Tower Communications, No. MSB-587 (August 29, 1997) Docket No. MSBE-97-2-20-2 UNITED STATES OF AMERICA SMALL BUSINESS ADMINISTRATION OFFICE OF HEARINGS AND APPEALS WASHINGTON, D.C. _______________________________ ) IN THE MATTER OF: ) Docket No. MSBE-97-2-20-2 ) Tower Communications ) Decided: August 29, 1997 ______________________________ ) APPEARANCES Antonio R. Franco, Esq., Piliero, Mazza & Pargament for Petitioner Tower Communications. Sandra L. Park, Esq., John T. Spotila, Esq. for Respondent Small Business Administration. DIGEST The SBA must explain its rationale when finding that an individual's average personal income and total fair market value of assets are so excessive that they support a conclusion that the individual is not economically disadvantaged. When calculating an individual's total assets, the SBA cannot count an asset twice, first as a personal asset and then as part of the individual's ownership interest in the applicant concern. When calculating an individual's average personal income, the SBA must consider certain losses along with other items of income. The individual's access to credit and the applicant concern's access to credit are two distinct concepts requiring separate analyses. FINAL DECISION ARKOW, Administrative Law Judge: Petitioner Tower Communications (Tower) challenges a decision by the Respondent Small Business Administration (SBA) denying it entry into the 8(a) program.1 The SBA found Tower ineligible for the 8(a) program because its owners, Mr. Keith Bass and Mrs. Paulette Bass, are not economically disadvantaged. The basis for that conclusion was the SBA's assessment of their personal income for the past two years, the fair market value of their assets, and their access to business and personal credit. See 13 C.F.R. Section 124.106. Tower claims the SBA's determination is arbitrary, capricious, and contrary to law. I agree. Jurisdiction Jurisdiction to decide this appeal is proper. 15 U.S.C. Section 637(a)(9); 13 C.F.R. parts 124 and 134. The appeal is timely. 13 C.F.R. Sections 124.210(b), and 134.202(a). Issue Whether the action of the SBA denying Tower Communications entry into the 8(a) program is arbitrary, capricious, or contrary to law. 15 U.S.C. Section 637(a)(9)(C), 13 C.F.R. Section 124.210(h)(1). Facts Tower, a telecommunications/data service company, applied for admission into the 8(a) program on August 13, 1996. The firm is owned equally by Mr. Keith Bass and his wife, Mrs. Paulette Bass, Black Americans, who claim they are socially and economically disadvantaged.2 On November 12, 1996, the SBA denied Tower's application because it found that the Basses were not economically disadvantaged. The SBA advised Mr. Bass that the basis for that finding was: [Y]ou and your spouse have accumulated substantial wealth and have been able to access significant personal credit and capital. We note that your individual assets total $1,260,971 each and you own real estate worth $1,840,000 and have been able to qualify for and service $1,642,000 in mortgages on these two properties with monthly mortgage payments of $10,847. In addition, while your average adjusted income for the past two years is low, it has been substantially reduced through Net Operating Loss (NOL) Carryovers from your passive partnership of $229,254. Without this NOL, your average separate incomes are $73,148 for the past two years. We note that your individual equity in the applicant firm is over $250,000 and has been in excess of this figure for four years. In addition, your personal tax returns reflect significant interest earnings and capital gains over the past three years. The totality of evidence suggests that you are not economically disadvantaged. Administrative Record (AR) at Ex. 7. Tower requested that the SBA reconsider its decision denying entry into the 8(a) program on November 21, 1996, and submitted additional documentation to support its position that the Basses were economically disadvantaged. AR at Ex. 6. On January 6, 1997, the SBA denied the reconsideration request, concluding that Tower had not presented sufficient evidence to cause the SBA to change its determination. The SBA concluded: [A]lthough your family partnership operates at a break even rate, the net operating losses generated by this partnership have generated over $500,000 in tax benefits to you and your spouse over the last three tax years. And, while your access to credit for business operations is now limited, it appears that this has occurred due to the significant amount of credit utilized to fund business real estate and operations in the past several years. We also note that your indi vidual shares of the applicant firm have increased to over $284,000 as of September 30, 1996, despite significant corrective amortization of goodwill. As indicated in your initial decline, you have properties valued at $1,840,000, with mortgages of $1,642,00 [sic] and a total monthly payment of $10,847. Based on this information provided, you have been able to utilize $1.6 million in credit to purchase business properties and provide operating funds. The ability to qualify and service this level of credit as well as accumulate assets of this value is not indicative of individuals who are economically disadvantaged. AR at Ex. 1. Tower appealed the reconsideration denial on February 20, 1997. Position of the Parties Tower contends the SBA improperly assessed the personal financial condition of the Basses and their access to business and personal credit. Among other points, Tower argues that the SBA did not compare Tower's access to credit to other concerns as required by the regulation, and should not have considered the mortgages used to secure financing for the business. Therefore, the SBA's determination that Tower is not eligible to participate in the 8(a) program because the Basses are not economically disadvantaged is arbitrary, capricious, and contrary to law. The SBA contends it properly assessed the personal financial condition of the Basses and their access to business and personal credit, and properly concluded that the Basses are not economically disadvantaged. With respect to access to credit, the SBA argues it made the correct comparisons to other concerns and properly considered the mortgages. Therefore, the denial of admission is not arbitrary, capricious, or contrary to law. Discussion Among the requirements for admission into the 8(a) program is that the socially disadvantaged owners of the applicant concern also must be economically disadvantaged. See 13 C.F.R. Sections 124.101, 124.106. Economically disadvantaged individuals are: socially disadvantaged individuals whose ability to compete in the free enterprise system has been impaired due to diminished capital and credit opportunities as compared to others in the same or similar line of business who are not socially disadvantaged, and such diminished opportunities have precluded or are likely to preclude such individuals from successfully competing in the open market. 13 C.F.R. Section 124.106(a)(1)(i). In assessing economic disadvantage, the SBA examines factors that fall into three general categories: (1) the personal financial condition of each individual claiming disadvantaged status, including that individual's access to credit and capital; (2) the financial condition of the applicant concern; and (3) the applicant concern's access to credit, capital, and markets. 13 C.F.R. Section 124.106(a)(2). Here, the only issues are the personal financial condition of the Basses and their access to business and personal credit. In evaluating the personal financial condition of individuals claiming economic disadvantage, the SBA examines: (1) their personal income for at least the past two years; (2) the total fair market value of all their personal assets; and (3) their personal net worth.3 13 C.F.R. Section 124.106(a)(2)(i). A finding adverse to the applicant on any of these factors is sufficient to conclude that an individual is not economically disadvantaged. See generally Matter of Pride Technologies, Inc., SBA No. 557 (1996) (holding net worth of $250,000 or less does not necessarily mean the individual is not economically disadvantaged, because excessive personal income or excessive total assets alone can preclude a finding of economic disadvantage) and cases cited therein. See also SRS Technologies v. United States, 843 F. Supp. 740 (D.D.C. 1994) (holding total assets alone can preclude a finding of economic disadvantage). I Personal Income The analysis of this factor of personal economic disadvantage consists of two steps: (1) the calculation of the individual's personal income, and (2) the determination of whether that amount of income is so excessive as to preclude a finding of personal economic disadvantage. The SBA's analysis of the Basses' personal income is defective at both steps. First, the SBA uses an individual's Adjusted Gross Income (AGI),4 as reported on his federal income tax return, as the starting point for determining personal income.5 Matter of Pride Technologies, Inc., SBA No. 557 at 12 (1996); Matter of TAO of Systems Integration, Inc., SBA No. 528 at 3 (1995); Matter of Autek Systems Corporation, SBA No. 417 at 11 (1992) (Decision and Remand Order); See also Autek Systems Corp. v. United States, 835 F. Supp. 13 (D.D.C. 1993), aff'd 43 F.3d 712 (D.C. Cir. 1994) (aff'g SBA Nos. 417 and 420). The use of an individual's AGI for determining the amount of his personal income has a rational basis and, thus, this methodology has been held not to be arbitrary, capricious, or contrary to law. Pride, SBA No. 557 at 12 (citing Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)). The use of AGI makes the source of the income irrelevant. Pride, SBA No. 557 at 12; TAO, SBA No. 528 at 5 (both comparing 