2009 Subcommittee Reports of the Legal, Tax and Accounting Committee Page

2009

Legal, Tax and Accounting

Subcommittee Reports

INTRODUCTION

The LTA subcommittee reports are prepared annually through the efforts of individuals who serve on NCFC’s Legal, Tax and Accounting Committee. NCFC is deeply grateful for the dedication and generosity of these volunteers, many of whom are national experts in their respective areas of practice.

The purpose of the reports is to interpret and highlight the legal, tax and accounting events of the past year, and to discuss in detail many of the issues faced by cooperatives.

The legal, tax and accounting issues of farmer cooperatives are affected by a number of external forces and general practice issues, with the added focus of specific industry issues. The LTA subcommittee reports are the only resource summarizing all these issues in a single volume.

If you have questions or need materials referred to in the reports, please notify me by e-mail at [email protected] or by telephone at 202.879.0825.

Sincerely,

Marlis Carson General Counsel & Vice President Legal, Tax & Accounting

The following reports do not constitute specific advice and may fail to address aspects of an issue or development relevant to the reader. Readers should be particularly aware of the importance of checking for subsequent developments, as these reports may not have been updated since originally composed.

Table of Contents

2009 Subcommittee Reports of the Legal, Tax and Accounting Committee Page

Introduction ...... 2

Financial Reporting and Audit Issues of Agricultural Cooperatives ...... 5 - Dick Cisne, Jay McWatters and Ken Wise

Overview of New Tax, Other Legislation and Implementation Issues Affecting Farmer Cooperatives ...... 20 - Barry Jencik and Kevin Feeley

Operating on a Cooperative Basis for Subchapter T and Section 521 Cooperatives ...... 28 - Terry Costello, Ron Peterson and Lisa Maloy

Cooperative Structures: Mergers, Acquisitions, Joint Ventures and Subsidiaries ...... 30 - David Swanson and Charles Woltmann

Calculating Patronage Dividends ...... 37 - Mark Stewart, Dan Groscost and Daniel Schultz

Issues Specific to Marketing Orders and Bargaining Cooperatives ...... 47 - Kendall Manock, Julian Heron and Steve Zovickian

Litigation between Cooperatives and Their Members, Including Member Insolvency ...... 58 - David Hayes, Terry Bertholf and William Hutchison

AMT, Tax Accounting and State and Local Tax Issues Affecting Agricultural Cooperatives ...... 74 - David Simon, Wayne Sine and Brett Huston

Antitrust ...... 77 - William Sippel, Michael Lindsay and Don Barnes

Environmental Laws and Regulation ...... 106 - B. Andrew Brown

Digest of Cases ...... 117 - George Benson and David Antoni

IRS Industry Specialist ...... 160 - Marla Aspinwall

Financial Reporting and Audit Issues of Agricultural Cooperatives

2009 Report

Chair Vice-Chair Vice-Chair

Dick Cisne Jay McWatters Ken Wise Hudson, Cisne & Co. LLP Dopkins & Company, LLP PricewaterhouseCoopers 11412 Huron Lane 200 International Drive 225 South 6th St, Ste 1400 Little Rock, AR 72211 Williamsville, NY 14221 Minneapolis, MN 55402 Ph: 501-221-1000 Ph: 716-634-8800 Ph: 612-596-6427 Fax: 501-221-9236 Fax: 716-634-8987 Fax: 813-329-7893

E-mail: [email protected]

Contributors: David Burlage, Co-Bank Russ Wasson, National Rural Electric Cooperative Association

The information available on financial reporting issues which could be applicable to agricultural cooperatives is vast and is beyond the scope of this subcommittee’s resources to analyze and report on each one. This year’s report will cover the most talked about developments, some with effective dates prior to 2009, but whose application is still of interest to cooperatives and their advisors.

Pronouncements of the Financial Accounting Standards Board Accounting Standards Codification can be obtained from its website at www.FASB.org. Statements and pronouncements on auditing standards along with statements of position, interpretations and professional pronouncements by the American Institute of CPA’s can be obtained from its website at www.AICPA.org. Exposure drafts outstanding are listed each month in the Journal of Accountancy by issuer, which also lists the issuer’s web address and mailing address.

Definitions/Terms:

GAAP - Generally Accepted Accounting Principles AICPA - American Institute of Certified Public Accountants EITF - Emerging Issues Task Force FASB - Financial Accounting Standards Board FSP - FASB Staff Position IASB - International Accounting Standards Board IFRS - International Financial Reporting Standards ASU - Accounting Standards Update ARB - Accounting Research Board SFAS - Statement of Financial Accounting Standards ASC - Accounting Standards Codification SAS - Statement of Auditing Standards SEC - Securities and Exchange Commission the “Boards” - FASB and ISAB joint projects

ASC 105-10 – The FASB Accounting Standards Codification and Hierarchy of GAAP (SFAS 168):

On July 1, 2009, The FASB Accounting Standards Codification (“Codification”) became the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. ASC 105-10 (SFAS) 168 replaces FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles, and superseded all existing non-SEC accounting and reporting standards (including those of FASB, the Emerging Issues Task Force, and the AICPA). Following issuance of this new statement, FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, FASB will issue Accounting Standards Updates which will serve to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the changes in the Codification. All nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. All of the Codification’s content will carry the same level of authority.

The Codification includes all accounting standards issued by a standard setter within the Levels (a) through (d) of the current GAAP hierarchy. The Codification reorganizes the existing GAAP into 90 accounting topics and displays the topics in a more consistent structure. The Codification follows an established pattern or classification system of XXX-YY-ZZ-PP, where XXX = topic, YY = subtopic, ZZ = section, and PP = paragraph. The Codification includes a web-based search tool with advanced features including the ability to select multiple sections from different topics and subtopics and join them into a single document. Another feature will allow users to cross-reference current standards to where they are located in the codification topical structure.

This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. A calendar year entity that is required to issue interim financial statements must implement ASC 105-10 for its third quarter ending September 30, 2009.

ASC 855-10 – Subsequent Events (SFAS 165):

An entity, including a public company, expected to widely distribute its financial statements to shareholders and other financial statement users is required to evaluate subsequent events through the date that the financial statements are issued, according to ASC 855-10 (SFAS 165). All other entities will evaluate subsequent events through the date that the financial statements are available to be issued.

This Statement should not result in significant changes in the subsequent events that an entity reports in its financial statements besides defining the difference between financial statements that are issued and financial statements that are available to be issued. Financial statements are considered issued when they are widely distributed to shareholders and other financial statement users for general use and reliance in a form and format that complies with GAAP. Financial statements are considered available to be issued when they are complete in a form and format that complies with GAAP and all approvals (from management, board of directors, or significant shareholders) necessary for issuance have been obtained. This Statement is effective for financial statements issued for interim and annual periods ending after June 15, 2009.

