By Bernard Hickey
On Monday Fonterra will hold meetings aound the country on Monday to vote on its Trading Among Farmers (TAF) proposal to decide whether to open up ownership of the profits from New Zealand's largest Cooperative to outside investors.
It is shaping up as a battle royale between farmers nervous about outside investors gaining some control over their profits and milk price, and Fonterra's desire to reduce the risk of farmers gutting its capital base in any mass exodus, known as redemption risk.
The rhetoric between the two sides has ramped up in recent weeks with both sides warning of the ultimate end of Fonterra if the other side wins. Lobbying for the support of Fonterra's farmer shareholders has been intense.
In the last week I've interviewed two of the main protagonists, former Federated Farmers Dairy Section head Lachlan McKenzie and Fonterra Chairman Henry van der Heyden, both of whom are dairy farmers and both of whom are convinced of the rightness of their argument.
In many ways this vote pits hard-core supporters of the cooperative movement against those who believe a publicly listed company open to outside investment is a better way to run a company. This debate encompasses several of the great themes of our age. The include:
What type of ownership structure is best to grow a company over the long term? Do stock investors make better long term decisions than cooperative owners?
Can Cooperatives have stable capital bases?
How does New Zealand grow and transform its biggest company and export industry to reap more value right along the value chain?
How will an ageing generation of farm owners exit the industry and pass on those assets to another generation of farmers and investors without crashing asset prices and Fonterra's capital base?
How will New Zealanders more broadly participate (or not) in the growing wealth and activity of the dairy industry?
Can farmer/shareholders trust professional managers and professional investors to do the right thing by farmers?
This article is designed to showcase what's proposed, what's at stake and the pros and cons of TAF.
What is TAF?
Trading Among Farmers is a system that allows farmers to sell the economic rights to their Fonterra shares to other farmers and outside investors. Fonterra is creating a private 'Fonterra Shareholders' Market' (FSM) where an appointed 'Registered Volume Provider' or market maker buys and sells shares.
A Fonterra Shareholders Fund (FSF) is being created where outside investors can buy units in the fund, which will operate to buy and sell shares in the market. When a farmer sells the economic rights to their shares to the the Fund, the legal title to those shares is held by the Fonterra Farm Custodian. This Custodian is owned and controlled by three farmer shareholder trustees.
The economic rights to the shares include any dividends and gains or losses in the value of the shares. The voting rights with the shares are retained by farmer shareholders, as is the right to retain the share-backed milk price.
The fund will raise money by issuing units listed on the New Zealand Exchange (NZX) that will be sold to outside investors. The minimum size of the fund will be NZ$500 million and be between 7-15% of voting shares, with a limit of 25%.
Farmers will vote on whether a 33% limit on the amount of economic rights they can sell for their shares. Also, no individual farmer can hold 'dry' shares (shares without production) worth more than 5% of those on issue or more than 200% of their own production.
The first resolution in favour of TAF itself requires a 50% approval to go through. A second resolution for constitutional changes to tighten ownership of shares requires a 75% vote. Fonterra has not specified if it would go ahead with TAF it got the first resolution through but not the second. The results and a decision are likely to be announced late on Monday. See the full resolutions here.
See more details here in Fonterra's 2 page fact sheet.
See the full details in the 63 page proposal
Pros of TAF, as argued by Henry van der Heyden
Fonterra says it needs TAF to protect its capital base. Under Fonterra's current system, any farmer wanting to leave the industry and reduce production can sell their shares back to Fonterra for cash. If many farmers do this at once then Fonterra's capital could be depleted.
"It's all about permanent capital. At the end of every financial year, capital washes in and out of Fonterra's balance sheet. That's what we call redemption risk," Fonterra Chairman Henry van der Heyden told me in this double shot interview this week (also above) said.
"Trading Among Farmers is about removing redemption risk and removing the obligation to redeem shares," he said.
Fonterra says it has built a 'firewall' between the Fonterra Shareholders Market and the Unit Fund.
"We are not allowing outside investors into the cooperative. These two things run side by side. It's not investors within the cooperative."
Fonterra says outside investors in the units do not have the power to change the milk price paid to suppliers.
