Is it Possible to be a Disadvantaged Business Enterprise Supplier under DOT Regulations?

Most public procurement contracts have participation goals or requirements for minorities and other disadvantaged groups (Disadvantaged Business Enterprise or “DBE”).  Many general contractors and subcontractors are reluctant to use DBE subcontractors, feeling that they are difficult or impossible to find. There may be greater chances of default or impact on the project schedule. General contractors and subcontractors may also be reluctant to subcontract part of the labor, if this is their primary source of profit on a project. This has lead to an industry practice of obtaining DBE participation through the supply of materials. Materials make up a significant portion of any construction contract price. There may be less chance of delays or other defaults that can impact completion of the project.

The actual participation of DBE Suppliers varies, but at times the DBE Supplier simply “purchases” materials from a traditional non- DBE Supplier and then resells these materials to a general contractor or other end user.  Even then, the actual participation of the DBE Supplier varies.  At times they are “mere pass throughs,” that have no on site presence and only receive the traditional supplier invoices, mark them up 2 or 3% and reinvoice the end user. This does not seem to achieve the public policy objective of getting actual experience for disadvantaged groups, so that they will eventually no longer be disadvantaged.  This may also violate public procurement regulations.

As we reported, a national pipe supplier recently agreed to pay a $4,950,000 fine to settle a federal investigation based on U.S. Department of Transportation (“DOT”) and Environmental Protection Agency (“EPA”) regulations. See this and other related newsletters at our website.  The supplier agreed that it participated in transactions in which a certified “regular dealer” DBE acted “merely as a pass through” and did not perform a “commercially useful function” (“CUF”). General contractors, subcontractors and traditional non DBE suppliers are now concerned about their risk for violating CUF regulations. This result may be possible only with DOT and EPA regulations, although other regulations are similar. It is also curious, because the “regular dealer” portion of the regulations contains no CUF requirement. This is discussed below. The investigation was also resolved by a voluntary settlement agreement, so we do not know how a court would interpret these regulations or whether a court would impose a penalty.

The DOT has always had the most complete regulatory scheme for DBE participation goals. DOT regulations state that there are no DBE participation points unless the DBE contractor performs a CUF.  The regulations do not allow the DBE to be an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation.” A DBE performs a CUF when it is actually performing, managing, and supervising the work. To perform a CUF with respect to materials, the DBE must be responsible for negotiating price, determining quality and quantity, ordering the material and paying for the material.[1]

These last four requirements are sometimes referred to as the four “pillars” or “touchstones” of legitimate CUF participation. General contractors, subcontractors and traditional non DBE suppliers now more often insist that a DBE suppliers actually negotiate the price, determine the quality and quantity, order the material and pay for the material.”

Is this a safe harbor?  Or is it possible that a DBE Supplier is still a “pass through” or “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation.” It is questionable whether the public policy objectives are achieved by such a relationship, although there may be good experience in negotiating price, determining quality and quantity, etc. Reliance on these four “pillars” or “touchstones” may be misplaced and may not satisfy the DOT regulations for legitimate CUF participation.

An internet search for 49 CFR 26.55 will locate the U.S. Department of Transportation Code of Federal Regulations on this subject. You will see that these four “pillars” or “touchstones” appear 49 CFR 26.55(c).  However, this and the immediately prior subsections seem to be speaking about subcontractors and not suppliers, stating that “[w]hen a DBE participates in a contract, you count only the value of the work actually performed by the DBE toward DBE goals”[2] and that you “[c]ount the entire amount of that portion of a construction contract . . . .that is performed by the DBE's own forces. Include the cost of supplies and materials obtained by the DBE for the work of the contract.”[3]

49 CFR 26.55(c) then states [emphasis added]:

(c) Count expenditures to a DBE contractor toward DBE goals only if the DBE is performing a commercially useful function on that contract.

(1) A DBE performs a commercially useful function when it is responsible for execution of the work of the contract and is carrying out its responsibilities by actually performing, managing, and supervising the work involved. To perform a commercially useful function, the DBE must also be responsible, with respect to materials and supplies used on the contract, for negotiating price, determining quality and quantity, ordering the material, and installing (where applicable) and paying for the material itself. To determine whether a DBE is performing a commercially useful function, you must evaluate the amount of work subcontracted, industry practices, whether the amount the firm is to be paid under the contract is commensurate with the work it is actually performing and the DBE credit claimed for its performance of the work, and other relevant factors.

(2) A DBE does not perform a commercially useful function if its role is limited to that of an extra participant in a transaction, contract, or project through which funds are passed in order to obtain the appearance of DBE participation. In determining whether a DBE is such an extra participant, you must examine similar transactions, particularly those in which DBEs do not participate.

