Tuesday, August 31, 2004

The major activities in mergers and acquisitions in South Africa have taken place recently in the black economic empowerment (BEE) sphere.  BEE is a central part of the South African government’s economic transformation strategy.  BEE aims to increase the number of black people that manage, own and control the local economy.  South African business accordingly has to achieve the BEE ownership and control targets that have recently been incorporated in BEE legislation and related BEE industry-specific charters and scorecards.  The affected sectors to date have been mining and resources, financial services and ICT. 
The majority of recent BEE transactions have involved the acquisition of equity by BEE investors.  One of the main challenges relating to such transactions is the low level of access to capital resources and funding by BEE investors.  This problem, together with related transaction and finance costs, has to been addressed to some extent through innovative financing structures.  These structures are elaborate and complex, generally involving a combination of debt, equity and hybrid instruments (such as deferred shares, options and preference shares), together with various legs and multiple parties (special purpose vehicles, community and employee share trusts, etc.).  The structures also have to ensure that the BEE investors have some measure of voting control over the equity acquired, even though the economic benefits may be deferred for a period.
A consistent problem facing lawyers to these BEE transactions is the possible contravention of section 38 of the South African Companies Act, which prohibits a company from giving any type of financial assistance, directly or indirectly, for the purpose of or in connection with the purchase of or subscription for its shares or shares in its holding company.  The consequences of contravening this section are severe – the transaction will be void and the contravention cannot be cured by any shareholder, creditor or court approval.  In addition, the company giving the financial assistance and each of its directors will be guilty of a criminal offence.
The section 38 problem is commonly addressed in these structures through issuing the equity at a discount to market value.  Effectively the shareholders fund the subscription through the dilution in value of their shares.  The equity is not acquired at the expense of the company and therefore the company itself gives no assistance, financial or otherwise. The subscription price for the discounted equity is often funded through the issue of preference shares to existing shareholders.  Parties to these deals also try to structure their transactions so as to fall within the specific exceptions to the financial assistance prohibition.
Standard Bank and Liberty Life in the largest BEE deals announced to date, intend (subject to court and shareholder approval) funding the transactions through the issue of preference shares to wholly owned subsidiaries.  The subsidiaries will then acquire a certain percentage of ordinary shares from the shareholders of Standard Bank and Liberty in terms of a scheme of arrangement.  The equity in these subsidiaries will then be transferred to various BEE investors and employees at a nominal value.  It is estimated that the economic cost to shareholders in the Standard Bank deal, calculated on the difference between the market price and the acquisition price for the ordinary shares, amounts to approximately R201 million or 15 cents a share.
ABSA Bank intends using options to effect a transfer of 10% of its equity to BEE shareholders.  ABSA will issue a number of redeemable preference shares to a BEE company at par value.  The redeemable preference shares will each have an option attached to them entitling the BEE company to subscribe for 1 ABSA ordinary share at a strike price, which at the time of exercise of the option, could be at a significant discount (up to 31%) to market value of the ordinary shares.  The options can be exercised during a 2 year period, 3 years after the date of issue of the redeemable preference shares.  When and if the options are exercised, the redeemable preference shares will be redeemed at their par value.
While these structures may circumvent the section 38 problem, they are complex and often unwieldy in their implementation.  There are also often negative tax consequences for the parties involved.  In addition, there is a view that issuing shares at a discount to market value may be regarded as the giving of financial assistance in terms of section 38.  Although it is not a commonly held view, it has not been tested in our courts. 
The government has recognised that there are legislative impediments and disincentives to its BEE policy (in particular, in relation to the transfer of ownership and control) and is looking to address this urgently.  As part of this process, a decision has been taken to review and reform our company law.  Section 38 in its current form is therefore likely to be amended.  There is recognition that in many instances, the giving of financial assistance by a company to enable a BEE investor to acquire shares in it can only be in the interests of the company and it shareholders.
There are obviously other more conventional methods of funding BEE transactions involving third party financing.  These methods are inevitably more expensive and carry more credit risk for the parties concerned.  This could impact on the sustainability of the BEE transaction in question.