The Circle of Responsibilities for Co-Op Boards

The Circle of Responsibilities for Co-op Boards

REPRINT Management Tip Series By James Baarda Foreword

All boards of directors are under increasing pressure to perform well and justify their decisions. Cooperative boards are no exception. But increasing scrutiny of director behavior is not always accompanied by better information about exactly what directors are supposed to do and how they are to perform their many duties. The series of articles reprinted here originally appeared during 2002 as Management Tip articles in three issues of USDA’s "Rural Cooperatives" magazine. These articles lay out fundamental guidelines for cooperative directors. Along with practical guides, the articles explain underlying principles and give suggestions for specific actions cooperative boards and directors can take to improve their service to cooperatives. Cooperative members can use this well-received series to assess board and individual director performance and make informed choices about directors. Directors can apply the information to carry out the full range of their responsibilities with the assurance that they are satisfying the high standards of conduct required of them.

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Cooperative Information Report 61 Reprint Published: February 2003

2 January/February 2002 / Rural Cooperatives MANAGEMENT TIP Co-op boards’ circle of responsibilities

By James Baarda The three articles in this series cer- tive meaningful. An added source of USDA/RBS Ag Economist tainly don’t give all the answers. Howev- guidance is a cooperative’s own bylaws. [email protected] er, existing information related to coop- The bylaws are not the place to give erative directors, as well as the directors detailed descriptions of what the board is Editor’s Note: This is the first of a of other kinds of organizations, can be supposed to do, and bylaws typically do three-part series about cooperative boards of distilled and focused for cooperative not. However, in describing certain directors. This article identifies the sources of director use. Concise guidelines are giv- processes and actions of the cooperative, authority for boards and describes seven en that can be tailored to the needs of bylaws often identify decisions the board basic responsibilities imposed on every coop- individual directors on the boards of a must make on specific issues. Some of erative board of directors. The next article specific cooperative. these will be described when board func- discusses the legal standards directors must This article identifies authority that tion and personal responsibilities are not- meet and outlines practical ways directors gives directors the rights and responsi- ed in the next article in this series and— can protect themselves as well as the cooper- bilities to carry out their work as direc- even more so—when special issues are ative. The last article describes the numer- tors on behalf of the cooperative and its described for directors in the final article. ous special difficulties faced by cooperative members. Then it describes the seven The problem faced by directors (who directors and shows why a cooperative direc- basic responsibilities imposed on all represent members) when members want tor’s task is more difficult than for directors directors of all cooperatives: the “circle something that will be detrimental to of other organizations. of responsibilities.” their cooperative (to whom directors also owe a duty) is also noted in the final arti- eing a director of a coop- Board authority cle. erative isn’t easy. In fact, it What gives a board of directors its Finally, the board will establish its own B is harder to be a good authority? The basic authority, and the internal structure, rules and operations to cooperative director than ultimate statement of responsibility, is supplement the broader statements in the a director of almost any other organiza- imposed by law. Statutes under which statutes and the bylaws. These cannot tion, including the largest corporations cooperatives are incorporated identify remove or diminish the responsibilities in the country. Cooperative directors the board of directors as the key institu- imposed by statute, but can create a make decisions that aren’t required in a tion responsible for the direction and framework in which the overall responsi- non-cooperative corporation, and bad management of the cooperative. A typi- bilities and authority are useful in the decisions can hurt the cooperative and all cal cooperative statute says: “The affairs everyday work of the board. of its members. of the association shall be managed by a These are the technical sources of Frequently, directors just have too board of not less than five directors, authority. The ultimate authority, little information about what they need elected by the members or stockholders though, comes from the cooperative’s to do as directors. Information that is from among their own number.” Varia- members. The cooperative is theirs, and available to help them become excellent tions exist, of course, among statutes without members’ desire to create and directors is often not appropriate for and states, but the theme is always the perpetuate the cooperative, the board cooperative directors. Often, advice is same: the law places a cooperative’s would not exist. Members place their so general it isn’t applicable and some is management and guidance in the hands trust, their needs, and authority in a so specific that it cannot be applied easi- of its board of directors. board of directors of their own choosing. ly. Advice and information may not The statutory mandate is broad but focus on the real issues and sometimes isn’t described in further detail by most Circle of seven responsibilities the advice is conflicting. statutes. This is one reason that further Despite significant differences among explanation is needed to make the direc cooperatives in the United States in