ASC 820-10 – Fair Value Measurements (SFAS 157-4):

This FASB Staff Position provides additional guidance for estimating fair value in accordance with ASC 820-10, Fair Value Measurements, when the volume and level of activity for the asset or liability have

significantly decreased. This staff position also provides guidance on identifying circumstances which indicate a transaction is not orderly.

The provisions of ASC 820-10 (SFAS 157-4) emphasizes even if there has been a significant decrease in the volume and level of activity for the asset or liability and regardless of the valuation techniques used, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions.

A reporting entity should evaluate the following factors to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with normal market activity for the asset or liability. These factors include, but are not limited to:

• There are few recent transactions. • Price quotations are not based on current information. • Price quotations vary substantially either over time or among market makers (for example, some brokered markets). • Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for asset or liability. • There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability. • There is a wide bid-ask spread or significant increase in the bid-ask spread. • There is a significant decline or absence of a market for new issuance (that is, a primary) for the asset or liability or similar assets or liabilities. • Little information is released publicly (for example, a principle-to-principle market).

If the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability, transactions or quoted prices may not be determinative of fair value. Further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value in accordance with ASC 820-10 (SFAS 157).

Even if there has been a significant decrease in the volume and level of activity for the asset or liability, it is not appropriate to conclude that all transactions are not orderly (that is, distressed or forced). Circumstances that may indicate that a transaction is not orderly include, but are not limited to: • There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions. • There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. • The seller is in or near bankruptcy or distressed, or the seller was required to sell to meet regulatory or legal requirements.

• The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability.

The determination of whether a transaction is orderly is more difficult if there has been a significant decrease in the volume and level of activity for the asset or liability. Accordingly, a reporting entity should consider the following guidance on transactions that are not orderly: • If the weight of the evidence indicates the transaction is not orderly, a reporting entity shall place little, if any, weight on that transaction price when estimating fair value or market risk premiums. • If the weight of the evidence indicates the transaction is orderly, a reporting entity shall consider that transaction price when compared with other indications of fair value will depend on the facts and circumstances such as the volume of the transaction, the comparability of the transaction to the asset or liability being measured at fair value, and the proximity of the transaction to the measurement date. • If a reporting entity does not have sufficient information to conclude that the transaction is orderly or that the transaction is not orderly, it shall consider transaction price when estimating fair value or market risk premiums. However, the transaction price may not be determinative of fair value. A reporting entity shall place less weight on transactions on which a reporting entity does not have sufficient information to conclude whether the transaction is orderly when compared with other transactions that are known to be orderly.

In August 2009, the FASB issued 2009-05 (previously exposed for comments as proposed FSP FAS 157- f) to provide guidance on measuring the fair value of liabilities under ASC 820. The ASU clarifies that the quoted price for the identical liability, when traded as an asset in an active market, is also a Level 1 measurement for that liability when no adjustment to the quoted price is required. In the absence of a Level 1 measurement, an entity must use one or more of the following valuation techniques to estimate fair value (in a manner consistent with the principles in ASC 820), which can be classified into two broad categories:

1. A valuation technique that uses a quoted price: • Quoted price of an identical liability when traded as an asset. • Quoted price of a similar liability or of a similar liability when traded as an asset. 2. Another valuation technique (e.g., a market approach or an income approach), including one of the following: • A technique based on the amount of an entity would pay to transfer the identical liability. • A technique based on the amount an entity would receive to enter into an identical liability.

ASU 2009-05 is effective for the first interim or annual reporting period beginning after its issuance.

On August 28, 2009, the FASB issued a proposed ASU on improving disclosures about fair value measurements. The proposed ASU would amend ASC 820-10 to clarify existing requirements regarding disclosures of inputs and valuation techniques and levels of disaggregation. In addition, the proposed update would require the following new disclosures:

• Sensitivity disclosures regarding the effect of changing Level 3 inputs if the change in the fair value measurement would change significantly.

• Significant transfers in and out of Levels 1 and 2 and the reasons that such transfers were made. • Additional disclosure in the reconciliation of Level 3 activity, including information on a gross basis for purchases, sales, issuances, and settlements.

Comments on the proposed ASU were due by October 12, 2009.

FASB Standards Update 2009-06, Income Taxes (Topic 740)- Implementation Guidance on Accounting for Uncertainty in Income Taxes and Disclosure Amendments for Nonpublic Entities (FIN 48):

ASC 740-10 (FIN 48) was issued in June 2006 and was effective for fiscal years beginning after December 15, 2006. However, subsequent to its issuance, FASB deferred the effective date for nonpublic enterprises to the annual financial statements for fiscal years beginning after December 15, 2007.

On December 30, 2008, the FASB again deferred the effective date of ASC 740-10 (FIN 48) (via the issuance of FSP FIN 48-3), for certain nonpublic enterprises’ annual financial statements for fiscal years beginning after December 31, 2008. An enterprise that chooses to defer the implementation of ASC 740- 10 must explicitly disclose this election in its financial statements. In addition, such an enterprise must disclose its current accounting policy for evaluating uncertain tax positions for each set of financial statements to which the deferral applies.

On September 1, 2009, FASB issued ASU 2009-06, Implementation Guidance on Accounting for Uncertainty in Income Taxes and Disclosure Amendments for Nonpublic Entities. The amendments to the FASB Accounting Standards Codification in this update provide implementation guidance, through examples, to answer three main issues on how to apply the standards for uncertainty in income taxes. The guidance is as follows: 1. If income taxes paid by the entity are attributable to the entity, the transaction should be accounted for consistent with the guidance for uncertainty in income taxes in Topic 740. If income taxes paid by the entity are attributable to the owners, the transaction should be recorded as a transaction with owners. The determination of attribution should be made for each jurisdiction where the entity is subject to income taxes and is determined on the basis of laws and regulations of the jurisdiction. 2. The amendments clarify that management’s determination of the taxable status of the entity, including its status as a pass-through entity or tax-exempt not-for-profit entity, is a tax position subject to the standards required for accounting for uncertainty in income taxes. 3. A reporting entity must consider the tax positions of all entities within a related group of entities regardless of the tax status of the reporting entity.

