DIVISION OF LEGISLATIVE SERVICES
VIRGINIA LEGISLATIVE ISSUE BRIEF
Number 16                       July 15, 1996

In-State Preferences in Public Procurement:

How Far Can Virginia Go?

Diane E. Horvath, Staff Attorney

Through their public procurement laws, states may choose to provide preferences to in-state (or "local") vendors, products, or both. In a competitive procurement, local preferences generally operate by requiring some fixed percentage to be added to the out-of-state vendor's bid. If the in-state vendor's bid is less than the out-of-state vendor's bid (which includes the preference), the in-state vendor wins the contract. A 1988 survey by the National Association of State Purchasing Officials (NASPO), an affiliated organization of the State Council of Governments, showed that 12 states provided a formal preference to local vendors in their procurement procedures. In NASPO's 1994 update to that survey, 15 states reported the existence of vendor preferences. The highest level of vendor preference is 10 percent; the most popular is five percent.

According to NASPO's survey, Virginia provides a preference to in-state vendors only in the case of tie bids, all other things being equal. A majority of states (39) provide such a preference. The Virginia Public Procurement Act (Virginia Code § 11-35 et seq.) does not currently contain other preferences for in-state vendors (15 states do), products produced in-state (17 states do), or in-state printing (10 states do). However, these types of local preferences are frequent subjects of legislative and research requests by members of the General Assembly. The purpose of this Issue Brief is to consider some new twists in the traditional legal and policy issues raised by local preferences in public procurement.

Constitutional Implications

Under the federal constitution, local preferences in public procurement typically implicate the commerce clause of Article I, § 8 and the equal protection and due process clauses of the fourteenth amendment. In the recent case of Smith Setzer & Sons, Inc. v. South Carolina Procurement Review Panel, 20 F.3d 1311 (1994), the Fourth Circuit Court of Appeals analyzed these provisions in the context of local vendor and local product preferences in South Carolina's public procurement law. This case is particularly relevant because Virginia is in the Fourth Circuit and both litigants were from Fourth Circuit jurisdictions.

Background

South Carolina's procurement law states a general preference for products made, manufactured, or grown in South Carolina, if available, and if unavailable, for American products "before any foreign-made . . . products may be procured," so long as the cost of the product is not "unreasonable." "Unreasonable" means (i) any South Carolina product that exceeds by more than five percent the lowest qualified bid or (ii) any American product that exceeds by more than two percent the lowest qualified bid. Certain categories of purchases are wholly exempted from this scheme. Another statute provides a two-percent preference to resident vendors for contracts under $2.5 million; for contracts over $2.5 million, a one-percent resident vendor preference is provided. South Carolina's procurement agencies have combined the product and vendor preferences, resulting, on certain bids, in a seven-percent preference for a South Carolina vendor offering a South Carolina product.

Smith Setzer & Sons, Inc., headquartered in North Carolina, manufactured reinforced concrete pipe at plants in North Carolina, Virginia, and Georgia. As such, the company only qualified for the two-percent preference for offering an American-made product. In 1989, Smith Setzer bid on two separate requests for proposals (RFPs) issued by the South Carolina Department of Highways and Public Transportation. Together, the RFPs contained at least 47 sub-bids, on which Smith Setzer was the lowest bidder on at least 15. However, due to the application of South Carolina's local preference scheme, the company was awarded only two contracts. Smith Setzer sued on several grounds, unsuccessfully challenged the scheme in federal district court, and then appealed to the Fourth Circuit, which affirmed the trial court's decision upholding South Carolina's local procurement preferences.

Commerce Clause Analysis

The commerce clause reserves to the Congress the power "to regulate commerce . . . among the several states." From that express Congressional power, courts have long recognized "an implied limitation on the power of the States to interfere with or impose burdens on interstate commerce" (Western & Southern Life Insurance Company v. State Board of Equalization of California, 101 S.Ct. 2070, 2074 (1981)), known as the "negative" commerce clause. Thus, in the absence of Congressional approval, "regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors . . . are routinely struck down unless the discrimination is demonstrably justified by a valid factor unrelated to economic protectionism" (Smith Setzer at 1318).

The negative commerce clause "has been restricted to apply only where the state acts as a market regulator, exercising its taxing, regulatory or other police powers, and is inapplicable in situations in which the state acts as a market participant similar to private actors in the market" (emphasis added). Thus, state action that merely prescribes how the state (and its political subdivisions) participate in the marketplace is immune from attack under the negative commerce clause. Conversely, state action that regulates, taxes, or polices non-state entities in a discriminatory manner based on residency is subject to such attack. Having stated the legal test to be applied, the court held that South Carolina "entered the market to purchase a product for its own consumption, an action clearly outside the scope of the negative Commerce Clause," and rejected Smith Setzer's challenge on that ground.

Equal Protection and Due Process Analysis

The equal protection and due process clauses of the fourteenth amendment provide that "no State shall . . . deprive any person of life, liberty, or property, without due process of law; nor deny any person within its jurisdiction equal protection of the laws." In deciding whether the equal protection clause has been violated, a court must initially determine the appropriate legal test to be applied, a determination which turns on the nature of the fundamental right or classification at issue.

