SBA REGULATIONS RELATING TO 


UNCONDITIONAL OWNERSHIP 


REQUIREMENTS FOR INDIAN 


TRIBES 


Report Number: 10-07 


Date Issued: January 25,2010 

U.S. Small Business Administration Memorandum 

Office of Inspector General 

Date: To: 	 Joseph G. Jordan January 25,2010 

Associate Administrator for Government 

Contracting and Business Development 

lsi Original Signed 

From: 	 Debra S. Ritt 


Assistant Inspector General for Auditing 


Subject: 	 Audit of SBA Regulations Relating to Unconditional Ownership Requirements for 

Indian Tribes, Report No. 10-07 

During our review of Alaska Native Technologies, LLC (ANT), we determined 

that SBA' s business development regulations do not clearly implement the Small 

Business Act's (Act) statutory requirement that firms owned by Indian tribes be 

unconditionally owned. We also determined that SBA's regulatory definition of 

unconditional ownership appears inconsistent with restrictions discussed in the 

legislative history of the Act. We are notifying you of these issues so that you can 

take immediate action. 

To participate in the 8(a) program, the Act requires that small business concerns 

be socially and economically disadvantaged. Section 8(a)(4)(A)(ii) of the Act 

defines a socially and economically disadvantaged small business concern as one 

that is at least 51 percent unconditionally owned by, among others, an 

economically disadvantaged Indian tribe. 1 The Act does not define unconditional 

ownership. However, SBA's regulations implementing the Act define 

unconditional ownership as ownership that is not subject to any arrangement that 

removes present or future rights of the ownership interest through a mechanism 

the disadvantaged individual or entity does not control. 2 The purpose of 

unconditional ownership is to ensure that disadvantaged owners are the primary 

beneficiaries of the 8(a) program. 

1 15 u.s.c. § 637(a)(4)(i)(II). 

2 	l3 CFR 124.3 specifically prohibits conditions precedent, conditions subsequent, executory agreements, voting trusts, restrictions on 

voting rights, or other arrangements that cause or potentially cause ownership benefits to go to other than the disadvantaged 

individuals upon whom eligibility was based. 
Under SBA's regulations Indian tribes are not subject to the unconditional 

ownership requirement, 3 but instead, must comply with the "special ownership 

requirements" of 13 CFR 124.l09. Those special ownership requirements state 

the tribe must own 51 percent or more of the concern, but do not seem to contain 

an unconditional ownership requirement. 4 Notwithstanding the Act's 

unconditional ownership requirement, SBA's regulations do not appear to mandate 

that an Indian tribe's ownership be unconditional. 

Additionally, SBA' s regulations have defined unconditional ownership 

inconsistent with the Act's legislative history. The legislative history of the 

unconditional ownership requirement only addresses arms-length 5 transactions 

with legitimate financing institutions.

6 The regulatory definition, however, allows 

the "pledge or encumbrance of stock or other ownership interest as collateral, 

including seller financed transactions." These pledges or encumbrances must only 

follow the undefined "normal commercial practices," with the owner retaining 

control of its ownership interest. 7 SBA' s regulatory definition, with its reliance on 

the undefined "normal commercial practices" and permissiveness toward seller 

financed transactions invites program abuse. 

In ANT' s case, the 8(a) firm was started with [FOIAex. 4Jin goodwill8 representing 

the value of the expertise and contacts of a non-disadvantaged individual (NDI). 

Prior to ANT's existence, the goodwill was reportedly a self-valued9 intangible 

asset of a company owned by the NDI. [FOIA ex. 3] 

The NDl's company contributed goodwill worth 

[FOIA ex. 4Jto ANT. The remaining goodwill, valued at [FOIA ex. 4] was sold to an 

Indian tribe that consequently contributed the goodwill to the formation of ANT. 

The parties agreed to share ownership of ANT, with the tribe owning 51 percent 

and the NDl's company owning the remaining 49 percent. No cash was 

contributed in the formation of the 8(a) firm, and a Certified Public Accountant 

has yet to recognize the [FOIA ex. 4Jin goodwill on ANT' s audited financial 

statements. 

