Contract farming and the role of government

To integrate farmers with agro-industries, the Ministry of Agriculture has released a draft Model Contract Farming Act, which seeks to create a regulatory and policy framework for contract farming. In this article, Smriti Sharma contends that the legislation should aim to protect farmers and incentivise buyers to freely contract with each other. Rather than creating bureaucratic hurdles, the government should focus on providing an enabling environment for contract farming.

The government has been making efforts to integrate farmers with agro-industries. The government wants to ensure that farmers realise better prices for their produce, reduce post-harvest losses, and are assured of job opportunities in rural areas. It is in this direction that contract farming has come to be seen as a panacea.

The Food and Agriculture Organization (FAO) defines contract farming as an agreement between farmers and processing and/or marketing firms for the production and supply of agricultural products under forward agreements, frequently at predetermined prices.

The contract between farmers and buyers may lie along the continuum of procurement contract, from partial to complete contract. The difference between the contracts is with regard to the involvement of the contracting firm in pre- and post-production processes. Some contracts specify only sale and purchase conditions while others may specify that the contracting firm will provide some inputs to the farmer and the produce will be bought at a pre-agreed price. And then there are contracts where the contracting firm supplies and manages all inputs to the farmer. In this way, contract farming insulates farmers from price risk and uncertainty, helps them develop new skills, and opens new markets for farmers. Nevertheless, the market for contract farming suffers from the following market failures:

Monopsony: Monopsony refers to a market structure where one buyer interacts with many sellers. This market structure gives the buyer an advantage over the sellers as they all try to sell to the same buyer. Typically, contract firms enter into an agreement with farmers to grow differentiated crops. This turns the firm into a sole buyer of the produce and farmers into price-takers. Contracting firms can exploit this situation to their advantage by offering lower prices to farmers. Literature suggests that when farmers do not have access to alternative production possibilities and markets, then the bargaining power of the farmers reduces and the contracting firm indulges in monopsonistic behaviour (Sivramkrishna and Jyotishi 2007).

Information asymmetry: Contracting firms do not have complete information on productivity and land quality of the contracted farmers. This can lead to a situation where the farmers produce below-quality crops. If the contracting firm agreed to purchase produce of the farmers on a pre-fixed price, then it leads to the contracting firm taking a loss. On the other hand, farmers (especially small and marginal) sometimes do not understand contract specifications like the quantity and quality to be produced, or the effect of price changes. Disputes between farmers and sponsors can also arise over grading of products.

These market failures lead to sub-optimal outcomes from contract farming. In order to prevent losses, either of the parties can indulge in opportunistic behaviour. Buyers may penalise farmers for not sticking to the quality parameters and offer them prices lower than agreed. Similarly, farmers may indulge in side-selling if the contracted price is lower than the local market price. Also, farmers may leak the technology provided to them by the contracting firm by using the technology for uncontracted crops.

Therefore, the question is: Is there a role for the government to intervene in the contract farming market, and what should it do to address the market failures?

Present arrangements

In India, contract farming is regulated under the Indian Contract Act, 1872. The Act provides the background legal framework for contract farming. It has many general provisions that are relevant to contract farming including formation of contracts, obligations of parties, and consequences in case of breach of contracts. In addition to the Indian Contract Act, the Model APMC (Agricultural Produce Market Committee) Act, 2003 provides specific provisions for contract farming. The Act requires contract farming sponsors to compulsorily register them with the Market Committee¹. Even though the Act allows the Market Committee to levy fees on the sale of agricultural produce, it makes an exception for contract farming whereby agricultural produce can directly be sold to contract farming sponsors²³. Also, if the agricultural produce covered under the contract farming agreement is sold outside the market yard then no market fees is levied by the Market Committee. The Act also provides for dispute settlement⁴. Disputes may be referred to the prescribed authority. The authority is mandated to resolve the matter within 30 days after giving the parties a reasonable opportunity of being heard, in the manner prescribed. If the party is aggrieved by the decision of the authority, then it can appeal the decision to an Appellate Authority within 30 days from the date of decision. The Appellate Authority shall dispose of the appeal within 30 days after giving the parties a reasonable opportunity of being heard and the decision of the Appellate Authority is final. The Model APMC Act 2003 was to act as a reference for the states. However, many states did not adopt it.

Regulation of contract farming: Some examples

Internationally, countries follow both models where they may use their existing legal framework of contracts and obligations to regulate contract farming. For example, in the US, the Uniform Commercial Code provides the backdrop for specific legislation regulating contract farming. In Argentina, the Civil Code contains many articles that are relevant to contract farming. However, there are some countries like France and Republic of Panama, where contract farming is regulated under an agrarian code. The code provides for general provisions governing sales contracts and vertical integration contracts. In addition, there are more specific regulations for contract farming. For example the code specifies that the contracts must include the scope of technical assistance that would be provided by the sponsor to the farmer. In Morocco, a contract between the farmer and sponsor is valid only if it includes the quality requirements set by the buyer. However, it is not possible to cover for all issues that may arise with contracts (Pultrone 2012).

