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."
26 Comments
Ironically the bottom line is....
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.
Thank you for at least asking the question Bernard.....but I would have bet my testes he wasn't going to answer the question....
Because they are making it up as they go along....! thanks for the transparency Henry ,that's the way to instill confidence going forward.
In the words of Gibber......".YAH..!."..( hope I did not misquote that time Gibber.)
No. It's an open market, where the market for the units is quarantined away from Fonterra. The units will be priced according to the availability of buyers and sellers. The units will carry a right to dividends, and if the market seizes and buyers back off, say down to $0.10 the yield will be +20% or more and will attract buyers. It will be a pure dividend play.
I initially voted for TAF in 2010, trusting the rhetoric from the board and co, and not understanding detail or implications. Shareholders who dared to question the sincerity of it caused me to think more about it, and now I'm definitely in Lachlan McKensies camp.
In my opinion it hasn't been a robust, honest, and open process. The board and Fonterra management hierarchy have drip fed shareholders what information that supports the TAF agenda, with no comparison to credible alternatives, of which there are many within a cooperative structure, as pointed out by Dr Onno van Bekkum.
It seems TAF is modelled from the so called new generation cooperative model. This model hybridises the traditional co-op with an investor owned firm, so as to make co-op capital more efficient and mobile. It's a continuum to demutualisation as it introduces non cooperative disciplines, mainly in focusing on return on capital, as opposed to maximising return on members’ product.
I hear they are quite worried. This week in the Waikato I had a mate attend a 'house' meeting with the local Councillor. Three people turned up. BUT the Councillor was able to convince those present, 2 of whom were set against TAF, that it is a good thing. This Councillor was holding 3 meetings a day for 5 days. Mind you at one of the meetings the day before only two people turned up one of whom is still voting no - it's a trust thing.
I have been threatened via txt with legal prosecution if TAF doesn't pass. I replied asking for a name but haven't heard back. I hope to see the person in court if it means TAF is voted down, as I believe there are better alternatives.
I attended a meeting with our shareholders councillor (Ward 19), and again three people. The night before the ward dinner was help in Rotorua, guest speaker Henry van der Hayden. The topic, what Fonterra has achieved since inception, and future prospects. At our three member meeting our councillor was bristling with hostility at my continued opposition to TAF, the debate we had was heated, mainly from his behalf. He claims the council have a much more harmonious working relationship with the board since 2007. I find that shocking as they are supposed to represent us as a watchdog, and therefore hold the boards feet to the fire. I would say they are weak and ineffectual; the only one with integrity and character was Simon Couper, who our councillor feebly tried to discredit. It's not a good refection of the integrity of Fonterra CO, and if the members vote on Monday doesn't reflect councils 93% support, how does that reflect on council. How has Henry managed to subdue and gain control of the shareholders council?
I thought the shareholders council only have the right to appoint two independent members to the milk price panel. What do you make of the signals on how the value of our milk is going to be treated with TAF CO? It seems to me the manual and panel are a subliminal guise to repress the inherent value in favour to return on capital. Suits the independents!
I have been threatened via txt with legal prosecution if TAF doesn't pass. Well done! I wonder if there will be a courtroom big enough to hold us all who voted against TAF. You wont be on your own Omnologo. :-) Your councillor only ever was interested in what was in his best interest, not the industry's when we lived around that way. I see his house at Ohope was for sale a while ago - perhaps he needs to sell some shares? They must be seriously worried. What a coward that unknown person is.
Do you think Fonterra governance and integrity should be mentioned in the same sentence, Omnologo? ;-) Council got 93% for the TAF vote but got less than that for the resolution 2 vote - but we don't hear about that too much. Our local councillor up here is one of those who is in Simon Coupers camp. There are still a couple or three of them left.
You are correct in the appointment to the milk panel. Despite what dear Henry says I believe that dividend will rule. But think of it this way - at a $12 share in Fonterra, folks like us could agree to sell out and start our own co-op - we could build a factory pretty much debt free - which would be a considerable advantage over the other current competitors. I know this has been mentioned, in passing, down south.
