How to get out of a BEE deal

Relationships end with death or divorce. Legal fees and taxes are certain:

Many relationships sour, once the excitement of the courting is over and the realization of the limitations of the partnership sets in.  Sometimes this turns ugly (or the partner does?) and ends in litigation, often highly emotionally charged and sometimes just plain vengeant.  A solid pre-nup can mitigate the damage and set out the rules, but even so the process of divorce often leaves both parties feeling cheated.  Legal and other advice means that neither side really wins, and the pie that remains to be shared is smaller than the pie before the divorce. The destruction of value is worth the ability to chart a course independently of the other party going forward.

Even when the other party is not even contesting the separation, divorces are never simple.  This applies to dissolving a marriage, a customs union or a commercial arrangement.  Look at the Bezos divorce, Brexit or the Growthpoint BEE dispute as examples.

BEE contracts, like any commercial union, often go the same way:

The reasons for a BEE relationship no longer working are the same as in a marriage – a party disappears; the enthusiasm goes; better prospects beckon; expectations are not being met or consummated; trust breaks down; or it is simply a waste of time.  This happens even when there isn’t a guilty party.  Sometimes it’s not working.

Undoing a BEE deal is very different to a divorce:

We’ve recently seen a number of cases where the aggrieved party in a BEE deal decides to get rid of the annoying partners, mistakenly thinking that the decision to do so is all that is necessary. Not so much.

There is one huge difference between a matrimonial relationship and a shareholder relationship: if one party wants a marriage to end, the other can’t save it.  The mere fact that someone wants to leave a marriage is evidence that the marriage has irretrievably broken down – a recognized ground for divorce.  So, staying married is as much of a choice as marrying.  Married people chose to stay married, even if its unhappily ever after.

In shareholding relationships there is often no such choice, especially when the shareholders don’t agree.  The unhappy partner in the BEE arrangement cannot simply chant “Go Away” three times or hope on a wing and a prayer that the other side will just slip into the sunset.

Firstly, for the BEE ownership points to be claimed the Black Person has to be the shareholder in the register (yes, this discussion ignores options and the BEE rules around them).  There may be contracts between the parties, but no matter what, a shareholder gets rights from a company’s Memorandum of Incorporation, Company Rules and the Companies Act.  Some of these rights, especially those in the Act cannot be taken away.

So, to be clear, if a shareholder hasn’t paid a seller for some shares, the seller may sue for payment, but he cannot simply take the shares back.  The registered shareholder is entitled to some rights and can claim these from the company, directors and other shareholders just because he is a shareholder.  It does not matter how one seduced and enticed one’s spouse into marriage, the spouse has special legal status just because they are the spouse!

How to get out of a BEE ownership deal:

In undoing any shareholder relationship, the basic objective must be to get the shareholder’s name out of the register.  This must follow the correct process or it will simply be put back (and other claims may still follow in respect of, say, lost dividends or legal fees).  It’s important to seek advice to ensure that this is done properly.

Simply put, the exiting shareholder needs to be part of the process and will be paid to leave in one of the following ways:

  1. Willing seller: If the BEExiter agrees to sell his shares, buy them.  The shares could be bought by the other shareholders, by a third party or even by the company itself (subject to additional Companies Act requirements).  In any case the buyer and seller must agree the price.  The fact is that there is a logical price at which a rational seller will say that it is a good deal and take his money and run.  This price may be one that the seller has named, or it may be one that the buyer made too good to turn down.  The seller may sell because the shareholder divorce is destroying value and it is better to jump ship and salvage what one can.  This price exists.  The challenge is that if the emotions have gotten too hot, if the expectations are too far from reality, then all it takes is for one party to act unreasonably or irrationally and then “expropriation with compensation” will fail. This is too often the case – both sides need to engage with independent advisors early in any process that’s likely to be acrimonious (and removing a shareholder quickly gets that way).

Either way, the exiting shareholder needs to agree to this and needs to be paid.

