Home Articles ANALYSIS: The Proper Tool for BEE Fronting Removal

ANALYSIS: The Proper Tool for BEE Fronting Removal

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Gerhardus Burger discusses past and current public sector procurement in the context of amendments to broad-based black economic empowerment legislation. He also identifies some unintended consequences of legislative changes and explores possible solutions

One of the major challenges of black economic empowerment (BEE) is fronting. The big problem with fronting is that it frustrates and circumvents government’s objectives. It is also not fair. But is BEE fair, or rather, what is seen as being fair in terms of doing business with government?

FAIR PROCUREMENT

National Treasury’s Preferential Procurement Policy Framework Act 5 of 2000 (PPPFA) was enacted by Parliament to provide a framework for government’s procurement policy as envisaged by the Constitution, which states that government procurement should be “fair, equitable, transparent, competitive and cost-effective”.

Next, the Preferential Procurement Regulations of 2001 (2001 PPR) were promulgated by the Minister of Finance in terms of the PPPF Act. It followed the well-known 90/10 or 80/20 preference point system: 80 or 90 points were awarded – depending on the value of the tender – for functionality and price, while the remaining 20 or 10 points were awarded to “a tenderer for being an HDI and/or subcontracting with an HDI”.

FAIR TO WHOM, AND WHO DECIDES?

An HDI means a “historically disadvantaged individual”, defined in the 2001 PPR as any black, female or disabled South African person. This definition includes all South African black people, but also non-black females and non-black disabled persons. The definition is similar to the Employment Equity Act 55 of 1998 definition of “designated groups” and the widely used term in labour law (previously disadvantaged individuals, or PDIs). However, non-black women and non-black disabled persons did not form part of the beneficiaries of the Broad-Based Black Economic Empowerment Act 53 of 2003 (B-BBEE Act).

In contrast, the Department of Trade and Industry (DTI) wanted trade and industry to focus on the defined “African, Indian and Coloured people” (the majority of our economically active population) and also on broad-based development of our economy. Where the 2001 PPR focused only on the ownership of the tenderer, the Broad-Based Black Economic Empowerment Codes of Good Practice promulgated in 2007 (2007 Codes) emphasised a balanced scorecard in which ownership had a weighting of only about 20%.

As National Treasury’s PPPFA and 2001 PPR were not aligned to the B-BBEE Act and 2007 Codes, broad-based policies had not yet been actively implemented by the government supply chain. The DTI needed National Treasury to align the PPPFA and 2001 PPR so that public entities and organs of state awarded tenders in accordance with broad-based black economic empowerment (B-BBEE) objectives and not according to 51% HDI ownership. Without such alignment, there was a conflict between the two sets of legislation, in which the narrow-based PPPFA prevailed.

The result was that the government’s procurement policies were until quite recently narrow-based and owner-centric and were applied to the benefit of HDIs – being 51% black-owned tenderers – instead of “black people” as broad-based beneficiaries of businesses throughout the local economy. It appears that the broad-based 2007 Codes had not yet received a proper opportunity to prove that they could work. Because narrow-based policies had been applied during the greater part of our 20 years of democracy, government procurement – the primary driver of B-BBEE – did not provide the impetus to allow broad-based empowerment to filter through to the economy as a whole.

EVENTUAL POLICY ALIGNMENT

Only in 2011 were the 2001 PPR amended by the Preferential Procurement Regulations, 2011 (2011 PPR). Among the amendments were that 20 or 10 preference points were awarded according to the tenderer’s B-BBEE level status as stipulated in the 2007 Codes and/or Sector Codes. National Treasury’s Implementation Guide: Preferential Procurement Regulations, 2011: Pertaining to the Preferential Procurement Policy Framework Act, Act No 5 of 2000, was published for the first time on 1 December 2011.

However, all public entities listed in Schedules 2, 3B and 3D of the Public Finance Management Act 1 of 1999 were exempted from most of the 2011 PPR in terms of Notice R 1027 published in Government Gazette 34832 on 7 December 2011. These entities included all 21 major public entities (for example Denel, Eskom, DBSA, SAA, SABC and Transnet) and their subsidiaries, as well as all national and provincial government business enterprises (at least another 45 public entities, not counting their subsidiaries). The exemption was valid until 7 December 2012, which meant these entities only had to start implementing the broad-based 2011 PPR after 7 December 2012.

In effect this means that the broad-based policy had only been implemented formally and effectively by the government supply chain from about the beginning of 2013.

