“Control” Is Based on the What the Governing Documents Say, Not How the Owners Act
December 15, 2015
By: Eric Whytsell
As businesses grow and change over time, practical aspects of their internal governance often change as well. If the owners’ day-to-day practices gradually diverge from their originally agreed upon approaches, it can be easy to forget the governing documents and what they say. Owners of small business contractors, however, do so at their peril. As the recent Small Business Administration (SBA) Office of Hearings and Appeals (OHA) decision in Potomac River Group, LLC, SBA No. SIZ-5689 (October 21, 2015) makes clear, in the context of determining size status, what a concern’s governing documents say is much more important than how its owners have chosen to deal with one another.
This appeal relates to a size dispute in connection with a small business set-aside contract for security services. When Potomac River Group (PRG) won the subject contract, a competitor filed a size protest. The resulting SBA Area Office size determination found PRG to be other than small based on affiliation. The area office based its finding on an application of the terms of PRG’s Operating Agreement (OA) in light of the owners’ relative percentage of ownership. When it submitted its initial proposal, PRG was owned by Frank Frysiek (48.54%), Intelligent Decisions, Inc. (48.54%) and Jacqueline von Wodtke (2.92%). Mr. Frysiek is President, Manager and CEO while Ms. Von Wodtke serves as Secretary and Vice President of Finance. The OA in place when PRG submitted its proposal established a 75% supermajority voting requirement for “[a]ll determinations, discussions, approvals and actions affecting the Company and its business and affairs.” Despite the fact that the OA also provided for delegation of authority to one or more elected Managers, an act of the Members still required an affirmative vote of Members holding at least 75% of the Voting Units.
The Area Office found PRG affiliated with Intelligent Decisions (ID), reasoning that the relevant OA gave both Mr. Frysiek and ID power to control PRG – and meant that Mr. Frysiek could not take action without ID’s consent. Because ID is a large business, the affiliation made PRG ineligible for the small business set-aside. It made no difference to the Area Office that that PRG subsequently revised its OA to remove the supermajority voting requirements or that Ms. von Wodtke sold her shares to Mr. Frysiek.
PRG appealed, arguing that the Area Office had elevated form over substance and submitting sworn declarations claiming that, notwithstanding the provisions of the original OA, Mr. Frysiek had final authority and made all decisions for PRG without any input, influence or vote by ID. More particularly, PRG asserted that its Members did not rely upon the OA, never voted on any actions, and vested all control in Mr. Frysiek, who alone had final authority and control over PRG's decisions, including which sales opportunities to pursue, the pricing of products, hiring, firing and employee discipline, determining compensation and benefits, approving company distributions, negotiating contracts, and administering contract performance and invoicing. According to PRG, ID had no authority or means to alter or direct any financial decisions or reporting, decide the timing of tax filings, or sign checks. PRG also pointed to the revised OA that removed the supermajority voting requirements and made clear that full control rested solely with Mr. Frysiek.
SBA’s OHA made short work of PRG’s arguments, explaining that (i) PRG’s size must be determined as of the time it submitted its initial offer (and self-certification regarding size); and (ii) affiliation may turn on the power to control regardless of whether such power is exercised. In this case, since PRG is a limited liability company (LLC) and the OA was its governing document when it submitted its offer, determining whether ID had the power to control PRG turned on the contents of PRG’s original OA. Because the relevant OA provided that all actions to manage PRG required a 75% vote and the 75% vote could not be reached by fewer than all three owners, ID had “the ability to block any ‘determinations, discussions, approvals and actions affecting the company and its business and affairs’, and any act of Appellant's Members requires its approval.” OHA found the declarations PRG submitted to explain the owners’ actual practice in running the company to be irrelevant. As OHA explained, the OA gives ID veto power over any company actions under the Agreement, regardless of whether or not ID chooses to exercise that power. The decision also expressly rejects PRG’s assertion that such a conclusion elevates form over substance and states: “Rather, it is a recognition of the actual, legal power given to ID by the Agreement, based upon the plain language of the Agreement itself.” This type of negative control mandates a finding that ID is affiliated with Appellant.
The lesson should be clear: small businesses must regularly review their governing documents to ensure that they accurately describe the manner in which the company is operated – and that they avoid affiliation and other issues that can render the concern other than small. You will not have the opportunity at a later date to explain away what the governing document says.
Eric Whytsell is responsible for the contents of this Article.
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