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Direct milk supply contracts: Less volatility and risk, more vertical integration

Progressive Dairyman Editor Dave Natzke Published on 22 January 2018

Relationships throughout the dairy supply chain – from the farm to the table – are changing. One touchpoint feeling the biggest impact regards dairy farmers and their supply contracts with milk buyers.

Attorney Todd Janzen discussed dairy supply contracts during a National Agricultural Law Center webinar, “The New Deal: Understanding Dairy Supply Contracts.”

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Historically, Federal Milk Marketing Orders and dairy cooperatives have provided marketing order and protection for dairy farmers. While milk production has continued to grow, both the number of dairy farms and dairy cooperatives has dramatically declined.

Janzen said more producers are facing new challenges with supply contracts, either with their dairy cooperatives or with direct supply arrangements with private processors.

“It’s really a changing time in the industry,” Janzen said, citing current milk supply/processing capacity imbalances and last year’s situation when dozens of Wisconsin dairy farmers were notified they were losing their milk market within 30 days.

“If you’re a dairy farm, it’s almost a death sentence in today’s market,” he said. “Milk prices are bad, and it’s hard to find a buyer for your milk. It’s troubling to imagine that an entire business turns on one single contract, and one party to that contract can terminate it for any reason at all.”

Janzen said 2018 will be the year direct marketing of milk “comes of age.”

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012217pd Janzen Photo

“A lot of farmers are starting to make hard decisions,” Janzen said. Questions being asked include:

• Do we leave the network of milk cooperatives that we have used since the 1930s?

• Do we try to do something else to put more dollars in our pockets?

“We now have some large buyers in the market that are approaching farmers seeking to bypass co-ops and buy milk directly from the farm,” he said. “This is likely the single-most important decision a farmer will make in the next five to 10 years. Farmers are having to decide whether to sign these contracts.”

Co-ops are farmer-led and, at least in theory, farmers have a seat at the table, and the contracts should be fair to farmers, he explained. Direct marketers, however, have more leverage over farmers once they have a contract.

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Janzen’s experience revealed dairy farmer understanding of existing contracts was limited, even though the contract represented the primary income source for their business.

Janzen, founder of Janzen Agricultural Law LLC, located in Indianapolis, Indiana, sits on the board of the Indiana Dairy Producers Association in an advisory/legal role. He also serves as administrator for the Ag Data Transparent Project, designed to bring transparency to contracts between farmers and technology providers.

He cited three reasons for undertaking the project: 1) to “level the playing field” because companies approaching farmers had an enormous advantage when negotiating contracts; 2) to provide comparisons to help farmers make informed decisions; and 3) to help companies identify problem areas in the contracts they were offering to farmers.

Beginning last summer, Janzen’s law firm reviewed about 10 milk supply contracts – from both co-ops and private processors – to identify standard terms and highlight unusual terms.

Major contract provisions

Janzen identified major contract provisions:

1) The supply obligation

Supply contracts identify the supply obligations of the milk producer, frequently in purchase and sale clauses. The contract likely creates an exclusive arrangement between the farmer and milk buyer. However, it’s important the contract outline whether the agreement addresses increased milk in event of a dairy expansion and clearly defines the farm under contract if a new or multiple dairies are owned by one family.

Additionally, the contract should declare actions in event of a failure to meet quality standards. Does one “bad” load of milk breech the entire contract?

Finally, does the contract establish minimum or maximum milk volume levels, and what actions are triggered if milk deliveries differ from those levels.

2) Contract term

Citing the Grassland situation in Wisconsin in 2017, where about 75 farmers were given 30-day contract termination notices, Janzen recommended the length of the contract and termination notice requirements be clearly identified.

In most case he reviewed, Janzen said direct-buy contracts had longer terms, usually three to seven years. The length of termination notice was also longer under direct-buy contracts, up to six months, compared to 30 days for most co-ops.

In most cases, language benefits the buyer, offering more lenient terms to exit a contract than those offered the producer.

3) Confidentiality demands

Some milk buyers imply “confidentiality” clauses related to contracts, prohibiting producers from sharing contract information with anyone, including their attorney.

“I really question why companies need to put these clauses in contracts,” said Janzen, who noted contract information may be shared with an attorney. Nonetheless, “carveouts” should identify who can view the content of the contract, and the contract should discuss consequences if confidentiality is broken.

4) Indemnity obligations

As direct-buy contracts become more common, indemnity obligations are becoming a thornier issue, shifting more liability to the producer, Janzen said.

Contract termination triggers might include producer performance, misconduct or negligent acts by the producer or employee.

When it comes to actual or alleged actions impacting product liability, there’s a big difference between the direct-buy model and the cooperative model, Janzen said. While co-ops might provide some protection in event of a drug residue or E. coli problem, direct-buy contracts might hold producers directly liable, not only for their own milk, but milk from other producers or the entire plant.

Additionally, terms of the contract should identify when the title of the milk changes hands, impacting both milk payment and quality or health issues that might arise. Related to that, the contract should identify whether the hauler is working for the producer or the buyer.

