The GovCon Bulletin™
SDVOSB Unconditional Ownership: E&L Construction Revisited and Rights of First Refusal
As we mentioned in our last GovCon Bulletin™ article, the SBA recently finalized its regulations that cover its new VOSB and SDVOSB certification program. Those regulations, which become effective on January 1, 2023, not only set out the procedural steps that small businesses have to take to become certified, they also make significant changes to the eligibility requirements. One change, for example, revises the definition of unconditional ownership.
Under the SBA’s SDVOSB regulations, an SDVOSB must be at least 51% directly and unconditionally owned by one or more service-disabled veterans. The regulations, in turn, currently define “unconditional ownership” to mean –
[O]wnership 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 of 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.
As we wrote about in a prior GovCon Bulletin™ article, earlier this year in March 2022, the Court of Federal Claims (COFC) in E&L Construction Group, LLC v. U.S had the opportunity to decide whether a limited liability company’s operating agreement, which imposed certain restrictions on the transfer of a member’s ownership interest including by granting a right of first refusal to other owners, contravened this definition. As we discussed in our article, in earlier decisions addressing a similar definition of “unconditional ownership” under the VA’s now-rescinded regulations covering the VA’s SDVOSB program, the COFC construed the definition in the VA’s regulations to permit rights of first refusal because, in the court’s view, inclusion of rights of first refusal provisions in organizing documents is a normal commercial practice.
In E&L Construction, however, the Court held back from applying this rationale to the definition in the SBA’s SDVOSB regulations. Instead, the COFC remanded the case back to the SBA’s Office of Hearings and Appeals (OHA) for further explanation of OHA’s decision in the proceedings below. In those proceedings, OHA found that the LLC operating agreement at issue in the case violated the unconditional ownership requirement under the SBA’s SDVOSB regulations.
In more recent developments since March, OHA, on remand, explained that the definition of unconditional ownership under the SDVOSB regulations was borrowed from the SBA’s 8(a) Business Development (8(a) BD)) program and that the definition left no room for any conditions on the ownership interests of eligible owners. OHA explained further that the exception under the SBA’s 8(a) BD program for terms that follow “normal commercial practices” that was incorporated into the SBA’s SDVOSB regulation is limited only to pledges or encumbrances of an ownership interest as collateral. Ultimately satisfied with OHA’s explanation, the COFC, in a subsequent opinion decided last August, upheld OHA’s determination that the operating agreement at issue in the case failed to meet the unconditional ownership requirements under the SDVOSB regulations.
With the SBA having persevered in its sustained effort in E&L Construction to prevail upon the COFC to affirm its finding that the operating agreement, which granted a right of first refusal to other owners, violated the SDVOSB regulation’s unconditional ownership requirement, it might at first glance seem odd that the SBA would, less than four months later, turn around and add a new exception to the SDVOSB unconditional ownership requirements for grants of rights of first refusal. Specifically, the SBA’s revised SDVOSB regulations that become effective on January 1, 2023 now state –
A right of first refusal granting the non-qualifying-veteran the contractual right to purchase the ownership interests of the qualifying veteran, does not affect the unconditional nature of ownership, if the terms follow normal commercial practices.
To be clear, the LLC operating agreement in E&L Construction contained other conditions on ownership interest transfers besides a grant of right of first refusal to other owners. But it seems that what may have driven the SBA to “go to the mat” in E&L Construction, as much as anything else, was an aspiration to shut the door on the judicially created and seemingly limitless exception for ownership restrictions considered to be “normal commercial practices” that underpinned the COFC’s earlier rulings that found right of first refusal clauses permissible under the VA’s rescinded unconditional ownership regulations. In any event, in light of the COFC’ s deference to the SBA in E&L Construction, after the new SDVOSB regulations become effective, the only two exceptions to unconditional ownership that contractors may rely on are for arrangements that constitute stock collateral pledges that follow normal commercial practices and grants of rights of first refusal that follow normal commercial practices.