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Government contractors can comply with set-aside requirements with some basic due diligence.

How Government Contractors Can Comply With Set-Aside Rules for Disadvantaged Businesses

  • 5/15/2014

Contracting for the government includes some unique requirements that are not included in the private sector. One requirement that has affected some high-profile firms is the set-aside work required on almost all government contracts for minority business enterprises (MBE) and disadvantaged business enterprises (DBE).

Government agencies have recently increased their scrutiny of contractors’ relationships with MBEs and DBEs.

Some firms have paid substantial fines to federal and state governments to settle criminal allegations for failing to satisfy set-aside requirements. For instance, James McHugh Construction Co. recently agreed to pay $14 million and Skanska USA Civil Northeast agreed to pay $19.6 million in March 2011 to resolve criminal allegations that it defrauded the government by failing to properly use DBE subcontractors.

The set-aside program helps disadvantaged companies (defined as small businesses or companies with a majority ownership by minorities, women, or veterans) obtain work by requiring that a percentage of work received by government contractors is subcontracted out to MBEs or DBEs. The belief is that without these provisions, such firms would be unable to obtain these contracts. The program is intended to promote growth of business and free markets.

Commercially useful function

Contracting firms become at risk for not meeting the set-aside requirements through various situations, but for many companies that have faced allegations, the regulatory agencies focused on whether a DBE performed a “commercially useful function.”

Although there are specific definitions of a “commercially useful function,” the regulatory agencies typically apply various tests when reviewing the arrangement. One test is to calculate how much risk the job has for the disadvantaged company and is generally assessed by finding the ratio of DBE labor to the total cost of the subcontract agreement with the DBE. This percentage is an indicator of risk of the subcontract agreement. The lower the percentage, the lower the risk, and the more likely it is that the subcontract is a “flow-through” arrangement specifically designed to meet the set-aside requirements.

Regulatory agencies also look at the financial health of the DBE (i.e., how well capitalized the company is). Thinly capitalized companies may show that financial transactions are flowing through the DBE/MBE to the sponsoring company. A company may come under scrutiny if there were “advances” made to the DBE or MBE during the project, to “help” the company meet payroll and other obligations.

Finally, regulators will look at the relationship between the two companies. Are there loans between companies? Are there former employees of the sponsoring company, now working for the MBE or DBE? Is the owner of the sponsoring company in a position of control on the DBE or MBE, such as on a board or advisory committee?

Increasing examinations

Government agencies have recently increased their scrutiny of contractors’ relationships with MBEs and DBEs. If these government agencies find questionable activities, the Department of Justice (DOJ) will take over the investigation, which will either fall under the civil or criminal division. Additionally, once a project has been selected for review, it is not uncommon for the DOJ to bring all contractors (even if not included in the initial examination) into the audit.

If companies are found to be in violation of the set-aside requirements, violators are prosecuted under the False Claims Act. If violations are egregious, contractors can be assessed fines banned from bidding on federally funded projects.

Compliance is common sense

The good news is that contractors can help protect themselves from claims relating to set-aside requirements by doing some simple due diligence:

  • Make sure your company has no affiliation with the MBE or DBE.
  • Thoroughly vet your MBE or DBEs for financial stability. Create a process requiring each potential subcontractor to meet certain minimum financial metrics. The process should be documented, retained, and frequently updated.
  • Review and discuss the projected cash flow for the project with the proposed subcontractor. Ensure that the subcontractor has the financial wherewithal to maintain financial liquidity throughout the project, without having additional advances from the sponsor.
  • Review the contract and check that the MBE or DBE has adequate risk and reward—that is they are significant partner in the project. Although there is no bright line on how much of the contract should be labor based, the percentage of labor cost to the total cost should make sense in the context of the work being commercially useful.

By doing some research on the MBE or DBE and the projects they are involved in, your company should be in compliance with the set-aside requirements and avoid regulatory scrutiny.