The historical background of cooperatives, with an emphasis on the cooperative movement in the United States, including impacts of the Capper-Volstead.
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Prepared by Larry Burt, Extension economist, Oregon State University. Why do something cooperatively? ..3 The nature of a cooperative. 4 Key people for success ..4 Avoiding common mistakes. ..5 Toward making the cooperative a success. ..6 Contrasting a cooperative with other forms of business. ..6 Historical background. .10 Common cooperative functions ..14 Underlying economic principles that may invite creation of cooperatives..16 Prospective strengths and weaknesses of a cooperative business form..18 Equity and debt considerations. ..23 Legal organization. 27 Cooperative management characteristics.. 28 The nature and role of cooperative directors.. .32 Membership responsibilities. 33 Cooperative influences on public policy. ..34 Relationships and linkages between independent, federated, and centralized cooperatives35 Sources for additional information 36 Acknowledgments. 41
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$The historical background ofcooperatives, with an emphasis on the cooperative movement in the United States, including impacts of the Capper-Volstead Act and recent developmentsCommon cooperative functions,including marketing, supply, and servicesUnderlying economic principlesthat invite the creation of coop- erativesÑelements of marketimperfection and the potential for increasing member returns through collective actionPotential benefits and limitationsof cooperativesEquity and debt considerations,including unique equity invest- ment aspects, sources of equity, and equity redemption systemsLegal organization, with empha- sis on articles of incorporation and bylawsCharacteristics of cooperativemanagementÑits role, functions,and toolsThe nature and role of coopera-tive directors as policymakers and individualsMembership responsibilitiesCooperative influences on publicpolicyRelationships and linkagesbetween independent, federated, and centralized cooperativesAt the end of this publication,you will find sources for additional informationÑlocal and nationalL. Burt his publication is designedto help you learn more about agricultural coopera-tives or to help you think through the process of organizing and operating such a business. While the focus is on creating a new cooperative, many of the ideas may be of interest to those thinking about reorganizing or expanding an existing agricultural cooperative. Likewise, many of the concepts apply to any type of cooperative businessÑagricultural as well asnonagricultural.As you consider an agriculturalcooperative, keep in mind that not all business concepts fit well into a cooperative form of business. It is important to explore alternative forms of business for meeting your economic goals. Perhaps a standard corporation or limited liability company might be better able to meet your goals and serve the business needs of potential coop- erative members. After a short discussion about why someone might want to act cooperatively, this publication provides a very brief overview of alternative forms of business.This publication exploresimportant considerations in devel- oping an agricultural cooperative:The nature of a cooperative, keyelements for success, and common mistakes to avoidA comparison with other busi-ness types and a discussion of cooperativesÕ primary operating procedurescooperative organizations as well as Web sites. A compelling need might lead you to consider forming an agricultural cooperative. Perhaps you need to expand in existing markets or develop new markets beyond the bargaining power or supply poten- tial of your business. Or, you might feel group effort is needed to secure lower-cost inputs or larger ItÕs owned and financedby its members, who also are its customers.Its purpose is to provide services to members at the lowest possible costÑnot to generatethe highest possible return to investors.It is controlled by members, usually on a one-person, one-vote basis.Profits are distributed to members based on how much they use the cooperative, not on how much theyÕve investedin it.
