Due Diligence Report This is a condensed version of the Due Diligence Committee’s Report to the Fonterra Board, provided for shareholders’ information. It contains all the relevant findings and recommendations of the Committee. Minor changes to the words of the original report have been made. Additional appendices to the report were provided to the Board and the Fonterra Shareholders’ Council.

Contents 1.

Executive Summary 1.1. 1.2. 1.3. 1.4.

2.

The Committee and its Role Satisfaction of the Pre-conditions 100% Farmer Control and Ownership Due Diligence Process and Summary of Issues Identified

The Committee 2.1. Establishment of the Committee 2.2. Role 2.3. Reporting

3.

Committee Process and Approach 3.1. 3.2. 3.3. 3.4. 3.5. 3.6. 3.7.

4.

5.

3 3 4 4 4 4 4 4 4 4 5 5 5 5 5 6

Advisors and their Role

6

4.1. Advisors 4.2. Role of Advisors 4.3. Reporting

6 6 6

Major Issues Identified

7

5.1. 5.2. 5.3. 5.4. 5.5. 5.6. 5.7. 5.8. 5.9. 5.10. 6.

Overall Due Diligence Approach Work Plan Appointment of Advisors Information Shared with Advisors Meetings of the Committee Issues List Review of Shareholders’ Documents

3

Co-operative Model Milk Price Process Legal Issues Financial/Markets Taxation Offer Documents and Prospectus Fall-Back Plans Legislation/Regulation Summary of Issues Identified

Advisor Reports 6.1. 6.2. 6.3. 6.4.

Key Feedback and Conclusions Feedback on Pre-conditions Feedback on the Responsibilities of the Committee Feedback on 100% Farmer Ownership and Control

7 7 8 8 8 9 9 9 10 10 10 10 10 10 10

7.

Scenario Analysis

10

8.

Committee Report/Recommendations

11

8.1. 8.2. 8.3. 8.4. 8.5. 9.

Satisfaction of the Pre-conditions 100% Farmer Control and Ownership Other Matters to be Addressed by the Committee under the Terms of Reference Board Objectives Other Issues

11 13 13 13 15

Conclusion

17

Appendix 1 – 100% Farmer Control and Ownership

18

Appendix 2 – Committee Terms of Reference

19

Appendix 3 – Profiles of Advisors

22

1 Executive Summary 1.1 The Committee and its Role

The Committee has engaged leading New Zealand legal, tax, financial and industry advisors to assist it in completing the due diligence review of TAF and these advisors have provided reports setting out key issues identified by the advisors and the status

The Trading Among Farmers Due Diligence Committee (the

of those issues in order to enable us to complete our report. The

“Committee”) was established by the Board of Fonterra Co-operative

Committee has also reviewed and considered the Blueprint for

Group Limited (“Fonterra”) to review proposals, processes, and

Trading Among Farmers (the “Blueprint”) and the report from

shareholder communications and offer documents relating to the

management to the Board on the satisfaction of the pre-conditions

implementation of Trading Among Farmers (“TAF”) and to meet

(the “Management Report”).

the objectives of the Committee approved by the Board including

The Committee’s views on the specific responsibilities of the

assisting the Board to ensure that:

Committee described in its Terms of Reference are also set out in

(a) In light of assurances that have been given by the Board and

the body of our report.

management to Fonterra shareholders, that Fonterra will

A summary of the Committee’s findings on the pre-conditions and

continue to be 100% farmer controlled and owned following

100% Farmer Control and Ownership is as follows:

the implementation of TAF; (b) The Fonterra directors fulfil their duties in relation to TAF and

1.2 Satisfaction of the Pre-conditions

appropriate due diligence is undertaken at each remaining stage of the implementation of TAF and the Board has

Prior to the launch of TAF, five pre-conditions must be satisfied.

adopted a due diligence process that is appropriate in the

These are set out in clause 49.2 of Fonterra’s “Form A” Constitution

circumstances, robust and defendable;

which is currently in effect (the “Form A Constitution”). The first four of these pre-conditions (which the Board is required to

(c) The Board’s objectives in proposing TAF and the preconditions to commencement of TAF contained in the

resolve, have been satisfied in order to enable Fonterra’s Form B Constitution to come into effect and TAF to be implemented)2 are:

Fonterra Constitution (the “pre-conditions”) have been addressed in a manner satisfactory to the Board; and

(a) Pre-condition 1: A satisfactory and functioning Authorised Fund with the necessary features and size to ensure trading

(d) The Board can provide appropriate formal assurances to the

in Fund units will be established.

Shareholders’ Council that key issues raised by the Council have been addressed and that TAF is consistent with the co-operative principles endorsed by the Shareholders’ Council.

(b) Pre-condition 2: A Fonterra Shareholders’ Market (“FSM”) that is a reliable and effective platform for the trading of Co-operative shares will be established.

This interim report addresses the objectives of the Committee listed above. In the case of objectives (b) and (d), the report addresses these matters as of the date of this report since the due diligence process and interaction with the Shareholders’ Council will continue up to the launch of TAF. Certain other objectives of the Committee stated in the terms of reference of the Committee (“Terms of Reference”) will be addressed in a final report to the Board prior to the issuance of offer documents.1

(c) Pre-condition 3: All changes to legislation that are necessary to facilitate TAF are in place. (d) Pre-condition 4: All necessary waivers, approvals, consents and confirmations for TAF have been obtained. The Committee has concluded that pre-conditions 1 and 2 are able to be satisfied at the date of this report and that pre-conditions 3 and 4 are able to be satisfied (subject to planned further work outlined in Section 8.1 of this report).

1 The Committee is also required to assist the Board to ensure that: (i) all documents sent to

shareholders and the offer documents relating to Fonterra shares and the units in the Fonterra Shareholders’ Fund comply with all relevant legislation; are, in all material respects, accurate and not misleading and do not omit any material information; and provide all information reasonably necessary for shareholders to form a reasoned judgement on the proposals, and (ii) TAF is consistent with communications made to Fonterra shareholders and other stakeholders including the New Zealand Government. The Committee considers that these are matters that are more appropriately addressed in the final report to the Board given the status of the TAF implementation process (including the fact that the offer process has only just commenced).

2 The fifth pre-condition requires support from 50% or more of members of the Fonterra

Shareholders’ Council to the Board’s resolution to bring the “Form B” Constitution in to effect and therefore implement TAF.

3

1.3 100% Farmer Control and Ownership

Under the Terms of Reference, the Committee is required to provide a final report to the Board (the “Final Report”) prior to issuance of

The Committee has concluded that implementation of TAF as

the offer documents (currently planned for November 2012).

described in the Blueprint will be consistent with the statement regarding 100% farmer control and ownership of the Co-operative contained in Appendix 1.

1.4 Due Diligence Process and Summary of Issues Identified The Committee and its advisors are satisfied that a robust and comprehensive due diligence process has been undertaken to date. A number of issues have been identified by the Committee’s advisors during this process. The Committee is satisfied that these issues have been suitably addressed, or will be suitably addressed

3 Committee Process and Approach 3.1 Overall Due Diligence Approach In order to meet its obligations under the Terms of Reference, the Committee adopted the following general process: (a) The Committee approved a due diligence structure and established a comprehensive work plan; (b) The Committee appointed a dedicated secretary (who is

ahead of the launch of TAF.

a senior member of Fonterra’s legal team) and a project

The Committee’s advisors were given the opportunity to review

manager to manage the work of the Committee;

and comment upon this report. The advisors’ comments have been incorporated in this report where appropriate.

2 The Committee 2.1 Establishment of the Committee The Committee was established in October 2011 and formally approved and ratified by a resolution of the Board passed on 13 December 2011. The Terms of Reference of the Committee as adopted by the Board of Fonterra by a resolution passed on 13 December 2011 are attached as Appendix 2. The Terms of Reference require that the Committee contains three

(c) The Committee appointed leading independent advisors to assist it in the due diligence process who were given access to all relevant documentation relating to TAF; (d) The Committee held regular meetings with its advisors; (e) Each advisor was required to provide regular written or verbal reports to the Committee on the status of the advisor’s work and issues raised by the advisor; (f) The Committee maintained a comprehensive issues list that enabled the Committee to monitor issues raised by the advisors and the status of those issues; and (g) The Committee reviewed the Management Report.

farmer-elected Directors and two appointed independent Directors. The

Aspects of the Committee’s due diligence approach are described

members of the Committee are John Waller (Committee Chairman),

in more detail below.

David Jackson, John Wilson, Jim van der Poel and Nicola Shadbolt.

2.2 Role The role of the Committee is to review proposals, processes, communications, and offer documents relating to the implementation of the changes to the capital structure of Fonterra known as TAF and to assist the Board in ensuring certain matters set out in the Terms of Reference are addressed.

