Watch Your Step: Avoiding False Claims Act Violations from Limitations on Subcontracting and Performance of Work Requirements

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By Matthew Feinberg

Members of the government contracting community are familiar with the contracting opportunities offered specifically to small and disadvantaged businesses through the U.S. Small Business Administration’s (SBA) 8(a) Business Development, Mentor-Protégé, and various set-aside programs (such as those available for service-disabled veteran-owned small businesses (SDVOSB) or women-owned small businesses). The availability of small business and other set-aside contracts offers important opportunities for small businesses to grow without competing against mega companies with endless resources. However, certain requirements for performing contracts under these programs can cause confusion and even liability under the False Claims Act (FCA) for contractors, subcontractors, and even sureties who don’t watch their steps throughout contract performance.

Background

The Small Business Act (the Act) codifies federal policy to promote the growth of small businesses through preferential award of procurement contracts. It also authorizes the SBA 8(a) Business Development Program, which is intended to help “eligible small disadvantaged business concerns compete in the American economy through business development.” According to the SBA, “once certified, 8(a) program participants are eligible to receive federal contracting preferences and receive training and technical assistance designed to strengthen their ability to compete effectively in the American economy.” Often, small and moderately sized federal construction contracts are set aside for small businesses under one or more of the SBA’s available programs.

In order to accomplish the goal of promoting small business growth, the Act also includes limitations on subcontracting provisions. The limitations on subcontracting provisions generally require that the prime contractor under a set-aside contract perform work amounting to a specific percentage of the overall cost of the contract to the government. These requirements seek to prevent small businesses from becoming pass-through vehicles for large businesses.

Currently, the SBA regulations generally require (with some exceptions) that the amount paid by the government on any contract awarded under a small business set-aside program—including contracts awarded to joint ventures (JV) or mentor-protégé JVs—is allocated at least as follows:

  • 50% to the prime contractor for small business set-aside contracts,
  • 50% to the prime contractor for 8(a) contracts, and
  • 40% to the prime contractor for mentor-protégé JVs.
  • If the contract is for a construction project, the prime contractor in any instance is required to perform work valued at no less than 15% of the total cost of the project.

Notably, subcontracts issued to “similarly situated entities”—for example, entities with the same socioeconomic classification as the prime contractor that are small under the North American Industry Classification System (NAICS) code assigned to the prime contractor’s procurement—may be counted towards the prime contractor’s performance calculation. And these limitations calculations may apply differently depending on if the contract has a services or supplies NAICS code. Further adding to the confusion, the sections of the Federal Acquisition Regulation (FAR) addressing limitations on subcontracting were recently amended, effective September 10, 2021. Prior to that time, the FAR included its own limitations on subcontracting rules. If a contractor entered into a contract prior to September 10, 2021, and the former rules were incorporated into the contract, then they remain a contractual obligation unless later made subject to a modification with the government.

The metrics of the limitations on subcontracting get even more complicated when an 8(a) small business and non-small business enter a joint venture eligible for the award of 8(a) contracts. For instance:

  • The parties must abide by the internal performance of work requirements, which require that the 8(a) firm must perform at least 40% of the work performed by the joint venture.
  • Additionally, because the JV is considered an 8(a) entity, the JV is also subject to the limitations on subcontracting applicable to 8(a) firms in general.
  • Thus, under the limitations on subcontracting rules, the JV itself can only subcontract out a certain percentage, depending on the nature of the work performed, of the cost of the contract; additionally, under the internal performance of work requirements, the 8(a) member must perform at least 40% of the work that the JV did not subcontract out.
  • If the joint venture is between a mentor and protégé, the protégé must perform at least 40% of the work performed by the joint venture and cannot include work subcontracted to a similarly situated entity in that calculation.

These requirements represent a veritable minefield, particularly on a complicated construction project with many subcontractors. But they are critical to understand. The United States Court of Federal Claims has held that the limitations on subcontracting clause is a material portion of a contract. And the SBA considers violation of the subcontracting limitations to be potential grounds for debarment from future federal contracting. Finally, the Department of Justice (DOJ) has not only pursued contractors under the FCA for violating this clause, but also has expressly stated its intent to continue to pursue investigations, initiate litigation, and/or bring charges for such violations. The FCA imposes hefty penalties for violations (including treble damages and statutory penalties that can be calculated on a per-invoice basis).

Without a doubt, the responsibility for complying with these complicated requirements falls on the contractors performing the work (both prime contractors and subcontractors). But sureties bonding these construction projects also can find themselves in the cross-hairs. Some recent FCA lawsuits filed by whistleblowers have named sureties as defendants. In theory, the prime contractor’s underlying failure to comply with the limitations on subcontracting requirements for its contract represents a breach of that contract. Thus, the argument follows, a surety with knowledge of the breach is obligated to pay the government pursuant to the bond, and the failure to do so allegedly violates the FCA. In other instances, sureties have been accused of conspiring with the prime contractor to violate the FCA when the surety allegedly knew or had reason to know of the prime contractor’s breach of the underlying contract and did not intervene to force the prime contractor into compliance. To date, federal courts have not officially determined whether these types of arguments hold water from a liability standpoint, but the risk of a surety being named as a defendant in an FCA suit remains significant.

