Background

"Stock" is an investment contract. Remember, a corporation is a person in the eyes of the law. It can enter into contracts with people and other legal entities. When a corporation sells stock, the buyer contracts to provide money (or something else of value) to the corporation and the corporation agrees that the buyer has certain ownership rights in the corporation, which may or may not include voting privileges.

The rise of cooperatives as a major factor in the rural economy and the enactment of laws permitting widespread use of the corporate form of doing business happened about the same time, in the mid to late 1800s.

Only a few states passed cooperative laws before 1909. They were modifications to existing state laws authorizing general business corporations. Cooperatives organized during this time issued stock and established their cooperative characteristics (one-member one-vote and distributions of earnings on the basis of patronage) in their articles of incorporation and bylaws.

In the early 20th Century, some leading cooperative "thinkers" decided co-ops that paid competitive prices and retained earnings to accumulate capital were just regular corporations with a unique way of allocating earnings. They felt a new structure that more closely adhered to the "operating at cost" principle was needed. Writers at the time characterized it as a movement away from the commercial "company" approach and toward a fraternal "association" of producers. The basic scheme they devised included:

1. The elimination of capital stock, with all invested capital being "debt",
2. Treating each individual transaction on an "at-cost" basis,
3. Eliminating nonmember business.

This approach influenced several state legislatures that were enacting cooperative laws, including important agricultural states such as California, Alabama and Texas. None adopted all of the suggestions, but they did generally promote non-stock associations of producers that would operate on a not-for-profit basis.

The influence of the non-stock advocates reached its peak just as Congress was debating legislation that became the Clayton Antitrust Act of 1914. As a response to antitrust actions taken against marketing cooperatives under the Sherman Act and state antitrust laws, Congress added sec. 6 to the Clayton Act providing that nothing contained in the antitrust laws shall forbid the existence and operation of agricultural "organizations, instituted for the purposes of mutual self help, and not having capital stock or conducted for profit…".

Many new cooperatives were formed under these statutes as non-stock co-ops. Most existing co-ops simply ignored the new laws. A few marketing co-ops, notably California Fruit Growers Exchange (Sunkist), converted from a stock to a non-stock association to take advantage of sec. 6 of the Clayton Act.

A cooperative model comporting to harmonize with cooperative purity in the sense that it didn't have any equity capital, conducted each transaction on an "at-cost" basis, and refused nonmember business sounded good. Unfortunately, it simply didn't work.

The need for a more pragmatic approach was most evident in California, where numerous new producer groups were being formed. Aaron. Sapiro, a sharp and enthusiastic San -Francisco attorney who represented many of the new marketing associations, took it upon himself to draft a new model state law. Then he took off across the country to market his draft legislation. Between 1921 and 1928, forty-six states and Puerto Rico enacted new state cooperative statutes based on the Sapiro model. Among other things, the Sapiro model:

1. Is strictly an agricultural cooperative law. Membership in an authorized cooperative is limited to agricultural producers and other associations of agricultural producers.
2. Authorizes both stock and non-stock cooperatives. It also facilitates the accumulation of capital by authorizing nonvoting stock which can be sold to nonmembers.
3. - Permits limited business with and for nonmembers,
4. Includes a one-member one-vote provision. Some states, including California, were sensitive to the dissatisfaction of large producers with this rule and did not include it in their bill. This opened the way for limited weighted voting based on patronage, at the discretion of the members of each cooperative.
5. Specifically provides for long-term marketing contracts with members and remedies for member breaches of these contracts.
6. States that any association organized thereunder is not a conspiracy or combination in restraint of trade or an illegal monopoly.

The Sapiro model was sweeping the country just as Congress was debating whether to strengthen the protection from antitrust liability for farmers marketing on a cooperative basis. The Capper-Volstead Act is consistent with the Sapiro model in that it covers any marketing cooperative (stock and non-stock) which limits membership to agricultural producers, either limits each member to one vote or limits the return on stock to 8% per year, and limits business with nonmembers to less each year than it conducts with or for members.

To Go "Stock" or "Non-stock"

Since the general acceptance of the Sapiro model 80 years ago, this has been essentially a non-issue. In a non-stock cooperative, the membership agreement is treated just like a stock certificate. The membership agreement is an investment contract wherein the member contracts to provide money (or something else of value) to the cooperative corporation and the cooperative corporation agrees that the buyer has certain ownership rights, including voting privileges.

At the federal level, whether a cooperative does or doesn't issue stock has no bearing on whether it qualifies for the limited anti-trust protection of the Capper-Volstead Act, is eligible to borrow from CoBank or the National Cooperative Bank, or on its ability to qualify for single tax treatment under the Internal Revenue Code.

It also has no bearing on where a cooperative stands with relation to the next subject we will cover, the federal securities law.

Two basic premises underlie this section:

Economic historians report that adverse economic conditions were the primary cause of the Great Depression of the 1930s. But they also attribute a good portion of the blame to the unscrupulous manipulations and outright fraud occurring -in the distribution and sale of investment securities.

