15 August 2011

Constitutional Court sounds a warning on fronting

In a post-apartheid society, it was accepted that measures were to be implemented to redress the socio-economic wrongs of the past. The enactment of the Broad-Based Economic Empowerment Act 53 of 2003 (BEE Act) introduced one such measure in South African law. During February 2007, the Minister of Trade and Industry promulgated the BEE Codes of Good Practice under the provisions of the BEE Act. However, along with the intended positive goals of BEE, a pathway was paved for instances of corruption and collusion in the corporate environment. This pathway is called BEE fronting.

As a point of departure, the Guidelines on Complex Structures and Transactions, and Fronting outline three situations that would constitute instances of BEE fronting:

  • "Window dressing" entails cases in which black people are appointed into an enterprise on the basis of tokenism while being discouraged or inhibited from substantially participating in the core activities of the business.
  • "Benefit diversion" refers to the initiatives by which the economic benefits received as a result of an enterprise's BEE status do not accrue to black people in the ratio provided for by the relevant legal documents.
  • "Opportunistic intermediaries" includes non-BEE compliant enterprises using enterprises with superior BEE credentials as intermediaries in order to leverage off that BEE status in winning contracts or business.

Although legislative tools exist to combat fronting, government enforcement was lacking. The courts had not definitively pronounced on government's duties regarding fronting practices until this came under scrutiny in the recent landmark Constitutional Court case of Viking Pony Africa Pumps (Pty) Ltd v Hidro-Tech Systems (Pty) Ltd and Another 2011 (2) BCLR 207(CC).

The case arose as a result of complaints made to the municipality about alleged fronting practices by Viking Pony. It was alleged that the historically disadvantaged shareholders in Viking were not remunerated or allowed participation in the affairs of Viking to the degree commensurate with their shareholdings and the seniority of their positions. Additionally, Hidro-Tech believed that Viking was guilty of routing to its wholly white-owned sister company, Bunker Hills Pumps, the benefits received from the tenders awarded to it.

The High Court found that an investigation conducted into the complaints made by Hidro-Tech was inadequate as the real issues, being the inner workings of Viking and the true representation of the previously disadvantaged shareholders, were not addressed. Furthermore, Viking was found to be guilty of fraudulent misrepresentation and the municipality was ordered to "act against" it in terms of the regulation 15 of the Preferential Procurement Regulations. Regulation 15 provides that an organ of state must act against a person who was awarded a contract on a fraudulent basis.

On appeal to the Constitutional Court (the Court), Judge Mogoeng held that one of the main issues for determination was the meaning of "detect" and "act against" in Regulation 15. "Detect" for the purposes of Regulation 15 was interpreted broadly by the Court and in essence means no more than having reason to believe that fraudulent conduct occurred. It was not necessary for Hidro-Tech to have conclusive evidence against Viking: a reasonable suspicion was sufficient to trigger the provisions of Regulation 15. Regarding to "act against", the Court held that this is broad enough to include the organ of state launching an appropriate investigation into the alleged fraudulent conduct. In effect, this creates an obligation on the organ of state that receives complaints about alleged fronting to investigate the conduct and to act accordingly.

The judgment not only sounds a warning to government entities to take action when fronting is suspected, it also makes it clear to private entities that the legislative tools created to combat fronting will now more readily be enforced.

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