124.106(a)(2)(i), which does not exclude any particular type of income when calculating personal income, with 13 C.F.R. Section 124.106(a)(2)(i)(B), which specifically excludes certain assets when calculating personal net worth). Accordingly, the SBA has, for example, properly considered as income the distribu tions from an "S" corporation as they appear on an individual's tax return. Pride, SBA No. 557. The SBA also has properly considered shareholder income from the applicant concern even though that income subsequently was reinvested in that firm. Matter of Super Solutions Corporation, SBA No. 461 (1994).6 I am unaware of any decisions addressing the modification of an individual's AGI to calculate personal income. Here, the SBA initially calculated the Basses' average AGI for 1994 and 1995 as $13,095 each. AR at Ex. 9 (BOS Analysis). However, the SBA also found that the Basses' income for both years had been "drastically" reduced because of NOL carryovers passed through to the Basses on their tax return from another business enterprise. Id. In evaluating Tower's initial application, the SBA recalculated the Basses' average income by adding back the NOL carryovers, and found each spouse's average income to be $73,148.7 AR at Ex. 7.8 Thus, in calculating the amount of the Basses' personal income, the SBA substantially departed from its long-standing policy of using an individual's AGI without any modification. Second, in determining whether the amount of an individual's personal income is so excessive as to preclude a finding of economic disadvantage, the SBA's policy is to compare the individual's income to that of other taxpayers. When that individual's income is in one of the top percentiles of all individual U.S. taxpayers, the SBA concludes he is not economically disadvantaged. This methodology and its specific applications repeatedly have been upheld as reasonable. See Pride, SBA No. 557 (AGI of $302,798, $275,901, $649,368, and $814,672 over 4 years in top 1% of gross income earners); Autek, 835 F. Supp. at 15 (AGI of $475,000 and $381,000, in top 1.5 percent of all U.S. taxpayers, as found in Autek, SBA No. 417 at 11 (Decision and Remand Order)); TAO, SBA No. 528 at 3 (AGI of $186,022 and $306,661 in the top two percent of wage earners); Super Solutions, SBA No. 461 at 7, 9-10 (average income over three years, including salaries of $122,932, $398,890, and $508,760, in the top percentile of all U.S. taxpayers). Such an analysis serves as a rational explanation of why any given amount of personal income is excessive and precludes a finding of economic disadvantage. Here, even if the SBA had correctly calculated the Basses' personal income as $73,148 each, it failed to explain why it departed from its comparison policy, and also failed to explain why it concluded that personal income of $73,148 is excessive.9 Without such an explanation, there is no rational connection between the SBA's finding of fact and its conclusion. Accordingly, because the SBA miscalculated the Basses' AGI by excluding their NOLs, and because it erroneously concluded that the Basses' personal income precludes a finding of economic disadvantage, the SBA's evaluation is arbitrary, capricious, and contrary to law. II Total Assets The analysis of this factor of personal economic disadvantage also consists of two steps: (1) the calculation of the amount of the individual's total assets, and (2) the determination of whether the total assets are so excessive as to preclude a finding of personal economic disadvantage. The SBA's analysis of the Basses' total assets is defective at both steps. The calculation of personal assets is distinct from a calculation of personal net worth. The Small Business Act and the regulations recognize the differences between "net worth" and "total assets, and require the SBA to consider both factors when evaluating an individual's economic disadvantage. 15 U.S.C. Section 637(a)(6)(A) ("In determining the degree of diminished credit and capital opportunities the [SBA] shall consider, but not be limited to, the assets and net worth of such socially disadvantaged individual.") (emphasis added); 13 C.F.R. Section 124.106(a)(2)(i) ("The specific factors to be considered include . . . total fair market value of all assets and the individual's personal net worth.") (emphasis added). Property excluded from "net worth" calculations is included in "total assets" calculations. Matter of Pride Technologies, Inc., SBA No. 557 (1996). In Pride, the ALJ held that the SBA reasonably found the individual not economically disadvantaged, despite his low personal net worth, because his personal assets of $4.1 million were excessive. Id. at 10. In SRS Technologies v. United States, 843 F. Supp. 740, 747 (D.D.C. 1994) the court held the SBA properly found that an individual's total assets of $4.6 million precluded economic disadvantage, despite low personal net