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SPOTTING A SHAM – WHAT YOU NEED TO KNOW ABOUT MEB/BD BUSINESS CERTIFICATION PROCESSES

 Introduction

     Minority and Women Owned Business Certification (MWBE) Programs were created by the federal government and officially began in the 1960s in response to the Civil Rights Movement. President John F. Kennedy issued Executive Order 10925, which created an Equal Opportunity Committee and mandated that projects financed with federal funds “take affirmative action” to ensure that hiring and employment practices are free of racial bias. President Lyndon B. Johnson issued Executive Order 11246, which requires government contractors to take specific measures to ensure equality in hiring, and encourage employment of underrepresented groups, including minorities and women. Subsequently, during President Richard M. Nixon’s Administration, the federal government established the Small Business Administration’s (SBA) Section 8(a) program to enhance federal purchases from socially and economically disadvantaged owners of small businesses and created the Office of Minority Business Enterprise in order to provide minority business owners with more federal resources. (Shomari Benton, David Lloyd, You Down with MWBE? Yeah You Know Me: A Summary of the MBE, WBE, and DBE Programs in the State of Missouri, 2 Bus. Entrepreneurship & Tax L. Rev. 1 (2018)).

     These federal programs and their state-level companion programs have created abundant opportunities for MWBE businesses on public construction projects. However, navigating the certification process to take advantage of these opportunities can be daunting. Also, some majority-owned companies have attempted to take advantage of the MWBE system by creating fraudulent “sham” companies and joint ventures that do not actually achieve the goals of MWBE programs and that hurt the industry as a whole. Disadvantaged Business Enterprise (DBE) fraud harms the integrity of the DBE program and law-abiding contractors, including many small businesses, by defeating efforts to ensure a level playing field in which all firms can compete fairly for contracts, according to Thomas J. Ullom, Regional Special Agent-in-Charge of the U.S. Department of Transportation (DOT) Office of Inspector General). (Nicholas Rivecca, Sr., and Sonag Ready Mix, LLC To Pay $629,732 To Resolve False Claims Act Allegations Regarding Disadvantaged Business Enterprises, 2018 WL 4358042.)

     This article discusses how to navigate the MWBE system the right way, which will allow businesses to utilize the MWBE system to help achieve its objectives of creating a more just and equitable society. It will also focus on joint ventures between MWBEs and majority-owned companies under Section 8(a) of the Small Business Act and will discuss how to certify a business/joint venture properly in accordance with the certification standards, as well as how to avoid “shams,” “fronts,” or “fraudulent transaction[s]” when applying for MWBE and/or DBE certifications.

Background Rules:

Executive Order 11246

   Executive Order 11246 – Equal Employment Opportunity (Executive Order 11246, As Amended) prohibits federal contractors and federally‐assisted construction contractors and subcontractors doing over $10,000 in government business in one year from discriminating in employment decisions on the basis of race, color, religion, sex, sexual orientation, gender identity or national origin. The Executive Order also requires government contractors to take affirmative action to ensure that equal opportunity is provided in all aspects of their employment. Additionally, Executive Order 11246 prohibits federal contractors and subcontractors from, under certain circumstances, taking adverse employment actions against applicants and employees for asking about, discussing, or sharing information about their pay or the pay of their co‐workers.

Qualifying as a MWBE

   Section 8(a) of the Small Business Act empowers the SBA to arrange for the fulfillment of other federal agencies’ procurement needs through contracts with qualifying small businesses. 15 U.S.C. § 637(a)(1)(A)–(B). “In order to qualify as a DBE, a company’s management must be controlled by a socially or economically disadvantaged individual such as a woman or minority. The purpose of the program is to give an economic advantage to minorities and women who run their own companies. However, the manager of the DBE cannot also engage in employment that would prevent him or her from devoting sufficient attention to the affairs of the DBE.” (Massachusetts Company Pleads Guilty In Connection With Disadvantaged Business Enterprise Fraud, 2016 WL 4591454). All federal agencies must set goals for awarding a percentage of their procurement contracts to 8(a)-qualifying firms. 15 U.S.C. § 644(g)(2). To qualify for these “8(a) set-aside” contracts, a small business must be owned and controlled by one or more “socially and economically disadvantaged individuals,” id. § 637(a)(4), (a)(1)(C), a category defined to include certain racial minorities and members of other historically disadvantaged groups, id. §§ 631(f)(1)(B)–(C), 637(a)(5)–(6); 13 C.F.R. §§ 124.103, 124.104. The 8(a) program, in other words, is an affirmative action contracting program.

