Must read for all Fonterra members

Taken from Cooperatives NEWS october – november 2009

A must read for all Fonterra members looking into the proposed Capital restructuring.

Caroline

Aligning with member interests
and democratic control
by Peter Harris
Historically, cooperatives and mutuals have played a massive part in the New Zealand economy. Despite this, the standard governance texts and best practice manuals fudges the distinction between different forms of commercial incorporation. Specifically, cooperatives form to correct imbalances that develop when traditional investor-owned companies operate in market economies.
These are to:
● Protect members from poor quality, unsafe services and overpriced goods that result from weak competition;
● Gain access to markets where infrastructure is weak or expensive (eg packaging, transport, distribution);
● Provide services that are not profitable to commercial operators (such as in remote areas);
● Capture a share of value added from commercial provision;
● Secure economies of scale with buying or selling power.
DUTY OF CARE
Cooperatives pursue mutual interests as users of services as opposed to the investor interests of providers of services. They therefore form and persist as an alternative to the delivery of service through conventional, investor-owned enterprises. Both are owned. Both are governed. Both have to have regard to commercial disciplines or else they will go broke. Both need to be aware of the interests of other stakeholders in order to retain patronage and support. Where they part company is where the directors focus their attention when they exercise a necessary “duty of care”. Commercial company directors do develop a set of tools that are of benefit in a cooperative company: audit and risk oversight, remuneration of senior managers, investment of treasury type funds, legal compliance disciplines and so on.
However, those common competencies are not sufficient. There is a need for an almost 180 degree reorientation of the duty of care in relation to promotion of the interests of the owners as users as opposed to owners as investors.
In checking whether co-ops are being governed in a way that is fully aligned with member interests and democratic control, I think we can develop some tests. Here are ten questions, but this is by no means an exhaustive list.
1. Do the directors ask whether there is more value to the owners from continuing in business and accumulating assets, or selling up and distributing them?
If they do, they don’t get it. They are operating outside the primary area of responsibility as directors of a cooperative, elevating the interest of investors to the cardinal interest. In fact most co-op members have very little skin in the game as investors, but a lot at stake as users. By way of example, owners of a fertiliser co-op do not really care what the value of their shares is:
they care passionately that the co-op delivers the right quantity and quality of fertiliser on time at a good price.
If directors ask whether there is still a market imbalance that needs to be addressed, or whether the interests of co-op members are being met by conventional enterprises, they are still focussing on the cardinal interests of the owners.

2. How often do directors review the shape and form of the benefit that their members get from participating in the co-op?
If the co-op simply matches the competition in form and price of service, it is not correcting a market imbalance: it is perpetuating it. The competition leads, the co-op follows. It competes essentially by using the margin created by its “free capital” (owners’ equity and accumulated reserves on which it does not have to pay a dividend). Nominally anyway, a “real cooperative” does pay owners market rates on capital left in the business: it just does not give voting rights pro rata with capital contributed and distributes surpluses (above those needed to sustain adequate reserves) on the basis of level of participation in co-op activities. In practice, accumulated reserves are an undifferentiated wash-up from past activities, so payment of a market rate to contributors is not a realistic option. But this should not detract from the need to keep the member interest top of mind, or else the co-op is largely benefiting directors and staff, not members.

3. Do directors regularly assess the extent to which their service configuration and price ensure that returns to members are pro rata with their participation in the trading activities of the co-op?

If they do not, they can easily see the co-op drift as members who cross-subsidise others react to another form of market imbalance (administered imbalance) and walk away.

4. What innovations has the co-op introduced in recent times?
Market outcomes change in a modern dynamic economy, so the member benefits that the co-op
can capture will alter as competition and technological change both reduce old imbalances and create opportunities for new benefits.
Innovations can be quickly imitated, so an effective co-op is innovating ahead of the competition.
If it simply imitates market innovations it loses that fundamental driver of its reason for being: to do things differently.

5. Is there an explicit succession plan for directors?
Co-ops need to be democratic and accountable. In a profit-maximising company, shareholders who are dissatisfied with the performance of directors can simply sell their shares, extract their capital and walk away. The threat of a hostile takeover bid tends to apply incentives to investor-owned company directors to maintain performance (although spectacular failures are still very frequent). However, because co-op shares can be issued with a nominal value and can be redeemed, capital market disciplines on directors are virtually nonexistent.
There is nothing wrong with that: it is just a consequence of the orientation of a co-op.
Especially in larger co-ops with diffuse memberships, it is very hard to articulate effective member voice. Hence democracy, transparency and accountability have to be worked on and led.