Choosing not to use a financial institution, the tribe opted to use seller-financing to 

pay for its [FOIA ex. 4] purchase of goodwill. To settle the debt, the seller (the NDl's 

3 l3 CFR 124.105. 


4 l3 CFR 124.109(c)(3). 


5 A transaction negotiated by unrelated parties, each acting in his or her own self interest; the basis for a fair market value 


determination. 

6 The conference committee discussed the relationship between financing and unconditional ownership in House Conference Report 

100-1070 (October 7, 1988). Congress amended the statute through Public Law 101-37, effective June 15, 1989. The 1989 revisions 

added the word "unconditional" to correct an omission in the 1988 statute. The legislative history describes unconditional ownership 

as critical to Congressional intent regarding ownership of a firm. 135 Congo Rec. S4489-01 , S4490 (April 19, 1989). 

7 l3 CFR 124.3. 

8 Goodwill is the advantage of having established a business. It has no value basis unless it is purchased and generally is the 

difference between the purchase price and the fair market value of the assets acquired. 

9 The goodwill was valued by the NDI and the Indian Tribe that owns 51 % of ANT. 

2 

company) required the tribe to (1) pay 50 percent of its share of ANT's profits to 

the seller, and (2) pledge its 51-percent ownership interest in ANT to secure its 

obligation. This effectively reduced the tribe's share of ANT's profits to 

25 percent, while the NDl's company received 75 percent. Notwithstanding the 

pledge of its ownership interest, the tribe retained the 51-percent ownership 

required by SBA regulations. Despite the tribe's 51-percent ownership, the NDl's 

company was the primary beneficiary of the program. Even if SBA' s regulations 

required the Indian tribes' ownership to be unconditional, the regulatory definition 

of unconditional ownership would probably have allowed the pledging of the 

tribe's ownership interest to secure purchase of the "goodwill." This pledge in the 

seller-financed transaction discussed above facilitated the re-direction of the 8( a) 

program's primary benefits from the tribe to the NDI. Transactions that encumber 

an ownership interest occurring outside of arms-length transactions with legitimate 

financing institutions invite program abuse similar to the abuse that occurred with 

ANT. 

In fiscal year 2008, 39 Indian tribes participated in the 8(a) program. Those tribes 

owned 54 participants, 31 of which received 8( a) obligations totaling 

$129.5 million. Without the unconditional ownership requirement, nondisadvantaged individuals or entities can reap the primary benefits from 

contracting preferences that allow tribally-owned firms to receive sole-source 

contracts of any value. Likewise, excessive flexibility regarding an owner's ability 

to pledge or encumber an ownership interest allows capital arrangements that steer 

the benefits of the 8(a) program to non-disadvantaged individuals or entities. 

RECOMMENDATIONS 

We recommend that the Associate Administrator for Government Contracting and 

Business Development: 

1. 	 Revise Title 13 CFR, Part 124 to mandate that tribally-owned firms be 

unconditionally owned as required by the Small Business Act. 

2. 	 Study the effect of allowing seller-financed transactions to encumber 

ownership shares, and if appropriate, revise Title 13 CFR, Part 124 to provide 

that a stock or other ownership interest that is pledged or encumbered is not 

unconditionally owned unless the pledge or encumbrance occurs within an 

arms-length transaction with a legitimate financial institution. 

3 

AGENCY COMMENTS AND OFFICE OF INSPECTOR GENERAL 

RESPONSE 

On November 19, 2009, we provided a draft of the report to SBA' s Office of 

Government Contracting and Business Development for comment. On 

January 5, 2010, the Associate Administrator for Government Contracting and 

Business Development provided written comments, which are contained in their 

entirety in Appendix I. 

We consider the actions proposed by management to be non-responsive to 

recommendation 1. Because management expressed that it needed to study the 

effect of allowing seller-financed transactions, we consider management's 

comments to be responsive to recommendation 2 and have revised the 

recommendation accordingly. The Agency's comments and our evaluation of 

them are summarized below. 

Management Comments 

Recommendation 1 

Management stated that it will review/evaluate public comments and feedback 

received from listening tours and tribal consultations regarding proposed rule 

changes to determine whether to revise Title 13 of the Code of Federal 

Regulations, Part 124 to mandate that tribally-owned firms be unconditionally 

owned. 