In Smith Setzer, the parties agreed that South Carolina's local preference scheme did not affect any fundamental right (e.g., speech), suspect class (e.g., race), or quasi-suspect class (e.g., illegitimacy). Thus, the Fourth Circuit applied the least stringent legal test to the classification created under South Carolina's scheme, known as the "rational basis" test. Under that test, "legislation is presumed to be valid and will be sustained if the classification drawn by the statute is rationally related to a legitimate state interest" (City of Cleburne, Texas v. Cleburne Living Center, 105 S.Ct. 3249, 3254 (1985)).

The Fourth Circuit's two-part analysis under the rational basis test involved determinations, first, of whether South Carolina's classification of in-state and out-of-state products and vendors served a legitimate state interest, and second, whether it was reasonable for lawmakers to believe that the classification scheme promoted that interest. On the first issue, the court found that "rules stating a preference that such [tax] monies [generated from the citizens of the state] be recycled within the local economy, either through the purchase of locally-produced products or through purchases from local vendors, rather than funneled out of state, reflect legitimate state concerns."

On the second issue, the court placed the burden on Smith Setzer, as it must, to show that "at the time of the enactment of these statutes and regulations, the legislature could not reasonably have conceived that the reinvestment of tax dollars into the community, even when it calls for purchasing goods for more than the lowest price available, would benefit its constituent citizenry." Smith Setzer presented trial testimony from an economist "to demonstrate that local preference schemes do not benefit state economies because the result of such parochial legislation is in fact a net economic loss." The court ruled that even if it accepted the testimony as true, "it is not our place to substitute our judgment for that of the democratic body that enacted these statutes." The court declined to "sit to judge the wisdom [of the legislature's action], nor is it for us to supplant the State's methods for achieving its objectives, so long as the Constitution is not offended in the process." The court held that Smith Setzer had failed to meet its burden, and wrote that "in the absence of evidence of such arbitrary and irrational behavior on the part of the legislature, the statute must survive rationality review."

How to Survive an Equal Protection Challenge

In upholding South Carolina's local preference scheme, the Fourth Circuit may have provided other state legislatures within its circuit (Virginia, West Virginia, North Carolina, and Maryland) a blueprint for enacting constitutionally permissible local preferences in their public procurement laws. Certainly, the state interests presumably furthered by such preferences--creating more jobs, retaining existing jobs, and generating additional tax revenue--are desired by legislatures nationwide, and, with Smith Setzer, are judicially recognized as constitutionally legitimate. To survive an equal protection challenge, however, a state must produce credible evidence at trial that the classification created by the local preference scheme is rationally related to such legitimate state interests.

For example: two companies submit competitive sealed bids on an RFP for concrete pipe issued by the South Carolina Department of Highways and Public Transportation. Smith Setzer bids $1 million. ABC Company, which sells concrete pipe manufactured in Hopkins, South Carolina, from its headquarters in Bristol, Virginia, bids $1,050,000. Under South Carolina's local preference scheme, ABC gets a five-percent preference for offering a South Carolina product. Thus, ABC wins the contract and South Carolina's taxpayers pay $50,000 more than they would have had the contract been awarded to Smith Setzer, ostensibly the lowest responsible and responsive bidder. At trial, how does South Carolina show that it will suffer an economic loss if it is not allowed to pay more for a local product?

One author (Hefner 1996) analyzed the example above using what is known as the "input-output (I-O) model." An explanation of the I-O model is outside the scope of this report; however, it is used as the "theoretical basis for most economic impact studies . . . ranging from measuring the economic impact of sporting events to the impact of military spending." (Hefner 1996, 34). Based on his I-O analysis, Hefner opined that if South Carolina chose to save $50,000 up-front by purchasing Smith Setzer's product, the state's economy would suffer an economic loss totaling over $2.1 million. Although the full calculation of that total is not illustrated in the article, the figure purportedly includes the loss of 27 potential jobs (about 12 of which would be in the concrete products industry), representing $656,300 in lost personal earnings.

Based on South Carolina's 1990-91 tax rate of about five percent on retail sales and individual and corporate income, Hefner calculated that the loss of 27 jobs would result in a $32,500 loss of state tax revenue. Thus, South Carolina's savings from purchasing Smith Setzer's concrete pipe would be reduced from $50,000 to $17,500. "If," Hefner concludes, "the public policy is only to save money then [purchasing Smith Setzer's product] would be the rational decision. However 27 potential jobs would be lost. The question to be asked is whether the state would or should be willing to spend $658 per job to generate 27 jobs."

The legislative policy choice posited by that question emphasizes a critical point in surviving an equal protection challenge to local preferences: Data that could support a constitutionally legitimate state interest can and should be gathered and analyzed prior to the enactment of a local preference scheme. Basing its decision on that data, the legislature can then carefully select levels of preference that produce either (i) long-term savings, which justify a higher up-front expenditure of public funds, or (ii) a break-even point, or something very close to it, which justifies the public policy choice of spending state funds in-state. If consideration of such data is part of the legislative debate, a challenger would be hard-pressed to persuade a reviewing court that the local preference scheme does not serve a constitutionally legitimate state interest or that the legislature behaved arbitrarily and irrationally in enacting the scheme.

