Radical Socio-Economic Transformation, State Procurement and Broad-Based Black Economic Empowerment

4 April 2017

Introduction

The role of state procurement and Broad-Based Black Economic Empowerment (B-BBEE) in promoting socio-economic transformation is not an uncomplicated topic.  In order to assist a reading of this brief, it may be useful to consider the way it is presented, in an effort to declutter such a wide-ranging matter:  as a starting point, it presents the government’s recent focus on the subject and then moves on to a summary of the rules which apply to B-BBEE, their relevance to state procurement, followed by what we see as the negative effects of the policies, together with some misconceptions and problematic issues.  Finally, some comments and potential solutions are provided. 

The recent focus

On 1 April in his first press briefing, the new Minister of Finance, Malusi Gigaba stated that regarding the Government's annual R500bn procurement spend, “We remain unapologetic about using the state’s spending power to grow black enterprises,” and that “the use of government’s vast procurement budget… to empower black people, we must not be apologetic about that.”

In the 2017 State Of The Nation Address (SONA), delivered on 9 February 2017, President Jacob Zuma made mention of a plan for “radical socio-economic transformation,” driven to a large degree by state procurement and Broad-Based Black Economic Empowerment (B-BBEE).

The President defined radical socio-economic transformation as a “fundamental change in the structure, systems, institutions and patterns of ownership, management and control of the economy in favour of all South Africans, especially the poor, the majority of whom are African and female, as defined by the governing party which makes policy for the democratic government.” Below is the part of SONA speech which mentions how the Government plans to achieve this: 

“Today we are starting a new chapter of radical socio-economic transformation. We are saying that we should move beyond words, to practical programmes.  The state will play a role in the economy to drive that transformation. In this regard, Government will utilise to the maximum, the strategic levers that are available to the state.  This includes legislation, regulations, licensing, budget and procurement as well as Broad-based Black Economic Empowerment Charters to influence the behaviour of the private sector and drive transformation.  The State spends five hundred billion rand a year buying goods and services. Added to this is the nine hundred billion rand infrastructure budget. Those budgets must be used to achieve economic transformation.

As a start, the new regulations making it compulsory for big contractors to subcontract 30 percent of business to black owned enterprises have been finalised and were gazetted on the 20th of January.  Through such regulations and programmes, government will be able to use the state buying power to empower small enterprises, rural and township enterprises, designated groups and to promote local industrial development.”

The importance of state procurement to the economy

The R500bn annual expenditure on the purchase of goods and services amounts to approximately 35% of total government expenditure and 12% of GDP.  If we add the planned R900bn infrastructure which is to be spent over the next 3 years, it is clear that state procurement plays an important role in the South African economy.

Some basic B-BBEE facts

Legal framework

B-BBEE is implemented through the Broad-Based Black Empowerment Act (No. 53 of 2003). It is a complex, incentive-based programme, based on the rationale that business entities will contribute to the defined B-BBEE goals in order to be in an advantageous position to secure economic opportunities from value chain participants, such as the Government and empowered suppliers.

As from April 2016, the B-BBEE Commissioner monitors and enforces compliance and is able to impose penalties for misrepresenting a B-BBEE status or fronting. Penalties include imprisonment of up to 10 years, fines of up to 10% of annual turnover and a 10-year ban on participating in contracts with all organs of state and public entities. [1]

B-BBEE status reporting is compulsory for:

- all organs of state and public entities; 

- companies listed on the Johannesburg Stock Exchange (JSE); and 

- Sector Education and Training Authorities (SETAs).

The following boxes provide an overview of the legal framework [2]:

Scorecard

In October 2014, the B-BBEE Codes were revised to merge Employment Equity into Management Control and Preferential Procurement into Enterprise Development. This reduces the Generic Scorecard from 7 elements to 5, as set out in the table below. The weighting of the points was also altered, shifting the emphasis from Ownership to Enterprise and Supplier Development. The reason for the latter change is discussed later in this paper.

Elements of the Generic Scorecard

Code series explanation:

- 100 - Ownership measures effective ownership of entities by black persons.

- 200 - Management Control measures the effective control of entities by black persons.

- 300 - Skills Development measures the extent to which employers carry out initiatives designed to develop the competencies of black employees and black people internally and externally.

- 400 - Enterprise and Supplier Development measures the extent which entities buy goods and services from suppliers with strong B-BBEE credentials. It also measures the extent to which entities carry out initiatives intended to assist and accelerate the growth and sustainability of black enterprises.