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*necessary for cooperative growthand enhanced returns to members. Net income (revenues above total costs) usually is returned over time to members as patronage dividends. Benefits typically are tied to the amount of use, not the amount invested. Returns to membersÕequity investment in the coopera- tive usually are limited in order to focus attention on returns based on use of the cooperativeÕs services.Most cooperatives are controlleddemocratically on a one-member, one-vote basis. However, some cooperatives permit a limited proportional vote based on the amount of use members make of the cooperativeÕs services.For a cooperative business to besuccessful, the members, as user- owners, must be active through their patronage, and they must be willing to make a capital invest- ment in the business and toa day-to-day basis by professionalswho function under policy set by the board.In other significant ways,cooperatives are quite different. Differences stem from the nature of the cooperativeÕs purpose, owner- ship, control, and distribution of benefits. The intent of a coopera- tive is to provide its services to members at the lowest possible costÑnot to generate the highestpossible return to investors. Yet, sufficient revenue must be gener- ated to meet continuing capital needs.As originally conceived, coop-eratives were to be operated on a nonprofit basis. The term ÒprofitÓwas avoided. Instead, revenues above costs were called Òsavings.ÓA portion of savings was retained by the cooperative, and the remain- ing amount was returned to mem- bers as patronage dividends.Today, most cooperative leaders no longer avoid the word profit. Instead, they speak of profit asquantities of inputs. Additional services or higher quality might be more readily available with joint efforts. Perhaps you simply need to increase the net income generated by your business.Whatever the need, creating aproducer cooperative requires a cautious approach. If done prop- erly, a cooperative can give farmers and ranchers a competitive edge by improving market returns or reducing operating costs. But, if done improperly, it can lead to disappointing financial returns. A cooperative is a special type of corporation that is owned and controlled by those who use its services. In furtherance of their mutual benefit, members finance and operate the business. By working together, members may be able to meet objectives that they could not meet as individuals. Hence, the financial returns to individual operations may be greater than they would be without cooperative effort. In many respects, a cooperativeis like any other partnership, corporation, or limited liability business. The physical facilities, functions, and business practices may be identical. Like any other corporation under state law, a cooperative has articles of incorpo- ration and bylaws that govern its actions. It has an elected board of directors and usually is managed onPatronage Use of a cooperative by its membersEquityMoney directly invested in a cooperativeNet returns or net savings (profits) The amount remaining after a cooperative subtracts its costs from its incomePatronage dividends Distribution of net returns to members based on how much each member uses (patronizes) the cooperative
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+participate in decision-making.They must be interested in the affairs of the cooperative, present ideas for improved performance, and promote the cooperativeÕs useby others who could benefit from it.Success also requires outstandingmanagement. The board of direc- tors, elected by members from within the membership, provides leadership by overseeing the cooperativeÕs business affairs and establishing broad policies. Com- munication with the cooperativeÕsprofessional management and with members is critical. Professional management must be well equipped to supervise and manage employ- ees, capital, and physical resources; routine business activities; planning and goal setting; and implementa- tion of board policy. The importance of the cooper- ativeÕs employees should not beoverlooked. Beyond job compe- tence, employees need to under- stand the cooperativeÕs purposes,objectives, and operating proce- dures. Well-educated and trained employees can improve member relations; enhance the cooperativeÕsimage with customers, vendors, and regulators; and increase the general publicÕs understanding of thecooperative. Sometimes people believe that forming a cooperative will auto- matically solve business problems faced by individual operations.In reality, forming a cooperative doesnÕt eliminate the limitationswith which businesses must con- tend. Cooperatives are subject to the same economic forces, legal restrictions, and interpersonal relations as other businesses.Even when a cooperativerestricts the volume of product delivered from its members, it cannot control their production. Neither have cooperatives been very successful at pooling labor resources, providing machinery, or production activities. The inability to control production means that cooperatives canÕt fix prices in themarketplace. In most cases, the availability of substitute products enables customers to avoid paying artificially high prices. Also, growers frequently can market outside the cooperative and, in the short run, still benefit from prices fixed by the cooperative.A cooperative may not be able toobtain market power. Frequently, member-patron ability to generate equity capital is not sufficient to acquire the size and diversification needed.Forming a cooperative generallydoesnÕt allow producers to elimi-nate marketing functions needed to move products to the consumer. However, a cooperative may be able to influence market structureÑwhere and how marketing functions are performed. Marketing functions may be replaced by the cooperative. Hence, cooperative efforts may improve inefficient marketing practices.Furthermore, cooperativescannot be expected to help mem- bers sell their surplus or poor- quality products. Neither can a cooperative be expected to sell the highest quality or most complete services at rock-bottom prices. Instead, cooperatives need to provide Òbang-for-the-buck Ósupplies and services to their members.While a cooperative is subject tothe same interpersonal problems as any business, additional problems typically occur, stemming in part from the fact that the cooperative is owned by many of those who patronize it. Differences in business acumen and objectives may put members at odds.DonÕt expect a market-ing cooperative to be able to control mem- bersÕ production or to raise prices for their products.A cooperative can Õthelp members sell surplus or poor-quality products.Pay attention to people problems. Competing objectives may limit a cooperativeÕs ability tomeet its potential.
