Full Submission on Preferential Procurement Regulations – 15 July 2016

IRR Full Submission on Preferential Procurement Regulations 15 July 2016.

South African Institute of Race Relations NPC
Submission to the Office of the Chief Procurement Officer,
National Treasury,
regarding the draft
Preferential Procurement Regulations, 2016
Johannesburg, 15th July 2016

Introduction, page 1
The urgent need to increase opportunities for the disadvantaged, page 2
Ever more onerous and damaging BEE requirements, page 2
The often negative impact of existing preferential procurement rules, page 4
The content of the regulations, page 5
Ambit of the regulations, page 5
An almost 10 000% increase in a key threshold, page 6
Local content requirements, page 6
No obligation to consider “functionality”, page 8
Tie-breaker provisions, page 9
Sub-contracts for BEE firms, page 9
Sub-contracting where objective criteria are specified, page 9
Sub-contracting according to pre-qualification criteria, page 10
Mandatory sub-contracting for all contracts above R30m, page 10
‘Objective criteria’ defined in other ways as well, page 11
Other pre-qualification criteria, page 11
Stipulated BEE status, page 11
A possible 51% BEE ownership requirement, page 11
Unconstitutionality of the regulations, page12
No socio-economic impact assessment conducted, page 14
Socio-economic ramifications of the regulations, page 15
A new system of “economic empowerment for the disadvantaged”, p17

The Office of the Chief Procurement Officer of the National Treasury (the Treasury) has invited public comment on the draft Preferential Procurement Regulations of 2016 (the regulations). These regulations were published in the Government Gazette on 14th June 2016, under the powers conferred on the Treasury by the Preferential Procurement Policy Framework Act of 2000 (the Act).

Public comment is due not later than 15th July 2016. However, this period is too short to meet the constitutional requirement for proper public consultation.

This submission is made by the South African Institute of Race Relations NPC (IRR), a non-profit organisation formed in 1929 to oppose racial discrimination and promote racial goodwill. Its current objects are to promote democracy, human rights, development, and reconciliation between the peoples of South Africa.

In gazetting the regulations, the Treasury has failed to comply with the Guidelines for the government’s new Socio-Economic Impact Assessment System (SEIAS), as adopted by the Department of Planning, Monitoring and Evaluation in May 2015 (the Guidelines). According to these Guidelines, socio-economic impact assessments are needed not only for primary legislation but also for ‘significant regulations’ of the kind in issue here. Hence, both initial and final impact assessments should have been attached to the regulations, as gazetted for public comment. Unless and until this has been done, the regulations cannot be adopted by the minister.

The urgent need to increase opportunities for the disadvantaged
Some 22 years after the political transition in 1994, it remains vitally important to increase opportunities for the poor and unemployed: the truly disadvantaged in the country. This cannot be done without overcoming key barriers to upward mobility, which include:

  • a meagre economic growth rate, now less than 1% of gross domestic product (GDP) a year instead of the 6% or more required;
  • one of the worst public education systems in the world, despite the massive tax revenues allocated to it;
  • stubbornly high unemployment rates on a broad definition (35% among South Africans in general and 67% among young people), made worse by labour laws that encourage violent strikes, deter job creation, and price the unskilled out of work;
  • pervasive family breakdown, as a result of which some 70% of black children grow up without the support and guidance of both parents;
  • electricity shortages and costs, compounded by general government inefficiency in the management and maintenance of vital economic and social infrastructure;
  • a limited and struggling small business sector, unable to thrive in an environment of low growth, poor skills, and suffocating red tape; and
  • a mistaken reliance on affirmative action measures, which (like similar policies all around the world) generally benefit a relative elite while bypassing the poor.

Constantly ratcheting up black economic empowerment (BEE) and other “transformation” policies, as the African National Congress (ANC) has been doing in recent years, will not help to overcome these problems. On the contrary, any further erosion of property rights and business autonomy will raise these barriers still higher. So too will any further exclusion of scarce skills and established business experience from the already floundering economy.

Ever more onerous and damaging BEE requirements
In 1994, shortly before it came to power, the ANC put forward a compelling case for affirmative action in employment, business, and land ownership. It did so, however, by holding out a beguiling vision of these policies, which in practice has proved flawed and false. Not surprisingly, the gains that were promised have thus not materialised. Instead, it is the ANC’s own warnings about the potential damage from affirmative action that have proved prophetic.

In arguing for black economic empowerment (BEE) policies in this document, the ANC said that BEE was needed to help remove “all the obstacles to the development of black entrepreneurial capacity” and “unleash the full potential of all South Africans to contribute to wealth creation”. In practice, however, BEE policies are very far from achieving these goals.

Instead, black entrepreneurship is being crippled (in the words of political analyst Moeletsi Mbeki) by BEE rules. These have “generated an entitlement culture”, in terms of which “black people...think they should acquire assets free and that somebody else is there to make them rich, rather than that they should build enterprises from the ground”. In addition, far from contributing to wealth creation, BEE’s major economic costs and ever shifting rules have also eroded business confidence, deterred investment, and helped reduce the economic growth rate to less than 1% of GDP a year.