"They have got some legal rights, but it's only legal rights that are no different to a bond holder or a capital note holder if they are disadvantaged compared to farmer shareholders on issues such as the dividend," he said.
Van der Heyden denied TAF was a 'thin end of the wedge' towards an ultimate move towards a publily-listed shareholder controlled company where there was a clear separation between the rights of suppliers and shareholders, who are different people with different interests.
"It's very clear there is a firewall between the Farmers Market, the Cooperative and also the unit fund, so investors are not investing in the cooperative. We've put belts and braces in place and that's why all the directors can stand up in front of farmers and give them the assurance there is 100% farmer ownership and control and the only way that can ever be changed is if 75% of farmers want to change it under the constitution."
Van der Heyden said the constitutional changes actually tightened the rules around cooperative ownership, rather than loosened them.
He said increasing retained earnings, as farmers have done to boost capital in recent years, was not a solution to the redemption risk issue.
"Retained earnings doesn't actually fix the fundamental issue of capital washing and out of the balance sheet. It helps strengthen your balance sheet but it doesn't stop it washing in and out," he said.
"What happens if the global markets freeze, if something happens in Europe like we had in 2008? It's removing that obligation."
Van der Heyden said if TAF did not happen then the government had said it would force Fonterra to stop using its current restricted share price of NZ$4.52 and return to a fair value price for the shares of around NZ$5.57 currently.
"It's actually going to magnify redemption risk because we're going back up to a fair value share price and I think you'll get more government involvement within Fonterra and the industry," he said.
Fonterra was looking for a much stronger mandate than a 51% or 52% vote in favour, but he wouldn't say what threshold would be enough for approval.
Cons as argued by Lachlan McKenzie
Opponents of TAF are worried the proposal will water down the Cooperative.
"The Cooperative is the best way to get the maximum amount of return back to farmers and the community in New Zealand. The TAF vote we believe is a vote to demutualise the cooperative," McKenzie said in a double shot with Interest.co.nz this week.
McKenzie said Fonterra could never eliminate redemption risk because there was always the risk of farmers removing their milk supply.
"The TAF is about permanentising the capital, but in that process they are allowing up to 25% of the equity to be owned by outside investors and therefore up to 25% of our profits will go to outside investors and inevitably go offshore," he said.
"There is no other cooperative in the world that is encouraging their suppliers to sell their equity to outside investors, so we lose the focus from being a cooperative which maximises the return back to the producers, which is the milk price, to a focus on investment and maximising the return to outside investors."
McKenzie also rejected the idea that Fonterra needed to sell its shares to have strong capital levels, given farmer shareholders had shown over recent years they could conserve capital within the cooperative through its dividend redemption policy.
"Our debt level has significantly reduced. Since 2007 they have had a retention programme which has reduced debt considerably. We've now changed the share standard so we can have dry shares and that gives us flexibility. We can introduce many, many other tools under a cooperative structure and still hold that cooperative principle and that maximise returns back to New Zealand," he said.
McKenzie referred to appraisals of the TAF plan by James Morrison Consulting for Parliament's Select Committee and one by Dr Onno Van Bekkum in support of his arguments. Those reports on are ourco-op.co.nz.
"On June 25 the cooperative ceases to exist and it becomes a farmer owned company," he said.
McKenzie rejected the argument that TAF was needed to reduce the cost of entry into Fonterra for young farmers.
"The prices will be set by outside investors who will have deep pockets and the price will go up significantly, and that will make it even more difficult for the next generation to come in," he said.
"The whole purpose of a cooperative is that you leave a strong vibrant cooperative for the next generation. This TAF is about putting the equity in the cooperative built up by past generations into the hands of the current owners so they can flog it off."
McKenzie rejected the argument that TAF had enough protections for farmers to retain 100% control of the cooperative and the milk price.
"The international experience is that farmers will sell their shares, their economic rights in their company and the future generations of farmers will not have the benefits of that. You can look at Kerry in Ireland where within one generation they have gone from seeing outside investment as a benefit to now being the lowest paid farmers in Ireland," he said.
"Demutualisation would be the death knell for the dairy industry in New Zealand."
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