  1. Forced sales: A properly written shareholders’ agreement/company rules or MOI sets out what happens in the event of a forced sale. If one has secured agreement in advance that one party can buyout shareholders on the occurrence of some event then one can force the sale.  But, there are two requirements: (i) there should be this advance agreement (normally included in shareholders’ agreement) and (ii) the event must have happened.  The type of events that could trigger a forced sale include certain misconduct (such as prohibited competition, or solicitation of clients or staff) or a change in circumstances (such as liquidation).  Importantly this could be the majority shareholder too who is forced to sell.  As this is a contractual provision it may be that the forced seller simply does not exit on the agreed terms, and one has to enforce a contract (while he remains a shareholder).  This is addressed by making the company a party to the shareholders’ agreement too so that it can be compelled to register a forced sale.

The exiting shareholder needs to pre-agree to this and needs to be paid.

  1. Optional sales: A sale can also be forced by giving someone an option to buy the shares at some time in the future at a pre-determined price.  This is a call option and if a party who has such an option calls on the shares and pays the agreed price, then the selling shareholder has to deliver the shares.  Unlike a forced sale, the option holder does not have to buy the shares, but should he elect to, then the shareholder has to sell the shares.

The exiting shareholder needs to pre-agree to this and needs to be paid.

  1. Donations: The BEExiter cannot simply resign as a shareholder, as say an employee could.  Even if he ceases to exist (because he dies or is sequestrated), his shares just pass to his successor in title (his executor, heirs or liquidator).  However, if a shareholder is not interested in conveniently dying (and the other remedies mentioned here are not available) then he can only cease to be a shareholder if he gives them away.  Donors are liable for donations tax, so even in this scenario the exiting shareholder does have cash flow consequences, albeit negative ones.

The exiting shareholder needs to agree to this and needs to pay.

  1. Other forced sales: The Companies Act does give aggrieved shareholders certain rights to address being wronged and they can approach the Companies Tribunal or the Courts to seek redress.  The most important rights are the so-called appraisal rights in section 164 which can force a company to buy out a shareholder at fair value in certain circumstances.  It doesn’t matter if neither the seller or the company agree to the value.  They have to, however this is obviously a long process and can be very expensive in terms of legal fees etc.

The exiting shareholder agrees to this (as he initiates the process) and needs to be paid.

What about trying to make it work?

As we’ve shown above, one party cannot simply remove another because they don’t like them.  Parties need to negotiate their coexistence and how they will exit from the relationship. Obviously, this is better done long before things fall apart.

Sometimes working on the relationship will yield the best results and this often starts with listening to and talking with one another.  We are no counsellors but why doesn’t the existing relationship work?

  • Are the intentions of the parties honourable at the outset? Do parties trust each other?
  • Are expectations and deal-terms reasonable and fair? Often in BEE transactions there’s unreasonable expectations for super returns – expecting business to flow just because of shareholding (yet without anything untoward) or for dividends simply to flow despite no real value added. Many entrepreneurs want a business partner – someone to get stuck in and run the business – rather than just a shareholder and when they get the latter face real disappointment.
  • Are the expectations of the after-life just a fantasy or is it better to stay where you are (not only because you committed to, but because you actually want to)?
  • What’s the vision? Can the parties still offer each other the promise of a future together?
  • Should stay in this less than perfect arrangement because the alternative is too costly to contemplate and isn’t great for future generations?

The Tusker approach:

As highly experienced experts in BEE and other shareholder transactions, we’ve taken extensive care to make sure that our agreements include very clear clauses that determine the rights of parties and the process to be followed in a potential divorce. These are standard in every deal we do and are agreed up front. The most NB thing however, is the setting of expectations as to what happens after we invest in a business, as its against these expectations that reality is always measured. Both parties are far more likely to be happy if people do what they say they’re going to do.

How the NCA sinks vendor-financed deals

This may be one of the more NB articles we’ve written. No kidding. The most common method used to finance BEE might just become spectacularly unstuck thanks to the NCA (National Credit Act) and a whole bunch of money owed to ‘white’ sellers of shares may be unenforceable. Read on, and expect a flurry of legal activity. 

Understanding Vendor finance:

Vendor finance is, very simply, the financing of the buyer by the seller.