The amendments eliminate the disclosures required by paragraph 740-10-50-15(a) through (b) for nonpublic entities. Users of private company financial statements have indicated that the disclosures required by that paragraph do not provide decision-useful information. The amendments do not alter the disclosure requirements for public companies as they have indicated that the information is useful. The eliminated disclosures requirements for nonpublic entities are as follows: • Paragraph 740-10-50-15(a) – requires a tabular reconciliation of the total amount of unrecognized tax benefits at the beginning and end of the periods presented. • Paragraph 740-10-50-15(b) – requires the disclosure of the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

For entities that are currently applying the standards for accounting for uncertainty in income taxes, the guidance and disclosure amendments are effective for financial statements issued for interim and annual periods ending after September 15, 2009. For entities that have deferred the application of accounting for uncertainty in income taxes in accordance with paragraph 740-10-65-1(e), the guidance and disclosure amendments are effective upon adoption of those standards.

ASC 815-10, Disclosures about Derivative Instruments and Hedging Activities (Formerly SFAS 161) – An Amendment of FASB Statement 133

On March 19, 2008, the FASB issued ASC 815-10 (SFAS 161) over concerns that the existing disclosure requirements in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, do not provide adequate information about how derivative and hedging activities affect an entity’s financial position, financial performance, and cash flows. Accordingly, this Statement requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improves the transparency of financial reporting. Specifically, ASC 815-10 requires: • Disclosure of the objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation. • Disclosure of the fair values of derivative instruments and their gains and losses in a tabular format. • Disclosure of information about credit-risk-related contingent features • Cross-reference from the derivative footnote to other footnotes in which derivative-related information is disclosed.

To meet the objectives of ASC 815-10, this Statement requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. This Statement has the same scope as SFAS 133 and applies to all entities. ASC 815-10 applies to all derivative instruments, including bifurcated derivative instruments and related hedged items accounted for under SFAS 133 and its related interpretations. ASC 815-10 is effective for fiscal years and interim periods beginning after November 18, 2008.

Differential Accounting (i.e. Big GAAP, Little GAAP):

In June of 2006, the FASB and the AICPA issued a joint proposal intended to improve the financial reporting process for private company constituents. Specifically, the joint initiative seeks constituent feedback on proposed enhancements to the FASB’s standard setting procedures that would determine whether the board should consider differences in accounting standards for private companies within GAAP.

The FASB and the AICPA have established a joint committee to serve as an additional resource to the FASB to further ensure that the views of private company constituents are incorporated into the standard- setting process. The joint committee formed is known as the Private Company Financial Reporting Committee (PCFRC). PCFRC members represent users and prepares of private company financial statements as well as CPA practitioners.

The Committee has made recommendations or offered its views to the FASB on FIN 46, Consolidation of Variable Interest Entities, financial instruments with characteristics of equity, disclosure of certain loss contingencies, subsequent events, going concern, and definition of a private company.

Current FASB projects that the Committee is addressing or will address include SFAS 144-d Criteria for Reporting a Discontinued Operation, FIN 48 (addressed in this report), joint FASB and IASB project on financial statement presentation, SEC efforts to adopt IFRS, FSP SFAS 107-a Disclosures About Certain Financial Assets, FSP SFAS 141(R)-a Accounting for Assets Acquired and Liabilities Assumed in a Business Combination that Arise from Contingencies. The PCFRC’s recommendations to the FASB are available at http://www.pcfr.org/recommendations.html. The PCFRC is committed to maintaining an open dialogue with interested parties and PCFR stake- holders. Anyone interested in learning more about the PCFRC should visit its web site to read meeting highlights or join the committee’s resource group.

IFRS – Moving Towards a Single International Accounting Standard

Presently, approximately 100 nations, including those of the European Union, have adopted IFRS as their accounting standards of choice. Recent trends clearly suggest that IFRS is on track to become the high quality set of common global accounting standards that many have been calling for. The much anticipated release in August 2008 by the SEC affirms that IFRS clearly have the “inside track” to achieving that distinction. In their proposed rule, the SEC provides a mandatory timeline for US public companies to adopt IFRS in a phased-in approach for fiscal year 2014 through 2016. The SEC also proposed to permit certain large companies to use for filings they submit in 2010 for their 2009 fiscal years.

Since 2002, the FASB has been working aggressively with the IASB to harmonize their respective set of accounting standards. It is clear from their slate of projects, the public statements of their leaders and the SEC’s recent actions that those harmonization efforts will only increase. The more recent US standards released by FASB have been assessed for the possibilities of cooperation with the IASB. Currently a full time IASB member is residing in the FASB offices and acting as a liaison Board member to the FASB. The role was created to facilitate information exchange and increase cooperation between the FASB and the IASB. What will likely result from these efforts over time will be a set of U.S. GAAP standards that have morphed to look very much like the international standards (logically, the reverse will also be true of the IFRS’ proximity to U.S. GAAP). On one end of that particular spectrum, this process could mean that there will remain few, if any, meaningful differences between the U.S. GAAP and IFRS when the harmonization efforts are concluded. In such a case, there would be no practical implication of a mandated conversion to IFRS – U.S. GAAP would already be there. However, there are some key differences between the IFRSs and U.S. GAAP that are noteworthy. The differences will vary with respect to individual companies depending on such factors as the nature of the company’s operations, the industry in which it operates, and the accounting policy choices it has made. Listed below are some of the key differences between IFRS and U.S. GAAP that could affect cooperatives.

Topic U.S. GAAP IFRS Measurement basis of Historical cost is generally Fair value with value changes agricultural, crops, livestock, used. However, fair value less recognized in profit or loss. orchards, forests costs to sell is used for harvested crops and livestock held for sale. Extraordinary items Extraordinary items are Extraordinary items are material items that are prohibited anywhere within infrequent, unusual, and rare the financial statements. which affect profit and loss. Inventory cost determination The cost-flow assumption FIFO or weighted average must be the one which most may be used to value clearly reflects periodic inventories. LIFO is not income. FIFO, LIFO, and permitted. weighted average permitted. Subsequent Reversal of an Reversals of impairment Impairment losses for assets Impairment Loss losses are prohibited. other than goodwill are reversed provided certain conditions are met.

Measurement of Impairment For goodwill and intangible Write down to recoverable Loss assets that are not amortized, amount if below carrying write down to fair value if amount. Recoverable amount below carrying amount. Fair is higher of value in use and value is the amount at which fair value less selling costs. asset could be bought or sold in a current transaction between willing parties not in a forced or liquidation sale. Reversal of Inventory Write- Reversal of write-down for Reversal of write-down for Downs increase in market value is not subsequent increase in permitted. realizable value permitted, limited to the amount of the original write-down. The reversal is recognized as a reduction in expense of the period. Classification of Interest and Interest and dividends Interest and dividends paid Dividends Received and Paid received and interest paid are and received may be shown as in the Cash Flow Statement classified as operating operating or financing activities. Dividends paid are activities in the cash flow classified as financing statement. activities. Basis of Property, Plant, and Valued at historical cost. May use either revalued Equipment Revaluation to fair value is amount or historical cost. prohibited. Revalued amount is fair value at date of revaluation less subsequent accumulated depreciation and impairment

loss. Classification of Convertible Generally, convertible debt Split the instrument into its Debt Instruments instruments are accounted for liability and equity as debt. An equity component components and measure the will arise only for instruments liability at fair value with the with a beneficial conversion equity component representing feature that exists at the the residual. inception of the instrument. Development Costs With exception of certain Intangible assets arising from costs related to computer development and other software, expenditures related internally generated to research and development intangibles must be capitalized activities are required to be if certain criteria are met. expensed as incurred.

