an owner's right to keep or sell his or her ownership interest like a right of first refusal. For example, in In re International Logistics Group, LLC, SBA No. VET-162 (2009), a transfer in ownership agreement gave two company officers a right of first refusal to buy a service-disabled veteran's shares and capped the price at which those share could be sold. The SBA argued that the provision placed restrictions on ownership and OHA agreed, concluding that the owner's ownership rights were conditional and encumbered and that the provision violated the SBA's SDVOSB regulation as construed by Wexford. Likewise, in In re Veterans Construction Services, Inc., SBA No. VET-167 (2009), the SBA and OHA found that a tag along provision, which required an owner to also arrange for the sale of a co-owner's interest before selling his shares, caused ownership to be conditional. And in In re Veterans Contracting Group, Inc., SBA No. VET-265 (2017), OHA agreed with the SBA in finding that a shareholder agreement that required a shareholder's stock to be sold to the company in the event of death or the shareholder's incompetency or insolvency imposed conditions that failed Wexford's formulation of unconditional ownership.
These cases were decided before the SBA amended its SDVOSB regulations in 2018 to explicitly define unconditional ownership. But in the SBA's 2010 WOSB Compliance Guide, published after the SBA issued its WOSB regulations that define unconditional ownership in nearly the same terms as those in its current SDVOSB regulations, the SBA reiterated that right of first refusal provisions cause ownership rights to be encumbered and conditional.
It is not surprising, therefore, that in the next SDVOSB case decided after the SBA amended its SDVOSB regulations to define unconditional ownership - In re Alog Corporation, SBA No. VET-285 (2020) - the SBA took this same position. In that case, OHA affirmed the SBA's determination that mandatory redemption provisions requiring an owner to sell his or her shares to the company and provisions prohibiting the transfer of shares to individuals who are not company employees violated the SBA's definition of unconditional ownership at 13 CFR 125.11. Indeed, in Alog, OHA made it clear that it viewed the SBA's definition of unconditional ownership to be nearly as absolute as the Wexford standard:
SBA later further defined unconditional ownership at 13 C.F.R. § 125.11, adding the exceptions for death, incapacity, and pledges of stock, but did not otherwise disturb the Wexford definition. 83 Fed. Reg. Thus, the definition of unconditional ownership is clear. The service-disabled veteran's ownership of the challenged concern must be unlimited, with no restrictions whatever on their ownership, or their ability to dispose of their shares in any way they choose. The exceptions are agreements dealing with the death or incapacity of a shareholder, and the pledge of stock as collateral if the terms follow normal commercial practices.
(In re Alog Corporation, SBA No. VET-285 (2020).)
To drive the point further, OHA concluded
The regulation provides for exceptions to unconditional ownership in terms of providing for a transfer of ownership in the event of death or incapacity, and for pledges of stock as collateral. Nothing in the regulation identifies any other exception to the requirement of unconditional ownership.
For its part, the Court of Federal Claims has taken a less direct approach to the issue of unconditional ownership in SDVOSB cases.
The Court examined the issue of unconditional ownership in Miles Construction, LLC v. U.S., 108 Fed. Cl. 792 (2013) (Miles I), which involved a contractor's SDVOSB eligibility under the VA's program and under the VA's regulation at 38 CFR 74.3 before it was amended to refer eligibility requirements to the SBA's SDVOSB regulations. As stated above, before it was amended, 38 CFR 74.3(b) described unconditional ownership in nearly the same terms as found in the definition in the SBA's current SDVOSB regulation:
Ownership by one or more veterans or service-disabled veterans must be unconditional ownership. Ownership must not be subject to conditions precedent, conditions subsequent, executory agreements, voting trusts, restrictions on assignments of voting rights, or other arrangements causing or potentially causing ownership benefits to go to another (other than after death or incapacity). The pledge or encumbrance of stock or other ownership interest as collateral, including seller-financed transactions, does not affect the unconditional nature of ownership if the terms follow normal commercial practices and the owner retains control absent violations of the terms.
(38 CFR 74.3(b)(pre-2018).)
