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Venture Funding and the NIH SBIR Program Appendix F SBA Administrative Ruling on Appeal of Cognetix, Inc.
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Venture Funding and the NIH SBIR Program Cognetix, Inc., No. 4560 (May 29, 2003) Docket No. SIZ-2003-04-28-26 UNITED STATES OF AMERICA SMALL BUSINESS ADMINISTRATION OFFICE OF HEARINGS AND APPEALS WASHINGTON, D.C. ) SIZE APPEAL OF: ) Docket No. SIZ-2003-04-28- 26 ) Cognetix, Inc. ) Decided: May 29, 2003 ) ) Appellant ) ) Solicitation No. PHS 2002-2 ) National Institutes of Bethesda, Maryland ) ) ) ) ) APPEARANCES Michael K. Wyatt, Esq. Michael J. Vernick, Esq. For Appellant Kevin R. Harber, Esq. for the Small Business Administration DIGEST The term "individuals" in 13 C.F.R. Section 121.702(a) means only natural persons and does not include venture capital funds, pension funds, and corporate entities for purposes of an SBIR award. Thus, a firm that is otherwise eligible for an SBIR award is disqualified because it is less than 51 percent owned by natural persons. DECISION BLAZSIK, Administrative Judge: Jurisdiction
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Venture Funding and the NIH SBIR Program This appeal is decided under the Small Business Act of 1958, 15 U.S.C. Section 631 et seq., and 13 C.F.R. Parts 121 and 134. Issue Whether a firm that is otherwise eligible for an SBIR award is disqualified because it is less than 51 percent owned by natural persons. Facts The National Institutes of Health (NIH), National Institute of General Medical Sciences, issued this small business set-aside solicitation on a Phase II proposal for the Small Business Innovation Research (SBIR) program. The title of the Phase II project is "Alpha-Conopeptides: Novel Rapid-Acting Muscle Relaxants." The applicable size standard for the SBIR program, including affiliates, is 500 employees. 13 C.F.R. Section 121.702(b). On March 5, 2003, the NIH's Contracting Officer (CO) requested a formal size determination from the Small Business Administration's (SBA) Office of Government Contracting, Area VI (Area Office) in San Francisco, California, on Cognetix, Inc. (Appellant), the SBIR awardee. The CO's request stated that Appellant was awarded a grant, but in the course of obtaining additional financial information, the applicant provided statements that raised concern on their organization's eligibility for SBIR funds.  The Size Determination On April 7, 2003, the Area Office issued its size determination. Based on the documents Appellant submitted, the Area Office made the following factual findings. First, it noted Appellant's size status would be determined as of the date of the SBIR award for Phase II. 13 C.F.R. Section 121.704. The Phase II SBIR award was made on April 1, 2003 - thus, Appellant's size would be determined as of that date.  Second, the Area Office noted Appellant's two largest stockholders are MDS Capital and AIG Global Investments. The documents submitted revealed no entities control or have the power to control Appellant. Appellant's number of employees do not exceed 500 employees. 13 C.F.R. Section 121.702(b). Third, Appellant provided the Area Office with a stock ownership chart showing its diverse group of investors and the holdings of each investor after outstanding stock options are given present effect. 13 C.F.R. Section 121.103(d) (the present effect rule). Shares of Appellant's voting stock are owned by natural persons, corporations, and non-corporate institutional investors, including venture capital funds and pension funds.