(3) If a DBE does not perform or exercise responsibility for at least 30 percent of the total cost of its contract with its own work force, or the DBE subcontracts a greater portion of the work of a contract than would be expected on the basis of normal industry practice for the type of work involved, you must presume that it is not performing a commercially useful function.[4]

The “four pillars’ appear in a discussion of a “DBE contractor” that is “actually performing, managing, and supervising the work involved” in the contract. Immediately following is the statement that the DBE cannot be “an extra participant in a transaction, contract, or project through which funds are passed in order to obtain the appearance of DBE participation.”

What do we make of the next subsection?  It states that the DBE must “perform or exercise responsibility for at least 30 percent of the total cost of its contract with its own work force.”  How does that apply to a DBE Supplier with no on site presence? All of these provisions, including the “four pillars,” may apply only to a subcontractor with an onsite presence and the materials that the subcontractor purchases.  DBE subcontractor labor counts towards DBE participation goals if the work is performed by the DBE’s own forces.  The materials that the DBE subcontractor uses do NOT count unless that DBE subcontractor was responsible for “negotiating price, determining quality and quantity, ordering the material and paying for the material.”[5]  The materials do not count if the general contractor performed any of these roles in acquisition of the materials.

The next subsection of the DOT regulations discuss the special factors in determining whether a DBE trucking company is performing a commercially useful function.[6]

Then the following subsection of the DOT regulations state [emphasis added]:

(e) Count expenditures with DBEs for materials or supplies toward DBE goals as provided in the following:

(1)(i) If the materials or supplies are obtained from a DBE manufacturer, count 100 percent of the cost of the materials or supplies toward DBE goals.

(ii) For purposes of this paragraph (e)(1), a manufacturer is a firm that operates or maintains a factory or establishment that produces, on the premises, the materials, supplies, articles, or equipment required under the contract and of the general character described by the specifications.

(2)(i) If the materials or supplies are purchased from a DBE regular dealer, count 60 percent of the cost of the materials or supplies toward DBE goals.

(ii) For purposes of this section, a regular dealer is a firm that owns, operates, or maintains a store, warehouse, or other establishment in which the materials, supplies, articles or equipment of the general character described by the specifications and required under the contract are bought, kept in stock, and regularly sold or leased to the public in the usual course of business.

(A) To be a regular dealer, the firm must be an established, regular business that engages, as its principal business and under its own name, in the purchase and sale or lease of the products in question.

(B) A person may be a regular dealer in such bulk items as petroleum products, steel, cement, gravel, stone, or asphalt without owning, operating, or maintaining a place of business as provided in this paragraph (e)(2)(ii) if the person both owns and operates distribution equipment for the products. Any supplementing of regular dealers' own distribution equipment shall be by a long-term lease agreement and not on an ad hoc or contract-by-contract basis.

(C) Packagers, brokers, manufacturers' representatives, or other persons who arrange or expedite transactions are not regular dealers within the meaning of this paragraph (e)(2). . . . . .

(4) You must determine the amount of credit awarded to a firm for the provisions of materials and supplies (e.g., whether a firm is acting as a regular dealer or a transaction expediter) on a contract-by-contract basis.

(f) If a firm is not currently certified as a DBE in accordance with the standards of subpart D of this part at the time of the execution of the contract, do not count the firm's participation toward any DBE goals, except as provided for in §26.87(i).[7]

This may be the only portion of the DOT regulations that contemplates the purchase of materials from a DBE Supplier, defined as either a DBE manufacturer or a “regular dealer.”  A regular dealer must be certified as a regular dealer by the DOT. A regular dealer must own, operate, or maintain a store, warehouse, or other establishment in which the materials required under the contract are kept in stock, and regularly sold to the public in the usual course of business.  The regular dealer must be an established, regular business. If the supplier qualifies, then the general contractor can then only count sixty percent (60%) of the cost of those materials towards DBE participation goals.  However, notice there is no apparent CUF requirement to be regular dealer.

Accordingly, supplies purchased from a DBE may count towards DBE participation goals on a DOT project only if:

1. They are used by a DBE subcontractor that performed a portion of a construction contract with the DBE's own forces and negotiated the price, determined the quality and quantity, ordered and paid for the material, or
2. If the materials were purchased from a DBE manufacturer, or
3. If the materials were purchased from a certified DBE regular dealer, in which case only sixty per cent (60%) of the cost counts towards DBE participation goals.

DOT regulations apply only on federal transportation projects.  However, more state and federal government agencies are adopting similar regulations.[8] The vast majority of investigations and penalties have come from DOT projects. It is not clear at this point whether state and local governments will ever actively initiate CUF investigations or enforcement actions. The risk is there, however, and the costs can be significant for suppliers and contractors.