Further background information on the U.S. GAAP converging towards single international accounting standards are available in last years’ “Financial Reporting and Audit Issues of Agricultural Cooperatives 2008 Report” or at http://www.fasb.org/intl/convergence_iasb.shtml. The FASB and IASB have come together and issued joint discussion papers. A summary of those papers follows:

Financial Statement Presentation (joint IASB and FASB project):

In October 2008, a Joint Discussion Paper entitle Preliminary Views on Financial Statement Presentation was issued by the IASB and FASB. This discussion paper contains an analysis of the current issues in financial statement presentation and the initial plans to tackle those issues. The proposed presentation model requires an entity to present information about the way it creates value (its business activities) separately from information about the way it funds or finances those business activities (its financing activities). The discussion paper shows examples of financial statements that are drastically different from the current requirements, including a new footnote that reconciles cash flows to comprehensive income and disaggregates comprehensive income into cash received or paid other than in transactions with owners, accruals other than remeasurements, remeasurements that are recurring fair value changes or valuation adjustments. If adopted, the basic equation of assets equals liabilities plus equity would no longer be shown on the statement of financial position. Instead, that basic equation would be shown as a footnote to the financial statements. The comments were due April 14, 2009.

During the six month comment period on the discussion paper, thirty entities participated in a field test in which they recasted two years of financial statements using the principles and application guidance in the discussion paper and completed a survey about the recasting exercise. In addition to the field test, the FASRI is in the process of studying investor use of financial statements prepared using the proposed presentation model by conducting a series of controlled tests.

The Boards hope to learn about the costs and benefits of the proposed presentation model through the field test, FASR’s study, the comment letters they received on the October 2008 discussion paper, and discussions with interested parties during the comment period. The Boards will consider all of the input when they deliberate the issues addressed in this discussion paper during the next stage, which will lead to publication of an exposure draft of a proposed standard. The exposure draft is expected to be published in April 2010.

Revenue Recognition in Contracts with Customers (joint IASB and FASB project):

In December 2008, a Joint Discussion Paper entitled Preliminary Views on Revenue Recognition in Contracts with Customers was issued by the IASB and FASB. This discussion paper was issued primarily to clarify the principles for recognizing revenue. Both U.S. GAAP and IFRSs have many revenue recognition standards with many being industry-specific and some can produce conflicting results for economically similar transactions. The Boards are developing a single, contract-based revenue recognition model that will give clearer guidance on when an entity should recognize revenue. As a result, the Boards expect that entities will recognize revenue more consistently for similar contracts regardless of the industry in which an entity operates. That consistency should improve the comparability and understandability of revenue for users of financial statements. The Boards have developed some preliminary views in developing a revenue recognition model. The views are summarized below: • Contract-based revenue recognition principle – The Boards propose that revenue should be recognized on the basis of increases in an entity’s net position in a contract with a customer. This occurs when an entity performs by satisfying an obligation in a contract. • Identification of performance obligations – An entity’s performance obligation is a promise in a contract with a customer to transfer an asset (such as a good or a service) to that customer. An entity accounts for performance obligations separately if the promised assets are transferred to the customer at different times. The objective of separating performance obligations is to ensure that an entity’s revenue faithfully represents the pattern of the transfer of assets to the customer over the life of the contract. • Satisfaction of performance obligations – An entity satisfies a performance obligation and recognizes revenue when it transfers a promised asset (such as a good or service) to the customer. The Boards propose that an entity has transferred that promised asset when the customer obtains control of it. Consequently, activities that an entity undertakes in fulfilling a contract result in revenue recognition only if they simultaneously transfer assets to the customer. • Measurement – The Boards propose that performance obligations initially should be measured at the transaction price, the customer’s promised consideration. If a contract comprises more than one performance obligation, an entity would allocate the transaction price to the performance obligation on the basis of the relative standalone selling prices of the goods and services underlying those performance obligations. The Boards also propose that after the contract inception, the measurement of a performance obligation should not be updated unless that performance obligation is deemed canceled.

For many contracts, the proposed revenue recognition model would cause little, if any, change. However, in some circumstances, applying the Boards’ proposed model would differ from present practice. Listed below are some examples: • Use of a contract-based revenue recognition principle – An entity would recognize revenue from increases in its net position in a contract with a customer as a result of satisfying a performance obligation. Increases in other assets such as cash, inventory in the absence of a contract with a customer, and inventory under a contract with a customer (but not yet transferred to the customer) would not trigger revenue recognition. • Identification of performance obligations – In present practice, entities sometimes account for similar contractual promises differently. The Boards revenue recognition model will recognize revenue more consistently for similar contracts regardless of the industry in which an entity operates.

• Use of estimates – Some existing standards limit the use of estimates more than the Boards’ proposed model would. For example, entities sometimes do not recognize revenue for a delivered item if there is no objective and reliable evidence of the selling price of the undelivered items. In contrast, in the proposed model, entities would estimate the standalone selling prices of the undelivered goods and services and recognize revenue when goods and services are delivered to the customer. • Capitalization of costs – At present, entities sometimes capitalize the costs of obtaining contracts. In the proposed model, costs are capitalized only if they qualify for the capitalization in accordance with other standards.

The Discussion Paper for revenue recognition was open for public comment until June 2009. A summary of comment letters were discussed at the July 2009 joint Board meeting, which assisted the Boards in identifying issues to be addressed and further developed. The Boards expect to publish the Exposure Draft in 2010.

Lease Accounting Revisions (joint IASB and FASB project):

The primary objective of the leases project is to develop a new model for the recognition of assets and liabilities arising under lease contracts to ensure that financial statements provide useful, transparent, and complete information about leasing transactions to investors and other users of financial statements.