2.3 Reporting The Committee is required to provide various reports to the Board as set out in the Committee’s Terms of Reference. This report is an interim report on certain matters which the Board is required to consider at its meeting on 22 May 2012 prior to the enactment of the legislative changes to the Dairy Industry Restructuring Act 2001 (“DIRA”) required to implement TAF. 4

3.2 Work Plan

relevant documentation that they requested. Advisors were also given full access to, and an opportunity to discuss issues with,

The Committee adopted a comprehensive work plan describing

members of management and Fonterra’s advisors involved in the

the various due diligence work streams to be addressed by the

TAF implementation process.

Committee and its advisors. The Committee’s advisors provided input on the scope of the work plan. The work plan identifies the following critical work streams: (a) Co-operative Model

3.5 Meetings of the Committee The Committee met formally on the following dates: 18 October 2011, 27 October 2011, 14 November 2011, 9 December 2011,

(b) Milk Price

17 February 2012, 24 February 2012, 20 March 2012, 20 April 2012

(c) Process

and 14 May 2012.

(d) Legal Issues

The Committee’s advisors attended all meetings of the Committee

(e) Financial/Markets (including Scenario Analysis)

other than the initial meeting of the Committee after they had been engaged by the Committee.3 Representatives from Fonterra

(f) Taxation

management also attended the meetings of the Committee.

(g) Constitutional

In addition to the meetings listed, the Committee and advisors

(h) Control/Ownership (i) Fall-Back Plans

attended a meeting of the Capital Structure Committee on 8 February 2012 at which Fonterra’s capital markets advisors, Oliver Wyman, presented and discussed a paper on the role of

(j) Legislation/Regulation

the Registered Volume Provider (“RVP”). At this meeting, the

(k) Satisfaction of Pre-conditions

Committee and advisors had the opportunity to discuss this paper with representatives of Oliver Wyman. The Committee

(l) Blueprint The work plan also identifies the time frame for addressing the

and its advisors also attended the meeting of the Capital Structure Committee on 12 March 2012 at which Fonterra’s TAF

various work streams, actions and documents relating to the work

capital markets advisors, Rothschild and Cameron Partners

streams, and the advisor or advisors with primary responsibility for

(“Rothschild/Cameron”), presented papers on launch of the

addressing each work stream.

Fonterra Shareholders’ Fund (the “Fund”) including an indicative process for launching the Fund, management of Fund size, and

3.3 Appointment of Advisors

unwind provisions. The Committee and its advisors were given the opportunity to discuss these papers with Rothschild/Cameron

The Committee appointed independent legal, tax, financial and

at the meeting. At the 12 March meeting of the Capital Structure

industry advisors to review and report on certain due diligence

Committee, Professor Michael Cook, the Robert D. Partridge

matters. These advisors are some of New Zealand’s leading

Professor of Co-operative Leadership, Division of Applied Social

experts in their respective fields. The Committee entered into an

Sciences, University of Missouri, Columbia, Missouri, also gave

engagement letter with each of the advisors which described the

a presentation on co-operatives that have changed their capital

preliminary scope of the due diligence work to be undertaken by

structure and the Committee and advisors were able to discuss

the advisor. The Committee confirmed with each advisor that they

aspects of the presentation with Professor Cook at the meeting.

had no conflict in connection with the performance of their work for the Committee. A list of the advisors and their role in the due diligence process is described in more detail in Section 4 below.

3.6 Issues List The project manager for the Committee maintained a comprehensive

3.4 Information Shared with Advisors

issues list with respect to the various due diligence work streams that enabled the Committee to monitor issues raised by the advisors

Management and the Committee have provided detailed project

and the status of those issues. As issues were addressed by

information (including copies of the Blueprint which outlines

management and its advisors, the “closed issues” were removed

the key requirements for TAF) to the Committee’s advisors. The

from the list, and the status of resolution of the issues and

Blueprint was the primary document reviewed by the advisors in

management responses and actions were also incorporated in the

the due diligence process. Other information (including copies of

issues list.

management papers and reports and other relevant documents) was provided to the advisors who were also provided with all

3 Robin Oliver and Mike Shaw only attended the meetings of the Committee on 20 April 2012 and 14 May 2012. Alan Galbraith only attended the meetings of the Committee on 27 October 2011, 14 November 2011 and 20 April 2012.

5

A summary of the major issues identified and the status of those

4.2 Role of Advisors

issues is provided in Section 5 below. The Committee is satisfied that the outstanding issues can be addressed ahead of the launch

The advisors were asked by the Committee to look at additional

of TAF.

aspects of the implementation of TAF under the various work streams in the work plan. In summary, the Committee has

3.7 Review of Shareholders’ Documents

requested its advisors to: (a) Review the core aspects of the implementation of TAF

It is apparent that before the launch of TAF and the release of

and related documentation, reports and advice including

the formal documents there will be a number of communications

the Blueprint;

about TAF by Fonterra to shareholders and/or the public. These should be reviewed by the Committee. Because of the limited time within which communications of this nature must be reviewed, the Committee has put in place a process whereby they will be reviewed on behalf of the Committee by the Chairman and by such Committee members and/or advisors as the Chairman selects.

(b) Provide input on the due diligence work streams to ensure that the scope of the Committee’s due diligence process was appropriate and comprehensive; (c) Provide comments on material TAF implementation documentation and identify any material issues relevant to TAF;

4 Advisors and their Role 4.1 Advisors

(d) Report to the Committee on the issues identified; (e) Meet with the Committee, and management and its advisors to discuss any issues identified and, where relevant, to suggest

The Committee engaged the following advisors to assist it in

resolution of these issues or changes to TAF implementation

carrying out its due diligence review:

documentation;

(a) Murray Gough, a former Chief Executive Officer of the New Zealand Dairy Board, who was primarily focused on the co-operative model, milk price, legislation/regulation, constitutional, and fall-back plans work streams; (b) Colin Giffney, Principal of Giffney & Jones, a corporate advisor, member of the Financial Markets Authority and Deputy

(f) Provide a view on the satisfaction of pre-conditions and other responsibilities of the Committee; (g) Provide a view on whether the issues required to be addressed by the Committee in this report have been addressed in the implementation of TAF to date; and (h) Provide a general view on the due diligence process.

Chairman of the Takeovers Panel, who was primarily focused on the financial/markets work stream;

In addition, at the request of the Committee, Alan Galbraith and Paul Oldfield have provided legal opinions relating to the

(c) Paul Oldfield, Director at Harmos Horton Lusk Limited, an experienced commercial lawyer, who was primarily focused

statement concerning 100% farmer control and ownership contained in Appendix 1.

on the legal issues and legislation/regulation work stream; The Committee’s advisors provided comments on various material (d) Eric Lucas, Partner at PricewaterhouseCoopers (“PwC”), who

TAF documents (including versions of the Blueprint) and where

was primarily focused on the co-operative model, milk price,

appropriate these comments were incorporated into

financial/markets and fall-back plans work streams;

these documents.

(e) Paul Nickels, Partner at PwC, who was primarily focused on review of the trading platform and processes work stream; (f) Robin Oliver, Director at OliverShaw and former Deputy Commissioner of the Inland Revenue Department, and Mike Shaw, Director at OliverShaw and a former senior tax partner at Deloitte, who jointly led the taxation work stream; and (g) Alan Galbraith QC, who was primarily involved in aspects of the legal issues, constitutional, and control and ownership work streams. Brief biographies of the Committee’s advisors are attached as Appendix 3.

6

4.3 Reporting The Committee required its advisors to deliver reports on relevant work streams in accordance with the project timetable. The reports contained a description of all material issues and questions which were still outstanding. The advisors were also asked to provide reports on their due diligence work to date to the Committee in connection with the preparation of this report.

5 Major Issues Identified A summary of the major issues identified by the Committee’s advisors, together with the status of those issues, is set out below. The issues have been grouped under each of the due diligence work streams.

5.2 Milk Price Given the absence of a market price for farmgate milk in New Zealand, the basis on which the Milk Price is calculated and governance over the Milk Price setting process will be of fundamental importance to farmers and external investors. It is fundamental that the current process is robust and defendable in order to minimise the risk of challenge or adverse farmer or

5.1 Co-operative Model

investor sentiment weighing on TAF.