Congress responded in the early 1930s with two landmark pieces of legislation:

Congress had the option, as some states had done earlier, to establish a regulatory system that prohibited the sale of "bad" investments. It chose instead to require extensive and honest disclosure of information on the condition of the offeror and the nature of the offering. This left it up to each investor to decide whether or not to purchase the stock.

Each of these acts contained special treatment for cooperatives:

Both cooperative exemptions were added to the bills as floor amendments and adopted without dissent or floor debate. Apparently the Congressmen and Senators who wrote these acts assumed they wouldn't apply to cooperatives, but cooperative supporters wanted reassurance.

One unanswered question is why the 1933 Act exemption is limited to so-called "tax exempt" cooperatives while the 1934 Act exempts securities of all farmer cooperatives. One guess is that in 1933 Congress had just finished reviewing cooperative tax status when it took up the securities issue. This was the only cooperative tax provision at the time, so it was adopted by reference in the 1933 Act without much thought. But even then many farmer cooperatives operated without tax exempt status (and deducted patronage refunds under IRS administrative rulings). When the 1934 Act was debated they made sure a broader exemption covering them was inserted this time, but it was too late to go back and open up the 1933 Act.

Thus we have a patchwork of cooperative provisions:

Thus, when working with cooperatives two issues related to federal securities law are paramount:

The gut issue for cooperatives becomes: "Is the cooperative issuing a "security?" The 1933 and 1934 Acts contain a very broad definition of the term "security." It includes "any note, stock,…bond,..., certificate of interest or participation, ..., or, in general, any interest or instrument commonly known as a' security."

The acts do not, however, include any guidance for distinguishing between something that is a "security" and something that is not a "security." Yet, as the courts have acknowledged, Congress clearly didn't intend to cover every transfer of funds to a business or else the detailed reporting requirements would seriously clog everyday commerce.

The result is a court established test that is analogous to the "rule or reason" under antitrust law. A security exists if (1) someone invests money (2) in a common enterprise (multiple owners) (3) with the expectation of profits to come solely through the entrepreneurial or management efforts of others. Even if something is called "stock," it isn't a "security" unless people are asked to buy it with a reasonable expectation of making money solely off their investment.

For almost 4 decades, the place of cooperatives under the securities laws was essentially a non-issue. A dozen large farmer cooperatives at one time or another sold nonvoting preferred stock to the general public and registered it under the 1933 Act. Then, in the early 1970s, two totally unrelated developments roiled the waters.

First, some the larger dairy cooperatives came under scrutiny from the press for their large contributions to politicians. Some staff at the SEC wondered out loud whether this was a misuse of member funds and began to explore applying the securities regulations as a means to make cooperatives engage in more complete financial disclosure.

Second, a small group of member-tenants at a very large housing co-op in New York City got upset about something and sued their co-op, alleging fraud in the sale of their membership in the co-op because that was a way to establish jurisdiction for the charges of a violation of their civil rights that they really wanted addressed. A federal district court judge in New York City ruled the ownership shares in the housing cooperative were not securities. However, the U.S. Court of Appeals for the Second Circuit reversed that decision and held membership shares in the housing cooperative were securities.

Just as farmer cooperative experts were getting serious about figuring out how to distinguish member investments in farmer cooperatives from those in housing cooperatives, they received a pleasant surprise. The U.S. Supreme Court, in a 6-3 decision, reversed the appeals court opinion and held that membership stock in the housing cooperative as not a security. Even better, the court used a line of reasoning that could easily be adapted to fit other types of cooperatives.

In simplest form, the Court held that the tenants didn't buy stock in the co-op with the expectation of making a profit on the stock itself, but rather to obtain a place to live. The Court relied primarily on the fact that when tenants wanted to sell their stock (and relinquish their apartment) they had to sell it back to the cooperative at the price they paid for it. These limits on transferability and on the chance to realize any appreciation in the value of their investment also apply to patronage-based investments in a traditional business cooperative.

After this case was decided, lower federal courts held that membership and patronage investments in other housing co-ops and in a farmer cooperative were not securities. A major dairy cooperative petitioned the SEC for an administrative ruling that its patronage paper was not a "security." The Commissioner responded with a "no action" letter indicating it would not pursue enforcement for failure of the cooperative to register its patronage paper. Subsequently, the SEC has granted similar "no action" letters to another dairy cooperative and to two wholesale grocery cooperatives.

These administrative rulings seem consistent with the intent of the federal securities laws. For example, farmers don't purchase a share of membership stock or par a membership fee to a traditional cooperative to get a dividend or realize a capital gain. They do so to gain access to necessary farm supplies at the lowest possible cost and to realize the highest possible price for the products they sell. In quasi-legalese. their investment is to facilitate commercial transactions and not to receive passive income from the efforts of others.

While patronage-based investments in traditional cooperatives are now generally considered outside the scope of securities regulation, the growth of so-called "new generation" cooperatives has raised the issue in a new context.

One of the major appeals to farmers to participate in new generation co-ops is the ability to sell their stock to the highest bidder eligible to be a member of the cooperative; i.e., a grower of the crop marketed by the association. Thus the farmer-members certainly appears to be hoping for more than the best commercial price for their crop. They are also hoping to make a profit purely on their investment.