At the same time, BEE benefits have gone mainly to a relatively small black elite, many of whom have used their political connections to garner great wealth through ownership deals and preferential procurement. Though BEE has thus helped to expand the black middle class, it has also fostered a toxic mix of inefficiency, waste, and corruption that frequently causes great harm to the 17 million poor black South Africans heavily dependent on the state for schools, hospitals, houses, water, sanitation, and other services. At the same time, these South Africans have little prospect of ever themselves benefiting from BEE ownership deals, management posts, procurement contracts, or new small businesses to run.

BEE requirements are nevertheless being constantly ratcheted up: mostly by the Department of Trade and Industry (DTI) but now also, via these regulations, by the Treasury. When the generic codes of good practice were gazetted in 2007 and made operative in 2008, business understood that BEE was to have a limited lifespan and would remain in place only until 2017. Yet, a mere five years after these codes took effect – and despite the fact that average compliance levels stood at around 70% in 2013 – sweeping changes were introduced via the revised generic codes brought into operation in May 2015.

Further major changes were effected under the BEE Amendment Act of 2013, which came into operation in October 2014 and now threatens firms with massive fines and prison terms for “indirectly” (that is, unintentionally) “undermining” BEE objectives. The BEE Amendment Act also includes a trumping provision which came into effect in October 2015. Under this provision, the BEE requirements set out in the Act and the revised generic codes are being given precedence over all other BEE rules, including those in the mining charter and other sector codes.

These are already very major policy shifts, which have fundamentally changed the BEE goalposts and greatly undermined business confidence. These shifts are now to be compounded by the regulations, which will enormously increase the scope for costly and often inefficient preferential procurement. This will damage the economy and make it still more difficult for businesses of any size or colour to thrive.

The often negative impact of existing preferential procurement rules
BEE preferential procurement in state tenders has often made for enormous wastefulness. Finance minister Pravin Gordhan lamented this in 2010, when he said that the government was paying more for everything, from pencils to building materials, than a private business would: “R40 million for a school that should have cost R15m, R26 for a loaf of bread that should have cost R7.”

In 2012 Gwede Mantashe, secretary general of the ANC, voiced a similar concern, saying that BEE companies must “stop using the state as their cash cow by providing poor quality goods at inflated prices”. He also criticised officials for “prioritising the enrichment of BEE companies through public contracts at the expense of…quality services at affordable prices”.

Later the same year, Mr Mantashe warned that the state would be ill advised to continue putting preferential procurement before service delivery. Said the ANC secretary general: “This thing of having a bottle of water that you can get for R7 procured by the government for R27 because you want to create a middle-class person who must have a business is not on. It must stop.”

The examples cited by both Mr Gordhan and Mr Mantashe involve contract prices roughly four times greater than market ones. Yet these examples arose under the current preferential procurement rules, under which BEE weightings are supposed to be very much smaller.

Under the Preferential Procurement Policy Framework Act of 2000 (the Act), a 90:10 formula applies to tenders worth more than a specified threshold (currently R1m). According to this formula, 90 points are allocated on price and 10 points for the BEE status of the tendering firm.  This means that BEE firms can charge 10% more than others and still be awarded a contract. Under the current rules, a 80:20 formula applies to contracts below the specified threshold, so allowing BEE firms to charge 20% more and still win the tender.  These authorised BEE weightings, of 10% or 20%, have often failed to prevent the much higher price escalations cited by Mr Gordhan and by Mr Mantashe.

One of the factors making for BEE price escalation was explained in 2012 by an unnamed BEE contractor who told The Star that BEE businessmen seeking state contracts have little choice but to charge inflated prices to “recoup the costs of paying mandatory kickbacks” to corrupt officials and “regularly donating huge sums” to the ANC and its allies.

Said the businessman: “You pay to be introduced to the political principals, you pay to get a tender, you pay to be paid [for completed work], and you must also ‘grease the machinery’. From time to time, you are called to make donations to the ANC. There are also donations to the youth league, the women’s league, and the SACP.”  Those who failed to make the necessary payments either in cash or “in kind” – by giving sub-contracts to the relatives of public servants and politicians – would find themselves excluded from state contracts worth many millions of rands, he said.

Though few other businessmen have admitted to making payments of this kind, the comment is consistent with what both Mr Gordhan and Mr Mantashe have said. It also seems to provide insight into a wider pattern of corruption estimated to cost the state some R30bn a year.

Once the threshold for the 80:20 formula is raised to R100m under the regulations (see below), the scope for price escalation will greatly expand. This may bring additional benefits to a relatively small group of BEE businessmen, but it will also impose great costs on poor South Africans dependent on the government for vital goods and services. For the more the government spends on preferential tenders, the less revenue it will have left over to spend on service delivery elsewhere.

The content of the regulations
As already noted, the Act authorises a 10% BEE weighting for contracts above a certain threshold, and a 20% BEE weighting for contracts below that threshold. The regulations go far beyond this. They not only increase the threshold a hundred-fold (by some 9 900%), but also introduce mandatory local content requirements, oblige tenderers to sub-contract between 30% and 100% of contracts to small black firms, and allow relevant organs of state to impose “pre-qualification” criteria that could exclude the country’s most experienced companies from tendering for government contracts at all.

