United States: New Decisions Clarify Small Business Minority Shareholder Protections

One of the easiest small business affiliation rules to apply is that a person that owns "50 percent or more of a concern's voting stock . . . controls or has the power to control the concern." 13 C.F.R. § 121.103(c)(1). It is far more difficult, however, for minority owners that own less than 50 percent of a concern's voting stock to determine what, if any, controls they can have over a small government contractor without jeopardizing their small business status. The Small Business Administration (SBA) has long held that minority owners may have negative controls to protect their investment without creating affiliation as long as the negative controls do not create control over day-to-day business operations. In recent cases, SBA's Office of Hearings and Appeals (OHA) has further clarified what specific arrangements may comply with that rule.

Generally, a minority owner will be found to control a concern if it can veto or block important business actions. For example, in Dependable Courier Services, Inc., SBA No. SIZ-2110 (1985), OHA found affiliation due to negative control where the minority shareholder could block disposal of corporate property, new debt obligations, amendment or termination of existing lease agreements, the purchase of equipment, or the increase of employee compensation. More recently, in Eagle Pharmaceuticals, Inc., SBA No. SIZ-5023 (Jan. 23, 2009), OHA held that an investor's ability to block the creation of debt and the payment of dividends supported a finding of negative control.

OHA further explained in EA Engineering, Science, and Technology, Inc., SBA No. SIZ-4973 (2008), that affiliation did not exist where a minority investor had the negative power to control only "extraordinary actions" of the concern, e.g., changing its Certificate of Incorporation or Bylaws, issuing additional shares of capital stock, or entering into a substantially different line of business. In other words, where a negative control does not affect a concern's day-to-day operations, OHA will not find affiliation.

These cases served as the baseline for minority-shareholder analysis until a pair of new cases expanded the list of allowable negative controls.

In Team Waste Gulf Coast, LLC v. United States, No. 17-1865C (Fed. Cl. Jan. 3, 2018), the Court of Federal Claims found affiliation where a minority owner held the power to block the payment of dividends, the removal or modification of a specific executive officer's compensation, and changes to a company's strategic direction. The Court found that, although veto power over substantial changes in lines of business did not rise to the level of negative control (as recognized in EA Engineering), a minority owner's broad power to block any changes to the company's strategic direction, including in currently existing lines of business, did.

Team Waste Gulf Coast was followed by OHA's decision in Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (Aug. 30, 2018), where OHA concluded that actions such as confession of a judgment or submission of a claim for arbitration are extraordinary actions that do not result in negative control because they put the company at risk of having to pay a claim. Similarly, OHA reasoned that amending the business's Operating Agreement or Articles of Organization to change the management of the Company are also extraordinary actions that do not result in negative control because such actions could completely restructure the company and seriously harm minority owners' interests.

So where does this line of cases leave minority owners and investors? It remains clear that budget, employee and compensation issues are a third rail, whereas limits on borrowing money and purchasing equipment – at least in the ordinary course – create affiliation risks. SBA has attempted to resolve the outstanding questions by producing a lengthy list of approved "extraordinary" actions that, at least based on the facts of those cases, do not constitute control. It is not clear, however, whether a lengthy list of controls over otherwise approved extraordinary actions would, by sheer quantity, nonetheless support a finding of control due to an analysis of the totality of the circumstances. As a result, minority investors should be careful to identify the controls that are important to their specific investment, and should not use a "more is better" approach.

The following list of negative covenants over extraordinary actions have been found by OHA to not result in a finding of control by minority investors:

  • Selling all or substantially all of a company's assets 1
  • Mortgaging or placing an encumbrance upon all or substantially all assets of a company 2
  • Engaging in any action that could result in a change in the amount or character of a company's contributions to capital 3
  • Changing the character of a company's business 4
  • Amending a concern's charter, bylaws, Operating Agreement, or the Articles of Organization 5
  • Taking an action in contravention of a concern's Operating Agreement 6
  • Commission of any act that would make it impossible for a company to carry on its ordinary course of business 7
  • Disposing of the goodwill of a company 8
  • Correcting a false or erroneous statement in a concern's Articles of Organization 9
  • Submitting a company's claim to arbitration 10
  • Confession of a judgment 11
  • Issuing additional stock 12
  • Entering into substantially different lines of business 13
  • Adding new members 14
  • Dissolving the company 15
  • Approving an increase or decrease in the size of the concern's Board 16
  • Approving an increase or decrease in the number of authorized interests, or reclassifying interests 17
  • Amending the operating agreement in any manner that materially alters the rights of existing members 18
  • Filing for bankruptcy 19

In contrast, OHA has found that the following ordinary actions give minority members control over the daily operations of a concern and thus result in a finding of negative control:

  • Payment of dividends 20
  • Forming a quorum of shareholders 21
  • Determining employee compensation 22
  • Ability to hire and fire executives 23
  • Broad power to block "any changes in the [company's] strategic direction" 24
  • Commission of any act that would alienate or encumber a concern's assets 25
  • Amending or terminating existing lease agreements 26
  • Purchasing equipment 27
  • Incurring debts or obligations 28
  • Making changes to the budget 29
  • Bringing or defending a lawsuit 30