You want a BEE partner but they don’t have money (usually the case), so you sell them the shares in the business but lend them the money (i.e. you become a credit provider) to buy the shares. They repay this debt and the interest thereon through dividends over time. You get your money and the BEE points you need; they get the shares and the economic value. As a credit provider, the credit risk is yours but once the shares (or portions thereof) have been transferred they belong to the new (presumably BEE) owners.

Almost half of BEE deals involved Vendor financing: the B-BBEE Commission reported that 39% of all BEE ownership transactions were vendor-financed and that a further 5% involved some combination of funding which included vendor financing.

A real world example: 

To fully understand vendor finance let’s look at what it is with a simple example (in this case, unrelated to BEE but the same principles apply):

Mr. Du Bruyn set up a business in 1984 sealing industrial leaks.  He and his wife knew a young man, Mr. Karsten, who they treated as their son.  Karsten was a law graduate, a university lecturer and a municipal councilor and the Du Bruyns involved him in the business in the early 2000s. They mentored him so that, by 2008, he was the technical director and he became a shareholder.

Eventually, in 2012, they agreed to part ways (the best way to get rid of a shareholder, as we discussed previously, is to buy them out) and they agreed that Karsten would buy out the Du Bruyns for R2.5 million.  They gave Karsten until 31 March 2013 to find the money.  When he couldn’t, they very kindly gave him another six months and when the finance still couldn’t be found, the Du Bruyns offered to buy Karsten out instead – for R1.5 million cash.

Karsten wanted R2 million which the elderly couple didn’t have, so the vendor (Mr. Karsten) agreed to vendor finance – the Du Bruyns would buy Karsten’s shares for R2 million with R500 000 to be paid in cash and the balance payable over five years with interest.

So far so good. The vendor gets the price he wants but to do this has to finance the buyer. Fairly typical. The difference is what happens when the buyer can’t come up with the money.

Enter the Supreme Court:

These (above) are the facts of a recent Supreme Court of Appeal court case Du Bruyn NO and Others v Karsten.

What went wrong: the business started underperforming and the Du Bruyns tried what they could to help it, even selling some personal assets.  Ultimately it made no difference and in the end they stopped paying Karsten and he started legal proceedings to recover the R1.1 million that they still owed him.

However, the Du Bruyns argued that they did not have to pay Karsten back in terms of their loan agreement and the highest court in the land agreed with them.  The court said that the loan agreement was void and unenforceable, which means that all its terms like interest rate, security and the like were not worth the paper they were written on.

The long arms of the National Credit Act:

The court reached its conclusion based on the National Credit Act 34 of 2005 which basically says that a lender needs to be licensed in terms of this Act to be able to enforce a loan agreement.

What is more, the vendor needs to have the licence at the time he makes the loan and it does not matter if he gets it later.  The court said that section 40 was clear and that if one makes any loan (even if it’s a once off or even if one is not in the business of making loans) then one needs a licence.

Implications for vendor-financed deals:

Before 2016 the lender had to be owed over R500 000 on his loans before falling under the NCA, since then the law states that a licence is needed for any loan is where there is an amount in excess of R0.01 that has to be repaid. i.e. every loan is now regulated.

In any vendor-financed situation where the buyer cannot come up with the cash – either because he doesn’t have it, can’t get it, or simply doesn’t want to pay – this is a very important judgment.

Yes, if I owe you any amount and you do not have a licence, you can forget about trying to enforce our loan agreement in any court – until parliament changes that section.  This won’t change fast – we do not have a sitting parliament at the moment (April 2019) and since a parliament seldom changes a law quickly and even less frequently backdates a law, we can expect a few years for this problem to be resolved.

Until then the BEE shareholders to whom you extended the credit to buy shares simply don’t have to worry about the contract, and the shares issued so far are theirs to keep.

Get legal advice:

Some of the reported B-BBEE ownership structures may have been vendor financed by licensed credit providers but there are (per the National Credit Regulator’s latest 2017/8 Report) only 6 191 credit providers. Chances are most of the vendors are at risk here.

All other vendor financiers should seek legal opinion on how they will get their money.

Their lawyers will no doubt point them to rules of unjust enrichment, but whatever without a valid contract no lender will get any interest, will not have their loan secured and can’t withhold instalments from dividends or remuneration.

