Limitations on Subcontracting for Nonmanufacturers: A Step-by-Step Compliance Guide
For small businesses, contracting with Uncle Sam can be very lucrative. But government contracts come with plenty of red tape. Most small business contracts are subject to the so-called “limitations on subcontracting,” a series of rules that many small businesses find particularly confusing. The confusion often increases when a company hopes to comply with the limitations on subcontracting as a “nonmanufacturer,” that is, an entity selling products manufactured by someone else.
Under the SBA’s regulations, the word “nonmanufacturer” is a term of art. To qualify as a nonmanufacturer, you must meet a special test set forth in 13 C.F.R. 121.406. If you miss even one of the regulatory criteria, you’re not a nonmanufacturer.
So, in this post, I will try to demystify the nonmanufacturer rule. We’ll walk through the steps you should follow to comply with each piece of the regulation.
A few notes before we get started.
First, if you’re not sure whether you are a manufacturer or a nonmanufacturer, you should check out the previous article in this series. In that article, I discuss how the SBA determines which company is the manufacturer of a product (and, again, “manufacturer” is something of a term of art).
Second, when I say that the nonmanufacturer rule is confusing, I’m not kidding. In my experience, even Contracting Officers and Contract Specialists often misunderstand it. It’s not uncommon to see solicitations that, basically, invite violation of the rule, such as small business set-asides requiring the end product of a large manufacturer. Similarly, it’s not uncommon to find your competitors submitting proposals that violate the rule.
When the former occurs, it’s wise to bring it to the attention of the Contracting Officer early in the solicitation process. The Contracting Officer can obtain a waiver of certain pieces of the nonmanufacturer rule, including the portion requiring you to provide the end product of a small manufacturer. If you know that all your competitors are likely to submit non-compliant offers, please remember that “everybody else is doing it!” is not a great legal defense. However, if you comply with the nonmanufacturer rule and the winning offeror doesn’t, you may be able to file a successful size protest.
Finally, this post is for your educational use only. As the disclaimer below reiterates, this post is not legal advice. If you have questions about how these rules apply to your specific circumstances, you should consult with a government contracts attorney.
With those caveats in mind, let’s dive into the steps to compliance with the nonmanufacturer rule.
Step #1 – Ensure You’re under 500 Employees
To qualify as a nonmanufacturer, your employee count cannot exceed 500. For most nonmanufacturers, this first criterion isn’t a problem. If there’s any doubt, you should review the SBA’s regulation about how to count your employees, 13 C.F.R. 121.106.
Remember that you must include the employees of any affiliates. If, for example, you’re a wholly-owned subsidiary of Walmart, the SBA will say that you have somewhere in the neighborhood of two million employees, even if only 10 of them work for your subsidiary. The SBA’s affiliation rules are found in 13 C.F.R. 121.103. Affiliation is a deep and complicated topic. If you’d like to learn more, a certain former government contracts attorney has co-written a GovCon Handbook on this very topic.
Step #2 – Verify (and Support) Primary Industry
A nonmanufacturer must be “primarily engaged in the retail or wholesale trade.” But what exactly does that mean? A separate SBA regulation, 13 C.F.R. 121.107, provides a little more guidance:
In determining the primary industry in which a concern or a concern combined with its affiliates is engaged, SBA considers the distribution of receipts, employees and costs of doing business among the different industries in which business operations occurred for the most recently completed fiscal year. SBA may also consider other factors, such as the distribution of patents, contract awards, and assets.
While this is helpful, it’s hardly crystal clear and leaves room for subjective judgment calls. If you’re uncertain whether you qualify, you’d be well-advised to seek guidance from the SBA or your government contracts legal counsel.
From a practical perspective, you ought to think about whether your online presence supports wholesale or retail as your primary industry. After all, if your website, SAM profile, and the like say nothing about it, competitors – and Contracting Officers – may be more likely to question your compliance.
You should, for example, consider listing wholesale or distributorship NAICS codes on your SAM and SBA Dynamic Small Business Search profiles. Don’t neglect the manufacturing NAICS codes, though: Contracting Officers can’t assign wholesale/distributorship NAICS codes to solicitations seeking products and are likely to search for prospective offerors using manufacturing NAICS codes.
Step #3 – Verify (and Support) Sales of Similar Items
Next, you should verify that you “normally sell the type of item being supplied.” Unfortunately, the SBA doesn’t provide any additional regulatory guidance to help interpret this requirement.
However, the SBA Office of Hearings and Appeals has held that the rule only requires sales of the “same type” of item, not the identical item. If, for instance, you’re a well-established medical supplier, you’ll likely meet these criteria if you’re proposing to provide catheters – even if you’ve never sold them before. But if you’re submitting under a solicitation calling for breakfast cereal, you may have a problem. Again, it’s wise to consult with the SBA or your government contracts attorney if you’re unsure.
