REPORT TO THE PORTFOLIO COMMITTEE ON PUBLIC ENTERPRISES ON A MEETING WITH DENEL: Martin Stephens MP

14 February 2007

INTRODUCTION

The committee will recall that the purpose of the meeting was to clarify and explore with Denel the status of any new Intellectual Property (IP) developed in Denel Optronics (DO) after the sale of 70% of the Shares to Zeiss Optronics (ZO). The concern was that as Denel was not being paid for the transfer of shares to ZO, and since the transfer would be effected in return for a ZO undertaking to pump money into DO for Research and Development (R&D), the only benefit that Denel stood to gain was the ability to use the IP so developed.

As will appear more fully from the minutes of the meeting attached hereto as Annexure A, the discussion ranged widely and all issues regarding IP and the risk to the state resulting from the sale of shares were fully covered.

THE IP SITUATION.

It appeared from the discussion that the industry identified two elements of IP: background and foreground. Background IP consists of the scientific knowledge, technical expertise and general know-how gained from the process of researching and developing particular products. It includes even the often very valuable knowledge that comes from failure. Nobody owns the background IP exclusively. It is owned by all who participated in the R&D process. There is thus no restriction on the use of this know-how and expertise in further research for other products. It amounts to acumen that is infused in the workforce concerned.

The foreground IP is the more commonly recognised element. That consists of the actual patented and registered elements of the product involved. The use of this IP would be legally restricted and is''.usually owned by those who funded the R&D. Thus whether or not the shares were sold to ZO, since they would fund the R&D, the foreground IP would belong to them anyway, with very restricted use to Denel or the Department of Defence, if at all. This is in fact the legal situation relating. to all IP developed in DO up to now.

The initial concern thus resolves itself into a concern that the present highly experienced workforce should:

a) not be lost either to Denel or to South Africa;

b) be retained and expanded to do the further R&D funded by 20, so ensuring the continued accrual of background IP to Denel and the workforce; and

c) that the company and its R&D function cannot be removed from South Africa without the prior consent and agreement of government.

IMPLICATIONS OF THE SHAREHOLDING

The shareholding of Denel in DO is intended to be twofold: a golden share and a 30% holding of ordinary shares. It is important to understand that the golden share and any percentage ordinary shareholding are entirely independent of one another.

As a result of the way the primary concern resolved itself as explained above, it then became necessary to explore the implications of the shareholding of Denel in DO. During the discussion it became abundantly clear that the golden share fully and sufficiently dealt with all the concerns related to the above. Indeed, it is quite clear that for the main purpose of the share transaction to be realised, only the golden share is required.

The concern that then immediately cropped up was what the implications of the 30% shareholding were. If it did not serve or further the purpose of ensuring the outcomes as set out above, was it necessary at all? Furthermore, what were the risk implications for Denel and eventually of course, the SA fiscus?

It must be kept in mind that a 30% gives the minority shareholder very little (actually zero) say in the running of a company, although it will have representation on the board. Board representation Denel would have in terms of the golden share in any event. A company that exists mainly for the purpose of R&D, as is the case with DO, is highly unlikely to ever declare a dividend. Profits are invariably ploughed back into R&D. To thus keep a share in the hope of clawing back some of the previously suffered losses is pure fantasy. Those losses should merely be regarded as sunk costs.

Having found no real upside to the shareholding, I explored the down, or risk-side of the equation. It appears that the proposed shareholder agreement would contain, as is quite normal and reasonable, an investment equivalence clause. This means that any amount of money invested by one shareholder must automatically also be invested, pro rata, by the other shareholder. In the present case it would mean that Denel loses control of its own investment budget.

The reason for this conclusion is that as a mere 30% shareholder, the decision to invest and the amount of money to be invested from one year to the next will be made by ZO, not by Denel. ZO would be driven to invest by its own exigencies, not by those of Denel.

Yet, because of the agreement, Denel would be legally obliged to cough up an amount 30% as big as the ZO investment, whether it could or wanted to or not If as a result of such forced investments Denel found itself insufficiently funded at any time, the fiscus would have to step in again and recapitalise Denel.