In Miles I, the VA determined that right of first refusal provisions in an operating agreement that required an owner to offer first the company, and then other owners, the opportunity to purchase the owner's shares violated the VA regulation's definition of unconditional ownership. On the appeal to the Court of Federal Claims, the government arguing the VA's case apparently took the position that the right of first refusal provision violated the regulation because it constituted an executory contract. Whether this was the government's only argument is not clear. What is apparent is that the Court took it as an invitation to focus exclusively on whether right of first refusal clauses are "executory contracts" and failed to address whether they might constitute prohibited "conditions" or "other arrangements" under the VA regulation.
More striking, perhaps, is the Court's gloss on the regulation arising from the regulation's exception for collateral pledges or encumbrances that follow normal commercial practices. Finding that a "standard right of first refusal" provision is "[l]ike the encumbrance of veteran-owned stock as collateral," the Court surmised that its inclusion in an operating agreement is a normal commercial practice that does not hinder an owner's interest unless the owner receives an offer and chooses to sell. Miles I, 108 Fed. Cl. at 803. The Court, thus, seemingly not only overlooked that the regulation prohibited conditions that "potentially" cause ownership benefits to transfer to others, but also that the "normal commercial practice" exception by its terms applied only to collateral pledges and encumbrances. Indeed, in a later related case, the Court succinctly reiterated its conclusion that the VA regulation "substantially alters 'unconditional' to accommodate practical commercial arrangements while preventing ownership benefits from falling into the hands on non-veterans." Miles Construction, LLC v. U.S., 113 Fed. Cl. 174, 179 (2013) (Miles II).
The Court, in Miles I, also found unpersuasive the government's reliance on Wexford and OHA's subsequent SDVOSB decisions to support the argument that the right of first refusal provision in the case violated the VA regulation. The Court reasoned that those cases involved a "different regulation" - the SDVOSB regulation at what was then 13 CFR 125.9 - that was unlike the VA regulation, which contained "an extended definition of unconditional ownership." Miles I, 108 Fed. Cl. at 802.
Later, in Ambuild Co., LLC v. U.S., 119 Fed. Cl. 10 (2014), the Court of Federal Claims yet again rejected the VA's interpretation of its own SDVOSB regulations under 38 CFR 74.3 and disagreed with the VA's finding that two involuntary withdrawal provisions requiring a service-disabled owner to transfer his shares upon bankruptcy or insolvency, or under law or by order of a court, meant he was not an unconditional owner. The Court found both provisions permissible under the VA's unconditional ownership regulation, holding that the insolvency provision was "a standard commercial arrangement" and, quoting Miles I, that the provision requiring transfers under law or by court order concerned "'normal commercial practices' for doing business." (Ambuild, 119 Fed. Cl. at 25.)
After the Miles I and Ambuild decisions addressing unconditional ownership under the VA's regulations, the Court next examined SDVOSB unconditional ownership under the SBA's SDVOSB regulations in Veterans Contracting Group, Inc. v. U.S., 135 Fed. Cl. 316 (2017), a case filed by the contractor challenging the OHA decision discussed above in which OHA found provisions requiring the transfers of ownership shares upon death, incompetency, or insolvency violated the SBA regulation's unconditional ownership requirement. In Veterans Contracting Group, the Court rejected the contractor's reliance on Miles I and Ambuild because those cases interpreted the VA's regulation rather than the SBA's SDVOSB regulations, which had not yet been amended to include a definition of unconditional ownership. Ultimately, the Court of Federal Claims gave deference to OHA's decision applying the Wexford standard and affirmed the SBA's determination that the right of first refusal clause violated the SDVOSB regulation. The Court lamented, however, that the SBA's omission of a definition in its SDVOSB regulations (and, implicitly, the application of Wexford) produced, in that case, "draconian and perverse results." Veterans Contracting Group, 135 Fed. Cl. at 330.
Importantly, before reaching this conclusion, the Court of Federal Claims expressed its notion that the Wexford formulation for unconditional ownership was an "absolutist interpretation" that was a "sharp departure from the definitions promulgated via regulation in the 8(a) and WOSB programs." Veterans Contracting Group, 135 Fed. Cl. at 322. Explaining further, the Court stated that "the definitions in those programs build in nuances virtually identical to VA's definition, particularly the allowance to 'follow normal commercial practices' common to each of them." Veterans Contracting Group, 135 Fed. Cl. at 322.
Against this backdrop, E&L Construction presented the Court an opportunity to address, once and for all, unconditional ownership under the SBA's SDVOSB current regulations, as amended to define unconditional ownership and that are now controlling for both the VA and the SDVOSB programs.
