Lost Horizon

Membership ‘horizon’ problem preceded demise of MCP

By Anthony C. Crooks, Ag Economist
USDA Rural Development

t the time that farmerowned ethanol co-ops and LLCs began popping up like wildflowers after a spring rain, the nation’s biggest and oldest producer-owned ethanol operation-- Minnesota Corn Processors (MCP)-- decided it was time to close up shop, selling out to agribusiness giant Archer Daniels Midland (ADM) in 2002. Why MCP chose to exit the industry just at the time when the ethanol market was starting to boil caused considerable second guessing at the time, and with the good times the industry is currently enjoying, the Monday morning quarterbacking has certainly not diminished.

While the demise of MCP as a producer-owned business has been well covered in the press, the spotlight has perhaps not focused as sharply as it should on the membership horizon problem the co-op was facing at the time. It’s a problem nearly every co-op faces to some extent, and is certainly a factor in some of the other recent proposed co-op sales and conversions.

In the case of MCP, cash-strapped members of what started as a New Generation co-op (before converting to an LLC) were offered a deal that paid them three times the depressed price their stock was trading for at the time, and the majority voted for the deal. Many of them have since objected bitterly that the board and membership were forced into a rush to judgment, and that the process should have been considered much more closely than it was before the vote was taken. One director has even been quoted as saying the board spent more time considering the purchase of one elevator than it did on the sale of the entire MCP business.

MCP launch helped
spark NGC movement In the early 1980s, corn and soybean farmers were caught up in the fervor of the early stages of what came to be known as the New Wave, or New Generation, cooperative movement. But while it may have had some of the earmarks of a religious revival, this movement was rooted firmly in the material world. At co-op organizational meetings, state economic development specialists and others preached a gospel of self-help and collective action in pursuit of new, value-added agricultural ventures.

The New Generation Cooperatives (NGC) promised to address shortcomings of the traditional farmer marketing cooperative structure, while maintaining the principles and benefits of collective action.

MCP was formed during this period in Marshall, Minn., by a group of reasonably successful farmers. They saw an opportunity to become a link in the value-added chain, intending to use this new-style cooperative structure to generate income by building a wet mill corn processing plant. They set up the co-op accordingly, agreeing to do a number of things differently than is typical with traditional co-ops. It started by processing corn starch, soon shifted into ethanol production and eventually added high fructose corn sweeteners (HFCS) to its products.

A difficult start was followed by a number of successful years. Within a year of the move to add HFCS to its product line, much of the soft drink industry switched over to HFCS, so for a time that product proved to be a great asset to the co-op. But eventually a combination of factors-- including drought, high corn prices and a saturated market for corn sweeteners-- combined to suck the wind out of the co-op’s sails. Another major factor was a horizon problem, in which the supposedly marketable equity shares in the co-op could not be sold due to a lack of other producers interested in investing in the plant.

Traditional vs. New
Generation co-ops
A successful traditional marketing cooperative offers two principal benefits: (1) a reliable market at a fair price for the members’ product and (2) patronage refunds at the end of a successful marketing year.

But there are problems with the traditional model. Because membership shares can’t be sold on the open market, they aren’t liquid and there is no way to confer upon the bearer expected present value of the firm’s future earnings. In other words, the value of the stock doesn’t go up to reflect the success-- present or anticipated-- of the business, and the owner can’t easily pass on his investment in the co-op to someone else.

An NGC is different. One of its major attractions is that the benefits of ownership accrue not just through members’ patronage, but through their equity investment. Just as with stocktrading, investor-owned firms (IOFs), a well-functioning secondary market is expected to confer upon the stock owners the option of cashing out their equity investment when they want to reduce or cease their dealings with the cooperative. They are also provided the opportunity to make capital gains on their equity investment.

However, these benefits are contingent upon the existence of a market for the NGC’s stock. If such a market doesn’t exist, or exists only in theory, this ownership benefit is reduced to those of the traditional co-op. As a result, rationally behaving NGC members, lacking a way to accrue or realize the equity they anticipated, can be expected to pressure the cooperative to increase current earnings at the expense of future investment and earnings.

