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