Also, while a member must be a producer of the commodity handled by a new generation cooperative, many of these associations do not require that the product delivered be actually grown by the producer-member. In fact, they don't even seem to be requiring that the producer-members have the capability to meet their delivery obligations with product grown on their own farms.

For example, assume a new generation cooperative is proposed for your state that will process corn into ethanol. Farmer Jones is a corn grower who, in a really good year, produces 10,000 bushels of corn. Farmer Jones is confident that the cooperative will succeed. In fact, he is so confident that he purchases the right to deliver 25,000 bushels of corn each year to the cooperative. He knows when he joins that he will likely have to purchase at least 15,000 bushels each year to meet his delivery obligation. Is this a commercial transaction to enhance his income as a corn grower, or an investment hoping to make a profit from the efforts of others?

And even assuming Farmer Jones can reasonably grow 25,000 bushels each year, he is usually under no obligation to deliver that corn to the co-op. He might feed his corn to hogs that he raises on his farm and satisfy his entire 25,000 bushel obligation to the cooperative with corn purchased on the open market.

Furthermore, some new generation co-ops are encouraging these types of practices. As processing firms, they make the most money by having the plant running all year long and keeping only the bare minimum inventory of raw product on hand. This is rarely consistent with the production schedules of the members, who usually have their crops ready for harvesting at c he same time, once a year.

Typically, each farmer-member is given a delivery schedule calling for several deliveries of a portion of his or her obligation throughout the year. The member has the option of storing the necessary crop on the farm or in an elevator and physically delivering it on the appointed day. The member can -also buy product on the open market and arrange for its timely delivery to the co-op. But many new generation co-ops will purchase product on the open market as it is needed for their purposes and assign it to the delivery obligation of those members who ask for that service. Again, does it appear that members operating in this fashion are merely looking for a home for their production or making an investment with the expectation of realizing a profit on their investment?

Attorneys working with new generation cooperatives have approached SEC staff about the likelihood of securing a favorable no-action letter and were told no way. Thus new generation cooperatives are faced with two unappealing options: (1) Try to comply with the various requirements to secure and maintain section 521 tax status, or (2) register the stock representing transferable delivery rights with securities regulators.

Thus far no clearly preferable strategy has evolved. Given their choice, compliance with sec. 521 of the Internal Revenue Code has a major cost advantage. It can easily save $100,000 or more in cash outlays and untold hours of staff time preparing materials for securities registration that lead to documents of virtually no value to anyone.

The problem is that compliance with the requirements of sec. 521 is not easy and, if IRS audits the co-op and finds it has not been in compliance, it can retroactively revoke a co-op's section 521 status. This would likely be an open invitation to the SEC or state regulators to begin an enforcement action for failure to register.

I'll just focus on one aspect of sec. 521 compliance. To qualify for sec. 521 status, the cooperative can only market the products of members and other producers. IRS and the courts have interpreted this requirement to mean all of the product handled by the cooperative must have been obtained from a member or other farmer who actually produced the product.

If members, and/or cooperative staff, are buying product on the open market for processing by the cooperative, it can be very cumbersome to require that such purchases only be made directly from producers. And even if the cooperative establishes a policy requiring this procedure, the temptation to ignore it when cheaper product is available from a non-producer (broker, elevator) may be too much for a farmer-member or even a staff member to resist.

Cooperation is not a religion. Rural residents shouldn't be encouraged to form a cooperative because cooperatives are "good," but rather as a means to meet a challenge or seize an opportunity that can provide them enhanced economic returns and a better quality of life.

A natural response from someone who has just sat through the standard spiel on "What is a Cooperative" might be, "This is all find and dandy, but what can a co-op do for me?" This is my list of responses you can use to explain the benefits of cooperation. to your customers.

1.    Access to quality supplies and services at reasonable cost. By banding together and purchasing business supplies and services as a group, individuals offset the market power advantage of firms providing those supplies.

 

2.    Increased clout in the marketplace. Marketing on a cooperative basis, like purchasing supplies and services, permits members to combine their strength while maintaining their status as independent business people.

3.    Share in the earnings. Some people talk about non-cooperative firms operating "for profit" while cooperatives operate "at cost." This isn't totally accurate. Most cooperatives generate earnings. They differ from non-cooperative firms in how they allocate and distribute their earnings.

 

4.    Local economy enhanced and protected. Having its businesses owned and controlled on a cooperative basis helps your entire community.

5.    Help your industry solve its problems. A cooperative can also serve as a vehicle for people selling goods and services to work with their customers to promote industry research, reduce regulatory burdens, and develop markets for their products. The cooperative can help create a "win-win" situation for the entire industry, a business environment where both producers and buyers have more income.

If you have mature people leading both your farmer cooperatives and the firms that sell them supplies or buy their products, the various parties can engage in vigorous negotiation over sales prices and contract terms, yet work together to solve problems threatening the industry as a whole.

 

6.    Political action. Growers small business owners, and other rural residents have to realize that no one gives you a favorable law or regulatory ruling just because you think you deserve it. You have to build your case and argue your point convincingly.