Unity and the Vote

If you want to purchase the right to one vote within Fonterra, you can do so for $4520.  Purchasing rights within Fonterra will now be easier in the future thanks to TAF.  Without knowing it, the acceptance of TAF has also enhanced the role of markets within the cooperative to allocate all things, including those things we traditionally placed non-market values on.  But importantly, we didn’t arrive at this state through a deliberate choice. To unify the cooperative, we must now look at how we arrived here and whether this is in our long-term best interests.
To investigate how this happened, consider this:
Should votes within Fonterra be subject to market share, tradeable and therefore viewed as private property, or rather seen as a civic responsibility to the cooperative, and therefore an obligation of membership?  
This is actually a question about the appropriateness of markets without limits within the cooperative.  But why should we worry that we are moving towards a cooperative in which everything is up for sale?  For two reasons: one is about inequality, the other is about corruption.
Consider inequality: Larger farmers who have more money invested in the cooperative should have a greater say because they have more to loose.
 This sounds like a strong market based argument, but implicit in this comment is that smaller farmers are less able to make appropriate decisions for the good of the cooperative because supply size is the best measure of democratic competency.  Of course rational thought says that this argument is flawed, but for the last 10 years, this argument has prevailed largely unchallenged.  For ten years, those with more means have mattered more.
The second reason, corruption, is about the corrosive nature of markets.  Markets change the way we view the things being exchanged.  When we decide that certain things should be tradable, we decide, at least implicitly, that it is appropriate to treat them as commodities, as instruments of profits and use. This means that if you have the ability to influence the outcome of a vote, you would be more inclined to vote towards an outcome that is to your personal advantage. Conversely, if you had no more ability to influence the result than any other member you would be more inclined to vote towards the collective good, believing that everyone else would do the same too.  
Markets should have limits within the cooperative.  Markets promote inequality and corrupt the non-market values of the things they allocate.  They change member attitudes towards the value of the cooperative, towards other members, and towards working together for the collective good.
Encouraging markets into all areas of our cooperative will not promote unity.  A 66% majority of a market-based vote might be the easy way to claim unity, but we all know that to truly have cohesion within the cooperative requires brave leadership.  Leaders who can step back from heady market values and rediscover the truly priceless non-market values that can unit us and drive dairying sustainably into the future.