Reports from Professor Cook and PwC highlighted a number of

PwC undertook a high level review of the Milk Price Manual.

issues experienced by other co-operatives that had undertaken

Overall, PwC concluded that they do not consider there to be any

capital structure changes. While the TAF structure differs from

material changes required to Fonterra’s current approach and

all those in the comparative sample, some learnings can be taken

do not consider there to be a more appropriate approach to set

from them. In particular, the reports discussed examples where

the Milk Price under TAF. In reaching this view, PwC made the

the rights of external investors invited to invest in a co-operative

following observations:

were subsequently expanded beyond those originally envisaged.

i. The Milk Price Manual is the result of many years of

However, in many situations such examples were the result of a

development of the key Principles and detailed rules

combination of factors not purely related to the capital structure

guiding their application which are used to calculate the

change, including major changes in strategy, aggressive use of

Milk Price;

leverage, and poor governance. ii. In PwC’s opinion a comprehensive process and While TAF is unique, relevant observations from these reports to

governance structure (central to which are the Milk

help minimise the prospect that farmer control is put at risk were

Price Panel and independent Milk Price Group) has been

the need to maintain:

put in place to ensure that the Milk Price is calculated

i. The Fund size as low as practically possible to minimise

in accordance with the Principles and that all areas of

any exposure to the potential conflict between Farmgate

uncertainty are thoroughly reviewed and independently

Milk Price and profits, and to ensure Fonterra’s ability to

verified so that the Milk Price is as robust and accurate

buyout the Fund if it does not perform as intended;

as possible;

ii. Strong responsible governance and prudent leverage

iii. Fonterra’s Milk Price setting process and supporting

post TAF to avoid risks associated with aggressive debt-

structures have been set up so as to ensure, as far as

funded expansion; and

possible, that any areas of subjectivity do not lead to

iii. A close relationship between ownership interest and supply to maintain the co-operative nature of the enterprise. The Committee and its advisors were actively involved in discussions with management regarding the Board’s proposed Fund Risk Management Policy to help address the observations noted above (discussed further in Section 5.5 below).

bias. However, it is not possible to completely eliminate all areas of subjectivity from the calculation of the Milk Price, and it is self-evident that small changes in the Milk Price can have a material impact on the level of distributable profit; iv. The most fundamental control over the Milk Price setting process is the Fonterra Board taking a long term view and understanding clearly the need for an accurate

The sale of economic rights of some wet shares to the Fund will

split between Milk Price and distributable profit in order

result in some farmers having an economic interest in Fonterra

for Fonterra to make appropriate investment decisions

that is not fully aligned with their supply. However, farmers already

and assessments of its underlying performance; and

have the ability to buy shares above the share standard (i.e. dry shares), and TAF will now allow some farmers to hold shares below the share standard. Voting will remain aligned with production. The Committee is satisfied that by keeping the Fund size low, ownership interest will remain closely aligned with supply.

v. The Board will need to ensure that appropriate disclosure and transparency is maintained to maximise the level of stakeholder confidence in the process. In addition, two of the Committee’s advisors reviewed the level of Milk Price disclosure to determine whether it is appropriate. They have suggested a number of minor improvements to the Farmgate Milk Price Manual and Milk Price Statements designed 7

to further strengthen the integrity of the Milk Price. These will

5.5 Financial/Markets

be considered by the Milk Price Group, and will form the basis of recommendations to the Milk Price Panel. If accepted, they will

A number of potential issues were identified in this work stream.

be included in the next version of the Milk Price Statement to be

These can be grouped as follows:

released in September 2012. Comments in relation to the Milk Price Manual will also be considered as part of the next update of the Manual. These advisors have concluded that these two

i.

Share Price;

ii. Fund Size;

documents provide full and appropriate disclosure to the market

iii. Managing Fund Size;

of the principles and procedures followed in setting the Farmgate

iv. Fund Launch; and

Milk Price. v. Fund Wind-up. The Committee is satisfied that issues associated with the Milk Price have been considered and appropriately addressed.

Share Price The initial Fund unit price and subsequent trading price will

5.3 Process

be important to the success of TAF. A price materially below the current Fair Value Share Price of $4.52 may not be viewed

PwC has reviewed the internal control environment, such as the

favourably by farmers. Conversely, a higher unit price may put

IT systems and trading platforms under which TAF will operate to

pressure on the Co-operative’s ability to attract new suppliers.

ensure it is appropriate, including assessing those aspects that will be operated under contract by third parties.

The final initial unit price will be determined during the Fund launch process.

PwC has confirmed that the designed internal controls are suitable. A project plan has been developed comprising additional validation

Fund Size

and testing activities to be undertaken prior to launch. PwC has confirmed that they have no reason to consider that the remaining

The Fund needs to be large enough to ensure appropriate liquidity

project activities set out in this plan will not be delivered in

and price discovery.

accordance with the planned timetable.

The Dairy Industry Restructuring Amendment Bill (the “DIRA Bill”) introduced to Parliament on 27 March 2012 requires a minimum

5.4 Legal Issues

Fund size of $500m, which at an issue price of $4.52 implies a Fund size of approximately 8% of Fonterra’s total issued shares. Based

A number of legal issues have been raised by Mr Oldfield during

on analysis undertaken by Fonterra’s capital markets advisors,

the due diligence process. Where relevant he has discussed these

Rothschild/Cameron, which was reviewed and discussed by the

issues with Fonterra’s legal advisor, Russell McVeagh, and sought

Committee and its advisors, the Committee is satisfied that a Fund

to resolve them by agreement.

size of at least $500m should provide sufficient liquidity and

One legal issue remains outstanding in relation to the proposed

price discovery.

market operator agreement with the NZX. The original terms of the proposed operator agreement could have permitted the NZX to

Managing Fund Size

issue rulings and waivers with respect to the FSM Rules in conflict

The Fund size is intended to be dynamic, as farmers and the RVP

with the Fonterra Constitution. The NZX has agreed to include

will have the ability to sell economic rights of shares to the Fund

language in the operator agreement that would require Fonterra to

(which will result in units being issued) and to convert units into

consent to any such waivers or rulings provided such consent is not

shares (which will result in units being cancelled). The Form B

unreasonably withheld. The terms of the market operator agreement

Constitution provides that the size of the Fund shall not exceed 25%

still need to be approved by the Financial Markets Authority.

of all Co-operative shares on issue. However, it is critical for the

Certain exemptions or waivers from regulators which may need

Board and management to ensure that the Fund size remains within

to be granted to facilitate TAF remain outstanding, however this

manageable limits well below this threshold. Appropriate controls

is due to the structure of the offer and of the offer documents not

and processes to manage the Fund size are therefore required.

being settled to the degree necessary to allow these exemptions or

The proposed Fund Risk Management Policy sets out parameters

waivers to be fully identified and applications made.

under which the Fonterra Board will manage the size of the Fund. Central to this is a target actual Fund size of 7-12% of issued shares and a target potential Fund size of 7-15% of issued shares. In determining the target actual and potential Fund sizes, a balance

8

has been struck between ensuring sufficient liquidity and price

The DIRA Bill includes a provision that Fonterra must not engage in

discovery while also ensuring the Fund does not grow to a size

any conduct that limits the ability of unit holders to liquidate the

larger than it needs to be for the purposes of TAF.

Fund. Fonterra’s submissions to the Primary Production Committee

The proposed Fund Risk Management Policy sets out actions that must be taken by the Board should the actual Fund size grow beyond 12% of Fonterra’s issued shares or the potential Fund size grow beyond 15% of issued shares, including the need to consult with the Shareholders’ Council. It also includes provisions in relation to balance sheet (financial) capacity to be maintained to manage the

on the DIRA Bill made it clear that this provision in its current form cannot be accepted, and would prevent Fonterra from launching TAF. Accordingly Fonterra has required that this provision be removed or amended. Resolution of this issue is therefore dependent on changes to this provision in the DIRA Bill requested by Fonterra in its submissions on the DIRA Bill.

Fund by buying back units (or dry shares) that exceed the threshold. Management has undertaken scenario analysis to determine an appropriate level of balance sheet capacity for this purpose. This analysis will be required to be updated at least annually. The Committee and its advisors have had considerable discussion with management regarding the proposed Fund Risk Management Policy. The Committee is satisfied that the policy is appropriate to manage the Fund size within appropriate bounds, and to ensure action is taken to prevent the Fund reaching a size that might threaten farmer control over the Co-operative.

5.6 Taxation OliverShaw has undertaken a review of any tax related issues associated with TAF and have tested the robustness of TAF from a tax perspective, and concluded that: (a) All relevant tax matters have been properly considered and addressed; (b) Fonterra has received advice which addresses all of the tax issues relevant to TAF and has complied with all recommendations in that advice; and

Fund Launch

(c) Fonterra has obtained, or at this stage applied for, all

A framework has been developed for launching the Fund. Preference

appropriate rulings from the Inland Revenue Department

will be given to existing wet and dry shares held by farmers.

addressing all tax issues for which a ruling would be appropriate.

