SOUTH AFRICA: THE UNINTENDED CONSEQUENCES OF BEE

C O N F I D E N T I A L SECTION 01 OF 04 PRETORIA 002781

SIPDIS

USDOC FOR 4510/ITA/IEP/ANESA/OA/JDIEMOND
DEPT PASS USTR FOR PCOLEMAN
TREASURY FOR BCUSHMAN

SIPDIS

E.O. 12958: DECL: 7/05/2016
TAGS: EINV ETRD EFIN ECON USTR SF
SUBJECT: SOUTH AFRICA: THE UNINTENDED CONSEQUENCES OF BEE

REF: (A) 05 PRETORIA 4854

(B) 05 PRETORIA 4855
(C) 05 PRETORIA 4856
(D) 06 PRETORIA 337
(E) 06 PRETORIA 575
(F) 06 PRETORIA 646
(G) 06 PRETORIA 700
(H) 06 PRETORIA 879
(I) 06 PRETORIA 1021

Classified by: Charge' d'Affaires; Reason: 1.5(b/d).


1. Summary. (C) Black Economic Empowerment (BEE),embodied in the
proposed Codes of Good Practice, is the government's policy
initiative to redress the economic legacies of apartheid. While
endorsing the goals of BEE, U.S. companies believe that the codes'
unintended consequences will undermine the government's drive for 6
percent annual growth. The codes will impose significant costs and
risks for investors. Dow Chemical estimates that BEE could cost it
70 percent of its South African earned profit before tax, while Ford
believes BEE compliance would cost 30-50 percent of profit before
tax. Ford estimates that equity equivalent requirements will make
new investment unprofitable. The proposed purchasing codes would
require 50-70 percent of purchases to be sourced locally, unrealistic
for most foreign investors. As a result, U.S. companies in South
Africa are rethinking their business models and putting on hold new
investments. In creating the comprehensive regulation embodied in
the proposed BEE Codes, the government created a policy that will
likely result in a multitude of unintended consequences, the most
important of which is the discouragement of investment. End Summary.

The Need to Overcome the Legacy of Apartheid
--------------


2. (SBU) South Africans, in general, agree that the government must
embark on some sort of affirmative action program to rectify the
injustices of the country's apartheid past. Indeed, South Africa
must do something to bridge the racial divide between the "haves" and
the "have nots" if it wants to unify the nation. Unemployment is
stuck at nearly 30 percent and is disproportionately higher among
Black South Africans. Income inequalities remain among the highest
in the world. Black Economic Empowerment (BEE) is the government's
policy initiative to bring "previously disadvantaged" South Africans
into the formal economy, promote a racially representative economy,
and redress the economic legacies of apartheid. Mainstream South
African business, which remains largely white-owned, accepts BEE as
part of the landscape and has moved in concrete ways to improve Black
participation in its businesses and publicly tout adherence to BEE
principles. U.S. companies have long supported the goals embodied in
South Africa's BEE policies and have been leaders, particularly in
employment equity and skills development, since the days of the
Sullivan Principles.


3. (C) To implement the government's BEE policies, the Department of
Trade and Industry (DTI) has developed a comprehensive affirmative
action program for the private sector, known as the Broad-based Black
Economic Empowerment Codes of Good Practice. Post has filed a series
of reports on the core elements of the proposed BEE Codes of Good
Practice (reftels). These reports cover how BEE targets will apply
to ownership, management, employment equity, skills and development,
enterprise development, and corporate responsibility. While
endorsing the goals of BEE, the local American Chamber of Commerce
(Amcham) and U.S. companies individually believe that the codes will
have unintended consequences that will undermine the government's
stated objective of 6 percent annual real growth. U.S. companies see
the codes as overreaching and likely to falter on implementation.
This cable details the key weaknesses in the proposed BEE Codes of
Good Practice as expressed by U.S. business. Business organizations,
including Amcham, submitted in March extensive comments on the draft
codes. The final draft codes are expected in late July. The Trade
and Industry Minister hopes that Parliament will pass the codes by
year-end.

Points Versus Dollars
--------------


4. (SBU) Once implemented, the BEE Codes of Good Practice will affect
practically every element of a company's income statement and balance
sheet. Central to measurement of BEE performance are scorecards
containing numerical targets that determine the award of points.
Scorecards cover practically every aspect of business operation, from
ownership to management, general employment, skills and training,
purchasing and supply, related enterprise development, and corporate
responsibility. For example, targets relate to how much equity South
African Blacks must own, what percentage of management and workforce
must be Black, what percentage of income must be devoted to training,
what percentage of purchases must be from BEE companies, as well as

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what percentage of profit before tax must be spent on corporate
responsibility projects. In all, there are forty-four point scoring
categories that a typical firm must navigate to score a 100 or so
points (there are a few bonus points).