6. Is there a regular review of whether the organisation has been captured by a minority or special interest: be that an activist grouping within the membership, management and staff, or the incumbent directors themselves?
It is very easy, in a large organisation where owners have very little investor interest in its asset base, for complacency to set in, and for directors and managers to overlook the vested interest of minority activist groups. They are the ones that need to be pacified, so it is easy to build up a comfort blanket that says that the activists are the members.

7. Are there formal limits on the scope and level of trading with non-members?

Some form of transactions with non-members is inevitable in any co-op. The question becomes whether non-member transactions start to dominate the financial affairs of the cooperative to the extent that they subordinate the interests of members. This is particularly acute when various covenants are placed on the terms of loans and when constraints are placed on the discretion of the organisation as a contractual condition of some other transaction. The risk is that there can be a tipping point, beyond which the non-members, by virtue of financial weight, become de facto cardinal stakeholders, and the fundamental character of the coop is lost.
8. What processes are in place to ensure
capital adequacy to underpin possible
expansions of activity and to ride through periodic
difficult trading conditions?
There is a delicate balance to be struck. With relatively few exceptions (Fonterra being a major one!), members of co-ops do not have a fundamental commercial interest in the co-op: it is a part of their lives, not the centre of them. Hence they will stump up a joining fee in the form of a capital contribution but cannot be expected to regularly subscribe to new capital issues, especially since the co-op is not designed to serve their interests as investors. There are many options for capital raising:
retained surpluses, joint ventures, preference shares, subsidiary investor-oriented companies,
capital notes and the like. The point here is that it is usually too late to seek
capital to ride out a crisis, but over-capitalising “in
case” runs into demoting the member service orientation of the company. A formal recognition of where the capital adequacy boundary lies, how it is to be sustained, and how capitalisation strategies support the member interest focus of the co-op is required: capital management
should not be a default outcome of governance.
9. Are special steps taken to reinforce a sense of belonging among members: to reinforce and refresh the “common bond”?
A robust cooperative relies partly on individual members seeing personal value in the collective
benefits that flow out of their joint activities, but that attachment can be weak and fickle.
The co-op can be reinforced if there are routine reviews of what binds members as opposed to simply what benefits them.
10. Is there a director approved programme of induction of managers and staff to reflect the member benefit orientation of the organisation?
Organisational values penetrate management and staff slowly and unevenly, and can be a source
of tension within the staff (especially among managers) if they are not formally communicated and supported. Fundamentally, the question that directors need to ask is whether the co-op is a membership mutual benefit organisation, an insiders’ support facility, or a directors and staff benevolent society.

SHORTCOMINGS
The Institute of Directors has assembled a framework for the governance of companies that brings together values, principles and practices. On the face of it, they seem like the sorts of values that might sit easily with any co-op: integrity, enterprise, fairness, transparency, accountability and efficiency. What is missing is a clear specification of what the interests of the “shareholder” are. There is not a robust recognition that the very reason for owning an enterprise can reflect different and divergent dimensions of the personal interests of the shareholder. It is covered in the overall wash-up of achieving the “mission and purpose” of the organisation, and to be fair that can be something other than value maximising. My question, though, is if in practice the natural orientation of directors of co-ops leads them as a matter of first principle to question the fundamental orientation of the interests of the owner.
Even if it happens, I really doubt that it is pervasive, but for co-ops to be fully on mission, that orientation needs to be pervasive.
If it is, all is well.
If not, the question becomes how to overhaul cooperative director induction, training, assessment, and compliance routines and manuals to achieve it.●

Fonterra's "new" Capital Structure

I have to say, when I look at the new Fonterra capital structure proposal, I feel completely underwhelmed. There is nothing here that we have not seen or heard before. It looks like a rehash of previous ideas, rather than looking at the issues in a whole new light; which all the build-up hype led me to believe was happening. I have to concur with other skeptics that this is just a small step towards the ultimate goal of floating the company as there is nothing new in this proposal that would make me think otherwise.
The key omission in this proposal is how these changes in the capital structure will support the co-operative nature of the business. Retaining the co-operative nature of Fonterra has been a clear message from shareholders since the 2007 capital restructuring option and one I would have thought this option would capitalise on. I suspect that genuinely using the co-operative principles as the cornerstone of Capital Structure discussions has not happened. Rather the ideas of farmer ownership and control have monopolized debate, producing a clumsy and difficult option.

I wonder what the original proposal put forward by the Board to the SHC looked like and how different is the proposal in front of us compared with that one???

