MANAGEMENT TIP

Cooperative directors face
unique challenges


By James Baarda, USDA/RBS
Economist
james.baarda@usda.gov

Editor’s Note: This is the third of
three articles dealing with issues facing
cooperative directors. The first installment
appeared on page 30 of the July-August
2002 issue while part two was on page 15
of the September-October 2002 issue.
These and other past issues of this magazine
can be assessed via the Internet at:
http://www.rurdev.usda.gov/rbs/pub/
openmag.htm

ooperative directors regularly face problems that directors of even the largest and most complex corporations need not even think about. The tough issues don’t depend entirely on cooperative size either. Directors of small cooperatives face many decisions as difficult as any confronted by the largest cooperatives.

Special cooperative director challenges require personal wisdom and good collective decisionmaking abilities. In some ways, cooperative directors need to know more and think about issues more carefully than directors of other kinds of businesses. Cooperative boards certainly demand more time and work. In addition, the dual role of a director in a cooperative as both a director and a member puts every director in a sensitive position.

This article, the last in a series about cooperative directors, identifies some unique issues that cooperative directors must consider on a regular basis. It focuses on issues that are “in addition to” the responsibilities expected of directors of all businesses.

The character of the cooperative
Cooperatives are unique kinds of businesses. Members justifiably expect their cooperative to operate on a cooperative basis with the appropriate mix of rights and obligations for everyone. Members trust the board to fully support those expectations.

Sometimes cooperative characteristics are defined by law. In other situations they are just an inherent part of the cooperative that members’ understand and expect. In any case, directors have the ultimate responsibility to preserve the cooperative character of the organization.

This responsibility presents some hard questions for the board. Is the organization truly operating on a cooperative basis? How do directors know it is? What observable criteria can be established to guarantee the integrity of a cooperative’s implied promise to be a cooperative? Are measures taken either on a periodic basis or in preparation for significant business changes to be sure that basic cooperative principles are preserved? Has the board established policies, operating procedures and internal controls to guarantee operation as a cooperative? Does the cooperative have danger points in its operations that require special monitoring and attention?

Although difficult, the directors’ role in maintaining the ability of the cooperative to serve members in a uniquely beneficial manner can be a rewarding professional and personal experience for directors. Each director is a gatekeeper of the principles and practices that empower members to cooperate to create true value for themselves and others.





Cooperative-based decisions
Cooperative boards of directors make decisions not made by boards of any other kinds of business. These decisions are, for the most part, unusually difficult. They require directors to have a clear understanding of financial documents, performance measures and the short and long-term consequences of decisions made and actions taken. Situations may make the board a conflict resolution body that balances divergent and often deeply held interests among members. Some of these involve business and financial issues, while others are emotional in nature.

Operating within proper authority was mentioned in a previous article. The cooperative’s authority and limitations on that authority may be found in several places. The board’s authority may be defined by the cooperative’s charter, including the applicable incorporation statute. The board of a cooperative considers incorporation statutes, the articles of incorporation and bylaws to determine the obligations and limitations of the cooperative.

Laws that apply generally to all businesses apply to cooperatives as well, but sometimes in a different manner. Such laws mean that cooperative boards must make decisions for the cooperative based not only on generally applicable laws, but laws that are especially applicable to cooperatives. Examples include special tax laws that apply to cooperatives, cooperative antitrust laws that mandate or prohibit certain business structures and behavior, and state cooperative incorporation statutes that contain special requirements for cooperatives.

A cooperative’s charter, its bylaws, its contracts, membership agreements and other binding agreements are all subject to review by directors as they establish policies and procedures to guarantee that the cooperative adheres to laws and other legal obligations. Directors may, of course, rely on counsel and accountants to identify the rules, but directors themselves make the decisions and bear the responsibility for decisions made.

Determining and allocating patronage refunds is one of a cooperative board’s major concerns. Of course, the board does not make decisions about refunds on the spur of the moment each year. The system used to determine and calculate refunds should have been established in the bylaws and in written policies, all of which are subjects of careful director study and periodic review. Decisions about allocations and distributions are complicated by short-term and long-term implications as well as balances among those who use the cooperative for different purposes. All this leads to possible leads to possible conflicts among cooperative members. The cooperative may also face circumstances that weren’t contemplated when the policies were established. The board must decide what modifications can be made in response to special circumstances to recognize the cooperative’s purposes.

Any patronage refund system has many implications for the cooperative and its members. These include fairness, operation on a true cooperative basis, tax implications, rules in state laws, interpretations of bylaws, members’ expectations and desires, and the very health and survival of the cooperative. Successful solutions to sensitive issues ultimately rest in the hands of an informed, deliberative board of directors.