5. (C) This very comprehensiveness of BEE is its greatest weakness.
The Codes of Good Practice are neither simple to understand nor
direct. They require companies to set up a separate accounting
system to track performance. They require independent auditing, and
an auditing oversight agency to adjudicate disputes and interpret BEE
language. In the end, they require companies to spend significant
amounts of time away from their core business, i.e., activities that
earn income, in favor of earning points. This does not sit well with
U.S. companies' home offices for whom South Africa is, in general, a
small market with average returns.


6. (C) By prescribing forty-four specific point scoring categories,
the government has assumed that all competing businesses within an
industry have organized themselves along similar lines, i.e., the
same organizational and cost structures. The truth is that companies
in the same industry often embark on different global strategies that
affect how they constitute themselves in any given market. Having so
many point scoring categories precludes a flexible response by firms
and, in effect, raises the cost of each point earned. Dow Chemical
(please protect) estimates that BEE compliance could cost the company
4.2 percent of South African sales, or about 70 percent of its South
African earned profit before tax. Ford Motor Company (please
protect) believes that it has done a good job of integrating its work
force, but estimates that the cost of scoring just half of all BEE
points, rendering Ford a "good BEE performer" would be 30-50 percent
of profit before tax.


7. (C) So overwhelming is BEE policy as currently drafted that each
company may have to rethink its business in South Africa. In the
words of Lynnette Chen (please protect) of Hewlett-Packard, co-Chair
of Amcham's BEE Committee and a strong proponent of affirmative
action, "Each company will have to re-evaluate their business in
South Africa and decide if they want to stay." Of course, no country
manager wants to be the one to close down an operation. Their first
inclination is to see how many BEE points they have already, and how
many more "inexpensive" points they can pick up. Local managers have
also put on hold new investments due to uncertainties about the
specifics of the BEE codes. For example, we know of three such
projects.


8. (SBU) For U.S. companies deciding on whether to enter the market,
the prospect of spending so much time and money on scoring points as
opposed to earning income is a serious disincentive to investment.
Unless the investment is extremely lucrative, such as platinum
mining, foreign firms have an extra incentive to enter the market
through South African distributorships that are BEE qualified rather
than to build production plants. In most cases, access to the South
African market, the world's 33rd largest and equivalent to about 1%
of world GDP, does not require an investor presence if the costs are
too high or policy uncertainties too many.

BEE Ownership
--------------


9. (C) The South African government has placed ownership at the
forefront of its BEE policy, requiring every firm seeking BEE
compliance to put at least 25 percent of its equity in the hands of
Black South Africans. Because Black South Africans often lack
capital, BEE equity sales are typically financed through loans
serviced by dividend payments. Dividend schemes, however, by their
nature are not growth inducing, since profits are distributed rather
than reinvested in growing a business. Moreover, the distribution of
BEE equity usually comes at a discount, to make it more affordable to
the prospective shareholder and to write off the expense of
structuring a BEE equity deal. Anecdotal evidence suggests a 20-25
percent discount on market value in BEE deals. Finally, if Black
owners choose to sell their shares to non-Black owners, the onus lies
with the firm to find new Black owners to maintain the BEE-mandated
level of 25 percent and incur the cost.


10. (SBU) BEE policy also presumes that the ownership of all firms
doing business in South Africa, including foreign firms, is
structured similarly. The truth is that global practice for many
foreign firms is to operate internationally as wholly-owned
subsidiaries, although there are exceptions; e.g., joint ventures,
acquired companies, or a tremendously important market like China.
Foreign firms structure themselves this way for a variety of reasons,
including to facilitate central direction of worldwide operations
and, for example, in the case of IT and pharmaceutical companies, to
limit local access to proprietary technology. Entering a BEE
ownership scheme presents additional costs, such as constituting a
local board of directors and taxation of both profits and dividends

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before repatriation, and risks.

Equity Equivalents: Apples and Oranges
--------------


11. (C) In early discussions of the codes, foreign firms argued that
they would have a difficult time meeting 25 percent BEE ownership
requirements. As a result, DTI's proposed Statement 103 on Equity
Equivalents permits firms that maintain a written global policy
(versus global practice) -- with no exceptions -- to substitute
adherence to BEE equity provisions with what is termed an "equity
equivalent." An "equity equivalent" is a donation of up to 25
percent of local equity (for maximum ownership points) to
government-approved projects not yet identified. As Ford's General
Manager (please protect) explains, this raises the cost of building a
new plant, for example, from R1 billion to R1.25 billion, with
corresponding implications for hurdle rates and profit. In short,
Ford would not build its next plant in South Africa because the
capital cost of each car produced would be too high.


