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?

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.