Co-op stock exchange

Why choice of trading rules matters for new-generation co-op stockholders

By Steven J. Holland
Macalester College
Robert P. King,
University of Minnesota


Editor’s note: Holland is policy associate,
Macalester College. King is professor and
head of the Department of Applied
Economics, University of Minnesota.
Please e-mail questions to:
Rking@apec.umn.edu

he new-generation cooperative (NGC) is an institutional innovation that has helped many farmers establish valueadded processing operations that would have been impossible to capitalize with a traditional cooperative. NGCs — with well-defined delivery rights/obligations and tradable shares — were a driving force in the sharp increase in the number of cooperatives formed during the 1990s. More recently, though, concerns have begun to emerge about the long-run viability of NGCs.

In 2002, for example, members of Minnesota Corn Processors approved the sale of their cooperative ethanol and corn sweetener business to Archer- Daniels-Midland, and members of Dakota Growers Pasta Co. approved conversion of their cooperative to an investor-owned corporation (see page 8). Should these and other takeovers and conversions be considered aberrations, or do they reveal an inherent vulnerability of the NGC organizational form?

Each takeover or conversion case is unique, with a sequence of events and decisions that led to organizational change. In order to explore the question of whether there are fundamental forces common to all situations, we developed a simulation model of cooperative formation and the market for cooperative stock.

Our model is “populated” by farmers who produce a crop that can be the raw product for a value-added processing facility. These farmers differ in the amount of land they farm, location and risk attitudes, but all manage their resources and make investment decisions in a way that maximizes their long-run welfare.

The model also includes a noncooperative firm that is not involved in farming but can build a processing plant or purchase a cooperatively owned plant. The farmers in the model can join together to create a cooperatively owned value-added processing plant, and the procedures for trading cooperative stock can be modified in the model in order to explore the implications of these organizational design decisions.

Our findings help explain NGC takeovers and conversions. They also point to some practical steps cooperative boards can take to make an NGC more attractive to new farmer investors and more robust when faced with takeover threats.

Why do co-ops often lead in the
development of new types of
value-added processing?
A significant, but rarely mentioned, advantage of farmer investment in an NGC value-added processing facility is the benefit of diversification. Consider the case of corn producers who have an opportunity to invest in an ethanol plant. These farmers always face the risk of large downward swings in the price of corn.

However, low corn prices increase the operating margin for an ethanol NGC, yielding higher patronage refunds. While investment in an ethanol plant carries its own risks, it can also result in a moderation of a member’s overall exposure to uncertainty by blunting the impact of downward corn price fluctuations. In short, the NGC provides benefits to members beyond the ability to share in the enterprise’s profits.

The opportunity to diversify helps members, but it also helps the cooperative. If cooperative investors benefit from the diversification offered by shares of an NGC, then they should be — and they apparently are — willing to invest in an NGC processing plant that is slightly less profitable than would otherwise be necessary to attract investment. The practical implication is that it is easier for the cooperative to sell shares when the benefits of diversification are known to potential investors.

The diversification benefits of NGC stock ownership may help explain why so many ethanol plants are NGCs. For example, according to the Minnesota Department of Agriculture, 11 of Minnesota’s 14 ethanol plants are NGCs — accounting for over 85 percent of total ethanol production in the state.

As a general rule, investor-owned firms (IOFs) invest in ethanol production because it promises to be profitable — not because it helps to diversify their portfolios. Consequently, they will build an ethanol plant only when it promises a level of profitability sufficient to fully recoup the cost of their investment. New-generation cooperatives, on the other hand, can tolerate lower profitability because they offer the added benefit of diversification to their members. It follows that NGCs can raise the money to build processing plants under conditions where IOFs would shy away.

Figure 1 illustrates this point. An ethanol plant is highly profitable when the ethanol price is high and the corn price is low. This corresponds to the area in the upper left corner of the figure, which represents conditions under which investment is desirable for anyone. In the lower right corner, the ethanol price is low, the corn price is high, and the ethanol plant is likely to be losing money. Here, no one wants to own an interest in the plant. The “investment thresholds” in figure 1 represent the conditions under which an NGC and an IOF will first find investment in an ethanol plant desirable.