Pricing models

Separate from milk price calculations, Janzen identified three primary methods of pricing models under supply contracts:

1) Base + Premium. The farmer gets a guaranteed base price for every load of milk, plus premiums for meeting additional standards such as animal welfare certification or volume levels. Unless there’s a guaranteed floor, these contracts may be subject to market swings, so farmers still face pricing risk, but might receive additional premiums.

2) Cost +. This model pays for milk based on cost to produce, plus a profit margin. While offering protection from wide market swings, the challenge under this contract is to minimize costs and restrict cost increases.

3) Price – Marketing. A primary model for co-ops, this model pays a base price, deducting a portion of the payment to cover marketing costs. It is highly subject to market swings.

The three models have enormous differences, requiring dairy farmers to do “series accounting” to make a marketing decision.

Non-GMO considerations

Prohibition of genetically modified feeds (GMOs) is becoming increasingly common in direct-supply agreements, Janzen said. The provision may not be specifically listed in a contract, but may be included in a company’s “sustainability” requirements or specifications, and may be subject to change outside of a contract.

Producers entering supply contracts should ascertain implications of non-GMO terms, including producer liability for GMO contamination, and make sure milk payments reflect any premiums garnered from the marketplace.

Animal care standards

Animal care standards were included in all contracts Janzen examined, covering everything from animal abuse, judicious use of antibiotics, use of recombinant bovine somatotropin, tail docking, tiestalls or other animal welfare standards. Contracts might cover buyer audit and inspection rights related to animal welfare.

It’s important to describe the resolution process for any violations of animal welfare standards, including whether an incident is grounds for contract termination. Also, identify whether the contract’s antibiotic residue violations are equal to or exceed U.S. Food and Drug Administration standards.

Choice of law

Although some state laws may pre-empt laws covering milk contracts, legal disputes may not be subject to laws in states where the dairy farm is located, but rather where the milk buyer is incorporated. That covers all questions concerning the construction, validity, enforcement and interpretation of a contract. Companies will seldom if ever negotiate on this point, so Janzen frequently recommends using mediation or arbitration to settle a dispute – before litigation.

Forced shutdowns

An important provision to work through covers occasions when either the producer or the processor are forced to shut down due to weather or other factors. Dairy farmers must retain the right to ship milk elsewhere in event of a processor shutdown and address responsibilities of both parties to “return to normal” after a shutdown.

Employee considerations

“In today’s world, consumers care about everything, including how employees are treated on the farm,” Janzen said. Companies are worried about the reputation of farms where they source milk and might impose contract requirements related to employment practices. That means farm managers might have to alter hiring practices related to drug use or criminal convictions to reduce liability. Employers must pay attention to working conditions and workplace safety, and be aware of potential requirements for health care or insurance.

What does this mean?

On the positive side, direct-supply contracts will decrease price volatility for individual farms, reducing some of the economic risk by taking out market swings and offering long-term contracts. That could lead to improved profitability.

However, new direct-supply contracts will lead to more vertical integration of the dairy industry and hasten the demise of small farms, Janzen warned.

“You no longer have the buyers and processors disinterested in how milk is produced,” he said. “You are bringing those buyers onto the farm, and they’re going to want to control as many aspects of production as they can. Even though it won’t be the traditional vertical integration we’ve seen in poultry and swine, in many ways, it is very similar.”

Specifically, Janzen said the “Cost +” model is especially similar to a grower contract in the broiler or swine operation.

Additionally, Janzen foresees the farmer will see less control over production practices, with both milk buyers – and consumers – having stronger influences on some farming decisions.

From his analysis, Janzen concludes the change will be the nail in the coffin for many small dairies.

“If you’re a big buyer of milk, it’s much easier to sign up 10 2,000-cow dairy farms than it is to sign up 100 200-cow dairy farms,” Janzen said. “There’s less burden as a buyer. It gives the large dairy farmer more options. Many of these dairy farmers have few options (for milk markets), so they don’t get to choose.”

An additional factor is the declining number of milk haulers, making single-source loads more common.

Under the new supply contract environment, milk buyers become the new regulators, imposing their own rules related to things such as climate change, GMOs, antibiotic use and animal welfare, he said.

Janzen urged fellow attorneys representing dairy farmers to work to ensure contracts are fair and to argue for potential damages when a contract gives too much power to the milk buyer.

“The farm doesn’t have much leverage,” said Janzen, who advised fellow attorneys to modify contracts based on tradition or state law.

More information, including a recording of Janzen’s presentation, is available at The National Agricultural Law Center website.  end mark

Read also:

McCartys, Dannon take non-traditional approach to non-GMO business model

Marketing milk when there is too much to go around  

PHOTO: Attorney Todd Janzen is founder of Janzen Agricultural Law LLC, located in Indianapolis, Indiana. He also serves as administrator for the Ag Data Transparent Project, designed to bring transparency to contracts between farmers and technology providers. Courtesy photo.

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