TAF and critical thinking

The basis for my concern for the TAF proposal is that the governance of Fonterra appears to lack critical thinking and therefore rational judgement. I would never dispute the absolute importance of ensuring any governance decision meets robust economic scrutiny, but higher reasoning suggests that it should never be the primary motive for decisions. When governance decisions of a cooperative are made to meet economic desires or market preferences firstly, they are without a reasoned and rational judgement basis, and as a result are at the mercy of circumstance rather than being free and unburdened to shape the cooperative’s destiny. Continuous flip-flopping of policy and the protracted capital structure debate are examples how leadership have tied the cooperative to the arbitrary nature of their markets, both internal and external. This is in contrast to a rational judgement position that would allow the governors to unlock the full potential of the cooperative for its members.
Without policy arrived at from a rational judgement basis, the cooperative will lack a unified and clear vision of the future for members.  Members become confused and frustrated with continually changing policy and this generates mistrust of the leaders and their motives, and at times, outrage for decisions that appear dictatorial.  It has been argued many times that these outbursts of anger are emotive reactions to policy members do not, or have not taken the time to fully understand.  But in dismissing this anger, the governors fail to recognise that anger, and especially outrage, are the specific reactions people have to injustices imposed upon them. People are rational beings capable of reason and therefore should be treated justly and with respect.  You can only be ensured that you consistently and deliberately treat people justly if you act with rational judgement in dealings with them.
Governance that is founded on rational judgement is stronger than arbitrary decisions. It is stronger and more enduring because in addition to being able to promote economic sustainability it offers direction to strategy, galvanises membership and enhances the collective recourse value of Fonterra. It also sends a clear message to the government and the wider community that the organisation stands for something of value, and that value is worth protecting.  How individual Boards judge what is right and just is for each board to determine, but through judgement and rational reason rather than arbitrary reaction, governance decisions must be made.
To illustrate my point, I will use environmental sustainability as an example.  It was identified that the approach to environmental sustainability by Fonterra and it farmers’ is becoming increasingly important to markets, both here and overseas.  In response Fonterra has launched a concerted environmental sustainability program throughout its sites and began to introduce a number of punitive measures to try to fast-track farmers into improving their environmental compliance performance and meet customer expectations.  The result was general outrage from the membership base and this was scaled back to the introduction of urgent, but somewhat ad hoc, on-farm environmental support programs such as every farm every day. The decision to undertake these measures was driven entirely by economic need.  The decision to undertake operations sustainably should have been from a rational moral judgement first. Fonterra should choose to participate in environmental sustainability because the governors have engaged with members to understand their positions on the issue, then stripped these arguments back and rationally evaluated them.  From this evaluation they would then drawn a reasoned judgement about the environment having an intrinsic value that is worth protecting for Fonterra, its farmers and the community it serves. Therefore working to improve environmental sustainability becomes the right thing to do for the cooperative and its members.
It could be argued that regardless of the approach, the result still remains the same; environmental sustainably.  But this is only true in the short term.  Once the whims of the market move in another direction, so too will the policy and the commitment that comes with it. The fundamental difference between the two approaches is that a decision based primarily on economics uses environmental sustainability as a means to an end.  Governance based on rational judgement would view environmental sustainability as an end in itself. When the leadership always follows a rational judgement position, it sends a consistent message to members, and the wider community, that Fonterra wants to make a meaningful difference for reasons beyond “it makes good commercial sense.”  People want to interact with an organisation that treats them and the things they value justly.  This behaviour creates a powerful competitive advantage; but this should not be the motive in itself.
The practice of reacting primarily to economic stimuli and market pressures for making governance decisions is why I still hold grave concerns for the TAF proposal.
The most enduring reasons that have been presented to me as the driving purposes for the TAF proposal is to remove redemption risk and free up capital to pursue economic options as part of the strategic plan.  What has not been made clear is the how the capital structure plan is intended to support and protect the collective resource value of Fonterra.  Although some issues surrounding this have been addressed in-part by the proposal, their handling is somewhat clumsy and critically impinges on the justice of such a proposal.   On the face of it, it appears that this proposal presents a capital structure that uses members’ rights and the collective resource value of Fonterra to galvanise the economic flexibility of the company, rather than to galvanise member rights and preserve the collective resource value as the end in itself.  Below I present my reasoning on how I arrived at this position.
(It is important to note that I am not supporting the current system as an alternative as this too is heavily flawed and fails the critical thinking test.)
My first clue to the reasoning of TAF comes from when I question how free the TAF market will be. In a regular investor market a potential investor is free to choose, when, how often, and to what levels they participate. This means investors are free to participate with the market as they choose, creating a free market.  In contrast, farmer members are coerced in their participation by the compliance aspect of membership into the cooperative.  The primary motivation for participating in the TAF market by cooperative members is not investment, rather access to the cooperative, investment is secondary. This means that to participate with the cooperative to supply milk, farmers are required to participate with the market. This policy works on the assumption that because all members of Fonterra are farmers, they are also equally capable as investors.  This position is morally contingent in so much as their success in this market is contingent on their natural talents and abilities or their opportunities to acquire satisfactory trading skills. Farmers are choosing to be farmers but are being coerced into being investment traders.  As farmers are also bound in the level they can participate due to the membership compliance requirements I feel that there is also a material level of coercion in their freedom to interact with the market, which is in addition to their desire to even engage. This inequity in access to the market between farmers and investors could expose the cooperative to free-riding on the capital value and the distributable profit.
The second clue to the reasoning comes from member access.  Under the current constitution, members wishing to access the cooperative are free to transact directly with the cooperative.  Under the TAF proposal, farmers wishing to join or increase membership in the cooperative can only do so on the condition that they compete for membership through the market.   Making supply conditional, transfers members’ rights from a collective constitutional arrangement to an individual contractual agreement. It could be argued that this is now a condition of supply and anyone wishing to supply the cooperative must adhere to the rule of supply. This reasoning is flawed as it implies that producing milk constitutes consent to participate in the market because farmers must engage with the market if they receive services.  It moves consent from explicit to tacit. Tacit consent to compete in the market in this case means that the agreement may not be wholly voluntary, due to the superior bargaining position of Fonterra created by the perishable nature of milk.  It moves membership from a position of freedom to one of condition.
The third clue to the reasoning is how membership entitlements are protected.  Take as an example two farmers.  Farmer A meets the share standard to supply based on their three-year rolling average.  This farmer chooses to place 10% of their shares into the fund.  In effect has laid out total capital for 100% of supply minus the 10% that he has re-couped by placing shares into the fund.  Farmer B also meets the share standard to supply based on his three-year rolling average.  This farmer has a bumper year producing 10% above this three-year average, a one-off year, and now has in effect invested capital for 100% of supply minus 10%. Each farmer is supplying 10% more than the shareholding they have money invested in the cooperative for.  Both qualify for full membership by meeting the three-year rolling average share standard, but only one, farmer A, will be entitled to the just deserts of this membership (full milk price and full voting rights).  If farmer B wishes to also receive the just deserts, he is forced to engage with the market in addition to meeting the share standard for membership.  This creates an inequity in membership entitlements that is not equally reflected in membership obligations.  This action appears to put the need for liquidity in the market ahead of membership rights.
The forth clue to the reasoning is the milk pricing mechanism.  In investor owned companies, producers of raw products are contracted to supply a pre-determined volume of goods for a particular price.  If the processor experiences unforseen increases in the cost of producing their product that they are unable to pass on the their customers, the shortfall for this amount would be met by investors through reduced distributable profit, not by the supplier of the raw materials that are contracted at a fixed price.  This is in contrast to Fonterra where this shortfall would not come from distributable profit, rather the milk price as this fits with the milk pricing formula.  The important thing to note with dairy cooperatives is that the farm-gate milk price is set after the company knows what it has achieved from the market, not before as is the case with other types of contractual supply. This means that the success or failure of NZ milk supply must be born entirely by the suppliers, as the owners of the milk, because the profit from the value-add portion of the business must be distributed as dividend and not subsidise the performance of NZ milk.  This model works well in times of market largess because an economic based policy dictates milk price will be the focus.  This becomes an issue when the market shifts and greater economic rewards can be found for value-add, or more worryingly, off-shore supply (distributable profit); as apposed to enhancing and following the collective purpose. This puts Fonterra’s economic growth needs ahead of the collective purpose.
My overall assessment of the TAF proposal is that Management have produced a clever option that does exactly what was asked of it. Unfortunately I have serious concerns about what was asked. It appears that the Board has failed to match the proposal to the collective purpose of the cooperative resulting in a miss-match of synergies. The four objections I presented are just off the top of my head, and I know others would be found if critical thinking was applied to the whole proposal in any great detail.   The mere existence of these objections says that no reasoned judgement has been applied. The only judgement appears to have been whether it met the financial objectives for restructuring set by management. There is no rational judgement as to rights, responsibilities, entitlements, desirable virtues, just deserts, honours, loyalties and collective purpose that TAF should encourage, protect and enhance.  The proposal is about securing Fonterra’s financial future alone.  This proposal appears to use the inter-generational collective resource value and members’ rights to achieve this end, rather than the protection of this value and these rights being the end in itself.