Ambit of the regulations
The organs of state covered by the Act – and hence also by the regulations – include all national and provincial departments, all municipalities, Parliament, and the nine provincial legislatures. Also included are all “constitutional institutions” identified in the Public Finance Management Act of 1999. These range from the Commission for Gender Equality and the Human Rights Commission to the Independent Electoral Commission, the Municipal Demarcation Board, and the Public Protector. This is a comprehensive list.

However, the Act (and the regulations) also apply to any other institution which falls within the definition of “organ of state” in Section 239 of the Constitution, and is also “recognised by the minister of finance as an institution to which the Act applies”. [Section 1, Act]  Section 239 of the Constitution defines an organ of state as including any institution which “exercises a public power or performs a public function in terms of any legislation”. This definition is wide enough to cover Eskom, Transnet, Postnet, and various other state-owned enterprises performing public functions. The finance minister must first recognise them as covered by the Act, but such recognition could of course be provided to a range of such entities.

The “goods” to which the regulations apply are expressly defined as including “infrastructure”. This in turn is defined as including both immovable assets “acquired through construction operations”, and “moveable assets which cannot function independently from purpose built immovable assets”. The “services” to which the regulations apply are similarly defined as “including any services to build or maintain infrastructure”. [Clause 1, Regulations]

The goal of the regulations is clearly to give BEE firms much of the benefit of the government’s proposed roll-out of infrastructure projects worth R1 trillion or more. However, these set asides are likely to be costly. They could also often see large contracts awarded to firms with less experience and know-how than others. This could undermine quality and make for delays in delivery. It could also contribute to wastefulness in the use of scarce revenues and make it harder still to attract investment, expand the economy, and generate jobs for the 8.9 million now unemployed.

An almost 10 000% increase in a key threshold
As earlier described, the Act authorises a 10% BEE weighting for contracts above a certain threshold and a 20% BEE weighting for contracts below that threshold. That threshold was initially set at R500 000, which limited the contracts to which the 20% preference would apply. That threshold was doubled to R1m in 2011, which was itself a major change.

According to the regulations, the threshold is now to be increased by 9 900%, so as to raise it from R1m to R100m. This means that a 20% BEE preference will apply to all the procurement contracts entered into by all the organs of state earlier described, provided that these are worth less than R100m. A 10% BEE preference will apply to contracts valued above R100m. [Clause 5, Regulations] This will vastly increase the number of government contracts in which BEE firms will be able to charge 20% more and still be awarded the tenders. Based on previous experience, actual price escalations will often be significantly higher than this.

The change poses a major threat to cost-effective tendering. It also provides still more scope for a relatively small elite to benefit at the expense of the poor. Inevitably, the regulations will result in more public revenue flowing to this small group, while less public money will be left available to meet the needs of the truly disadvantaged.

This enormous increase in the threshold below which the 80/20 formula will apply is a very substantive policy change. It thus needs to be debated and approved by Parliament, not introduced via regulation.

Local content requirements
According to the regulations, minimum local production and content requirements will apply wherever the Treasury has “designated” a sector for interventions of this kind. [Clause 9, regulations] In such sectors, any invitation to tender must be made subject to “a specific condition that only locally produced [or] manufactured goods, meeting the stipulated minimum threshold for local production and content, will be considered”. [Clause 9, regulations]

The DTI has already designated various sectors as ones in which local procurement is obligatory. These include buses, rail rolling stock, steel power pylons, electrical and telecommunications cables, and components for solar water heaters, along with canned vegetables, clothing, and footwear. Often the minimum local content required in these spheres varies from 70% to 90%, and sometimes it goes as high as 100%. [DTI sectors and minimum thresholds for local content, 7 December 2011]

According to the DTI, the aim of these requirements is to boost the manufacturing sector and counter the de-industrialisation of South Africa. However, the department has yet to acknowledge how much the government itself has undermined the competitiveness of domestic manufacturing through its coercive labour laws and unrealistic BEE requirements, along with its failures to improve education, curb crime, or expand essential infrastructure quickly enough. The DTI’s “solution” has simply added to the bureaucratic burden of doing business in the country. It is also likely to increase procurement costs where imported goods are cheaper or better than locally made ones.

The Treasury will not necessarily follow the DTI’s lead in deciding what sectors should be designated for local content requirements. The Treasury must, however, make its decisions “after consulting” the DTI and bearing in mind the country’s “national development and industrial policies”, along with “competition and other economic factors”.  The sectors designated by the Treasury could thus differ from those already identified by the DTI, which would extend the scope of local content obligations and add to the complexity of doing business in South Africa.

Moreover, the most pressing need is for the government to identify and overcome the policy and other problems undermining the manufacturing sector. The regulations instead seek to give an artificial and costly boost to the manufacturing sector by insisting on a percentage of local procurement within all Treasury-designated spheres. Again, this is likely to benefit a relatively small number of firms, while driving up procurement costs and leaving less revenue available for service delivery to the poor.