At meetings in July 2009, the Boards announced tentative decisions reached on the basis of a model which would result in the lessor’s recognizing a performance obligation. The tentative decisions are summarized below: • Sale and leaseback transactions – A seller/lessee would consider whether the entire leased asset qualifies for derecognition. If the entity determines, after applying the applicable guidance for the underlying asset, that the transaction qualifies as a sale, it would derecognize the leased item and recognize a right-of-use asset and an obligation to make rental payments for the leaseback. The Board will consider whether additional criteria are needed to help entities determine whether a sale and leaseback transaction represents a sale and how to account for a sale and leaseback transaction when the sales prices or rental payments are not at market rates. • Impairment of the right-of-use asset – A lessee applying U.S. GAAP would follow SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to determine whether its right- of-use asset is impaired and a loss should be recognized. • Revaluation of the right-of-use asset – A lessee would subsequently report a right-of-use asset at cost adjusted for amortization and impairment losses, if any. A lessee would not be permitted to subsequently remeasure its right-of-use asset to fair value unless required to do so to recognize an impairment loss. • Initial direct costs – A lessee would expense any initial direct costs as incurred. • Transition – A lessee would apply the new lease standard by recognizing an obligation to pay rentals and a right-of-use asset for all outstanding leases at the transition date. The obligation and the asset would be measured at the present value of the lease payments, discounted using the lessee’s incremental borrowing rate on the transition date.

The Boards have announced their intention to produce a revised standard for lessees by mid-2011. Consequently, after publishing the lease discussion paper, the Boards intend to work on an exposure draft

of a proposed new standard for lessees. The Boards will decide on the timing of any new standard for lessors after publishing the lessee discussion paper. In developing an exposure draft, the Boards will review the responses to this paper and decide whether to modify or confirm their preliminary views.

New Options for Private U.S. Companies to Report Under IFRS

U. S. Private companies have a new choice for accounting and financial reporting – a slimmed-down version of IFRS tailored more to their needs. IFRS for SMEs (small and medium-size entities) is a simplification of full IFRS. The International Accounting Standards Board (IASB) released the standards in July 2009 after five years of work. It defines SMEs as businesses that publish general-purpose financial statements for external users and do not have public accountability.

The new standard is expected to ease some of the financial burden, which has increased as full IFRS has become more detailed, on SME preparers.

Private companies in the United States can prepare their financial statements in accordance with U.S. GAAP, and “other comprehensive basis of accounting” (OCBOA), such as cash or tax-basis; or full IFRS, among others. The governing Council of the AICPA recognizes the IASB as an accounting body for purposes of establishing international financial accounting and reporting principles. Full IFRS and IFRS for SMEs are generally accepted accounting principles.

The new standard is separate from full IFRS and is available for any jurisdictions to adopt whether or not is has adopted full IFRS.

Some of the key differences between IFRS for SMEs and U.S. GAAP are:

• Disclosures are simplified in a number of areas including pensions, leases, and financial instruments.

• LIFO is prohibited

• Goodwill and indefinite life intangible assets are amortized over a period of 10 years or less.

• Depreciation is based on a components approach.

• There’s a simplified temporary difference approach to income tax accounting.

• Reversal of impairment charges is allowed if certain criteria are met.

• Accounting for financial assets and liabilities makes greater use of cost.

One of the key challenges of using IFRS for SMEs includes understanding the differences between the new standard and U. S. GAPP.

Information about IFRS for SMEs can be found at ifrs.com or on the IASB Web Site, iasb.org

Financial Instruments with Characteristics of Equity, ASC 480-10 (formerly Liabilities vs. Equity Project- SFAS 150) – Joint Project of FASB and IASB

Many cooperatives do not apply the provisions of ASC 480-10 (SFAS No. 150) by classifying their patron equities as liabilities because they believe their patronage and other certificates are not mandatorily redeemable if their redemption is subordinate to the general creditors or the Board may defer redemption if it would violate loan covenants.

In November 2007, FASB issued their Preliminary Views – Financial Instruments with Characteristics of Equity, and opened a comments period through May 2008. The main concern with the latest preliminary view is that the FASB has decided on the “basic ownership approach” for distinguishing between equity and liability. Under this approach, “an instrument” would be classified as equity if it 1) is the most subordinated interest in an equity (i.e. the members have a claim to a share of the assets that would have no priority over any other claims if the organization were to liquidate) and 2) entitles the holder to a share of the entity’s net assets after all higher priority claims have been satisfied (i.e. the members are entitled to a percentage of the assets that remain after all higher priority claims have been satisfied). All other instruments, for example, all forward contracts, options, and convertible debt, would be classified as liabilities or assets. If the instruments have a basic ownership component and a liability component, then the values would be separated and only the basic ownership component would be classified as equity.

As of September 2009, FASB and IASB reviewed comment letters on this Joint Project. A total of 68 respondents provided comments, of which 25 identified themselves as either a preparer or professional organization relating to Cooperatives. The majority of the respondents do not support the basic ownership approach. The significant issues raised by them include: • The classification as liabilities of all perpetual instruments that are not basic ownership instruments (measurement was also cited as a potential issue). • The classification as equity in consolidated financial statements of basic ownership instruments of a subsidiary. • Reporting changes in fair values of many types of liabilities in net income. • Certain puttable financial instruments and obligations arising on liquidation (for example, certain partnership arrangements) that are currently classified as equity would be liabilities under the basic ownership approach. • Many instruments classified as equity by cooperatives would be classified as liabilities under the basic ownership approach because they have fixed redemption prices or upper limits on the amounts the holders would receive in liquidation.

A majority of the cooperative respondents expressed a preference for International Financial Reporting Interpretations Committee (IFRIC) 2. IFRIC 2 states that a redemption requirement does not prevent shares (that otherwise would be equity) from being equity if either a) the entity has an unconditional right to refuse redemption or b) if redemption is unconditionally prohibited by local law, regulation, or the entity’s governing charter. The cooperative respondents also encouraged the Board to consider incorporating certain features of the Loss Absorption Approach in any model that is developed. One change in particular that was identified was to classify all perpetual instruments as equity and remove references to upper limits on distributions from the definition of a basic ownership instrument.