  We hope this newsletter is helpful to you in understanding some of the recent events, concepts and issues involved in construction law. It is important to understand, however, that this law firm is not providing you legal or professional advice in supplying you this newsletter. We have generalized and simplified many legal concepts, so that the explanations are short, uncluttered and easily understandable. You should consult this firm or another attorney in dealing with any specific problem.

Regular Dealers

As discussed in the immediately prior subsection, a regular dealer must own, operate, or maintain a store, warehouse, or other establishment in which the materials required under the contract are kept in stock, and regularly sold to the public in the usual course of business.  The regular dealer must be an established, regular business. Sixty per cent (60%) of the cost of materials purchased from a qualified regular dealer count towards DBE participation goals.[9]

A DBE must meet the criteria as a regular dealer on a contract-by-contract basis. In other words, a DBE that acts as a regular dealer on one contract (receiving DBE credit for 60 percent of the value of the goods supplied) does not necessarily act as a regular dealer on other contracts. The DBE may act simply as a “transaction expediter” or “broker” (receiving DBE credit only for the fee or commission).

In order to qualify as a regular dealer on a particular contract, the DBE must “regularly” engage in the purchase and sale or lease of the products involved in the contract to the general public. This involves attention to the activities of the business over time, both within and outside of the DBE program. There is a difference between the regular sale or lease of the products and merely occasional or ad hoc involvement with them. It is not critical that every single item be physically present in the DBE’s store or warehouse before it is sold to a contractor. However, the store or warehouse should be more than a token location. For example, a mere showroom, the existence of a hard-copy or on-line catalog, or the presence of small amounts of material are generally not sufficient to demonstrate that a firm regularly deals in the items.[10]

In some circumstances, items are “drop-shipped” directly from a manufacturer’s facility to a job site, never in the physical possession of or transported by a supplier. In many such cases, the supplier’s role may involve nothing more than contacting the manufacturer and placing a job-specific order for an item that the manufacturer then transports to the job site. The supplier’s role may then be better described as that of a “broker” or “transaction expediter.”[11]

Notice that there is no apparent CUF requirement in this definition of a regular dealer in the DOT regulation. There is also no apparent prohibition in the regulation against acting as an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation,”[12] although there is discussion of CUF and “extra participants” in DOT’s Official Questions and Answers.[13]  In the regulation itself, both of these requirements appear only in the discussion of expenditures to a DBE contractor, discussed above.[14] This may make the result in the $4,950,000 fine case, discussed above, curious.

Notice that 49 CFR 26.55 (e)(2)(ii)(B) states that a person may be a regular dealer in such bulk items as petroleum products, steel, cement, gravel, stone, or asphalt without owning, operating, or maintaining a place of business, if the person both owns and operates distribution equipment for the products. As discussed below, legitimate DBE participation credit is available for the trucking services provided by a DBE trucker that owns at least one truck. DBE participation credit is also available for sixty per cent (60%) of the cost of bulk items delivered by that DBE trucker, even if the DBE trucker has no store or warehouse. This is an opportunity for DBE truckers.

[1] 49 CFR (Code of Federal Regulations) for DOT and 26.55 (c)(2) and 40 CFR 33.503 for EPA.

[2] 49 CFR 26.55 (a).

[3] 49 CFR 26.55 (a)(1).

[4] 49 CFR 26.55 (c)(1) – (3).

[5] 49 CFR 26.55 (c)(1).

[6] 49 CFR 26.55 (d).  There are several specific provisions applicable to trucking, because of its unique features and past abuse.

[7] 49 CFR 26.55 (E)(1) & (2) & (f).

[8] See e.g. Maryland State Fin. & Proc. § 14-303 Code Section 9-104(a)(2)  and COMAR 21.11.03.12-1; Maryland State Code Education § 5-301(h) and COMAR 23.03.03.06(D); Maryland Minority Business Enterprise Program Manual (July 2014) at pages 6, 36 & 105-115; Philadelphia Code § 17-600.

[9] It is not clear whether a regular dealer must be separately certified as a regular dealer by the DOT, in addition to certification as a DBE.   The DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 50- 51indicate that there is no separate certification, only a later administrative decision that the DBE acted as a regular dealer.  https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf.

[10] This explanation seems somewhat circular and inconstant, but does come from the DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 50-51 at https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf .

[11] DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 51 at https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf [In such a situation, the supplier’s role may often be better described as that of a “broker” or “transaction expediter” (see 26.55(e)(2)(ii)(C)) than as a “regular dealer.” In such a case, DBE credit is limited to the fee or commission the firm receives for its services. If the firm does not provide any commercially useful function (i.e., it is simply inserted as an extra participant in a transaction), then no DBE credit can be counted].

[12] 49 CFR 26.55 (c)(2).

[13] See DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 51 at https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf.

[14] 49 CFR 26.55 (c)(1) – (2).