To create an added layer of complication, there is also an important caveat with regard to Service Disabled Veteran Owned Small Businesses (SDVOSBs). Specifically, in a rule that took effect October 1, 2018, SBA explained that minority owners may only block majority owners of SDVOSBs from taking five "extraordinary" actions: (1) adding a new equity stakeholder; (2) dissolving the company; (3) selling the company; (4) merging the company; and (5) the company declaring bankruptcy. 31

SBA's new rule appears to be limited to SDVOSBs and not SDVOSB joint ventures, based on OHA's decision in Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (Aug. 30, 2018). Furthermore, based on the language in SBA's SDVOSB rulemaking, it remains unclear whether mentor protégé joint ventures are subject to the SBA's new rule. SBA's rulemaking limits the scope of the new rule to control of SDVOSBs by service-disabled veterans, explaining that:

SBA proposed to add a definition for "extraordinary circumstances" under which a service disabled veteran owner would not have full control over a firm's decision-making process, but would not render the firm ineligible as a firm owned and controlled by one or more service disabled veterans. This definition will be used to identify discrete circumstances that SBA views as rare. The new definition will be used to allow minority equity holders to have negative control over these enumerated instances. [ . . . ] These five circumstances are exclusive, and SBA will not recognize any other facts or circumstances that would allow negative control by individuals that are not service disabled.

In sum, while the language suggests that SBA's rulemaking was limited to SDVOSBs and not SDVOSB joint ventures, firms should tread carefully, as OHA has not fully weighed in on this topic and, as a result, it is not entirely clear whether SBA's new regulations apply to joint ventures or mentor protégé joint ventures.

Footnotes

1 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018); Size Appeal of Dooleymack Government Contracting, LLC, SBA No. SIZ-5086 (2009).

2 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

3 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018); Size Appeal of Dooleymack Government Contracting, LLC, SBA No. SIZ-5086 (2009) (finding that accepting additional capital contributions from a member was an extraordinary action).

4 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

5 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018); Size Appeal of EA Eng'g, Sci. & Tech. Inc., SBA No. SIZ-4973 (2008).

6 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

7 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

8 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

9 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

10 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

11 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018).

12 Size Appeal of EA Eng'g, Sci. & Tech. Inc., SBA No. SIZ-4973 (2008) (holding that requiring supermajority vote to amend the charter or bylaws, issue additional shares of capital stock, and enter into substantially different business served to protect the minority shareholder's investment and did not interfere with the majority owner's operation of the business).

13 Size Appeal of EA Eng'g, Sci. & Tech. Inc., SBA No. SIZ-4973 (2008).

14 Size Appeal of DHS Sys. LLC, SBA No. SIZ-5211 (2011); Size Appeal of Dooleymack Government Contracting, LLC, SBA No. SIZ-5086 (2009).

15 Size Appeal of Carntribe-Clement 8AJV # 1, LLC, SBA No. SIZ-5357 (2012).

16 Size Appeal of DHS Systems, LLC, SBA No. SIZ-5211 (2011).

17 Size Appeal of DHS Systems, LLC, SBA No. SIZ-5211 (2011).

18 Size Appeal of Dooleymack Government Contracting, LLC, SBA No. SIZ-5086 (2009).

19 Size Appeal of Dooleymack Government Contracting, LLC, SBA No. SIZ-5086 (2009).

20 Team Waste Gulf Coast, LLC v. United States, No. 17-1865C (Fed. Cl. Jan. 3, 2018) (finding negative control where minority owner has ability to block the payment of dividends).

21 Jensco Marine, Inc., SBA No. SIZ-4330 (1998) (OHA found affiliation because the large concern had the ability to prevent a quorum at shareholders' meetings).

22 Team Waste Gulf Coast, LLC v. United States, No. 17-1865C (Fed. Cl. Jan. 3, 2018) (ability to block an executive's removal or changes to the executive's compensation is a form of negative control); Size Appeal of DHS Sys., LLC, SBA No. SIZ-5211 (2011) (finding that minority shareholder's negative control over compensation committee was sufficient support for a finding of affiliation).

23 Team Waste Gulf Coast, LLC v. United States, No. 17-1865C (Fed. Cl. Jan. 3, 2018) (ability to block an executive's removal or changes to the executive's compensation is a form of negative control).

24 Team Waste Gulf Coast, LLC v. United States, No. 17-1865C (Fed. Cl. Jan. 3, 2018).

25 Size Appeal of Dependable Courier Services, Inc., SBA No. SIZ-2110 (1985).

26 Size Appeal of Dependable Courier Services, Inc., SBA No. SIZ-2110 (1985).

27 Size Appeal of Dependable Courier Services, Inc., SBA No. SIZ-2110 (1985).

28 Size Appeal of Dependable Courier Services, Inc., SBA No. SIZ-2110 (1985).

29 Size Appeal of Carntribe-Clement 8AJV # 1, LLC, SBA No. SIZ-5357 (2012).

30 Size Appeal of Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (2018) ("Confessing a judgment is not an ordinary action because doing so is not similar to bringing or defending a lawsuit since it ends litigation and puts a judgment on the record.").

31 SBA's new regulations were accompanied by the Department of Veterans Affairs' (VA) own rule amending its regulations and providing that the VA will follow the SBA's regulations governing Veteran-Owned Small Business (VOSB) Verification Guidelines.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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Authors
Damien C. Specht
Victoria Dalcourt
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