This conflict of planning horizons-- today’s earnings vs. tomorrow’s returns, is called a horizon problem. This can occur when members pressure the co-op into making unrealistically large cash payouts, speeding up equity retirement programs or liquidating co-op assets (see sidebar, page 24). In the case of MCP, it contributed to the complete liquidation of the coop’s assets through the sale to ADM.

Proud beginning
In 1980, MCP leaders proposed to not undertake this new ethanol enterprise on the cheap, as is often the case with traditional marketing co-ops. Every prospective member had to make a substantial investment, at least $10,300 in equity capital to build the plant.

And for each share of stock the members purchased, they received the right and the obligation to deliver corn to the cooperative, along with a residual claim on the net returns of the cooperative. In addition, their equity was tied directly to those delivery rights-- which would be transferable and for which it was expected that a secondary market would develop.

In 1983, MCP began operating a $55 million plant on the north side of Marshall, Minn. Equity had been raised by farmers who purchased stock in 5,000-bushel increments. The co-op also received $1.9 million in tax assis tance from the city. MCP struggled to break even for the first four years. By its own admission, members were just farmers trying to find their way in a new business and a new industry. They first had to learn how to manufacture a product to a customer’s specifications-- and they nearly went broke in the process. But by 1987, they had expanded into ethanol production, worked bugs out of their delivery system and had started to turn a profit.

Even the Minnesota legislature was caught up in the excitement over ethanol. Seeing public investment in farmer-owned fuel ethanol plants as a positive way of supporting rural communities, Minnesota lawmakers developed a plan to subsidize plants on a per-gallon basis. MCP received approximately $33 million in ethanol production subsidies from Minnesota during the next 10 years.

New Wave flagship
The MCP plant soon became a great source of pride to a large number of people. And rightly so-- success has many fathers. In an area with a rich tradition of collective action, this New Generation cooperative was assuming a leadership position in a new industry, in its community and state, as well as among farmer cooperatives. Better still, it was returning some real money to its members.

For the next seven years, and especially from 1991-95, the cooperative grew in number of locations, capacity and prosperity. A plant in Columbus, Neb., was added in 1991. Further expansion occurred, including the addition of high fructose corn sweetener production in 1995-- a move which required the co-op to borrow $124 million.

By that time, the cooperative was becoming a major player in the agriculture industry, standing among corn-processing giants such as Cargill and ADM. The value of the membership’s initial investment more than doubled as stock appreciated from an initial offering price of $2.06 to $4.50 in the mid-1990s. And, as a result of several stock splits in the mid-1980s, charter members more than tripled the value of their holdings. There were reports of paper millionaires among initial investors during those halcyon days.

Fighting for our lives
However, the flagship was soon buffeted by very heavy seas, and began taking on water. Market shocks, competition from a sister NGC and some glaring gaps in oversight in the cooperative’s operations all combined in 1996 to give MCP a very hard lesson in the realities of being a major player in the commodity manufacturing business. Board Chairman Jerry Jacoby, Springfield, Minn., told the Minneapolis Star-Tribune forget all the warm, fuzzy buzzwords of ‘farmerowned’ and ‘value-added.’ We were in a fight for our lives.

Cost overruns from the 1995 expansion made for a rough start in 1996. But the cooperative’s most serious difficulties were caused by a drought that began in 1995 and persisted into 1996, causing corn prices to skyrocket. And because it had no hedging strategy to lock in its offering price to members, MCP found itself especially vulnerable as the costs of its feedstocks nearly doubled.

Grain marketers traditionally use the futures market to protect themselves against major price movement. But MCP’s leaders believed that the market assurances offered by a hedging operation were, if not redundant, surely an extravagance, because their members were contractually obligated to deliver grain. They soon learned that they were wrong.

Members had the option of selling corn in 1996 for a high farm-gate price or supporting their co-op, and many chose the former (although they still had to deliver what they were contractually obligated for). The fact that so many declined to sell additional corn to their co-op when it was badly needed led some to say greed won out. Others said it was simply farmers doing what they had to do in order to survive. Regardless, in hindsight it is obvious that management should have been hedging, just as almost everyone else was.