In addition, as Tebogo Makube, chief director for industrial procurement at the DTI, has pointed out, international trade law developed under the auspices of the World Trade Organisation (WTO) precludes the government from forcing local procurement on the private sector. This is why a 2011 local procurement accord had to be negotiated between the government and its social partners at the National Economic Development and Labour Council (Nedlac). [Legalbrief 26 June 2016] The regulations overlook this prohibition in insisting that companies wanting to do business with the state in designated sectors must meet specified local content quotas.

No obligation to consider “functionality”
The regulations define “functionality” as meaning “the ability of a tenderer to provide goods or services in accordance with specifications set out in the tender documents”. [Clause 1, Regulations] A tenderer which cannot comply with such basic requirements should not, of course, be considered for any state contract at all.  Worryingly, however, the regulations do not require that tenderers be evaluated for functionality. Instead, they make it clear that organs of state may choose whether to embark on such an evaluation or not.

According to the regulations, “if” an organ of state decides to evaluate a tender on functionality, then it must do so on the basis of “objective” evaluation criteria that are clearly specified in the invitation to bid. [Clause 4, Regulations] However, as this conditional wording makes clear, there is no obligation on any organ of state to include an evaluation of functionality in any tender, no matter how big the price or how important the project may be.

Under the regulations, organs of state also have a choice as what “minimum score for functionality” they decide to set. This should not be set “so low that it jeopardises the quality of the required goods or services”, but it must also not be “so high that it is unreasonably restrictive”. These criteria are vague enough to give organs of state enormous discretion in how they apply them. This, of course, increases the scope for bureaucratic abuse and even for corruption.

So long as functionality remains an optional criterion, performance on BEE tenders is likely to be poor. Shoddy performance has also been identified as a major problem in many instances in the past. In 2007, for example, the premier of Mpumalanga, Thabang Makwetla, warned that many of the black-owned companies benefiting from state contracts were “letting the government down” through bad workmanship, cutting corners, or walking off contracts before they were finished.

Shoddy performance has been particularly evident in state contracts for the building of “RDP” (Reconstruction and Development) or “BNG” (Breaking New Ground) houses. In 2011 the National Home Builders Registration Council (a body responsible for ensuring compliance with building standards in the construction of new homes) thus warned that no less than 87% of the houses built by the state since 1994 were “high risk”. By then, moreover, the bill for fixing these houses – some of which would have to be knocked down and rebuilt from scratch – was estimated at some R59bn.

This was an enormous sum, amounting to more than twice the budget for housing development that year and to 7% of the government’s entire infrastructure budget for the next three years. Not all these badly built houses had been constructed by black contractors, of course. However, as the then minister of human settlements, Tokyo Sexwale, commented in 2012, many had indeed been built by BEE “chance-takers [who] thought their blackness would help them get into the money very quickly”.

Against this background, no state contract should be awarded unless the tenderer is first able to demonstrate a proper level of “functionality”. That this is seen as an optional extra under the regulations is extraordinary. It is also contrary to the Constitution, as further described below.

Tie-breaker provisions
According to the regulations, “if two or more tenderers score an equal number of points”, the contract must generally be awarded to “the tenderer that scores the highest points for BEE”. It is only “if functionality is part of the evaluation process” that the contract must go to the tenderer that “scores the highest points for functionality”. [Clause 8, Regulations]

This wording will give organs of state which prefer to put BEE above other considerations yet more reason to exclude functionality as a factor in the evaluation of tenders. Yet functionality – which, as earlier noted, means the tenderer’s “ability to provide” the specified goods and services – is vital in public procurement. The more it is left out of consideration, the greater the harm that is likely to result, especially to the poor and disadvantaged who depend on state delivery.

Sub-contracts for BEE firms
According to the regulations, a significant level of sub-contracting for the benefit of small black firms – those with annual turnover below R50m – may be required in three sets of circumstances.

Sub-contracting where objective criteria are specified
Under Section 2(1)(f) of the Act, a contract “must be awarded to a tenderer who scores the highest points, [on price and BEE status] unless objective criteria [in addition to those aimed at benefiting historically disadvantaged South Africans or implementing the RDP] justify the award to another tenderer”. [Section 2(1)(f), Act] The Act does not define what “objective criteria” it has in mind. The regulations seek to fill this gap by giving various meanings to “objective criteria”, which may be very different from what the drafters of the Act intended.

According to the regulations, objective criteria may include a sub-contracting requirement, under which a tenderer must sub-contract “a minimum of 30% of the value of the contract to one or more EMEs or QSEs [which are] owned by black people”, or by black people who are also female, young (aged 14 to 35) or disabled.