Notable FCA Cases

Recent FCA litigation activity offers a glimpse into these issues. Last year, the DOJ announced a settlement to resolve allegations that a non-small business “violated the False Claims Act by fraudulently obtaining construction contracts reserved for disadvantaged small businesses.” The DOJ alleged that a non-small business and 8(a) small business entered a JV agreement. The JV successfully secured an 8(a) set-aside award on a Multiple Award Construction Contract at Scott Air Force Base in Illinois. Notwithstanding internal performance of work requirements, the non-small business managed the JV and used its own employees to complete nearly all the work the JV performed. Although the non-small business did not admit liability in the settlement, it did pay $400,000.00 to resolve the allegations. The Special Agent in charge of the Air Force Office of Special Investigations (OSI) specifically cautioned:

The Department of the Air Force takes the protection of federal SBA set-aside funds seriously, especially when abuses impact the military’s warfighting capability. . . . OSI along with our joint partners are dedicated to protecting the integrity of government procurement practices from fraud, waste and abuse while ensuring those who violate the law are held accountable.

This settlement follows an earlier case in which an 8(a) program mentor agreed to pay an FCA settlement of $928,000.00. There, again, a large construction company mentor and 8(a) small business entered an SBA-approved JV to bid on set-aside contracts. In addition to allegations that the businesses did not form a qualifying JV and thus were ineligible to jointly bid on 8(a) contracts, the DOJ alleged that the large business’s relationship with the 8(a) business violated the terms of a set-aside contract awarded to the small business, which required the 8(a) small business to perform at least 15% of the cost of labor on the contract. There, the SBA General Counsel warned as follows:

SBA has no tolerance for waste, fraud or abuse in any government contracting program and is committed to working with our federal partners to ensure the benefits of these programs flow to the intended recipients.

In a separate case, Scollick v. Narula, pending since 2014 and still active, a whistleblower claimed that a large group of defendants conspired to obtain federal construction contracts set aside for SDVOSBs, small businesses operating in Historically Underutilized Business Zones (HUBZones), and 8(a) companies, despite not qualifying for those types of contracts. The whistleblower also claimed that the bond producer who helped procure the bonds and the sureties issuing the bonds on the projects were liable under the FCA because: (a) the fraud would not have been possible if the sureties had declined to issue the bonds, thus the sureties played an integral role in the prime contractors’ fraudulent activities; (b) the sureties allegedly knew that the prime contractors were shell companies that did not qualify for the set-aside contracts, but issued the bonds anyway; and (c) when the sureties discovered that the prime contractors were not eligible for the set-aside contracts and therefore had breached their government contracts, the sureties did not pay the government pursuant to the bonds. The bond producer and sureties challenged all of these claims through various motions to dismiss and other filings, but the United States District Court for the District of Columbia preliminarily allowed the whistleblower to pursue them. The case remains pending, the claims are subject to new challenges from the bond producers and sureties, and the court is expected to weigh in again on the issues sometime in 2022. The Scollick case does not involve performance of work requirements. Nevertheless, it, and cases like it, have inspired a number of whistleblowers to pursue FCA claims against bond producers and sureties in recent years on a wide range of issues related to performance of government construction contracts; and it is expected that trend will continue for the foreseeable future.

Conclusion

Plainly, the DOJ, the SBA, and federal investigative agencies remain committed to ensuring that those who participate in 8(a) and other set-aside contracts at any level (prime contractors, subcontractors, and sureties) do so honestly and fairly. Although the FCA imposes a “knowing” or “reckless” standard for violations, the inherent complications of calculating and maintaining the limitations on subcontracting and internal performance of work requirements can easily form a trap for the unwary. It is essential that contractors, subcontractors, and sureties on small business set-aside contracts keep these requirements in mind and monitor contractor performance of work throughout these contracts.

Matthew Feinberg is the Practice Group Chair for PilieroMazza’s Litigation & Dispute Resolution Group and Co-Chair of the Firm’s False Claims Act and Audit & Investigations Team. He has significant first-chair trial and appellate experience over a wide range of practice areas, including False Claims Act, labor and employment; wage and hour disputes; business litigation, including business torts, unfair competition, trade secrets, and non-compete and non-solicitation disputes; shareholder direct and derivative litigation; securities fraud defense; government and private sector contracts; commercial transactions; and appeals. He can be reached at mfeinberg@pilieromazza.com or 202.655.4177.