Piliero, Mazza and Pargament, PLLC.

Piliero Mazza & Pargament, PLLC Vol. 6, Issue 4 Fourth Quarter 2004

LEGAL ADVISOR
An Update for Federal Contractors and Commercial Businesses

A R T I C L E S


CORPORATE - Trade Association Members Should Be Cognizant of Legal Obligations
SMALL BUSINESS - A Challenge for Selling Small Businesses: The SBA's New Regulation


CORPORATE

Trade Association Board Members Should be Cognizant of Legal Obligations

Representatives from federal contractors and commercial businesses frequently find it to be in their company’s best interests to join trade associations involved in activities that affect their product or service industry. Although mere membership in a trade association typically does not create legal issues for the representative, the situation is much different when the representative becomes a member of the association’s board of directors. Although board members have many legal obligations, two of the more common issues that can arise involve conflicts of interest and anticompetitive activity.

Conflicts of Interest

Like board members of all corporations, board members of trade associations owe a fiduciary duty to act in the best interests of the association. As part of this fiduciary obligation, board members owe a duty of loyalty to the association, which means that they must take appropriate action to avoid conflicts of interest. In order to meet this obligation, each board member must constantly be aware of the duality of interest that he has by virtue of being a board member, as well as a paid employee of a private company in that same industry. This duality of interest is not unlawful in itself. However, in some circumstances that are presented to the Board for consideration, these interests come into direct conflict. That is, the board member, personally, or his company, may stand to derive a financial benefit from a particular transaction being considered by the Board. In such a situation, the board member is considered to be an "interested director" for purposes of the Board’s consideration of the transaction. A typical example is where the association is considering a business relationship with a board member’s company.

Although corporate laws vary slightly from state to state, when a potential conflict arises, the fiduciary obligation generally requires an "interested director" to take two fundamental steps:

• Make full disclosure to the Board of the conflict of interest prior to the Board’s consideration of the issue; and
• Abstain from voting on the matter.

In some situations, an interested director may feel, despite the potential conflict, that he can be fair and impartial and vote on the matter objectively. Therefore, he may choose not to reveal to the Board that he is an interested director. However, by proceeding in this fashion, the board member would not only be breaching his fiduciary duty, but he would also be jeopardizing the validity of the Board’s action, which could be subject to legal challenge. It is imperative, therefore, that board members be vigilant in making full disclosure of such conflicts. Where there is any doubt about whether a board member is "interested" in a particular transaction, the prudent course of action is to disclose the matter to the Board.

Antitrust Issues

Trade association board members should be particularly cognizant of antitrust laws. This is because action by board members, who are also representatives of different companies, can constitute "collective action" under those laws.

The relevant statute for antitrust analysis is Section 1 of the Sherman Act, 15 U.S.C. § 1, which makes unlawful "[e]very contract, combination . . . , or conspiracy, in restraint of trade or commerce." The Supreme Court has interpreted this statute to forbid only unreasonable restraints of trade, rather than all restraints. Some restraints are per se unreasonable, and therefore, will be struck down regardless of the surrounding facts and circumstances. Examples of per se violations include price fixing agreements, market allocation agreements and group boycotts.

More commonly, board decisions, while not constituting a per se violation of the Act, may have an anticompetitive impact. For example, a trade association’s establishment of certain guidelines for an industry may have the effect of excluding certain businesses, thereby reducing the level of competition. The issue of whether or not these types of restrictions run afoul of the Sherman Act would likely be evaluated under what is known as a "rule of reason" analysis, wherein the court will examine the reasons for the restriction and weigh those reasons against its anticompetitive effects. To survive an antitrust challenge, a particular practice or rule of a profession must serve the purpose for which the profession exists. Practices and rules that only suppress competition will fail to survive the challenge.

In applying the rule of reason analysis, courts will review, among other things, whether the activity is justified in light of the market, the nature of the profession or field of endeavor, the nature and effect of the restraint, the reasons for adopting the practice, and the condition of the profession or field before and after the restraint. In other words, in applying this analysis, courts will generally consider: (1) the extent of the economic impact of the restriction; (2) the motives for the restriction; and (3) the substantive reasons for the restraint. Each of these three factors are briefly discussed below.

Extent of the economic impact. In examining the economic impact of the restriction, the court will review the extent to which the restraint bars competitors from a particular market and/or causes harm to the public.

Motives for the restriction. Importantly, proper motives, though not dispositive, play a powerful evidentiary role in determining whether a restraint of trade has an anticompetitive effect, or neutral or pro-competitive effects. Courts examine "the purpose or end sought to be obtained . . . not because a good intention will save an otherwise objectionable regulation or the reverse, but because knowledge of intent may help the court to interpret facts and to predict consequences."

