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Small Business Bond Indemnification

The Federal Acquisition Regulations ("FAR") are silent on the question of whether a large business concern may provide bonding indemnification to a small business. When this issue arises, it is normally reviewed in the context of a challenge to the size status of the small business concern under applicable SBA regulations. These regulations, found at 13 CFR 121 and 126 address those circumstances under which a relationship between a large business concern and a small business concern amounts to an "affiliation" that renders the small business as no longer being small. Under the regulations, affiliations exist under the following circumstances:

(1) Concerns are affiliates of each other when one concern controls or has the power to control the other, or a third party or parties controls or has the power to control both.

(2) SBA considers factors such as ownership, management, previous relationships with or ties to another concern, and contractual relationships, in determining whether affiliation exists.

(3) Individuals or firms that have identical or substantially identical business or economic interests, such as family members, persons with common investments, or firms that are economically dependent through contractual or other relationships, may be treated as one party with such interests aggregated.

(4) SBA counts the receipts or employees of the concern whose size is at issue and those of all its domestic and foreign affiliates, regardless of whether the affiliates are organized for profit, in determining the concern's size.

The legal dilemma that any large business faces when contemplating a relationship with a small business concern, is whether it can protect its interests without structuring the relationship in such a way that the SBA might later determine that, as a result of the relationship, the small business has become affiliated with the large business. More precisely, the SBA can be expected to focus on whether the relationship is such that the large business has the power to control the small business concern. If the power to control is evident, an impermissible affiliation will be found to exist.

The legal issue of whether bonding indemnification results in the power to control, and thereby an affiliation, has been examined by the SBA in a number of cases. In C.E. Wylie Construction Co., 1984 WL 41895 (S.B.A.), the SBA ruled that an indemnification for fee agreement whereby a large business concern indemnified the bonds of a small business concern on a fixed fee basis and which, by its terms, amounted to an arms length business transaction in which both parties benefitted and to which neither was inextricably tied and, which was not otherwise characterized by provisions that gave control or the power to control the small concern by a large concern, was not an impermissible contractual relationship, or affiliation. Similarly, in Steel Style, Inc., 1986 WL 57542 (S.B.A.), the SBA ruled that an indemnification for fee arrangement was permitted where the small business held the large business harmless from the indemnification, and where the small business did not give the large concern exclusivity with respect to the small business concern's bid indemnification business.

It must also be noted, however, that in another case, the SBA decided that where the small business and the alleged large business affiliate were in the same industry, where the large business provided assistance in the preparation of bid documents, and where the large business provided technical services to the small business, the bond indemnification, coupled with these other factors, gave rise to the power to control and to an affiliation. Interface Construction Co., 1988 WL 219876 (S.B.A.). The power to control, therefore, is very important and is subject to considerable scrutiny by the SBA.

A large business concern can legally furnish bond indemnification to a small business, or to a HubZone contractor, provided that the circumstances of the particular case are examined and fully addressed in a written indemnification agreement between the parties. Even though large and small construction contractors are in the same general business, there are significant differences in their equipment ownership, experience, financial strength, and performance capabilities. Great care must be taken to avoid any inference of the power to control the small business concern, and the indemnification should be the result of an arms length transaction with few, if any, strings attached.

It is particularly important that the agreement address the unique characteristics of the procurement under which indemnification is contemplated. In those cases where the viability of the small business concern exists even without the indemnification, and where the indemnification is offered because of the unique aspects of a particular procurement, the ability to defend the indemnification is even stronger.

The practical problem that the large business concern will face is that if competitors of the HubZone contractor suspect that there is assistance from a large business concern, there will undoubtedly be a size status protest and the nature of any bond indemnification will be scrutinized. In such a case, there must be full disclosure to the SBA about the nature and terms of the indemnification. Provided that there is no attempt to conceal the indemnification, neither the large business nor its surety need to be concerned about violating the law.

As explained above, it is very important to enter into an agreement that complies with the SBA's restrictions on affiliation, that discloses the indemnification, and that fully explains the rights and responsibilities of the parties.