Rural Cooperatives / July / August 2002 3 size, function, complexity, organiza- thorough understanding of the cooper- to serve patrons in one way or another. tional form, financing methods and ative’s resources and its employees so An overall responsibility of the board is membership makeup, it is possible to they can be used to the members’ best to establish policies with respect to summarize a “circle” of seven responsi- advantage in a successful cooperative. acquisition and preservation of the bilities applicable to all cooperative 2. Board establishes cooperative cooperative’s assets. Cooperatives are policies entrusted with other people’s money Directors put their and must account for it at all times. The General definitions: member representation assets of a cooperative were purchased role into effect by mak- with member money, and the coopera- Responsibilities: What boards of directors must do to ing policy. Indeed, many tive is obligated to those members. meet their obligations to the cooperative under laws discussions about coop- This board responsibility is shown and other guiding sources. erative directors summa- in two specific obligations. First, the rize the board’s job as board is responsible for guaranteeing Standards of conduct: Sometimes called duties, stan- establishing cooperative that the cooperative establish and use dards specify how the responsibilities must be carried policy. Policies may be accounting systems that keep track out. They impose standards of conduct on the board broad and long-range or of all aspects of the cooperative’s and individual director board members. they may be specific and finances and resources. The account- immediate. Both are ing system must also accurately Liabilities: These are consequences when directors necessary. If the board reflect the true financial condition of fail to carry out required responsibilities with the fails to establish cooper- the cooperative. required standards of conduct. Liability may be ative policy, either some- The second obligation is that the imposed on the cooperative or individual members one else will establish the board monitor the cooperative’s finan- of the board. policy or the cooperative cial performance and establish policies will operate without that protect the cooperative from direction and control. In financial shocks and risky situations boards of directors. Of course, each of either case, the cooperative cannot be that undermine its financial health. the responsibilities will be carried out successful and disaster is likely to follow. Proper audits and careful board differently depending on the coopera- 3. Board hires and supervises man- response to audit reports is the first tive, but fundamentally the circle of agement step towards meeting this responsibili- seven responsibilities describes all Directors do not run the cooperative ty, but a range of board decisions can cooperative boards of directors. themselves. Employees are used to do spell financial success or failure. 1. Board represents cooperative the work necessary, given policies the Whether financially related policies are members board has established about the purpos- short-term or long-term, the board of Cooperatives are created and oper- directors has the ulti- ated to serve members’ needs. Mem- Boards of directors and management often struggle mate responsibility for bers invest in the cooperative, they with the division of duties, supervision, and opera- the cooperative’s finan- patronize it and they exercise ultimate tional detail between the board and management. cial affairs. control of the cooperative. The board This issue can be detrimental to the cooperative if It is clear that these of directors is the means by which the conflicts are not resolved satisfactorily. responsibilities require needs and desires of individual cooper- a great deal of care, ative members are incorporated into attention, and skill by the cooperative. In some circum- es of the cooperative and specific poli- each member of the board. Board stances, of course, members vote cies guiding cooperative operations. members must understand what a directly on a cooperative issue. But for The board hires and supervises manage- financial reporting system is, what it the most part, members are represent- ment. Normally, direct involvement by must do, and what financial informa- ed by the board of directors. board members is limited to only top tion can and cannot tell directors Directors are elected by members management, but the board’s responsi- about the performance of the coopera- and directors’ role is to represent those bility does not end with the employ- tive and its management. members. To represent members effec- ment of a chief executive officer. Super- 5. Board preserves the cooperative tively, directors must know what mem- visory responsibilities vary according to character of the organization bers need. They also assess the cooper- structure and circumstances. The board, as the policy-making ative’s capabilities to meet those needs. 4. Board is responsible for acquisi- body and representative of the cooper- Directors must understand the tion and preservation of cooperative ative’s members, is responsible for strengths and weaknesses of the coop- assets maintaining the special character of the erative and make judgments based on a Cooperatives acquire and use assets cooperative. If the cooperative is

4 Rural Cooperatives / July / August 2002 ciates that a wide range 6. Board assesses the cooperative’s This may be one of the most misunderstood and of operating methods performance neglected of directors’ responsibilities. In most situa- and structures is avail- Every organization evaluates its per- tions, it does not require specific action on the part of able to cooperatives. formance to assess the policies and the board, but only if the proper safeguards have been Preserving cooperative actions taken during the year and to plan established and are in place for all to see. A periodic principles doesn’t mean effectively for the future. For coopera- review of the cooperative along with established poli- that the cooperative is tives, performance rules are not identical cies and rules requiring operation on a cooperative either small or simple. to those that generally apply to other basis are essential. But nothing gives the cooperative It only means that the types of businesses, although they are as much protection as an articulated dedication to fundamental character deceptively similar. A cooperative is cooperative principles understood by the board, the of the organization is indeed concerned with the “bottom line” members, and management. that of a cooperative and its success as measured by financial regardless of size or criteria, but it is not organized to simply complexity. benefit itself. The cooperative’s perfor- allowed to deviate from principles to The responsibility imposed on the mance is ultimately measured by the the extent that it is no longer a cooper- board to preserve the cooperative benefit it confers on those who use it. ative, the directors have failed in this character of the organization means Performance is judged by the coopera- responsibility. This can be a breach of that the directors must know what that tive’s fundamental objectives. the trust that members have placed in character is, how it operates in the This may be accomplished in differ- the board, and in some cases it can be a structure of their organization, and ing ways, as no single standard of mea- violation of law. what kinds of events and actions may sure is available to the board. The board At the same time, the board appre- undermine cooperative fundamentals. is faced with multiple criteria, and some may be conflicting. Some criteria may be measured in numbers, and some cannot be measured by any financial docu- Implementing exercise ments. Despite the variations, the board must keep its eye on the cooperative’s At your next board meeting, consider conducting a complete assessment of ultimate goals, make careful assessments sources of the board’s authority, including statutory requirements, bylaw provi- of performance and strategies, establish sions, policies, board structures or another source of board authority. appropriate policies, and make hard • What is the source of the authority? decisions on behalf of the members. • What does it mean for the everyday operation of the board? 7. Board informs members • Does the board fully appreciate its authority—and its limits? Cooperative boards of directors • How can the board respond better to the authority it is assigned? inform members about the cooperative organization—the members’ own busi- At each of the subsequent seven board meetings, thoroughly consider one ness. This duty is rather unique among of the responsibilities listed. businesses in its importance and impli- • What specifically does the board currently do to meet the responsibility? cations for member control. • What are the weaknesses in the board regarding its responsibility? Without accurate information, • Does each director have the skill, interest, and time to consider and respond to the members cannot make decisions about responsibility? their cooperative and will not be pre- • Does the board have the knowledge and information necessary to meet each pared to make decisions imposed on responsibility? them as cooperative members. Mem- • What specific steps can be taken to make the board meet every responsibility? bers will not be able to understand • Is there a consensus on the board’s performance? whether their cooperative is successful, • Would members agree with the board’s self-assessment? or whether basic changes must be made to correct problems identified by the The most effective way to make the responsibilities “up close and personal” board. And without accurate and com- is to have each director individually address the issue and propose his or her own plete information, members will not be solution to problems perceived about the responsibility under discussion. Board able to make judgments about coopera- meetings or ancillary sessions to board meetings can then provide the forum for tive management or about the board’s discussion within the board. These sessions may be more effective if management own performance. is not present. Member information completes the directors’ “circle of responsibility” leading to member representation. ■

