Showing a “Clear Fracture” Does Not Rebut Presumption of Affiliation Based on a Common Investments Identity of Interest
January 25, 2016
By: Eric Whytsell
Small Business Administration (SBA) rules relating to the concept of “affiliation” can render an entity “other than small” for a wide variety of reasons. Unfortunately, as demonstrated by the recent decision of SBA’s Office of Hearings and Appeals (OHA) in Size Appeal of Tenax Aerospace, LLC, SBA No. SIZ-5701 (December 23, 2015), these rules are complex and often difficult to apply. The Tenax decision considers a number of affiliation concepts that have posed challenges to more than one company attempting to achieve and maintain a “small” size status.
One issue central to the Tenax matter is that of affiliation based on identity of interests. However, unlike many identity of interest situations, Tenax involved an identity of interest based on common investments, rather than familial relationships. When SBA’s Area Office issued a protest-initiated size determination finding Tenax not small, Tenax appealed, asserting that the Area Office clearly erred in finding Tenax affiliated with a number of other entities, including Tenax-Heritage, LLC (Heritage) and The Vineyards of Brandon, LLC (Vineyards). Both of these companies were found to be affiliated with Tenax because the majority owner of Tenax’s parent (Investor 1, in the terminology of the decision) and his brother-in-law (Investor 4) both invested in Heritage and Vineyards.
Tenax argued to the Area Office that no identity of interest existed because Investors 1 and 4 were not immediate family members. However, the Area Office found an identity of interest based on common investments, rather than a familial relationship. Specifically, the Area Office found that Investors 1 and 4 each owned at least 25% of Heritage, and at least 25% of Vineyards, and that, by virtue of their combined (majority) ownership interest in Heritage and Vineyards, they have the ability to control both companies. Since Investor 1 also has the power to control Tenax, the Area Office found the three firms to be affiliated. Together with revenues from other affiliates, the Heritage and Vineyards revenue pushed Tenax’s revenue over the applicable size standard and rendered Tenax ineligible.
On appeal Tenax argued, among other things, that there was a clear fracture between Tenax and Vineyards and Heritage that rebuts the presumption of their identity of interest. According to Tenax, it does not share officers, employees, facilities or equipment with the other firms, is in a separate line of business, and no financial assistance, loans or subcontracting has taken place, such that Tenax is totally separate and independent from Vineyards and Heritage. Tenax argued that, without an identity of interest, the finding that Investors 1 and 4 control Vineyards and Heritage was clearly erroneous. And without common control, the Area Office should not have found Tenax affiliated.
OHA rejected this argument, first noting that the SBA affiliation regulations create a rebuttable presumption that family members, entities with common investments, and economically dependent firms are affiliated. With respect to identity of interest based on common investments, OHA previously has held that common investments in eight firms other than the challenged firm itself constituted “significant ownership interests” that “clearly bespeaks a common purpose such that a finding of identity of interest is appropriate,” and that “three common [minority] investments are insufficient to justify a finding of an identity of interest.” Based on these precedents, “the common investments of the persons must be substantial, either in number of individual investments, or in total value, in order to find that there is an identity of interest between the investors.” Here, Investors 1 and 4 invested together in eight firms not including Tenax, and they each have an interest of at least 15% in each of such firms. Thus, the Area Office did not err in finding an identity of interest.
According to OHA, Tenax’s attempted “rebuttal” of the presumption – based on a showing of “clear fracture” – was misplaced and without merit. This is because the “clear fracture” approach is grounded on the reasoning underlying the family relationship identity of interest presumption, which arises, not from the degree of family members' involvement in each other's business affairs, but rather from the family relationship itself. That relationship is presumed to give rise to identical interests unless the family members are estranged or are not involved in each other’s business transactions (i.e., there is a “clear fracture” between them). However, where, as here, the presumption is based on common investments, the presumption instead is that the investors have a common purpose such that their investments should be aggregated. Rebuttal of this type of presumption requires a showing that the parties have no common purpose (not that a clear fracture exists). Since Tenax did not argue that Investors 1 and 4 do not share a common purpose -- or do not invest together in eight firms – OHA found Tenax failed to rebut the presumption that, as common investors, there is an identity of interest between those investors.
This aspect of the Tenax decision underscores the importance of carefully considering each of the affiliation presumptions established by the SBA regulations to determine whether they might apply – and whether, and how, you can make the showing required to rebut each separate presumption. The rules can be complicated, and their application is always highly fact-specific. Be careful out there.
Eric Whytsell is responsible for the contents of this Article.
© Jackson Kelly PLLC 2016