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Venture Funding and the NIH SBIR Program The amount held by natural persons combined with that held by non-corporate institutional investors based in the United States exceeds 51 percent, but the amount held by natural persons alone is less than 51 percent. Based on the above, the Area Office determined that the majority of Appellant's stock is owned by institutions which, by Appellant's own admission, "are primarily venture capital operating companies, investment companies, and employee benefit or pension plans." Finally, the Area Office concluded that, although Appellant met the 500-employee size standard mandated by 13 C.F.R. Section 121.702(b), it did not meet section (a) of the rule. That section requires that a business concern to be eligible to compete for an SBIR award must be at least 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in the United States. The Area Office noted in Size Appeal of CBR Laboratories, Inc., SBA No. SIZ-4423 (2001) (CBR), this Office held that the terms "individuals" and "citizens" in the regulation mean only natural persons and not entities such as corporations. Accordingly, the Area Office concluded Appellant is ineligible for the SBIR Phase II award. Appellant received the size determination on April 11, 2003, and filed its appeal April 28, 2003.  On May 2, 2003, the Administrative Judge directed the SBA's Office of General Counsel (OGC) to submit comments on the issues raised in the appeal on or before May 13, 2003. She also gave permission to Appellant to file a reply to OGC's comments on or before May 23, 2003. She ordered the record to close on that date. The Appeal Appellant asserts the Area Office erred in applying CBR here. In distinguishing the facts in CBR from those in the instant proceeding, Appellant asserts in CBR, the challenged firm was wholly owned by a single corporation, whereas Appellant here is owned neither by corporations alone nor wholly by any single investor. Alternatively, Appellant asserts the Area Office erred in interpreting the CBR decision to mean that the term "individual" excludes venture capital funds and pension funds as well as corporations in determining SBIR eligibility. Thus, the Area Office erroneously counted shares held by Appellant's non-corporate institutional investors (pension funds and venture capital funds) as if those shares were held by corporations, rather than by individuals. Appellant asserts its non-corporate institutional investors hold Appellant's shares "on an aggregated basis for individual investors," and thus that stock should be counted as if owned directly by individual investors. Appellant asserts the Area Office's interpretation of CBR is
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Venture Funding and the NIH SBIR Program contrary to one of the Congressional intents of the SBIR program; that is, to attract to awardees private capital including venture capital funds and pension funds, which are typically organized as limited partnerships and trusts. Moreover, Appellant asserts SBA itself has acknowledged CBR is controversial in its new SBIR Policy Directive, and SBA plans to change it in a forthcoming rulemaking. As relief, Appellant requests the Administrative Judge either to reverse the size determination or to remand the matter to the Area Office. OGC's Comments On May 13, 2003, OGC filed its comments in opposition to the appeal. First, Counsel asserts the CBR decision is not limited to those instances where the applicant is a wholly-owned subsidiary of another firm. Second, CBR expressly stands for the proposition that a firm not 51 percent owned and controlled by natural persons is ineligible for the SBIR program. Pension funds and venture capital funds, as limited partnerships and trusts, are entities, not natural persons. Further, Appellant's approach, to count shares owned by pension funds and venture capital funds as if individuals owned them would undermine 13 C.F.R. Section 121.702(a). Finally, Counsel disagrees with Appellant that Congressional intent favors Appellant's approach, and cites exhaustively from legislative history to support his contention. On May 23, 2003, Appellant filed a reply to OGC's comments. Appellant disagrees with OGC's brief and reiterates its appeal's assertions that the SBIR Program's legislative history clearly supports Appellant's eligibility for a Phase II award. Appellant reasserts that Congress's intent cannot be questioned and that Congress intended the program to encourage investments from venture capital and other sources of private investment such as pension funds. Finally, Appellant asserts limiting CBR will not create an exception inconsistent with Congress's clearly expressed intent. Appellant repeats its request for either remand to the Area Office or reversal of the Area Office's determination. Discussion As noted, supra, fn. 3, the appeal is timely filed. On the merits, Appellant has the burden of proving, by a preponderance of the evidence, all the elements of its appeal. Specifically, it must prove the size determination is based on a clear error of fact and law. 13 C.F.R. Section 134.314; Size Appeal of Rebmar, Inc., SBA No. SIZ-4713 (1996). To reiterate the general elements, to be eligible for an SBIR award, a firm must be "at least 51 percent owned and