Controlling the Cooperative

The key difference between a cooperative and an investor-owned company is that a cooperative is a business owned and operated by its members for their mutual benefit.  An investor-owned company’s only owner focus is financial. 

Because a cooperative is operated for the mutual benefit of its members by its members, member control beyond the levels usually accepted in an investor-owned company is imperative to achieving successful outcomes for members, both financial and in services.  Control by cooperative members is important because in cooperatives, purpose includes how the cooperative interacts with its members’ businesses and this can vary and change over time. By contrast in investor-owned companies, purpose is always clear, to make money through shares and dividends.

The types of controls members have over the decision making of cooperatives are:

1. Redemption of membership – Ultimate form of control, very dissatisfied, Rarely used.
2. Voting rights at AGM – Official level of control. Used annually, more frequently with concern.
3. Engagement with the co-operative – co-operative level of control and is directive or interactive only. Used regularly/daily.  Used in a variety of mediums. NB: Increases in reciprocal engagement decreases the dependence on other forms of control by improving outcomes for members.

Redemption of membership (ownership) – Exercised Anytime

1. Remove capital and cease trading with the co-op. 

• Personal risk to own business as trading security reduced.
• Galvanises remaining members to direct the board

Voting rights at AGM: - Exercised Annually

1. Election of Board members
2. Changes to constitution – changes are to the parameters of the business (not on how the business is run)
3. Passing the annual report
4. Appointment of Auditor
5. Winding up the organisation

Engagement with co-op: - Varied and ongoing

1. Directive remits at AGM/SGM
2. Speaking rights at AGM/SGM
3. Access to co-op communications and publications
4. Access to Directors
5. Access to member representatives
6. Invitation to member update meetings
7. Access to member only areas on co-op website
8. Participation in focus groups or local forums
9. Clear complaints procedures on operational or governance issues
10. Information-sharing networks
11. Member/management working parties
12. Cooperative training and education
13. Advocacy
14. Other forms of formal and informal communication through-out the co-op

Improving member participation is the key to a successful, member controlled, member focused cooperative.  It all starts with the constitution. Having a constitution that clearly defines the parameters of how the cooperative operates, how membership is defined and the rights and responsibilities of members is important in setting the framework for a successful cooperative. 