Effluent Improvement System

Taranaki Federated Farmers Dairy applauds Fonterra for investigating ways to help reduce effluent non-compliance amongst its shareholders; however we have some concerns around how the new Effluent Improvement System (EIS) will impact on sharemilkers working on Fonterra supplying farms. Information from Fonterra explicitly states that Regional Council infringement notices and prosecutions will incur the Fonterra effluent deduction and Fonterra staff will not be involved in any decision about whether compliance or non-compliance has occurred. Fonterra also anticipates deductions will be directly in line with the existing payment structure the Company has in place for that supplier. This means that if grades are the responsibility of the sharemilker, Fonterra will deduct this amount from the sharemilker with no regard for where the fault actually lies. In the interests of equity, Fonterra needs to commit to negotiating with the Regional Council, the farm owner and the sharemilker every time there is an infringement involving a property that has a sharemilker on it before deductions are justifiably made. The lack of consultation from Fonterra staff before deductions are to be made and the method of these financial deductions are of concern to us because most sharemilking contracts require both farmers and sharemilkers to indemnify each other against effluent non-compliance because effluent non-compliance could be the fault of the sharemilker, farm owner or both.
In addition, if a sharemilker does incur a deduction from their milk payment for non-compliance, they would be unlikely to be eligible for the “relief” as they would not be required to undertake capital works to up-grade or improve the farm’s effluent system. It appears, therefore, that sharemilkers will be the ones that are penalised the hardest under this system. This is of concern to us given that, as a cooperative, Fonterra is bound to act with equity, treating people justly and fairly, and with social responsibility to ensure that key stakeholders, such as sharemilkers, are not disadvantaged or prejudiced against in policy development. Acting with concern for our key stakeholders (sharemilkers) plays a major roll in creating a modern cooperative culture. This group is likely to become the cooperative’s future members and by properly valuing them now they will become important ambassadors for our future cooperative success.

The Success and failure of cooperatives

The modern cooperative movement began in Rochdale, England at the end of 1844 as a way for workers to help themselves out of poverty and provide a future for their communities. Since that time, cooperatives have spread throughout the world and continue to promote sustainable economic and social growth. Globally, co-ops have more than 800 million members. They employ in addition 100 million people across more than 130 countries. The estimated economic contribution of the top 300 co-ops globally in 2006 was almost 1 trillion $US. To put this in perspective, this is about equivalent to GDP of the world’s 9th largest economy, Canada.

The top co-ops are some of the most successful large organisations globally, and provide their members with a level of economic and social support they would be unlikely to receive without them. Although cooperatives can be big business players, cooperatives also exist at the other end of the economic scale, acting as the financial lifeline for many third world people struggling to make a living. Regardless of their size, cooperatives play an important part in the world’s economies and support many people. The number of people who are benefitting from cooperatives is significant enough for the United Nations to assert in 1995 that, “Cooperatives contribute directly to improve the standards of living of half the world’s population.”

Cooperative structures vary in size and complexity, but here in New Zealand they are essentially formed by a group of smaller businesses or sole traders who identify a common need they have when operating in a larger market. Private businesses will sometimes come about to meet this same need, usually when an individual identifies this need as an opportunity to make money from others, or when the business community involved is not willing to participate cooperatively. As co-ops are formed to serve members’ needs, cooperatives have to be owned entirely by their members because any profit a cooperative makes is distributed back to its members and their communities, instead of going to outside investors who often have little or no connection to the community the co-op serves.

Regardless of the size or complexity of the cooperative, voting and the election of directors is usually conducted on the basis of one member one vote. This is because it is believed that all members play an important role in the overall success of the business, and therefore are entitled to an equal say. When a single member holds a larger financial investment in the co-op they should engage and communicate actively with the co-op to ensure their needs are addressed; not look to control the co-op with a dominating voting right.

Unlike shares in private business, the value of the membership share is usually fixed. In addition, these shares need to be withdrawable as membership to the cooperative should be voluntary. A successful cooperative should value the importance of membership and be continually responding to members’ desires to become involved in their business. The complexity of some cooperative structures comes about from a need to balance members’ rights to withdraw form the co-op and redeem their membership while providing the cooperative with some longer term capital to offer some financial stability.

As cooperatives are groups of people working together for their collective good, it is important that a strong and clearly defined set of values binds them together in a unified direction. How these values are implemented is up to individual cooperatives, but their existence should be at the bedrock of the organisation and underpin any activity of the cooperative.