Thanks for your comments my friends, I put it down to strong emotions, and I suppose I have been frank in my opposition, however try not to get personal. CO if TAF results in demutalisation and disenfranchisement, I agree with your thoughts on banding together as farmers and starting a new co-op or tendering our milk.
Like you I want to see Fonterra succeed as a co-op, not just for the sake of my future as a dairy farmer, also because the cooperative model provides compelling benefit to rural community and the NZ economy. Given what I see and understand, particularly in lieu of 2008 , I'm unconvinced that mobilising and leveraging capital through TAF hybrid or an investor owned company, would capture any more value. Although my financial and investment knowledge is limited at best, if there is a way for investors to get involved in the industryt without compromising the cooperative structure which is integral to maximising the value of NZ milk, I'm all for it. TAF is not the answer.
Fontera "leadership" have done nothing but squeal about the restaints of the 2001 law that allowed them a monopoly, since the ink dried. They have frustrated supplying competitors, gouged the local market and now they (with TAF) even want to stiff their own members. The "firewall" is far from secure and in years to come will attract unforseen common law challenges. The redemption "risk" is just a cost of having a privileged monopoly position in the NZ economy.
Ergophobia
An Australian dairy industry monitoring website says Fonterra is taking a gamble with the trading among farmers (TAF) scheme.
In a post on Xcheque, agribusiness expert Dr Jon Hauser and Kai Tanter argue TAF does not remove the redemption risk as Fonterra says it will and that it is possible the market valuation of Fonterra shares will drop, potentially destroying the wealth of many Kiwi dairy farmers.
"Alarm bells are ringing here," they say.
http://www.nbr.co.nz/article/fonterras-taf-scheme-risk-not-worth-taking-aussies-ca-121805
Thank you. I thought I was missing something when I couldn't see how the redemption risk would be removed under TAF. Risk, like energy, can't be removed, only transferred. Under TAF, the redemption risk is transferred off Fonterra as an entity and passed onto farmers themselves. Imagine a really bad year in which a lot of farmers want to sell up. Under TAF it seems to be that there could be a rush for the door as, like in any market, when there's selling pressure, prices drop. Thus if you know that you and many other are keen to exit, you're better off being one of the first people to sell up while the TAF shares are high. Those farmers who're highly indebted and sell their shares when they've dropped in value might findthemselves in big trouble. Risk transferred, not elimintated.
What has been missing from discussions over redemption risk is the relationship of the magnitude of risk to co-operative performance. As co-operative performance slips against its competition redemption risk escalates.
Through 2006 Fonterra denied it faced any redemption risk.
Now Fonterra claims redemption risk it is critical.
Flawed rational employed by MPI, government, com com, independent processors, and those wishing to leverage dairy cooperative capital through misguided DIRA legislation, as I see it, according to Steve Keen, (Debunking Economics P75, Zed Books 2011).
“Economists attempt to derive the supply curve from the theory of how profit-maximising firms decide how much output to produce. One essential in this derivation is that firms must produce so that the price they are paid for their output equals what is known as the ‘marginal cost’ of production – the additional expense incurred in producing one more unit of output. Unless this condition is met, a supply curve cannot be drawn.
This explains the extreme hostility that neoclassical economists have towards monopolies. It’s not only because they can abuse the power that being a monopoly can confer: it’s also because, according to neoclassical theory, a monopoly will set its price above the marginal cost of production. If monopolies were the rule, then there could be no supply curve, and standard neoclassical microeconomic analysis would be impossible.
Conversely, neoclassical economists love the market structure they call ‘perfect competition,’ because it guarantees that profit-maximising behaviour will cause firms to produce an output at which marginal cost equals price.
Only it won’t. The manner in which neoclassical economics derives the result that profit-maximising behaviour by competitive firms means that they will produce where marginal cost equals price commits one of the simplest mathematical mistakes possible: it confuses a very small quantity – an ‘infinitesimal,’ as mathematicians describe it – with zero.
When that error is corrected, it is easily shown that a competitive market will also set price above marginal cost….”
