Part 2 - Cognac & Conversation with Nelson Sebati: Understanding The Modified Flow Through Principle....

Cognac & Conversation with Nelson Sebati: Understanding The Modified Flow Through Principle.

www.enterprisesupplierdevelopment.co.za recently met up with Chief Empowerment Advisor, Nelson Sebati at a Global Entrepreneurship Network South Africa (GEN SA) function for some "cognac and conversation" on understanding the Modified Flow Through Principle. Listed below is some of the information that he shared...

Nyeleti Shirilele: Board Chair GEN SA, David Petersen:Head of Procurement & Enterprise Supplier Development., Minister of Small Business Development, Lindiwe Zulu & Nelson Sebati: Chief Empowerment Advisor.

What is it?
Let's start with the flow through principle. It says, for example, if a company (A) is 24% black owned and it owns 10% of another company (B), then Company B is 2.4% black owned. (24% times 10%.)  If Company A is 100% black owned and it owns 25% of Company B, then Company B is 25% black owned (100% times 25%). There is no controversy over the use of the flow through principle, but the modified flow through is different!

The codes state the following;

3.4    Modified Flow-Through Principle

• 3.4.1  A Measured Entity applying this Modified Flow-Through Principle cannot benefit from the Exclusion Principle. 
• 3.4.2  The Modified Flow-Through Principle applies to B-BBEE owned or controlled company in the Ownership of the Measured Entity.
• 3.4.3 In calculating Exercisable Voting Rights under paragraph 2.1.1, and Economic Interest under paragraph 2.2.1 of the Ownership scorecard the following applies:
•  3.4.3.1 Where in the chain of Ownership, Black people have a flow-through level of participation of at least 51%, and then only once in the entire ownership structure of the Measured Entity, such Black participation may be treated as if it were 100% Black.
•  3.4.4 The Modified Flow-Through Principle may only be applied in the calculation of the indicators in paragraphs 2.1.1 and 2.2.1 of the Ownership scorecard. In all other instances, the Flow-Through Principle applies.

What the codes are saying is there is an extra benefit to a black owned (at least 51% black owned and controlled company) in having shares in your company. That benefit will manifest itself in the calculations of certain indicators on the ownership scorecard.

These indicators are:

• 2.1.1 Exercisable voting rights in the entity in the hands of black people (4 points with a target of 25% plus one vote) and
• 2.2.1 Economic interest in the entity to which black people are entitled (4 points with a target of 25%).

How it works:
The modified flow though allows us to increase the level of black ownership, from for example 51% to 100%. If Company A is 51% black owned and it owns 10% of company B, then instead of using the Flow Though Principle and stating that Company B has Voting rights in black hands of 51% times 10% = 5.1%, we can state that Company B has Voting rights in black hands of 100% times 10% = 10%. The 51% has been increased to 100% because Company A has at least 51% black ownership. From a points perspective Company B will earn 1.6 points for voting rights (10%/25% times 4) instead of 0.82 (5.1%/25% times 4).

The exact same will apply to indicator 2.2.1 for Economic Interest. It can be seen that the modified flow though principle has a significant effect on the scorecard. In line with clauses 3.4.3 and 3.4.4 it cannot be used for any other indicator, e.g. "Exercisable voting rights in the hands of black women".

The controversy applies to the next section “Net Value”: Net Value is the most important indicator on the Ownership scorecard. Net value uses the economic interest value used for indicator 2.2.1 ie "Economic interest in the entity to which black people are entitled". The question is which number must be used? The value based on the modified flow through or the standard flow though? The number used for Net value is the one that is printed on a BEE verification certificate showing percentage black ownership.

Using the above example do we use an economic interest of 5.1% (using the flow though) or 10% (using the modified flow through)? This makes a huge difference. If we use the modified flow through then 10% is sufficient to achieve the priority element status level of 10% (assuming all other requirements are met). If we use 5.1% then the entity will drop a level.

A better example is where a company is 51% black owned and it owns 51% of the entity. Using the flow through principle the entity is 26.01% black owned. Using the modified flow through the entity is 51% black owned. This has huge ramifications - EMEs and QSEs are automatically level 2 and generics are seen as 51% black owned. Any company that procures from these companies will earn procurement points via procurement from 51% black owned entities.

As always certain entities seemed to look for shortcuts. Their usual way to achieve 51% black ownership is as follows: The owner sets up a 51% black owned entity and he retains 49%. The entity is often a trust where he can exert indirect control. The trust owns 51% of the entity, with the original owner retaining 49%. The original owner owns 49% directly and 49% indirectly of the other 51%, i.e. in total 74% of the business. However, the entity is seen to be 51% black owned and obtains its valid BEE certificate on this basis.

To us this sounded wrong. We saw the modified flow through as only applying to certain indicators - nowhere in the codes does it refer to actual levels of ownership. The objectives of the Codes and key principles seemed to frown upon not following the substance rather than the legal form of the codes.

What is right?
Most, if not all verification agencies recognise the use of the modified flow though principle in calculating levels of ownership. Many state on BEE verification certificates "Modified Flow Through Principle: YES". SANAS, and previously also IRBA were well aware that the modified flow though principle was being applied by the agencies they were/are regulating. Recently the B_BBEE Commission issued a Practice Guide on the subject: (the Commission only mentioned EMEs and QSEs.)

Its conclusion in paragraphs 12 to 14 was:

• 12. The introduction of this intervention brought about an exception to the extent to which entities can rely on the modified flow through principle to calculate black ownership. It is our view that this limits the calculation of 51% and 100% black ownership for EMEs and QSEs only through the application of the flow through principle, in line with the B-BBEE objectives outlined in section 2 of the B-BBEE Act.
• 13. While we do recognise that the Codes have not explicitly provided limitations of the applications of the modified flow through principle in claiming the enhanced recognition status for black owned and controlled EMEs and QSEs, it must not be applied to circumvent the policy objectives. Therefore, it is the effect of the application of the principle that in our view limits its application to the extent that it would undermine the objectives of the Act.
• 14. Therefore, the B-BBEE Commission in accordance with the requirements to advice on the interpretation of any provision of the Act as per section 13F(1)(a) and (3)(b) (ii) of the B-BBEE Act, hereby concludes that the modified flow through principle cannot be used to benefit from the enhanced recognition status reserved for 51% and 100% black owned EMEs and QSEs. Any contrary advice would be regarded as a misrepresentation of Entity B’s B-BBEE status which is an offence in terms of section 13O (1) (a) of the Act.

To emphasise, The B-BBEE Commission "concludes that the modified flow through principle cannot be used to benefit from the enhanced recognition status reserved for 51% and 100% black owned EMEs and QSEs."

The BEE Commission is saying that an EME and QSE cannot use the modified flow through principle to state that they are 51% to 100% black owned to take advantage of the enhanced recognition to be an automatic level 1 or level 2.

As mentioned the guideline only referred to EMEs and QSEs and enhanced recognition. It did not mention Generics or other entities' ownership levels. We would think that its conclusions for the modified flow through principle would apply to Generic entities as well, i.e. do not use the modified flow though principle to calculate effective ownership, but it does not say so.

What to do??
If your entity is a EME and QSE and it is relying on the modified flow though principle to state it is 51% or more black owned, the BEE Commission may take action against you for fronting.

If your entity uses the modified flow though for any other purpose to state ownership levels, you MAY have a problem. In general, if your entity's ownership percentage is relying on the modified flow through principle, start planning now to change this and get a plan B.