I submit therefore that a shareholding carries an enormous, unnecessary and unacceptable risk to Denel and the Fiscus. Of course, the shareholder agreement would provide that if the minority shareholder does not make are equivalent investment, it loses it shares to the majority shareholder. Due to the vast losses previously sustained and no

hope of future dividends for the reasons already discussed, I submit that it would never be in Denel's interest to invest anything further in DO. We already stand to gain everything we are going to gain through the golden share alone. It is therefore futile to take any shareholding in the first place.

RECOMMENDATION

It is recommended that the committee supports the share transfer to Zeiss with the golden share proviso and without special provision for rights to Intellectual Property, but that it takes a strong stand against Denel's retention of any percentage shareholding in the company.

ANNEXURE : A Minutes of Meeting with Denel

Discussion with Martin Stephens regarding Zeiss Optronik (ZeO) investment in Denel Optronics (DO)

Meeting attendees:

Denel

Warren Ingram - Strategy Implementation

Lana Kinley - Strategy Implementation

Tanya Swiegelaar - Legal and Commercial

Portfolio Committee on Public Enterprises

Martin Stephens

Review of the DO business

Optronics is involved in the design, development, industrialisation, manufacture and assembly, as well as the marketing, sale, after-sale support, repair, overhaul and refurbishment of optical, electro-optical and laser. systems, subsystems and components. Optronics products include:

· Laser products. This includes a range of hand held, mounted or modular laser range finding products, some of which are integrated with digital compasses, GPS, binoculars and digital cameras. These can be used in surveillance, observation, targeting and fire control systems.

· Electro-optical stabilised target acquisition systems, observation and surveillance systems. These are gyro stabilized observation and targeting systems. They provide the means to mount an optical payload (various cameras, range finders and designators) on an aircraft, helicopter or land vehicle in a protective environment. The stabilisation reduces or eliminates base motion and vibration, providing the ability to achieve clear, high quality images. Control units provide the user with the ability to steer and control the payload in a variety of law enforcement, search and rescue and military operations. With its open architecture construction, these systems allow for the introduction of new generation sensors, providing users access to the latest day/night imaging technology. The payload can be configured to include the cameras (day / night, colour I black & white, wide angle / zoom / telephoto) and other sensors (range finders and designators) most suited to the user's application.

· Submarine periscopes. Optronics capabilities include the maintenance and upgrade of existing periscopes as well as the design and development of new periscopes. Upgrading of periscopes involves, a total redesign of the optical channel, allowing for improved optical characteristics and integration of electronic imaging sensors such as range finders and various cameras. The upgrade provides state-of-the-art performance and enhanced functionality to old equipment without any structural changes to the submarine. Optronics provides customers with complete integration, commissioning, training and logistic support services. Optronics also cooperates with Zeiss Optronik in the design and manufacture of new submarine periscopes.

· Helmet systems. These systems provide a head-tracking ability and a means of displaying "heads-up" information to the operator, significantly reducing the workload of the operator. The helmet system comprises three parts – the helmet, that must provide protection, be ergonomically suited to the user and must cater for different mission scenarios; the optical helmet tracking system which provides infonnation on the position of the helmet in the cockpit, thus allowing accurate determination of where the pilot is looking; and the helmet mounted display systems that provide the ability to project images and infonnation to the pilot via the visor.

Thermal imaging systems and optical sensors. Successful operations dictate that the user has the right sensor for the application. Thermal imaging systems allow the user to obtain information from the invisible infrared spectrum, thus providing the ability to see in totally dark situations or detect hot and cold areas in fire fighting or search and rescue situations. Wide-angle cameras allow the user to survey large areas and zoom cameras allow the operator to focus on specific areas of interest. Optronics has the ability to design and assemble these types of sensors to fit their systems and meet user requirements.

These products cater for aerospace, land and marine applications in the military and paramilitary markets (police, fire services, search and rescue). Optronics sells their products both directly to certain end users or through co-operation with, or as subcontractor to suppliers of optical and laser systems. .

Background to Intellectual Property in DO

Denel Optronics has background Intellectual Property (IP) which is not registered. That background IP allows DO to obtain export contracts. Much of the research and development for these contracts is customer funded and therefore the foreground IP for these products is either owned by the customer or jointly owned. The use of this IP is therefore restricted.

