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The Commission’s Approach to ESOPs in Mergers
Episode 1517th October 2024 • Perspectives – Legal Voices on Business • Fasken
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::

Welcome to Perspectives.

::

Fasken's legal voices on business.

::

Welcome to Fasken podcast on the competition

and B-BBEE aspects to consider regarding

::

employee share ownership plans, otherwise

known as ESOPs.

::

My name is Lesley Morphet and I head up the

competition team at Fasken.

::

So not surprisingly, I shall be looking at

the topic from a competition law perspective.

::

My name is Daphney Willem.

::

I am a partner in our Labour and Employment

Department which houses our B-BBEE practice

::

group. I will provide insight on the B-BBEE

aspects of ESOPs imposed by the Competition

::

Commission.

::

Welcome, Daphney.

::

I look forward to your insights.

::

Maybe I can start with giving some

background on the topic, from a competition

::

law perspective.

::

The purpose of the South African Competition

Act is set out in section two and includes

::

provisions such as promoting the efficiency

of the South African economy and providing

::

consumers with competitive prices and

product choices.

::

But the act also aims to correct the wrongs

of the past and therefore has public interest

::

aspects. In 2018, the act was amended, with

the amendments coming into force in February

::

2019, and one of the provisions, as it now

reads, is to promote a greater spread of

::

ownership, in particular to increase the

ownership stakes of historically

::

disadvantaged persons.

::

The act in general focuses both on

competition and public interest aspects, and

::

this dual focus is particularly notable with

respect to the merger provisions, where, when

::

determining whether a proposed transaction

should be approved or not, the Commission has

::

to weigh up both competition and public

interest aspects in determining whether to

::

approve a merger or not, and if it does

approve the merger, whether the approval

::

should be subject to conditions or not.

::

Since the amendments came into force.

::

The Commission has been exceptionally active

from a public interest perspective in its

::

assessment of a merger.

::

Section 1283 requires a consideration of the

effect that a merger will have on, amongst

::

others, the promotion of a greater spread of

ownership, in particular to increase the

::

levels of ownership by historically

disadvantaged persons and workers in firms in

::

the market. The Commission sees these

provisions as placing a positive obligation

::

on parties to mergers, to ensure that there

is a positive effect on ownership by

::

historically disadvantaged persons and

workers.

::

Therefore, there are regular requirements

that merging parties either introduce an ESOP

::

or increase the ownership levels of the

ESOP.

::

Daphney, can you perhaps provide background

to ESOPs from your perspective, what are they

::

and how do they work?

::

So an ESOP is an employee share ownership

scheme, which is established to enable

::

employees to enjoy the benefits associated

with indirect ownership.

::

The scheme is housed in a vehicle either in

the form of a company or a trust, which buys

::

or has shares donated to it in a measured

entity.

::

In the competition case, the measured entity

would be the merged entity and the shares are

::

held for the benefit of the beneficiaries of

the scheme.

::

In essence, the employees would be

considered indirect shareholders of the

::

measured entity by virtue of either being

shareholders of an intermediary company or

::

beneficiaries of a trust, depending on the

entity that the employer, or in this case,

::

the merged entity uses as an intermediary.

::

From a B-BBEE perspective, black people are

allowed to hold shares in a measured entity

::

through a recognised business entity,

provided that they do so using a recognised

::

business entity that meets the prescribed

qualification criteria.

::

An ESOP is one of the recognised business

entities, and it can hold shares and

::

contribute to a measured entity's black

shareholding, provided that it meets a

::

qualification criteria for such recognition.

::

In that case, an ESOP would be regarded as

any other shareholder, and it will have

::

voting rights and share in the measured

entity's dividends in proportion to the

::

shares that it holds in such a measured

entity.

::

Super. Thanks very much, Daphney.

::

Now that we understand in general what an

ESOP is, let's look more closely at what the

::

Commission requires in this respect.

::

It's noteworthy that the previous Minister

of Trade, Industry and Competition, Ebrahim

::

Patel, was very in favour of ESOPs, which is

why I think they hold such prominence in the

::

public interest guidelines.