worth. Here, the SBA incorrectly valued the Basses' total assets at $1,260,071 each. It counted Tower's office building, valued at $850,000, twice. First, it counted the building as a personal asset of the Basses. AR at Ex. 9, pp. 44-45; Ex. 17A, pp. 316-17 & 329-30. Second, the SBA counted the office building as a business asset of Tower and hence as part of the Basses' ownership interest in Tower.10 AR at Ex. 9, pp. 44-45; see Ex. 17A, pp. 316-17 & 329-30; Ex. 5, p.11 (Tower's balance sheet reporting the building as an asset and the Basses' ownership interest as owners' equity). Such double-counting is arbitrary, capricious, and contrary to law. It appears that the appropriate method of calculating total assets would be to treat all of the assets of the applicant concern only as a part of the disadvantaged individual's ownership interest in it, rather than to treat the concern's assets both as separate personal assets of the owners and as part of their ownership interest. In this case, the calculation of the Basses' assets is complicated because Tower is a sole proprietorship rather than a separate entity such as a partnership or a corporation. Thus, the Basses have title to these assets. Even so, just as a corporation's assets should be treated separately from its shareholders' personal assets, it would appear inequitable to calculate total assets differently for partnerships and sole proprietorships. Because it is clear that the SBA incorrectly counted Tower's office building as both a personal asset and a business asset, I need not decide, at this time, how the SBA should calculate total personal assets. Moreover, even if the SBA had properly calculated the total assets to be $1,260,971, this figure alone cannot lead to the conclusion that the Basses are not economically disadvantaged. The SBA failed to explain why it reached its conclusion that such an amount precludes a finding of economic disadvantage. For example, the SBA did not compare the Basses' total assets with those of other entrepreneurs or other American taxpayers to determine if they are excessive. Also, the Basses' total assets are far below the amounts that have been held to be excessive in earlier cases. See Pride, SBA No. 557 at 10 ($4.1 million); SRS Technologies, 843 F. Supp. at 747 ($4.6 million). Without an explanation of why total assets of $1,260,971 led the SBA to the conclusion that the Basses were not economically disadvantaged, there is no rational connection between that finding and that conclusion. Accordingly, the SBA's evaluation of the Basses' total assets is arbitrary, and capricious. III Access to Credit The regulations governing the determination of economic disadvantage require the SBA to consider the socially disadvantaged "individual's access to credit and capital" as part of the assessment of personal financial condition. 13 C.F.R. Section 124.106(a)(2). The regulations also require the SBA to evaluate separately the applicant concern's access to credit and capital. The SBA must: evaluate the ability of the applicant concern to obtain the external support necessary to operate a competitive business enterprise. In making the evaluation, SBA shall consider the concern's access to credit and capital, including, but not limited to, the following factors: Access to long-term financing; access to working capital financing; equipment trade credit; access to raw materials and/or supplier trade credit; and bonding capability. 13 C.F.R. Section 124.106(a)(2)(iii).11 Moreover, because the concern's access to credit is an aspect of its business and financial profile, the SBA must also compare the applicant concern's access to credit to non-disad vantaged concerns in the same or similar line of business. 13 C.F.R. Section 124.106(a)(1)(i); Matter of Gulf Construction Group, Inc., SBA No. 426 (1993); Matter of Joanna T. Lau and Lau Acquisition Corporation, SBA No. 391 (1992) (Decision and Remand Order).12 Thus, the regulations and case law clearly establish the individual's access to credit and the applicant concern's access to credit as two distinct concepts requiring separate analyses. With respect to access to credit, the SBA concluded in its initial denial letter: [Y]ou and your spouse . . . have been able to access significant personal credit and capital. We note that . . . you own real estate worth $1,840,000 and have been able to qualify for and service $1,642,000 in mortgages on these two properties with monthly mortgage payments of $10,847. AR at Ex. 7 (emphasis added). Subsequently, in its reconsideration denial letter the SBA concluded: [W]hile your access to credit for business operations is now limited, it appears that this has occurred due to the significant amount of credit utilized to fund business real estate and operations in the past several years. . . . As indicated in [the initial denial letter], you have properties valued at $1,840,000, with