There may have been far more economic empowerment in these deals than anyone realised…

How the Government shoots BEE in the foot

Tusker is a BEE private-equity fund and our articles inevitably illicit quite a lot of reaction – much of it’s against BEE, and especially the perceived link between BEE and corruption (the extent of which understandably draws angry responses from fed up South Africans, especially in the business community).

To be clear, Tusker believes in the need for transformation and has built its business around making BEE ownership financially sensible and strategically advantageous for our clients.  However, this does not mean that Tusker is blind to the challenges that BEE presents.  Some challenges are ideological.  Other challenges relate to practicalities such as bad implementation or regulatory uncertainty.  But, the biggest single problem is that Government has given BEE a bad name as we explore further below.

On many levels, BEE has been a real success:

Credit must be given where credit is due:  Government brought us BEE and it has not all been bad. Despite the common perception, it is just not true that only a handful have benefitted from BEE. There is no doubt that the South African economy’s racial composition has changed significantly in the decade and a half that we have had BEE: many BEE schemes have generated wealth for black people in shares; many black managers and youth were trained and recruited for BEE purposes; and multiple suppliers and communities have benefitted from BEE.

In the BEE Act’s lifespan the spending power of black people and the size of the middle class of black people has also ballooned, changing forever the racial makeup of the economy.  Whether this could have been achieved more efficiently is a rearward-looking policy question, but economic statistics show that Black people now have the majority of jobs in the economy, own the most houses, make up up most of the membership of pension funds.

However, black people also remain the majority of the unemployed, homeless and poor.

To say that too few have seen the benefit of BEE is impossible to argue with. To say that the corrupt have used BEE as a vector is also impossible to argue with (but it’s not true that BEE causes corruption either).

Where’s the blame?

The limited success of BEE cannot however be blamed entirely on Government, especially since Government has not made BEE compulsory.  The fact that many businesses have effectively ignored BEE is a choice they have been allowed to make.

What then has Government done wrong?

Government isn’t leading by example: 

We analysed the B-BBEE Commissions’ report here and compared it to the analysis of our own database. Probably the most telling fact is this:

“…even that is not as surprising of the state’s coverage – remembering that the state is the champion of champions for BEE.  The report states that only 4 out of 299 State-Owned Entities and Organs of State Entities submitted their annual Compliance Reports.

Yes, you read that correctly. The government doesn’t care enough about BEE to get verified.”

Simply put, Government is not in compliance with its reporting obligations in terms of the BEE Act.  They have not been leading by example, making it more difficult for the B-BBEE Commission to take other serial offenders to task.

Maybe this could be overlooked if Government championed BEE in other ways, but have they?

In theory, the BEE Act aims to encourage procurement from black providers of an equivalent service at an equivalent price, but in practice it appears that the government pays a heavy premium to procure from black companies even though the price and quality would be worse than otherwise. This is obviously wasteful expenditure and an inefficient use of taxpayer money, but does it circumvent the purposes of the BEE Act? Since the Act’s purpose is to transform, the answer is no.

Government is not good at juggling all of South Africa’s needs: 

Government has an unenviable task. The theory behind the BEE Act was that Government would use its enormous purchasing power and annual expenditure budget of nearly R1 trillion on promoting black businesses and participation in the economy by black people.  This would be hard enough if this were Government’s only objective, but Government has to also consider the existing economy (read tax collections), international investor sentiment (read investor capital flows) and consumer and business confidence (read economic activity) to promote economic growth.

Such imperatives promote economic growth (which would also be radical, given the state of the economy at the moment), but might not change the racial composition of the economy.  Even though it’s unclear what the target or ideal racial composition of the economy is, more should definitely benefit from being active participants in the South African economy.

Luckily, Government is also tasked with growing the economy and this, of necessity, means it cannot be solely obsessed with BEE.  So, the second Government BEE problem is that it has been bad at its impossible task of juggling BEE and other competing objectives.

No definition of success:

Some policies are easy to understand. E.g. reduce unemployment to an acceptable level of say 5%.