In January and May 2009, the Boards held meetings to discuss issues and concerns raised by the respondents (some are mentioned above). The FASB/IASB project is continuing to try and improve or

simplify the financial reporting requirements for financial instruments with characteristics of equity or liabilities. The Boards tentative conclusions as of August 2009 were implied in the board minutes and are summarized below: • A perpetual instrument is one whose holder has no right to force the entity to distribute assets unless the entity decides to cease its activities and distribute all of its assets. If the holder of an instrument cannot require the entity to make a payment, other payments automatically come first. Therefore, except in unusual and deliberately contrived circumstances, a perpetual instrument is considered equity. • All liabilities have settlement features either on a specified or determinable date or if specified conditions or events occur. All equity instruments have redemption features (but, for perpetual instruments, only if the issuer chooses to distribute all of its assets). Instruments that do not require redemption unless the entity chooses to wind up its affairs are the lowest claim status instruments issued by that entity and are equity. The currency (cash or shares) used for settlement does not matter. The distinction between settlement and redemption is based on why the instrument is settled or redeemed. • Redemptions of equity instruments occur for the following reasons: 1) The entity issuing the instrument chooses to or is required by an event such as bankruptcy to distribute all of its assets, 2) the issuer chooses to pay a dividend (partial redemption) or repurchase shares, 3) the terms of the instrument require, or permit the holder or issuer to require, retirement of that instrument to allow an existing group of shareholders, partners, or other participants to maintain control of the entity when one of them chooses to withdraw, and 4) the terms of the instrument require, or permit the holder or issuer to require, retirement of that instrument when the holder has ceased to engage in transactions with the entity or otherwise participate in the activities of the entity. In contrast, settlements of liabilities have both of the following characteristics: 1) the payment date is fixed or determined by events or conditions other than those that determine redemption dates and 2) the issuer may be able to influence the timing of the event that triggers settlement but cannot prevent the event or condition from occurring. • Derivative instruments represent claims against an entity or rights of the entity. Holders or writers of derivative instruments based on an entity’s equity instruments may suffer because of losses or benefit because of profits. However, those claims are not equity under the Board’s approach because they fail one or both of the criteria for equity instruments: 1) the claim against the writer of a derivative instrument is seldom, if ever, among the lowest status claims against the entity and 2) even if the claim is a very low status claim, the delivery of assets or issuance of equity instruments under a written derivative instrument is required on a fixed date or on the occurrence of an event that the writer has no ability to prevent. • Treating equity derivatives such as call options, put options, purchase warrants, and forward purchase or sale contracts as derivative instruments means that they will be subject to the same requirements as derivatives that are unrelated to the writer’s or holder’s own stock. That is, they will be reported net and measured at fair value through profit and loss.

The Boards will continue to develop a classification model. Specifically, the Boards will consider 1) balance sheet presentation issues, 2) when an entity is required to reassess an instrument’s classification, and 3) how the Board’s classification decisions will impact the earnings per share calculations. Overall, this situation is still very fluid, with convergence issues and the desire of both boards to reach a consensus theory. An exposure draft is expected in the first half of 2010, with a final document to be issued in 2011.

This concludes out the committee’s coverage of selected current issues and pronouncements for 2009. We welcome any comments or additional information and would appreciate any suggestions and information related to these issues which should be covered in future reports.

END.

LTA REPORTING SUBCOMMITTEE

OVERVIEW OF NEW TAX, OTHER LEGISLATION AND IMPLEMENTATION ISSUES AFFECTING FARMER COOPERATIVES

December 31, 2009

Barry Jencik, Chair Greendyke, Jencik & Associates, PLLC 110 Linden Oaks Ste C Rochester, NY 14625-2832

Kevin Feeley, Vice Chair McDermott Will & Emery LLP 227 West Monroe Street Chicago, IL 60606

This Report provides a summary of the key provisions of Federal and state tax legislation adopted in 2009 that may be of particular interest to farmer cooperatives and their members. The legislation described below is set forth in the reverse order of adoption. We have also included brief summaries of pertinent proposed tax legislation.

Enacted Federal Legislation

Haitian Disaster Relief Legislation (H.R. 4462) On January 21, 2010, the Senate approved legislation to allow individuals to claim a deduction on their 2009 tax returns for qualified cash Haiti disaster relief contributions made after January 11 and before March 1, 2010. The contributions would have to be made to U.S. charities actively involved in Haiti relief efforts. A cell phone statement that showed the date, amount, and recipient of the contribution would serve as adequate support for the deduction. The House passed the measure earlier, on January 20, 2010. The measure now goes to the President, who has indicated that he will sign the bill into law as soon as it reaches his desk.

Department of Defense Appropriations Act, 2010 (P.L. 111-118)

Under this bill, signed by the President on December 19, 2009, unemployed workers will be eligible for an additional two months of COBRA premium assistance for their health insurance coverage. The bill extends eligibility for the 65% COBRA premium subsidy originally enacted as part of the American Recovery and Reinvestment Act of 2009 (2009 Recovery Act) (P.L. 111-5). Under the new law, employees must have faced involuntary termination between September 1, 2008, and February 28, 2010, in order to qualify for the COBRA benefits.

Federal Aviation Administration Extension Act, Part II (HR 4217)

Under the bill, signed by the President on December 16, 2009, authority to collect taxes that fund the Airport and Airway Trust Fund, make expenditures from the Airport and Airway Trust Fund and provide grants to airports under the Airport Improvement Program is extended through March 31 2010.

The Worker, Homeownership, and Business Assistance Act of 2009 (H.R. 3548) (“The Act”)

Under The Act, signed by the President on November 6, 2009, certain popular tax incentives are extended and enhanced.

Homebuyer’s Credit The first-time homebuyer credit is extended to apply to home purchases made and certain purchase contracts entered into before May 1, 2010. Some new restrictions apply, but the phase-out threshold is increased. A reduced credit is available for some

existing homeowners, and recapture rules and expiration dates are relaxed for certain government workers.

Extended Carryback Period for 2008 or 2009 Net Operating Losses or Insurance Company Losses Taxpayers may elect to use an extended three-, four-, or five-year carryback period for either a 2008 or a 2009 net operating loss (“NOL”). Life insurance companies may elect to use an extended four- or five-year carryback period for either a 2008 or a 2009 loss from operations. Small businesses that elected an extended carryback period for 2008 NOLs may also elect an extended carryback period for 2009 NOLs. Certain participants in the Troubled Asset Relief Program (TARP), however, cannot take advantage of the extended carryback periods. The Act benefits businesses experiencing financial difficulty by expanding their ability to use net operating losses (NOLs) attributable to 2008 or 2009. Taxpayers may elect to carry back a 2008 or a 2009 NOL for three, four or five years, instead of the normal two years. Life insurance companies may elect to carry back a 2008 or a 2009 loss from operations for four or five years, instead of the normal three years. The tax benefit of the extended carryback period is reduced by a limitation on the amount of loss that can be carried back to the fifth tax year preceding the loss year. Also, taxpayers, other than small businesses, can make the election for only one year. Special carryback rules apply to eligible losses and corporate equity reduction transactions (CERTs) (see below). Taxpayers that qualify for the extended carryback period for applicable NOLs must make an affirmative election to use the longer carryback period. The election can be made for only one tax year. The election must be made by the due date, including extensions, for filing the return for the taxpayer's last tax year beginning in 2009. Once an election is made, it cannot be revoked. The Internal Revenue Service (“IRS”) will set forth the procedure for making the election.

