Iowa Attorney General Tom Miller and 16 state Attorneys General have proposed new laws to protect contract growers and producers. By contract growers, we refer to the growing number of farmers and ranches who produce livestock or grain on a contract with large contractor companies or other farmers. Former Indiana Attorney General Karen Freeman Wilson was one of the cosponsors of the model Producer Protection Act. Senator Thomas Harkin of Iowa has proposed similar legislation in the U.S. Senate.

Miller and the Farm Division of his office led the multistate project drafting the model legislation, which is designed to be introduced in individual state legislatures. Several of the measures are based on laws that recently were adopted in Iowa – banning confidentiality clauses in contracts, for example, and giving farmers a first priority lien for payments in case a contractor company goes out of business.

In a joint statement accompanying the model Producer Protection Act, Miller and the 16 state Attorneys General said the legislation would “help preserve competition in agriculture for the benefit of farmers and consumers.”

The Attorneys General cited their concern about “the rapid trend toward consolidation in agriculture” and about the fact that fewer firms control the production, processing, preparation, and retailing of agricultural commodities and food. The rapid rise of production contracts and marketing contracts is a trend that has dramatically increased vertical coordination in U.S. agriculture. This change is most noticeable in the pork and poultry industries.

Attorney General Miller said: “In production contracting, we worry about the great disparity in bargaining power and marketing information between the contractor companies and individual producers. Large companies often offer contracts to producers on a take-it-or-leave-it basis. Risks to producers are buried in pages of legalese, and producers easily can be stuck with unfair contract terms. On top of that, they may be barred from disclosing any of the terms to others.”

The Attorneys General said contracting often results in unfair shifting of economic risk to farmers and ranchers, especially those who are required to make large capital investments in buildings and equipment.

The model state legislation Producer Protection Act contains at least five key provisions:

1. Requires contracts to be in plain language and contain disclosure of material risks.
2. Provides contract producers with a three-day cancellation period to review production contracts and allow them to discuss contracts with advisors.
3. Provides producers with a first-priority lien for payments due under a contract in case the contractor company should go out of business.
4. Protects producers from having contracts terminated capriciously or as a form of retribution if farmers already have made a sizeable capital investment required by the contracts.
5. Prohibits tournament contracts whereby grower compensation is determined in part by performance compared to other growers.

Some important questions

The dialogue concerning the advantages and disadvantages of contract production and the proposed Producer Protection Act raises a number of questions that merit discussion and investigation. The article identifies some of the important issues raised by this proposed legislation in the spirit of furthering that dialogue. We are not here criticizing or supporting this proposed legislation; rather, our goal is to further the discussion and debate on this important public policy issue.

General Issues

A key general issue that must be considered in assessing this or similar legislation is the intended impact, and whether there may be unintended consequences. It would appear that the intended impact of the Producer Protection Act is to reduce the potential for exploitation of producers by processors and packers in contractual arrangements, and to foster continuation of a relatively independent (although aligned through contracts and other arms-length business arrangements) agricultural sector. A key concern is whether the rules imposed by the Producer Protection Act may be sufficiently restrictive with respect to contracting and similar arrangements that the unintended consequence and end result would not be to maintain a relatively independent agricultural structure, but instead to encourage vertical integration through ownership of production facilities by processors and packers. For example, in the early 1990s the state of Missouri enacted tough anticorporate farming legislation. In a few short years afterward, the independent pork industry declined significantly and was ultimately replaced by the vertically integrated Premium Standard Farms company and other contract production systems.

A second general issue that must be considered in any legislation concerning the provisions surrounding contracting is that it is virtually impossible to write a long-term contract that will meet all contingencies. Because of this, contracts must be flexible and based on trust. In fact, the major goals of public policy in the area of contracting should probably be:

1. to facilitate informed decision making by both parties to a contract, and
2. to encourage an environment of trust and confidence in contracting arrangements.