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-business. That person can help committee members seek members, choose a site, develop facilities, devise legal structures, acquire capital, finance operations, and enhance communications. An emphasis on communication can make members feel informed and involved, thus encouraging them to invest time and money in the cooperative as well as to patronize it.A mindset that encourages soundbusiness practices lays the founda- tion for success by developing an appropriate accounting system, preparing operating and capital improvement budgets and financial reports, communicating to the membership on a regular basis, and conducting long-range planning efforts. Continuing education is vital tothe successful operation of a cooperative. A democratic, major- ity-rule approach to governance requires an involved and enlight- ened membership. The cooper- ativeÕs responsiveness to memberneeds depends on informedmembers expressing themselves.Furthermore, members must recognize that they have a responsi- bility to participate in financing the operations of the cooperative and to educate those outside the coopera- tive environmentÑother busi-nesses, government personnel, and the general public. In many respects, a cooperative is the same as any other business entity. It is proprietary in the sense that it is owned by its investors and is operated privately, as opposed to being a public institution. It seeks to increase the economic well- being of its owners.A major difference lies in how cooperatives distribute net income (profits). Cooperatives return net income to their investors based on investor patronage (usage of cooperative services or purchase volume). Other businesses tend toDirectors of cooperativesfrequently must choose between building the financial strength of the cooperative through retained patronage refunds and returning savings to members, who may want to receive a short-term benefit for investment in their own operations. Investing in the cooperative may help it meet its full potential in the longer run.Limited objectives of somemembers may restrict the cooper- ativeÕs volume and opportunities toreduce per-unit costs. Additionally, the democratic process, especially when large numbers are involved, may delay decision-making and restrict the expansion of business activities. Frequently, cooperatives that enhance membersÕ competitive edge exhibit the same key ele- ments. In the beginning, the use of professional advisors (frequently a manager) and committee structures for decision-making typically are important. Timeliness of decision- making is critically important. Also, keeping members informed and involved becomes an ongoing effort. Following sound business practices, conducting businesslike meetings, and maintaining a formal board/management working relationship also are important.An experienced advisor oncooperative organization can be a real asset when forming such aProfessional advisorsCommunicating with membersA mindset that encourages sound business practicesConducting businesslike meetingsMaintaining a formal board/management relationship
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1There is no minimum size for acorporate form of enterprise.Articles of incorporation andbylaws must be filed with the Secretary of State. As with other types of businesses, recording fees, annual license fees, and annual reports must be filed. If these requirements are not met, the state will dissolve the business. The Articles specify the purpose of the corporation, the Bylaws identify operating rules and officers, and the reports include updated information about the corporation, such as current directors, change of address, etc. Shares of stock are given in exchange for cash and the value of property and services provided by the shareholders (owners) to the corporation. Annual and special meeting minutes must be recorded and archived. The overall management of a corpora- tion is vested in a board of directors, which is elected by the shareholders.In general, shareholders are liablefor corporate acts only to the limit of their investments. A corporation has a life of its own and can be dissolved only by its shareholders or creditors. The identity of sharehold- ers, managers, and directors makes no difference. Income is ÒdoubletaxedÓ; the corporation pays taxeson net income, and after-tax income distributed to shareholders is taxable to shareholders at their individual rates. However, after-tax income may be retained by the corporation for investment up to specified IRS limits.Corporations offer numerous possibilities for creating benefit programs for employees, who also may be shareholders. If properly constructed, those programs are tax deductible for the corporation. They frequently include retirement plans, medical insurance programs, group or key-employee insurance coverage, and housing and meal expense programs. Estate planning is made easier by the transfer of shares. Important for many family corporations, the Òoriginal ownersÓof the corporation typically can maintain control of the business by having bylaws that require approval of 51 percent of the corporationÕs stock for fillingboard of director positions and 67 percent for questions related to dissolution, merger, or sale of the corporation.Most cooperatives are distin-guished in the federal tax code as subchapter T corporations. Other categories include subchapter C (regular corporations), subchapter S (small, also known as tax option, corporations, which transfer all profits and losses back to share- holders), and nonprofit corpora- tions, which vary in terms of the tax treatment of net income and losses.Unlike other corporations,subchapter T corporations are chartered in Oregon (and many other