The District Court for the Eastern District of Virginia denied a subcontractor’s motion for temporary restraining order and preliminary injunction because the subcontractor sought to enforce an illegal contract that violated SBA 121.103 and SBA 125.6(a). The dispute arose from a loan servicing support contract that was set aside for socially and economically disadvantaged small business concerns. The incumbent contractor no longer qualified as an SDB due to its increased revenues, so it approached an SDB janitorial and maintenance firm about submitting a joint bid. The parties entered into a teaming agreement where the SDB would serve as the prime contractor and the incumbent would act as a subcontractor and provide key services such as information technology support. After contract award, the parties entered into a subcontract agreement. When the prime contractor attempted “to squeeze out” the subcontractor from participating in the prime contract, the subcontractor sought to enjoin the prime from withholding payments allegedly due under the subcontract and require the prime to restore the subcontractor’s access to a joint account.

Ostensible Subcontractor

However, a court cannot enforce an illegal contract, and the loan servicing support contract was an “agreement conceived in fraud.” The parties deliberately procured a government contract that violated applicable federal regulations, including SBA 121.103 and SBA 125.6(a), and they were not eligible for the contract under those regulations. Under SBA 121.103(h)(4), “[a] contractor and its ostensible subcontractor are treated as joint venturers, and therefore affiliates, for size determination purposes.” The Small Business Administration uses a seven-part test to determine whether a small business is unusually reliant on its subcontractors, and here, six of those factors weighed heavily in favor of a finding of undue reliance. The subcontractor had equal management rights; it had the requisite background and expertise to carry out the contract; it was the party that “chased the contract”; the parties collaborated on the bid; the parties contemplated a relationship where the subcontractor would perform a relatively large share of the contract; and the subcontractor was the party that would perform the more complex and costly contract functions. A review of SBA precedent confirmed that the loan servicing support contract violated the “ostensible subcontractor” rule, and as a result, the parties were affiliates and ineligible for award.

50% Rule

Further, the parties did not comply with the “50% Rule” of SBA 125.6(a), which requires the SDB to perform at least 50 percent of the cost of the contract incurred for personnel with its own employees. A letter from a Certified Public Accountant stated the actual costs incurred by the parties did not meet “either the intent or letter” of the 50% Rule, and the parties’ expense reports showed the subcontractor incurred approximately 62 percent of the parties’ labor costs in one fiscal year and approximately 59 percent of the labor costs in another fiscal year. Since the prime was affiliated with the subcontractor under SBA 121.103, it was an other-than-small business concern, and because the prime’s certification that it was a small business concern was false, the parties’ bid was fraudulent at the time it was made. The court also held the parties’ subcontract was unenforceable and the requested relief was barred by the doctrine of unclean hands. (Morris-Griffin Corp. v. C & L Service Corp., DC ED Va, 54 CCF ¶79,415)

— October 18, 2010 – Walters Kluwer Law and Business