Whilst the NZ consumers angst over what they pay for dairy product in the supermarkets, and the role Fonterra plays in this, is understandable; the rest of DIRA, where the government and others wish to reallocate generations of cooperative capital under the guise of ‘fostering a competitive, dynamic and efficient raw milk market' (my god that’s funny), through forcing Fonterra to subsidise competitors, and pay out exiting suppliers at an artificially high ‘cooperative’ share value is ethically and economically wrong. We need to compete on a global stage, and the best way to do this is as unified cooperative, and if the US farm lobby et al complains, cut them loose. Why has Fonterra governance not galvanised membership to stand up against this unjust imposition, instead of collaboratively accepting it with the agenda of demutualisation?
Standing back, big picture: Why does this need be done:
1. HvdH has confirmed its not to raise new money to establish new businesses
2. What is the dollar benefit (to $kgMS) of doing this, or
3. What is the dollar cost (to kgMS) of not doing this
4. Where has this proposal worked the before (where the existing example that demonstrates this structures success)
5. Where has a co-op failed due to "redemption" by its suppliers
Comments: Cart before the Horse
6. Why should income/security of 11,000 suppliers be out ranked by the number (?) of suppliers that sell up. How many dairy farms are sold in order to stop producting milk. Even when farms are sold, most are to operators that continue to milk, ie shares survive. And Fonterra reserve right to approve suppliers coming on board anyway...
Comments: Keep your eye on the ball:
7. What is Fonterra doing to stop the current low and droppping farm incomes.
8. What is Fonterra doing to increase the return on its business assets and overseas operations.
9. What is Fonterra doing to get back the ANZ earnings otherwise taken by the Oz supermarkets.
Comments: And so:
10. How does doing this assist with points 7, 8 and 9.
11. How does doing this improve farm supply income?
Refer to earlier posts...
This has become a soap opera.
Some basics. A co-operative is not too far removed from an incorporated society with a membership structure. Where the members pay annual subscriptions. Subscriptions are paid in advance. Some members may fall into arrears. The convention is the current years subscriptions are available for the ongoing operations of the society. Where subscriptions are paid several years in advance, the prepaid out-years (ie the non-current-year) are "usually" placed into a "redemption fund" or "sinking fund" not to be touched until the out-year arrives.
Sinking Fund
Definition of a Sinking Fund
http://financial-dictionary.thefreedictionary.com/sinking+fund
Sinking fund. To ensure there's money on hand to redeem a bond or preferred stock issue, a corporation may establish a separate custodial account, called a sinking fund, to which it adds money on a regular basis.
It would seem that prudential management in the case of Fonterra, where there is a known potential obligation of redemption of let's say 20%, then the co-operative should put aside at least 20% of the cash value of members subscribed shares in to a redemption fund. Or a sinking Fund. That way there is no risk.
So the real questions are
(a) Why isnt Fonterra doing this?, and
(b) What is Fonterra doing with the funds?
Havent seen these aspects discussed.
I think iconoclast, in an early piece provided or perhaps it was a link, Fonterra were looking to capitaise ventures offshore in an effort to reassure the Corporates entrenched investment position ..as opposed to fund a new venture at this point in time.
It may well be that between Sth america and China Fonterra has become exposed financially and are trying to get this through before a reversal in trends becomes a position from which they may not extricate themselves, even it it was desireable to do so.
This has become a soap opera.
True. The star is a meglomaniac you wouldn't buy a used car off.
The storyline is that capital keeps disappearing as the star's business (a reasonably efficient commodities manufacturer) tries to become a high risk, high return global brands business without having the required capital, skills or abilities.
As the business urgently searches for additional capital, suppliers are becoming anxious that they may not in future be paid reasonable prices.
The deception required to keep up the appearance of being a successful business is a major sub plot.
The story is a tragedy that we know will end in disaster, but as in all soap operas the conclusion is dragged out as long as possible.
Low and dropping incomes, they are result of "efficiencies" sort of like the supermarket theory where the profit margin is lowish and the turnover is what provides proit. The more and more efficient you get the less per cow, hectare whatever you get, you just have to keep getting bigger and bigger to stay in the same place.
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