     The certification process is undertaken by states to ensure that the program “benefits only MBEs (DBEs) which are owned and controlled in both form and substance by one or more minorities or women.” 49 CFR 23.51. The state is required to have procedures to verify information provided by an applicant to support its claim for DBE status. The state is the certifying agent and must make its determination based on eligibility standards set forth in Sec. 23.53. These include bona fide minority group membership, and an entity that is an independent business. Highlights of the requirements include:

• “... The ownership and control by minorities or women shall be real, substantial, and continuing and shall go beyond the pro forma ownership of the firm as reflected in its ownership documents... DOT recipients shall consider all relevant factors, including the date the business was established, the adequacy of its resources for the work of the contract, and the degree to which financial, equipment leasing, and other relationships with minority firms vary from industry practice.
• The minority or women owners shall also possess the power to direct or cause the direction of the management and policies of the firm and to make the day-to-day as well as major decisions on matters of management, policy, and operations....
• If the owners of the firm who are not minorities or women are disproportionately responsible for the operation of the firm, then the firm is not controlled by minorities or women and shall not be considered an MBE (DBE).
• Where the actual management of the firm is contracted out to individuals other than the owner, those persons who have the ultimate power to hire and fire the managers can be considered as controlling the ” (Emphasis Added) 49 CFR 23.53(a). (Proposed Suspension of Mainelli (Hugo R.), Brown (Mariano J., Brenda Francis), Aetna Bridge Holding Co., B&F Excavating, Inc., DOTCAB No. 12, 1985 WL 17691 (D.O.T.C.A.B. July 22, 1985).

     Similarly, pursuant to regulations adopted by the United States DOT at the direction of Congress, a state that receives federal funds for highway construction projects must set an annual goal for participation by disadvantaged business enterprises (“DBEs”). Prime contractors, in turn, must ensure that the subcontracts awarded in connection with a highway construction project meet the DBE participation goal for that project. A DBE is a for-profit small business that is at least 51 percent owned by one or more socially and economically disadvantaged individuals, and whose management and daily business operations are controlled by at least one of those individuals. A DBE must be certified by the state in which it operates. In order to satisfy DBE participation goals, a DBE that is awarded a subcontract on a project must perform a commercially useful function—that is, the DBE itself must perform, manage, and supervise the subcontract work and must order and pay for the materials used. A contractor will not receive credit for DBE participation if the relationship between the contractor and the DBE “erodes the ownership, control, or independence of the DBE.” United States v. Bunn, 26 F. App’x 139 (4th Cir. 2001).

     Certification is an annual process, and generally is not project specific. Sec. 23.53(f). Certification is primarily a function of the state; however, it is subject to two kinds of reviews. The process adopted by the state is subject to review by the DOT model administration (in this case, Federal Highway Administration (FHWA), and the certification determinations are subject to appeal to U.S. DOT under Sec. 23.55. (Proposed Suspension of Mainelli (Hugo R.), Brown (Mariano J., Brenda Francis), Aetna Bridge Holding Co., B&F Excavating, Inc., DOTCAB No. 12, 1985 WL 17691 (D.O.T.C.A.B. July 22, 1985)).

     To count towards the DBE participation goal in a contract, the DBE must perform a “commercially useful function on the contract.” (citing 49 C.F.R. § 26.55). On past projects, it has been alleged that “[f]ailure by a contractor to carry out the requirements of 49 C.F.R. part 26,” including the DBE conditions, “is a material breach of the contract.” (citing 49 C.F.R. § 26.13(b)). United States ex rel. Hedley v. Abhe & Svoboda, Inc., 199 F. Supp. 3d 945 (D. Md. 2016). For example, the Abhe Court determined:

• Relators alleged with sufficient particularity that contractor made false claims for payment to federal government.
• Relators alleged with sufficient particularity that contractor’s alleged false statements regarding its use of certified disadvantaged business enterprise subcontractor were material to federal government’s payment of funds; and
• Relators sufficiently alleged

 The Abhe holdings demonstrate the importance of following applicable guidelines and standards for the certification processes to minimize liability and substantial damages.

Examples of Fraudulent “Sham” MWBEs and Related Issues

     As found in Baja Contractors, Inc. v. City of Chicago, 830 F.2d 667 (7th Cir. 1987), “[s]ubstantial concern has been expressed about the infiltration of DOT-assisted programs by “fronts”—businesses that claim to be owned and controlled by minorities, women, or other disadvantaged individuals, but which, in fact are ineligible for participation is [sic] DOT-assisted programs as MBEs, WBEs or disadvantaged businesses.” In Baja, the DOT took the opportunity to reemphasize the importance of scrutiny of all firms seeking to participate in DOT-assisted programs. Moreover, it expressed that DOT strongly believes that states should take prompt action to ensure that only firms meeting the eligibility criteria of 49 CFR Part 23 participate as MBEs, WBEs, or disadvantaged businesses in DOT-assisted programs. This guidance means not only that states should carefully check the eligibility of firms applying for certification for the first time, but also that they should review the eligibility of firms with existing certifications in order to ensure that they are still eligible.