- 500 - Socio-Economic Development measures the extent to which entities carry out initiatives that contribute to Socio-Economic Development or Sector specific initiatives that promote access to the economy for black people.

Large enterprises have a minimum compliance requirement of 40% for Code series 100, 300 and 400. Qualifying Small Enterprises (described below) have a minimum compliance requirement of 40% for Code series 100 and either 300 or 400. Failure to achieve this will result in the measured entity being downgraded by one Level.

Determination of B-BBEE status

A company’s B-BBEE Status or Level is calculated using the Generic (or, if applicable, a Sector specific Scorecard) and is used when comparing tender bids. 

B-BBEE for “small” and start-up businesses:

Exempted Micro Enterprise (EME):

- An enterprise with a total annual revenue of R10 million or less qualifies as an EME and is deemed to have a B-BBEE status level 4.

- An EME which is 100% black owned qualifies for elevation to a level 1 contributor.

- An EME which is 51% black owned qualifies for elevation to a level 2 contributor.

Qualifying Small Enterprise (QSE):

- An enterprise with a total annual revenue between R10 million and R50 million qualifies as an QSE.

- A QSE which is 100% black owned qualifies for elevation to a level 1 contributor.

- A QSE which is 51% black owned qualifies for elevation to a level 2 contributor.

Start-up Enterprises:

- Start-up Enterprises are measured as an EME for the first year following formation or incorporation.

All the B-BBEE Government Gazettes can be found on the Department of Trade and Industry (dti) website.

Preferential Procurement and B-BBEE

The Preferential Procurement Policy Framework Act (Act no. 5  of 2000) (PPPFA) defines preferential procurement as a policy contemplated in section 217(2) of The Constitution:

217. (1) When an organ of state in the national, provincial or local sphere of government, or any other institution identified in national legislation, contracts for goods or services, it must do so in accordance with a system which is fair, equitable, transparent, competitive and cost-effective.

(2) Subsection (1) does not prevent the organs of state or institutions referred to in that subsection from implementing a procurement policy providing for—

(a) categories of preference in the allocation of contracts; and

(b) the protection or advancement of persons, or categories of persons,

disadvantaged by unfair discrimination.

According to the PPPFA, when an organ of state opens an invitation for tenders, the relevant organ of state must indicate if a required minimum level of functionality and or B-BBEE is applicable.  In this context, “functionality” refers to non-BEE considerations, comprising typical issues such as quality, expertise and track record. Tender applicants that do not achieve the minimum functionality and or B-BBEE level will not qualify for the tender. Applicants that do qualify are then evaluated in terms of the 80/20 and 90/10 preference points systems:

- The 80/20 preference point system means that:

80 of the 100 points used to evaluate tender bids are taken from the bidder’s price.

The remaining 20 points are from the bidder’s B-BBEE status.

- The same applies to the 90/10 preference point system (see below for further explanation).

On 1 April 2017, new Preferential Procurement Regulations aimed at giving B-BBEE a boost, change the most pertinent points of the PPPFA affecting all procurement above R30 000. The changes are as follows:

- The 80/20 preference point system will apply to all tenders equal to or above R30 000 and up to R50 million. (This previously applied to amounts between R30 000 and R1 million.)

- The 90/10 preference point system will apply to all tenders above R50 million. (This previously applied to amounts above R1 million.)

- An organ of state may apply a minimum B-BBEE level as a prequalifying criteria in addition to advance designated groups.

- (1) If feasible to subcontract for a tender above R30 million, an organ of state must apply subcontracting to advance designated groups.

- (2) If an organ of state applies subcontracting as contemplated in sub-regulation (1), the organ of state must advertise the tender with a specific tendering condition that the successful tenderer must subcontract a minimum of 30% of the value of the contract to specific empowered entities.

Some negative effects of B-BBEE and general misconceptions

Policy uncertainty and shareholder dilution

A recent International Monetary Fund report cited implementation of B-BBEE codes in the mining sector as one of the examples of policy uncertainty hindering private investment in South Africa. [3]  The Department of Mineral Resources’ 2016 Review Of The B-BBEE Charter For the South African Mining and Minerals Industry specifies that it will require stakeholders to achieve a minimum of 26% black ownership per mining right. It will also require this minimum black shareholding to be maintained, effectively terminating the “once empowered, always empowered” principle.  Such is also the stance taken by the B-BBEE Commissioner in her latest newsletter.  However, the question surrounding the validity or otherwise of the “once empowered, always empowered” principle has not yet been resolved.