Too many mouths at the trough
If the price of either ethanol or high fructose corn sweetener were tied to its cost of production, the cooperative might have been able to pass on a portion of its higher costs to its customers. However, product prices were, if anything, inversely related to production costs in 1996, as MCP and all market participants discovered. And fructose prices were not improved later that year when Mexico closed its borders to imports of the sweetener in order to shore up its own market.

But the worst blow to the co-op members may have come at the hands of another NGC. Corn fructose prices went into a two-year tailspin with the arrival of another competitor in the already saturated market. It’s hard to imagine a worse time for the opening of the $261 million ProGold corn sweetener plant in Wahpeton, N.D. Just how unfortunate these circumstances were became clear when ProGold was forced into an alliance with Cargill, which soon acquired it outright.

In the words of a board member quoted in the Star Tribune, MCP ended 1996 with an upside down balance sheet. The cooperative realized net losses of $63 million, had acquired long-term debts in excess of $410 million, and its bankers were demanding payment.

Distress signals
By early 1997 it was clear that MCP was in need of a rescue. The cooperative needed, if not a savior, certainly a sympathetic partner to help pay its bills and get it through a very tight spot. There was no shortage of interested parties. Candidates included Cargill and A.E. Staley Mfg. of Illinois. However, the MCP board was most receptive to ADM’s chief, Duane Andreas. Andreas was seen as calm, well-spoken, down-to-earth and easy to deal with, according to reports in the Star-Tribune.

The MCP board chose ADM in 1997 as the best possible suitor because its requirements were the least onerous. In return for the $120 million in cash that the cooperative received to pay its bankers, ADM received only 30 percent of MCP’s stock and asked for a very limited oversight privilege: the corporation wanted to be consulted before any major capital investments were undertaken.

With its bankers appeased, corn prices returning to normal levels and a modest recovery of the fructose and ethanol markets, MCP began to turn things around in 1999, with significant gains in revenue and net returns. And with continued progress over the next two years, MCP was able to report modest net returns and reduce its long-term debt by 40 percent, to $245 million.

Short-term respite
Meanwhile, a significant but relatively unnoticed transformation occurred in the cooperative’s legal structure and bylaws. In 2000, MCP went through a tangle of legal procedures to convert from a Minnesota Cooperative to a Colorado Limited Liability Company (LLC). The reason given was tax purposes. Perhaps it was, but of significantly more consequence may have been the fact that, as a LLC, MCP was no longer restricted to the requirement that its members be farmer-producers. Now MCP could, for example, have as one of its members a multi-billion-dollar multinational corporation.

The change was enormously beneficial to the former cooperative’s balance sheet. With a few strokes of a pen, ADM changed from a $120 million creditor to a 30 percent partner. The LLC also re-valued its stock to $1.02 per share.

On April 22, 2002, a team of legal and financial experts from New York and ADM headquarters flew in to attend a regularly scheduled board meeting. Ethanol and fructose prices were on the agenda, but this meeting turned out to be anything but routine. A month earlier, ADM had tendered an offer to purchase MCP outright. And, according to press reports, Dan Thompson, MCP’s CEO, presented ADM’s offer to the board.

According to directors quoted in the Star Tribune, there were implications and vague threats of lawsuits issued to any director who might publicly voice opposition. Each board member was reportedly asked point blank if he or she had hired legal representation or discussed any financial details prior to this meeting. Several directors have said the atmosphere of these meetings was one of intimidation and coercion.

Golden parachutes
Some co-op members have said sweetheart payments to executive staff greased the wheels for ADM’s takeover of MCP. A reported $8.5 million was to be awarded at sale to MCP’s executives, and the amount was doubled if the sale went through by a specified date. A total of $20 million in accelerated pensions was to be divided among eight management-executives, and the balance of his annual salary of $385,000 was to be paid immediately to CEO Thompson when the merger went through, according to Minnesota Public Radio reports.

The board voted 19-5 in favor of bringing the decision to sell MCP to ADM to the membership for a vote. Under the terms of the sale, ADM agreed to purchase individual shares of MCP stock for $2.90 per share, a total of $396 million. ADM also agreed to assume MCP’s remaining debt of $240 million.