Rural Cooperatives / July / August 2002 5 MANAGEMENT TIP Co-op directors held to high standards

By James Baarda individual director’s participation in the USDA RBS Economist cooperative. Decisions are board of [email protected] The Circle of Seven director decisions, so an individual Responsibilities director must be able to work effectively Editor’s note: In the last issue we exam- within the dynamics of the board to ined the circle of seven responsibilities that influence board decisions. The board as (As described in the previous article all directors have. This second article in a a whole will be effective only if proce- in this series, see July-August 2002 series of three discusses standards of conduct dures, committee structures and interac- issue, page 30.) applied to directors and the sources of legal tion is conducive to good decision-mak- liability imposed on directors when they ing. If a director objects to a decision, it Directors: don’t meet the standards. It concludes with is imperative that a negative vote be 1. Represent members a discussion of protections for individual recorded, otherwise the director will be 2. Establish cooperative policies directors against personal liability. Just as held to have agreed with the decision. 3. Hire and supervise management responsibilities can be divided into seven Responsibilities, standards of con- 4. Oversee acquisition and preserva- distinct, yet related, items, standards of duct and possible liabilities fall on tion of cooperative assets conduct, liabilities and responses can be board members as individuals. If the 5. Preserve the cooperative charac- viewed in seven steps. standards of conduct are not met, indi- ter of the organization vidual directors may be liable to share- 6. Assess the cooperative’s perfor- Directors’ roles in holders and members, to the coopera- mance perspective tive, to creditors, to patrons and to the 7. Inform members A number of responsi- public through civil or criminal laws. 1. bilities are imposed on a What are the standards of conduct by cooperative board of financing techniques, they impose which directors are measured? directors, but where do individual direc- unusual decisions on the board of directors fit in? Four perspectives of directors and they give cooperative directors 2. Standards of conduct tors’ roles help identify board and indi- “something else to think about.” Standards of conduct for corporate vidual director responsibilities. Starting Narrowing the perspective further, directors have been developed over with the broadest perspective and nar- the board of directors acts as a body. many years by judicial decisions and rowing the view to the individual direc- The power to act on behalf of the legislative action. Although cooperative tor gives the following breakdown. cooperative is given to the board of directors face numerous special prob- The cooperative is a business orga- directors as a body, not to individual lems, no separate set of standards has nization, almost always a corporation. directors. No special power is given to ever been developed for cooperative All of the substantial rules governing an individual board member to act offi- directors. Therefore, corporate rules cooperative directors come from cor- cially. As an individual, a board mem- generally apply to cooperative directors. porate law. ber has no greater authority than an Standards applicable to cooperative The cooperative is a very special ordinary cooperative member. The directors (as is the case with corporate kind of corporation. Cooperatives oper- board derives its authority from the directors) are usually divided into three ate according to appropriate coopera- incorporation statutes, articles of incor- “duties.” These are summaries of many tive rules or principles. These unique poration, bylaws, and the members. decisions and statutes and are stated in cooperative attributes define coopera- These all identify the board of direc- general terms in this article. The three tives’ unique objectives, they require tors as the governing body. duties are “duty of obedience,” “duty of specialized income distribution and This perspective further defines an care” and “duty of loyalty.”

