Unless you’ve been living under a very large rock for the last couple of months you’ll have noticed the words ‘TAF’ or ‘Trading Among Farmers’ popping up all throughout the Kiwi dairy news (for anyone who doesn’t read the dairy news; why are you here?). People are either for or against it. This has created a secondary market of people attacking those who are for or against it. At Xcheque.com we suspect that some (particularly those outside New Zealand) may be a little confused about just what ‘it’ is. Here is a, hopefully not-too-dry, explanation for anyone for wants to dive into the debate.
TAF in a nutshell
In a nutshell, TAF is a proposed change to Fonterra’s capital structure - the way their ownership and shares work. Fonterra would change from having redeemable capital - shares that farmers can sell back to Fonterra - to permanent capital - shares that would be traded between farmers and outside investors.
Understandably many farmers are worried that allowing non-farmers to own shares will spell the beginning of the end for their co-operative. It’s a kind of social experiment, trying to answer the question: ‘when does a co-op stop being a co-op?’[1].
This should be enough to grab the interest of those who otherwise aren’t Kiwi dairy watchers. And if you’re not interested in the NZ dairy industry you should be – Fonterra is the world’s largest dairy exporter and its failure or successes will greatly affect the global dairy trade.
Fonterra’s future will be determined by two farmer votes on June 25.
(1) Implementing TAF. Fonterra farmers already voted for the constitutional changes required for TAF in 2010 so this will technically only require a 50 per cent majority to pass - although Fonterra have said they want an overwhelming majority.
(2) Tightening up TAF. In response to criticisms of the initial TAF proposal, Fonterra management have proposed a special resolution intended to reduce the possibility of a loss of farmer control. Because the special resolution requires changing the constitution it’ll require a 75 per cent majority to pass.
Why TAF?
Given how successful Fonterra’s current model is, it’s easy to think ‘If it ain’t broke, don’t fix it’. Why has Fonterra management proposed TAF?
The short answer is because Fonterra wants to grow. Just like capitalist-shareholders, Fonterra’s farmer-shareholders want to keep making more money. To do this they need Fonterra to find more buyers for their milk - read China - and/or to create value added products.
Added to this is the pressure from New Zealand’s economic reliance on their dairy industry. Dairy makes up to 7 per cent of their economy and 26% their exports.[2] NZ’s future wealth is riding on a cow’s back. This then comes down on Fonterra because they are most of the Kiwi dairy industry.
In order to fund their continued expansion they need money (capital) and this is where they run into problems given Fonterra’s existing capital structure.
Currently Fonterra’s shares are redeemable - farmers buy and sell them directly with Fonterra - and the number of Fonterra shares there are is tied to milk production.
If you’re a Fonterra farmer you have to own at least one share for every kilogram of milk solids (MS) produced. Since 2009 they’ve been allowed to buy shares equal to 120 per cent of what’s required for their milk production. E.g. If I produce 100 kg of MS then I have to own 100 shares but I can own up to 120 if I want.
This is different from most capitalist firms. If I invest in Warrnambool Cheese & Butter (WCB) and then no longer want my shares I can sell them to somebody else, but I can’t withdraw them from WCB.
Tying the number of shares to how much milk farmers sell means that if milk production goes down then the total number of shares drops with it, pulling all that capital out of Fonterra. Fonterra’s capital base is in theory less secure than a capitalist firm because their owners can bail if things go bottom up – a run on Fonterra is possible (but not necessarily probable).
This puts the brakes on Fonterra’s plans for aggressive expansion. They feel they can’t bank on having the capital in the future to fund any current expansion, forcing them to play conservatively. It also limits their capacity to borrow using their existing capital base as collateral because they can’t guarantee that it’ll still be around in the future.
TAF is designed to provide this missing capital security for the NZ dairy giant.
The Nitty Gritty
The introduction of TAF would make Fonterra shares non-redeemable. They’d have a permanent capital base, so no need to fear a run. But farmers would still need to be able to increase or decrease the number of shares they hold in line with milk production.
One solution is that Fonterra would, just like a capitalist firm, be able to issue new shares and buy back shares (called ‘Treasury Stock’) if they needed to. However, the two main mechanisms for enabling farmers to vary their shareholdings are the Fonterra Shareholders Market (FSM) and the Fonterra Shareholders Fund (FSF).
Fonterra Shareholders Market (FSM)
The first mechanism for allowing farmers to increase or decrease their shareholders is the Fonterra Shareholders Market (FSM). This would be be a closed market where Fonterra farmer-shareholders (and only Fonterra farmer-shareholders) would be able to trade shares amongst each other.
Rather than selling their shares back to Fonterra when they decrease milk production, a farmer would sell what would be called ‘dry shares’ – shares not not backed by milk production – to other farmers.
Another idea behind it is that it’d give farmers more flexibility to own more or less shares than are required by their level of milk production. Farmers that are doing well could increase their capital investment without raising milk production, while those that are having a hard time would be able to decrease their capital investment (lowering their costs) without having to lower milk production.
