Keith Woodford identifies six big governance failures at the icon dairy coop. Without knowledgeable, passionate member-directors, the board becomes captured by management

Keith Woodford identifies six big governance failures at the icon dairy coop. Without knowledgeable, passionate member-directors, the board becomes captured by management

By Keith Woodford*

Late last year, Fonterra’s farmers rattled the cage by voting for a change in governance rules. However, the voting majority was insufficient to change the rules. Fonterra’s Board has now responded with its own proposals for new governance structures.

To me, the new proposals look like a continuing meander towards corporatisation, without recognition of the special features of a huge co-operative conglomerate like Fonterra.

The proposal last year, led by former Fonterra directors Greg Gent and Colin Armer, was to reduce the number of directors. But would a smaller number of directors really make a difference? And what would it do in terms of further disconnecting the Board from the grassroots?

Among the farmers that I talk to, those who voted for a change did so as a way of voicing their discontent. They remain committed to Fonterra – within limits that in some cases are being sorely tested – but they are not happy with Fonterra’s performance.

At that same time as the Gent-Armer proposals, there were three directors up for re-election. Chairman John Wilson was voted back for his fifth term on the Board, and Nicola Shadbolt was voted back for her third term. Blue Read was the unlucky director, replaced by Ashley Waugh. So farmers wanted to retain some experienced heads up on the bridge, but also saw in Ashley Waugh someone who had lots of experience in value-add dairy. 

In this situation, the only other way to lash out and send the directors a message was to argue for a change in governance.  But was it a considered move?

The latest proposal is to reduce Board numbers from 13 to 11, but so far Fonterra has not been explicit as to whether both of these will be farmer directors. There are currently nine farmer members.  It is even possible, and being discussed, that three farmer director positions will go and the non-farmer directors will increase from four to five. 

There are also proposal to change the voting system, from direct farmer voting under a single transferable vote (STV) to company-nominated directors being endorsed or rejected at Fonterra’s annual meeting.

The current Board structure has sufficient farmer members that if one or two are non-performers then the wheels do not immediately fall of. These farmer-voted directors are complemented by four non-farmer directors, appointed by the annual meeting on the recommendation of the Board, who are chosen to provide skill sets that are otherwise absent on the Board.

Governance at Fonterra involves huge responsibilities. Not only is Fonterra a company of some $19 billion assets (although with equity of less than $7 billion) but Fonterra’s performance feeds straight back to more than 10,000 farm businesses with assets of about 80 billion. Operating globally, it has a complexity unlike any other New Zealand business.

What Fonterra needs is farmer directors who are knowledgeable, passionate, and with the necessary time commitment to really understand Fonterra’s global business. It is not a job that can be done in just a few days each month.  Directors need to be well paid because so much depends on them making the right decisions. That means they have to be ‘out there’ in the international market place, and also listening to and communicating back to their farmer members.

If farmer directors are not continually monitoring what is happening all around the world, both within Fonterra and beyond, then they become captives to management.  From where I sit, it seems that too many of Fonterra’s directors have too many other commitments to really stay on top of Fonterra’s business.

Every Fonterra director needs to be able to read a set of accounts. In Fonterra’s case, that is not easy because the accounts are indeed complex. And my suspicion is that many of the directors do not understand those accounts. As a consequence, they cannot keep asking the hard questions.

Fonterra also needs directors who can stand up and not be dominated by either management or the Chair. It is no place for shrinking violets.  The Board is a place where there needs to be robust discussion, but where differences are not taken personally.  That requires a very skillful Chair.

One of Fonterra’s big problems is culture, and it would seem this applies both at management and governance level. Fonterra needs diversity of thought both at the Board table and right through the organisation.

The role of external directors is different to the farmer directors. They cannot be expected to put in the same time commitment required of farmer directors. They are there for their specific areas of expertise and experience. Inevitably, they are going to be people who have multiple directorships. Their role is to provide specific expertise in board room discussions, but as a co-operative, the Board needs a clear majority of committed member directors.

With a skillful Chair, 13 directors is not too many for there to be a strong dynamic culture within the Board.  Use of within-board committees is important, but every director has to be personally accountable for the big decisions.

The notion of shifting from the STV voting system to an endorsement system is likely to have unintended consequences. With the STV system, it is possible for a minority group of farmers to elect a Board member who shares their thinking. This creates diversity of thinking on the Board.

With the proposed voting system, it will create an environment where old-boy networks can dominate in the selection process. It will also further the distance of directors from their Board.

Over the 15 years since Fonterra’s formation, I see six big errors of governance.

The first was the failure to retain sufficient profits in the first eight years. These chickens are now coming home to roost.

The second failure was the lack of expertise on the Board to recognise the A1 beta-casein issue which is now going to bedevil Fonterra going forward. There was no-one on the Board who could wrestle with the science and ask the right questions. Relying on ‘management advice’ and management-selected consultants is not good enough.

The third failure was the San Lu melamine debacle. That was an accident waiting to happen. With a director who really understood China, San Lu would never have been chosen as the investment partner.