12. (SBU) Statement 103 belies a fundamental misunderstanding within
government of how business functions. The Statement confuses what is
essentially an expense on the income sheet with equity on the balance
sheet. Donations are not equivalent to equity in any way. They are
cash outflows, not inflows. Moreover, grouping ministerial
discretion with corporate donations is asking for trouble. The
potential for corruption is immense.

Management
--------------


13. (SBU) The BEE Code of Good Practice for managers presumes a
typical hierarchical organization commonly found in South African
firms, i.e., a Chief Executive Officer, Chief Operating Officer,
Chief Financial Officer, etc. Many U.S. firms, however, employ one
internationally experienced Country Manager to manage local
operations within a worldwide corporate matrix that houses other
senior managers in the home office, where most decisions are taken.
These structures exist for reasons of cost, efficiency and control.
Prescribing how large foreign companies should organize themselves in
South Africa for the purpose of scoring BEE points is unlikely to
produce the result that the government intends.

Employment Equity
--------------


14. (SBU) The problems with the Code of Good Practice on employment
equity center on too many point scoring categories, dividing and
subdividing types of "previously disadvantaged individuals." This
policy may induce discrimination within classes of "previously
disadvantaged individuals" because, for example, a company gets more
points for hiring a Black female than it does for hiring a Black
male. The target for disabled workers is 4 percent of the total
workforce of a firm.

Skills Development
--------------


15. (SBU) The Code of Good Practice on skills development requires
companies to uniformly create paid internships at levels tied to the
number of employees, i.e., 5 percent of the workforce, rather than
company needs. For companies that pride themselves in low attrition
rates in stable industries, or for companies in hard times, incurring
the cost of training people for a job that will not be available to
them defies logic.

Purchasing and Supply
--------------


16. (SBU) As it now reads, the Code of Good Practice relating to
purchasing and supply requires that 70 percent of all purchases and
supply come from BEE companies. Since all BEE companies are
inherently South African, the policy discriminates against imports.
Companies may exempt 25 percent of all "non-discretionary" (a term
not defined) purchases coming from foreign sources before calculating
the 70 percent. This brings the ratio of domestic to foreign goods
to a hefty 52:48. For many foreign companies, especially those
selling imported products or producing complex products for the
international market, this is not feasible. Purchasing decisions are
frequently made at the corporate level, so costs can be kept down and
worldwide inventory controlled. Automobile manufacturers, for
example, may source 100,000 parts and components to build a single
automobile. These parts are manufactured around the world in large
volumes to keep unit costs down. In addition, automobile
manufacturers often have long-term contracts with their suppliers,
are obsessed with quality, and want inventory delivered
"just-in-time" to keep costs down.

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Corporate Responsibility
--------------


17. (SBU) Code 700 requires firms to donate money to organizations
and projects where 75 percent of the benefits accrue to Black South
Africans. This raises the question of how one measures the benefits.
Would an environmental or wildlife conservation project qualify? If
not, one unintended consequence is that firms may stop funding such
projects. It is also unclear how one would measure a project that
benefits a region as opposed to a specific community.


18. (SBU) Another problem with this target is that it is measured as
a percentage of net profit after tax, like many of the measures
within other codes. This raises the question of how to measure a
company that does not earn a profit, or a multinational that keeps
its transfer prices low so that it can take its profit at the
international level.

Comment
--------------


19. (C) Our business contacts are consistent in their support for the
goals of BEE, but they are also consistent in their concern that in
creating the comprehensive regulation embodied in the proposed BEE
Codes, the South African government is likely to create serious
unintended consequences. By being prescriptive, they have precluded
the ingenuity of the market place. By being all encompassing, they
have raised the cost of each point scored, and in so doing will raise
the cost of doing business. By placing much of the burden of
transforming South African society on the private sector, they have
created disincentives for investment, especially foreign direct
investment. By taking a one size fits all approach -- one that even
requires industry charters already negotiated to be aligned with the
generic codes -- they have discounted how industries differ. It is
likely that implementation of the BEE Codes of Good Practice will
result in a plethora of redefinitions, interpretations, and red tape
when it comes to annual verification. Points will be awarded on
different company calculations of what is profit. Tenders will be
lost because some firms do not score enough BEE points. And firms
will challenge the tendering decision in the courts, thus holding up
time sensitive projects.


20. (C) The government did no modeling on how BEE would affect the
competitiveness of South African-based firms or tax revenue. In
short, the government created a policy to help solve the country's
socioeconomic problems, but it may come at a high cost of
discouraging investment. Government goals might be better served by
finding ways to encourage investment and embarking on massive
education and training programs for the previously disadvantaged
population. TEITELBAUM