The level of spend by the 000 is approximately 10% of DO's breakeven turnover of R300 million per annum, which means that local defence spend is not sufficient to sustain DO and although the 000 has stated that it considers DO to be strategic, its treatment of the entity and its need for DO's products reflect a position that DO is not strategic to 000. DO's products can be sourced by 000 through imports with similar price and performance characteristics.

Denel does not consider that new IP that would be developed by DO, with Zeiss as an equity partner, would be strategic to the Department of Defence (000).

The conclusion therefore is that DO does not have existing IP that can be registered and retained by Denel. New IP that would be developed after an equity transaction with ZeO would be primarily funded by Zeiss and would not be easily utilised by Government.

It should be noted that this situation only applies to DO and the IP process for any equity investment in any of the Denel NewCos would need to be treated on its own merit.

Equity partnership process

Without an equity partner like ZeO, it was likely that the volatility in DO's turnover would result in a closure of DO - as it could not survive without increased market access.

Given the position on IP, more important in terms of the equity partner transaction is to ensure that DO retains access to markets (which are reducing as a result of the consolidation of the defence industry internationally), a retention of economic activity in South Africa and a retention of human capital and development.

In terms of the transaction Denel will retain this through:

· An identification of the business (to ensure continued economic activity at a high technology level) that must be retained in South Africa to be contained in the transaction documents;

· Export earnings;

· The golden share (see section below);

Denel Optronics was recapitalised by approximately R150 million at 31 March 2006. At end of March 2007, further recapitalisation will be required to cover losses and cash flow requirements for plant and equipment and product development. All recapitalisation to 31 March 2007 is considered sins of the past" and part of the strategic turnaround to get the entity to commercial viability.

Two of the departments within DO are considered non-core - these are the machine shop and the printed circuit board - these entities will not be included in the transaction with ZeO, but will be divested to create additional SMMEs. A long-term contract with DO will need to be developed to ensure sustainability of these non-core entities.

The initial transaction is for ZaO to hold 70% of DO, with Denel holding 30%. A divestiture strategy for Denel's 30% share is being developed, with questions as to whether Denel should allow ZeO to have a call option so that their eventual holding will be 100% and the State will not have an equity holding but will still be afforded some protection from the golden share.

Discussion ensued as to the funding requirements, should there be a need for further investment in DO - the commercial principle that each shareholder would fund in accordance with their shareholding would be provided for in the transaction documents.

Martin Stephens was of the view that this was a risk to the State as R&D entities usually require significant investment and as a 30% shareholder Denel would not really be party to the decisions regarding funding and therefore may be compelled to finance DO or lose its shareholding as a forfeit for providing its share of the funding. Given the previous conversations regarding IP and the strategic nature of DO, it may be better for the State to divest completely. There may be an argument that given the State's previous investment there may be some clawback of the recapitalisation through dividends or capital appreciation of shares once ZeO is on board - but it was likely to be minimal. In addition, there may be an argument that Denel is the custodian of the State's high technology defence industry and DO falls within this category - again the risk of funding a high technology entity could also outweigh the benefits of retaining a minority shareholding.

Golden Share

The legal terms for the Golden Share are as follows. The Golden Share shall be issued to Government to protect their interest in the Company. The rights in respect of the Golden Share shall be exercised to ensure that:

· the SANDF and the SAAF continue to receive an uninterrupted supply of goods and services being supplied to them on commercially acceptable terms and conditions from the Company;

· all the technologies which are. as at the time of the incorporation of the Company. proprietary to. or licensed to, the Company and which are necessary to enable the Company to conduct the Business shall not be disposed of by the Company without the approval of the Government; and

· the Business will be conducted within the territory of the Republic of South Africa and will not be terminated. sold or alienated in any other manner without allowing the Government or its nominee. as the case may be, an opportunity to acquire part or all of the Business.

The Golden Share shall not be transferable to any third party.

The Golden Share shall not entitle Government to:

· share in the dividends and/or profits of the Company

· otherwise benefit from the operation of the Company.

The Golden Share shall not create any obligations for the Government toward the Company and/or the Shareholders, including without limitation, the funding of the Company.

29 November 2006