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The rise in fronting practice

The recently established BEE Commission has been tasked to oversee the implementation of the BEE Act and Codes of Good Practice and to ensure compliance by entities seeking to gain recognition for empowerment of black people. One of the issues that the Commission has prioritised is to eradicate the scourge in fronting practice, and to refer offenders for prosecution accordingly. Fronting practice, whether deliberate or unknowingly, is now a criminal offence as per the recent amendments to the BEE Act. Offenders may face serious penalties such as fines of up to 10% of annual revenue, imprisonment, or even being prevented from doing business with the government.

Overstatement black beneficial ownership

In recent years, there has been an increase in the number of companies choosing to establish broad based ownership schemes as part of compliance with the ownership element of the BEE scorecard. The DTI and industry experts have indicated that broad based ownership schemes are susceptible to fronting. The most significant risk is the overstatement of black beneficial ownership in the BEE scheme, which is a fronting practice as defined in the BEE Act. Companies choosing to implement BEE ownership through broad based ownership schemes need to be aware of the related risks of fronting. One way of doing that is to ensure that broad based ownership schemes are properly governed and managed. Beneficial ownership by black people is measured in three main pillars – economic interest by black participants, exercisable voting rights by black participants, and the net equity value of black people in the measured entity. It is important to understand how black beneficial interest is measured. This article provides an overview each of these pillars, together with related fronting risks, and how Transcend can assist you to govern your scheme in a manner that doesn’t expose you to fronting risk.

Economic interest

Economic interest is similar in nature to a dividend right in the measured entity. A potential fronting risk is the abuse of this definition since it does not accommodate payments outside distributions directly linked to the ownership in a sufficient manner. For instance, economic interest may be diluted through excessive management fees, partner drawings, and profit share agreements, which may leave a black participant with a diluted return on ownership. In determining whether a measured entity meets the criteria for economic interest, a verification agency may review and take into account the memorandum of incorporation of the measured entity to determine the economic interest attached to each class of equity instruments, trace the economic interest in the hands of black participants through a shareholders’ agreement or similar document, or through share certificates or security certificates held by black participants, as the case may be, and interviewing black participants to determine whether they understand their rights to economic interest.

Voting rights

Voting rights are rights attached to an equity instrument which allows a black participant meaningful participation in the measured entity at shareholder level. A verification agency must determine whether these rights factually exist, whether the black participants are fully aware of them and whether they can actually exercise them. The verification agency should trace the voting rights to some or other relevant documents such as the measured entity’s memorandum of incorporation, and any shareholders’ agreement, as the case may be, to inspect clauses that grant or restrict voting rights of black shareholders.

Net value

Net value is measured according to the value of assets, economic interest and any financial instruments or rights of ownership in the hands of black participants. A verification agency takes into account all outstanding debt, including notional debt associated with the acquisition of the shares by the black participant, and if there are any third party rights attached to the equity held by black participants. As per the Revised Codes, the Ownership element of the scorecard is one of the three priority elements, the others being Skills Development and Enterprise & Supplier Development and a measured entity needs to achieve at least 40% of the points available for all of the priority elements, failing which the measured entity will automatically drop a level on the BEE scorecard. Under the Ownership element, the specific subminimum that needs to be achieved in order not to drop a level is actually 40% (at least 3.20 points) of the available net value points. Therefore, being aware of the value of the business and the actual net value in the hands of the BEE structure is also crucial as part of the administration of the structure.

Transcend’s trust admin services

The Amended Draft BEE Verification Manual was published in November 2015. The Draft Manual is to replace the 2007 verification manual as the framework for accreditation and verification by all verification agencies. At this stage, the Draft Manual has not been issued by the DTI for commencement. We had anticipated that the Draft Manual would have been issued sometime towards the latter half of 2016. This has not happened and at this stage we are not sure when the Draft Manual will be issued and the DTI has not given an indication on a commencement date. In this article, we have highlighted in brief some of the verification guidelines and documentation that verification look for when verifying ownership schemes. The verification process for a measured entity can be an elaborate and time-consuming process. The related risks of fronting also need to be taken into account as part of the governance of a broad based ownership scheme. If a scheme is not properly managed and governed, it could cause serious problems for the measured entity for which it represents. Furthermore, the BEE Commission is now also going to be firm on persons who overstate black beneficial ownership in order to gain BEE recognition. Many BEE deals are successfully implemented, however, the participants tend to underestimate the amount of time and resources that are required to ensure good governance in the administration of those schemes. As a result, Transcend has recently established a trust administration unit, a team of experts who are fully qualified to provide guidance on all the relevant legal and regulatory compliance issues related to broad based ownership schemes and to provide administrative support to schemes where necessary. Should you be interested in getting assistance from our team on how we can help you govern and implement your scheme, please do not hesitate to contact our team accordingly.

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