One problem confronting mining companies is that if their B-BBEE partners sell their shareholding to non-B-BBEE entities after the minimum prescribed lock-in period (assumed here to be 3 years) [4], the owner of the mining right would have to find a new B-BBEE partner to once again achieve the required 26% black ownership level. This process results in diluted shareholder equity as shown in a worst case scenario calculation: 

let us assume a company has 100 shares: 74 non-BEE and 26 BEE. After holding them for 3 years, the BEE shareholder sells to a non-BEE shareholder. The company will then need to issue 35 new shares to another BEE investor to bring black ownership back to 26% (35 out of 135 shares).  If after another 3 years, the new BEE shareholder sells to yet another non-BEE shareholder, the company will have to issue 47 new shares to a BEE partner to achieve 26% black ownership (47 out of 182 shares). The company now has a total of 182 shares outstanding, with the original non-BEE shareholders holding 74 shares.  Their ownership of the company has therefore been diluted to 40%, from the original 74%.

The problem of shareholder dilution applies to all business sectors and not just mining. According to the B-BBEE Amended Codes of Good Practice, after B-BBEE shares have been sold they can only contribute up to 40% of B-BBEE ownership and continued recognition cannot be for longer than the period for which the shares were held.

Additionally, the prospect of shareholder dilution also decreases the number of companies willing to bid for government procurement, thereby decreasing the level of competition within the process.  According to a report released by the Economist Corporate Network in late March 2017, an anonymous executive said that “My principals in North America are not going to approve of us essentially having to ‘give away’ equity to raise our B-BBEE rating. We would rather run the risk of losing business for now.”    

JSE share ownership and executive employees

In the latest SONA, the president said that “only 10% of the top 100 companies on the JSE are owned by black South Africans, directly achieved principally through black-empowerment codes, according to the National Empowerment Fund (NEF).”
However, according to research commissioned by the JSE, at the end of 2013 black South Africans held at least 23% of the Top 100 companies, comprising 13% through mandated investment and 10% held directly, largely through BEE schemes. White South Africans held about 22% of the Top 100 companies while foreign investors held about 39%. [5]

The difference between the NEF and the JSE-commissioned study is due to the NEF excluding mandated investments from their calculation. Mandated Investments are any investments made by or through any third party regulated by legislation on behalf of the actual owner of the funds pursuant of a mandate given by the owner to the third party. The NEF allege that mandated investments represent a “passive-shareholding.”  However, the economic benefits of these holdings flow through to the ultimate beneficiaries (black pensioners for example), and secondly, the voting rights attached to the holdings at worst sit with an investment manager mandated to vote in the best interests of the ultimate beneficiaries.  It is therefore not clear why such shareholdings are not included in the NEF analysis.

The B-BBEE codes stipulate 25% Ownership and Economic Interest targets. Thus, given its 23% black ownership in 2013, these were close to being achieved for the JSE top 100 companies at that time.  B-BBEE played a significant role, accounting for 43% of such holdings (ie. 43% of the 23% share).
On the other hand, in 2015 black South Africans made up only 21% of the JSE top 100 companies executive employee positions.  This is well below the B-BBEE codes Management Control target of 50%. [6]  

Share liquidity discounts

One clear example of the negative effect the Government’s B-BBEE policies could have on black shareholders is that they are effectively locked in.  If, for example, black shareholders lose faith in the company’s management and would prefer to sell their shares, they are in practice often unable to do so.  The black shareholder would typically be under an obligation to sell to another BEE investor  -  and since potential BEE investors often do not have their own funding for such deals and do not find it easy to find funding elsewhere, it is more than probable that the shares could only be sold below their fair price.  The process has therefore effectively created a second-class share which trades at a discount.

Flawed financing

B-BBEE transactions are often financed using debt, either provided internally by the majority shareholders or externally by commercial banks. 

In the case of external financing, it is very rare for share dividend payments to come even close to the level of interest charged for financing the share purchase.  Unless the BEE investors have their own financial resources and are prepared to play a long game in the expectation of an increase in the value of their investment over many years, they would not be able to cover the debt costs from the dividend flow.  Any legal process against the BEE investor unable to service the debt can obviously create major problems for the company itself.

Fronting

According to the BEE Commissioner, fronting is the biggest challenge. Numerous allegations of fronting have been made and over 100 official fronting complaints have been lodged with the Commissioner since April last year but no rulings have been released yet.