However, Fonterra retains the discretion to meet any shortfall by issuing new shares to the Custodian which will hold the economic

5.7 Offer Documents and Prospectus

rights of those new shares for the Fund in order to ensure a minimum Fund size of $500m. Precisely how the Fund will be launched therefore cannot be determined at this stage, as it will depend on the extent to which farmers tender their shares into the offer. Joint Lead Manager investment banks (“JLMs”) were appointed on 12 April 2012 and are now working with management to put in place a detailed transition plan to Fund launch. This will include an assessment of the most appropriate offer process and structure

Preparation of offer documents and prospectus has only just commenced. While no issues have been identified at this early stage, the timetable for completing the required offer documents is tight and will require significant management time. The Committee will oversee and monitor the preparation and review of the offer documents and provide comfort to the Board as to the content of the documents.

to help ensure a successful launch of TAF and avoid any gaming opportunities. The Board has recently approved a moratorium on the issue of additional dry shares until the launch of TAF. Accordingly this work stream remains work in progress. No issues have been identified at this early stage. Fund Wind-up It is imperative that Fonterra does not have any obligation to buy out the Fund, nor accept any new fund or investor, should unit holders wish to liquidate the Fund. Were this not the case, then TAF would have addressed its fundamental purpose of removing

5.8 Fall-Back Plans Fonterra’s ability to unwind or buy back the Fund will mitigate the risk that TAF does not perform as intended. Fonterra will retain a right to buy out the Fund exercisable in the first 24 months following launch upon 12 months prior notice to the unit investors. Management is working with the JLMs to establish appropriate valuation parameters for this right. The Committee is satisfied that the proposed fall-back plans in relation to Fonterra’s ability to unwind the Fund are appropriate.

redemption risk under DIRA but would have introduced a new risk similar to a compulsory redemption obligation, and Fonterra would be exposed to the actions of Fund investors.

9

5.9 Legislation/Regulation As set out in the Management Report, Fonterra management and its advisors have reviewed the TAF provisions in the DIRA Bill and consider that they will allow TAF to be implemented, subject to certain amendments described in Fonterra’s submission to the Primary Production Committee in relation to the DIRA Bill. Some of these amendments are intended to improve the workability of TAF provisions, and the Committee considers that TAF could be implemented even if these particular amendments were not made. However, the Committee considers that there are a number of amendments that must be made to the TAF provisions before the Board could formally resolve to implement TAF. Ultimately, Parliament will decide on the final wording of any amendments to the TAF provisions in the DIRA Bill, and the Board will need to

to be made to the DIRA Bill to allow TAF to be implemented. With respect to pre-condition 4, Mr Oldfield’s report describes certain exemptions or waivers from regulators which may need to be granted to facilitate TAF. Mr. Oldfield notes that Fonterra’s legal advisor, Russell McVeagh, has prepared an application to the Financial Markets Authority seeking various exemptions from the Securities Act and is also requesting the Minister of Commerce to make regulations exempting parties from various provisions of the Securities Markets Act necessary to enable the effective operation of the FSM and Fund structure. Mr. Oldfield agrees with the view of Russell McVeagh that the structure of the offer, and of the offer documents, has not yet settled to the degree necessary to allow other necessary exemptions or waivers to be fully identified and applications made.

subsequently determine whether it considers that all necessary amendments have been made. The Committee is satisfied that Fonterra’s submission to the

6.3 Feedback on the Responsibilities of the Committee

Primary Production Committee on the DIRA Bill addresses the key

The Committee was advised that the matters required to be

issues with respect to the DIRA Bill.

addressed by the Committee as set out in Section 7 of its Terms of Reference have been and are being addressed in a timely and

5.10 Summary of Issues Identified

appropriate manner. A concern was raised in relation to a risk of misunderstanding about TAF’s ability to provide Fonterra with

The Committee is satisfied that a robust and comprehensive due

additional capital. It will be important to ensure all audiences

diligence process has been put in place.

understand TAF’s limited role in that regard.

A number of issues have been identified by the Committee’s advisors during this process. The Committee is satisfied that these issues have been suitably addressed, or are likely to be suitably

6.4 Feedback on 100% Farmer Control and Ownership

addressed ahead of the launch of TAF. Messrs. Oldfield and Galbraith have each provided a legal opinion

6 Advisor Reports 6.1 Key Feedback and Conclusions

relating to the 100% farmer control and ownership statement contained in Appendix 1.

7 Scenario Analysis

Key issues identified by the advisors have been summarised in the previous section. The advisors have confirmed that they consider the due diligence process to date has been appropriate for the purposes of TAF, and that they have had sufficient access to management and its advisors in order to address issues raised.

6.2 Feedback on Pre-conditions

Fonterra’s Management has stress tested TAF under various scenarios in order to understand the impact on potential Fund size and the value of unit purchases by Fonterra required in order to maintain the Fund within the target range. For each scenario, management has also determined the likely estimated total redemption value if TAF does not proceed (the “Status Quo”) in order to compare the relative impacts of TAF and the Status Quo on Fonterra’s balance sheet.

The Committee’s advisors have confirmed that they are not aware

The scenario analysis is applied over a five year time period starting

of any reasons why pre-conditions 1 and 2 cannot be met.

with the 2012/13 season. The two key variables for the scenario

With respect to pre-condition 3, the DIRA Bill does not in its present form

analysis are annual New Zealand milk production and Fonterra’s

contain the amendments necessary to facilitate TAF. The Committee’s

share of annual New Zealand milk production. Parameters for these

advisors have confirmed that Fonterra’s submission to the Primary

two key variables were provided by Fonterra’s Milk Supply group

Production Committee addresses all changes which in their opinion need

based on the latest information available. Other variables include Fonterra’s share price and financial performance over the period.

10

The analysis assumes a maximum potential Fund size of

of

(in the case of Status Quo) by Fonterra will likely be required at the

issued shares (i.e. below the upper bound of the potential target

end of the

range of -

by Fonterra required under TAF will be significantly less than under

of issued shares), with unit purchases undertaken

by Fonterra if the Fund grows above this level, and a target Dry share percentage of at least

/

season. However, the extent of purchase of units

the Status Quo.

of issued shares.

The analysis was supported by an analysis of , that indicate that to protect against

simulation runs

of all potential outcomes

over the year period, the balance sheet cover of NZ

-

Committee Report/ Recommendations

m

required under TAF to manage Fund size is significantly lower

Based on the activities undertaken by the Committee to date, the

than the NZ

current version of the Blueprint, the observations contained in

-

m of cover required to manage redemption

risk under the Status Quo (with the range depending partly on

the Management Report (and appendices), the reports from the

assumptions about share price).

Committee’s advisors and advice from the advisors during the due

Five discrete scenarios have been assessed by management as follows:

diligence process to date, the Committee’s unanimous opinions in respect of the matters set out in the Terms of Reference are as follows.

(a) Base Case - continuation of current New Zealand long term milk production growth (approximately .

per annum) and

gradual loss of Fonterra’s market share (approximately . over years);

Satisfaction of the Pre-conditions In order to launch TAF, five pre-conditions must be satisfied. These are set out in clause

(b) Temporary Drought - as per the Base Case except for a drought experienced in production (

/

four pre-conditions which the Board must resolve have been

resulting in a fall in milk

satisfied are as follows:

season used as a proxy), with milk

production recovering in the following season;

(a) Pre-condition

established) as an authorised fund, and the Board is satisfied

except for a rapid decline in Fonterra’s market share from at present to approximately

in

;

(d) Downside Case - flat growth in New Zealand milk production combined with rapid decline in Fonterra’s market share (as per the scenario in (c) above). Management considers this scenario to be highly unlikely; and (e) Upside Case - strong growth in New Zealand milk production of approximately

The Fund has been established (or will, at

or about the commencement of Trading Among Farmers, be

(c) Rapid Decline in Market Share - as per the Base Case approximately

. of the Form A Constitution. The

per annum and flat market share.

that the Fund has, or is reasonably likely to have, appropriate mechanisms, rules, and governance structures, and the Board considers that such Fund is reasonably likely to have sufficient number and dispersion of securities on issue so as to facilitate trading in those securities. (b) Pre-condition

The FSM has been established or will (at

or about the commencement of Trading Among Farmers) be established, for trading of Co-operative shares in the manner

Management’s key finding was that TAF provides farmers and

contemplated by Fonterra’s Form B Constitution and the

Fonterra with reduced balance sheet exposure, less obligations and

Board is satisfied that such Market is reasonably likely to

more options. In particular, management’s analysis shows that under

have appropriate mechanisms, rules, and governance

each of the above scenarios Fonterra’s balance sheet exposure is

structures (including as to liquidity, market conduct and

significantly lower under TAF relative to the Status Quo. This is due to

disclosure), and the Board considers that sufficient number

TAF replacing Fonterra’s current redemption risk with a less onerous

and dispersion of Co-operative shares are or will be on issue,

Fund size management risk. Under TAF, the potential Fund size is

such that, in the Board’s opinion, the Market is reasonably

able to fluctuate within the target limits and action is only required

likely to provide a reliable and effective platform for the

once it approaches those limits. The introduction of a three season

trading of Co-operative shares.

rolling average share standard in the

/ season also reduces the

variability of the share standard, further reducing Fonterra’s balance sheet exposure to an event (e.g. drought) in any one year. For each of the scenarios New Zealand milk production is expected to fall in the

/

season. This reflects the latest view of the

Milk Supply group following the strong production up

on

/

season (i.e. milk

/ season). On this basis, management’s

(c) Pre-condition

All necessary amendments to legislation

including DIRA which the Board considers necessary to facilitate Trading Among Farmers have been enacted. (d) Pre-condition

All waivers, approvals, consents or other

confirmations from regulatory and other bodies the Board considers are required to facilitate Trading Among Farmers have been obtained, on terms acceptable to the Board.

analysis shows that the purchase of units (in case of TAF) or shares 11

Pre-condition 1: The Committee has concluded that this pre-condition

i

is able to be satisfied as of the date of this report on the following basis:

which are awaiting approval from the FMA) and contain detailed requirements in relation to market conduct.