The core cooperative values are:
Self-help: working together for a mutual benefit.
Self-responsibility: acting responsibly and playing a full part.
Democracy: where members control the organisation.
Equality: where members have equal rights, and according to their contribution have equal benefits.
Equity: treating people justly and fairly.
Solidarity: supporting each other and other cooperatives.

Cooperatives also hold a strong set of ethical values which should extend through the membership to it employee, suppliers, customers and the wider community. They are:
Honesty
Openness
Social responsibility
Caring for others

Strong cooperative and ethical values have lead to a set of cooperative principles that all cooperatives should hold. These principles flow from the values, the primary motivation of co-ops, and their unique operating structures. Following these values and principles should drive the way cooperatives approach business and if applied properly will promote the health of the cooperative, as well as offering guidance and direction for the cooperative members and its governors.

The seven principles of cooperatives are:
à 1st Principle: Voluntary and open membership
à 2nd Principle: Democratic member control
à 3rd Principle: Member economic participation
à 4th Principle: Autonomy and independence
à 5th Principle: Education, training and information
à 6th Principle: Cooperation among cooperatives
à 7th Principle: Concern for community

These cooperative principles are not only important in guiding the development and growth of cooperatives, they are also important in assessing the soundness of a cooperative and its chances of success. In 1999 Sir Graham Melmoth, the former Chief Executive of the UK Co-operative Group stated that, “Most failed Cooperative Societies over the last twenty years failed not only commercially but democratically as well.” His comments come about because democracy, the second principle, is seen as pivotal to the effectiveness of a cooperative and is the key indicator for assessing cooperative health. Ways of a measuring the vibrancy of the cooperative’s democracy are the voter turn-out, the number of contested elections, the average term length of directors, and how current directors support succession planning and emergent leadership. Are all members able to participate equitably and fairly, and how effectively are the values and principles of the co-op communicated to members, employees, customers and the wider community?

Cooperatives should have a strong value system and set of principles, a complex mission and operating structure, unique governance structures, and a requirement for different leadership skills from traditional private businesses. These unique qualities of a cooperative are there to serve its members and, if harnessed properly, provide a distinct competitive advantage.

Successful cooperatives are those that truly embrace their cooperative difference. They work towards meeting their cooperative and ethical values and strongly adhere to the cooperative principles. By doing this they effectively work for their members, through their members. Successful cooperatives see the importance of a strong and active membership and engage in activities that promote and enhance this. Cooperatives that fail do so because they lose sight of what it is that brings them together. They are unable to clearly see their cooperative competitive advantage and as a result start to act like a clumsy private company. What makes a cooperative fail is simply a failure to be a cooperative.

Effective Cooperative governance

When a member of a cooperative is newly elected to the board, they are taking on a demanding role which will require them to foster and enhance the relationship between the members of the cooperative who own the business and elect the Board that govern the business, and the management who manage the business for its owner members.

To manage this role and be an effective cooperative governor, individual board members have to uphold four duties as part of a code of conduct for directors. They are to undertake:
* a duty to obey the law
* a duty of good faith
* a duty to take care, and
* a duty to maintain the cooperative status of the organisation.

A duty to obey the law means that directors undertake to comply with or ensure the statutory requirements of the various Acts of Parliament imposed on them as directors, and on the business are met.

A duty of good faith is an undertaking to protect the interest of members by working in a manner that is truthful and honest at all times. Good faith ensures confidentiality when individual directors have no legal authority to disclose things that are not already in the public domain. It means always acting in the best interest of the cooperative and not using their position for personal advancement. A duty a good faith also includes working to avoid conflicts of interests and, if they arise, any material conflict of interest should be declared to the board and the members of the co-op.

A duty to take care simply means that each director should give the task their best. This includes reading board papers before meetings, attending meetings, taking advice from the executives and independent advisors, at the same time asking questions of them and challenging them, as well as undertaking ongoing relevant training.

Every board member in addition is responsible for maintaining the cooperative status of the organisation. This includes continuing to provide the goods and/or services that the cooperative was established to provide for its members, and ensuring that the business remains committed to cooperative values and principles.

To achieve a well-constructed cooperative board, the required skills of potential candidates should be clearly articulated to the members of the co-op so that appropriate members come forward for election. Elected board members are not expected to be experts, but rather to actively use and develop the expertise they have.

In following the directors’ code of conduct, board members should also undertake professional development training. It is not sufficient to rely solely on current knowledge and experience if they wish to carry out their responsibilities effectively in a continually changing environment.

Regardless of the skills required on a board, candidates for election to the board of a co-op should always come from its membership. An effectively governed cooperative will identify and articulate the skills required of potential candidates to ensure the right balance of skills and experience sit around the board table. That these governors are elected from the membership base is important as it means the membership is at the centre of a cooperative’s governance and ensures that cooperative principles and values will continually underpin governance.