mortgages of $1,642,00 [sic] and a total monthly payment of $10,847. Based on this information provided, you have been able to utilize $1.6 million in credit to purchase business properties and provide operating funds. AR at Ex. 1 (emphasis added). The SBA's analysis and conclusions regarding access to credit make it apparent that the SBA confused, and treated as one, Tower's access to credit and the Basses' access to credit. The initial denial letter relies upon the Basses' mortgages on their personal residence and Tower's office building to reach its conclusion that the Basses "have been able to access significant personal credit and capital." AR at Ex. 7 (emphasis added). On the other hand, the reconsideration denial letter also relies upon the mortgages on the Basses' residence and Tower's office building to reach the conclusion that Tower's access to credit is now limited because it used a significant amount of credit when it mortgaged those same properties. This failure to separately analyze personal and business access to credit is contrary to the requirements of the regulations. Further, in reaching its conclusion, the SBA failed to make and to utilize the required separate analysis of Tower's access to credit comparing it to other concerns in the same or similar line of business.13 The SBA based its conclusion upon the assumption that a concern currently has access to credit where it has had access to credit in the past, but now has limited access to credit because its credit has been exhausted. The regulation governing the analysis of the applicant concern's access to credit requires the SBA to determine, at the time the 8(a) application is considered, whether the concern is able to obtain the "external support necessary to operate a competitive business enterprise." 13 C.F.R. Section 124.106(a)(2)(iii). This is no different from the requirement that the applicant concern's business financial condition be assessed "at a specific point in time," rather than what has occurred years earlier. 13 C.F.R. Section 124.106(a)(2)(ii). Thus, the SBA's conclusion is based upon a flawed analysis of Tower's access to credit.14 Accordingly, the SBA's evaluation of the Basses' and Tower's access to credit is arbitrary, capricious, and contrary to law.15 IV Standard of Review The SBA's denial of Tower's 8(a) application can be sustained only if a review of the written administrative record demonstrates the SBA has not acted arbitrarily, capriciously, or contrary to law in concluding that the Basses were not economically disadvantaged, as required by 13 C.F.R. Section 124.106. See 15 U.S.C. Section 637(a)(9)(C); 13 C.F.R. Section 124.210(h)(1). Such a review is narrow and does not permit me to substitute my own judgment for that of the SBA. The review should examine whether the SBA considered all of the facts presented and correctly applied the applicable laws and regulations to those facts in deciding whether or not to approve Tower's 8(a) application. Then, the review must examine whether there was a clear error of judgment by the SBA in making the determination, before a finding of arbitrary and capricious can be made. See Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983). A clear error of judgment can be found if the SBA: Fails to properly apply the law and regulations to the facts of the case; fails to consider an important aspect of the problem; offers an explanation for its determination that runs contrary to the evidence; or provides an implausible explanation that is more than a difference between my views and those of the SBA. In sum, the SBA must articulate a satisfactory explanation for its action, including a rational connection between the facts found and its determination. See id. The SBA failed to correctly apply the laws and regulations applicable to economic disadvantage determinations to the facts in this case before concluding that the Basses are not economically disadvantaged. The SBA made clear errors of judgment in failing to apply the established methodology for assessing the Basses' personal income; for properly calculating their total assets; and for evaluating their personal and business access to credit. Thus, there were clear errors of judgment in reaching the conclusion that the Basses are not economically disadvantaged, and that Tower therefore has not established its eligibility for admission into the 8(a) program. Accordingly, the SBA's decision is arbitrary, capricious, and contrary to law.16 Conclusion Respondent Small Business Administration's determination denying 8(a) program entry to Petitioner, Tower Communications, is ARBITRARY, CAPRICIOUS, AND CONTRARY TO LAW. See 15 U.S.C. Section 637(a)(9)(C); 13 C.F.R. Section 124.210(h)(1). This is the final decision of the Small Business Administration and is binding upon all parties, including those within the employ of the Agency. 