Further supplementary memorandum submitted
by Mr Philip Moody (DFoB 45)
INQUIRY INTO
DAIRY FARMERS
OF BRITAIN
LTD ("DFB")
I thought it would be helpful for me to draw
to your attention those aspects of the DFB story that demonstrate,
in my opinion:
(b) what lessons that can be learned from the
failure of DFB; and
(c) the implications for cooperatives generally.
Capitalisation
DFB was charged by its members to pursue a vertical
integration strategy of acquiring and owning processing businesses
downstream from farm gate. However, for such a strategy to be
pursued on a scale sufficient to influence the overall milk price
return to members for a business the size (in UK terms) of DFB,
was always likely to require an extent of capital in excess of
the capability or willingness of members to provide.
I stated in evidence that the Board assessed
that the total amount of capital available to it to invest in
the strategy without outside investors was in the region of £100
million to £150 million. We always identified that circa
£50 million was the reasonable maximum that we could raise
from members leaving the balance to be secured from borrowings,
dependent on the financial performance of the underlying business.
At that time, banks were typically lending between 50% and 65%
of total capital assuming suitable debt performance covenants.
I also stated that DFB was under-capitalised
to achieve its strategic aims. This is because the Board understood
the need to be capable of raising capital of in the order of £250
million to £500 million in total, such was the scale of ambition.
This identified a "capital gap" which
was exacerbated with a reducing member base as this presented
a long term contraction in capital available to the business.
However, DFB could not attract third party equity investment due
to the conflict between profit and milk price—members would
want a high milk price whereby investors would want the lowest
milk price necessary to secure supply, in order to maximise profits.
The Board sought to innovate a solution by approaching
the US Private Placement market (low yield long term income bonds),
and attracted strong interest in its strategic ambitions. However,
the requirements of this financial market are quite restrictive
and whilst DFB may have been able to satisfy them, it is not an
opportunity afforded to most cooperatives in the UK due as much
to scale as anything else.
The fact is that most financial institutions
do not understand the cooperative model and those that do are
not attracted to invest long term capital in most cases. That
means that farmers have to bear the capital strain in the development
years and, unlike many successful European cooperatives who were
helped in their formative years with Government supported "soft
loans", and have had many years of steady growth to build
their balance sheets, the UK market is moving too fast to afford
that luxury. This places a huge burden in the short term on farmers,
leading to cooperatives being under-capitalised compared to their
private competitors.
If, therefore, the UK wishes to see the successful
development of a strong cooperative sector, it needs to provide
long term capital to enable them to bridge this gap until the
cooperatives have had an opportunity to get established and to
build their balance sheets as a result.
This issue has been identified by the English
Farming & Food Partnerships Ltd who are seeking to identify
innovative solutions to this need. However, Government could help
by improving the environment (such as in areas of tax reliefs)
to kick-start investment in this area. The reality, however, is
that HM Customs & Excise has ruled not to grant tax relief
for farmers' losses in DFB or, to put it another way, to tax them
on money they have never received, which can only add considerably
to the damaging industry impact of DFB's collapse. Correcting
this unfairness and granting tax relief for inward investment
into focussed agrifood funds or companies would be helpful.
Operating Model
To seek to bridge this capital gap, DFB chose
to operate what is called a "margin organisation" business
model. That is to say that the milk price would always be set
at a level that enabled the business to have sound finances, passing
the risk onto the members in proportion to their milk supply and
thus utilising their collective financial strength in support
of the cooperative. It was on this basis that banks lent to DFB.
DFB also chose to retain capital from members
through retention from their milk price, effectively deferring
part of the payment for their milk price to form part of the businesses
long term loan capital. However, Council always opted to prevent
this mechanism from being used to build reserves.
This proved ultimately to be a flawed model
as members increasingly compared their milk price with alternatives
available from other milk processors whose capital needs and risk
was borne by shareholders, not the milk suppliers.
This put pressure on DFB to either pay an unsustainably
high milk price that would undermine the business, or to risk
member disaffection and resignation that would equally undermine
the business.
The point here is that this issue dominated
financial policy in the Board as milk price was seen as the overriding
priority at all times (putting farmer directors who were in the
majority in an impossible position of conflict), leading to the
delay or postponement of rationalisation projects if the cost
suffered in any one year was greater than the benefit returned.
Ultimately, the Board was forced through member
pressure of resignations to pay a milk price that the business
could not afford without implementing bold restructuring programmes,
and this led to a breakdown of trust with the banks who were depending
on the margin organising principle of members standing fully behind
the risk of the business.
I would suggest that the lesson to be learned
from this experience is to ensure that the price paid for milk
is set by open market forces and that any losses sustained by
the business be taken into context of the overall capital needs.