Back To E&L Construction
It should be noted that E&L Construction involved the eligibility of a contractor for SDVOSB status in the VA's program. In its review of OHA's decision, which held that an operating agreement's right of first refusal, involuntary transfer, and member withdrawal provisions precluded a service-disabled veteran's ownership from being unconditionally owned, the Court of Federal Claims recited the OHA's analysis nearly in its entirety.
In that chronological analysis, OHA first recited the requirement under 13 CFR 125.12 (formerly 13 CFR 125.9) that an SDVOSB must be at least 51% "unconditionally" and directly owned by a service-disabled veteran. OHA next explained that this requirement was construed under Wexford and quoted Wexford's standard, which precludes any conditions or limitations on an individual's ownership and on any impediments to the exercise of ownership rights. OHA then cited its post-Wexford cases in which it had "consistently applied the Wexford standard."
OHA did not leave it there, however. OHA noted next the amendment to the SBA's regulations in 2018 defining unconditional ownership, before quoting the regulation's definition. In explaining how this definition compared to the formulation in Wexford, OHA stated that the regulation "add[ed] the exceptions for death, incapacity, and pledges of stock as collateral if the terms follow normal commercial practices, but did not otherwise disturb the Wexford definition." (E&L Construction Group, LLC, SBA No. CVE-198-P (2021).)
OHA concluded its analysis with an assessment of the meaning of the regulation's definition:
The definition of unconditional ownership is therefore clear. The Service-Disabled Veteran's ownership of the challenged concern must be unlimited, with no restrictions whatever on their ownership, or their ability to dispose of their chares in anyway they choose. The exceptions are agreements dealing with the death, incapacity or bankruptcy of a shareholder, and the pledge of stock as collateral if the terms follow normal commercial practices. It is important to note that the exception the regulation carves out for “normal commercial practices” is limited to provisions involving the pledge of an ownership interest as collateral.
(In re E&L Construction Group, LLC, SBA No. CVE-198-P (2021).)
In other words, in OHA's view, the definition in the SDVOSB regulations requires unlimited and unrestricted ownership, with only a few enumerated exceptions. Importantly, OHA also clearly expressed its view that the "normal commercial practices" language was not a broad exception swallowing the rule, but rather was to be read literally and applied only to pledges of stock or ownership interests as collateral. Consequently, "[a]pplying the regulations to [the] case," OHA concluded that the "Operating Agreement places significant limitations on [the service-disabled veteran's] ownership."
Oddly, OHA's conclusion notwithstanding, in its review of OHA's decision, the Court of Federal Claims construed OHA's comparison of the regulation's definition to Wexford as an application of the Wexford standard itself. Indeed, the Court's remand to OHA directed it to provide "further explanation for the legal basis for applying the Wexford definition." In fact, however, in its decision OHA seemingly rejected an invitation to connect its ruling to Wexford. In the OHA proceedings, the contractor argued that the Wexford standard was superseded by the adoption of the SBA regulation defining unconditional ownership. The contractor argued that OHA should, therefore, rely on Miles I as precedent and find that any limitation on ownership that follows "normal commercial practices" does not change the unconditional nature of ownership. Declining to rely on any "precedent," OHA instead, again, pinned its ruling on the language in the regulation's definition:
[T]he regulation includes the broad language in its definition of “unconditional”, making clear that there must be no limits on the Service-Disabled Veteran's ownership interest. As already noted, the exceptions the regulation carves out for “normal commercial practices” are limited to provisions involving the pledge of an ownership interest as collateral.
(E&L Construction Group, LLC, SBA No. CVE-198-P (2021).)
It would not be surprising, therefore, that on remand OHA may clarify that its holding is not based on the Wexford standard at all.
However OHA responds, it should be expected that any further explanation by OHA will reiterate the SBA's position that provisions like right of first refusal clauses violate the unconditional ownership requirements for SDVOSB's as set forth in the definition contained in SBA's amended SDVOSB regulation. At that point, the Court of Federal Claims will likely either walk back or double-down on the seemingly bottomless exception for arrangements that constitute “normal commercial practices” that it created in its jurisprudence under the old VA regulation at 38 CFR 74.3. Until then, small businesses and their consultants and advisors are left with OHA's decision and a sense of uncertainty about how the Court may construe the SBA's SDVOSB regulation.