Corporate Estimated Tax Payments The estimated tax payment required to be made in July, August, or September of 2014, by a corporation with at least $1 billion in assets is increased by 33 percentage points from the amount required to be paid under the Corporate Estimated Tax Shift Act of 2009. Thus, the required estimated tax payment is 133.25 percent of the amount otherwise due. The amount of the next required installment is then reduced to reflect the increase.

American Recovery and Reinvestment Act of 2009 (P.L. 111-5) On February 17, 2009, the President signed the American Recovery and Reinvestment Act of 2009 (The Stimulus Bill”). The $787 billion ten-year cost of the package is 65 percent allocated to spending and 35 percent allocated to tax breaks, heavily loaded toward the 2009 and 2010 period. The legislation includes a number of tax provisions affecting individual and business taxpayers. Following is a brief summary of those provisions that may be of particular interest to cooperatives and their members.

First-time Homebuyer Credit The amount of the first-time homebuyer credit is increased to $8,000 and the availability of the credit is extended through November 2009. The repayment requirement is eliminated for purchases made after December 31, 2008, and before December 1, 2009. Recapture rules apply if the home is disposed of or ceases to be treated as a principal residence within 36 months of the date of purchase. The prohibition against claiming the credit if the residence was financed by proceeds from a mortgage revenue bond is lifted. Residential Energy Efficient Property Credit The present law cap on the residential energy efficient property credit is eliminated beginning in 2009 for solar hot water, geothermal, and wind property. Any reduction in the credit due to the use of subsidized energy financing is also eliminated.

Non-Business Energy Property Tax Credit A number of enhancements are made to the credit for non-business energy property, including raising the rate of the credit from 10 percent to 30 percent. Energy property that would have been allowed a $50, $100, or $150 credit is instead eligible for a credit of 30 percent of qualifying expenditures and the aggregate amount of the cap on such expenditures is raised to $1,500 for property placed in service during 2009 and 2010. Modified standards are imposed for energy-efficient building property including electric heat pumps, central air conditioning units, and water heaters, as well as for oil furnaces, hot water boilers, and for energy efficiency improvements (e.g., windows, doors, skylights, insulation, etc.).

Alternative Minimum Tax (“AMT”) The AMT exclusion amounts for tax years beginning in 2009 are $70,950 in the case of married persons filing a joint return and surviving spouses, $46,700 for single filers, and $35,475 for married persons filing separately. In addition, the ability to fully utilize nonrefundable credits (e.g., the adoption credit, the child tax credit, and the retirement savings contribution credit) against the AMT is extended through 2009. Estimated tax payments. The applicable safe-harbor percentage governing estimated tax payments of an individual who has an adjusted gross incomes of less than $500,000 ($250,000 for married persons filing separately) and who receives more than 50 percent of his or her gross income from

a small business (those with an average of less than 500 employees), is lowered from 100 percent to 90 percent for 2009.

Bonus Depreciation

The new law extends the 50-percent first-year bonus depreciation allowed under the 2008 Economic Stimulus Act through December 31, 2009. The extension is retroactive to January 1, 2009. The new law also extends, through 2010, the additional year of bonus depreciation allowed under the 2008 Economic Stimulus Act for property with a recovery period of 10 years or longer, for transportation property (tangible personal property used to transport people or property), and for certain aircraft.

Code Section 179 Expensing

The new law extends the increased 2008 limited expensing (aka, small business expensing) amounts to 2009. The 2008 Economic Stimulus Act increased the amount of limited expensing for 2008 to $250,000 and increased the threshold for reducing the deduction to $800,000. Without the 2009 extension, businesses placing property in service in 2009 would have been limited to a $125,000 inflation adjusted maximum deduction with a $500,000 cap.

Net Operating Loss (“NOL”) Carryback

The new law provides a five-year carryback of 2008 NOLs but only for qualified small businesses with average gross receipts of $15 million or less. The new law gives these businesses the choice to carry back NOLs three, four or five years. The new treatment will apply only to NOLs for any tax years beginning or ending in 2008. The normal NOL carryback period, which is two years for all businesses returns for NOLs incurred in 2009.

Refundable Credits in Lieu of Bonus Depreciation

The new law allows businesses to monetize accumulated AMT and R&D credits in lieu of taking bonus depreciation. The election to accelerate these historic AMT and R&D credits originally applied only to 2008, but the new law extends this option to all property qualifying for bonus depreciation placed in service through 2009.

Cancellation of Indebtedness

The new law will allow certain businesses to elect to recognize cancellation of indebtedness income over five years, beginning in 2014, for specified types of

business debt repurchased by the business after December 31, 2008, and before January 1, 2011. An applicable debt instrument under the new law means a bond, debenture, note, certificate, or any other instrument constituting indebtedness issued by a C corporation or any other “person” in connection with the conduct of a trade or business by such person.

COBRA Benefits

The new law allows an individual who is involuntarily separated from employment between September 1, 2008, and January 1, 2010, to elect to pay 35 percent of his/her COBRA coverage and have it treated as paying the full amount. The former employer will be required to pay the remaining 65 percent but, in effect, will be reimbursed by crediting those amounts against income tax withholding and payroll taxes it is otherwise required to remit to the federal government. Income and other limitations on COBRA coverage apply.

Renewable Electricity Production Credit

Code Sec. 45 provides a credit for electricity produced from renewable sources, such as wind. The new law extends (generally, through 2013; through 2012 for wind facilities) the placed-in-service dates for qualified wind and other facilities under Code Sec. 45. Cooperatives may apportion the credit.

Energy Investment Credit

The Economic Stimulus Act expanded the Code Sec. 48 energy investment credit to include qualified small wind energy property. The new law removes the credit cap for qualified small wind energy property. A 30 percent credit presently is available for qualified small wind energy property expenses made by the taxpayer during the tax year.

State Legislation

North Dakota Senate Bill No.2405 (April 22, 2009)

The Bill enacts legislation to reduce the amount of the add back required to federal taxable income related to the domestic production activities deduction (“DPAD”). A cooperative that elects to pass some or all of the deduction through to its members is required to add back to federal taxable income only the portion of the DPAD not passed through to members and deducted at the cooperative level.

Proposed Federal Legislation Following are brief summaries of significant tax legislation not enacted as of this writing that may be of interest to cooperatives and their members.