Substantive reasons for the restraint. Courts will also give a reasonable level of deference to the substantive knowledge underlying restraints. This should not be interpreted to mean, however, that any reason offered by an organization will be accepted by a court. Restrictions must be consistent with legitimate business interests to pass the rule of reason analysis. In addition, restrictions that restrain trade must be narrowly drawn so as not to create needless limitations, and they must not be motivated by a desire to stifle competition. Indeed, the need for the restriction to be amply supported by sound business judgment is even more compelling where there is a planned exclusion of a party. In short, if the primary purpose, however disguised, is to stifle competitors, then the regulation or policy will likely be struck down. However, if the primary purpose for the regulation or policy is based on legitimate business justification, then the court will generally hold any incidental restraint of trade, not harmful to competition or the public, to be lawful.

Obviously, the antitrust analysis is extremely fact-specific and therefore, dependent on the circumstances of any given situation. If antitrust concerns are raised, the wisest course is to enlist the assistance of counsel. At a minimum, to help avoid antitrust claims, board members developing rules, restrictions or policies within an industry should consider the following steps:

1. Establish, in writing, the association’s motive/intent in developing the guidelines;
2. Establish, in writing, the substantive reasons for the guidelines, which should be consistent with the association’s legitimate business interests, and evaluate why the guidelines are important and necessary;
3. Avoid restrictions that are arbitrary; each restriction should be supported by a legitimate business reason;
4. Establish restrictions that are as narrow as possible to accomplish the objective;
5. Evaluate the likely impact of the guidelines on the consumer;
6. Evaluate the overall impact of the guidelines on the affected businesses; and
7. Keep the process for development of the guidelines fair and open, considering all points of view.

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SMALL BUSINESS

A Challenge for Selling Small Businesses: the SBA’s New Regulation

Owners of small businesses performing government contracts should be aware of a new regulation that may impact their ability to sell their companies. Generally, successful small businesses in the government contracting arena have a backlog consisting of contracts awarded as small business set asides. The SBA’s new regulation may have a significantly adverse impact on the ability of these companies to sell these contracts or the company itself.

New Rule

Specifically, the SBA has amended 13 C.F.R. § 121.404 by, among other things, adding a subsection which provides that when a novation or change-of-name agreement has been executed pursuant to FAR subpart 42.12, the new entity must submit a written self-certification that it is small so that the procuring agency may take the appropriate small business credit. See 13 C.F.R. § 121.404(i). Under this new size regulation, if a small business is sold after June 21, 2004, and a novation is required, the buyer must submit certification of small business size status along with the novation documentation. The new regulations do not require that the transferred contracts be terminated if the buyer is unable to certify as a small business. Rather, in that event, the procuring agency would no longer be able to count the contract towards its small business goals.

Adverse Effects

This rule may have a serious adverse impact on small companies performing contracts with small business eligibility requirements. The prior SBA regulations provided that a small business’ size was determined at the time it submitted its final proposal, including price, for a small business set aside contract. If the assets of a small business, including its government contracts, were purchased by a large business, the new company performing the contracts was still considered small until completion of the contracts, including any options. This was an extremely marketable selling point for owners of small businesses.

However, the revised regulations cause the buyer (or the new combined entity) to have to re-certify as small at the time the novation documentation is submitted to the procuring agency, which could be several years after the small business set aside contract was awarded and after the seller company is no longer considered small. Further, the new entity would have to determine its size based upon the joint employees or revenues of the new combined company. A procuring agency, anxious to meet its small business goals, may be reluctant to exercise options under pending small business set aside contracts once it is apprised that the business performing the contract is not small. This diminishes the value of such contracts and causes small businesses performing such contracts to be less attractive to potential buyers.

Further, companies that have been conducting due diligence and negotiations for several months in connection with the sale and purchase of such businesses, may argue that they have needlessly expended time and money for a transaction whose terms have been significantly revised as a result of this new requirement. In other words, because of the new regulation, the purchaser may indicate its unwillingness to consummate the deal, or may seek a reduction in the purchase price.

Although there were some concerns that this rule was not issued in accordance with the Administrative Procedures Act (as there was no prior notice or comment period provided for this subsection), the rule states that it is currently effective for all solicitations issued on or after June 21, 2004. Despite the language of the rule, the SBA initially indicated that it would begin enforcing the rule immediately for all novation documentation submitted after June 21, 2004. However, the SBA has since clarified its position by issuing a technical correction to the rule such that it will be applied to any novation (and change-of-name) documentation executed on or after December 21, 2004, regardless of when the solicitation for the relevant contract was issued.

Practical Measures

Small companies that are contemplating the sale of their businesses to larger entities in the near future may need to reconsider the structure of such transactions. The novation of federal government contracts is required in connection with the sale of businesses that are structured as asset sales and mergers, but not as stock sales. Thus, a new entity is not required to submit certification of small business size status in connection with a stock sale. However, buyers typically resist stock acquisitions because they generally result in the assumption of all of the seller’s liabilities. Further, in some circumstances, the tax consequences of structuring a business as a stock sale may not be as favorable to the parties.

In order to avoid the negative ramifications discussed above, small companies may want to move ahead as quickly as possible to consummate asset sales and mergers, such that the novation of all government contracts can be completed before December 21, 2004.

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