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Venture Funding and the NIH SBIR Program controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United States." 13 C.F.R. Section 121.702(a).  In CBR, after an exhaustive analysis of the pertinent regulation, its legislative history, and the pertinent SBIR Policy Directives, this Office held that the word "individuals" can refer only to natural persons and cannot refer to entities. CBR, at 11-12. The Administrative Judge rejects as specious Appellant's first argument, that the holding in CBR cannot be applied to any challenged firm not wholly owned by one corporation because the challenged firm in CBR was wholly owned by one corporation. The regulatory requirement quoted above is not premised on any particular ownership structure, and the discussion in CBR clearly considered the broad issue of whether the word "individuals," as used in 13 C.F.R. Section 121.702(a), could have any meaning other than natural persons. The Administrative Judge also must reject Appellant's second argument, that the stock holdings of non-corporate institutional investors should be treated as if owned directly by individual investors, because the institutions hold them "on an aggregated basis for individual investors." Institutional investors, whether organized as limited partnerships or trusts, clearly are entities and not individuals. Moreover, the Administrative Judge agrees with SBA's Counsel that if the definition of "individuals" in Section 121.702(a) contained an exception for non-corporate institutional investors, for which Appellant argues, this exception would eviscerate the rule. In the time since this Office issued the CBR decision in January 2001, SBA has revised its SBIR Program Policy Directive. 67 Fed. Reg. 60072 (Sept. 24, 2002). SBA changed its definition of "small business concern" to permit program applicants that are joint ventures. Policy Directive Section 3.y(2), 67 Fed. Reg. at 60084. In discussing ownership, the SBA retained precisely the same language interpreted in CBR, except with respect to joint ventures: at least 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United States, Id. at Section 3.y(3); see 13 C.F.R. Section 121.702(a); CBR at 3. In its preamble to the Policy Directive, SBA addressed a comment regarding the eligibility of wholly-owned subsidiaries by referring to this language, and noting this Office also addressed the issue in CBR. SBA further commented: At this time, SBA is considering this issue and if SBA determines that a change in the regulation is necessary, it will issue a proposed regulation pursuant
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Venture Funding and the NIH SBIR Program to Notice and Comment rulemaking. If there is a change in the regulation, the Directive will be changed accordingly. 67 Fed. Reg. at 60076. Shortly after issuing this Policy Directive, SBA proposed revisions to the size regulations. 67 Fed. Reg. 70339 (Nov. 22, 2002). Except for new language pertaining to joint ventures, the proposed text of Section 121.702(a) retains the same language as before. 67 Fed. Reg. at 70350. The preamble to the proposed rule states: The current requirement … requires 51 percent direct ownership by individuals who are U.S. citizens or permanent resident aliens in every case. This change is being made to make the size regulations consistent with a recent change made to the SBIR Policy Directive. 67 Fed. Reg. at 70344-45 (emphasis added). Based on the above, the Administrative Judge concludes that, as of both April 2, 2003, Phase II award date determining Appellant's size eligibility and the present time, this Office's holding in CBR still governs the issue of whether the term "individuals" in 13 C.F.R. Section 121.702(a) must refer to natural persons. Accordingly, Appellant's arguments to the contrary have no basis of fact or law and, thus, are without merit. In the circumstances, the Administrative Judge affirms the size determination and reaffirms this Office's decision in CBR. Conclusion For the above reasons, the Administrative Judge DENIES the instant appeal and AFFIRMS the Area Office's size determination. This is the Small Business Administration's final decision. 13 C.F.R. Section 134.316(b). GLORIA E. BLAZSIK Administrative Judge 1 On May 7, 2003, the CO notified this Office that the grant was suspended pending resolution of this appeal.
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Venture Funding and the NIH SBIR Program 2 The Area Office incorrectly stated it as April 2, 2003. 3 The appeal is timely under 13 C.F.R. Section 134.304(a)(1), because Appellant filed the appeal within 15 days of the receipt of the size determination. Because the 15th day was on a Saturday, the following business day (Monday) is the determinative date. 4 The other eligibility criterion, that the challenged firm, including its affiliates, has no more than 500 employees, is not at issue in this appeal. Posted: June, 2003