(a) The Authorised Fund will be the Fund as described in the Blueprint and the Fund will meet the requirements of

The FSM rules which have been agreed with NZX (but

ii

The FSM will be a registered market and will be operated as a

the definition of an Authorised Fund under the Form B

registered exchange under the Securities Markets Act

Constitution. The Fund will be a unit trust established under

1988 which will require it to adopt and comply with

the Unit Trust Act 1960.

continuous disclosure requirements.

(b) The Fund will be established at or about the launch of TAF. (c) The Fund will have appropriate mechanisms, rules and governance structures (which are summarised by management in the Management Report and described in detail in the Blueprint). The Committee’s advisors have endorsed this view. (d) Terms sheets and other documents relating to the Fund have been reviewed by Mr. Oldfield and he has confirmed that he knows of no reason why the Fund cannot be established on the terms presently contemplated at the date of this report. (e) Based on advice from Rothschild/Cameron, the Fund is reasonably likely to have sufficient number and dispersion of Fund units on issue so as to facilitate trading in those Fund units. This view is endorsed by the Committee’s finance/ markets advisors. (f) Rothschild/Cameron has advised that a Fund size of at least $500 million would provide a deep and liquid market. This view is also endorsed by the Committee’s finance/ markets advisors. (g) The Committee’s advisors have confirmed that they are not aware of any reason why this pre-condition has not been satisfied.

iii The trading platform has been developed by NZX and is based on the trading platform used by NZX for its own public exchanges. The trading platform has been independently reviewed and confirmed by Fonterra’s capital markets advisor, Oliver Wyman. iv The share registry function for the FSM will, at the launch of TAF, include appropriate controls and functionality to enable trading activity and compliance with constitutional and other limits and thresholds to be monitored. (d) Term sheets relating to the FSM have been reviewed by Mr. Oldfield and he has confirmed that he knows of no reason why the FSM cannot be established on the terms set out in the term sheets. (e) Based on advice from its advisors and advice from Fonterra’s capital markets advisors, the Committee considers that sufficient number and dispersion of Co-operative shares will be on issue such that the FSM is reasonably likely to provide a reliable and effective platform for the trading of Co-operative shares. The Committee’s advisors have endorsed this view. (f) Liquidity in the FSM will be assisted by the RVP and by the ability of farmer shareholders and the RVP to readily and without cost convert shares into units and vice-versa. The RVP will be under obligations to buy and sell shares in the

Pre-condition 2: The Committee has concluded that this pre-condition is able to be satisfied as of the date of this report on the following basis: (a) The market for trading Co-operative shares will be the FSM

continuous basis. Fonterra has sought independent advice from Oliver Wyman, a leading international advisor in this area, on how to best structure the role of the RVP to enhance liquidity in the FSM. This advice, which was reviewed and

as described in the Blueprint and the FSM will meet the

commented on by the Committee’s financial/markets advisors,

requirements of the definition of the FSM under the Form

has provided the Committee with confidence that farmers will

B Constitution. The FSM will be operated by NZX Limited

be able to buy and sell shares in the FSM when they wish at

(“NZX”).

prices that reflect a well informed and liquid market.

(b) The FSM will allow for trading of Co-operative shares in the manner set out in the Form B Constitution. (c) The FSM has appropriate mechanisms, rules and governance structures (including as to liquidity, market conduct and disclosure) which are summarised by management in the Management Report and described in detail in the Blueprint. These mechanisms, rules and structures include:

12

FSM within a defined maximum spread on a substantially

(g) The Committee’s advisors have confirmed that they are not aware of any reason why this pre-condition has not been satisfied.

Pre-condition 3: The Committee has concluded that this

8.2 100% Farmer Control and Ownership

pre-condition is able to be satisfied provided that certain critical amendments to the DIRA Bill which were requested by Fonterra

The Committee has also been requested to provide a view on

in its submission to the Primary Production Committee are

whether Fonterra will continue to be 100% controlled and owned

made to the DIRA Bill prior to enactment. The provisions of the

by its farmer supplier shareholders following the implementation

DIRA Bill that management consider must be amended to enable

of TAF. The Committee has concluded that implementation of TAF

implementation of TAF, the concerns of Fonterra management

as described in the Blueprint will be consistent with the statement

with such provisions, and Fonterra’s proposed amendments

regarding 100% farmer control and ownership of the Co-operative

to these provisions are described in detail in the Management

contained in Appendix 1. This view has been supported by opinions

Report. If these amendments are made to the DIRA Bill prior to

from Alan Galbraith and Paul Oldfield on this issue, and the

enactment, the Committee are of the view that this pre-condition

conclusions reached by management in the Management Report.

will be satisfied on an unqualified basis prior to the launch of TAF. The Committee believes that it will not be possible to implement TAF unless these amendments to the DIRA Bill are made. The Committee’s advisors have endorsed this view. Pre-condition 4: The Committee has concluded that this pre-condition is able to be satisfied (subject to the qualifications

8.3 Other Matters to be Addressed by the Committee under the Terms of Reference The Terms of Reference require the Committee to report to the Board in respect of a number of specific issues. Set out below is:

outlined below) as of the date of this report. The Committee notes

i. A description of each issue;

that certain waivers, approvals, consents and other confirmation

ii. The view of the Committee in respect of that issue; and

from regulatory and other bodies which are required for the implementation of TAF (which are described in detail in the

iii. The grounds on which the Committee’s view is based.

Management Report) have not yet been obtained. To the extent

The Committee requested its advisors provide their views on

that these waivers and approvals are necessary to enable the

whether they consider that these requirements have been met in

structure of the FSM (including the RVP) and Fund to operate

the proposed structure of TAF. The Committee’s conclusions below

properly, applications for these waivers and approvals will be filed

take into account these views and the views of management on

with the FMA and the Minister of Commerce. Other exemptions

certain of these objectives as detailed in the Management Report.

and waivers relating to the structure of the offer of units in the Fund and the offer documents have not yet been prepared or filed because in the view of Russell McVeagh, legal advisor to Fonterra,

8.4 Board Objectives

the structure of the offer documents and offering process has not

The Committee is required to report on whether the following

yet been settled to the extent required to allow these exemptions

objectives of the Board set out in the Terms of Reference are

or waivers to be fully identified and applications made. Mr. Oldfield

addressed by the implementation of TAF. As of the date of this report:

concurs with this view. In addition, OliverShaw have noted that Fonterra has obtained, or at this stage applied for, all appropriate

(a) Maintaining Fonterra as a sustainable co-operative with voting rights linked to milk supplied to Fonterra.

tax rulings from the Inland Revenue Department addressing all tax issues relating to TAF for which a ruling would be appropriate.

The Committee has concluded that this objective has been

If the required waivers, approvals, consents, tax rulings and other

met. Following the implementation of TAF as described in the

confirmations identified required for the implementation of TAF

Blueprint, voting rights in the Co-operative will remain tied to

are obtained, the Committee considers that pre-condition 4 will be

milk supply. The Management Report highlighted certain areas

able to be satisfied. The Committee and its advisors have no reason

where this fundamental concept has been enhanced and protected

to believe that such waivers, approvals, consents, tax rulings and

in the Form B Constitution. The Committee considers that TAF

other confirmations will not be obtained.

will enhance the sustainability of the Co-operative by providing permanent share capital which will enable the Co-operative to effectively execute its strategy. (b) Removing Fonterra’s obligation to redeem shares. This provides permanent share capital on which the business can operate and invest.

13

The Committee has concluded that this objective has been met as of the date of this report. If TAF is implemented in accordance with the requirements of the DIRA Bill, Fonterra will not be under any obligation under DIRA to redeem Co-operative shares. (c) Ensuring Fonterra has sufficient permanent share capital to give

iii. “Super-users” will be trained to train farmers and rural professionals; and iv. Ongoing support from Fonterra Area Managers and TAF team specialists will be provided at informal meetings, farmer meetings and Field Days.

Fonterra the funding needed to continue to have the ability to drive the highest sustainable returns to farmers.

Consistent with our conclusion on pre-condition 2 relating to the

The Committee has concluded that this objective has been met.

FSM, TAF will provide a platform for the prices of Co-operative

Under TAF, Fonterra will have a permanent share capital base since

shares to reflect a well informed and liquid market. The FSM will be

it will no longer be required under DIRA to redeem Co-operative

a registered market and will be operated as a registered exchange

shares. This will improve Fonterra’s ability to drive the highest

under the Securities Markets Act 1988 which will require it to adopt

sustainable returns for its farmers.

and comply with continuous disclosure requirements. The FSM rules will require continuous disclosure of all material information.

