Agricultural Producer Security Program Depends on One’s Perspective

Wednesday, June 18, 2008 10:36 AM CDT

John Petty

Editor’s note: This week’s column is written by John Petty, executive director of Wisconsin Agri-Service Association and vice-chair of the Producer Security Council.

The Wisconsin Agricultural Producer Security (APS) program is, depending on one’s perspective, either one of the least understood or most misunderstood programs affecting agribusiness and producers alike in Wisconsin. The program’s intended purpose is to reimburse producers in case of a default by a licensed buyer of their goods. Most, but not all, transactions between producers of dairy, grain and vegetables and licensed buyers in the state of Wisconsin fall under the umbrella of this program. In addition, depositors of grain in licensed warehouses are also covered to an extent in case of default by a licensed grain warehouse.

That seems pretty straight forward; so where is all the misunderstanding? Simply put; some confusion lies in what is covered, who is covered and how much would be paid out in case of a default? I hear these types of questions every week from both agribusinesses and producers. And behind each of those questions and their answers are philosophical assumptions and more questions, regarding individual responsibility and the role of government. It can get complicated very quickly.

In order to attempt to understand at least what the current program’s goals were when conceived, a little background is in order. Prior to 2001, all licensed buyers of dairy, vegetables and grains were required to be licensed by the state, provide financial statements to the state and submit to state audits of their facilities. (There are exceptions to this statement; however for purposes of this discussion I will ignore those few exceptions, and I will ignore the grain warehouse program due to its unique characteristics.) The state was primarily regulating the industries by “looking in the rearview mirror.” That is, the criteria by which state regulators made their decisions were based on largely financial history of the licensed business.

The state regulators used the previous year’s financial data to base the decision whether to hold security from the business or not. The idea was based on the thought that history was an accurate indicator of future performance by the licensees. That’s a nice rule-of-thumb, but read any financial investment disclosure statements to see how well you can depend on that.

Assuming specific financial ratios as reported by the licensee were above an arbitrary threshold level, the state had no further financial requirement of most licensees. If however, those specific financial ratios fell below those thresholds, the licensee was required to deposit a third party bond with the state. An issue soon developed, in which the state was holding and, in the eyes of many in the industry, “tying up” millions of dollars in working capital for the state’s dairy, vegetable and grain industries.

The idea behind this program from the regulator’s viewpoint was that a business with “poorer” financial ratios was more likely to be at risk of default. So a bond, in an amount calculated to cover a potential default, was required and held by the state to assure that producers would be paid monies owed them. As an unintended consequence, a company that had a tight cash flow situation and poor financials (by even one one-hundredth of a percentage point) as measured by the department was required to take some of that needed cash to post a bond to satisfy the state’s licensing requirements. The result was the program pushing some of the very companies whose customers the program was attempting to protect even closer to a potential default - not at all what was planned.

The current APS, initiated in 2002 after years of study, was designed to solve these dual problems of 1) being costly to the financially weakest licensee and 2) tying up hundreds of million of dollars in industry working capital. The new program featured instead an indemnity pool of dollars providing coverage in case of a default by any licensee that had not been required to deposit security with the state.

To build this fund, Wisconsin charges licensees assessments based on a complicated formula which includes a combination of dollar volume of producer purchases by the licensee and their individual business’ financial ratios. These assessments are assumed to be a cost of doing business for the licensee and added to their cost structure; that is, passed onto the producers selling to the licensee in the form of marginally lower prices. In reality, at least for dairy, competition for milk forces the cost of assessments upward, driving up the cost of our dairy products compared to other states.

In addition, Wisconsin regulators envisioned a relatively low-cost umbrella bond purchased by the state using the proceeds of the assessments. The umbrella bond was intended to cover “catastrophic” defaults and would have a deductible which would have to be met before any payout from the bond would occur. (Proposals of how large the bond amount should be have ranged between $10 million and $40 million over the course of the program.) The collected assessments would form a pool that would serve as a source to pay out small default claims, pay the annual premium on the bond, and in the case of a very large default, and cover the deductible of the umbrella bond.

Well, things didn’t go as planned. The state, for a variety of reasons, has never been able to secure an umbrella bond for the program at a reasonable price. Obviously that immediately removed a major component of the new program, and as of this writing an umbrella bond has not been added. The assessment program did go into effect with licensees paying into the pool. Since inception, almost 10 million dollars has been collected across the dairy, vegetable and grain industries combined.