When a governance board works to uphold cooperative values and principles they should use them to support the development of a strategic framework. This should be a cyclical process that involves setting a vision and strategy for the business. The implementation of the strategy and vision should have clear targets that are clearly communicated to both management and the members.

An effective board monitors the implementation of this plan, gathering feedback and reviewing it. It will learn from the feedback and adjust their vision and strategy to ensure their members’ interests are maintained. This process forms the bedrock of effective cooperative governance.

An effective cooperative board comes from its membership. They will develop a robust strategic framework that grows the cooperative for the mutual benefit of all its members who collectively own the business. They will work to uphold the cooperative values and principles, ensuring the competitive advantage of being a cooperative is maximised and assets remain robust and in trust for future generations.

Trust

Golbaldairytrade is Fonterra’s new on-line milk powder trading platform. It was launched in 2008 as part of the Board’s strategy to offer greater transparency around the true value of milk and so shareholders could more accurately measure the price of milk in their final payout. Since its launch, world commodity prices have plummeted. Critics of Fonterra have been quick place responsibility, perhaps not so much for the decline in commodity prices, but for more the speed and levels to which they are falling at the feet of globaldairytrade., So concerned, the Chairman of the Independent Milk Processors Association, Wyatt Creech, wrote an open letter to Fonterra farmers calling for them to demand a review to the Board’s decision to introduce this new and untested auction system at this time in the commodity cycle. So is there cause for concern?

When I ask farmers how they think Globaldairytrade.com is performing, the message I get is that they don’t really understand how it works, or how its success could be measured. Interestingly, when I have asked industry analysts the same question, I get the same response. This leads me to ask three questions. Why is there not more information available on the objectives of Globaldairytrade? How does it actually work to achieve these objectives? And finally, if the success of the online auction is so hard to measure, how has the Board developed meaningful risk management and key performance indicators for them to assess its ability to meet their objectives and adding value to the cooperative?

To me, the only clear objective of globaldiarytrade is to offer greater transparency around the true value of milk. In their own discussion document to Fonterra Networkers, the Board argues that as the price generated by globaldairytrade is a function of supply and demand, “shareholders can be confident of Fonterra getting the best prices at each trading event.” It is not clear on how they reach this conclusion. Firstly no-one outside Fonterra is entirely sure how many buyers are eligible to trade on-line, or how many of these eligible buyers are participating in each event. Being able to measure this would add confidence to this argument. In the same discussion document Fonterra say, “it simply provides a means by which all our customers are gathered in one spot to compete for product.” Yet a Fonterra Director has conceded to me that bidding at each trading event is optional. This means that even if buyers are signed up, they can just watch others bid for the basic commodities, then when the event is finished, use the price achieve at auction as the starting price for contract negotiations. Whether the ability for customers to do this was part of the design or has happened by default is not clear. A review would clarify this issue, and answer questions around who the transplant prices benefit most and, whether a transparent milk price is in fact the true value of milk.

When it comes to the governance of the auction platform, shareholders can only trust that the Board’s performance criteria and risk management assigned to globaldairytrade is robust. But herein lies the problem. Trust. The introduction of globaldairytrade comes at the end of a rocky year for the cooperative members. They have felt devalued by the Board following the capital structure review. Betrayed by the Board’s initial embracing of contract milk supply as a solution for inaccessibility to shared membership for some suppliers, then shocked to discover that the board’s risk management policies lacked adequate robustness as the San Lu disaster unraveled. When trust is gone, you have nothing. For the sake of the cooperative I hope the Board can rally and begin to repair some of the damage that has been done to credibility over the last 18 months. Open and honest dialogue with cooperative members to ensure they understand the objectives of globaldairytrade, and all the identified risks and benefits they could expect would go a long way towards making this happen.

The Board is a servant of the cooperative who in turn is a servant of its members. Globaldairytrade is a tool created by the board to assist them with their job. The members need to trust that their directors have the right tools to do their job, and the humility to honestly review the caliber of the tools and adjust the tool kit accordingly. In turn, the directors need to trust that the members have the capacity to understand and offer valuable feed-back on them to support the Board’s performance. If the cooperative’s leaders can’t make this happen then some dramatic steps need to be taken by shareholders to ensure trust is restored; for the sake of confidence in the cooperative’s performance, principles and future. Federated Farmers has asked for a review of the GlobalDairytrade, without that review, we farmers cannot begin to repair that confidence.