(d) Ensuring that the arrangements give farmers confidence that they will be able to buy and sell shares when they wish at prices

The RVP will enhance liquidity in the FSM. The RVP will be under

that reflect a well informed and liquid market.

obligations to buy and sell shares in the FSM within a defined maximum spread on a substantially continuous basis. Oliver

The Committee has concluded that this objective has been met. Farmer shareholders will have access to the FSM through multiple mechanisms including the Fencepost trading site, a dedicated 0800 number, or through use of a participating broker. It is proposed that the FSM will be open for trading shares during business hours on every business day during the year. The Committee’s finance/ markets advisors have advised that the FSM will likely provide a

Wyman, a leading advisor in this area, has provided Fonterra with advice on structuring the role of the RVP to enhance liquidity in the FSM. This advice, which was reviewed and commented on by the Committee’s financial/markets advisors, has provided the Committee with confidence that farmers will be able to buy and sell shares in the FSM when they wish at prices that reflect a well informed and liquid market.

reliable and effective platform for the trading of Co-operative shares. (e) Ensuring the arrangements produce a stable outcome in the sense Fonterra has put in place an extensive TAF training plan targeted

that they will meet the above objectives for the foreseeable future.

at farmers and rural professionals. The majority of this training will be rolled out from August 2012 until the launch of TAF. To date, the

The Committee has concluded that this objective has been met.

following training activities have taken place:

The Committee is not aware of any reason why TAF would fail to meet the objectives of TAF described above for the foreseeable

i. Informal (pre-training) meetings with farmers on TAF have been conducted by Fonterra Area Managers and/or specialist TAF project team members; ii. CDs containing a TAF trading demo and simulation

future. The Committee considers that management has undertaken appropriate and robust scenario analysis to help ensure that TAF can operate effectively in connection with a broad range of potential future circumstances and the Committee considers

are being distributed to Fonterra Area Managers and

that various TAF structures provide the Board with a means of

Councillors (system also to be available via Fencepost);

addressing these circumstances.

iii. Trading demonstration sites have been operating at all

(f) Ensuring the Board can provide appropriate formal assurances

Field Days and other farmer meetings (e.g. the Network

to the Shareholders’ Council that key issues raised by the Council

Conference);

have been addressed and that TAF is consistent with the

iv. The May 2012 TAF Booklet was distributed to all farmers explaining TAF and its structure and options to trade; and v. Fencepost material has been updated continuously, including FAQs.

co-operative principles endorsed by the Shareholders’ Council. The Committee has concluded that this objective has been met. The Committee is not aware of any key issue that has been raised by the Council to date that has not been addressed by management during the TAF implementation process to the extent

Future TAF training will include: i. TAF training on how to trade (approximately 100 workshops are planned); ii. Quick-reference guide to be provided to every farmer as a ‘how to’ guide;

that such issue can be addressed at this stage in that process. The Committee considers that TAF is consistent with the current co-operative principles of Fonterra for the reasons stated in paragraphs 1 – 5. below. In doing so, the Committee, however, notes that: (i) the Fonterra shareholders have already endorsed the construct of TAF in the June 2010 vote; (ii) the co-operative

14

principles are subject to change from time to time and may need to be updated to reflect the TAF structure; and (iii) the Fonterra shareholders have approved the issuance of dry shares to supplier shareholders. (1) Shares in the Co-operative can only be held by supplying shareholders. As discussed in connection with the

requirement of 100% farmer control and ownership, the only shareholders of the Co-operative can be farmers who supply milk to Fonterra, those people who supplied milk to Fonterra but are selling down their shares over three seasons, and the Fonterra Farmer Custodian, which will be ultimately owned and controlled by farmers who supply milk to Fonterra and hold Co-operative shares. (2) Fonterra supplying shareholders agree to the dual commitment to supply milk and invest capital. Under TAF, our supplying

shareholders will continue to be required to supply milk and provide capital to the Co-operative. (3) Supplying shareholders will be issued and must hold Co-operative

in proportion to their total milksolids supplied to the Co-operative. A particular supplier may elect to acquire additional Co-operative shares up to 200% of the share standard, however, this entitlement to purchase additional shares (and therefore increase the financial benefits allocated to the shareholder) will still be calculated with reference to the amount of milksolids supplied to the Co-operative by the relevant supplier. The Committee does not consider that these changes are inconsistent with the underlying principle.

8.5 Other Issues The Committee is required to report on the following issues to the extent relevant at this point in time in the process of the implementation of TAF: (a) The TAF Project is being properly and reasonably managed in the context of the Board’s timetable and objectives.

shares in proportion to their total milksolids supplied. The

The Committee has concluded that to date this objective has been

Fonterra “share standard” requires a supplying shareholder to hold one Co-operative share for each kilogram of milk solids obtainable from milk supplied to the Co-operative. However, the Form B Constitution introduces the concept of a three season rolling average for calculation of the level of supply and, following the introduction of TAF, the share standard will be able to be satisfied by supplier shareholders holding Co-operative shares and vouchers that retain the voting rights of shares that have been transferred to the Custodian so that economic rights can be held for the Fund. The Form B Constitution will provide that supplying shareholders may hold Co-operative shares equal to up to 200% of the required share standard (but subject to the aggregate constitutional thresholds). The Committee does not consider that these changes are inconsistent with the underlying principle since any additional shares held in excess of the share standard do not entitle the supplying shareholder to any additional voting rights or milk price entitlement.

met. The Committee considers that management is appropriately

(4) Control of Fonterra is exercised by its supplying shareholders who have voting rights in proportion to their total milksolids supplied.

As discussed in connection with the requirement of 100% farmer control and ownership, farmers who supply milk to Fonterra and who hold Co-operative shares and vouchers are the only people who can vote on Co-operative matters on the basis of and in proportion to their production and appoint and remove Fonterra Directors. (5) Financial benefits and obligations that arise from cornerstone

managing all aspects of the TAF implementation process which have been required to be undertaken to date. (b) Appropriate expert advice has been taken on key aspects of the TAF Project and that key areas for advice have not been omitted. The Committee has concluded that this objective has been met in the TAF implementation process to date. The Management Report and the Committee advisor reports indicate that suitable and appropriate levels of advice have been obtained. Additional advice will still be required during the offering process and in connection with the preparation and verification of the offer documents. (c) Management and advisors have: i. Considered all material risks in connection with the TAF Project (including any new risks that have been identified by management and advisors since their prior reports in connection with Capital Structure Stage 3 were delivered to the Board) and have developed and provided a full risk analysis and appropriate risk mitigation plans; ii. Undertaken appropriate scenario planning and stress testing in connection with the key areas of the TAF Project including the rules, structure and processes underlying the Fonterra Shareholders’ Market and the Fonterra Shareholders’ Fund. The Committee has concluded that this objective has been met. The Committee has put in place a robust and comprehensive due diligence process, and its advisors have confirmed that they have

activities are allocated to supplying shareholders in proportion

had sufficient access to management and management’s own

to their total milksolids supplied. Under TAF, the financial

advisors to discuss issues identified. Material issues identified

benefits and obligations from the Co-operative’s business will continue to be allocated to supplying shareholders

by the Committee’s advisors are summarised in Section 5 of this report, including the status of each issue. The Committee 15

is satisfied that these issues have been suitably addressed by

Adequate consideration has been given to alternatives available

management or are likely to be suitably addressed ahead of

to Fonterra, and planning has been undertaken, in the event that

the launch of TAF. For example, management has developed a

circumstances arise which:

proposed Fund Risk Management Policy with respect to the size of the Fund and the balance sheet capacity required to adequately

i. Prevent the TAF Project being implemented after it is approved; or

manage Fund size for approval by the Board. The Committee and its advisors provided material input on the terms of this policy. In addition, management has undertaken robust and comprehensive

ii. Put the Fonterra balance sheet at risk prior to the TAF

Project being implemented.

stress and scenario testing of the TAF structure (see Section 7 of

In the period leading up to the June 2010 vote, the Board

this report), trading platform and related infrastructure to date.

considered a range of alternatives to the TAF structure that was

This testing on the trading platform and related infrastructure and

approved by Fonterra shareholders in the June 2010 vote. In the

controls will continue in the period leading up to the launch of TAF.

event that TAF is not implemented, the DIRA Bill provides that

(d) All changes necessary to be made to the Fonterra Constitution to implement the TAF Project have been made and no additional changes are required to the Fonterra Constitution to successfully

Fonterra will continue to be subject to the requirement to redeem Co-operative shares as this currently exists. (f) All necessary amendments to the Dairy Industry Restructuring

implement the TAF Project in a manner consistent with the

Act 2001 and other legislative changes have been enacted to

objectives of the Board.

enable Fonterra to complete, and no changes to legislation

The Committee has concluded that this objective has been met.

will prevent the completion of, the TAF Project in a manner

Based on review of the legal advice obtained by management to

consistent with the objectives of the Board.

date, the Committee’s primary legal advisor, Mr. Oldfield, is not

The Committee has addressed this requirement in its conclusions

aware of any additional changes that are required to implement

relating to pre-condition 3. As noted in those conclusions,

TAF as presently proposed. In his report, Mr. Oldfield noted that

the Committee noted that certain provisions of the DIRA Bill

Fonterra’s legal advisors should be asked to confirm this in a formal

required to be amended to enable implementation of TAF and

legal opinion prior to the launch of TAF.

the Committee believes that it will not be possible to implement

(e) The documents provided to shareholders in connection with TAF and the offer documents: i. On the basis of legal advice received, comply with all relevant legislation; ii. Are, in material respects, accurate and not misleading and do not omit any material information; iii. Provide all information reasonably necessary for shareholders to form a reasoned judgement.