6 Rural Cooperatives / September / October 2002 3. Duty of obedience have the highest obligation to the understand the financial condition of The term “duty of obedience” cooperative and stand in a relationship the cooperative and its business opera- sounds odd but is logical when of trust—a fiduciary relationship. tions. Directors are presumed to know explained. The duty means first that Good faith, conscientious care and best what is in the cooperative’s books and directors must perform their roles in judgments are expected of each and records. As a general statement, direc- conformity with the statutes and terms every director. tors will be charged with knowledge of of the cooperative’s documented Diligence and care raise two particu- what it is their duty to know. requirements for the directors. The lar challenges for cooperative directors. authority given to the board of direc- Directors may fail in their duty if the 5. Duty of loyalty tors is defined, as is the purpose of the board does not adequately supervise Loyalty is perhaps the most trouble- cooperative. Acts beyond those limits management. The board must devise some area of liability in corporate law, are “ultra vires” and are not autho- some way to be sure that management including cooperative law. It is trouble- rized. and employees conduct themselves in some because it is not well understood, Neither may the board make deci- the cooperative’s affairs in an ethical and and the presence of disloyalty or conflicts sions that are either themselves illegal legal manner. The board also establishes of interest is devastating to a director’s or that will cause the cooperative to do the cooperative’s strategic direction and personal position of trust in the coopera- something illegal. The duty of obedi- evaluates management’s progress toward tive. As has been mentioned, directors ence also implies that the board should the cooperative’s goals. In addition to occupy a position of highest trust and mandate necessary records and record- selecting top management (usually the confidence upon which the cooperative keeping, internal procedures, policies manager or CEO), the board’s duty of and the entire membership relies. That and compliance programs, then super- diligence requires that the board evalu- position must be protected in any action vise the process to the extent necessary ate management’s performance, estab- taken and in any decisions made. to protect the cooperative from illegal lish succession plans and, if necessary, Several kinds of behavior are prohib- or improper actions. dismiss top management. ited by the duty of loyalty. Self-dealing, Often, questions about a director’s where the director makes a special prof- 4. Duty of care performance revolve The duty of care, also called the duty around what the direc- of diligence, has developed in judicial tor knows. Generally, Conflicts of interest decisions but is also found in many cor- ignorance does not porate statutes. Statutes typically excuse a director from Conflicts of interest involving directors are unavoid- describe the duty of care in three parts: liability. Directors must able and can have serious consequences if not handled good faith, prudence and judgment. know what they are properly by the board and the cooperative. This topic Directors are required to act in doing or they cannot will be further examined in the third part of this series. good faith in all circumstances. Direc- satisfy their duty of care. tors must also exercise care that an The knowledge requirement is usually it by doing business with the coopera- ordinary person in a like position divided into two important parts. tive, is a breach of the duty of loyalty. would in similar situations. Finally, a Directors will be held accountable for director must make decisions for the what they know and what they should As discussed in the previous article, cooperative in a manner that he or she know. A director who is actually igno- directors of cooperatives are placed reasonably believes to be in the best rant of a fact is not excused if the law almost automatically in a position of interests of the cooperative. Directors requires that the fact should have been dealing with the cooperative. This is known by the director. not a problem if handled properly. In How is a director to fact, a common statutory provision Do corporate statutes apply gain this knowledge? describes permissible situations. A typi- Directors are sometimes cal provision states “No director, during to cooperative directors? said to have a duty to the term of his office, shall be a party to inquire about facts a contract for profit with the association Generally yes, for two reasons. Cooperative incorpo- which are required for differing in any way from the business ration statutes usually state that corporate law applies them to carry out all of relations accorded a regular member or to cooperatives unless corporate law conflicts. Coop- their responsibilities. holders of common stock of the associ- eratives are incorporated bodies that have all of the Directors have a right to ation or others, or differing from terms basic characteristics of corporations; directors’ roles, inspect all books and generally current in that district.” Con- duties and responsibilities are no exception. records. They have the flicts of interest situations always pose additional duty to special challenges.

Rural Cooperatives / September / October 2002 7 The duty of loyalty imposes other restrictions on directors. A director Implementing exercise will violate the duty of loyalty by dealing with someone directly who could Establish a schedule to consider—at board meetings or ancillary meetings— have otherwise dealt with the coopera- each of the standards of conduct imposed on directors. Systematically consider tive. This is called “appropriating the each standard and its requirements. At each meeting, thoroughly examine one cooperative’s opportunity.” Loyalty of the standards outlined in this article. also requires the highest degree of • What specifically does the board currently do to meet the standard? honesty and fair dealing with the coop- • What are board’s weaknesses regarding the standard? erative and on the cooperative’s behalf. • Does each director have the skill, interest and time to consider and respond Directors are often in a position to the standard’s requirements? where they could violate the final aspect • Does the board have the knowledge and information necessary to meet the of the duty of loyalty: that of confiden- standards? tiality. Directors are privy to informa- • What specific steps can be taken to make the board meet every standard? tion about the cooperative that may not • Is there consensus on the board’s performance? be public. This is particularly the case • Would members agree with the board’s self-assessment? where directors have access to informa- Even more than the board’s responsibilities, the standards are personal to each tion about the affairs of other members director. Each director should individually address the issue and propose his or of the cooperative. Directors are under her own solution to problems perceived about the standard of conduct under dis- strict prohibitions about either cussion. These sessions may be more effective if management is not present. divulging confidential information to The board should also consider the mechanisms the cooperative has in place anyone else or using it for their own to protect directors, such as indemnification provisions and D & O insurance. benefit regardless of the harm to the Assessment of state law applicable to the cooperative and directors will be part cooperative. of the analysis. Generally, a violation of the duty of loyalty, typically in situations referred to as conflicts of interest, is the quick- Few members would be willing to tors are guilty of willful abuse of their est and surest way to make a director serve as cooperative directors if they discretionary powers, or bad faith, or of liable for wrongdoing. faced personal liability for good faith neglected duty, or of perversion of the errors in judgments that results in purposes of the corporation, or when 6. The business judgment rule harm to the cooperative. Courts also fraud or breach of trust is involved. Oth- Directors constantly exercise judg- recognize that courts themselves are erwise, directors are not personally liable ment on behalf of the cooperative, and ill-equipped to make business judg- for mistakes while exercising their sometimes that judgment does not lead ments for directors and that second- informed, best judgment. to the best outcomes for the coopera- guessing board decisions is not an effi- tive. Unexpected events can turn a cient way to monitor directors. Finally, 7. Minimizing risk good plan bad. Or directors may simply a cooperative cannot be managed effi- An easy but inadequate suggestion make a mistake in judgment. What ciently if directors are not given wide for avoiding problems as a cooperative happens when directors’ actions lead to latitude in law to handle the coopera- director is to understand and appreci- losses or other detriment to the cooper- tive’s affairs. ate the responsibilities listed in the first ative? It is important to understand the lim- article in this series, know and adhere Normally, courts will not interfere its of the business judgment rule. Courts to all standards of conduct in this arti- with the internal operations of a busi- usually say that the authority of directors cle and make no mistakes that may be ness to replace the judgments of the is absolute when they act within the law, detrimental to the cooperative. The directors with the court’s own judgment and questions of policy and internal first two suggestions are in the control on business matters after the fact. The management are—in the absence of non- of each director and are, in fact, the business judgment rule says that, absent feasance, misfeasance or malfeasance— best defenses to legal challenges to fraud or self-dealing, business judg- left wholly to their discretion. The rule is director performance. ments made by directors will not be not a protection if the offending action Protection is best when a proactive overturned by the courts and will not was an abuse of the board’s discretion, attitude is adopted by each director to lead to director liability. Directors do was tainted with board member conflicts know the responsibilities and standards, not and cannot guarantee the success of of interest or was a result of the directors’ understand what it means for the direc- the cooperative or each decision made. abdication of their duties to the coopera- tor’s performance and identify particu- Courts have generally given three tive. Courts will step in and hold direc- larly sensitive issues in the cooperative, reasons for the business judgment rule. tors liable for their actions when direc- for the board of directors and regarding