There are several potential problems and solutions that are intended to solve these.
Everyone will buy and sell at once. When one farmer wants to buy more shares (because their milk production is increasing) then it’s probably also a time when most other farmers will want to buy more shares. Fonterra plans to have ‘Registered Volume Providers’ (RVPs) whose job would be to ensure that there’s sufficient liquidity in the market. They will buy and sell shares at all times in order to counteract surges and dips in demand/supply for shares.
Control will shift to capital. If share ownership begins to be de-coupled from milk production then there’s a worry that supplier control will start to decrease. Even if someone’s a farmer, if they own enough capital that isn’t linked to milk production then their interests will start to be in capital not milk - running contrary to other farmers. Whether Fonterra’s solutions to this problem are enough is the focus of most of the debate.
Dry shares won’t have any voting rights. You’ll receive dividends from shares but votes and milk payments will still be tied to milk production.
There’s a limit on how many dry shares you can own. Farmers won’t be able to own more than 200 per cent of the number of shares they’re required to own for their milk production. This number also wouldn’t be allowed to exceed 5 per cent of the total number of co-op shares.
The total number of dry shares will be limited. Fonterra say they’ll aim for around 5 per cent of shares to be ‘dry’ and the current constitutional limit for dry shares is 25 per cent of total shares. If the special resolution is passed this will be lowered to 15 per cent.
Fonterra Shareholders Fund (FSF)
Besides the possibility of losing farmer control the biggest hurdle for TAF is making sure that there’s enough liquidity (shares available to be bought or sold) in the shareholder market. As said above, the RVPs are intended to help with this but a better way to do this would be to find a source of demand/supply for shares that isn’t linked to milk production, i.e. non-farmers.
The Fonterra Shareholders Fund (FSF) is essentially a go-between for farmers and outside investors.
The way it’d work is a farmer would sell shares to the Custodian of the FSF - who then has legal ownership of the shares. The farmer would retain a voucher recording the voting and milk payment rights that stay attached to their milk production.
What's available for sale in the FSP are 'units' which can be bought by other farmers or outside investors. A unit gives you the the economics rights that go with owning a share - the share dividend - without the voting rights or the milk payment.
Only beneficial rights to the shares that farmers have put in/sold to the fund would be available for outside investors to buy so Fonterra won’t actually be using it as a direct fundraising tool.
The particular model for the FSF that Fonterra has chosen (and claim was preferred in feedback from farmers) is for the FSF to operate as a farmer custodian. The FSF will be owned by Fonterra farmers not Fonterra and will have a board of trustees, at least predominantly made up of farmers - a certain number of the board will have to qualify as 'independent' and non-farmer unit holders
The FSF opens up even more concerns about losing control than the FSM. Non-farmers would begin owning bits of Fonterra, bringing their own interests with them. There are safeguards intended to prevent them having any control but their efficacy has been questioned by opponents of TAF.
The size of the FSF will be limited. Currently the constitutional limit is 25 per cent of total shares but the special resolution would see this lowered to 20 per cent.
The number shares anyone can own in the fund will be limited. This will most likely be set at 15 per cent of the total number of shares in the fund.
There’s a limit on how many shares a farmer can sell to the fund - probably 33 per cent of their total ‘wet shares’ (shares backed by milk production).
Despite these safeguards plenty of people are worried that any outsider investment will require meeting their interests, which may run contrary to those of farmers. Fonterra will at least have to make it attractive for investors if they want them to buy-in in the first place. There may need to be shift towards dividends and away from milk payments.
This is probably the most serious worry. Fonterra claims that TAF won’t affect milk payments and if the special resolution is passed the milk price setting mechanism will be enshrined in the Fonterra constitution. It could then only be changed by a 75 per cent majority of farmer-shareholders.
Will these safeguards be enough or will TAF end up degrading Fonterra’s identity and ethos as a co-operative? See next week’s blog for Xcheque’s opinion!
This article has been published to promote public understanding of TAF. It is provided in good faith to the best of our knowledge.
[1] Say you start off with a bunch of farmer-shareholders. Replace one of them with a capitalist-shareholder and then repeat until you no longer have a co-op anymore. http://plato.stanford.edu/entries/sorites-paradox/
[2] The dairy industry's direct contribution to the economy is 2.8 per cent but its flow on contribution is up to 7 per cent. See "Dairy's role in sustaining New Zealand - the sector's contribution to the economy, NZIER, December 2010," & "Fonterra cuts milk payout f'cast, sees prices stabilising, Naomi Tajitsu, Chicago Tribune, 22 May 2012."
Relevant Fonterra Documents
"Trading Amoing Farmers Summary Sheet, Fonterra, May 2012"
"Trading Among Farmers - Blueprint, Fonterra, 22 May 2012"
"Fonterra Special Meeting - Notice of Special Meeting of Shareholders, Fonterra, May 2012"
"2010 Proposed Constitutional Changes, Fonterra, June 2010"