TAF unless these amendments to the DIRA Bill are made. The Committee’s advisors have endorsed this view. (g) Verification and other procedures have been established and implemented to ensure the Shareholder Documents and the offer documents comply with item (e) above. The offering process has just commenced and no offer documents have been prepared. As a result, the Committee is unable to provide a view on this requirement at this time. The Committee expects to provide its conclusions on this requirement in its Final Report to the Board to be issued prior to the formal launch of TAF

Other than the TAF proposal booklet, meeting materials and

and following completion of the preparation and verification of

constitutional changes booklet distributed to shareholders in

the offer documents and a comprehensive due diligence process

connection with the June 2010 shareholder vote (“Initial TAF

relating to the offer documents.

Shareholder Documents”) and the May 2012 TAF Booklet which has been recently distributed to Fonterra shareholders, no other material documents relating to TAF have been issued

(h) Due diligence material is appropriately filed and all statements contained in the Shareholder Documents and the offer documents are cross referenced to appropriate due diligence material.

to shareholders as at the date of this report. The May 2012 TAF Booklet was not reviewed by the Committee or its advisors prior

The Committee has concluded that this objective has been met in

to release because that was considered to be unnecessary. The

the TAF implementation process to date. The Committee expects

offering process has just commenced and no offer documents

to provide its conclusions on this requirement in its Final Report

have yet been prepared. The Committee expects to provide its

to the Board to be issued prior to the formal launch of TAF and

conclusions on this requirement in its Final Report to the Board

following completion of the preparation and verification of the

to be issued prior to the formal launch of TAF and following

offer documents and a comprehensive due diligence process

completion of the preparation and verification of the offer

relating to the offer documents.

documents and a comprehensive due diligence process relating to the offer documents. 16

9 Conclusion The Committee has seen its role as being to provide comfort to the Board in respect of the matters dealt with by this report. However, that does not affect the obligation of the Board to form its own judgement. This report is given solely for the benefit of the Directors of Fonterra. No other person may rely on this report. This report has been approved unanimously by the members of the Committee.

John Waller Chairman of the Committee 15 May 2012

17

Appendices to Report to the Board Shareholder information version Appendix 1 – 100% Farmer Control and Ownership 100% farmer control and ownership of the Co-operative Fonterra will be 100% farmer controlled and owned under Trading Among Farmers.1 100% farmer ownership This means that the only shareholders of the Co-operative can be: ä farmers who supply milk to Fonterra; ä those people who supplied milk to Fonterra but are selling down their shares over three seasons (exiting farmers); and ä the Fonterra Farmer Custodian, which will be ultimately owned and controlled by farmers who supply milk to Fonterra and hold Co-operative shares. If you look at Fonterra’s share register at the end of a trading day, you will only see as legal owners of Co-operative shares the people described above. Fonterra will be using a system approved by the Reserve Bank to transfer Co-operative shares between parties who are entitled to hold them. As part of this approved system, shares may be temporarily held during the course of a day by approved market participants who are subject to the rules of the Fonterra Shareholders’ Market. There have always been and will continue to be people who have beneficial rights in Co-operative shares – such as the beneficiaries of a family trust or passive investors in a farm syndicate. This will not change under Trading Among Farmers. Under Trading Among Farmers both the FSF and the RVP will have beneficial rights in Co-operative shares. However, they will not be legal owners of Co-operative shares. 100% farmer control This means that farmers who supply milk to Fonterra and who hold Co-operative shares are the only people who can: ä vote on Co-operative matters on the basis of their share-backed production; and ä appoint and remove Fonterra directors. However if Directors or farmer shareholders try to take an action which will adversely affect the rights of the Fonterra Shareholders’ Fund or the Registered Volume Provider, then those parties may have legal rights to take steps to protect their interests. Under the terms of the documentation constituting Trading Among Farmers, those steps would be taken in the name of the Fonterra Farmer Custodian.

1 As set out in TAF Blueprint (version 3.9)

18

Appendix 2 – Committee Terms of Reference Fonterra Co-operative Group Limited Capital Structure – Trading Among Farmers Due Diligence Committee Terms of Reference December 2011

provide all information reasonably necessary for shareholders to form a reasoned judgment on the proposals. (h) The Project is consistent with communications made to Fonterra shareholders and other stakeholders including the New Zealand Government.

3 Duration of Review The Committee will operate during the remaining stages of the Project (i.e. up to and including the commencement of the Fonterra Shareholders’ Market and the issuance of units in the Fonterra

1 Constitution

Shareholders’ Fund).

The Board of Fonterra Co-operative Group Limited (“Fonterra”)

4 Membership

has resolved to establish a Committee to be known as the Capital Structure – Trading Among Farmers Due Diligence Committee (“the Committee”).

2 Objectives The objectives of the Committee will be to:

The Committee shall consist of five Directors: (a) Three Directors elected to the Board under clause 12.2 of the Constitution (“Elected Directors”); (b) Two Directors appointed to the Board under clause 12.4 of the Constitution (“Appointed Directors”);

To review proposals, processes, and shareholder communications

The Chairman of Fonterra will be an ex officio member of the

and offer documents relating to the implementation of Trading

Committee. The Committee Chair shall be appointed by the Board.

Among Farmers (“TAF”) and to assist the Board to ensure that:

5 Authority

(a) In light of assurances that have been given by the Board and management to Fonterra shareholders, that Fonterra will

The Committee is authorised by the Board to undertake any

continue to be 100% owned and controlled by its shareholders

activity within its Terms of Reference.

following the implementation of TAF (the “Project”). (b) Directors fulfil their duties in relation to the Project. (c) Appropriate “due diligence” is undertaken at each remaining stage of the Project. (d) The Board has adopted a due diligence process that is appropriate in the circumstances, robust and defendable. (e) The Board’s objectives in proposing the Project and the pre-conditions to commencement of TAF contained in the Fonterra Constitution have been addressed in a manner satisfactory to the Board. (f) The Board can provide appropriate formal assurances to the Shareholders’ Council that key issues raised by the Council have been addressed and that the Project is consistent with the co-operative principles endorsed by the Shareholders’ Council. (g) All documents sent to shareholders and the offer documents

The Committee is authorised by the Board to obtain independent professional advice and to secure the attendance at meetings of persons with relevant experience or expertise if it considers this necessary.

6 Reporting The Committee will provide the following reports to the Board: (a) An report prior to enactment of the legislative changes to Dairy Industry Restructuring Act (“DIRA”) required to implement TAF (currently expected to occur in April/May 2012); (b) A final report prior to issuance of the Offer Documents (currently planned for November 2012); and (c) Any other report that the Board may request from time to time.

relating to Fonterra shares and the units in the Fonterra

All minutes of Committee meetings will be provided to the Board.

Shareholders’ Fund (“Offer Documents”) comply with all

The Committee will, at the request of the Chairman of the Board,

relevant legislation; are, in all material respects, accurate and

present the Committee’s report to the Shareholders’ Council.

not misleading and do not omit any material information; and 19

7 Responsibilities of the Committee

(e) All changes necessary to be made to the Fonterra Constitution to implement the Project have been made and no additional changes are required to the Fonterra Constitution to successfully implement the Project in a

The Committee shall address the following issues in its final report

manner consistent with the objectives of the Board.

to the Board and in earlier reports to the extent relevant: (f) All documents provided to shareholders in connection with (a) The objectives of the Board set out below are addressed in

the Project and all Offer Documents:

the Project: i. On the basis of legal advice received, comply with all i. Maintaining Fonterra as a sustainable co-operative with

relevant legislation;

voting rights linked to milk supplied to Fonterra. ii. Are, in material respects, accurate and not misleading ii. Removing Fonterra’s obligation to redeem shares. This

and do not omit any material information;

provides permanent share capital on which the business can operate and invest.

iii. Provide all information reasonably necessary for shareholders to form a reasoned judgment.

iii. Ensuring Fonterra has sufficient permanent share capital to give the Co-operative the funding needed to continue

(g) Adequate consideration has been given to alternatives

to have the ability to drive the highest sustainable

available to Fonterra, and planning has been undertaken, in

returns to farmers.

the event that circumstances arise which:

iv. Ensuring that the arrangements give farmers confidence that they will be able to buy and sell shares when they wish at prices that reflect a well informed and liquid market. v. Ensuring the arrangements produce a stable outcome

(a) Prevent the Project being implemented after it is approved; or (b) Put the Fonterra balance sheet at risk prior to the Project being implemented. (h) That all necessary amendments to Dairy Industry Restructuring Act (DIRA) and other legislative changes have

in the sense that they will meet the above objectives for

been proposed/enacted to enable Fonterra to complete, and

the foreseeable future.

no changes to legislation will prevent the completion of, the

These objectives are underpinned by the ongoing need to give

Project in a manner consistent with the objectives of the

shareholders and other stakeholders confidence around the

Board (if such amendments or changes have been proposed/

determination of the Milk Price.

enacted at the time of the relevant report).