EMEs are defined (as in the revised BEE generic codes of good practice of October 2013) as “exempted micro enterprises” with annual turnover of less than R10m. QSEs are defined, again as in these generic codes, as “qualifying small enterprises” with an annual turnover of between R10m and R50m. [BEE Codes of Good Practice, gazetted 11th October 2013]  The regulations add that the required sub-contracts may also be awarded to local co-operatives, or to “enterprises conducting business in a township or rural area…where the goods or services are required”. [Clause 7, Regulations]

These provisions greatly increase the scope for uncompetitive tender awards – especially as the 30% sub-contracting requirement is a “minimum” which may in practice be significantly exceeded. A tender could thus stipulate, for example, that 90% of the value of the contract must be sub-contracted to small black businesses, which might in fact have a limited capacity to produce the required goods and services at cost-effective prices. In addition, where such a sub-contracting requirement is included, a tenderer will be able to win the contract even if it does not score the highest number of points on price and BEE status. This will further encourage wastefulness and undermine efficiency in state procurement.

According to the regulations, if an organ of state awards a tender on this additionally preferential basis, it must report this to the Treasury within 30 days. In so reporting, the organ of state must state, among other things, the difference between “the price of the tenderer awarded the contract and the price of the tenderer that scored the highest points”. [Clause 7(4), Regulations] However, the Treasury’s consent for the higher-priced tender is not required. Nor do the regulations empower the Treasury to set aside an uncompetitive tender, no matter how large its price inflation may be. 

Sub-contracting according to pre-qualification criteria
According to the regulations, an organ of state may also “apply pre-qualifying criteria in the evaluation of a tender”. These criteria must be stated in the tender documents and may include a requirement that the tenderer must sub-contract “a minimum of the value of the contract to one or more EMEs or QSEs [which are] owned by black people”, or by black people who are female, young (aged 14 to 35), or disabled. [Clause 10, Regulations]

A tender which “fails to obtain any pre-qualifying criteria” (sic) – presumably, one that does not comply with the stipulated criteria – “is not an acceptable tender” and may not be considered at all. [Clause 10(2), Regulations]

Again, these rules will greatly increase the scope for sub-contracting in state tenders – and could often see between 30% and 100% of a given contract being passed on to small black firms with limited capacity to supply the requisite goods and services in a cost-effective way.

Mandatory sub-contracting for all contracts above R30m
The regulations also make sub-contracts for BEE firms mandatory in all “contracts above R30m”. In all such instances, the tenderer “must sub-contract a minimum of 30% of the value of the contract” to EMEs or QSEs which (again) are either “owned by black people”, or by black people who are female, young (aged 14 to 35), or disabled. [Clause 13, Regulations]

Since very many state contracts are worth more than R30m, this will greatly increase the scope for sub-contracting to small black firms with limited capacity. Again, moreover, the 30% sub-contracting requirement is a minimum proportion, which could be greatly exceeded in practice. This could severely undermine the quality of delivery – especially on major infrastructure projects – but also in a host of other spheres.

‘Objective criteria’ defined in other ways as well
The regulations also define “objective criteria” in other ways. This is particularly important because, where objective criteria apply, tenders may be awarded to firms that have failed to score the highest points on price and BEE status.

According to the regulations, objective criteria may include “economic and financial projections regarding the capacity of the tenderer to deliver on the required goods and services”.  What this clause means – and how it would be applied in practice – is entirely unclear.

Under the regulations, objective criteria may also include:

  • “a quantity surveyor’s projection as to the time it is likely to take to complete an infrastructure project”; and
  • “the anticipated lead-time to deliver the required goods or services”.

These criteria are easier to understand, but their salience is questionable. Why should a contract – say, for the construction of a new dug-out port in Durban – be awarded to a tenderer who has failed to muster the highest points (on price and BEE status) simply because “the anticipated lead-time to deliver the required goods and services” has been inserted into the invitation to bid as an “objective criterion”?

Other pre-qualification criteria
As earlier noted, the regulations allow an organ of state to stipulate a minimum 30% sub-contracting requirement as a “pre-qualification criterion” which must be met if a tender is to be considered at all. The regulations also make it clear that various other pre-qualification criteria may be stipulated as well. 

Stipulated BEE status
According to the regulations, pre-qualification criteria may include “a stipulated B-BBEE status level as a contributor”. [Clause 10(1)(a), Regulations]  An organ of state will thus be allowed to specify that it will contract solely with firms having a “level of BEE recognition” standing at “level 1” (which requires more than 100 points on the BEE scorecard), or “level 2” (which requires 95 to 100 points).

If such onerous requirements are imposed as pre-qualification criteria, this would exclude many of the country’s largest and most experienced firms – including almost all of the top 100 companies listed on the JSE – from bidding for state contracts at all. [2016 South Africa Survey, IRR, Johannesburg, 2016, pp350-353]

A possible 51% BEE ownership requirement
The regulations make it clear that the two examples provided are not exclusive. Hence, various other pre-qualification criteria could also be laid down. Organs of state could thus stipulate, for instance, that they will contract only with firms that have 51% BEE ownership. (This is also not an idle possibility, for Eskom already insists on 51% black ownership for its coal suppliers, even though the mining charter lays down a 26% BEE ownership requirement.)

If 51% BEE ownership is indeed identified by an organ of state as a “pre-qualification” criterion, then a tender from a firm with BEE ownership at a level less than this would not qualify for consideration at all, irrespective of how cost-effective that tender might be. That the firm in question had met the 25% BEE ownership requirement laid down in the generic codes (or the varying ownership targets laid down in other sector codes) would also be irrelevant.