Regarding the coal industry, in 2015 the media reported that “one of the reasons behind Eskom’s coal shortage, is that traders are struggling to get coal to Eskom due to BEE requirements restricting companies from supplying the utility.  The Mining charter and Eskom are held to different standards. … companies that seek to supply Eskom are expected to be 50% black owned.”  The same article goes further to say that “businesses are bringing in ‘middle people’ or black trading companies. … The use of fronting and middle-people means that other companies would benefit without delivering true industry transformation.” [7]

Elitism

BEE has been heavily criticised for unproportionately benefiting the connected few.  In an attempt to correct this, the new B-BBEE codes that came into effect in 2014 emphasise Enterprise and Supplier development instead of Ownership, which was the emphasis of the old codes. 

Price

Due to the 80/20 and 90/10 preference point system as well as a possible minimum B-BBEE level as a prequalifying criteria, the prices charged by tender bidders with higher B-BBEE scores may rise, especially if they are aware that competing bidders have lower B-BBEE scores. A bidder with a higher B-BBEE level could therefore outperform more competitively priced bids, and the latter might be completely excluded if  they do not meet the minimum required B-BBEE level. This may result in the government having to spend more on procurement than if the tender process excluded B-BBEE criteria.

Potential solutions for some B-BBEE issues

Share dilution and financing

B-BBEE deal financing should in principle be supported by the majority shareholders to a far greater degree than by outside funders.  The reason for this is simply that there is (or should be) a commonality of interest between shareholders, whereas outside funders usually have their own agendas, especially if the debt is not being serviced as required.  What about “Support-equity” in this context ?  This is a term coined here to represent B-BBEE equity exchanged not for finance but instead for a manner of payment-in-kind.  Examples might be the B-BBEE partner committing his/her time and effort for a fixed period or for specific purposes.  This would also have the effect of drawing BEE-shareholders into the framework of an enterprise in a far more meaningful manner than in the case of simply holding shares which have been financed by some or other external entity.  This results in a relatively common situation where the B-BBEE shareholders are to all intents and purposes, relegated to the position of external onlookers. 

A Trust or a Trust housing an Employee share ownership plan (ESOP) is allowed by the B-BBEE codes and should be explored further and implemented wherever possible.  The fact remains that it has taken some time for reality to sink in in this regard: mining companies, for instance, should have implemented B-BBEE-structures with far greater community shareholdings and more substantial staff share schemes at a much earlier stage.  In order to ensure that community shareholdings apply the dividends for community benefit (and do not end up as discretionary spending for one or two lucky individuals), the holdings could be structured in a manner that ensures transparency and accountability. Furthermore, these shares could be allocated to a Trust without financing costs attached.

Executive employees in JSE-listed companies

Regarding the under-representation of black executive employees in JSE-listed companies, Government would do well not to downplay black JSE-ownership and instead encourage transformation through shareholder activism.  For example, the Public Investment Corporation (PIC) is the largest manager of mandated investments and one of the single largest JSE shareholders, controlling about 12.5% of the JSE’s market capitalisation.  Transformation at the director and executive levels is a part of the PIC’s governance mandate.  Yet despite some examples of PIC shareholder activism from time to time, there is little evidence of this aimed at transformation at board and executive level.

Other problems in procurement

“I would estimate that more than 60% of tenders currently are contaminated with some sort of influence that is untoward.”  -  Deputy Public Protector, Kevin Malunga. [8]

Within the last two years there have been three pertinent high profile reports dealing extensively with procurement irregularities at State-owned Entities (SOEs), as well an extraordinary ruling by the Constitutional Court in the recent case regarding the Social Security Agency (SASSA).

In the State of Capture report released in October 2016, several major SOEs were mentioned, mostly regarding allegations of irregular procurement.  The SOEs in question are Eskom, Transnet, Denel and SAA.  Former Public Protector Adv Thulisile Madonsela stated in the Report that she had decided to investigate the SOEs, which will form part of the next phase of the investigation.  It remains to be seen whether the new Public Protector, Adv Busisiwe Mkhwebane, will follow through with the investigations.

In August 2015, the previous Public Protector also released a report on 37 cases of mostly procurement irregularities by the Passenger Rail Agency of South Africa (PRASA). The findings of the report are too expansive to list here, but the gist is summarised under the section titled General Observations:

“The transactions investigated and related findings reveal a culture of systemic failure to comply with the Supply Control Management policy, particularly involving failure to plan for bulk procurement, test the market appropriately for competitive pricing and to manage contracts, which culture may have cost PRASA millions in avoidable expenditure and preventable disruption of services.”

