Fonterra Cooperative Group penalised South Canterbury farmers who had been supplying a failed dairy company it took over to avoid bad optics with its existing suppliers and to show there would be consequences for leaving, the farmers' lawyer has told the Supreme Court.

Last November, the Court of Appeal rejected Fonterra's application to throw out a High Court ruling that it breached the Dairy Industry Restructuring Act by imposing less favourable terms on farmers who had previously supplied the failed New Zealand Dairies. Fonterra bought the independent processor's plant out of receivership in 2012 for $48.5 million and took on the farmers, who supplied milk from farms in North Otago and South Canterbury.

Fonterra made a deal with the farmers, agreeing to buy their milk under a "growth contract", rather than a fully share-backed supply, where farmers purchase one Fonterra share for every kilogram of milk solids they supply in a season and are paid the farmgate milk price plus a dividend on each share. Under the growth contract, the farmers were entitled to 5 cents less per kilogram of milk solids than the contract milk price and bought 1,000 Fonterra shares but couldn't "share up" - become fully share-backed - in their first year of supplying Fonterra.

According to DIRA, under the legislation enabling the merger of the Dairy Board with the New Zealand Dairy Group and Kiwi Cooperative Dairies, Fonterra isn't able to give new entrants different terms from its existing shareholding farmers. The High Court ruled the farmers qualified to become fully-fledged shareholders and Fonterra misled them about their ability to buy more shares, a finding which the Appeal Court upheld.

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David Goddard QC, lawyer for the farmers, said the 5 cents per share discount was "essentially arbitrary" and had been imposed by Fonterra as a small but material visible penalty on the farmers.

"One executive said of course they could avoid that by sharing up early like everyone else under a growth contract; the senior executive comes back and says we shouldn't allow that, we should prohibit sharing up for at least a year," Goddard said. "The whole point of this was that there should be a penalty, and that it should stick for at least a year."

Goddard said Fonterra hadn't sought to pay the farmers less because of the cost of acquiring NZDL's assets, as those were sunk costs, and evidence in earlier hearings was that the company doesn't seek to recover differential costs of taking milk from different farmers.

"It's not as if Fonterra said, how can we afford this price, only if we get this corresponding reduction in what we pay for the milk," Goddard said. "It was very optics-driven, not only to these farmers but to future farmers who might consider leaving Fonterra in the hope of coming back. This was a signal that there would be consequences for doing that."

Earlier in the day Fonterra's QC, Jack Hodder, said DIRA wasn't a "dairy farmer's bill of rights" but was there to regulate milk supply in a way that enhances contestability, and the South Canterbury farmers didn't count as new entrants.

"These people were not seeking to or part of the contestability processes, it wasn't an open-entry, open-exit exercise in any sense. It was a contractual arrangement," Hodder said. "Nothing in this Act abolishes the power to have a contract that isn't one of share-backed supply."

The hearing is set down for two days, with Goddard set to continue submissions tomorrow.