The fourth was the failure to invest in UHT processing facilities back in about 2008. An expert in the China dairy situation would have seen those opportunities, as some of us involved in China saw with great confidence.

The fifth failure was not understanding the internal culture problems that created the botulism scare.  No-one could have predicted the specifics of that situation, but the management and directors of that time have to take joint responsibility for the food safety and associated structures that allowed it to occur.

The sixth failure was the implementation of the so-called ‘Trading Among Farmers‘ (TAF), which in reality means external equity investors. The long term reckoning on this one is still to come. To some extent, TAF was driven by the failure to invest in the early years.

I cannot see how any of these problems would have been avoided by having a smaller Board. What I can see is that the Board lacked diversity, and relied far too much on the ‘management line’.  Quite simply, the directors lacked the collective diversity that was needed, and the Board lacked an adequate questioning culture to prevent gross management failures.

The big issue that Fonterra now faces is to sort out seasonal payment systems to provide better rewards to farmers who produce milk outside the traditional seasons. These will be contentious and it will require strong leadership to get these ideas accepted. But without them, Fonterra is destined to remain a commodity company.

Presumably, Fonterra will now put some reworked governance proposals to members at a special meeting, well before the AGM at which directors are voted in. This year’s elections could be particularly interesting, with one current director, should he stand, up for re-election to a fifth term, one to a fourth term, and one to a second term. 

Even if the constitutional changes are not voted in by farmers, this has the potential to create a tight field. Will all three seek re-election?  Will some new qualified and committed candidates step up?  To me, it is evident that more new blood is needed.

Regardless of electoral structure and outcomes, the bottom line is that Fonterra needs to encourage diversity of thought from farmer directors. These directors must have the time and intellectual commitment to monitor everything that is happening and to keep management up to the highest levels of performance. Directing Fonterra has to be their number one priority, not just one of many.


Keith Woodford is Honorary Professor of Agri-Food Systems at Lincoln University. He combines this with project and consulting work in agri-food systems. His archived writings are available at http://keithwoodford.wordpress.com

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Some good points Keith. I think Fonterra have to stop being/feeling responsible for the N.Z Dairy industry and start to get ruthless with their own business. Measures need to be put in place to stop making Fonterra responsible for additional milk production and the efficiency of taking outlying milk. Any new stainless expense should be vertical not horizontal. Outlying milk should cost the supplier more.
Yes there would need to be changes for this to happen but Fonterra needs the freedom to run as a lean business.

Total red herring this outlying and extra milk. Fix the culture first. Fonterra are not and never have been into value added. The closet they have come is buying into other companies to try and suck up some of their value, Sanlu, Australia, etc, fail.
Points one and six are the biggies for me, the cultural imperative being that they thought size would create its own self sustaining momentum, it didn't. Was never going to work it still requires innovation and hard work plus some saved capital to get from a to b , and huge paybacks don't automatically get you there either.

Zeebeck, as Fonterra has been legislated to take new supply regardless since inception, I would think the damage has already been done eg investment in plant capacity. I think the DIRA legislation was based on spurious economic theory and fallacy advocated by politicians and industry leaders and their puppet masters, that were either ignorant or motivated by opportunistic self interest in the undermining of the cooperative dairy industry.
It amazes me that Fonterra directors have consistently justified DIRA despite the crippling costs it has had and the lack of progress in maximising return to shareholders for milk supplied.

Insightful analysis as always Keith. I am not sure I agree with keeping the board numbers at such high level but I do share your concerns re the proposed new appointment process for farmer directors. If I was a shareholder owning several hundred thousand, or millions of dollars worth of shares, and totally reliant on Fonterra's performance for my income, I sure as hell would want direct voting rights on who my farmer directors were.

It needs breaking up. Commodity and value don’t sit effectively or efficiently under a single management structure, and extensively diversified businesses have a lower return on capital than those that are more closely focused.

There is also a decisive and conflicted failure in thinking as to the nature of value. Some of this is process based, as in manufacturing value-add - derived ingredients, fractions, etc. Some is first-stage production based, being value capture via grass-fed and organic.

These are two companies, requiring separate accountability. And New Zealand as a whole deserves far better from this vastly influential and environmentally baleful, if not calamitous, business.

Ever since Henry lost the vote to split off Fonterra Brands, the breaking up of Fonterra IMO has been the end game. The question is - will it be a fire sale or will the shareholders at the time be rewarded for staying loyal?

Why farmers fight for the status quo is because even opposition processing suppliers and staff say that the industry needs a strong Fonterra or farmers will become price takers at the lowest price the processors can get away with. How would you counter this perception/argument workingman? (Genuinely interested in your reply as I believe it is a conflicted company)

I wonder, CO, whether farmers' and New Zealand's interests would be better served within a structure of two companies, and these held perhaps by a trust.

One company handling improved or processed value - meaning value not dependent on farm production methods (thus commodity and ingredient outputs, etc; palm kernel, feed-lot inputs, etc). The other handling value that is dependent on farm production methods (thus grass-fed, organic, etc). The two companies are the operating units of a whole - the suggested trust.

