Negative control and buddy-cop films

A stated goal of the US procurement system is to encourage small businesses to sell to the government. Many efforts support that goal. For example, the federal government sponsors "APEX Accelerators" to provide technical assistance to small businesses that are trying to win government contracts.[1] Or, as another example, each federal agency sets minimum small-business utilization targets each year, which of course means that there's a scorecard. To help hit those targets, contracting officers will occasionally "set aside" contracts for small businesses ensuring that a small business will win.

Another program—the SBA Mentor-Protégé Program—enables a small business (the protégé) to learn from an experienced government contractor (the mentor) through the creation of a joint venture (JV).

A way to think of JVs is like a terrible "buddy cop" movie. You've got a grizzled veteran who remembers the glory years, before GWACs ruined everything. You've got the hot-headed rookie, eager to earn their stripes and mix it up. They commisserate over the all of the paperwork that keeps them from getting the bad guys. You get the idea.

As we've discussed before, though, the program isn't only about helping a protégé learn the ropes; the program is also a way for a large company to indirectly participate in small-business set asides. The grizzled veteran isn't doing this entirely out of the goodness of their heart, after all; they still need to get that pension.

The way it works is that the JV gets the formal benefit of the past performance of both the protégé and the mentor and the formal small business designation of the protégé. So, if a particular contract is set aside for Service-Disabled Veteran-Owned Small Businesses (SDVOSB) and the protégé is a SDVOSB, the JV can compete.

This is a pretty neat super power in the land of #govcon, but it comes with red tape. There are formalities to JVs, like having a separate bank account and having a written joint-venture agreement.

There are substantive limitations, too. For example, the protégé needs to do 40% of the JV's workshare. Also, the regulations prohibit JVs "if SBA determines that the assistance to be provided is not sufficient to promote any real developmental gains to the protégé, or if SBA determines that the agreement is merely a vehicle to enable the mentor to receive small business contracts."

That last part is important: JVs are not supposed to be shells for big businesses! They're supposed to be primarily a vehicle for small businesses to learn the ropes. And one of the ways that the SBA enforces that no-shell policy is requiring the protégé to be "responsible for controlling the day-to-day management and administration of the contractual performance of the joint venture."

In other words, the rookie is supposed to be the lead in this particular buddy-cop film. This ain't Law & Order. The noob gets to drive!

As you can imagine, there's a tension here because the mentor is putting time and effort and money into the JV and if the protégé manages the JV poorly, the mentor not only loses out on its direct costs, but it also misses potential opportunities for contracts! As such, some mentors will push for stronger governance and decision rights for the JV.

In 2020, the SBA adopted regulations that allow both partners to "participate in all corporate governance activities and decisions of the joint venture as is commercially customary." Legally, though, where a company fit on the spectrum between totally unconstrained protégé and totally mentor shell operated in a sort of limbo with regard to what decisions are "commercially customary." Could a mentor block a JV from taking on debt? Could a mentor veto which contracts to go after? Could a protégé hire whomever it wanted?

This area of ambiguity is what is called "negative control." And in May, the SBA reiterated that although a mentor can't have negative control over the day-to-day operations of the JV, the commercially customary decisions exception means that "[a] non-managing venturer's approval may be required in, among other things, determining what contract opportunities the joint venture should seek and initiating litigation on behalf of the joint venture."

On paper, those are pretty big spaces for negative control! If a mentor can determine what contracts the JV goes after, that seems like a lot of power. Surely, that "commercially customary" exception feels like a big opportunity for mentors to throw their weight around.

And yet, in August, the SBA rejected a pair of JV agreements on the grounds that the mentors exercised too much "negative control."

In the first case, the judge found that a mentor had too much power over the JV because the the operating agreement specified that "each party shall be responsible for this task within their scope of work." What this practically meant is that the mentor could "exercise negative control by controlling the hiring and firing of employees, and other HR actions" and "could conceivably exercise control by withholding enough employees from performance of the contract." Because this intruded on "control of the day-to-day management and administration of contract performance," the JV was invalid.

The grizzled veteran, according to the SBA, doesn't get to do their own independent investigation. They have to work with the rookie; again, the rookie's gotta drive.

The next day, the judge again ruled in another case that a JV was invalid because the mentor exercised too much negative control:

The record makes it clear that [the JV's] Management Committee has control over the project management, and consequently, the mentor firm... has negative control over the Management Committee, when it can block any action by the [protégé] members by causing a tie vote and/or denying a majority. [The SBA] has held that businesses with managing directors from each member, each having equal authority, do not meet the regulatory requirements of being controlled by the SDVOSB concern....

Here, the Management Committee has control over [the JV] and its Responsible Manager, and [the mentor] can exert negative control over the Management Committee. This goes beyond mere participation in corporate governance.

Sorry, pal. Rules is rules. Rookie's gotta drive. The vet can navigate, but they can't take the wheel.

Deciding whether a mentor has too much negative control over a JV is a fact-intensive exercise and I doubt we've seen the last of this tension. We certainly haven't seen the end of arguments around what is "commercially customary."

One thing is for sure, though: once a grizzled veteran and the rookie are put on the case, they need to agree that the rookie's the lead. And they better buckle up for some comedy to follow.[2]

[1] Obligatory disclosure: I am a Board member of the Wisconsin Procurement Institute, the APEX Accelerator here in Wisconsin.

[2] Drama? Tragedy? Nah, this is government contracting! Comedy all the way.

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