8 Rural Cooperatives / September / October 2002 the director’s own personal performance. tion of procedures in place and recom- called D & O insurance because it cov- Directors may also give attention to mendations for changes needed to ers both directors and officers, the several other actions and practices that address weaknesses. insurance is often in the form of two are beneficial to their performance. Whatever action is taken, the overall policies. One covers directors to the Board structure, proper use of commit- attitude of directors should be active, extent the cooperative does not fully tees, effective board discussions and positive, creative and dynamic. The indemnify them for their costs. The leadership, flows of information from great responsibilities imposed on coop- other covers the cooperative itself for management to the board and good erative directors and the associated the indemnification made to directors. board-management relations can avoid potential for liability should not lead to As with nearly any insurance a number of problems. Directors may a defensive posture. arrangement, each policy will be tai- rely on experts, advisors, employees, lored to the needs of the cooperative. and board committees, within certain Indemnification Terms will be negotiated that include: limits. Reliance does not relieve direc- Legal challenges to cooperative level of coverage, exclusions, claims or tors of their responsibilities but does directors and litigation involving direc- occurrences methods, deductibles and show care and diligence. tors cannot always be avoided. The general claims procedures. ■ Reliance on others must, of course, trauma of such actions against directors be justified and cannot amount to abdi- is significant. In one regard, the bur- cation of responsibilities and duties. dens can be relieved somewhat in most Director training is key to effective circumstances. directorship. Effective training pro- Legislation has been used in many grams must go far beyond indoctrina- states to allow a corporation (and pre- tion by management about the cooper- sumably a cooperative) to indemnify ative’s business from management’s directors who are subject to legal viewpoint. action that requires expenditures of Compliance programs can be help- sometimes substantial sums in defense. ful, and in some cases are necessary, to Indemnification in this context simply implement directors duties of care and means that the cooperative pays for management monitoring. Compliance costs incurred by a director who is programs are formalized internal pro- responding to legal actions for some grams to monitor certain types of act as a director. behavior to be sure neither the cooper- In addition to authorizing indemni- ative nor employees violate some law or fication and describing procedures for fail to take a required action. These indemnification, statutes usually estab- programs are typically designed around lish standards of conduct permitting legal requirements such as environmen- indemnification. A cooperative may not tal issues, antitrust and securities laws, be permitted to indemnify a director financing issues, or special problems where the director’s conduct in ques- that may be sensitive for a particular tion fails to meet certain standards of cooperative. To be effective, the board conduct. For example, directors who must insist on workable programs, must cause harm to the cooperative by self- monitor their implementation and dealing or fraud against the cooperative insist on full support by management at cannot demand indemnification when all levels. In some cases, a poor compli- they are sued for such actions. When ance program is more likely to cause contemplating indemnification, a board problems than no program at all. considers not only the applicable statu- Legal audits are another technique tory requirements and restrictions, but directors may use to assist them in also determines under what circum- their duties. A legal audit can include stances the cooperative should or review of the cooperative’s legal struc- should not indemnify a director. ture and documents that govern the cooperative internally as well as its Insurance relationships with members and oth- Cooperatives can purchase insurance ers, analysis of assets and liabilities, to protect the cooperative and its direc- evaluation of potential claims against tors in case costs are incurred defending the cooperative, a thorough examina- litigation against directors. Usually

Rural Cooperatives / September / October 2002 9 MANAGEMENT TIP Cooperative directors face unique challenges