::

In fact, he held a conference on them

shortly before the elections earlier this

::

year to showcase all the successful ESOPs

that had been put in place to buy parties to

::

mergers. President Ramaphosa was the keynote

speaker at that conference, and he

::

highlighted the value of ESOPs as an

instrument to broaden ownership and with

::

time, to enable greater control of the

economy by previously disadvantaged groups,

::

especially women and black South Africans.

::

He also stated that the schemes allowed

workers a seat at the table where strategic

::

corporate decisions were made, so it can

clearly be seen why the government considers

::

them such a valuable instrument to rectify

the wrongs of the past.

::

And the DTIC has used ESOPs in this way in

its competition legislation.

::

Turning back to mergers and ESOPs in

mergers, the Commission has sought to provide

::

guidance to merging parties as to how they

will deal with the application of the law

::

regarding public interest, including putting

in place ESOPs through issuing guidelines.

::

Although these guidelines are not binding on

the Commission, they do give guidance on how

::

they are likely to tackle the public

interest aspects of a merger before them.

::

In draft guidelines issued late last year,

the Commission included detailed provisions

::

regarding the requirements for the ESOP.

::

In March this year, final revised public

interest guidelines came into effect.

::

The point of departure is that a merger must

promote a greater spread of ownership.

::

They will look at pre-merger ownership

levels by workers and historically

::

disadvantaged people, where a merger does

not promote a greater spread of ownership.

::

In this way, they will look at ownership

remedies, in particular ESOPs in relation to

::

workers. There is far less detail regarding

the requirements for ESOPs than there was in

::

the draft guidelines.

::

The final guidelines simply say an ESOP

concluded in accordance with the design

::

principles articulated in case precedent and

refined by the competition authorities from

::

time to time.

::

The ESOP must hold a minimum range of 5 to

10% of the equity of a merging party or the

::

merged entity and must represent a broad

base of workers as opposed to a few highly

::

skilled workers.

::

However, the comment that it should be in

accordance with the design principles

::

articulated in case precedent does lead one

back to the more detailed provisions that we

::

have seen in past mergers.

::

Daphney, perhaps you can take us through

these.

::

Thanks, Lesley.

::

And as you have already said, the the final

guideline does not set out these design

::

principles that the Commission will use.

::

However, if we look at the draft guidelines,

as well as past mergers that the Competition

::

Commission has approved.

::

They indicate the type of design principles

that the Commission may impose.

::

So I'll deal with some of these design

principles.

::

The first theme I will start with is the

structure of the SOP.

::

The Commission has indicated that it prefers

a unitised employee share ownership trust.

::

And this obviously is as opposed to a

company that can also be used to house an

::

employee share ownership scheme.

::

A Unitised trust presents challenges and

complicates the trust provisions.

::

Units presents the risk of being regarded as

equity instruments that present tax

::

challenges and may require complex

structuring in order to avoid the vesting of

::

the units and tax liabilities for the

beneficiaries due to the units vesting in

::

them. Units also add an unnecessary layer of

complexity and administration for the trust,

::

as a register of units must be kept

regulating the issuing and cancellation of

::

units given the resignation and employment

of new beneficiaries, this will require

::

administration that often leaves the

trustees with no choice but to outsource the

::

administration of the trust.

::

This will increase the expenses that the

trust will incur, and consequently reduce the

::

benefits that may be shared by the

beneficiaries.

::

An alternative and simple way to deal with

the distribution of benefits to beneficiaries

::

would be to use a formula.

::

Formulas are easily applied by the trustees

when benefits are paid to the trust, and

::

would not be subject to any manipulation, as

the trustees would not have any discretion

::

when it comes to the distribution of the

benefits.

::

This approach is very simple and only

requires keeping of a register of

::

beneficiaries, which can easily be

reconciled by the employer with the

::

employee's information.

::

The use of formulas is an approach that is

also recognised by the triple B codes.

::

The second item under the theme structure is

whether an SPV may be interposed between the

::

ESOP and the measured entity.

::

There isn't a commercial reason for

interposing a company between the ESOP and

::

the measured entity, but this may be

appropriate if the intention is for the ESOP

::

to eventually hold shares in other entities.