These provisions are similar to rules earlier proposed in the draft BEE regulations that were gazetted in January 2016 by the minister of trade and industry, Rob Davies, under the Broad-Based Black Economic Empowerment Act of 2003, as amended in 2013.  Under that initial draft, organs of state wanting to stipulate additional pre-qualification BEE criteria in procurement (and other spheres) would have had to apply to Dr Davies, motivate for the increase, and obtain his consent. [Clause 19(1), Draft Broad-Based Black Economic Empowerment Regulations, Government Gazette on 17th February 2016] All organs of state would also have been obliged to “give more consideration” in procurement (and also in licensing and other decisions) to firms with 51% BEE ownership. [Clause 20(1)(a), DTI Regulations]

These clauses have been deleted from the DTI’s regulations, as gazetted by Dr Davies in their final form in June 2016. However, the Treasury’s regulations now suggest that similar ownership demands are being introduced in a roundabout way and without any explicit mention of a 51% BEE ownership requirement.

If the regulations are adopted in their current form, many organs of state will be able to impose a 51% BEE ownership criterion in all their procurement decisions (and without any reuirement to obtain ministerial consent). Yet the more organs of state start insisting on 51% BEE ownership in procurement, the greater the accompanying costs and overall damage to the economy will be. 

Unconstitutionality of the regulations
Section 217 of the Constitution states that, “when an organ of state…contracts for goods or services, it must do so in accordance with a system which is fair, equitable, transparent, competitive, and cost-effective”. As an exception to this general rule, the Constitution allows an organ of state to implement a procurement policy that provides for “categories of preference in the award of contracts”, and for “the protection or advancement of persons…disadvantaged by unfair discrimination”. [Section 217 (1) and (2), Constitution]

However, any measure aimed at “protecting” or “advancing” the unfairly disadvantaged must be rationally and reasonably connected to that objective. Whether the Act itself meets these tests is uncertain, for it is simply a framework law which provides little of the detail needed for such an assessment. At the same time, the Act’s vague terms undermine its constitutionality on other grounds. This is because the Constitution identifies the ‘supremacy of the rule of law’ as one of its founding values – and the rule of law requires that legislation be certain and clear.

The Act also opens the way for law-making by the executive, so contradicting another core principle underpinning the Constitution: the separation of powers. Executive law-making inconsistent with the Constitution is particularly evident in the regulations, which (among other things):

  • raise the threshold at which the 90:10 formula kicks in by 10 000%, from R1m to R100m;
  • introduce mandatory local content requirements in all sectors designated by the Treasury;
  • demand that between 30% and 100% of all contracts above R30m be sub-contracted to small black-owned firms;
  • introduce similar sub-contracting requirements in a host of other spheres, and
  • allow very many organs of state to set pre-qualification criteria – including a possible 51% BEE ownership requirement – in all the tenders they issue.

The regulations thus aim to bring about radical changes in the state’s preferential procurement system. At present, all that the Act allows is a 10% or 20% price advantage – for contracts worth more or less than R1m – for the historically disadvantaged. Major changes of the kind envisaged in the regulations cannot be made by ministerial fiat without infringing on the separation of powers. The Constitution vests the capacity to make new law in parliament, not the executive. Hence, if the state’s preferential procurement rules are to be changed so comprehensively, this must be done via statute, not subordinate regulation.

However, even if Parliament were to adopt new legislation incorporating all the changes proposed in the regulations, the problem of unconstitutionality would still remain. As noted, the Constitution lays down a general requirement that state procurement must be “fair, equitable, transparent, competitive, and cost-effective”. [Section 217, Constitution] It also demands the “efficient, economic, and effective use of [public] resources”. [Section 195, Constitution] These are binding requirements, which the proposals in the regulations comprehensively contradict.

The Constitution does allow some derogation from its general procurement rules where that derogation will “protect” or “advance” the disadvantaged. But the derogation in issue must be rationally and reasonably connected to that objective. The proposed rules do not meet this test. They will allow a relatively small number of black businesses to gain state tenders at inflated prices and irrespective of how inefficient they might be. However, in allowing this, the new rules will greatly prejudice the great majority of disadvantaged South Africans, who depend on the state for vital goods and services. Such goods and services should always be provided in the most cost-effective and efficient way, so as to husband scarce public resources and ensure that these are spread as broadly as possible. The proposed new system is so damaging to the truly disadvantaged that it cannot be accepted as a rational or reasonable way of overcoming apartheid injustices.

