Blog

Recently, the Small Business Administration ("SBA") issued a proposed rule, which could significantly alter the status quo for permissible negative control. Impacted small businesses and their minority shareholders and investors should consider submitting comments to ensure that SBA's final rule provides sufficient clarity and flexibility so as not to upend current common practices when drafting operating agreements or stifle investment. Comments on the proposed rule are due on or before October 7, 2024.

Prior to diving into the proposed rule and its ripple effect, a recent SBA Office of Hearings and Appeals ("OHA") decision warrants discussion. In VSBC Appeal of Snowfensive, LLC, SBA No. VSBC-368-A (2024), a small business, appealed an Area Office decision to deny its application for SDVOSB certification on the grounds that the SDV did not fully control the company because the operating agreement said that amendments to it required unanimous consent. During the appeal proceedings, OHA requested comments from SBA on whether "amending an operating agreement should be considered a type of 'extraordinary circumstance' within the meaning of the SDVOSB rules [which includes five circumstances]." SBA said it shouldn't be considered a type of extraordinary circumstance (discussed below), while the appellant said it should.

In denying the appeal, OHA said that appellant's position (the provision was allowed) lacked support in SBA's regulatory history, wherein "SBA made clear that '[t]hese 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.'" OHA further rested its conclusion on the fact that "SBA considered, and specifically rejected, a proposal to broaden the list to include amendment of an operating agreement." In OHA's view, it was therefore clear that SBA did not intend that unanimous consent to amend operating agreements would constitute an "extraordinary circumstance" over which a non-SDV may exert control. Notably, OHA confirmed this issue (and Snowfensive's holding) just two months later in VSBC Appeal of Facekay LLC, SBA No. VSBC-388-A (Sept. 3, 2024).

Turning back to the proposed rule, and among other things, SBA proposes to clarify its negative control affiliation rules.

In prefatory comments, SBA recognized that while its negative control affiliation regulation does not list any "extraordinary circumstances" (which typically have derived from OHA caselaw) that would not give rise to negative control affiliation, the SDVOSB program rule nevertheless includes five such circumstances. To fix the inconsistency in its regulations, SBA proposes to add new language to its negative control rule under 13 C.F.R. § 121.103(a)(3) to clarify that a minority shareholder does not have impermissible negative control where its consent is required to (1) add a new equity stakeholder; (2) dissolve the company; (3) sell the company or all assets of the company; (4) merge the company; (5) declare bankruptcy; and (6) amend the company's governance documents to remove the shareholder's authority to block any of (1) through (5).

To further promote consistency across its socio-economic programs, SBA likewise proposes to add the same language to new 8(a) and WOSB rules and to amend the current SDVOSB rule to include the sixth item on the list. Notably, with the sixth item, SBA appears to be addressing the issue in Snowfensive.

Given the nature of SBA's proposed changes, SBA requested feedback from industry, stating that it "specifically requests comments as to whether the six identified exceptions are sufficient or whether one or more additional exceptions should also be included in the regulations." Reasons abound as to why small businesses and their minority shareholders and investors should heed this request and submit comments.

To begin, if SBA codifies the limited circumstances over which a minority shareholder may exert permissible negative control (unanimous vote), it is foreseeable that OHA could take the position that by speaking directly to this issue and listing permissible provisions across its regulations, SBA intended that all other "extraordinary circumstance" provisions are impermissible. Indeed, SBA's prefatory comments could be interpreted as supporting that notion because SBA not only calls them "explicit exceptions" but also seems to be concerned with OHA's "broad interpretation of the negative-control rule." The Snowfensive decision also would provide support because, in denying the appeal, OHA expressly relied on SBA's regulatory history, including that the list of circumstances was exclusive and that "SBA considered, and specifically rejected, a proposal to broaden the list to include amendment of an operating agreement."

And so, in light of the fact that (a) SBA requested feedback on whether to broaden its proposed list of permissible negative control provisions, (b) SBA called the provisions "explicit exceptions" and appears to take issue with the broad interpretation of its negative control rule, (c) SBA seeks to harmonize its rules, and (d) OHA has examined SBA's regulatory history to determine whether a negative control provision in an SDVOSB's operating agreement was permissible, small business and other interested parties – minority shareholders/investors – should consider submitting comments. In so doing, industry may want to cover at least the following four issues: (1) whether the rule is actually good for small business, (2) if SBA moves forward, any additional negative control provisions that should be included in SBA's regulations; (3) that SBA should clarify in the final rule that any "extraordinary circumstances" provisions are merely examples, not exhaustive; and (4) whether amendments to corporate governance documents should be tethered to the provisions in the proposed rule.

In that regard, the middle issues are relatively straightforward. In fact, there are a number of potential permissible negative control provisions that probably should be included in SBA's final rule. As SBA even noted in its prefatory comments, the negative control provisions are derived from OHA case law, see, e.g., Southern Contracting Solutions III, LLC, SBA No. SIZ-5956 (Aug. 30, 2018) (collecting cases), so it makes sense that SBA's final rule remains flexible. The fourth issue, however, potentially complicates things. That is, the proposed rule ties amending corporate governance documents to the "extraordinary circumstances" provisions in the proposed rule, which means the permissible provisions in the OHA caselaw are underinclusive (notwithstanding the notion that as the OHA case law develops, the list grows). Ordinarily, amending an operating agreement applies to the document as a whole, not specific portions of it. Thus, were SBA to limit the type of permissible amendments to a concern's corporate governance documents, a host of other provisions, like some investment-related definitions or other terms, might also need to be included in the regulation.

Finally, and with regard to the first and perhaps most important issue, it is worth noting that robust industry comments are particularly warranted given that the proposed list of “extraordinary circumstances," in SBA's view, "would permit all small businesses to seek equity funding without becoming affiliated with the investors solely because of a broad interpretation of the negative-control rule." Yet, if SBA's final rule includes only a limited number of provisions and does not provide sufficient flexibility, the opposite will likely happen –– SBA's final rule will stifle minority investment. Indeed, as evinced in the survey of cases in Southern Contracting and in other OHA decisions, a reason why investors are willing to purchase minority equity positions in small businesses is, in part, because of the flexibility under the current framework. That is, negative control is permissible so long as the provisions are "crafted to protect the investment of the minority shareholders, and not to impede the majority's ability to control the concern's operations or to conduct the concern's business as it chooses."

Takeaway

SBA's proposed rule, while well-intentioned, could potentially upend common practice in the small business contracting community regarding supermajority or unanimity provisions in an operating agreement that do not impact the day-to-day control of a company and, instead, merely seek to protect a minority shareholder's financial investment in the concern. Because SBA not only requires certifications for entry into its socio-economic contracting programs, which must be renewed but also requires notifications regarding changes that impact program eligibility, SBA's proposed rule could potentially put small businesses – and possibly their SBA joint ventures – at risk of having to amend their operating agreements in a manner that is consistent with whatever (limited) provisions SBA includes in its final rule but that which may depart from the status quo. As written, the proposed rule could potentially stifle investment and hinder growth opportunities for small businesses. The industry should, therefore, take the opportunity to submit comments so that SBA can consider these issues when drafting the final rule.