(b) The Project is being properly and reasonably managed in the context of the Board’s timetable and objectives. (c) Appropriate expert advice has been taken on key aspects of the Project and that key areas for advice have not been omitted. (d) Management and advisors have:

(i) Verification and other procedures have been established and implemented to ensure additional documentation sent to shareholders and the Offer Documents comply with paragraph 7(f) above. Due diligence material is appropriately filed and all statements contained in additional documents provided to shareholders and the Offer Documents are cross referenced to appropriate due

i. Considered all material risks in connection with the Project (including any new risks that have been identified by management and advisors since their prior reports in connection with Capital Structure Stage 3 were delivered to the Board) and have developed and provided a full risk analysis and appropriate risk mitigation plans; ii. Undertaken appropriate scenario planning and stress testing in connection with the key areas of the Project including the rules, structure and processes underlying the Fonterra Shareholders’ Market and the Fonterra Shareholders’ Fund.

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diligence material.

8 Meetings The Committee shall meet at such times as the Committee Chair shall deem necessary in order to fulfil its duties. The Committee shall regulate its meeting in the manner it sees fit.

9 Confidentiality Subject to the reporting requirements set out in these Terms of Reference, all deliberations of the Committee shall remain confidential unless otherwise agreed by the Chair of the Committee.

10 Secretariat The Chair of the Committee shall from time to time appoint a Secretary.

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Appendix 3 – Profiles of Advisors

and a director of Rural Equities Limited. He was formerly a director of AMP, Anzco Foods, Auckland Milk Corporation, Dunlop Living, Forestry Corporation, Kiwi Dairies, Kiwifruit Marketing Board, Medic Corporation, Sealord Group, Te Kairanga Wines, Tasman Agriculture, Tui Milk Products,

Alan Galbraith QC

Wakefield Hospital, and Williams and Kettle.

Alan is one of New Zealand’s leading commercial Queen’s Counsel. Alan attended Auckland Grammar School before commencing his law degree at Auckland University where he graduated with an LLB

Eric Lucas, Partner – Corporate Finance and Forensic Services, PricewaterhouseCoopers

(Hons). He was awarded a Rhodes Scholarship in 1967 and attended

Eric is a Corporate Finance Partner at PwC, specialising in complex

Oxford University where he gained a BCL in 1970. Alan went to the

valuation issues, investigatory work and dispute resolution with

Bar in 1979 and was appointed a Queen’s Counsel in 1987.

PwC. He is responsible for the Firm’s Forensic Services Practice in

ä Public & Administrative Law Reform Committee member 1985-1987

New Zealand. He has presented expert evidence in the New Zealand High Court

ä Legislation Advisory Committee member - 1987-1996

on numerous occasions, as well as provision of expert evidence at

ä Deputy Chairman, New Zealand Broadcasting Commission -

arbitrations and mediations. He also has experience, acting as Expert,

1989-1993

nominated by both the New Zealand Institute of Chartered Accountants

ä Member, New Zealand Racing Authority - 1990-1992

and by direct appointment in determining commercial disputes.

ä Member, New Zealand Racing Industry Board - 1992-1996

Eric has provided valuation and advisory services to a wide range of

ä Member, New Zealand Totalisator Agency Board - 1996

companies in relation to:

ä Deputy Chairperson, Sports Tribunal - May 2008-August 2012 Alan has appeared as counsel in commercial litigation on behalf of Air New Zealand, Auckland City Council, Auckland International Airport Limited, Bank of New Zealand, Brierley Investments Limited, Cards NZ Limited, the Commerce Commission, Feltex Carpets directors, Fisher & Paykel Limited, Fletcher Challenge Limited, Lion Nathan, Manukau City Council, National Provident Fund, Natural Gas Corporation, Perry Corporation Limited, PPCS Limited, and Vector Limited.

ä Business Acquisitions and Mergers ä Sale of Businesses ä Share and Business Valuations Qualifications and Professional Associations ä BA (Hons), University of Lancaster, England ä Fellow of the Institute of Chartered Accountants in England and Wales ä Chartered Accountant, New Zealand Institute of Chartered

Colin Giffney, Principal, Giffney & Jones Colin’s career began in 1971 in the research department of the forerunner firm to Goldman Sachs/JB Were - Jordan Sandman Smythe. Later, returning from 4 years in London he became a partner at the same firm in 1978. He specialised in research and corporate advisory work. He became managing director in 1986, and retired in 1995 to start niche investment bank Giffney & Jones.

Paul Nickels, Partner – Risk and Control Solutions, PricewaterhouseCoopers Paul brings 17 years experience, with 9 as a partner. He is responsible for PwC’s systems assurance practice in New Zealand and leads PwC’s Auckland risk and control team. He is an expert in his area and regularly consults to a broad range

Giffney & Jones specialises in mergers and acquisitions. He is

of organisations on technology risk and change initiatives. Paul’s

currently deputy chairman of the Takeovers Panel, a member of the

areas of expertise include:

Financial Markets Authority, chairman of small listed companies,

ä Board risk governance reviews

Renaissance Corporation and Solution Dynamics, and a director

ä Risk management

of several other companies. He is on the Listing Subcommittee of

ä IT security

the NZX and was formerly a member of the New Zealand Stock Exchange’s Market Surveillance Panel. He has over 40 years experience in New Zealand’s capital markets.

ä Third party independent assurance ä Internal controls design, implementation and independent assessment

Murray Gough OBE Murray was the Chief Executive Officer of the New Zealand Dairy Board from 1985 to 1992. He is currently Chairman of Rangatira Limited, Precision Dispensing Systems Limited and Cosine Public Health Network 22

ä Providing quality assurance over large systems projects ä Internal Audit establishment and operation

Qualifications and Professional Associations

Mike Shaw CA, Director of OliverShaw, Tax Advisors

ä BA Hons Accounting and Finance, University of Essex

Mike is a very experienced tax practitioner with a strong

ä B Com (Business Studies), University of East Anglia

reputation in tax policy and structuring advice having advised

ä Certified Information Systems Auditor (CISA)

high wealth individuals, large corporates, the Corporate Taxpayers

ä Past president Auckland Chapter of ISACA

Group, Ministers of the Crown and Government policy officials.

ä Member of NZICA

He was previously a senior tax partner at Deloitte until November 2010 and was a member of the Tax Working Group that reported to

Paul Oldfield, Director, Harmos Horton Lusk Limited

the Government in 2010.

Paul specialises in securities offerings, company, business and asset

Before becoming a tax partner he was seconded to the office of

acquisitions and disposals, financing, and complex contractual

five different Ministers’ of Revenues as their in house personal tax

arrangements.

policy adviser.

Robin Oliver MNZM, Director of OliverShaw, Tax Advisors Robin is a very experienced tax practitioner with a reputation for bringing different perspectives (private and public sector, practitioner and manager) and disciplines (legal, accounting and

Mike has publicly represented a number of Institute of Chartered Accountant continuing education courses. Over his career, Mike has commented on most areas of taxation law and policy.

economics) to issues. Robin holds a Master of Arts degree with first class Honours and a Bachelor of Laws degree from the University of Auckland. He has undertaken additional studies in economics, accounting and management. He was Deputy Commissioner of New Zealand’s Inland Revenue Department from 1995 to November 2011. As Deputy Commissioner of Inland Revenue, Robin was a member of the New Zealand Inland Revenue Executive Board and subsidiary bodies overseeing the strategic direction and management of the Department. For services in that role he was appointed by the Queen a Member of the New Zealand Order of Merit in the 2009 Queens’s birthday Honours list. In 2009, Robin was appointed by the Secretary General of the United Nations to the UN Committee of Experts on International Tax Co-operation, a position he still holds. He has also been a member of the International Monetary Fund’s expert group on taxation. In addition to this public sector role, Robin is a leading technical expert on taxation. He is the co-author of New Zealand’s leading text on the taxation of financial instruments which has been quoted as authoritative in both the Privy Council and New Zealand’s Supreme Court. He was appointed a member of the New Zealand government’s 1988 Consultative Committee on the Taxation of Superannuation and Life Insurance. He was on the Secretariat of the Consultative Committee on the Taxation of Income from Capital (1989-91). His skill set embraces all aspects of taxation policy, tax administration, international tax and the taxation of the financial sector. Over his career, Robin has commented on most areas of taxation law and policy.

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