By statute, only 60 percent of the accumulated assessment pool can be paid out for a default. That provides about five million dollars available today of a total current $9 million fund balance, in case a major processor defaults in any one of the three covered industries. Even so, given the finite amount of dollars available in the pool and with no umbrella bond in place, there is the very real possibility that producers will only receive pro-rated amounts of their actual losses. As a reminder, ideas of an umbrella bond amount had gone as high as $40 million on top of the five million in the pool. And another threat always looms: given the state’s fiscal condition and history of “raiding” funds, how safe is the indemnity pool from prying hands of state budgeters?

The lack of an umbrella bond and the small, but serious, threat of losing these funds to balance the state budget are only two concerns. There are more. Because of the assessment formula used by the state, in many cases companies could purchase third party bonds for less than the cost of the assessment while providing greater default coverage for their producers than that provided by the APS. This fact is analogous to many safe drivers’ complaints about auto insurance: As the argument goes, if I’m a safe driver (a business with solid financials) why should I pay insurance to fund those reckless drivers (business operators with less than sterling credit)?

An additional issue related to the insurance analogy, directed at producer behavior, is the “moral hazard” argument. Moral hazard refers to the prospect that a party insulated from risk may behave differently from the way they would behave if fully exposed to the risk.

For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company. Thus, why should a producer differentiate between the dealers that might buy their produce on the basis of financial soundness, if the state is going to pick up the tab in the case of a default? In other words, what’s the risk to the producer in choosing which firm to deal? At that point, it is solely price as a deciding factor. So what advantage is it for a buyer, in this setting, to have a “golden reputation” if that is no longer a competitive advantage in the marketplace?

Another concern with today’s APS program is a “Doomsday” scenario. What happens if there is a catastrophic default by a business in one of the three covered industries? Payments would be made to producers with eligible claims. Let’s assume the entire five million dollars available today is used. How would those funds replenished? Would the dairy industry be assessed to replenish the fund in the case of a default by the grain or vegetable industry or vice versa? If a single industry has to replenish the depleted fund pool, how many years would that take? What financial impact is a major default (and replenishment of the fund) going to have on that industry and could it accelerate the move to consolidation in already mature industries?

And, what happens if there is another large default after the fund has just paid out on a default? (There would be the remaining 40 percent of the original pool fund, of which 60 percent of that could be paid out. In any case, it is a rapidly decreasing number.) There aren’t definitive answers to those questions and that’s a very real concern to many of us in industry and it should be to producers as well. And against this backdrop, ask yourself the question; is this a business environment that is attractive to new buyers or contractors entering Wisconsin?

Last fall, the Wisconsin Department of Agriculture, Trade and Consumer Protection pulled together a working group to discuss the problems with APS outlined in this article. The group, which finished its work in April and should release a report by July, fully examined the program. A very fundamental issue discussed by the working group was the concept of what coverage should be offered by the program. The range of answers literally ran from “total coverage” to levels below current coverage.

While dairy and vegetable buyers have fairly well defined risk limitations due to the nature of how products are procured in each industry, the grain industry is very different. A standard type of contract in the grain industry is what is known as deferred payment. That is a situation in which the grain is delivered to the buyer, title passes to the buyer and the seller for a variety of either tax or marketing reasons, asks the buyer not to pay upon delivery. Under current Wisconsin APS law, a seller with an unpaid three year old (or any aged contract receivable) deferred payment contract would have the same standing in case of a buyer default as someone that had delivered the day before the default. This fact dramatically increases the risk and the payout from the fund. The question is; should someone who asked not to be paid upon delivery, yet could have been, be covered by the fund in case of a default?

The APS program is widely not understood by the very people it is intended to serve. Part of the reason for that is the fund has only been accessed once by the default of a small dairy operation. But the main reason for the lack of knowledge is producers simply don’t see or feel the costs associated with the program. Perhaps if the program was funded by a check-off-like system (one possible alternative), producers would instantly see their costs and begin asking the question, “What are we getting for that money?”

John Petty is executive director of Wisconsin Agri-Service Association, which represents the feed, seed and grain industries of the state, headquartered in Madison. Petty has served as vice-chair of the Producer Security Council, an advisory panel to DATCP, since the APS program’s inception. In addition, he has served on the Board of Directors of the National Grain and Feed Association and the American Feed Industry Association. Petty serves on numerous boards and committees for both state and national agricultural and civic organizations. He is a nationally known speaker on a variety of topics and has co-authored a standard industry reference work, The Practical Grain Encyclopedia. A graduate of DePaul University, he is an Honorary Fellow at the UW-Madison College of Agriculture and Life Sciences.

Comments »

Comment on this story

Comments will be approved within 48 hours

Name:

Email: (optional)

Comments:

Image Verification: (Case sensitive)