OIG Response 

We believe that an evaluation of public comments is irrelevant when Agency 

regulations are not consistent with the enabling statute. In addition, if the legally 

mandated requirement for unconditional ownership is not being enforced for one 

tribally-owned 8(a) firm, it is not being enforced for other tribally-owned firms. 

Our report clearly shows that the inconsistency exists, and that it invites program 

abuse. Therefore, the Agency should revise its regulations to ensure that the 

regulations are consistent with the Small Business Act. 

Recommendation 2 

Management agreed that the pledge or encumbrance of ownership interest in an 

8(a) firm should take place only through an arm's length transaction. However, 

the Agency believed that requiring such transactions be conducted with legitimate 

financial institutions would cripple an 8(a) firm's access to capital. 

4 

OIG Response 

Management did not address the concerns raised in our recommendation, but 

indicated that it needed to study the issue. Accordingly, we revised the second 

recommendation to include, as an alternative to immediately changing the 

regulation, that the Agency study the effect of changing the definition of 

unconditional ownership and then make any appropriate change to its regulations. 

The study should examine the effect of allowing seller-financed transactions to 

encumber ownership shares focusing, specifically on: (1) how many 

disadvantaged individuals in the 8(a) Program have encumbered ownership 

interests arising from their purchase of the 8( a) company or assets of the 8( a) 

company, (2) what constitutes normal commercial practices for seller-financed 

transactions, and (3) what, if anything, would be the effect on 8(a) participation 

levels if disadvantaged individuals were only allowed to encumber or pledge their 

shares in arms-length transactions with legitimate financial institutions. An 

assessment of whether changing the regulation would affect program participation 

should identify the availability of other SBA programs such as the 7(a) loan 

guaranty program, to assist disadvantaged business owners as an alternative to 

seller-financing of transactions. 

ACTIONS REQUIRED 

Based on your comments, we have revised recommendation 2 and request your 

response on the attached SBA Form 1824, Recommendation Action Sheet within 

30 days from the date of this report. Your response should identify the specific 

action(s) taken or planned and the target date( s) for completion. Because you have 

non-concurred with recommendation 1, we plan to refer the issue to the next 

higher level of management for resolution, in accordance with Standard Operating 

Procedure 20 35. 

We appreciate the courtesies and cooperation of the Small Business 

Administration during this review. If you have any questions concerning this 

report, please call me at (202) 205_[FOIAex2]or Riccardo R. Buglisi, Director, Business 

Development Programs Group, at (202) 205- [FOIAex.2] 

5 

• • 

APPENDIX I. MANAGEMENT COMMENTS 


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January 5, 2010 

Ms. Debra S. Ritt 


Assistant Inspector General for Auditing 


Office of Inspector General 


U.S. Small Business Administration 


Washington, DC 20416 


Dear Ms. Ritt: 

, 

Thank you for the opportunity to comment on the draft report issued November 19,2009, 

entitled, "SBA Regulations Relating to Unconditional Ownership Requirements for 

Indian Tribes." (Project No.: 9008). 

It is important to note that this draft report and subsequent recommendations - stating 

that "SBA's business development regulations do not clearly implement the Small 

Business Act's statutory requirement that firms owned by Indian tribes be 

unconditionally owned" - are based solely,upon a review of one firm (Alaska Native 

Technologies, LLC (ANT). We believe that the issues that surfaced as a result of a 

review conducted ofANT are isolated and are not indicative ofthe tribally-owned firms 

that participate in the 8(a) Program. 

However, SBA has undertaken a comprehensive review ofthe rules cove~ing a variety of 

areas ofthe 8(a) Program, including tribally-owned firms. Public comments are currently 

being sought regarding the best way to determine whether a tribe meets the criteria of 

being economically disadvantaged for the 8(a) program. 

