The World Bank has promoted contract farming as a way of creating dynamic partnerships between private capital and smallholders.
--BY JANAK RAJ ACHARYA
Contract farming refers to a system where a central processing or exporting unit purchases the harvests of independent farmers and the terms of the purchase are arranged in advance through contracts. The terms of the contract vary and usually specify how much produce the contractor will buy and what price they will pay for it. The contractor frequently provides credit inputs and technical advice. Contracting is fundamentally a way of allocating risk between producer and contractor; the former takes the risk of production and the latter the risk of marketing. A contract farming agreement is not a partnership; it is a joint venture between two parties. It is basically is a joint venture between two parties, the farmer (owner or tenant) and the contractor (typically a local farmer or business companies).
Agricultural production under contract between producers and their buyers has long been practiced for many agricultural commodities, in most countries around the world. Through contract farming, food processors, traders, distributors and other purchasers of agricultural products organise their procurement systems in accordance with their specific needs for quantity, quality, and timing of delivery, among other supply chain management requirements. Contracts may also specify the desired processes for agricultural crop production or livestock rearing, often to comply with domestic and international quality and safety standards for food and agricultural production and trade.
The definition of contract farming focuses on the coordination between the different parts of a supply chain, involving various participants and contract modalities. However, contract farming is different from direct sales between producers and buyers through open market spot transactions where the product is delivered immediately against a price. Indeed, contract farming relies on agreements that are made either during production or, more often, before it begins, thus providing certainty for the future delivery and supply of the product. Contract farming is the generic term that covers various types of contract between companies and farmers.
Contract farming is a well-known mechanism to co-ordinate agricultural production and trade, but its use has increased noticeably in recent years. This growing interest in contract farming is associated with recent transformations in food and agricultural systems which make it increasingly difficult to meet consumer demands under more traditional, open-market-based procurement strategies. The use of contract farming is expanding in developing countries, where it opens significant opportunities for economic and social development by providing local producers with access to markets and support in the form of technology transfer and credit facilities.
Origin of Contract Farming
There are several global factors that led to the emergence of contract farming. One was the breakup of many plantations in colonial countries after Independence when foreign agri-businesses were subject to nationalist pressures, threats of expropriation and new conditions of profitability with a changing international division of labour. In a world of price instability, political uncertainty over nationalisation and tax regimes, unionisation of some labour forces, it is easier for a foreign company to drop short-term contracts with smallholders than the management of an estate.
Second, independent peasants and newly settled pioneer farmers are drawn into out grower schemes under state and/or private auspices. These schemes are often run in co-operation with international lending agencies and development banks. The International Finance Corporation and the Commonwealth Development Corporation are amongst the biggest supporters of out grower schemes and have pioneered palm oil, cocoa and rubber contracting across Asia, Latin America and Africa. Little and Watts (1994) trace the recent popularity of contract farming to IMF austerity measures and attempts to revive flagging export markets.
The World Bank has promoted contract farming as a way of creating dynamic partnerships between private capital and smallholders, which will lead to technology transfer, innovation and market growth. Contract farming is a means to assist small growers in gaining market access and reducing market price related risks, and as such it has attracted attention from development agencies and governments in developing countries.
Advantage of Contract Farming
Contract farming provides farmers with production inputs (such as seeds and fertilisers), quality control, and advice on new production methods. Prices are fixed in advance and credit facilities may be associated with the contract. Above all, contract farming can make agriculture remunerative. Farmers make a long-term investment, for example by building a special drainage system, over a short term contract. Early termination of the contract by the contractor will translate into a loss. If payment is made after the crop is harvested the farmer depends entirely on the contractor’s trustworthiness. If the crop is lost, the risk falls on the farmer and often no compensation is provided. For investors and contractors, contract farming overcomes land constraints and is more politically acceptable. Quality is controlled by the investor and crop risks are shared with the farmers.
Wiboonpongse and Sriboonchitta (2007) find that potato growers in the oldest production sites have accumulated production know-how and successfully innovated seed storage in place of seed supplied by contract firms. However, investments in training and know-how, farmer discontent and disputes, extra-contractual marketing by the farmers, and diversion by farmers of inputs supplied to them, all are risks to be supported by the contractor.
Legal Aspect on Contract Farming
Nepal has yet to have an act on Contract Farming. The establishment of a Contract Farming Agreement will be legally binding upon both the farmer and the contractor once they have signed the documentation under the Law of Contract. It is essential that such an agreement is documented and signed to protect both parties whilst at the same time providing clarity over areas that could be misunderstood or that cover areas that happen rarely. A good contract farming agreement which delivers returns for the farmer and leaves the contractor with an adequate surplus will leave both parties happy.
However, there may be occasional situations which may result in references being required to the ‘official’ document which can provide clarity to the issue and as a result minimise any risk of conflict or confusion. In a typical agricultural production relationship the parties undertake a variety of reciprocal and connected obligations. This raises the question of how those obligations are regulated under domestic law. Consideration of the different approaches followed in domestic law for the characterisation of agricultural production contracts is important in determining the scope of the future Legal Guide, since it helps define the kind of agreement to which the Legal Guide is supposed to apply. Furthermore, it will impact on the question of what role should be played by the parties’ autonomy in shaping their contractual relationship and in establishing a good balance between default rules and mandatory provisions.