By James Baarda, USDA/RBS either. Directors of small Economist cooperatives face many Cooperative directors are responsible for [email protected] decisions as difficult as maintaining the cooperative character of the any confronted by the organization. Editor’s Note: This is the third of largest cooperatives. three articles dealing with issues facing Special cooperative cooperative directors. The first installment director challenges require personal hard questions for the board. Is the appeared on page 30 of the July-August wisdom and good collective decision- organization truly operating on a coop- 2002 issue while part two was on page 15 making abilities. In some ways, cooperative basis? How do directors know it of the September-October 2002 issue. erative directors need to know is? What observable criteria can be These and other past issues of this maga- more—and think about issues more established to guarantee the integrity zine can be assessed via the Internet at: carefully—than directors of other of a cooperative’s implied promise to be http://www.rurdev.usda.gov/rbs/pub/ kinds of businesses. Cooperative a cooperative? Are measures taken— openmag.htm boards certainly demand more time either on a periodic basis or in prepara- and work. In addition, the dual role of tion for significant business changes— ooperative directors regu- a director in a cooperative—as both a to be sure that basic cooperative larly face problems that director and a member—puts every principles are preserved? Has the board directors of even the director in a sensitive position. established policies, operating proce- C largest and most complex This article, the last in a series about dures and internal controls to guaran- corporations need not cooperative directors, identifies some tee operation as a cooperative? Does even think about. The tough issues don’t unique issues that cooperative directors the cooperative have danger points in depend entirely on cooperative size must consider on a regular basis. It its operations that require special mon- focuses on issues that are “in addition itoring and attention? to” the responsibilities expected of Although difficult, the directors’ The Circle of Seven directors of all businesses. role in maintaining the ability of the cooperative to serve members in a Responsibilities The character of the cooperative uniquely beneficial manner can be a Cooperatives are unique kinds of rewarding professional and personal (As described in the previous article businesses. Members justifiably expect experience for directors. Each director in this series, see September-October their cooperative to operate on a coop- is a gatekeeper of the principles and 2002 issue, page 15.) erative basis with the appropriate mix practices that empower members to of rights and obligations for everyone. cooperate to create true value for Directors: Members trust the board to fully sup- themselves and others. 1. Represent members port those expectations. 2. Establish cooperative policies Sometimes cooperative characteris- Cooperative-based decisions 3. Hire and supervise management tics are defined by law. In other situa- Cooperative boards of directors 4. Oversee acquisition and preserva- tions they are just an inherent part of make decisions not made by boards of tion of cooperative assets the cooperative that members’ under- any other kinds of business. These 5. Preserve the cooperative character stand and expect. In any case, directors decisions are, for the most part, unusu- of the organization have the ultimate responsibility to pre- ally difficult. They require directors to 6. Assess the cooperative’s performance serve the cooperative character of the have a clear understanding of financial 7. Inform members organization. documents, performance measures and This responsibility presents some the short- and long-term consequences

10 Rural Cooperatives / November / December 2002 of decisions made and actions taken. tee that the cooperative adheres to laws tors should recognize the importance of Situations may make the board a con- and other legal obligations. Directors keeping good membership roles and flict-resolution body that balances may, of course, rely on counsel and purging those who no longer deal with divergent and often deeply held inter- accountants to identify the rules, but the cooperative. The behavior of some ests among members. Some of these directors themselves make the decisions members may harm the cooperative involve business and financial issues, and bear the responsibility for decisions and therefore other members. Direc- while others are emotional in nature. made. tors have the unenviable task of taking Operating within proper authority was Determining and allocating patronage appropriate action to protect the coop- mentioned in a previous article. The refunds is one of a cooperative board’s erative. Predetermined, neutral rules cooperative’s authority and limitations major concerns. Of course, the board that avoid ad hoc decisions about indi- on that authority may be found in sev- does not make decisions about refunds vidual members will help avoid confu- eral places. The board’s authority may on the spur of the moment each year. sion and hard feelings. be defined by the cooperative’s charter, The system used to determine and cal- Decisions with federal income tax conse- including the applicable incorporation culate refunds should have been estab- quences are pervasive. Directors are not statute. The board of a cooperative lished in the bylaws and in written expected to be tax experts, but they do policies, all of need to appreciate the implications of which are subjects all of their decisions. Examples of deci- Cooperative principles should be of careful director sions with direct tax implications study and periodic include use of qualified or nonqualified familiar to every cooperative review. Decisions notices of allocation, per-unit retains, about allocations allocation of margins and losses and director. and distributions most issues regarding calculating mar- are complicated by gins and distributions. 1. The User-Owner Principle: The people who own and short-term and Patron or non-patronage business finance the cooperative are those who use the cooperative. long- term implica- and the allocations and payment of 2. The User-Control Principle: The people who control tions as well as bal- related net margins have direct income the cooperative are those who use the cooperative. ances among those tax implications. Added to the direct who use the coop- effect on the cooperative is the impact 3. The User-Benefits Principle: The cooperative’s sole erative for different that any such decisions have on mem- purpose is to provide the distribute benefits to its users purposes. All this bers or other patrons. A seemingly on the basis of their use. leads to possible simple business decision by cooperative conflicts among directors becomes one of balancing considers incorporation statutes, the cooperative members. many interests. articles of incorporation and bylaws to The cooperative may also face cir- determine the obligations and limita- cumstances that weren’t contemplated Conflict of interest tions of the cooperative. when the policies were established. Like other members, directors use Laws that apply generally to all The board must decide what modifica- the services of the cooperative. This businesses apply to cooperatives as tions can be made in response to spe- means that directors deal personally well, but sometimes in a different man- cial circumstances to recognize the with the cooperative. They have their ner. Such laws mean that cooperative cooperative’s purposes. own obligations toward the cooperative boards must make decisions for the Any patronage refund system has and their own expectations of benefits cooperative based not only on general- many implications for the cooperative from it. Decisions that directors make ly applicable laws, but laws that are and its members. These include fairness, about the cooperative will affect them especially applicable to cooperatives. operation on a true cooperative basis, tax as member-users just as they affect the Examples include special tax laws that implications, rules in state laws, inter- cooperative and other members. apply to cooperatives, cooperative pretations of bylaws, members’ expecta- The previous discussion of “duty of antitrust laws that mandate or prohibit tions and desires, and the very health loyalty” pointed out that the single action certain business structures and behav- and survival of the cooperative. Success- most likely to impose personal liability ior, and state cooperative incorporation ful solutions to sensitive issues ultimately on a director is a conflict of interest. The statutes that contain special require- rest in the hands of an informed, delib- personal dealings that a director has with ments for cooperatives. erative board of directors. the cooperative places the director in a A cooperative’s charter, its bylaws, its Member qualification is important to a precarious position. What appears to be contracts, membership agreements and cooperative, whether the qualifications innocent when done may in hindsight other binding agreements are all sub- of applicants for new membership are look very bad for the director. ject to review by directors as they estab- at issue or continued qualification of Many examples exist of directors’ lish policies and procedures to guaran- existing members is in question. Direc- dealings with the cooperative that will