Member qualification is important to a cooperative, whether the qualifications of applicants for new membership are at issue or continued qualification of existing members is in question. Directors should recognize the importance of keeping good membership roles and purging those who no longer deal with the cooperative. The behavior of some members may harm the cooperative and therefore other members. Directors have the unenviable task of taking appropriate action to protect the cooperative. Predetermined, neutral rules that avoid ad hoc decisions about individual members will help avoid confusion and hard feelings.

Decisions with federal income tax consequences are pervasive. Directors are not expected to be tax experts, but they do need to appreciate the implications of all of their decisions. Examples of decisions with direct tax implications include use of qualified or nonqualified notices of allocation, per-unit retains, allocation of margins and losses and most issues regarding calculating margins and distributions.

Patron or non-patronage business and the allocations and payment of related net margins have direct income tax implications. Added to the direct effect on the cooperative is the impact that any such decisions have on members or other patrons. A seemingly simple business decision by cooperative directors becomes one of balancing many interests.













Conflict of interest
Like other members, directors use the services of the cooperative. This means that directors deal personally with the cooperative. They have their own obligations toward the cooperative and their own expectations of benefits from it. Decisions that directors make about the cooperative will affect them as member-users just as they affect the cooperative and other members.

The previous discussion of “duty of loyalty” pointed out that the single action most likely to impose personal liability on a director is a conflict of interest. The personal dealings that a director has with the cooperative places the director in a precarious position. What appears to be innocent when done may in hindsight look very bad for the director.

Many examples exist of directors’ dealings with the cooperative that will affect both the director and the cooperative and pose possible conflicts of interest. These include:
Directors must make these and all other decisions regardless of the shared interests of directors and the cooperative. Cooperative incorporation statutes recognize the problem, at least with respect to the patronage relationship. A typical provision says that “no director, during his term of office, shall be party to a contract for profit with the association differing in any way from the business relations accorded regular members or holders of common stock of the association or others, or differing from terms generally current in that district.”

Directors should not have problems if the conflict is clearly recognized, decisions are made solely with the interests of the cooperative foremost and all questions are addressed openly and honestly.

















Financial matters
Directors must give careful attention to the effective financial structure and strong financial condition of the cooperative. Directors are entrusted with the ultimate responsibility for the care of the funds and property of the cooperative and its members. Although similar general rules apply to non-cooperative corporations, a cooperative’s directors handle unusual issues because cooperatives have special techniques to finance the organization. Because cooperatives operate for the mutual benefit of the members and not as purely profit-seeking organizations, they have financial needs, opportunities and limitations not found in other businesses. Ultimately, the most difficult financial decisions are in the directors’ hands.

Patronage refund distributions are closely related to equity allocations in most cooperatives. Directors are involved in the balance between current monetary returns to members and additions to the cooperative’s equity structure. For example, patronage refunds may be paid in a combination of cash and written notices of allocations.

The choice carries major implications for the long-term financial health of the cooperative. At the same time, members may expect high cash payout as a return for their involvement in the cooperative and their own tax considerations. Allocations and choices of the income to allocate, equity vs. debt financing and patronage-based vs. non-patronagebased sources of financing, are all part of plans and strategies that boards of directors establish.

Equity redemption is an integral part of a cooperative financing system. It can also be a source of dispute. Decisions about equity redemption are often assigned specifically to the board’s discretion. How is the board of directors to exercise that discretion? Do short revolving periods jeopardize the cooperative’s financial health and robustness? Do long revolving periods show poor planning, do cooperatives use former members’ money to generate benefits for the current users, and does slow revolvement present fairness issues? Courts usually support director decisions on equity redemption in a legal dispute, but the major challenge for a board is to meet obligations of past, present and future members with fairness and forthrightness to avoid unresolvable problems.

Special events
Directors bear added responsibilities when the cooperative considers a major change in its organization or in its relationships with other businesses. Mergers or establishing long-term, significant joint-venture arrangements with other businesses are examples of events where directors have a major responsibility for decisions that are of critical importance to the cooperative. Such events affect members’ interests in the short run and in the long run. Decisions affect benefits that all parties involved will receive, including financial obligations (past and future), differential impacts among members and planning horizons for all parties. Directors not only assess overall costs and benefits of such actions, they will be required to address conflicts among members about the action.

A decision to dissolve a cooperative is, of course, among the most difficult the board will make. The process not only occurs under typically unpleasant circumstances; it challenges the abilities and dedication of all involved.

Directors will be well served by making every effort to recognize how standards of conduct discussed in previous articles in this series can guide them. Adequate information about the implications of the action,the mechanics of the process, impacts on members and the future of the cooperative are all critically important. Balancing member interests and measuring the financial and other needs of the cooperative will guide directors’ decisions.

Assessing the cooperative’s success
Important decisions about the performance of management, success or failure of strategic plans or specific programs, and designing plans for the future are all based on an accurate and realistic assessment of the cooperative’s current performance. Such an assessment is not necessarily easy under any circumstances.