TREATING THE SYMPTOMS AND NOT THE CAUSE

Meanwhile, government was already of the view that B-BBEE transformation had not been achieved by the 2007 Codes, and the solution was an amendment with a different focus. The proposed amendments were published for public comment on 5 October 2012 – two months before major public entities and government business enterprises were required to apply the 2007 Codes. Furthermore, the amendments had already been passed on 11 October 2013 (Amended Codes), which will come into operation after 30 April 2015, although early adoption is permitted.

The formal policy move to broad-based empowerment was very short lived, as the Amended Codes have moved somewhat away from an inclusive, broad-based emphasis to a narrow-based, owner-centric strategy. In the Amended Codes, 48% of the scorecard relates to either direct black ownership or the exclusive development of entities that are at least 51% black-owned.

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The Amended Codes impose onerous requirements on businesses with an annual revenue in excess of R50 million, but entities whose annual revenue is less than R50 million are exempt from measurement, unless the entity is less than 51% black-owned and has an annual revenue between R10 million and R50 million. Unfortunately, the Amended Codes do not have a scorecard for those non-black “qualifying small enterprises” (QSEs). The good news is that entities below R50 million revenue that are least 51% black-owned are by default Level Two Contributors to B-BBEE and do not need the conspicuously absent QSE scorecard. Those that are 100% black-owned are by default considered Level One Contributors to B-BBEE – the highest level one can achieve. These very high levels are very costly to achieve when a business is over the R50 million threshold, however. Verification will not be required for smaller black-owned businesses and an affidavit confirming such a status will suffice.

This change in the Amended Codes was partly the result of the view that the most significant part of the economy consists of only a relatively small number of businesses – those who earn more than R50 million in revenue – in South Africa. The second part of the rationale behind exempting black-owned businesses earning less than R50 million in annual revenue (and all businesses earning less than R10 million) from B-BBEE verification is that those smaller businesses would not really have a significant impact on B-BBEE.

It would thus seem that the reasoning is that if only the small number of businesses, but whose revenue constitutes the bulk of the economy, “complied” with B-BBEE, broad-based participation of the economy would in substance be achieved.

The additional “benefit” of this policy is that 51% black-owned entrepreneurs will also receive a financial boost by:

  • Not having to pay for verification
  • Not having to contribute to B-BBEE initiatives themselves (they are beneficiaries of B-BBEE), and
  • Having by default very competitive B-BBEE status levels in order to boost local black entrepreneurs

The Amended Codes have therefore not only onerous requirements for those businesses above the R50 million annual revenue threshold, but also place a sharp focus on empowering 51% black-owned businesses under the R50 million threshold.

Until 2013, public sector tenderers had to focus on 51% HDI ownership compliance instead of B-BBEE. However, since 2007 some leading private sector businesses wanted to have good B-BBEE status levels and therefore wanted their businesses to align with the 2007 Codes. They followed this process because they were concerned with the long-term sustainability of their organisations and the South African economy. They thus embraced B-BBEE voluntarily, but such leadership did not come without a price.

Since the full implementation of B-BBEE in terms of the 2011 PPR in 2013, both public sector tenderers and private sector businesses have had to produce good overall B BBEE status levels with lower – and less significant – black ownership targets. Only since 2013 was B-BBEE considered compulsory to obtain business from either private or public sector, where before 2013 B-BBEE was seen more as liberal business leadership and voluntary forward-thinking.

FROM THE FRYING PAN INTO THE FIRE

At the time of writing, the 2011 PPR is yet to be aligned to the Amended Codes. However, this is likely to take place, in which case public sector tenderers are likely to again focus only on black ownership and continue to enter into black-owned joint venture (JV) arrangements, as were done pre 2013. It appears that narrow-based owner-centric policies are returning. However, the reported reason for this is that B-BBEE policies will be focusing on local black entrepreneurs, which sounds very good.

The unidentified risk is that many large enterprises may in future form and run separate government contracts from 51% black-owned JVs in order to circumvent the Amended Codes, and consequently those large enterprises will have had achieved no broad-based transformation. Their JVs will not be subject to scrutiny for verification either, and so fronting may go undetected.

Another possibility is that because the cost of complying with the Amended Codes may outweigh the benefits for those large businesses, they may be under pressure to establish new JVs in order to keep tendering separately under the R50 million threshold.