Rural Cooperatives / November / December 2002 11 affect both the director and the cooper- bers or holders of common stock of the patronage-based vs. non-patronage- ative and pose possible conflicts of association or others, or differing from based sources of financing, are all part interest. These include: terms generally current in that district.” of plans and strategies that boards of • Price differentials or special con- Directors should not have problems directors establish. cessions for large producers and if the conflict is clearly recognized, Equity redemption is an integral part patrons. decisions are made solely with the of a cooperative financing system. It • Directorship in both a local cooper- interests of the cooperative foremost can also be a source of dispute. Deci- ative and the federated cooperative. and all questions are addressed openly sions about equity redemption are • Extension of credit to member- and honestly. often assigned specifically to the patrons. board’s discretion. How is the board of • Methods of obtaining capital. Financial matters directors to exercise that discretion? • Allocation of patronage refunds, Directors must give careful attention Do short revolving periods jeopardize especially when the cooperative is a to the effective financial structure and the cooperative’s financial health and multi-functional cooperative and the strong financial condition of the cooper- robustness? Do long revolving periods functions are not totally separated. ative. Directors are entrusted with the show poor planning, do cooperatives • Cash or non-cash patronage ultimate responsibility for the care of use former members’ money to gener- refunds related to patron tax the funds and property of the coopera- ate benefits for the current users, and brackets. tive and its members. Although similar does slow revolvement present fairness • Equity redemption decisions, general rules apply to non-cooperative issues? Courts usually support director including when to redeem, financ- corporations, a cooperative’s directors decisions on equity redemption in a ing methods and equity- building handle unusual issues because coopera- legal dispute, but the major challenge programs. tives have special techniques to finance for a board is to meet obligations of Directors must make these and all the organization. Because cooperatives past, present and future members with other decisions regardless of the shared operate for the mutual benefit of the fairness and forthrightness to avoid interests of directors and the coopera- members and not as purely profit-seek- unresolvable problems. tive. Cooperative incorporation statutes ing organizations, they have financial recognize the problem, at least with needs, opportunities and limitations not Special events respect to the patronage relationship. A found in other businesses. Ultimately, Directors bear added responsibilities the most difficult finan- when the cooperative considers a major cial decisions are in the change in its organization or in its rela- Standards of conduct directors’ hands. tionships with other businesses. Merg- Patronage refund distri- ers or establishing long-term, signifi- applicable to cooperative butions are closely related cant joint-venture arrangements with to equity allocations in other businesses are examples of events directors include: most cooperatives. where directors have a major responsi- Directors are involved in bility for decisions that are of critical 1. Duty of Obedience. Directors must ensure that they the balance between cur- importance to the cooperative. Such or the cooperative do not engage in illegal or rent monetary returns to events affect members’ interests in the improper actions. members and additions short run and in the long run. to the cooperative’s equi- Decisions affect benefits that all par- 2. Duty of Care. Directors are expected to act in ty structure. For exam- ties involved will receive, including good faith at all times, exercise prudence, and ple, patronage refunds financial obligations (past and future), apply their best judgments for the benefit of the may be paid in a combi- differential impacts among members cooperative. nation of cash and writ- and planning horizons for all parties. 3. Duty of Loyalty. Directors have a position of ten notices of alloca- Directors not only assess overall costs highest trust and must avoid conflicts of interest, tions. The choice carries and benefits of such actions, they will self-dealing, actin in any other than the best inter- major implications for be required to address conflicts among ests of the cooperative or divulging confidential the long-term financial members about the action. information. health of the coopera- A decision to dissolve a cooperative tive. At the same time, is, of course, among the most difficult members may expect the board will make. The process not typical provision says that “no director, high cash payout as a return for their only occurs under typically unpleasant during his term of office, shall be party involvement in the cooperative and circumstances; it challenges the abili- to a contract for profit with the associa- their own tax considerations. Alloca- ties and dedication of all involved. tion differing in any way from the busi- tions and choices of the income to allo- Directors will be well served by ness relations accorded regular mem- cate, equity vs. debt financing and making every effort to recognize how