     And, where it was adequately alleged throughout the First Amended Complaint in a claim under the False Claims Act that Defendants received sham minority business enterprise certifications which allowed them to participate in contracts that were set aside for small, disadvantaged businesses, the false claims as alleged are thus that but for this certification, Defendants would not have been entitled to the set-aside projects upon which they were paid). United States ex rel. Lazo v. Vratsinas Constr. Co., No. SACV1800270JVSDFMX, 2019 WL 13078497 (C.D. Cal. Dec. 9, 2019).

     Finally, on April 25, 2006, the Mine Safety and Health Administration (MSHA) invited the submission of bids to clean and repaint the Severn River Bridge. As a recipient of DOT funding, MSHA was “require[d]... establish annual statewide [Disadvantaged Business Enterprise (“DBE”)] participation goals[.]” MSHA thus was obligated to “award the contract [for a project] only to a bidder or offeror who meets or makes good faith efforts to meet the [DBE] contract goal.” (citing 49 C.F.R. § 26.53). MSHA was then “required to implement appropriate mechanisms to ensure compliance with regulatory requirements by all program participants, including DBEs and prime contractors.” Id. (citing 49 C.F.R. § 26.37).

Joint Ventures in the M/WBE Context

Section 8(a) and Joint Ventures

     To become eligible to receive 8(a) set-aside contracts, a firm must participate in the SBA’s business development program or otherwise obtain SBA approval. 13 C.F.R. § 124.501(g). Once deemed eligible, an 8(a) firm can seek contracts either through the SBA or directly from the procuring agency. Id. § 124.501(d)–(e). Some awarded contracts are executed between the procuring agency and the 8(a) firm, while others include the SBA as a third party. Id. § 124.508(a). Contracts can be awarded under the 8(a) program either competitively among multiple eligible small businesses or non-competitively on a “sole source” basis. Id. § 124.501(b).

     Where an 8(a) firm lacks capacity to perform a particular 8(a) set-aside contract on its own, it may enter into a joint venture agreement with a non–8(a) small business for the purpose of performing the contract. Id. § 124.513(a). This can be advantageous to both the MWBE and the majority-owned venturer because it can open up project opportunities that would not otherwise exist for either business. Joint ventures have often been used to pool talent and pursue projects of greater magnitude and of specialized natures, allowing all venturers to gain valuable experience and access to unique opportunities.

     In the Section 8(a) context, the agreement must be approved by the SBA before any contracts are awarded to the joint venture, id. § 124.513(e), and the SBA’s regulations warn that approval will be withheld where “an 8(a) concern brings very little to the joint venture relationship in terms of resources and expertise other than its 8(a) status,” id. § 124.513(a)(2). Federal regulations permit joint ventures between qualified 8(a) participants and non–8(a) participants for the purpose of obtaining work set aside for 8(a) participants, so long as a number of conditions are met. Such agreements are permitted only where the MWBE participant lacks the capacity to perform the contract on its own. 13 C.F.R. § 124.513(a)(2). Joint venture agreements must be approved by the SBA, which must conclude that the agreement is “fair and equitable and will be of substantial benefit to the 8(a) concern.” 13 C.F.R. § 124.513. In addition, each joint venture agreement must contain a number of provisions:

1. The purpose of the joint venture;
2. Designation of the MWBE as the managing venture and a named employee of the MWBE as the manager with ultimate responsibility for performance of the contract;
3. A statement that, for joint ventures organized as a separate legal entity, the MWBE participant must own at least 51% of the JV entity;
4. Provision for the MWBE to receive profits either commensurate with the work it performs or exceeding the percentage commensurate with the work it performs;
5. Provision for the establishment and administration of a special bank account in the name of the joint venture;
6. Itemization of all major equipment, facilities, and other resources to be furnished by each party to the joint venture, with a detailed schedule of cost or value of each, where practical;
7. Specification of the responsibilities of the parties with regard to negotiation of the contract, source of labor, and contract performance, including ways that the parties to the joint venture will ensure that the joint venture and the MWBE to the joint venture will meet the performance of work requirements, where practical;
8. Obligation to all parties to the joint venture to ensure performance of the 8(a) contract and to complete performance despite the withdrawal of any member;
9. Designation that accounting and other administrative records relating to the joint venture be kept in the office of the managing venturer, unless approval to keep them elsewhere is granted by the District Director or his/her designee upon written request;
10. Requirement that the final original records be retained by the managing venturer upon completion of the 8(a)-contract performed by the joint venture;
11. Statement that quarterly financial statements showing cumulative contract receipts and expenditures (including salaries of the joint venture’s principals) must be submitted to SBA not later than 45 days after each operating quarter of the joint venture; and
12. Statement that a project-end profit and loss statement, including a statement of final profit distribution, must be submitted to SBA no later than 90 days after completion of the contract.