As with Step #2, it’s smart to publicly demonstrate that you sell items of the type being procured. In fact, in another SBA Office of Hearings and Appeals decision I blogged about a few years ago, the SBA Administrative Judge instructed the SBA to obtain “advertising materials, price lists, website information, etc.” from a firm whose compliance was in question.
Step #4 – Take Ownership or Possession
To qualify as a nonmanufacturer, you must “[take] ownership or possession of the item(s) with [your] personnel, equipment, or facilities in a manner consistent with industry practice.”
If you’re like many of the small businesses I’ve worked with, you’re a drop-shipper: you never physically possess the products you’re selling. Fortunately, in a 2012 decision, the SBA Office of Hearings and Appeals held that drop-shipping could satisfy these criteria.
In the case, the Administrative Judge noted that the regulation requires ownership or possession, not both. Importantly, though, the Administrative Judge held that “[o]wnership is a question of law, and one need not take physical possession to take ownership of an item if title to the item has passed under a contract.”
I’ve italicized the end of this sentence because, in my experience, this is where many small businesses may inadvertently fail to comply. I have reviewed many (many!) contracts between drop-shippers and manufacturers, and many of them don’t clearly call for the title to pass to the drop-shipper. In fact, many contracts suggest that the title passes directly from the manufacturer to the Government, with the drop-shipper solely serving as a broker.
Contracts like these don’t meet the “ownership” piece of the regulation. Assuming that you’re not taking physical possession, either, you’ve got a compliance problem.
Step #5 – Ensure Item is “Made in the United States” (or Requirement Waived)
A nonmanufacturer must sell items “made in the United States” unless the requirement has been waived. (We’ll discuss waivers below).
Contrary to a common misconception, the requirement is that the item be made in the United States, not that the company making the item be American-owned. But, if the item is made outside the U.S., even a very small manufacturer won’t qualify. In one case I wrote about, the manufacturer had only “one or two” employees but did its manufacturing in Turkey. The SBA Office of Hearings and Appeals held that the company reselling those products didn’t qualify as a nonmanufacturer.
As a reseller, you’d be wise to make your manufacturer certify, in its contract with you, that it will make the products in the United States – and indemnify you for any damages you may suffer if that certification proves untrue.
Step #6 – Ensure Manufacturer is a Small Business (or Requirement Waived)
Ah, here’s the biggie. In my experience, when firms violate the nonmanufacturer rule, it’s usually because they are reselling the products of a large business. Unfortunately, that’s usually noncompliant. The nonmanufacturer rule requires that you “supply the end item of a small business manufacturer, processor, or producer” unless the SBA has waived the requirement.
We’ll talk about waivers in the next section, but assuming there is no waiver, you can’t be a nonmanufacturer if you’re selling a large business’s products. It’s really that simple, but it’s still widely misunderstood.
First things first: how does a manufacturer qualify as a “small business”? Unlike you – the nonmanufacturer – the manufacturer isn’t necessarily bound by a 500-employee size standard. Instead, the manufacturer’s small business status is determined by the solicitation’s NAICS code and its associated size standard. If, for example, the Contracting Officer assigned NAICS code 316210 (Footwear Manufacturing), the associated size standard, according to the SBA’s Size Standards Table, is 1,000 employees. So, you must judge your manufacturer’s “small” status against the appropriate size standard.
But once you know the threshold, how do you determine if your manufacturer is a small business? In many cases, of course, it’s pretty obvious that the answer is “no.” If you’re dealing with, say, Boeing, you shouldn’t need to know anything else. (Although, if you’re curious, the corporate website says that Boeing has 140,000 employees. That’s definitely not small, under any size standard in the SBA’s Table).
Theoretically, you could demand that your manufacturer provide its payroll data, as well as detailed information about its affiliates, like that required by SBA Form 355. Realistically, though, few, if any, manufacturers are willing to provide this sort of information to their resellers.
Often, the best – that is, the best realistic – solution is to get a contractual certification of the sort I suggested for Step #5. Of course, if you also want to do a little bit of your own research (the sort of research my wife calls “Google Stalking”), there’s nothing stopping you.
Nonmanufacturer Rule Waivers
I’ve mentioned nonmanufacturer rule waivers a couple of times, so let’s discuss this important piece of the rule.
The SBA – and only the SBA, not the Contracting Officer or anyone else – can waive the “made in the United States” and “small business manufacturer” portions of the nonmanufacturer rule, that is, the portions I’ve described in Steps #5 and #6. Contrary to a common misconception, SBA waivers apply only to these portions of the nonmanufacturer rule. Even when a waiver is in effect, you’ll still need to comply with the rest of the rule – the parts I described in Steps #1 through #4. But Steps #5 and #6 are often the real deal-breakers, making waivers potentially powerful tools.