12 Rural Cooperatives / November / December 2002 standards of conduct discussed in pre- Directors balance members’ interests than the organization can provide and vious articles in this series can guide The cooperative’s fortunes are those still maintain its financial and opera- them. Adequate information about the of its members, and if the cooperative tional integrity. Directors may actually implications of the action, the mechan- is not responsive to members’ needs, be put in a position of balancing some ics of the process, impacts on members the basic principles of member control members’ needs against the interests of and the future of the cooperative are all and user benefit are weakened. The the cooperative itself. Diplomacy and critically important. Balancing member cooperative will simply cease to exist good communication are valuable, but interests and measuring the financial and serve. no easy resolution may be possible. and other needs of the cooperative will The membership of most coopera- guide directors’ decisions. tives is not homogeneous. Each mem- Board-management relations ber has an interest in the cooperative. A good working relationship Assessing the cooperative’s success These interests differ to some degree, between the board of directors and Important decisions about the per- sometimes dramatically from other management is very important for formance of management, success or members. Members may have differing cooperatives. At the same time, the failure of strategic plans or specific planning horizons, as would be the case relative responsibilities of the board programs, and designing plans for the between someone just starting in the and management create natural ten- future are all based on an accurate and farming business and someone contem- sions about roles and responsibilities. realistic assessment of the coopera- The cooperative board has a distinct tive’s current performance. Such an role and make-up that places obliga- assessment is not necessarily easy tions of independence and leadership under any circumstances. on the cooperative board of direc- As with any business, the “bottom tors that are not necessarily found in line” is critical. But unlike other busi- other boards. nesses, for cooperatives the bottom Does the board defer excessively to line is only the beginning of an assess- a forceful manager? If so, what might ment of its true success. Every director the consequences be? Does the board needs to understand financial state- interfere inappropriately in the coop- To be effective, board members must have a solid ments, organizational growth, project grasp on co-op financial statements. Request to erative’s management and day-to-day plans, overall strategies and levels of meet with the co-op manager or accountant if you operations? If so, what are the conse- service offered. But more is required. need more background on how to read them. quences? How does the board assess Difficult questions require addi- USDA Photo by Ken Hammond management and what corrective tional board consideration. What was measures are in place in case of diffi- the net benefit of an action to members, plating imminent retirement. These culties? Is there an effective chain of including their share of savings and two members could have markedly dif- communication and command between margins? What was the tradeoff ferent interests in financing, revolving the board and management? What between benefits distributed to mem- periods for patronage payments and does management think of the board of bers and the net income of the coopera- cash vs. non-cash payments. Members directors? If necessary for the good of tive? What is the financial condition of may be in different tax brackets, which the cooperative, is the board of direc- the cooperative and what are the trends has implications for the amount and tors capable of making and executing a and expectations for future capital form of patronage refunds. decision to replace management? needs? Some members may be more con- Were all members treated equitably cerned with price while others may find The rewards in distributions and financing obliga- certainty of supply or a market more With all of the responsibilities tions? Did the cooperative serve some important. Producers of different prod- placed on boards of directors outlined members at the expense of greater ucts may have distinctly different needs in the first article in this series, the returns to others? If so, is that practice from the same cooperative. Disparity of high standards of conduct required of part of the cooperative’s greater pur- business volume among members may individual directors discussed in the pose? What was the trade-off between lead to calls for differential pricing. second article and the many difficult short-run and long-run needs, obliga- These and other variables make the decisions directors make as noted in tions and benefits? Are successes or directors responsibility to represent this article, why would anyone agree to failures attributable to management, members quite different from decisions be a cooperative director? Individuals board decisions, the economic environ- for non-cooperative businesses. can point to at least five reasons to ment or member actions? What can or Members, or prospective members, serve as a cooperative director. cannot be corrected about the coopera- may want more from the cooperative The rules that apply to responsibili- tive’s performance? ties, liabilities, duties and requirements

Rural Cooperatives / November / December 2002 13 are pretty clear. With diligence and care, Implementing exercise a cooperative director has guidance to avoid the many pitfalls suggested by a As a board, review the character of your cooperative: cautious view of a director’s job. Though • What is the stated purpose of the cooperative? a director may face unpleasant, and some- • What does this mean when balancing interests? times unexpected circumstances, adher- • Identify the “stakeholders”—those who have an interest in what the coop- ence to high personal standards of con- erative does and how the cooperative performs. duct is excellent insurance against • Identify the principle things that make the organization a cooperative and personal problems. distinguish it from other kinds of businesses. Directors are part of a team. This Revisit the cooperative’s vision statement, mission statement and objectives. team is not only a source of support, it is • Are they adequate, realistic and up-to-date? a reward in itself. Difficult issues are • Did they come form the membership or were they devised as a board- discussed within the board before deci- management exercise? sions are made; information is generated • Are members familiar with their cooperative’s vision, mission and purposes? and shared, and decisions are made as a • What do the members think of them? board. Responsibilities are shared with others in a similar position. The team Set aside some time at a board meeting (after preparation) to discuss what mea- concept includes not only the board of sure of success the board should use to assess the cooperative’s performance, its directors, but management and, most management, and the board of directors. importantly, the cooperative’s members. • Start with the broadest list and set priorities. The opportunity to take an active role • Are some measures incompatible with others? in multiple constituencies is unusually • If trade-offs are required, what decision rules can be devised? valuable for a cooperative director. • What would members think of the trade-offs and decision rules? The sheer challenge of being a Make it personal—it already is! cooperative director can be added as a • Identify the issues that you personally find to be the most uncomfortable, third source of reward. Directors see a those you’d really rather not have to make decisions about. problem from its discovery. They • Make a plan to share the burdens of the decision. define the issues it raises for the coop- • List the factors you will consider in addressing the problem. erative and members, identify the • Do you think others share your discomfort? range of possible solutions, gather and study the information needed to assess the solutions, determine what the con- which the cooperative operates. Indi- sequences of various courses of action viduals considering being a director might be, make a decision, create the should consider the significant policies and directives needed to imple- impacts they can have beyond the ment the chosen solution, and assess boardroom and even on the coopera- the consequences of the board’s deci- tive. sions. The more difficult the problem, Finally, board membership carries the greater the rewards of finding an personal prestige despite the many answer. The more critical the issue is duties and difficulties. Serving on a to the success of the cooperative, the cooperative’s board of directors is a wor- more satisfying is the problem-solving thy personal and professional goal. process. Directorship should be a source of great Directorship presents an opportu- personal pride and satisfaction. ■ nity to serve others in direct and important ways. Beneficiaries of a suc- cessfully 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

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16 January/February 2002 / Rural Cooperatives