No socio-economic impact assessment conducted
Since 1st September 2015 (as President Jacob Zuma told the World Economic Forum in Davos in January 2016) all legislation and regulation must be subjected to a “socio-economic impact assessment” before it is adopted. This must be done in terms of the Guidelines for the Socio-Economic Impact Assessment System (SEIAS) developed by the Department of Planning, Monitoring, and Evaluation in May 2015. The aim of this new system is to ensure that ‘the full costs of regulations and especially the impact on the economy” are fully understood before new rules are introduced. [SEIAS Guidelines, p3, May 2015]

According to the May 2015 Guidelines (the Guidelines), SEIAS is also intended to ensure that “government policies do more to support [four] core national priorities”, which are “social cohesion, economic inclusion, economic growth, and environmental sustainability”. [Guidelines, p6]  Add the Guidelines: “A common risk is that policy/law makers focus on achieving one priority without assessing the impact on other national ones.”  Moreover, as the document goes on to stress: “A balance has to be struck between protecting the vulnerable and supporting a growing economy that will ultimately provide them with more opportunities.” [Guidelines, p6]

The Guidelines deal specifically with proposed new rules that aim to ‘achieve a more equitable and inclusive society”, but which “inevitably impose some burdens on those who benefited from the pre-existing laws and structures”. The document notes that “relatively small sacrifices on the part [of past beneficiaries] can lead to a significant improvement in the conditions of the majority”. However, “the challenge is to identify when the burdens of change loom so large that they could lead to excessive costs to society, for instance through disinvestment by business or a loss of skills to emigration”.  [Guidelines, p11] It is, of course, precisely such major economic risks that the regulations raise.

According to the Guidelines, SEIAS must be applied at various stages in the policy process.  Once new regulations (or other rules) have been proposed, “an initial assessment” must be conducted to identify different “options for addressing the problem” and making “a rough evaluation” of their respective costs and benefits. Thereafter, “appropriate consultation” is needed, along with “a continual review of the impact assessment as the proposals evolve”. [Guidelines, p7]

A “final impact assessment” must then be developed that “provides a detailed evaluation of the likely effects of the [regulation] in terms of implementation and compliance costs as well as the anticipated outcome”.  When the regulation is published “for public comment and consultation with stakeholders”, the final assessment must be attached to it. Both the draft regulation and the final assessment must then be revised as required, based on the comments obtained from the public and other stakeholders. Thereafter, when the draft regulation is submitted for approval (in this case to the minister of finance), the final assessment, as thus amended, must be attached to it. [Guidelines, p7]

The Guidelines stress that SEIAS must be applied not only to legislation, but also to “significant regulations” and any “major amendments of existing regulations…that have country coverage with high impacts”. In addition, where “legislation provides an enabling framework for more detailed regulations”, as does the Act, then “the subordinate regulations should be the main subject of the assessment process”.  [Guidelines, p8]

However, no SEIAS assessment of the regulations has been made available, as the Guidelines require. The regulations thus cannot be approved by the minister until this step has been taken.

Socio-economic ramifications of the regulations
The regulations will have many damaging socio-economic ramifications. They will further encourage inflated pricing in virtually all state procurement. They will introduce mandatory local content requirements, which will push up costs still more whenever imported products are cheaper and better. They will require or promote the sub-contracting of between 30% and 100% of state contracts to black firms with limited experience and capacity. They could also push many of the most experienced companies right out of state procurement – especially if pre-qualification criteria are used to require 51% BEE ownership or high levels of BEE compliance which the new generic (and sector) codes make difficult to attain.

Any insistence on 51% BEE ownership as a pre-qualification criterion will be particularly damaging, as the costs of compliance will be high and the damage to investor confidence enormous.  The mere possibility of this is particularly worrying at a time when foreign direct investment (FDI) into South Africa has dropped to its lowest level in ten years ($1.8bn), according to the United Nations Conference on Trade and Development’s World Investment Report for 2016. [News24 13 July 2016] If FDI diminishes still further, then economic growth – which is already unlikely to exceed 0.1% of GDP in 2016, according to the International Monetary Fund – could well turn negative, pushing South Africa into a damaging recession.

Tax revenues would then diminish, while the cost of government spending on procurement would increase under the impact of the regulations. Public debt, which has already increased very rapidly, from R805bn in 2009 to around R2 trillion now, would then rise even faster. In such circumstances, downgrades of the country’s sovereign debt rating to sub-investment or “junk” status would become increasingly difficult to avoid. Yet any such downgrades would further increase borrowing costs, accelerate capital outflows, and push the economy into an even more damaging downward spiral.

Mr Gordhan is already under great pressure to stave off damaging downgrades of this kind. If this is to be achieved, as international ratings agencies have made clear, the government must hold public spending in check. It must also implement reforms to ramp up economic growth.  The regulations put both these key requirements at risk.

Raising the growth rate critically depends on the government’s success in boosting business confidence and implementing key reforms. This in turns means that the regulatory shackles weighing on the private sector must be reduced, not made heavier still. Hence, instead of constantly increasing the BEE burden, it is time for the Treasury (and all other  government departments) to call a halt.

As earlier noted, when the ruling party urged the introduction of BEE in 1994, it said this was aimed at ‘removing all the obstacles to the development of black entrepreneurial capacity and ‘unleashing the full potential of all South Africans to contribute to wealth creation’. BEE was never supposed to put a stranglehold on the economy, exclude the most experienced companies from participating in state procurement, or threaten property rights. Nor was it intended to keep ever more South Africans mired in poverty for the benefit of a relatively small and politically connected elite. 