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The ripple effect of this is that B-BBEE will then not flow through the local economy, notwithstanding that enterprise and supplier development is described in the Amended Codes as a “priority element”.

IN FOR A PENNY, IN FOR A POUND

Consider the following example:

Company A has a net profit after tax (NPAT) margin of 10% historically before making any contribution to B-BBEE. Their payroll is about 30% of revenue:

  • Revenue = R10 billion
  • Payroll = R3 billion
  • NPAT = R1 billion

In terms of the Amended Codes, Company A has to make a 40% sub-minimum on the elements of ownership, skills development and enterprise and supplier development, otherwise their status will be discounted by one level.

Skills development

Company A must spend R180 million on skills development to achieve target – such spend being a direct charge each year to the income statement.

Enterprise and supplier development

Management has decided that they will provide loans to enterprise development and supplier development beneficiaries instead of contributing by means of annual donations. They have also decided that, because they cannot use public shareholders’ money to provide interest-free loans – and because SARS may construe it as unproductive interest – they will grant loans at market-related interest rates. This means that in terms of a B-BBEE score, the values of the loans are discounted by 50%.

It was already a challenge to find beneficiaries, because a myriad smaller loans to start-ups were considered a great administrative burden and are also very high risk. However, providing larger loans to larger beneficiaries will grow them over the R50 million revenue mark within a year or two, and consequently those loans will in the very near future no longer qualify. Company A cannot simply call the loans to loan the funds again to new beneficiaries, as the funds will be invested in the borrowers’ working capital and assets.

However, they finally managed to find enterprise and supplier development beneficiaries. For enterprise and supplier development, they will spend the target of R60 million on loans, which was a cash flow in year one.

Socio-economic development

For five extra points, they must spend R10 million each year on socio-economic development as a direct charge to the income statement.

The relevant cost of B-BBEE v benefits

This means that without counting costs associated with obtaining a good ownership or management control score, Company A’s cost to “comply” with the Amended Codes will be R250 million before tax in year one. One can ignore the interest revenue from the loans, because there is a similar cost of capital for Company A to provide the funds for the loans. If the loans hold in terms of counting towards their B-BBEE score, it will cost them R190 million before tax each year thereafter, based on current results.

Assuming the R190 million, including the socio-economic development spend of R10 million, will be tax deductible, the after-tax cash flow in year one will be R196,8 million and R136,8 million each year thereafter. However, the NPAT margin will decrease to 8,6% due to the additional B-BBEE costs, so one may decrease the socio-economic development and enterprise and supplier development spend a bit in order to just meet the targets:

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To break even, Company A needs to make a net profit after tax of at least R135,8 million (R129,6 million + R6,2 million) from doing business with government. That means that, on a NPAT margin of 8,6%, Company A must secure revenue from public sector business of R1,57 billion, which is about 16% of total revenue.

Company A is also:

  • Taking risk by providing loans which is not factored into the above costs, and
  • Not guaranteed of future government business, notwithstanding a good B-BBEE status level

The direct benefit of Company A’s B-BBEE spend is by securing government business, which has to be way over R1,57 billion. Company A would expect much more than 16% of revenue coming straight from doing business with the public sector.

If Company A rather opted for using 49% JVs with black enterprises, it may very well achieve the same business objective, but with much less cost to the shareholders. The ripple effect of such a decision, as mentioned earlier, is that the 51% black-owned JVs are not going to require any supplier’s B-BBEE certificate, as those JVs will have by default achieved Level Two Contributor statuses. Therefore, Company A’s suppliers will not have to “comply” with the Amended Codes either, because Company A is never going to request their B-BBEE certificates. In fact, they do not need even to have black ownership.

FRONTING AS AN UNINTENDED CONSEQUENCE

In my opinion, narrow-based owner-centric policies open the door to rudimentary fronting. Fronting is defined in the Broad-Based Black Economic Empowerment Amendment Act 46 of 2013 (B-BBEE Amendment Act) as:

“1(e) … a transaction, arrangement or other act or conduct that directly or indirectly undermines or frustrates the achievement of the objectives of this Act or the implementation of any of the provisions of this Act, including but not limited to practices in connection with a B-BBEE initiative –

(a)          in terms of which black persons who are appointed to an enterprise are discouraged or inhibited from substantially participating in the core activities of that enterprise;

(b)          in terms of which the economic benefits received as a result of the broad-based black economic empowerment status of an enterprise do not flow to black people in the ratio specified in the relevant legal documentation;

