August 11, 2015

When Is One Pie Actually Two Pies? The Court of Federal Claims Upholds the Small Business Administration's Hardline Approach to Small Business Stock Ownership Requirements

5 min

Small business owners holding specific classes or series of stock in their companies should be aware that issuance of more than one class or series of stock could affect whether they meet the "ownership" requirements for purposes of small business contracting program eligibility.

The United States Court of Federal Claims in Precise Systems, Inc. v. United States recently issued a bid protest opinion regarding the ownership requirements for a service-disabled veteran-owned (SDVO) small business with an employee stock ownership plan (ESOP). The opinion has important implications not only for SDVO small businesses, but also other classes of small businesses with similar ownership requirements, such as participants in the 8(a) business development program, and women-owned and economically-disadvantaged women-owned small businesses. Any businesses that participate in Small Business Administration (SBA) programs such as these should be aware of how this decision affects their continued eligibility and ability to offer stock ownership plans to their employees.

The Court Affirms the SBA's "Hardline Approach" to Stock Ownership

At issue in the case was the SBA's interpretation of 13 C.F.R. § 125.9(d), which concerns the stock ownership requirements for an SDVO small business corporation:

In the case of a concern which is a corporation, at least 51% of the aggregate of all stock outstanding and at least 51% of each class of voting stock outstanding must be unconditionally owned by one or more service-disabled veterans.

The company whose contract award was challenged in the protest maintained what it termed two "series" of stock: Series A Common Stock and Series B Convertible Preferred Stock. The service-disabled veteran owner of the company owned at least 51% of all stock outstanding, but all of his ownership was in Series A Common Stock, while the ESOP held all of the Series B Convertible Preferred Stock on behalf of employees of the company.

Notably, the Series A and Series B stock carried equal voting rights of one vote per share. There were, however, differences between them. As the court noted, Series B shareholders were entitled to cumulative preferential dividends and to convert their shares to Series A (there was no reciprocal right for Series A shareholders), and only Series B shares were subject to redemption by the company. Additionally, if the company wished to pay a dividend to the shareholders of only one series of stock, the consent of the shareholders of a majority of the shares in the other series was required. Finally, the Series B stock had to meet various requirements under the Internal Revenue Code applicable to ESOPs, while there were no such restrictions on Series A stock.

The SBA's Office of Hearings and Appeals (OHA) affirmed a decision by the SBA's Acting Director of Government Contracting that the company did not satisfy the ownership requirements of 13 C.F.R. § 125.9(d). While the service-disabled veteran owner did own "at least 51% of the aggregate of all stock outstanding," he did not own "at least 51% of each class of voting stock outstanding." OHA found that (1) the plain meaning of "common stock" and "preferred stock" supported a class distinction; (2) even if the definitions themselves were not dispositive, the two series were not "functionally equivalent" and thus should be viewed as separate classes; and (3) OHA would not consider the materiality of those distinctions because that was irrelevant for its purposes. In the absence of any express regulatory guidance as to the definition of a "class" of stock, the Court of Federal Claims upheld OHA's "hardline approach," and as a result the service disabled veteran was determined not to be the owner of the business concern, notwithstanding the fact that he owned at least 51% of the aggregate of all stock outstanding.

What This Means for You

Stock ownership requirements like those discussed above are not unique to the SDVO program. Indeed, closely similar language appears in the regulations regarding the SBA's 8(a) business development program, as well as those for women-owned and economically disadvantaged women-owned businesses. See 13 C.F.R. §§ 124.105(d), 127.201(f). Thus, any small business participating in such programs should take a close look at its capital structure, including any ESOPs, to ensure that it complies with the hardline approach adhered to by the SBA and now affirmed by the Court of Federal Claims.

Neither the court's nor OHA's decision elucidated the circumstances under which there could be a functional equivalence among different classes of stock, but OHA's consideration of the question suggests that it is possible for two series of stock to be considered functionally equivalent and therefore not different classes if there are merely administrative, superficial, or non-substantive differences. Additionally, OHA's examination of state law may leave open the possibility that if state law is dispositive as to what constitutes a separate class of stock, the SBA might defer to that definition. That raises the specter of non-uniform decisions, however, and it remains to be seen whether the SBA would be willing to accept that outcome.

If you have any questions about the ownership requirements for your small business, please contact Keir Bancroft, John Wilhelm, Nathaniel Canfield, or any of the other attorneys in Venable's Government Contracts Group or Employee Benefits and Executive Compensation Group.