In addition, what “black” business most needs for increased success is not the damaging set-asides mooted in the regulations but rather a rapid rate of economic growth (ideally, 7% of GDP a year). This would see the economy doubling in size every ten years. This in turn would generate millions more jobs, and vastly increase domestic consumer demand.

At the same time, the quality of schooling must be greatly improved. Some 80% of public schools are dysfunctional, while roughly half the pupils who start school in Grade 1 drop out without ever reaching Grade 12. Mainly because their schooling has left them so poorly prepared, only 20% of the black South Africans who manage to enroll at universities are able to graduate in regulation time, while 40% drop out and never graduate at all.

The often dismal public education system, coupled with the country’s unemployment crisis, puts black entrepreneurs at a particular disadvantage. As research by the FinMark Trust has shown, the people most likely to succeed in business are those who come from stable two-parent families, have the benefit of solid schooling, obtain university degrees, work for a number of years in existing firms, have a strong entrepreneurial spirit – and branch out on their own when they already significant skills and experience on which to draw. If such entrepreneurs are to build up their businesses, they must also have the benefit of a rapidly expanding economy with low unemployment rates and growing consumer markets.

This is a proven formula for success. In South Africa, however, only 30% of black youngsters grow up in two-parent homes, while the great majority attend dysfunctional public schools which often fail to equip them even with the most basic skills. Not surprisingly, many then battle to find jobs. This is partly because South Africa’s growth rate has long been too low. Also relevant, however, are labour laws which raise entry level wages so high as to price the poorly skilled and inexperienced out of the jobs market.

These factors – coupled with a crippling burden of red tape, high crime rates, often poor infrastructure, and limited access to venture capital – combine to put black entrepreneurs at a severe disadvantage. These fundamental obstacles to their success cannot be overcome through a simplistic reliance on preferential state procurement. Moreover, what the regulations propose is particularly damaging as it will clearly inflate prices, erode quality, reduce growth, and decrease jobs – all of which will leave the truly disadvantaged even worse off than before.  Such outcomes will also widen inequality and undermine social cohesion.

The regulations contradict at least three of the country’s four national priorities, as set out in the SEIAS Guidelines. These are “social cohesion, economic inclusion, and economic growth”. (The fourth priority, of environmental sustainability, is likely to be put at risk as well as poorer countries have less capacity to address environmental challenges.) The regulations should thus be abandoned in favour of far more effective ways of promoting inclusive growth, stimulating job creation, and empowering the disadvantaged.

A new system of “economic empowerment for the disadvantaged”
Instead of adopting the regulations (and otherwise ratcheting up BEE requirements), the country needs to embrace a new system of “economic empowerment for the disadvantaged” or “EED”.

EED differs from BEE in two key ways. First, it no longer uses race as a proxy for disadvantage. Instead, it cuts to the heart of the matter by focusing directly on disadvantage and using income and other indicators of socio-economic status to identify those most in need of help. This allows racial classification and racial preferences to fall away, instead of becoming permanent features of policy. This in turn will reduce racial awareness and potential racial polarisation, helping South Africa to attain and uphold the principle of ‘non-racialism’ embedded in the Constitution.

Second, EED focuses not on outputs in the form of numerical quotas, but rather on providing the inputs necessary to empower poor people. Far from overlooking the key barriers to upward mobility, it seeks to overcome these by focusing on all the right “Es”. In essence, it aims at rapid economic growth, excellent education, very much more employment, and the promotion of vibrant and successful entrepreneurship.

EED policies aimed at achieving these crucial objectives should be accompanied by a new EED scorecard, to replace the current BEE one. Under this revised scorecard, businesses would earn (voluntary) EED points for:

  • any direct investment within the country;
  • maintaining and, in particular, expanding jobs;
  • contributing to tax revenues;
  • helping to generate export earnings;
  • appointing staff on a ‘wide’ definition of merit which takes into account the extent to which people have succeeded in overcoming poor schooling and other disadvantage;
  • providing intensified training and mentoring for personnel appointed on this basis;
  • entering into employee share ownership programmes with all staff;
  • topping up the state-funded vouchers provided to the disadvantaged to enable them to meet their needs for good education, health care, and housing within a competitive and cost-effective environment; and
  • entering into public-private partnerships to improve the delivery of essential services, ranging from electricity to clean water and efficient transport logistics.

After decades of damaging BEE policies, it is time to call a halt. South Africa cannot hope to expand opportunities for the disadvantaged unless it raises the annual growth rate to 6% of GDP or more. A shift to EED will help achieve this. By contrast, the regulations (and other stepped up BEE policies) are likely to push the economy into persistent and destructive recession.

In a speech earlier this year, the deputy president, Cyril Ramaphosa, said that the government is “obsessed with empowering black South Africans” and is sometimes “fanatical” about it. If that is so, the ruling party cannot do better than endorse the EED idea. Unlike the regulations (and other BEE policies), EED will be effective in empowering the many and putting the country on the path to inclusive growth and rising prosperity for all.

South African Institute of Race Relations NPC                            15th July 2016

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