states) under statutes that specifically address the unique nature of a cooperative form of business. Any income the coopera- tive earns is taxable to thecooperative if it is derived fromsources not associated with provid- ing member services.Limited Liability Companies(LLCs) have become an increas- ingly popular business form for agricultural enterprises. A primary reason is the flexibility of an LLC with respect to liability protection and its tax treatment (income is taxed only once, as with a partner- ship). Increasingly, it is the pre- ferred form of business when access to income, reduced formality, and protection from personal liability are important. In some cases, LLCs are used to own land, which in turn is leased to the operating business. In many cases, both are controlled by the same operators.The organization of an LLC is fairly straightforward. The designa- tion LLC must appear after the name of the business. The company must file a Certificate of Formation (similar to articles for a regular corporation) with the Secretary of State and pay applicable fees. As with a corporation, annual reports and renewal fees generally are required. An Operating Agreement (similar to a partnership agreement) is required in many states, but usually is not filed with the state.The LLC has members ratherthan partners or shareholders. Any person or entity may be a member. There is no restriction on the number of membersÑone personmay form an LLC. Members share
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2in gains and losses as specified inthe Operating Agreement, but are taxed like partnerships. Ownership is based on certificates (shares), which may or may not be based on capital investment. Frequently, certificates are issued for manage- ment expertise, technical skills, etc. Like a corporation, the LLC owns all of its assets.Voting rights may be based on ownership, a distribution formula for gains and losses, or an arbitrary rule. There may be managing members and nonmanaging mem- bers. The distinction typically is the same as that between general and limited partners. Unlike the per- petual nature of a corporation, the lifetime of an LLC may be speci- fied or unlimited. Dissolution after the withdrawal of a member can be avoided by a provision in the LLC Operating Agreement.No members are personallyliable for LLC debts. However, as with other protected business forms, there is liability for debt guaranteed by a member or tort liability outside the LLC. Also, members cannot avoid liability related to taxes, environmental laws, and negligence or breach of a memberÕs obligation to the LLC.Single-member LLCs are taxedlike individual proprietors, includ- ing self-employment tax. If there is more than one member, an LLC Õsnet income can be taxed as it would for a regular corporation, or it can be distributed to members, who then are taxed as individuals (as in a partnership or subchapter S corporation). Nonmanaging members do not pay self-employ- ment taxes. Estate planning rules for partnerships apply to managing members; for nonmanagingmembers, the limited partnershiprules apply. Investor liability is a key consider- ation affecting business organiza- tion. All owners (members) of a cooperative have limited liability equal to their equity investment. Losses, debts, and other claims on the business can be satisfied only up to the limit of the equity invested in the business. Creditors cannot seek additional outside funds from the owners to satisfy claims against the business.Similar to subchapter S corpora-tions, cooperatives under subchap- ter T pay no income taxes on net returns from ÒregularÓ operations.Only distributions to owners are taxable at the ownerÕs individualrate. Cooperatives do pay other taxes, including those levied on property, sales, employment, and fuel.Economic returns to cooperativemembers are emphasized over returns to invested capital. Return to investment in many cases is set at zero. Members usually receive returns based on their patronage (purchases or use of cooperative facilities and services). Typically, some net returns or assessments are retained to finance operating and capital needs of the cooperative. These retained returns are paid back to members at a later date on a patronage basis. While not
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45guaranteed, many cooperativesestablish a desired retained returns payback schedule. Depending on the cooperative, the schedule may range from a few years to more than 20 years.For tax management purposes,net returns from regular coopera- tive operations in a particular year can be handled in two ways. Part or all of those net returns can be identified by the cooperative as a dividend known as a Òqualifiedallocation.Ó The cooperative must pay a minimum of 20 percent of that dividend to members as cash. The full amount of the dividend, whether received by the member or not, is treated by the member as income received in the year the dividend is earned. The 20-percent cash dividend helps members pay income taxes owed on the full amount of the dividend. The entire dividend is tax deductible from the cooperativeÕs earnings for that year. Any of the dividend retained in the cooperative and paid to the member at a later date is completely tax deductible for the member at that time since taxes were paid by the member on those monies in the year the dividend was earned. In other words, member dividends that are qualified allocations and retained by the cooperative donÕtpermit the member to defer taxes on those monies until they are received.On the other hand, part or all ofnet returns may be identified by the cooperative as dividends that are Ònonqualified allocations.