The BEE-Act not so much. When has enough transformation happened? When has enough BEE been done? Should BEE be stopped when black people are the majority of the economy?  If this were Government’s sole objective it could achieve it by chasing away citizens (like Zimbabwe) or by discouraging foreign investors (like Venezuela).

The lack of sunset clauses is probably deliberate. The argument is probably that “we’ll know when when we know” that sufficient transformation has occurred, and in the meantime it’s a useful political tool.

Government removes the incentive to do BEE:

The most common criticism of BEE (read the comments on our facebook page) is that it has fostered cadre deployment, bribery and corruption and resultant poor service delivery.

These are completely separate problems that are global phenomenon and have existed long before and independently from BEE, but one should critically consider whether the way Government has transacted has advanced B-BBEE or if it has in some way frustrated the objectives of the BEE Act.

There are many good corporate citizens that have organized their BEE affairs (which involve giving up money, control or both) by doing the right things, only to lose a tender to someone who won it in because they are better at stuffing cash in Louis Vuitton handbags, offering real estate in Dubai or by bribing a verification agent to falsify a certificate.

Inevitably the question is asked: why bother with BEE? Every corrupt deal removes the incentive to do BEE.

BEE trumps all other commercial considerations for Government:

BEE as we know it is not the first time in history that one group has tried to dominate a market place by giving itself preferable terms.

Stereotypical examples abound of how Jewish businessmen, freemasons and local business chapters have promoted their members’ business interests.  The Broederbond and the Proudly South African campaigns are local examples, which are similar to BEE in that they want to encourage business with one group (to the exclusion of others).

Obviously, they are different in that these are not legislated, but as BEE is voluntary (for everyone in the private sector), they also seek to give preference to one group.  So, the theory is that when all else is equal (cost, quality, ability to deliver) then preference should be given to black businesses. This is how BEE is supposed to work and this form of BEE is really hard to argue against.

In reality though BEE trumps all other commercial considerations and contracts are awarded to black businesses sometimes at the expense of quality or cost.  Awarding a contract to construct a road to a black business may look cheap until someone pays with his or her life, which could be the result of shoddy workmanship not being considered in awarding the contract.  Quality should always be considered.  So should price.  Why pay more than the market price?  The Jewish, Broederbond and masonic business deals were always done at a special price “for my friends” but Government’s special price is sometimes above the market cost, because a middle man takes a cut or simply because a black person is offering the service.

In a free market one would not pay more than one should for anything – unless there is corruption, bribery or some other form of rent seeking or because it is somebody else’s money and there is no regard to that. When BEE trumps commercial considerations of quality and price then taxpayer money is wasted and frustrations build, making it harder to encourage others to comply.

Government is not always a great client to have: 

No matter how much business one wins from any contract, it is worth nothing until actually banked.  Despite ongoing assurances, Government is a notorious late payer. Every time Government is late in paying, it affects the working capital of the black business.  Only businesses with much more other business or with sufficient cash reserves can survive.  Unfortunately, many businesses are not in such a position and either go out of business (waiting for the cheque from Government) or decide to do business with everyone except Government, not bothering to tender for its business.  This cuts Government efficiencies and fails to promote BEE.

So what should Government do?  They should support B-BBEE fully – by doing good clean business on the best terms it can, and rewarding those that have legitimately transformed with contracts that pay them as promised.

Is BEE a farce?

Is BEE really a farce, or is that just ego speaking?

Dr. Iqbal Surve (chairman and shareholder of Sekunjalo which in turn owns Independent Media) has been appearing before the Mpati Commission of Inquiry which is looking to the affairs of the Public Investment Corporation or PIC.

In his testimony before the Commission Dr. Surve is quoted as saying “BEE is a Farce” – this was the front-page headline of The Star, a paper in his stable of (not-so) independent publications.

He was also quoted as stating that BEE is fundamentally flawed and needs to be reviewed.  In support of this he cites well known examples of BEE companies that imploded after their share prices failed to perform: Nail, REAL, Thebe, Mvelaphanda and his own Sekunjalo.

Really?

As believers in free markets and the power of stock markets, we do not believe that a failed share price can ever be used to argue that BEE has failed.