15 U.S.C. Section 637(a)(9)(D); 13 C.F.R. Section 124.210(i). ______________________________ RICHARD S. ARKOW Administrative Law Judge _______________________________ 1 Small Business Act of 1958, Section 8(a), as amended, 15 U.S.C. Section 637(a); 13 C.F.R. part 124. The purpose of section 8(a) is to "promote the business development of small business concerns owned and controlled by socially and economically disadvantaged individuals so that such concerns can compete on an equal basis in the American economy." 15 U.S.C. Section 631(f)(2)(A). 2 Black Americans are presumed to be socially disadvantaged. See 13 C.F.R. Section 124.105(b). 3 The SBA does not contend that the Basses' personal net worth exceeds the regulatory maximum of $250,000. Thus, the Basses meet this requirement. 4 On the individual tax return, "Adjusted Gross Income" is "Total Income" minus certain adjustments, such as retirement plan deductions. See IRS Form 1040 (1995 & 1994) at Lines 23a through 31 (calculation of AGI). "Total Income" is the sum of all items of income, including subtractions for certain allowed losses. See IRS Form 1040 (1995 & 1994) at Lines 7-22 (calculation of Total Income). 5 Where the individual is married, the SBA calculates each spouse's share of AGI. See Pride, SBA No. 557 at 11, n.10; Matter of Anil Verma Associates, Inc., SBA No. 536 at 6 (1996). 6 Conversely, the SBA properly has not subtracted Schedule A personal deductions for home mortgage interest from AGI for purposes of determining economic disadvantage. Super Solutions, SBA No. 461 at 16. 7 The SBA added back the carryovers to the Basses' Total Income, not their AGI. 8 The Basses' 1994 tax return also includes a large capital gain passed through to them from the sale of partnership property. AR at Ex. 13E. The SBA did not subtract the amount of this gain from its calculation of the Basses' personal income. 9 In this connection, I note that $73,148 is far below the average personal incomes found to be excessive in Pride, Autek, TAO, and Super Solutions. 10 The SBA did not include Tower's other assets, such as cash and equipment, in its calculation of the Basses' personal assets. No explanation is given for such disparate treatment. Perhaps there is confusion over how assets should be reported on the Personal Financial Statement (SBA Form 413). 11 The SBA recently proposed new regulations for the 8(a) program. These new regulations would eliminate the applicant concern's access to credit as a separate factor in the determination of economic disadvantage. 62 Fed. Reg. 43583, 43587 (Aug. 14, 1997) (preamble to proposed rule). 12 Analysis of the disadvantaged individual's access to credit does not require a comparison to other individuals in the same or similar line of business. See Matter of Autek Systems Corporation, SBA No. 420 at 4 (1992) (discussing personal financial condition generally). 13 The SBA compared Tower's business financial condition to other concerns in SIC code 7374, which represents 20% of Tower's business, because no comparison data was available for SIC code 7375, Tower's primary industry. AR at Ex. 4, p. 9. The SBA should have compared Tower's business financial condition to other concerns in Major Group 73, and should have assessed all of Tower's business. See 13 C.F.R. Sections 124.106(a)(2)(ii) (requiring the comparison); 124.100 (defining same or similar line of business). 14 The reconsideration denial letter mentions only the mortgages as the factual bases for the SBA's conclusion that Tower and the Basses have sufficient access to credit to support denial of eligibility on that ground. Thus, Tower and the Basses seem to meet all other eligibility requirements relating to access to credit. See 13 C.F.R. Section 124.206(c)(1) (Where admission is denied on reconsideration, the "letter shall set forth findings based on the facts . . . for every material issue relating to each eligibility factor with specific reasons for each finding"). 15 On appeal, the SBA's counsel argues that certain financial ratios calculated from Tower's financial statements support the conclusion that Tower has access to credit and capital. Answer at 12 (citing AR at Ex. 4, p. 9). The SBA's counsel thus appears to be arguing these financial ratios as additional reasons for denying Tower's application on the ground of access to credit. Although these ratios themselves do appear in the AR, the SBA did not base its determination denying Tower's 8(a) eligibility on them. Thus, this argument is without merit. See Lau, SBA No. 391 at 16, n.8 (citing Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983)). 16 Because each of the SBA's conclusions regarding income, total assets, and access to credit is arbitrary and capricious, they cannot support the SBA's conclusion, based on the "totality of evidence," that the Basses are not economically disadvantaged. See AR at Ex. 7 (initial denial letter). Posted: September, 1997