Because of the benefits of diversification, potential NGC members are willing to invest in value-added processing facilities under less favorable circumstances than IOF investors. As a result, there should be market conditions (those between the two investment thresholds) where NGC members would be willing to invest in a processing facility when IOF investors would not. This can give a start-up NGC the opportunity to form without interference from a competing IOF.

When is an NGC most likely to be
vulnerable to takeover by a noncooperative
firm?
One of the reasons NGCs offer diversification benefits is because members can constantly adjust their exposure to risk by trading their NGC shares. Of course, this argument fails when the member’s shares cannot be easily traded. This is called the “thin market” problem.

In most cases, only a limited number of individuals are in a position to buy NGC stock because cooperative laws require that members produce the product being processed. Among those who can buy stock, even fewer actually will want to.

For example, many corn producers considering investment in an ethanol plant will be too far from the ethanol plant to make membership in the NGC a viable investment. Some simply will not be interested in investing.

The thin market problem is made worse by the fact that members tend to have the same general objectives. For example, when an ethanol plant is doing very well, there will be many potential investors but there might be a shortage of sellers. On the other hand, when an ethanol plant is not profitable, many members may be willing to sell but few will be willing buyers.

In either case, little NGC stock will be traded unless there are large increases or decreases in share prices, and investors will begin to fear that they will not be able to get out of the investment. In other words, a thin market can make the decision to invest irreversible.

This irreversibility can have two important effects on an NGC. First, potential investors may hesitate to buy shares if they anticipate the investment may be irreversible. This sort of thinking makes it much more difficult for the NGC to raise initial capital.

The second problem occurs when the NGC is able to form, but the market for NGC shares becomes thin later on. Our model suggests that this is a distinct possibility.

Generally, when an NGC makes its initial offering, there are interested investors who are not able to buy stock. Over the first few years after the NGC forms, both the volume of stock trading and the share price are propped up because producers who did not invest initially are trying to buy into the NGC. Once most available investors have achieved a level of investment that fits their needs, though, fewer people want to buy and sell NGC stock and the thin market problem sets in.

Our analysis suggests the trading volume and share price of an NGC will remain relatively high as investors adjust their holdings of NGC stock. However, trading volume and share price will settle to much lower levels after this initial period of adjustment, and this may present an opportunity for an IOF looking to invest.

If the NGC share price drops far enough, the cost to an IOF of purchasing an existing processing plant will be lower than the cost of building a new one. This might be sufficient to pull the IOF into the market. At the same time, NGC members who have been frustrated about their inability to sell shares to other producers might see an offer from an IOF as too good to pass up. This response to the thin market problem may help explain why NGCs are sometimes taken over by IOFs or choose to convert to legal forms that allow investment by non-producers.

How do rules and procedures for
trading NGC stock affect co-op
formation and vulnerability to
takeover?
The thin market problem reduces the demand for NGC shares, makes it more difficult for NGCs to raise capital, and increases the chances of takeover by an IOF. If NGCs are to fully realize their advantage over IOFs, they must find a way to alleviate the thin market problem. Here are three strategies that can help.

1) Choose trading procedures carefully.
NGCs use a variety of procedures to trade their stock. In some cases the cooperative acts as a clearinghouse that puts willing buyers in touch with willing sellers. Many other NGCs organize periodic stock auctions. When establishing rules for trading stock, few boards consider the effect on the cooperative’s ability to raise money or survive a takeover attempt.

Economists often refer to a “perfect” market, with many buyers and many sellers shouting out the prices at which they are willing to buy or sell the good. If the quantity offered for sale at the prevailing price is less than the quantity demanded, buyers will bid up the price in an effort to buy the limited supply before their competition does so.

The same process brings the price down when supply exceeds demand. The immediate and accurate exchange of information makes this process happen quickly and results in an equilibrium “market price” at which supply equals demand. This is called a perfectly competitive market.

For a perfectly competitive market to exist in the real world there must be many buyers and sellers and free exchange of information. However, the pool of potential buyers and sellers for NGC stock is often small. Also, despite an NGC’s best efforts, there may not be a free flow of information when information about members wishing to buy or sell shares is simply listed on a bulletin board or a Web site. This does not provide a mechanism for potential buyers and sellers to quickly adjust price or quantity to reflect market conditions.