The Model Contract Farming Act: Not thought through

The Department of Agriculture and Farmers Welfare has now come out with a draft Model Contract Farming Act, 2018. Some of the key proposals of the Model Contract Farming Act include setting up a state-level agency called Contract Farming (Development and Promotion) Authority. The Authority would be responsible for implementing the Act. The Model Act requires both the sponsor and the farmers to register the contracts with a Registering and Agreement Recording Committee. The Model Contract Act puts contract farming outside the ambit of APMC. This means buyers would not have to pay market fees or commission charges to APMC. The Act also proposes to give price protection to farmers by determining pre-agreed price.

The Model Contract Farming Act, 2018 intends to establish a win-win framework for both the parties. Instead, some of the clauses, in fact, do the opposite. Registration imposes additional procedures and costs on the parties, and especially small and medium farmers cannot easily afford these costs. Besides, the Model Act's proposal to provide price protection to farmers will be counterproductive. How would the sponsors incentivise the farmers to perform if the State will provide the farmers the perverse incentive to not perform? Also, this kind of rigidity in legislation will stifle innovation in contract design. The entire premise of the Model Contract Act seems to be aimed at creating a legal infrastructure to see to it that both parties honour the contract. This approach is flawed.

Suggested approach

The government should correct for problems that lead to contract failing and not put both parties into an ‘inconvenient marriage’. In order to develop the contract farming market, the government should focus on attracting private sector investors and encourage farmers to link with agri-businesses. The solution lies in creating a competitive, strong and well-functioning ecosystem where both farmers and contracting firms engage with each other freely and are guided by mutual benefit. Some suggested measures could include:

Foster more competition: Government needs to create market-based incentives for both farmers and buyers. This requires creating enough competition in the agricultural markets. The government should improve farmers' connectivity to spot markets and mandis⁵ across the country. E-NAM (National Agricultural Market)⁶ is a great initiative in that direction already. This would encourage contracting sponsors to raise their bids and compete to enroll farmers for securing their input supplies. The competition amongst sponsors would also incentivise them to offer better terms and services to farmers.

Provide public goods: The government should maintain a repository of both the farmers and contracting firms. The repository can provide information about individual farmers or the Farmer Producer Organisations (FPOs) with regard to land availability, default rate, and performance standards. Similarly, the information repository with details of sponsors can give information about the services provided, requirements of crops, and the default rate. This transparency can help both farmers and sponsors evaluate each other prior to formation of contracts. Also, the government can facilitate contract farming by establishing and enforcing standards for crops. This will provide common understanding and set clearer expectations between farmers and buyers regarding the contracted crop. In addition, the government should see to it that there are enough grading agencies and test labs that can help with ascertaining quality of the produce. This will ensure that farmers and buyers have access to independent grading agencies.

Encourage softer means for contract enforcement: Simple measures like improving contract design can achieve contract enforcement. Literature suggests that contracts incorporating risk-sharing mechanisms, incentive schemes, repeated contracting and renegotiation options, and simplified and transparent contract terms help with better contract enforcement (Gumataw et al. 2013). Contract enforcement can be achieved by group lending and tripartite arrangements with financial institutions. A successful mechanism may be to leverage social sanctions as a means of countering side-selling. Government can educate farmers and make them more aware about contract farming and model contracts. This can be achieved by public programmes on DD Kisan, radio shows, and agriculture universities.

Conclusion

In conclusion, it may be said that contract farming holds the potential to help upgrade small and marginal farmers and integrate them into agricultural value chains. The Model Contract Farming Act, 2018 makes a good move in that direction by stating the intent to promote contract farming. However the bureaucratic hurdles instituted in the form of a new regulator to oversee contract enforcement between farmer and buyers is counterproductive. The legislation should aim at protecting farmers and incentivising the buyers to freely contract with each other. The government should focus on providing an enabling environment. This can be achieved by creation of market infrastructure, farmer education, and bridging information asymmetries between farmers and buyers. Unless this ecosystem is provided, there is very little reason to believe that the new Model Act can promote contract farming.

Notes:

Section 38(1) of APMC Act, 2003.
Section 42 of APMC Act, 2003.
Section 40(1) of APMC Act, 2003.
Section 38(2) of APMC Act, 2003.
Mandis refers to rural wholesale markets.
National Agriculture Market (NAM) is a pan-India electronic trading portal which networks the existing APMC mandis to create a unified national market for agricultural commodities.