In addition to seeking public comments, SBA will hold tribal consultation meetings 

which are intended to provide a forum in which interested parties can discuss their views 

on the issues impacting tribally-owned firms. These meetings will enable SBA to obtain 

the views ofthese stakeholders and obtain their input as it relates to tribal eligibility for 

8(a) certification and various approaches to the 8(a) Program regulations. The outcome 

ofthese consultations, along with the comments obtained, will significantly impact the 

finalized regulations and the manner in which tribally owned companies and Alaska 

Native Corporations and all other small disadvantaged businesses participate in the 8(a) 

Business Development Program. 

The first consultation meeting was held December 16, 2009, in Seattle, W A and the 

second will be held January 14,2010, in Albuquerque, NM. In addition to the formal 

tribal consultations, listening sessions will be held around the country for the general 

public's participation. 
APPENDIX I. MANAGEMENT COMMENTS 


Office of Government Contracting and Business Development's Response to Draft Audit 

Report 

Page 2 

Following is the Office of Government Contracting and Business Development's 

response to the recommendations outlined in this draft report. 

RECOMMENDATIONS 

Recommendation # I: 

1. 	 Revise Title 13 CFR, Part 124 to mandate that tribally-owned finns be 

unconditionally owned as required by the Small Business Act. 

Response: 

Our office will review/evaluate the public comments as well as evaluate the feedback 

received regarding the from the listening tours and tribal consultations regarding the 

proposed rule changes to determine whether or not there is a need to revise Title 13 ofthe 

Code of Federal Regulations, Part 124 to mandate that tribally-owned firms be 

unconditionally owned. 

Recommendation #2: 

2. 	 Revise Title 13 CFR, Part 124 to provide that a stock or other ownership interest 

that is pledged or encumbered is not unconditionally owned unless the pledge or 

encumbrance occurs within an arms-length transaction with a legitimate financial 

institution. 

Response: 

We agree that any pledge or encumbrance of an ownership interest in an 8(a) firm should 

take place only through an arm's length transaction. Currently, the 8(a) regulations 

require such transactions to follow nonnal commercial practices. The tenn "normal 

commercial practices" is used multiple times in the Federal Acquisition Regulation and is 

used by several other agencies, including the IRS and the V A, in their own regulations. 

However, if there is any ambiguity in the use ofthe term, SBA is open to seeking 

comment on changing the language ofthe regulation to recognize that, as SBA has 

always required previously, unconditional 8(a) ownership interests may be pledged only 

through ann's length transactions. 

We also believe that, when Congress added the unconditional ownership requirement to 

the Small Business Act, the emphasis of the change was to require that pledges of 8(a) 

interests follow normal commercial practices and be performed only through arm's 

length transactions. The "legitimate financial institution" language was oflesser 

importance. 

7 
APPENDIX I. MANAGEMENT COMMENTS 

Office of Government Contracting and Business Development's Response to Draft Audit 

Report 

Page 3 

The legislative history shows that Congress sought to address fraud, waste, and abuse 

uncovered during the Wedtech case and investigation. Based on the experience ofthat 

case, we believe that Congress's primary concern was to address holes in how 8(a) 

ownership might be used for financing, not who the financier might be. Requiring that 

"normal commercial practices" be followed during 8(a) financing transactions does a 

great deal to prevent abuse. Although limiting pledges of 8(a) financing to "legitimate 

financial institutions" might curb some additional abuse, we believe it also may have a 

great detrimental effect on the ability oflegitimate 8(a) firms to find credit and grow their 

businesses. By definition, 8(a) owners are already economically disadvantaged. 

Limiting their ability to obtain credit from other than "legitimate financial institutions" 

would cut off credit sources that were previously available to the 8(a) firms, and still 

available to all other small businesses. Before instituting such a change, SBA would 

need to solicit wide public comment on the issue and study the impact that the change 

would have on the business development of 8(a) firms. 

We look forward to working with the Office of Inspector General as we continue to 


provide the highest quality of program delivery and oversight ofthe 8(a) Business 


Development (BD) Program. Since 2006, significant internal controls have been 


implemented in an effort to continuously improve 8(a) Program delivery. 


Sincerely, 

[FOIA ex. 6] 

Joseph G. Jordan 

Associate AdIDinistrator for 

Government Contracting 

and Business Development 

Enclosures 

8