Yesterday, 10,500 New Zealand farmers voted to allow Fonterra, one of the world’s leading dairy cooperatives, to be exposed to outside investors for the first time. 66.45% of Fonterra members voted for the Trading Among Farmers scheme, which decouples the ownership of share capital from the co-op liability to redeem shares at a value determined by independent assessment. The proposed changes also involve the creation of a second class of share capital to be traded openly on the stock market. This will be known as the Fonterra Shareholders Fund (FSF).
However, the constitutional changes for the TAF scheme to be introduced received only 72.8% of votes, which was short of the 75% threshold that had been set as a clear endorsement of the scheme. This would have changed the co-op’s constitution to tighten the limits on the size of the FSF.
Commenting on the outcome of this vote, Fonterra chairman Sir Henry van der Heyden said that the board would operate TAF under the same tight limits that had been proposed for the Fonterra Shareholders’ Fund.
Fonterra and fair value shares
An important element of the foundation of Fonterra was the design of its share capital structure. The rules of its establishment were a principle known as “fair exit and entry”. Before the TAF scheme was introduced, members entered and exited the co-op with no change to the price of their membership. Unlike a conventional shareholder, who seeks capital growth from their share portfolio, the co-op member gained no such value. Their only benefits were their ability to trade with the co-op. This allowed for late entrants into the co-op to secure benefits that had been created by the pioneer members without having to pay a premium price for new share capital.
This was viewed by many as a weakness in the co-operative business model. To correct this apparent flaw, Fonterra created a system of fair value shares (FSV). Under this scheme farmer shareholder/members are required to own a minimum of one share for every kilogram of milk solids they supply to the co-op. Members can apply to commence or increase (or cease and decrease) their supply of milk. Under the Diary Industry Restructuring Act (DIRA), Fonterra is required to issue and redeem co-operative share capital according to these farmer/member/shareholder applications.
History of the TAF scheme
In 2009 the Fonterra board announced a three-step process for the restructuring of the co-op’s capital structure. Rather than seeking a public listing, the aim was to keep the company 100%-owned by farmers and to retain its co-operative status.
The first step in this restructure allowed farmers to hold shares above their level of annual milk production. They could now own 20% of “dry” shares and they were offered incentives to retain their shares even in periods of falling production. Adjustments were also made to the end of season share valuation and redemption process.
The second step involved a change to how Fonterra valued shares. Share ownership was restricted to farmers and the previous scheme of treating their value as if they were a publicly traded share was removed. This resulted in a devaluation of the shares of up to 25% due to the fact that it was now restricted in its ownership.
These first two steps generally received the support from members. However, the third step - adopting the TAF - has been more controversial. Under the TAF scheme, farmer shareholders will be entitled to trade shares amongst themselves via a Fonterra Shareholders’ Market (FSM).
The FSM will be a registered and regulated private stock exchange that members can trade in via an online brokering service or 0800 telephone line as well as a conventional broker. However, as only 10,500 New Zealand dairy farmers will be eligible to form this “market”, the total pool of available investment capital is likely to have some limitations. Share value is also likely to be lower than that which might be redeemed from an open market.
The Fonterra Shareholders’ Fund (FSF) - a second class of share capital to be publicly traded on the market – is anticipated to see up to 25% of the company’s share capital issued, although Fonterra is predicting that this may only be between 8% and 10% of total co-op shares. Holders of these FSF shares will have no voting rights within the co-op.
Redemption risk problem
A feature of the Fonterra share scheme was the use of an independent valuation by ratings agency Standard & Poors as to the market value of the share capital. This independent advice was then used by the board of Fonterra to set the price of shares at the start of the growing season. Members who wished to enter or exit the co-op would then seek to purchase or redeem their share capital based on this market value.
One of the inherent problems in such as scheme is the need for Fonterra to be able to hold sufficient capital within its balance sheet to pay out the shareholders should they seek to redeem their shares. Although Fonterra sought to implement controls within its constitution to protect against a run on the share capital by members, the redemption risk problem never fully disappeared.
In the first five years after its establishment in 2001 the value of Fonterra’s share capital grew from NZ$3.00 to NZ$5.44. By 2009, the share capital had risen in value to NZ$6.79 per share. However, the company was engaged during this period in a major international expansion, which created a significant demand for investment as it sought to acquire offshore businesses and set up subsidiary companies.
In 2007 the Fonterra board announced a plan to restructure its share capital. This proposed splitting its co-operative business from its mainstream business operations. The co-op would continue to own two-thirds of the new business entity, with 15% distributed to producers, and the remaining 20% floated on the stock market. This move towards partial demutualisation sounded a warning bell for many of Fonterra’s members and saw strong opposition and significant media debate.