These goals are likely to be more achievable than a goal of specifying the full set of conditions and contingencies that must be included and considered in the specification of a complete contract. In essence, determining a set of rules that the public will enforce for the specification of a complete contract is almost surely doomed to failure.

A third general issue in the discussion of the Producer Protection Act or similar legislation is what provisions or protections are already available in current law, and what new provisions are needed that are not part of current law. This issue is particularly important as one considers whether producers entering contracts need unique protections compared to other parties entering a contract, or whether they need to be better informed about the protections already provided by current contract law.

A fourth general issue relates to the long-term location of the world’s livestock industries. Greater regulation on a state (or even multistate) level is likely to shift production away from that state (or states) in the longer run. Binding regulation at the federal level could result in a movement of an industry to Canada, Latin America, Asia, and Australia. Are the benefits of contract regulation worth the risk of losing the economic and employment benefits of these industries?

Specific Issues

Specific issues that must be considered relate to the key provisions of the Producer Protection Act noted earlier. They include the following:

1. What are the benefits of the provisions requiring plain language and a description of risk? What are the costs that this will impose? Will there be a standardization of terms in all contracts? Will disclosure include layman discussion of compensation technique and method? If the best advice is to have a contract reviewed by an attorney, or accountant, should there be a requirement or certification that has occurred as part of the contract or should all production contracts be scrutinized by a state Attorney General’s staff? What are the benefits compared to the costs of full disclosure?

2. Does the three-day right to review provision provide significant benefits? What are the disadvantages or costs of providing this three-day right to review? If better informed decision making is desirable, it appears reasonable that a producer should have the opportunity to discuss contracting provisions with advisors. Thus, provisions prohibiting confidentiality seem desirable. However, what does this disclosure requirement mean to the processor/packer in terms of revealing strategically important information relative to their competition? What does it do to the creativity and innovation in incentives for compensating suppliers for various attributes if a packer cannot obtain any competitive advantage from this innovation?

Furthermore, contractors invest significant legal expense in the development of contracts and contract language. Making contracts open to public scrutiny allows others to “free ride” on the investment by simply copying contracts and making minor alternations. Is there any way that information with respect to the contract might be shared with advisors, but a prohibition be imposed in terms of sharing this information with competitors? If contract information is shared with those who will help the producer make a more informed decision, then steps must be taken to prevent seepage of contracts into the public domain. This could take the form of a nondisclosure statement to be signed by all advisors and appended to the contract.

3. With regard to the producer being provided with a first-priority lien, production contract liens will likely not be acceptable to lenders as they consider the financial risk of providing capital to processors and packers. If the real issue is concern about the financial losses of a producer who does not get paid for his services under a contract production arrangement because of financial problems of the packer or processor, an alternative might be for the packer to post a bond. Alternatively, a state or federally sponsored insurance fund to indemnify producers (much like those currently used in the grain industry to protect producers from elevator bankruptcies) might be considered. In essence, alternatives to a lien that might be as effective in protecting producers from packer or processor financial failure should be considered. Also to be considered is that most production contracts eliminate price risk for the grower in exchange for the risk of contractor bankruptcy and increased access to investment capital. This shift from short term price risk to long-run risk of contract termination has drawn significant investment into livestock industries, and therefore, must be preferred by a significant group of producers.

4. Provisions concerning production contracts that involve investment requirements need serious consideration before adoption. If the fundamental issue is that producers are making long-term investments based on a short-term contract, an alternative is to make sure that producers are fully informed as to the risk they are taking in such a contract. Or it might be required that under contracting arrangements where the producer makes a long-term financial commitment to fulfill the contract, the processor or packer is required to also make a long-term contract commitment that more closely matches the maturity of the investment. More creative ways for solving this classic holdup problem should be considered. If this provision were to make it necessary for the processor to take all of the financial risk of the producer’s investment, a natural response would be for the processor to make that investment and have complete control. In this situation, the end result may be vertical integration, the exact opposite of the proposed legislation’s intent.