The Public Protector has commissioned Werkmans Attorneys to conduct a forensic investigation into PRASA based on the Report and this investigation is still underway.

Regarding Eskom, the following is quoted directly from the July 2015 Denton Report, an investigation instituted by the board of Eskom into the challenges faced by the parastatal:

- There is a significant list of examples of questionable procurements, and poor contract management, even including areas that should be in the spotlight such as ad hoc arrangements with suppliers of diesel not subject to discounts despite the purchasing power Eskom have.

- Of over 300 investigations conducted in the past two years by Assurance & Forensics, the department responsible for investigating allegations of financial misconduct, 63 have had sanctions recommended that have not been finalised. 79% of these have been outstanding for more than three months.

- Moreover, various officers have provided to us verbally examples of senior executives seeking opportunities ostensibly for the benefit of themselves at the expense of Eskom.

Most egregious, the Report found that Eskom procured coal in terms of contracts at non-competitive prices for an unjustifiably extended period.  Given that over R30 billion was spent by Eskom on coal alone in 2015, there is no doubt that this questionable procurement practice placed an already struggling parastatal under further pressure.

In its judgements of 2013 and 2014, the Constitutional Court declared invalid the tender awarded to Cash Paymaster Services (Pty) Ltd (CPS) to facilitate the payment of social grants nationwide.  In order not to compromise the SASSA payment system, the Constitutional Court suspended the invalidity of the contract, pending a new tender to be undertaken by SASSA.  Over a period of almost 3 years since the last judgment, SASSA not only failed to find a suitable alternative to CPS but also to take over the payment system itself (which it had announced to the Court in 2015).  This represents one of the most glaring examples of ineptitude within the state procurement system.  As an aside, one of the other reasons why the Constitutional Court declared the original contract invalid, was that the B-BBEE credentials claimed by CPS had not even been proven. 

Conclusion

The Government’s BEE-policies have had a positive effect in increasing black participation in the economy, and also in an indirect manner, in increasing an awareness that a much more meaningful black participation at all levels of the economy is necessary and needs to be supported.  Whilst it is also accepted that the policies were put in place with the best of intentions, it is clear that many problematic consequences of the policies were not foreseen and the practical difficulty of implementing and monitoring them continues to be underestimated.  One of the major obstacles in this context is simply that many state entities lack the resources to deal with intricate policies of this nature.  This is quite apart from other factors such as corruption, which seem to have become a widespread feature of state procurement.  A lack of resources does not just imply inadequate departmental budgets, but the appropriate personnel and systems are often not available to execute complex projects.  Once again, the SASSA case provides the most extreme example in this context:  SASSA’s own advocate was forced to admit in the hearing at the Constitutional Court on 15 March 2017 that it had not been able to take over the payment of social grants itself (as it had undertaken to the Constitutional Court in November 2015) because it had been overly ambitious.

In order for preferential procurement to increase black economic participation in a meaningful manner, the following steps are necessary:

1. a review of B-BBEE is needed to mitigate its negative impacts and to make it simpler to implement and monitor;

2. Government departments need to have adequate resources available to manage their procurement function (and quite apart from finance, the necessary personnel and systems need to be at hand); and

3. greater vigilance and accountability by Government and SOEs is required to combat irregular and fraudulent procurement. 

Presidential pronouncements on radical economic transformation being supported by Government’s procurement policy may have some success in playing to the gallery, but the realisation of such a policy is seriously threatened in practice if these minimum steps are not taken.

By Charles Collocott, HSF, 4 April 2017

Notes:

[1] The B-BBEE Commissioner is appointed in terms of the B-BBEE Amendment Act (No. 46 of 2013)
[2] Nicolene Schoeman, “Broad-Based Black Economic Empowerment”, 28 February 2008
[3] IMF Country Report No. 16/217, “South Africa,” July 2016
[4] A minimum lock in period of 3 years is assumed because in order for black ownership to be recognised after those specific black owned shares have been sold, they must be held for at least 3 years. Note also that continued recognition cannot go on for longer than the shares were held for.
[5] Craig Atherfold, “Black South Africans hold at least 23% of the Top 100 companies listed on the Johannesburg Stock Exchange,” 20 February, 2015
[6] JackHammer Executive Report, Volume 3, 2016
[7] Qama Qukula, “Power problems compounded by BEE requirements,” 09 February 2015
[8] News24, “60% of tenders are corrupt in some way: Deputy Public Protector,” 11 March 2016