Nonmanufacturer rule waivers come in two flavors: “class” and “individual.”
A class waiver means that the SBA, after extensive market research, has determined that “there are no small business manufacturers or processors available to participate in the Federal market for that class of products.” The SBA’s regulation at 13 C.F.R. 121.1202 provides more detail about how the SBA makes class waiver determinations.
The SBA can also issue an individual class waiver at the request of the Contracting Officer. The Contracting Officer’s request will state, in essence, that regardless of whether domestic small business manufacturers exist, the Contracting Officer’s market research indicates that no such manufacturers are likely to be available for a particular procurement. The SBA’s regulation at 13 C.F.R. 121.1203 provides more detail about how the SBA makes individual waiver determinations.
When a class waiver is in effect, any procurement for that product should be subject to the waiver. Anyone can request that the SBA adopt a new class waiver, but the process can take months, or even years, to complete. For this reason, requesting a new class waiver is rarely (if ever) a viable solution to qualify for an upcoming procurement.
In contrast, an individual waiver applies to a single procurement. Only the Contracting Officer can request an individual waiver, but the SBA generally processes the requests fairly quickly. If an individual waiver might help you qualify for an upcoming procurement, you may wish to consider asking the Contracting Officer to make a request.
How do you know if a waiver is in effect? Until a few years ago, it was largely up to offerors to try to figure it out for themselves, using tools like the SBA’s class waiver list. Fortunately, in 2016, the SBA changed its regulations to make life easier for small businesses. Under current law, “contracting officers must provide written notification to potential offerors of any waivers being applied to a specific acquisition.” The notification generally “must be provided at the time a solicitation is issued.”
While the regulations don’t explicitly require the Contracting Officer to provide the notification within the solicitation itself, that’s generally where you’ll find it. Importantly, if the Contracting Officer doesn’t provide a written notification, “the waiver cannot be applied to the solicitation.” In other words, if you are bidding to supply something you know is covered by a class waiver, but you don’t see a written notice, you should reach out to the Contracting Officer right away. No notice, no waiver.
The Nonmanufacturer Rule Exemption
Sometimes, you don’t have to comply with the nonmanufacturer rule at all. The nonmanufacturer rule simply doesn’t apply to small business set-asides under the simplified acquisition threshold (which is periodically adjusted for inflation but, at the time of this writing, is $250,000 for most procurements).
As I wrote when the exemption was adopted, the SBA believes that the exemption will encourage Contracting Officers to set aside more lower-dollar procurements for small businesses. When the nonmanufacturer rule exemption applies, it wipes out the entire rule – not just a portion of the rule, like a waiver. If you’re bidding on a small business set-aside solicitation under the simplified acquisition threshold, you’re in luck because all this nonmanufacturer rule compliance stuff just doesn’t apply.
However, in my experience, there is a very, very, very common misconception regarding the exemption: namely, the mistaken belief that the exemption applies to socioeconomic set-aside and sole-source contracts, that is, those reserved for 8(a)s, SDVOSB/VOSBs, HUBZones, or WOSBs/EDWOSBs. (If you’re not familiar with one of those acronyms, you can be pretty confident that it doesn’t apply to you).
Let me be crystal clear: the nonmanufacturer rule exemption applies only to small business set-asides beneath the simplified acquisition threshold. It does not apply to socioeconomic set-aside or sole-source contracts.
You don’t have to take my word for it. In its rulemaking announcing the exemption, the SBA said that the requirements “would continue to apply to all 8(a), HUBZone, SDVOSB, and WOSB/EDWOSB set-aside contract awards regardless of value.” The FAR Council (the group that writes and updates the FAR) has said essentially the same thing.
Some Final Thoughts
Nonmanufacturers occupy a special place in the Federal procurement landscape: they are exempt from the ordinary limitations on subcontracting. I’ve worked with many very successful nonmanufacturers in my career, and, when done right, nonmanufacturing can be very lucrative.
But, as you undoubtedly gathered if you read this entire (admittedly, rather lengthy) article, the nonmanufacturer rule means much more than “not being the manufacturer.” The nonmanufacturer rule is very commonly misunderstood, leading to potentially serious compliance concerns. By following this step-by-step guide, I hope you’ll be well on your path to lucrative nonmanufacturing.
[…] As a government contracts attorney, I’ve counseled hundreds of clients on the FAR and SBA small business regulations. Few of these rules have proven as confusing to my clients as the so-called limitations on subcontracting. So, in this post, I’m offering a step-by-step guide for manufacturers to comply with the SBA’s limitations on subcontracting in 13 C.F.R. 125.6. If you’re not a manufacturer, I’ve got you covered, too. Check out similar posts for construction contractors, service providers, and nonmanufacturers. […]
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