Thursday, October 6, 2016
In the 1990s when ag production contracts were more in the ag law news than they are now, I remember visiting with Washburn Law School Professor Jim Wadley on the subject because I was getting numerous calls from farmers about perceived (and real) contract abuses. I wanted Jim’s thoughts on the issue so that I could respond to the inquiries and also because I was beginning my research for what would become my college/law school text on agricultural law. Jim was a big help in framing the issues for me. He was working on a book on Kansas ag law at the time with Sam Brownback (now the Governor of Kansas) and many of his thoughts ended up in his book. I dusted off my notes from that original conversation the other day and also revisited the topic in the contracts chapter of my book after getting a couple of new emails on the issue. So, today’s blog post focuses on the issue and also illustrates how relevant Jim’s thoughts from two decades ago remain.
Crop farmers and livestock producers often enter into contracts with a vertically integrated processor to raise animals for the processor that meet a particular quality requirement. These contracts are known as “production contracts.” They are different from forward contracts. Forward contracts are entered into for tax and marketing purposes, but production contracts largely form the entire foundational basis for the farming operation. A producer may enter into a production contract if there is a belief that the market for his production isn’t stable either in terms of buyers or in terms of price.
Pros and Cons
So, what are the primary advantages and disadvantages of a production contract? They do tend to reduce the capital investment requirements, and economic returns tend to be more predictable. Similarly, less operating capital is required, and better use of available labor and facilities might result. Conversely, the big disadvantages include the producer losing control over management, and a limit on the return from the operation. Also, the facility use is not guaranteed and economic returns may not equal facility costs or replacement costs. Another possible negative factor is that the producer does not own the animals, but the producer could be liable for any death loss.
Many ag production contracts authorize the processor or an agent to inspect the producer’s facilities at any time and require any changes the processor deems necessary. Those changes can include such things as material changes in the facility (without any assurance or guarantee of a future contract); processor control over feeding rations and medication; and delivery at a particular time irrespective of market price at that time.
When it comes to a production contract, what should a producer know? The following are suggested items that a producer should have information on before the contract is signed:
- Which party is responsible for the cost of production inputs such as feed, medicine, transportation, facility upkeep, water, labor and utilities, and marketing costs;
- The extent of the processor’s right to enter and inspect the premises and require changes in the facilities;
- The extent of the producer’s control over the health and quality of the animals that the processor delivers to the producer;
- The extent of the producer’s control of the daily activity of raising the animals and whether there will be field employees of the processor who will serve as supervisors of the producer’s activity;
- How payment is to be made? There are various ways that the economic structure can be set up - flat fee per animal; the number of days that it will take to raise the animals; the final weight of the animals; a guaranteed price that is tied to cost per pound; or a profit-sharing arrangement;
- The manner in which marketing decisions are to be made and the party that is to make them;
- The circumstances and conditions under which the contract may be broken and the resulting consequences if there is a breach;
- The party that controls the quality and quantity of feed;
- Whether the processor will receive any liens on the property of the producer as a result of the contract.
Broder Economic Concerns
Clearly, very few farmers have anywhere near the level of bargaining power that the contracting firm (such as a seed supplier, livestock supplier or meatpacker) has. Consequently, the contracting firms can be expected to capture most of the yield premium as the division of revenue shifts over time to the party that has market power. The likely result is that less revenue, in the long run, will go to the producer, resulting in less compensation to producers and less to capitalize into land values. The contracting firm will receive more revenue and control of the rights to any associated technology, with more revenue capitalized into corporate stock. A key point is that the party holding the rights to any technology involved will capture the majority of the revenue, not the producer. Also, as indicated above, the contracting firm is likely to negotiate for ownership of the product involved with the producer only having the right to receive a contract payment for labor services rendered. But, while the producer receives only compensation under the contract, the producer still bears significant economic and legal risk.
Clearly, a producer thinking about entering into a production contract should have legal counsel examine any proposed contract and go through the issues listed above. Contract production of agricultural commodities is very important and comprises a great deal of agricultural production. It’s also important to get the best deal that you can and get fairly compensated for the risk that you are bearing.