::

The SPV may be considered an investment

holding company that will hold shares in

::

multiple companies for the benefit of the

ESOP.

::

Remembering that we are looking here at how

the Commission has dealt with aspects of

::

ESOPs in the past, and not at what they have

put in their final guidelines.

::

What are their views as to whether employees

must pay to participate in an ESOP?

::

The Commission has in the past noted that

workers are not required to pay to

::

participate in the ESOP.

::

This view is consistent with how ESOPs are

operating in the B arena and is welcome.

::

The third theme is governance of the ESOP.

::

The Competition Commission has noted that

the Board of Trustees must comprise of three

::

trustees one appointed by the workers, one

appointed by the founder of the ESOP, and a

::

third being an independent trustee to be

recommended and appointed by the workers,

::

provided that that person is acceptable to

the measured entity.

::

It is impractical to get all workers to

participate in the appointment of the

::

independent trustee.

::

Think about a situation where the measured

entity employs thousands of employees.

::

It will be impractical for all of them to

vote on the appointment of one independent

::

trustee. This will present great

difficulties if the appointment of the

::

independent trustee is a requirement for the

ESOP to be established.

::

Furthermore, the Commission does not define

what constitutes independent, nor does it

::

prescribe a qualification criteria for the

independent trustee.

::

So quite frankly, Daphney, it might never get

established.

::

Yes, a possible way around this impulse and

to ensure that the ESOP is registered is for

::

an independent trustee to be appointed by

the measured entity for registration

::

purposes. Was. Thereafter, an independent

trustee may be appointed by the trustees

::

jointly. The initial independent trustee

will only be for purposes of registration and

::

will resign simultaneously with the

appointment of the independent Trustee by all

::

the trustees together.

::

The trustee appointed by the merged entity

will assist with compiling a list of

::

independent trustees from which the two

trustees can choose, subject to an agreed

::

qualification criteria.

::

We have found that this alternative works in

resolving the impulse between the employees

::

as well as the employer and ensures that the

ESOP is registered timelessly.

::

The fourth theme is the duration of the

ESOP.

::

The Commission approves an evergreen ESOP

for purposes of catering to the ever-changing

::

workplace. This, in our view, is appropriate

given the ever-changing number of employees

::

in a specific workplace.

::

The last theme is participation benefits.

::

Here, the Commission recognises that the

ESOP will not be given shares in the merged

::

entity for free and approves the use of a

vendor financing loan, which will be an

::

interest free loan to be given to the ESOP

for purposes of acquiring the shares.

::

In addition to that, the Commission has

highlighted a dividend policy, which includes

::

the payment of a typical dividend to the

ESOP for as long as the vendor financing loan

::

remains outstanding, the dividend will be

used to pay off the loan and still provide

::

benefits to the beneficiaries, Series at a

ratio of 35 and 65.

::

35% of the dividends will flow to the

beneficiaries, and at most 65% of the

::

dividends will be used to service the vendor

financing loan.

::

While the vendor financing loan is an

acceptable way to introduce an ESOP in a

::

measured entity shareholding, the use of a

loan may have B-BBEE consequences on the

::

measured entity.

::

As such, a loan will be considered

acquisition debt and and may affect the

::

measured entity's net value points.

::

A trickle dividend is normal practice, but

the ratio recommended and seen from past

::

merger approved transactions may not be

sufficient to address the requirements of net

::

value and the repayment of the loan.

::

Thank you. Daphney, What do you think of the

interest free aspect that I can remember them

::

imposing in past matters?

::

Is that not perhaps onerous on the merging

entities?

::

Yes. We had said it shouldn't be interest

free.

::

It should be at a rate less than prime.

::

Because that's how much?

::

Oh, no. That. So this is what we said.

::

If the ESOP would go to a a bank, they would

have to pay interest.

::

So why is the commission looking at us and

saying we shouldn't get we shouldn't impose

::

interest. We are also understand that the

ESOP.

::

Well, what the commission is trying to do is

facilitate the introduction of the ESOP,

::

making it easy for them.

::

So if the Commission doesn't want to impose

interest at the rate that is charged at the

::

banks, rather reduce the rate, but still

impose the interest because it is a third

::

party transaction.