Some NGCs have tried to overcome their inability to create a perfect, liquid market for their stock by holding frequent stock auctions. But the design of the auction format can have a significant effect on market liquidity. We used our model to evaluate two types of auctions.

The first is called a “discriminatory” auction. Potential sellers submit a reserve price and potential buyers submit a bid price. The cooperative then matches buyers who submit high bid prices with sellers who submit low reserve prices until no more matches are possible. Inevitably, some people submit bids or “asks” that are unsuccessful. The defining characteristic of a discriminatory auction is that successful buyers pay their bid price.

While a discriminatory auction is a convenient and easy way to match buyers and sellers, it may not be the best way to increase market liquidity. Buyers, knowing they will pay their bid price, have an incentive to submit a bid that is lower than the amount they are truly willing to pay. However, lower bid prices can mean that trades that could have taken place if bids had been “honest” will not take place. This increases market thinness.

An alternative to the discriminatory auction is a “competitive auction.” Under a competitive auction mechanism, successful bidders do not pay their bid price. Instead, everyone trades at the same market clearing price — that is, the price at which the number of shares with bids at or above the market clearing price is equal to the number of shares with reserves at or below the market clearing price.

With this rule, successful bidders are guaranteed to pay an amount that is lower than or equal to their bid, so they have no incentive to bid below their true valuation of the stock. Higher bids imply more trading, and this increases market liquidity. Results from our modeling analysis indicate that the shift from a discriminatory to a competitive auction can significantly increase market liquidity and reduce the likelihood of takeover by an IOF.

2) Diversify the NGC membership.
Recall that a thin market can arise when investors all have the same general objectives. Another way, then, to improve liquidity in the NGC stock market is to increase diversity among members.

For instance, when the NGC is profitable, a young farmer may want to increase the level of his or her investment. Normally, he or she would have trouble finding a seller, but if the NGC has a number of members nearing retirement, some of them might take that opportunity to sell their shares. In this way, diverse ages can improve market liquidity.

Greater stock market liquidity can also be gained by making sure the NGC membership has a balance of large and small farmers as well as farmers from a wide geographic range. If members are affected differently by weather conditions, local prices and changes in production costs, then it is more likely that at any point in time some will want to buy shares and some will want to sell shares. This kind of diversity helps keep the NGC stock market healthy.

3) Grow the pool of potential
investors.
Internet auction Web sites, such as eBay, put sellers of myriad products in touch with a large audience of potential buyers, greatly increasing the chances of finding someone with whom to trade. Analogously, the market for NGC stock can be made more liquid if steps are taken to expand the pool of potential NGC investors.

The Internet can create opportunities for the inexpensive and timely exchange of information between farmers who have never met each other and live hundreds of miles apart.

It can also allow potential traders to quickly and easily adjust their prices and quantities to reflect market conditions. While an NGC might never be able to replicate the trading pit model of exchange, prudent use of technology might allow it to get closer to that model than it ever could before.

Two key constraints that limit the number of potential NGC investors are: legal rules that prevent non-producers from investing in an NGC and the cost of delivering a crop from a distant farm to the NGC. NGCs can do little to change the legal rules, but they can often circumvent these restrictions. The most common method of expanding the pool of potential investors is for the NGC to enter into a joint venture or partnership with non-producers.

In fact, many ethanol plants are LLCs or LLPs that are partially owned by the NGC and partially owned by outside investors. Some NGCs have gone a step further and chosen to convert to a non-cooperative business form.

Other NGCs are uncomfortable with partnerships with non-producers because it is feared that the organization can stray from its cooperative nature. Another possibility that does not require outside investment is to allow distant farmers to arrange for delivery of corn through the exchange of warehouse receipts at cooperating grain elevators. This practice is currently used by some NGCs to expand the area from which they find raw product and has the added benefit of increasing the number of stock market participants.

Conclusions
The NGC model makes it easier for farmers to invest in value-added processing facilities, creating new opportunities for profit-making and diversification. But thin markets for NGC stock can limit farmers’ ability to adjust their holdings and can leave a cooperative vulnerable to takeover by an IOF. The thin market problem cannot be eliminated, but it can be alleviated through careful design of stock trading procedures, diversification of membership and expansion of the pool of potential investors.




January/February Table of Contents