GATT and the WTO

The General Agreement on Tariffs and Trade (GATT) raises additional legal and policy issues about local procurement preferences. GATT was established in 1948 after the trade wars and protectionism of the 1920s and 1930s, which many believe were among the underlying causes of the Great Depression and World War II. GATT sets the basic rules for international trade among 123 signatory nations by seeking "to encourage free trade by reducing or eliminating barriers to international commerce such as tariffs, governmental regulations, taxes and subsidies" (Waren 1996, 14).

To accomplish this goal, GATT forbids "most favored nation" and "national treatment" principles in international commerce. The former prohibits favoring the producers of one nation over those of another; the latter prohibits a government from favoring its own citizens and enterprises over foreigners. Under these principles, a "wide range of state activities and state laws might be subject to challenge if other nations regard them as discriminatory. Indeed, the European Union already has compiled a long list of state laws and practices to which it objects" (Waren 1996, 15).

The eighth and most ambitious round of GATT negotiations, known as the "Uruguay Round" (UR), concluded on April 15, 1994. Among the subagreements negotiated at the UR is a procurement code applicable to the federal governments and subgovernments of the U.S., Western Europe, Denmark, Sweden, Finland, Switzerland, Austria, Canada, Singapore, Hong Kong, Korea, and Israel. The procurement code is intended to open up the market in government contracts between the signatories by eliminating trade barriers such as "Buy American" and local preference laws. The code will apply to all procurements above a threshold dollar amount, except those reasonably exempted by each signatory country. Mickey Kantor, the U.S. trade representative, negotiated exemptions for small, minority, and women-owned business procurement preferences, but there are no general exemptions for other preferential programs such as in-state vendor preferences.

The UR also created the World Trade Organization (WTO), based in Geneva, Switzerland, to manage and administer GATT, resolve disputes among member countries, and "review state statutes and regulations and enforce trade sanctions if state law is found to be a trade barrier in violation of the agreement."¹ GATT's standards of nondiscrimination will be interpreted by WTO dispute resolution panels, comprised of representatives from the signatory nations, who may have varying degrees of familiarity with the U.S. constitution and its unique federal system of government. As such, it is not known whether GATT's standards will be interpreted to be less than, more than, or equal to traditional U.S. constitutional standards and to what degree the WTO will recognize the powers reserved to the states under the tenth amendment to the U.S. constitution. In short, a state law that passes U.S. constitutional muster upon review in federal court--like South Carolina's local procurement preference scheme-- is not necessarily immune from a GATT attack.²

Amid these concerns and other uncertainties about how the new GATT and the WTO will affect the U.S., Congress passed legislation to implement the UR in 1994. Shortly after its passage, however, Senator Bob Dole introduced legislation that would establish a "WTO Dispute Settlement Review Commission." The commission, to consist of five federal judges, would review WTO panel decisions against the U.S. to determine if they are "arbitrary and capricious." If the commission made such a determination on three WTO panel decisions in a five-year period, the legislation would permit Congress to take action to withdrawal the U.S. from the WTO. The legislation is still pending in Congress.

Conclusion

The Virginia Public Procurement Act expresses "the intent of the General Assembly that competition be sought to the maximum feasible degree." Indeed, to ensure maximum competition, NASPO recommends as an essential statutory element that public procurement laws prohibit rules, clauses, or policies allowing in-state or other local preferences for vendors or products. Assisting Virginia companies may be a desirable public policy; however, competition is diminished in public procurement when one class of vendors or products is preferred over others in the marketplace. Thus, while it may be possible to enact a local preference scheme that can survive both judicial review in federal court and a GATT attack in Geneva, where the General Assembly can go with local preferences may be miles away from where it should go.

¹WTO rulings against the states, to be applied prospectively only, will not be binding on the states as a matter of federal law. The range of sanctions includes (i) comply with the ruling, (ii) negotiate compensation in the form of trade advantages for the injured nation, or (iii) accept WTO-authorized retaliation such as higher tariffs or other trade barriers directed at U.S. exports generally or the exports of a particular state (Waren 1996, 15).

²For example, in a case known as "Beer II," a dispute resolution panel ruled that a Minnesota statute offering favorable excise tax treatment for microbrewery production discriminated against large Canadian beer producers, even though the tax was conditioned solely on the size of the brewery and was absolutely neutral with regard to its location. The tax would have likely withstood U.S. constitutional review (Waren 1996, 16).

REFERENCES

Hefner, Frank L. 1996. State Procurement Preferences: Evaluating their Economic Benefit. Spectrum, The Journal of State Government 69 (no. 1): 33-38.

National Association of State Purchasing Officials (NASPO). 1994. State and Local Government Purchasing, 4th ed.

Waren, William T. 1996. Balancing Act: Free Trade and Federalism. State Legislatures 22 (no. 5): 12-17.

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