Unlike investor-owned businesses, reciprocal engagement with members is a key component to the success of co-operatives.  Having a Board that works to develop strong member engagement directly with members will strengthen outcomes for members.  There needs to be a clear pathway from the Board to the members and back again.  The use of external PR firms in communicating with members is extremely damaging to this process and actively destroys value for members.

Member control of a co-operative is vastly different from owner control in an investor-owned business.  It needs to be protected through the constitution and actively encouraged by a member-focused Board.  Lack of co-operatively focused professional development training by the Board, the use of outside PR firms to communicate with members, an overly complicated constitution that does not focus on the important issues, and no clear lines of open communication are all warning signs of poor co-operative health.  The use of reciprocal engagement methods that promote strong lines of formal and in-formal communication by the Board and member representatives is one of the key ways of helping members exercise control over their co-operative. Strong member control creates strong outcomes for the co-operative. 

Does the treatment of the Organic suppliers herald the introduction of Farmgate Pricing?

My concerns about the Fonterra decision to axe Organic milk from New Zealand are not so much the decision, but rather the way it was handled, and that this behaviour could this be an ominous preface on how Fonterra could treat other farmers under less cooperatively focused capital structures in the future.

Telling Organic farmers twenty minutes before the national media that their world was about to change can never be argued was genuine consultation.  It was nothing short of tyranny.  Organic farmers are still shareholders, they still have put the same capital in as every other supplier.  This does not bode well for the future of some regional supply groups that may be less profitable to pick-up and process than other regions. 

If Fonterra decides at some time in the future, that it was no longer economical to pick up from a certain region, what will stop them dis-incentivising them from producing.  The Chairman, Henry van der Hayden, has never made any secret of his desire to introduce farm-gate pricing.  He knows this can never happen under the traditional co-operative model, so has spent the entire time at the helm of the Board, trying to actively change the capital structure.  To this end, you will note that every capital structure option put forward has involved a trading platform of some kind.  If you don’t take the thinking that a form of share trading is the best model to transition Fonterra in to an investor owned company, you will concede that any form of share trading will all but remove redemption from the control mechanisms members have over their Board.  By doing this, the Board will be free to treat different groups of farmers as they chose, because although shareholders will still be free to leave, any mass exudes will not be felt on their balance sheet like it has in the past.  Farm-gate pricing will always be in the best financial interests of Fonterra, but not the best interest of all the members.  

The Role of Redemption

Redemption risk. Two very dangerous words if you believe the rhetoric from Fonterra. But what is redemption risk and what function does it play in co-operatives?

Redemption comes from the co-operative principle of voluntary and open membership. This principle has been set in place to ensure that individuals and businesses wishing to transact with a co-operative are able to do so if they are prepared to put in the required investment. But equally, if we choose to stop interacting with a co-operative, we are able to have our investment returned under the rules in that co-op’s constitution.

Redemption is the favoured method worldwide for managing member capital. In an investor-owned firm, shares only benefit their owners either through dividend payments or by increases in the share price. Co-operatives, on the other hand, primarily support their members through guaranteed access and maximised return for products. This means that redemption from a co-operative is not driven solely by lack of profit, but rather by dissatisfaction with the co-op.

Essentially, when members ask for their investment to be refunded they are not just withdrawing capital, they are withdrawing support and product. This is why redemption is so important to a co-operative. When members start redeeming their membership, they are sending a very strong message to the Board that their decisions are no longer meeting their needs as members. A strong co-operatively minded board should look on the risk of redemption as the flame under them to keep them agile and member focused. Redemption is the ultimate form of control for members.

This is all well and good in theory, but does the principle stack up in reality? In 2008, Fonterra suffered a major redemption crisis, and this is one of the most persistent arguments for the “Trading Amongst Farmers” proposal.

At the end of that season, Fonterra members were capitalising on the significant change in share price by cashing in any excess shares caused by the nationwide drought or by going to a capital-free competitor for one or more seasons. Like most New Zealand businesses, Fonterra was struggling to access debt to fund this due to the GFC. This put enormous strain on the balance sheet and would have been unbelievably stressful. On the face of it, much of this situation appears to be the result of circumstance, but look a little deeper any you will see that the Board had set themselves up for this fall.