The following year, the Fonterra board decided to postpone the restructure and agreed to a two-year period of consultation. Yet the matter continued to evoke debate between those who saw the move as a slippery slope to demutualisation and those who believed it was the only way to allow the company to compete globally.
Concerns over TAF and the road to demutualisation
Despite this farmer support for TAF and these comments from the Fonterra Chairman, not everyone is positive about the longer term implications for this restructure. At the New Zealand Association for the study of Co-operatives and Mutual (NZASCM) held in Wellington on 21-23 June 2012, there was a short but heated debate held over the introduction of TAF.
A speaker at the conference, Dr Onno van Bekkum from Co-op Champions, raised concerns that the introduction of TAF was placing at risk the longer term mutuality of the co-op. His argument was based on his long term analysis of many hundreds of co-operatives around the world, and his study of Fonterra since its foundation. His concerns were based on the decoupling of the member’s share rights from the co-op.
In Dr van Bekkum’s report entitled “Fonterra Farmers’ 2nd Vote on TAF: A Second Opinion”, he argues that the decision to adopt TAF will fundamentally separate the ownership and control rights that are inherent in the co-operative business model.
According to Dr van Bekkum, the underlying structure of the original FSV share rights issue was flawed. Rather than build value on the back of trading and cash accumulation in member accounts, which is common in most other large dairy co-ops, Fonterra built up this inflated value. For example, he points to the original value of the shares back in 2001 as redeemable at a value of NZ$3.00, which meant that Fonterra had a redemption risk of around NZ$3.3 billion. However, with the FSV price now inflated to NZ$6.79 per share, this redemption risk has increased to NZ$8 billion.
As he states in his report: “Phrased differently: in order to raise $300m extra capital, it built up an outstanding claim on its equity of $4.7bn. Based on this analysis, there is only one possible conclusion: this share valuation policy is completely irresponsible.”
His analysis goes on to suggest that the TAF scheme will do little more than shift the liability of the redemption risk from the co-op business to its members. These shares will be a form of derivative:
“The ‘Co-operative share’ under TAF is no longer a ‘cooperative share’, It has become a derivative of a cooperative share. It is a repackaged loan with a note saying I can ask someone else instead to repay me this loan. With uncertain conditions even. This is how banks create a financial crisis!”
At the heart of Dr van Bekkum’s concerns is what he sees as a shift from the member-owner model of the true co-operative, to a shareholder-based model of the conventional IOF business. He sees this risk because the focus of the co-op’s purpose is likely to shift from one of producer patronage in the supply of milk, to one of investor ownership and the ability to boost the price of the share capital.
These comments at the conference were challenged by executives from Fonterra who argued that the company had to make changes due to the redemption risk they faced and the requirements of the DIRA. His analysis was dismissed as being flawed and based on incorrect assumptions. What was interesting was that so few people in the audience seemed to understand or appreciate the strategic issue that Dr van Bekkum was raising.
There are many examples of co-operatives that have altered their share ownership structure only to trigger an eventual move towards demutualisation. South Australia’s AusBulk and ABB Grain Ltd are an example, which saw this former co-op convert to an ASX listed farmer owned business only to be taken over by Canada’s Viterra in 2009. Whatever now happens to Fonterra will have significant implications for co-ops, for New Zealand dairy farmers and for the wider New Zealand economy.
What will it matter if TAF passes?
While there are many complexities in the way the TAF/FSM and FSF share capital restructure will be managed, the underlying principle that he has raised should be a cause for concern.
Co-operative enterprises differ from investor-owned businesses in relation to ownership rights and patronage. The member is engaged with the co-op as an owner/shareholder, but their involvement is based on the patronage as either a supplier or buyer. The purpose for which a co-op is established is critical to its long-term survival, and the way that it establishes itself and structures is share rights and governance are likely to determine how long it lives.
Fonterra was established in an era when the United States had just introduced a concept of the new generation co-operative (NGC). These were designed to overcome the inherent weaknesses of the co-operative. Its original FSV was aimed at rewarding patronage but it was closely linked to milk supply. This new capital structure decouples the member-patron role from the shareholder-investor role within the co-op. The introduction of the TAF/FSM seems to risk the demutualisation process as suggested by Dr van Bekkum.
Time will tell how Fonterra continues to operate into the future. Its longer term success as a business may continue, but whether it remains a co-operative at heart may be open to scrutiny.