I would also suggest that sensible capital levels need to be established
at the outset (including general reserves) and for the ambitions
of the strategy to be set accordingly.
Role of Council
In nearly all other farmer cooperatives with
which I have come into contact, the Members Council is treated
as a communication body to enable the Board to assess likely member
reaction to particular issues under its consideration and to enable
views expressed by members to filter through to the Board. Voting
is still held in the hands of individual members who all have
the right to receive information, attend at general meetings,
ask questions of the directors, and vote.
In the case of DFB, however, the Council was
given a very different role in that it was formally enfranchised
by the members to vote on their behalf, with Council Members themselves
being appointed by a series of regional elections. Council was
set up to enable a democratic streamlined voting process but ended
up as a Member governance body.
I believe this model had two fundamental flaws:
1. Council Members were burdened with a responsibility,
for which they were not adequately trained or experienced, to
adopt a level of governance that they could never properly fulfil,
simply due to a lack of detailed knowledge of the business which,
for essential commercial reasons, always had to be held confidential
to the Board; and
2. the Governance structure of the company was
blurred in the sense that there was confusion as to exactly what
the role of Council was, and where the division of responsibility
fell between the Council and the Board.
I believe this structure, linked to the constant
comparison with European cooperatives, led to confusion between
the role of the Council as devised in the Rules and the role of
a supervisory board in a European corporate model.
The lesson to be learned here is to ensure that
all voting is retained in the hands of individual members (as
is the case with shareholders in publicly listed companies), to
ensure full engagement by them directly with their Board of Directors
and to avoid confusion and conflict within the governance structure.
Constitution of the Board
DFB was set up to be "farmer controlled"
as opposed to simply "farmer owned". This farmer control
was embedded within the rules and culture of the business. The
Rules limited the number of outside directors and always ensured
that the farmer directors were in the majority.
This structure denied the Board an essential
commercial balance between farmer representatives, experienced
non-executives and executive management and placed an extremely
onerous responsibility on the farmer directors who knew that,
ultimately, they had both the power and the obligation to direct
Board decisions.
It is important to add that there is no implied
criticism here of the farmer directors themselves who always discharged
their responsibilities with diligence and commitment, and who
earned my total respect for their integrity and dedication to
DFB.
I believe the lesson to be learned is for businesses
of this complexity to have farmer representation, not farmer control,
and for the constitution of the Board of Directors to comprise
farmer representation, senior executives and outside non-executives.
What was the root cause of DFB's Failure?
In the case of DFB, much focus has been applied
to whether or not, too much was paid for ACC. The fact is that,
irrespective of whether or not this was the case, it wasn't fundamental
to the failure of the business. Had the business generated the
profit stream expected by the Board at the time of acquisition,
the company would have had no difficulty in meeting its obligations
to the banks and members.
The most significant problem was an onerous
4 year contract that was signed by ACC immediately prior to the
sale, committing ACC to supply product to a competitor business
at a price that was below the cost at which DFB could produce
and deliver the product. This contract generated losses of in
the order of £4 million per annum and also enabled the competitor
to use the cheap DFB product to quote against DFB in respect of
customers it was already supplying, thereby causing it either
to lose these customers or reduce its prices with the resultant
impact on profit margin. The total financial impact was therefore
much greater.
These losses had a dramatic impact on DFB:
(a) they eroded cash and profit which impacted
directly on the ability of the business to pay a competitive milk
price which, in turn, affected member confidence and support for
the business;
(b) they worked against the efforts of management
to make the business less dependent on CRTG as a customer;
(c) they eroded the ability of the business to
finance much needed capital expenditure with which to improve
the efficiency of the processing factories; and
(d) they dramatically reduced the re-sale value
and opportunity of the business.
However, perhaps most importantly of all, it
was well recognised by the DFB Board that CRTG would most likely
put the milk supply contract out for open tender when it came
up for renewal in 2007, and that competitors would aggressively
price against DFB in that process. DFB therefore had a well articulated
business plan encompassing a range of profit improvement programmes
("PIPs") designed to make the business fully competitive
by that time. In the end, the company delivered on virtually all
of these PIPs but their effect was simply to recover some of the
losses suffered through the onerous competitor supply contract
as opposed to enable the business to become more competitive.
The 2007 renewal, which ultimately proved to be more competitive
than envisaged due to the impact of Wiseman's new Bridgewater
processing plant, resulted in a material reduction in price paid
by CRTG that placed a burden on the business from which it was
ultimately unable to recover.
There are many other contributory factors to
the failure but that, in my opinion, was the root cause and however
the Board tried to find commercial and strategic solutions, the
scale of the liquids division losses were ultimately too great.
This was foremost a commercial failure and was not caused by constitutional,
governance or structural issues. The corporate governance process
was both rigorous and robust.
Philip Moody
February 2010
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