::

So the ownership element under the B-BBEE

codes, and B-BBEE sector codes comprises of

::

three sub elements.

::

Economic interest, exercisable voting rights

and net value.

::

Net value looks at the loan that black

people are given to acquire their shares in

::

the merged entity, and the repayment of that

loan is subject to a time graduation factor,

::

which sets out the percentage that needs to

be repaid of the loan on an annual basis for

::

a period of ten years.

::

So if a measured entity is black, shareholder

has an acquisition debt, that acquisition

::

date needs to be repaid in accordance with

the time graduation factor, failing which the

::

entity will not receive any point under the

third sub element of the ownership element

::

being the net value element.

::

Importantly, the net value element is also a

priority element, meaning that in addition to

::

complying with the time graduation factor, a

measured entity to be able to get points

::

under that sub element needs to meet 40% of

the points available.

::

Failure to do so will result in that

measured entity being discounted by one

::

contributor status level.

::

So for example, if a measured entity gets

undergoes a B-BBEE verification, they get a

::

level five contributor status level.

::

However, the acquisition loan was not paid

in accordance with the time graduation

::

factor, and they don't get 40% of the points

available in that sub element.

::

They will be discounted by A level so they

will no longer be considered a level five B

::

contributor, but will now be a level six

B-BBEE contributor.

::

Moving one level down so that sub element is

is crucial for for measured entities that

::

actually have acquisition debt.

::

That's quite a big impact that it might have

on them.

::

So perhaps the competition guidelines need

to take this into account.

::

Or the Commission, in its imposition of

ESOPs as a condition of mergers, needs to

::

understand these dynamics and apply them

more carefully.

::

Definitely, Leslie, and the Commission needs

to take this into consideration, especially

::

when considering the ratio that they impose

as part of the dividend policy, because

::

currently that ratio is not subject to any

movement.

::

It is what the Commission has prescribed.

::

It says at most 65%.

::

So entities are not allowed to go past or

pay more than 65% of the dividends towards

::

the repayment of the loan.

::

We must be careful here because those were

the draft guidelines that set out all these

::

details that we've been unpacking, but we do

think that that is how they look at matters

::

based on case precedent.

::

Perhaps the flexibility that they've brought

in in the final guidelines gives us an

::

opportunity to negotiate more with the

commission on these points.

::

Definitely.

::

Thanks very much for these insights.

::

Do the requirements of the Commission

dovetail broadly with the provisions of the

::

triple B, double E codes?

::

It sounds as if they do.

::

But there are some differences.

::

Yes. So there is there is an overlap between

what the commission seeks to achieve and what

::

the B-BBEE codes regulate.

::

For example, I've mentioned that the an SOP

is one of the recognised entities that can be

::

used to contribute to one's black

shareholding.

::

However, the requirements or the design

principles that the Commission seeks to

::

impose may have adverse consequences on the

recognition of the ESOP from a B-BBEE

::

perspective. So to mitigate against any

adverse B-BBEE consequences that may be

::

suffered by the measured entity that has

adhered to the directions or conditions

::

imposed by the Commission, and the

Commission should, from now on, consider

::

aligning its requirements and possibly using

the same principles set out in the B-BBEE

::

code when imposing the ESOPs.

::

Because this will make the ESOP more

attractive to a measured entity, because they

::

can get recognition under the B-BBEE code,

as well as comply with the conditions that

::

are imposed by the Competition Commission.

::

If there is a gap, there may be a lot more

pushback from measured entities in adhering

::

to the conditions imposed by the by the

Commission because of the consequences that

::

the conditions may have on there be

recognition.

::

So to to kill two birds with one stone

alignment is crucial in these instances to

::

ensure that um measured entities are not

adversely affected.

::

Thanks very much, Daphney.

::

It's these have been an important factor in

our merger clearances, and certainly parties

::

need to think very carefully about how they

will deal with this provision.

::

Should it be something that the Commission

is looking to impose in future mergers and

::

make sure that they get proper advice from

somebody knowledgeable in the codes?

::

Thanks very much for this insight.

::

It's been a very interesting chat for me.

::

I hope you, our listeners, have found it

useful and informative.

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