Legal Corner
Co-op directors must adhere
to high standards of conduct
By Stephanie M. Smith, Senior Legal Adviser
Cooperative Programs, USDA Rural Development
Editor’s note: After a lengthy absence, the Legal Corner column is
back to provide valuable information on legal, policy and tax issues
affecting cooperatives.
ransparency in corporate business activity is
no longer an option. The line in the sand
drawn by Main Street dictates that Wall
Street provide complete accountability for
financial actions.
Cooperatives are not immune from this level of scrutiny.
Indeed, cooperatives have to be especially diligent about the
public perception of their business practices because they
represent the interests of member-owners, rather than
investors. Co-op members expect, and demand, the highest
level of ethical conduct by their directors.
This article summarizes the standards of conduct required
of co-op directors and some of the unique challenges they
face.
Directors are held to three standards of conduct: 1) duty
of obedience; 2) duty of care and 3) duty of loyalty to the
company or organization for which they serve and act in
good faith as decisionmakers.
Director responsibilities include: governing the
organization by establishing broad policies and objectives;
selecting, hiring, supporting and reviewing the performance
of management; ensuring the availability of adequate
financial resources and accounting to the stakeholders for the
organization’s performance.
When directors breach their duties, they can be held
personally liable to the organization for any injury it may
have suffered due to the breach.
Cooperative directors must conduct themselves at an even
higher level than other directors due to the complexity and
nuances of how cooperative businesses are structured. Co-op
directors also must be strong supporters and patrons of the
cooperative and must understand its unique role in business.
Duty of obedience
Directors must exercise their powers for a proper purpose.
They must ensure that they — and the cooperative — do not
engage in illegal or improper actions. Decisions must be
based not only on generally applicable laws, but laws that are
especially applicable to cooperatives.
It is critical that co-op directors have a reputation for
integrity, honesty and respect for the law. This also means
seeking appropriate legal counsel to assist the board.
Duty of care
Directors exercise control and management over the
company on behalf of the company. Although the duties of
directors are several, they must exercise those duties jointly.
Directors have the added pressure of maintaining the
cooperative character of the organization. They must be
familiar with, and understand, the importance of the
cooperative principles and establish policies based on these
principles, which must be well-communicated to the
membership.
Decisions must be based not only on corporate law, but on
specific cooperative state statutory laws. These may include
special tax laws that apply to cooperatives, cooperative
antitrust laws that mandate or prohibit certain business
structures and behavior, and state co-op incorporation
statutes that mandate special requirements.
Co-op directors are required to have a clear understanding
of financial documents, performance measures and the shortand
long-term consequences of decisions.
Because they operate for the mutual benefit of their
members (rather than solely to maximize the value of the
business), cooperatives use special techniques to finance the
business. They have financial needs, opportunities and
limitations not found in other businesses.
Directors must determine and distribute patronage
refunds to find a balance between monetary returns to
members vs. additions to the cooperative’s equity. There can
also be tension between the board and the members as to
whether the co-op chooses to use debt or equity as a source
of financing the business. The reasons for these types of
decisions must be communicated to members.
Duty of loyalty
As fiduciaries, directors may not put themselves in a
position where their interests and duties conflict with the
duties that they owe to the business. As such, their actions
must be transparent and accountable to the co-op. A director
will not be able to escape liability by asserting that a decision
was well meant if the action shows otherwise.
Co-op directors are in a different position than other types
of directors. Their decisions will affect them as member-users
of the co-op just as they affect other members and the co-op
itself.
The personal dealings directors have with the cooperative
can place them in a precarious position. An action that
appears innocent when taken may, in hindsight, look very
bad. However, they can avoid problems if the conflict is
clearly recognized and decisions are made solely with the
interests of the co-op foremost; all questions should then be
addressed openly and honestly.
The ‘good faith’ test
Directors must act honestly and in good faith. Courts have
long held the view that the test to determine if a director acts
in good faith is subjective and must take into account the
unique interests of the company. However, directors may still
be held to have failed in this duty if they fail to question
whether a transaction was in the best interests of the
company.
The single action most likely to raise personal liability
issues for co-op directors relates to their personal use of the
co-op and their duty of loyalty. It is imperative that directors
are sensitive to their dual role and measure their actions
using the good faith test.
When standards are breached
There are a variety of remedies available to companies that
seek legal recourse against directors in a case of breach of
duties. These include injunction, damages, rescission, account
of profits and summary dismissal.
After the Enron scandal in 2002, Congress passed the
Sarbanes-Oxley Act (“Act”), which introduced new standards
of accountability for boards of directors for U.S. companies
or companies listed on U.S. stock exchanges.
Under this Act, directors risk large fines and prison
sentences for accounting crimes. Internal controls of the
company are now the direct responsibility of directors. As a
result, the vast majority of public companies have hired
internal auditors to ensure that the company adheres to the
highest standards of internal controls.
The same remedies are available to cooperatives, except
for remedies allowed under the Act. The Act is only
applicable to publicly traded companies under jurisdiction of
the Securities Exchange Commission. But some states are
pushing for application to be extended to large nonprofit
organizations.
Although the provisions of the Act do not directly affect coop
directors, they should be used as a guide for best practices.
Co-op directors may be held personally liable if they fail to
act in accordance with statutory laws and regulations on
behalf of the cooperative.
Directors may look to the co-op to be indemnified in
defense of a lawsuit. Legal fees and costs could nearly
bankrupt a cooperative even if a loss is eventually recovered.
Co-op directors are charged to think through business
problems independently and to communicate to the members
any events that may adversely impact the cooperative with
the eye of avoiding possible litigation.
While they are held to very high standards, co-op
directors are usually compensated very modestly for serving
on a board. Yet the role of a co-op director is one of great
honor, from which they should garner personal pride and
satisfaction, knowing that the role of co-op director is
absolutely critical to the functioning of the cooperative
system of business.