If this were the case, we could point to Steinhoff to argue that “WMC” is no more or to the likes of Anglo, Barloworld, Edcon and other giants of the markets during apartheid to show that white economic disempowerment has been reached.  Really?  What is the link between any share price and the race of its shareholders?

BEE can be useful to blame but it alone has little bearing on any share price.  It may be relevant, indirectly, in helping a company land business or secure funding, but analysts valuing companies only care that the business or finance has been won.  Analysts don’t care how these are won, let alone whether it was because of BEE, especially if they are foreign analysts and don’t really care about or understand BEE.

Stock markets reward relative investment performance:

As with any stock market, South African markets punish the share prices of badly run companies and inflate those that are well run, irrespective of who owns their shares.  Badly run could be from fraud (Steinhoff), excessive risk (Aspen) or poor execution (Group 5).  No ordinary share has traded at a discount or a premium because of the race of its shareholders.  Besides being irrelevant, nobody knows the race of the shareholders at any point –in good liquid companies these are changing every minute of the trading day.

In simple terms share prices go down because shareholders “dump” them.  Sellers choose to sell for a number of reasons.   Some have nothing to do with the company e.g. the seller needs the money to pay off a personal loan or income tax.  Most are directly related to the company, where the seller believes that the share price will drop and wants to cash out while he still can.  When there are lots of sellers, it’s more likely that shareholders are selling because they think the company will be worth less in future than it is now. Why sell if you think it will go up?

We all want the same thing: a better ROI:

Black and white investors (including the foreigners who own ±70% of the JSE ) all look to make good investments.  On this, at least, all races are fully united.

If shareholders are united in their assessment of the company and have no immediate need to sell shares to raise cash for other reasons, then it’s a share price cannot drop – everyone is holding, and no trades happen so the price doesn’t move. This applies in every company, including BEE companies.

Therefore, every black-owned listed company (including those cited by Dr. Surve), that has seen its’ share price fall has done so because its black shareholders have decided to sell – en masse.  There may have been some white sellers too, but a BEE Company had to be mostly black sellers by definition. While there are myriad reasons for selling, almost all are because there is a better use (risk/return basis) for the money.  Such a decision is not a BEE-related decision.  When a shareholder wants to get out, he is voting with his money – in effect saying that he can deploy the capital better elsewhere than the companys’ management can.

Therefore, we question whether a company with a declining share price is a sign of BEE being a farce, or whether its future prospects and investment value are simply looking worse than before.

Perhaps the “good” doctor has underestimated not only the power of the markets to price correctly, but also the intelligence of the investors themselves.

What’s the role of the PIC in this?

One of the biggest investors on the JSE is the PIC, which although only Level 2 represents millions of black peoples’ savings and (where investment principals were followed, was often a seller of shares in BEE businesses too).

The PIC was formed by Parliament in 2004 and, at over R2 trillion in size, is one of the world’s largest fund managers (and definitely the biggest in Africa).  Given the size of the PIC it cannot simply concern itself with its members’ needs.  The PIC has a key role to play in not only South Africa’s capital markets but also in the development of the country as a whole…it has a major transformation role and as it states in its latest report:

The objective of transformation within PIC investee companies is to give effect to the country’s transformation agenda and the PIC’s transformation objectives are to, among others:

  • Promote and incubate the growth of broad-based empowerment;
  • Achieve wide-reaching social transformation;
  • Stimulate economic growth and transformation in South African investee companies; and
  • Integrate all the B-BBEE elements into business processes.

However, the PIC is a licenced financial service provider (like all fund managers, including Tusker) and like them it looks to give its clients a superior investment return.  Even its BEE transformation objectives are secondary to a client mandate, and if it buys or sells shares it is not (or should not be) because of BEE…

Where’s the real farce?

As reported in the Daily Maverick: “At the end of September 2018, after interest was added, Sekunjalo owed R1.35-billion to the PIC for Independent Media. The company has not been servicing its debt and, with a penalty interest fee added, Sekunjalo may owe as much as R1.5-billion, said commissioner Gill Marcus.”

Amongst other deals, the PIC has funded the doctor too, and he’s in front of the commission because it looks like the deal was far from correctly priced. Did he get the money because of real investment potential or because he was BEE or for some other reason?

Time will tell.