Over the previous eight years, Fonterra had taken no retentions, choosing instead to pay everything out to members. This meant that a sudden need for capital had to be met entirely by debt during the GFC. At the time, the Board was also incentivising management to grow “Total Shareholder Returns,” of which the share price was a major component. On top of this, Fonterra was not discussing the non-financial benefits of belonging to a co-operative with members, which could be argued was because, less than 12 months earlier, the Board had proposed a partial listing. So when investor-owned competitors came knocking, the promise of accessing tied-up capital was all that was needed to win some farmers over.

Things have now improved due to more co-operatively focused governance. Fonterra has begun taking retentions and this has strengthened the financial position. The share price is now far more stable. Changes to the constitution allow farmers to hold shares well above their production, milk-price penalties for production above the season-opening shareholding have been introduced, and capacity adjustment all work to discourage gaming of shares. And most importantly Fonterra is beginning to talk the co-operative talk to its members. All these changes have been driven by Redemption Risk.

A death by a thousand cuts?

IS TRADING Among Farmers (TAF) the first step towards a public listing, and the demutualisation of Fonterra? This is the key question dairy farmers have been battling with, both at the time of the June 2010 vote and again now.

While practically every dairy farmer wants to retain the co-operative status of our company, we are aware that the economic world is rapidly changing and we believe our leaders when they tell us the business needs more capital to grow. So how do we take the steps towards trying something so far removed from a traditional co-operative, without risking it all?

For me, the argument that TAF is a step in the direction of public listing is very compelling. The previous Shareholders Council was very clever in building into the June 2010 vote a longer timeframe for the roll out of the changes. This has allowed dairy farmers to be sure that we really do need TAF for the long term. It has also allowed farmers to see how the investor community has been behaving in the lead-up to its introduction. 15 months on, I have serious doubts with what I am seeing.

My main concern stems from the fact that there has been very little communication between the Shareholders Council and members regarding TAF. We are being told there is very little happening, so nothing to communicate. I don’t dispute this. Perhaps the changes were so insignificant on a piece by piece basis that it would have looked silly discussing them all with members.

But when the Chairman, Simon Couper, finally did come out and update farmers, what we saw was that the small changes over the 15 month period actually amount to significant change around control of the shares within the proposed fund. Although Couper dismisses this as evolution, farmers need to see that this process, if applied to the whole concept, as exactly how our co-operative could “evolve” into an investor-owned business without us being aware of where it began to unravel.

So exactly how significant is this evolution of control of the shares within the fund? Any farmer who uses the fund through either design or need, will have already taken that first step towards letting go of the cooperative ethos. This group of farmers, who will receive the full benefits of being a cooperative member without the full financial commitment, will be able to vote to increase both the percentage of shares an individual farmer can put into the fund and the percentage of total Fonterra shares held by the fund. Given the relatively low percentage of shares that will initially go into the fund, it is highly likely that the fund in its current form may not fulfil the purpose for which it was set up for. Although it could be argued that this group, who will not receive a dividend payment, would work to protect the milk payment through their voting rights, they won’t protect the co-operative ethos and the non-financial benefits of being a co-operative. Now mix this with the far more sinister threat on the horizon – the Fonterra “guardian” controlled shares in the fund.

We were originally told that control of the shares within the fund would remain with the farmer. This small evolution has meant that control of these shares will be blocked together under a single body.

So now there would be a group of farmers, with full voting rights, that no longer links in practice why full shareholding should be the only way to access full cooperative member benefits. After all, the only penalty so far has been the loss of the dividend. This will not have been of major concern as this group primarily cares about the milk price, and this has been protected by the constitution through their voting rights – which they may, or may not, be using. It would not be too difficult to convince the majority of this group to give up these shares entirely, especially if the price was high enough.

This means there would be a nicely packaged chunk of Fonterra shares with their farmer owners wondering if they actually need them. Controlled by a single entity, this bloc of shares is highly marketable and very valuable.

When small details evolve, they mark the first steps to change. The real risk now is that the Shareholders Council fails to see the wood for the trees. Because it was voted on, the Council may now be convinced that TAF is the only capital structure option available, so they tweak it to fit until it’s no longer of value to anyone.

Fonterra was set up as a consolidated co-operative to provide the best returns to New Zealand dairy farmers. Reducing export competition, sharing resources and being the largest processor all help make this happen because co-operatives are always the price setters at the farm gate. This comes about because co-operatives return their profits, after retentions for growth, back to their member/suppliers. Without the profits being returned to suppliers, are we still a true co-operative or will we be seeing the death of our cooperative by a thousand cuts?