5. The prohibition of tournament contracts should also be evaluated carefully. The purpose and function of tournament compensation does not appear to be well understood. Objection to tournament contracts can be summarized as:
   1. they place growers in a position of competing rather than cooperating with other growers,
   2. they place growers in the position that if all achieve better performance, none are rewarded for the better performance, and
   3. performance variation may be due to differences in quality of inputs supplied by the contractor rather than production practices of the grower.

The case for tournament compensation is that it automatically ensures that performance rewards keep up with technological progress, leaves the contractor free to alter input use to adapt to changing prices without penalizing the grower, and automatically reflects the effects on performance of outside factors such as weather.

Tournament based compensation is widely used by broiler chicken companies. It is a means of varying compensation to reflect performance of the grower. The practice recognizes the difficulty (impossibility) of monitoring or measuring in a meaningful way all aspects of the grower’s activity that affect performance. The method bases grower payment per unit (usually pounds reaching the processing plant) on the grower’s ranking relative to the average of all growers completing flocks in a specified period of time (usually a week or two) with respect to some index of performance. Factors may be feed conversion, death loss, or a prime cost calculation including chick and feed cost per pound produced (usually calculated using a standard price for feed and chicks).

Based on experience in the broiler industry, there are three significant advantages of this method of compensation, the third is of great significance to the producer.

Performance awards keep pace with technology. There is no way for a contractor or grower to safely agree to a long-term contract using fixed performance standards. Regulations, genetics, nutrition, etc. will change over time. Any fixed set of performance standards will be out of date and likely untenable for the company or the grower before the contract term expires. A compensation base tied to average performance of all growers automatically keeps pace with technology.

Performance standards reflect current best management practice. Changing demand for products or input prices require changes in the size of birds, feed nutrient density, or strain of birds that will maximize contractor profits. Any change in these practices will affect the performance measures used for compensation. If the performance standards are based on current average grower performance, the contractor is not inhibited from using the most efficient production practice. A fixed feed conversion standard would reduce the incentive to use a higher nutrient density feed when prices favor it. The average based compensation provides greater flexibility for the contractor and, if the same production practices are implemented across all farms in the tournament, then growers are not penalized by changes in the production system.

The tournament compensation system automatically adjusts for factors affecting all producers. Ambient temperature, humidity, disease conditions, feed quality, chick quality, etc. are factors affecting all producers. Inasmuch as these factors affect all producers in a specific time period in the same way, the use of an average performance base maintains a level playing field for the producer. Of course, farms in a tournament with each other must be within a limited geographic region where weather patterns etc. are similar.

Contract termination and/or renewal are related to the performance standard’s issue. The proposed legislation appears to require renewal of a contract except for breach of contract, a rather unusual concept of contract that ignores a specified term as part of a contract. What is breach of contract? This implies some quantitative standard of performance. A standard based on the average performance of the producer group seems much more equitable than any fixed standards set in the past or the qualitative judgement of a producer’s compliance with some list of practices which would need to be specified in much detail.

A Final Comment

 

The Producer Protection Act could have significant implications for the competitiveness of the grain and livestock industries in the state of Indiana. The proposed legislation and details of its intent can be obtained at <http://www.state.ia. us/government/ag/AGContracting Iowarelease.htm>. Whether or not this specific legislative proposal is debated in the state legislature or in the U.S. Congress, concerns about the impacts of the trend to more contract production and vertical coordination in agriculture will abound in the future. This article is an attempt to add to the discussion of the potential consequences of this and similar legislation to determine its possible impact on producers and the future competitiveness and characteristics of the agricultural industries. It is not meant to reflect on advocacy for, or against, the proposed law.

The Purdue Department of Agricultural Economics continues to develop educational materials and programs aimed at contract growers, potential contract growers, public officials, and other interested parties. EC675 “Production and Marketing Contracts in the Pork Industry” is available from the Purdue Cooperative Extension Service. This publication along with other useful information about agricultural contracting is available on the Internet at <http://www.agecon. Purdue.edu/extension/contracting/>.