Resignation sends a message to farmers

By BRIAN GAYNOR

Mike Smith's resignation from the Fonterra board is a huge wake-up call for the dairy company and its farmer shareholders.

Mr Smith is a highly respected and loyal businessman who would not have quit unless the company had serious governance problems and he saw little prospect of their being rectified.

Fonterra's problems are a major concern to all New Zealanders because it is the country's largest company by a wide margin.

The new group is forecast to have total revenue of $14.1 billion in the May 2002 year. That compares with revenues of $5.6 billion for Telecom and $4.1 billion for Carter Holt Harvey, New Zealand's two largest listed companies.

In the last June year, dairy exports were $7 billion or 21.8 per cent of total exports, and Fonterra accounts for 95 per cent of the dairy industry.

The root causes of its problems are the merger agreement and group structure, particularly its board composition.

The dairy industry has undergone a huge rationalisation in recent years, and at the end of 2000 there were two large dairy companies (the New Zealand Co-operative Dairy Company and Kiwi Co-operative Dairies) and two smaller ones (Tatua Co-operatives Dairy Company and Westland Co-operative Dairy Company).

Fonterra Co-operative Group was established on October 16 after the merger of Hamilton-based NZ Dairy and Hawera-based Kiwi. As part of the merger, the New Zealand Dairy Board became a subsidiary of Fonterra.

The amalgamation was a direct response to the Government's decision to deregulate the industry and to remove the Dairy Board's monopoly seller status.

It was argued that New Zealand needed a large dairy company to compete successfully on world markets and the merger would create annual benefits to the tune of $310 million by 2004.

These include annual cost savings of about $120 million, revenue enhancements and productivity improvements of $70 million as well as new initiatives estimated at $120 million.

Suppliers were issued shares in Fonterra on the basis of last season's production.

These shares cannot be traded but may be surrendered when no longer required for production. On surrender, shareholders will receive cash, capital notes or redeemable preference shares. Non-suppliers cannot own shares.

Fonterra has 13,030 shareholders, 1.08 billion shares on issue and the largest holder has well under 1 per cent of the capital.

As the shareholding base is dispersed, both in terms of holdings and geographic location, a shareholders' council has been established to give suppliers a stronger voice.

The council has 46 farmer councillors elected from 25 wards. Its powers mainly relate to receiving and commenting on reports from the board, consulting with directors and making recommendations to them.

It is difficult to imagine that this body will have a major influence over the company unless it gains widespread voting support.

Fonterra's main corporate governance problem is the size and structure of its board.

According to clause 12.1 of the company's constitution, the group can have no more than 10 directors elected by suppliers and no more than three appointed by the board.

A supplier-elected director must be a shareholder and board appointees must be ratified by shareholders at the first annual meeting after their appointment.

Fonterra now has 13 directors with 10 elected by suppliers and three board appointees, Graeme Hawkins, John Hood and Mr Smith. After May 31, next year there can be no more than nine farmer-elected directors and three board appointees.

There is a strong argument that all companies, even the larger ones, should have no more than 10 outside directors.

Microsoft has only eight directors and Coca-Cola, the world's largest food and beverage company, has 11 non-executive and one executive director.

Fletcher Challenge had 15 directors, including four executives, in the mid-1990s and this was partly to blame for its poor performance.

Air New Zealand had 13 directors during the Ansett debacle, but this has been reduced to seven because a smaller board is considered to be much more effective than a larger one.

NZ Dairy has had some experience of a large and unwieldy board. After merging with South Island Dairy Company, it had 17 directors, but this was quickly reduced.

The other major governance issue is that there are too many farmer directors with no experience of large organisations, manufacturing and marketing.

Farmer directors seem to have been elected to ensure that NZ Dairy and Kiwi have equal representation and that each part of the country has a Fonterra director.

The farmer directors are based in Whangarei, Dargaville, Hauraki, South Waikato, Otorohanga, Central Taranaki, Coastal Taranaki, Wanganui, Canterbury and Southland.

In other words, the board of directors has been chosen from a political, rather than a commercial, perspective.

Milk suppliers argue that the New Zealand dairy industry has performed very well under the farmer-dominated model and most supplier cooperatives throughout the world have a similar structure.

B UT have the suppliers received the full benefits of the strong export performance and have the payouts to them been as high as they should have been?

It is true that farmer-dominated cooperatives exist all over the world, but none of them are aiming to become a major global marketing organisation or are as important to their country as Fonterra is to New Zealand.

Fonterra needs a wide range of board skills, whether from farmer or outsider directors, particularly as chief executive Craig Norgate is relatively young and has had no experience running a global food giant.

Skills are needed in several areas including milk production, manufacturing, marketing, the global food market, finance, accounting, international trade and competition law, human resources, corporate governance and the management of large complex organisations.

The present board is overloaded with expertise on milk production but has little in-depth experience in most of the other areas.

Mike Smith, a former highly-respected Lion Nathan executive director and NZ Dairy director, probably had the widest range of skills and he is leaving on Thursday.

There are several highly successful directors, including Sir Roderick Deane, Ian Donald, Bill Falconer and Douglas Myers, who could make a huge contribution to Fonterra, but it also needs at least one overseas director with experience of the global food market.

As a first step, the number of non-executive directors should be reduced from 13 to nine with five farmers and four outsiders. Mr Norgate should also be appointed to the board.

These changes will require the approval of 75 per cent of shareholders and support of 24 of the 46 members of the Shareholders' Council.

This will be extremely difficult to achieve because the supplier shareholders will not want to lose their local board representative, regardless of whether he or she has the skills to make a meaningful contribution.

The Fonterra board is reported to be functioning effectively and cooperatively on business matters, although the Powdergate affair resurrected old antagonisms between NZ Dairy and Kiwi.

But on the major corporate governance issues there is a big split, several directors are totally opposed to reducing the size of the board or changing its composition.

Mr Smith believed that this opposition was entrenched and he decided to quit.

It is extremely unfortunate that supplier shareholders are unwilling to take a more flexible approach towards Fonterra's board structure because the current composition is inconsistent with its objective of becoming a successful global marketing organisation.

* Email Brian Gaynor