See 13 C.F.R. § 124.513(c).

     The regulations also specify that the 8(a) firm participating in an 8(a) joint venture must perform 40% of the labor on each contract awarded to the joint venture. Bus. Dev./Small Disadvantaged Bus. Status Determinations, 76 Fed. Reg. 8222, 8242–44 (Feb. 11, 2011) (codified at 13 C.F.R. § 124.513(d)). Previously, SBA regulations had required that the 8(a) firm complete “a significant portion” of the work on the contract but did not specify a percentage. Id.; 13 C.F.R. § 124.513(d) (1999). United States v. Harris, 821 F.3d 589 (5th Cir. 2016); see also, United States v. R.J. Zavoral & Sons, Inc., No. CIV. 12-668 MJD/JJK, 2014 WL 5361991 (D. Minn. Oct. 21, 2014). Both upon the completion of each contract and as part of its annual review, an 8(a)-firm participating in a joint venture must explain to the SBA how the labor-division requirement was satisfied for each contract awarded to the joint venture. Id. § 124.513(i). United States v. Harris, 821 F.3d 589 (5th Cir. 2016).

Key Considerations in Negotiating and Forming a Joint Venture

     Joint ventures and their accompanying written agreements in the construction industry are unique legal creatures that straddle the line between construction contracts and corporate formations. The unique role served by joint venture agreements brings with it an expansive set of considerations parties should consider before entering into a joint venture and for which attorneys should account when assisting their clients. When these joint ventures occur in the MWBE space for purposes of pursing Section 8(a) work, additional liabilities and requirements also come into play, as discussed above.

     Every joint venture agreement should be reduced to writing, a requirement in the Section 8(a) context. Several other considerations—many of which SBA requires for MWBE joint ventures for Section 8(a) projects—should be addressed in every joint venture agreement:

1. The date on which the JV is established;
2. The identities of the joint venturing businesses;
3. The name under which the joint venture will do business and whether a new corporate entity will be formed for purposes of carrying out the joint venture;
4. A full description of the JV purpose and the project(s) being pursued;
5. Establishment of a fund in a separate, dully controlled bank account by the venturers to finance the work and in which all payments related to the project will be deposited;
6. Provision for how additional capital contributions will be required, proportions to be contributed by each party, and impacts of failure by a party to contribute;
7. Declaration of the percentages of profits and losses to be borne by each party, which may or may not match the contribution percentages;
8. Description of any additional management or other fees to be paid to any of the parties, particularly the controlling venturer;
9. Which party is providing what equipment required for performance of the project;
10. Provisions addressing any specially acquired equipment and materials for purposes of the project, including division of payment responsibilities and disposal/distribution at the end of the project;
11. Which party is performing what work—and subcontracting what trades—for completion of the project;
12. Identification of the controlling/managing venturer, the scope of the managerial authority, and the procedures to be followed for decisions outside of the managerial authority;
13. Provisions addressing impacts of incapacity, death, bankruptcy, or insolvency of a venturer business or principal;
14. Who will acquire required licenses for the project in the name of the joint venture or for each venturer and allocation of the costs of those licenses;
15. Provisions addressing insurance that will be acquired for the joint venture, including types of coverage, in whose name the coverage will be held, whether any venturers need to be added as additional insureds on existing policies;
16. Addressing of what items will be considered costs and income of the joint venture for purposes of determining profits and losses, including what expenses are reimbursable and how to divide profits and losses;
17. When and how the joint venture will be terminated and procedures for windup of the joint venture entity, including how guarantees, warranties, insurance, and construction defects will be addressed following the project; and
18. Dispute resolution and choice of law/venue

 Conclusion

Diversity programs that are designed to increase equal employment opportunities in the construction industry have been in existence for decades. Many construction businesses have used the 8(a) program and MWBE/DBE certifications to become successful and employ disadvantaged individuals. However, like any program, there are individuals and businesses that have used these programs to create sham entities or sham joint ventures with non-minority companies. Consequently, government regulators are scrutinizing MWBE/DBE certifications to root out fraud, especially in the construction industry. To avoid issues, companies seeking MWBE/DBE certifications or joint ventures to obtain such certifications must seek experienced and competent legal counsel to guide them through the certification process, the recertification process, and the expansive process of creating joint ventures between majority and certified minority businesses.

For more information, please contact Marlon Primes at maprimes@bmdllc.com or 216.306.3047. Marlon is a Partner in BMD's Cleveland office and serves as the Co-Chair of BMD's Business and Tort Litigation Practice.