With such an influential business (economically, socially, environmentally) the national interest - in addition to farmer and business interests - does need representation, and a trust structure, involving a few of the great and good, may provide this.

Perhaps such a loosely sketched tripartite structure may meet farmer, business and national needs. It might offer each of these interests appropriate ownership, governance and management roles.

Splitting off the brands is a worthy thought CO, and then non-supplying participants could have been involved in 'adding value' to NZ milk instead of bemoaning suppliers lack of ability to do so.
I wonder how loyal suppliers could be rewarded when the melt down comes, could it be argued that Fonterra shareholders at the time of formation were rewarded with 'FVS' (fair value shares) as legislated by DIRA?
I agree with Workingman, in that value for NZ derived milk is in production method (ie milk derived from pasture is distinctive to that derived from pk, grain etc), however if such value was justifiably pursued and realised, would it be a burden on the value derived from the corporatised share investment, and thus be scuttled by non-supplying industry participants and politicians?

To my mind, Omnologo, the division between the brands, as added value, and commodity, is a false one, and obscures real and opposed sources of value. I don't see that a split between brands and commodities is entirely possible or provides realistic corporate structures - in terms of supplier accountability or market focus. Not all value add is achieved via processing inputs.

Like you, I see the fundamental division as being between production methods. If this production-based division were pursued, both operating structures would offer a range of value add, from B2B products through to highly branded consumer products. Some B2B or ingredients products - Lycra being a good example - are as highly branded and managed with the same skills as any leading consumer brand.

Farmers and customers would have a choice of route, and each of these would achieve clear and commensurate reward for their choice. (And, I am convinced, competition between these structures would ultimately, perhaps quickly, be of immense benefit to the country.)

I like your thinking, workingman. :-) But wonder how it would work in practice.

e.g.In our area we are one of the very few farms which are grass fed farms. It may be uneconomic for Fonterra to pick up ad hoc farms, so we could see that, like other incentive payments, the premium is only offered to select areas. That then reduces true choice for suppliers. It is, I believe a conversation that will happen in the next 12-24months - other NZ processors are now offering incentives for this.

I see the practical issue, CO, but structure follows strategy, and businesses find ways to structure, or restructure, themselves according to strategic imperatives - preeminently that of increased value capture in line with market evolution. Right now, it seems to me that Fonterra's structure is primary in its functioning, instead of a credible value strategy, and this is confining and reducing value for farmers, itself and the country. There is a world of available value difference (and you know this, of course, better than me), between grass-fed and organic dairy on the one hand, and that produced via palm kernel, GM-feed, grain, factory sheds, etc, on the other. Perhaps it'll be the other processors that force change. Certainly, in my world too, plenty of people are talking about market and producer movement to these 'new' (strange word to use) sources of value.

This strategy stuff matters.
What do you make of Murray Goulburn. Director resignations still going.
yesterday
http://www.asx.com.au/asxpdf/20160503/pdf/436z888rtch5hm.pdf
today
http://www.asx.com.au/asxpdf/20160504/pdf/43707hdnq5n0yn.pdf

and a parable for our times..
The board of Australia's largest dairy processor faces two weeks of gruelling meetings with farmer suppliers, to explain what went wrong with its strategy. Last week, the cooperative downgraded its profit outlook to half the value forecast in the prospectus a year ago, and slashed milk payments to farmers.

Managing Director Gary Helou, along with his chief financial officer, both resigned from the company but questions remain about their role in the float and promises of financial return to investors. Financial Review columnist Joe Aston said Murray Goulburn would take at least five years to get back on track. (AFR thought MG cash cost included: $200m of cashflow gone, plus the $160m worth of debt to fund farmers - note cash flow to FonterraOzz est. above )

"The Murray Goulburn promise was always sour, it was just that some people were yet to twig to it," he said. "There was no way that listing a co-op to pay off debt to fund a massive capital intensive program for so-called value added dairy products was going to work especially when half of those products were private label milk in huge volumes in very skinny margins."

In 2014, MG opened two new fresh milk processing plants at Erskine in Sydney and Laverton in Melbourne, valued at $160 million. It also forecast a $260-$300million spend on nutritional powders to expand production.

http://www.abc.net.au/news/2016-05-02/murray-goulburn-through-rear-visio...

This chapter explains the investment analysis process; it will show the methods for measuring the profitability of investment proposals, collectively referred to as investment criteria.
There is a clear distinction between financing and appraisal/evaluation in relation to investment proposals. Investment appraisal/evaluation in the context of this chapter means measuring profitability. Financing an investment proposal, on the other hand, is concerned with issues such as the balance between debt and equity capital, a suitable borrowing arrangement in a given set of circumstance, and which assets should be pledged as security for a loan, the costs associated with servicing that debt, and the resulting cash flow of the business.
An investment project may be profitable but not financially feasible, and, conversely, financially feasible but not profitable. Only those investments that are profitable and financially feasible should be considered for implementation.

FMNZ Shadbolt/Martin Oxford 2005 p223.