ÓMembersexpect to receive these dividends at a later date and pay income taxes on them in the year received. Meanwhile, the coopera- tive pays income taxes on these retained dividends in the year they are earned. When paid out in later years to members, the cooperative treats these dividends as tax- deductible expenses. The advantage of retaining nonqualified alloca- tions is that income taxes owed by the cooperative may be offset by tax credits. Those tax credits are usable only if there are income taxes due by the cooperative. An additional benefit is that members may find it to their advantage to defer income taxes on this type of dividend until the year it is received. The concept of human cooperation within the community is not new. As early as 1752, Benjamin Franklin helped organize the first formal cooperative in the United StatesÑthe ÒPhiladelphia Contri-butionship for the Insurance ofHomes from Loss of FireÓ; itcontinues to operate. But, the organizational characteristics that underlie modern cooperative businesses have mostly been developed within the past 160 years. Many point to the formation of the Rochdale Society of Equitable Pioneers, Ltd. in 1844 as the first successful cooperative business. It was formed by a group of tradespeople in England as a consumer (buyerÕs) cooperative.While not explicitly stated, thecooperative principles observed by the Rochdale Society were the key to its success. The members controlled the business by a one- member, one-vote democratic process. Membership was open. With respect to ownership, equity was provided by the patrons, and each personÕs equity was limited asa share of total equity. Limited dividends were paid on membersÕequity investment, and income after all costs were covered was returned
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44to patrons as a patronage refundbased on the value of the patronÕspurchases. All goods and services were exchanged at free market prices. Other principles that contributed to the SocietyÕs successincluded a duty to educate, cash trading only, no assumption of unusual risk, political and religious neutrality, and membership equal- ity between the sexes.Following the Civil War, agri- cultural cooperatives began to be formed in the United States. Most were patterned after the Rochdale system. The Grange and later groups such as CENEX (Farmers Union Central Exchange, Inc.) and the National Farmers Union (Farmers Educational and Coopera- tive Union of America) fostered the development of many cooperatives. But, in the 1890s, antitrust legisla- tion began to put a damper on agricultural cooperatives. Subse- quent court rulings effectively made farmer cooperatives illegal. Farmers were prosecuted for collective actionÑespecially foractivities that involved pricing agreements and terms of trade.In response to concerns aboutantitrust allegations, Congress passed the Capper-Volstead Act in 1922. It contained two key provi- sions. The first permits farmers to collectively market their products without the threat of antitrust action. By acting together, agricul- tural producers are permitted to create countervailing power whenbargaining with typically fewer, larger buyers. The second provision of the Act protects the public from Òundue price enhancementÓ causedby monopoly action by a group of producers.As a result of Capper-Volstead, agricultural producers not only may form associations, but those associations may form agencies. In order to reduce competition among producers, associations must be operated for the mutual benefit of their members, who must be agricultural producers. In addition, an association must deal in the products of its members to a greater degree than the products of nonmembers. Finally, an associa- tion must conform to at least one of the following rules: (1) no member of an association is allowed more than one vote because of the amount of stock or membership capital owned, or (2) the associa- tion does not pay dividends on stock or membership capital greater than 8 percent per year. While Capper-Volstead provides limited antitrust exemption, agri- cultural cooperatives can be prosecuted under antitrust laws if they are involved in prohibited business practices. Specifically, they may not engage in ÒpredatoryÓpricing practices or conspire or collude with third parties to fix prices, restrict membersÕ agricul- tural output, coerce competitors or customers, combine with other firms to Òsubstantially lessencompetition,Ó or engage in boy-cotts. If an association is found tobe monopolizing or restrainingtrade to the extent that it Òundulyenhances pricesÓ of agriculturalproducts, then it may be required to Òcease and desist from monopoliza-tion or restraint of trade.ÓSince the 1950s, agriculturalcooperatives have continued to develop with only a modest amount of government helpÑbroadresearch, education, and advice. While remaining separate, most agricultural cooperatives and general farm organizations have maintained friendly and comple- mentary relationships.Neutrality toward politicalparties is widespread, but agricul- tural cooperatives are increasingly involved in political action to influence agricultural policy and the economic and business environ- ment. Because of an increasingly global economy, many agricultural cooperatives have organized their structure and business strategies around an international economic dimension.Agricultural cooperatives haveincreasingly looked for ways to grow. Growth has come both internally and through consolida- tion of smaller cooperatives. Larger size has allowed many cooperatives to expand into value-added agricul- tural activities such as input manufacturing and product processing.A 1998 USDA national surveyof cooperatives (see USDAÕs RuralBusiness-Cooperative Service Web
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