The shareholders voted conclusively, 3,825 to 736 (a super-majority of 83 percent of voting members) in favor of the sale. The enterprise value of the sale was about $760 million, based on the cash amount, the 30 percent equity already owned by ADM and the agreed-upon debt assumption.

Antitrust concerns were raised by the merger of the No. 1 and No. 2 producers of ethanol and high fructose corn sweeteners. But in July 2003, the Department of Justice ruled in favor of the sale with the provision that a jointventure with Corn Products International was to be dissolved.

Some Minnesota lawmakers, angered that the state had provided $33 million in ethanol-producer subsidies to MCP, only to watch ADM acquire it, demanded a refund. At last account, however, no one was sure about what recourse, if any, the state might have.

New Age co-op had age-old problem
Incentive payments aside, the biggest reason to sell MCP may have been even more fundamental. Given the cooperative’s near-death experience in 1997, its heavy debt burden and its struggle to return patronage to members, it’s easy to appreciate that some members might be having second thoughts regarding their investment.

Moreover, the secondary market in MCP shares, by all evidence, was indeed non-existent-- a detail duly noted among a majority of the stockholders that were at, or approaching, retirement age. Because of the restriction that stock had to be sold to members, existing or potential, any member seeking to cash out of the cooperative had to be especially resourceful.

First, that member had to find another stockholder who was willing to purchase his or her equity at current prices, which meant that the buyer wasn’t actively planning his or her own retirement. Or the seller had to find a non-member seeking membership who also had the wherewithal to make the purchase in such cash-strained times.

Under the economic circumstances of recent years low corn prices and large indebtedness-- finding prospective members both willing and able to buy into the cooperative was difficult at best. Many members had even borrowed the capital to buy into MCP.

Thompson put it this way to Minnesota Public Radio: A lot of members in their 50s invested in this company. They can’t sell their stock: there’s no liquidity. Now they’re 75 years old and they want to cash out. They need cash for retirement purposes and have no way to do it.

MCP members shared these circumstances: their per-member investment was substantial, at least $10,240; some had invested hundreds of thousands of dollars; they were in a ‘cooperative’ with a closed-membership policy; very few of the member firms were legally incorporated; there was a large membership and ownership transfer, either intergenerational or otherwise, was relatively prohibited.

MCP’s situation met all the conditions for an extreme horizon problem.

Despite the questions raised by the way the board meeting was handled, directors were under pressure to increase cash flow to members. They had the choice of speeding up equity retirement programs-- which would result in a whole new set of problems-- or liquidating the cooperative’s assets in whole or in part. The sale to ADM was therefore, an extreme case in which the tendency to emphasize current cash flow at the expense of future earnings was fulfilled by total liquidation of the firm’s assets.

Some leaders of other Midwest ethanol cooperatives say they look at the MCP experience as a cautionary tale of what can go wrong, and that they hope to avoid a similar fate.


Co-op horizon problems: do you have one?

Editor’s note: the following is based on “The Structural
Characteristics of Farmer Cooperatives and their
Behavioral Consequences,” by John M. Staatz, which
appeared in Cooperative Theory: New Approaches,
USDA/ACS Service Report 18, July 1987.

A marketing cooperative is said to have a horizon problem when its members pressure management to:

Increase the proportion of cooperative’s current payments to members relative to investment, i.e., a larger “cash payout”; The horizon problem may also be reduced somewhat if the cooperative provides for an inter-generational transfer of membership within families. Whether retiring members derive satisfaction from bequeathing their heirs a stronger cooperative, or desire to gain a higher retirement from the association, the effect is the same: older members are more willing to help with long-term financing of the cooperative, even though they will not benefit directly from their investments.

If the cooperative has a completely open membership policy, then the value of the cooperative may also be fully capitalized into a farm’s sales value.

In smaller cooperatives — particularly those in which the members are strongly tied to one another, whether by common social or religious beliefs — the horizon problem may be diminished by older members’ moral obligation to their predecessors to leave a stronger cooperative to their heirs.

Extreme horizon problems
Members often pressure a cooperative’s decision makers to increase current payments at the expense of future earnings when the expected value of the cooperative may not be fully realized. A cooperative is said to have an extreme horizon problem if:



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