Defining the applicable legal regime involves characterising the contractual relation as possibly falling under one particular legally defined contract type. While parties can designate a particular type of structure to apply to their whole relation, or to a certain part of it, they would not be entitled to choose a form inconsistent with the economic purpose they have themselves defined. A legal characterisation also involves consequences regarding aspects outside the contractual agreement, such as the tax regime. Contract farming arrangements reflect multiple commercial practices and their success depends on many elements.
The legal framework plays a particularly important role in view of the complex nature of the relationship where parties are linked through a variety of obligations with different levels of risks and benefits. An additional feature is the typical disparity in economic and bargaining power between producers who are generally vulnerable parties - especially so for small farmers in developing countries – and contractors, often large food processing and marketing companies, which may lead to imbalanced or exploitative situations.
Contract Farming and Food security
Contract farming is seen as a potential tool for reducing poverty, contributing to rural development and employment, and increasing food security. Under a broad economic approach, “contract farming” generally refers to a form of supply chain governance adopted by firms to secure access to agricultural products, raw materials and supplies meeting desired quality, quantity, location and timing specifications.
The practice of producing under a contract developed in the industrialised countries several decades ago especially in the livestock production sector, and is now used for many agricultural commodities in all countries of the world. Under contractual arrangements entered into with agricultural producers, food processors and distributors organise the production process in accordance with their needs, from the supply of inputs until the delivery of the produce. It is used to increase and diversify the availability of products on local and global markets and may work as an efficient tool to strengthen farmers’ capacities.
Strengthening and improving relationships between farmers and the market on a sustainable basis is among the priority objectives in the agenda of many multilateral organisations, bilateral cooperation agencies and non-governmental organisations which work to support the agricultural sector in developing countries. Within the United Nations system, the Food and Agriculture Organization (FAO) and the International Fund for Agricultural Development (IFAD) are paying increased attention to the establishment of a conducive environment to promote the inclusion of small-holder farmers in agricultural value chains. Contract farming is bound to attract significant attention in the context of the current preparation of Principles for Responsible Agricultural Investment (RAI Principles) within the Committee on World Food Security.
UNIDROIT/FAO/IFAD Legal Guide on Contract Farming
There are UNIDROIT conventions on matters such as factoring, leasing, stolen or illegally exported cultural objects, international interests in mobile aircraft equipment and intermediated securities. UNIDROIT has also produced the highly successful Principles on international commercial contracts, a soft law codification of the general rules of contract law which exerts much influence not only on arbitrators, but also on legislators in search of inspiration for reforming their law of contracts.
The UNIDROIT/FAO/IFAD Legal Guide on Contract Farming is primarily addressed to the parties in a contract farming relationship, i.e. producers and contractors. It provides advice and guidance on the entire relationship, from negotiation to conclusion, including performance and possible breach or termination of the contract. In so doing, the Guide aims to promote a better understanding of the legal implications of contract terms and practices. It intends to promote more stable and balanced relationships and to assist parties in designing and implementing sound contracts, thereby generally contributing to building a conducive environment for contract farming. While not intending to provide a model for, or encourage the adoption of, special legislation, the Guide could, however, provide useful information for legislators and public authorities dealing directly or indirectly at a public policy level with contract farming.
The Guide could be recognised as a reference for good practice by reflecting a minimum internationally accepted standard of practice in contract dealing in this area. The Guide intends to provide practical guidance to international organisations and bilateral cooperation agencies, as well as non-governmental organisations and farmers’ organisations, engaged in strategies and capacity building programmes in support of contract farming, especially in developing countries. The Guide could also be useful for professional organisations, judges, arbitrators, legislators, and perhaps even most importantly, for mediators, because it promotes amicable dispute resolution.
The UNIDROIT/FAO/IFAD Legal Guide on Contract Farming is aligned with the Principles for Responsible Investments in Agriculture and Food Systems (RAI Principles) approved in October 2014 by the Committee on World Food Security. The Guide also shares with the RAI Principles the goal of providing a framework that stakeholders can use when developing domestic policies, regulatory frameworks, corporate social responsibility programmes, individual agreements and contracts in responsible and inclusive ways.
The Guide is composed of an introduction and seven chapters dealing with the various conceptual stages of the contract farming relationship. The chapters provide a description of common contract terms and a discussion of legal issues and critical problems that may arise under various practical situations.
Contract Farming and Legal Provisions in Nepal
The government has prepared a draft of the new Agriculture Enterprises Promotion Act that among other things envisages paving the way for contract or lease farming and promises incentives to insurance companies to sell farm insurance policies. The draft prepared by the Ministry of Agriculture Development (MoAD) in association with the Agro Enterprise Centre (AEC) of the Federation of Nepalese Chambers of Commerce and Industry (FNCCI) will soon be circulated among local stakeholders in the different development regions for feedback, according to a senior government official.
Contract farming is expanding in developing countries where it opens significant opportunities for economic and social development by providing local producers with access to markets and support in the form of technology transfer and credit facilities. The shift from need base to production base can only be a success through the commercialisation of the agricultural sector. For this capital investment must be followed by the contract farming model that has to be adopted. Nepal’s constitution has guaranteed food security as a fundamental right so to achieve it there must be seed sovereignty, farmer’s rights on seeds and commercialisation of the agricultural sector. And this can only be achieved through contract farming. It is also a win-win situation principally. In the context of Nepal now is the time for a contract farming act to enhance the productivity needed to industrialise the agricultural sector, ultimately helping the nation achieve the goal of food security.
The writer is Chairman at Legal Consult and Research Center.