As with any business, the “bottom line” is critical. But unlike other businesses, for cooperatives the bottom line is only the beginning of an assessment of its true success. Every director needs to understand financial statements, organizational growth, project plans, overall strategies and levels of service offered. But more is required.

Difficult questions require additional board consideration. What was the net benefit of an action to members, including their share of savings and margins? What was the tradeoff between benefits distributed to members and the net income of the cooperative? What is the financial condition of the cooperative and what are the trends and expectations for future capital needs?

Were all members treated equitably in distributions and financing obligations? Did the cooperative serve some members at the expense of greater returns to others? If so, is that practice part of the cooperative’s greater purpose? What was the trade-off between short-run and long-run needs, obligations and benefits? Are successes or failures attributable to management, board decisions, the economic environment or member actions? What can or cannot be corrected about the cooperative’s performance?

Directors balance members’ interests
The cooperative’s fortunes are those of its members, and if the cooperative is not responsive to members’ needs, the basic principles of member control and user benefit are weakened. The cooperative will simply cease to exist and serve.

The membership of most cooperatives is not homogeneous. Each member has an interest in the cooperative. These interests differ to some degree, sometimes dramatically from other members. Members may have differing planning horizons, as would be the case between someone just starting in the farming business and someone contemplating imminent retirement. These two members could have markedly different interests in financing, revolving periods for patronage payments and cash vs. non-cash payments. Members may be in different tax brackets, which has implications for the amount and form of patronage refunds.

Some members may be more concerned with price while others may find certainty of supply or a market more important. Producers of different products may have distinctly different needs from the same cooperative. Disparity of business volume among members may lead to calls for differential pricing. These and other variables make the directors responsibility to represent members quite different from decisions for non-cooperative businesses.

Members, or prospective members, may want more from the cooperative than the organization can provide and still maintain its financial and operational integrity. Directors may actually be put in a position of balancing some members’ needs against the interests of the cooperative itself. Diplomacy and good communication are valuable, but no easy resolution may be possible.












Board-management relations
A good working relationship between the board of directors and management is very important for cooperatives. At the same time, the relative responsibilities of the board and management create natural tensions about roles and responsibilities. The cooperative board has a distinct role and make-up that places obligations of independence and leadership on the cooperative board of directors that are not necessarily found in other boards.

Does the board defer excessively to a forceful manager? If so, what might the consequences be? Does the board interfere inappropriately in the cooperative’s management and day-to-day operations? If so, what are the consequences? How does the board assess management and what corrective measures are in place in case of difficulties? Is there an effective chain of communication and command between the board and management? What does management think of the board of directors? If necessary for the good of the cooperative, is the board of directors capable of making and executing a decision to replace management?

The rewards
With all of the responsibilities placed on boards of directors outlined in the first article in this series, the high standards of conduct required of individual directors discussed in the second article and the many difficult decisions directors make as noted in this article, why would anyone agree to be a cooperative director? Individuals can point to at least five reasons to serve as a cooperative director.

The rules that apply to responsibilities, liabilities, duties and requirements are pretty clear. With diligence and care, a cooperative director has guidance to avoid the many pitfalls suggested by a cautious view of a director’s job. Though a director may face unpleasant, and sometimes unexpected circumstances, adherence to high personal standards of conduct is excellent insurance against personal problems.

Directors are part of a team. This team is not only a source of support, it is a reward in itself. Difficult issues are discussed within the board before decisions are made; information is generated and shared, and decisions are made as a board. Responsibilities are shared with others in a similar position. The team concept includes not only the board of directors, but management and, most importantly, the cooperative’s members. The opportunity to take an active role in multiple constituencies is unusually valuable for a cooperative director.

The sheer challenge of being a cooperative director can be added as a third source of reward. Directors see a problem from its discovery. They define the issues it raises for the cooperative and members, identify the range of possible solutions, gather and study the information needed to assess the solutions, determine what the consequences of various courses of action might be, make a decision, create the policies and directives needed to implement the chosen solution, and assess the consequences of the board’s decisions. The more difficult the problem, the greater the rewards of finding an answer. The more critical the issue is to the success of the cooperative, the more satisfying is the problem-solving process.

Directorship presents an opportunity to serve others in direct and important ways. Beneficiaries of a successfully guided cooperative include members and patrons, the cooperative’s management and employees, the individuals and businesses that deal with the cooperative, the communities in which the cooperative and its members and employees are located, and the marketing and supply systems in which the cooperative operates. Individuals considering being a director should consider the significant impacts they can have beyond the boardroom and even on the cooperative.

Finally, board membership carries personal prestige despite the many duties and difficulties. Serving on a cooperative’s board of directors is a worthy personal and professional goal. Directorship should be a source of great personal pride and satisfaction.


























November/December Table of Contents