(c)           involving the conclusion of a legal relationship with a black person for the purpose of that enterprise achieving a certain level of broad-based black economic empowerment compliance without granting that black person the economic benefits that would reasonably be expected to be associated with the status or position held by that black person; or

(d)          involving the conclusion of an agreement with another enterprise in order to achieve or enhance broad-based black economic empowerment status in circumstances in which –

(i)            there are significant limitations, whether implicit or explicit, on the identity of suppliers, service providers, clients or customers;

(ii)           the maintenance of business operations is reasonably considered to be improbable, having regard to the resources available;

(iii)          the terms and conditions were not negotiated at arm’s length and on a fair and reasonable basis …”

At the date of writing, the B-BBEE Amendment Act has not yet come into effect. When it does become effective, fronting practices will be regarded as criminal activities, sanctioned by harsh penalties and/or up to ten years’ imprisonment.

Historically, Eskom had followed its own procurement policies. One of the indicators of ownership-fronting according to Eskom was cases where the black shareholders did not invest any money into the measured entity. In other words, the BEE shareholders did not take any financial risk.

In cases where black shareholders are not required to put any money into the measured entity, they may expect to receive no or a low dividend (because no investment was made). At the same time, the other (non-black) investors could easily rationalise male fide distributions or payments into their pockets as there is no reason, in their minds, why they have to share profits with shareholders who do not take any risk.

The problem in South Africa is that most businesses, especially small and medium ones, are equity-stripped. Often, investors only contribute the nominal or par value of the shares, and the business is in essence entirely funded by debt. The investors – usually also the managers and directors – take risk by providing the debt or personal surety for the debt.

Another striking fronting indicator, according to the DTI’s Guideline on Complex Structures and Fronting, occurs when the measured entity has no or limited operational capacity. Such phenomena are rampant where there is only narrow-based ownership empowerment, with opportunistic intermediaries serving as a window-dressing conduit (in which black shareholders are merely tokens) to channel payments to non-black parties, and with no real substance in these supposed intermediary “businesses”. The intermediary entity is paying for unsubstantiated blue-sky services that basically translate into an uneven distribution between the black and non-black shareholders (the non-black shareholders getting way more than their entitled ratio by providing some spurious “services”).

The “operational capacity” of a measured entity had always been disclosed by Empowerdex on their B-BBEE certificates, even before the draft B-BBEE Codes were issued for public comment in 2004. This fronting indicator made its way into part (b)(ii) of the definition of fronting in the B-BBEE Amendment Act, “the maintenance of business operations is reasonably considered to be improbable, having regard to the resources available” (see (d)(ii) above).

AN ALTERNATIVE?

One solution the public may have is to revert to the 2007 Codes, but does SAICA have an alternative for South Africa?

With broad-based policies like in the 2007 Codes, fronting practices are minimised to an extent, as mere black ownership structures on paper feature less. More prevalent broad-based activities and monetary contributions are easier to measure and verify.

SAICA came up with a great solution to this problem. It launched a publication, B-BBEE Though Leadership Paper: Insightful Corporate Reporting,1 at the Johannesburg Stock Exchange on 23 June 2014. It is the product of over two years’ work by SAICA’s B-BBEE Reporting Working Group.

It encourages organisations to recognise the importance of embracing B-BBEE strategies for true value creation and long-term sustainability. It promotes meaningful and transparent reporting to stakeholders on the success of those strategies and is intended to encourage organisations to adopt reporting practices that are consistent and comparable so that users of information can make meaningful assessments and comparisons.

Because it emphasises the importance of embedding B-BBEE in corporate strategy, as proposed by the International Integrated Reporting Framework, organisations are encouraged to report on the outputs and related outcomes of their true B-BBEE initiatives, which form part of their strategy and are the result of capital trade-offs.

If organisations follow SAICA’s proposal on meaningful reporting on B-BBEE, eventually organisations like Company A will find it very hard to explain what they have been doing to their stakeholders. Corporate South Africa can, by working together on this, better our country by bringing B-BBEE into their business models, rather than keeping it at arm’s length and complying with the minimum requirements only.

Let us not wait in apathy for the government to drop the axe on fronting practices. Let us root it out by shining the light. ❐

Note

1  The paper can be accessed at https://www.saica.co.za/Technical/ThoughtLeadershipPublications/ tabid/3482/language/en-ZA/Default.aspx

Author:     Gerhardus Burger CA(SA) is the Project Director: Public Sector, at SAICA

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