Tax Extenders Act of 2009 The bill would extend through 2010 numerous provisions set to expire at the end of 2009. Individual tax relief includes extensions of the deduction of state and local general sales taxes, the additional standard deduction for state and local real property taxes, the above- the-line deduction for qualified tuition and related expenses, and the deduction for educators' expenses. Business tax relief provisions include extensions of the research credit, the subpart F exception for active financing income, employer wage credit for employees who are active duty members of the uniformed services, and look-through treatment of payments between related controlled foreign corporations. In addition, empowerment zone and renewal community tax incentives are also extended, as are the new markets tax credit, the work opportunity tax credit for Hurricane Katrina employees, and the alternative motor vehicle credit for heavy hybrids. The bill also contains provisions to prevent tax evasion by U.S. individuals by requiring foreign financial institutions, foreign trusts, and foreign corporations to report information about their U.S. account holders. Finally, the bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as a carried interest in an investment fund.

Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009 The bill would make permanent the estate, gift, and generation-skipping transfer (GST) tax laws in effect for 2009. The applicable exclusion amounts for estate and GST taxes would continue to be $3.5 million, the applicable exclusion amount for the gift tax would remain at $1 million, and the current maximum estate and gift tax rate of 45 percent would be permanently extended. The bill would also repeal the enactment of the carryover basis rules and make permanent the repeal of the state death tax credit.

Patient Protection and Affordable Care Act The bill, which was passed by the House as the “Service Members Home Ownership Tax Act of 2009,” has become the Senate vehicle for health care reform and is being considered in the Senate as the “Patient Protection and Affordable Care Act.” The bill would impose a 40% excise tax on high-cost health coverage; limit health flexible spending arrangements to $2,500; increase the penalty for nonqualified distributions from health savings accounts to 20%; and expand information reporting requirements for corporations. The bill would also increase the threshold for the itemized income tax

deduction for medical expenses to 10% of AGI, and impose a 5% excise tax on cosmetic surgery and similar procedures.

Affordable Health Care for America Act The bill would impose a tax on individuals without health care coverage; create a credit for small business employee health coverage expenses; limit health flexible spending arrangements to $2,500, indexed for inflation; and increase the penalty for nonqualified distributions from health savings accounts to 20%. The bill would also impose a 5.4% surtax on AGI in excess of $500,000 ($1,000,000 for joint returns); require information reporting on payments to corporations; delay implementation of worldwide interest allocation until 2020; codify the economic substance doctrine; and impose penalties for underpayments.

2009 Report of the LTA Reporting Subcommittee on Operating on a Cooperative Basis for Subchapter T and Section 521 Cooperatives

I. Operating on a Cooperative Basis: Private Letter Ruling 200916004 (April 17, 2009) and Private Letter Ruling 200907014 (February 13, 2009).

A. These rulings address issues raised by a nonexempt electric cooperative and a nonexempt telephone cooperative, respectively. While not particularly noteworthy, the rulings provide the IRS’s view of case law governing “operating on a cooperative basis” and “patronage income” before and after the enactment of Subchapter T in 1962. In this regard, both rulings provide:

While subchapter T does not control the taxation of nonexempt telephone cooperatives, its foundations rest upon pre-1962 cooperative tax law. As a result, there are certain basic parallels between the tax treatment of nonexempt utility cooperatives and treatment of other cooperative organizations under Subchapter T. Therefore, to (the) extent that Subchapter T reflects cooperative taxation as it existed prior to 1962, it is instructive in resolving certain issues facing rural telephone cooperatives. This is because Congress stated that in enacting Subchapter T it was merely codifying the long common law history of cooperative taxation (with the exception of ensuring at least one annual level of tax at the cooperative or patron level. See S. Rep. No. 1881 87th Cong., Sess. 113 (1962)) and, arguably, the case law post-enactment is merely a continuation and refinement of the pre-enactment common law. This is particularly true with respect to defining certain terms such as “operating on a cooperative basis” and “patronage income.”

II. Section 521 Cooperatives: Shrimp Harvesting Cooperative Denied Section 521 Exemption: Private Letter Ruling 200841038 (October 10, 2008)

A. In this ruling, a cooperative was organized to market brine shrimp cysts on behalf of its members engaged in the fishing industry. The cooperative filed for an exemption under Section 521. The IRS denied the cooperative’s request for Section 521 status reasoning that the cooperative is not a farmers’, fruit growers’, or other like organization because harvesting brine shrimp cysts in public lake is not a farming activity. The ruling distinguished harvesting fish in a private fish/farm facility where fish are grown or raised which could be considered a farming activity. The ruling cited (1) Treasury Regulation Section 1.175-3 which states a fish farm is an area where fish are grown or raised, as opposed to merely caught or harvested and (2) Revenue Ruling 64-246, 1964-2 C.B. 154, which provides that fish or fish products could be considered farm products if raised in privately-owned waters.

September 24, 2009 Terrance A. Costello Lakes and Plains Office Building 842 Raymond Avenue St. Paul, Minnesota 55114 Telephone: 651-698-8102 E-mail: [email protected]

2009 REPORT

OF THE

LTA REPORTING SUBCOMMITTEE

ON COOPERATIVE STRUCTURES: MERGERS,

ACQUISITIONS, JOINT VENTURES,

AND SUBSIDIARIES

AS OF December 31, 2009

Prepared by:

David P. Swanson, Chair Dorsey & Whitney LLP 50 South Sixth Street, Suite 1500 Minneapolis, MN 55402-1498 Telephone: (612) 343-8275 E-mail: [email protected]

AND

Charles L. Woltmann Sr. Vice President and General Counsel Sunkist Growers, Inc. 14130 Riverside Dr. Sherman Oaks, CA 91423 Telephone: (818) 379-7532 E-mail: [email protected]

Introduction

There are three sections in this year’s subcommittee report for the Reporting Subcommittee on Cooperative Structures. Each section reflects the different types of transactions or ventures involving cooperatives highlighted by the news media this year and are as follows: Sales or Acquisitions of Assets; Mergers; and Miscellaneous Transactions and News.

I. News Regarding the Sale or Acquisition of Assets

1. AgStar buys and sells six VeraSun plants

In March, AgStar, a Farm Credit System bank based in Mankato, Minnesota, purchased six ethanol plants formerly belonging to bankrupt VeraSun. The bank’s credit bid was for $324 million. According to press reports, a number of farm groups were interested in acquiring some of the plants, but did not have the financial clout to win them during the auction conducted by the bankruptcy court. But the bank, itself a cooperative, had hoped to give them a chance to do so. The six plants purchased by AgStar, located in five Upper Midwest states, are described by the bank as being state-of-the-art facilities with annual production capacity of 470 million gallons of ethanol. The Woodbury, Michigan plant was sold to Chicago-based Carbon Green BioEnergy in May. Two of the Nebraska plants were sold to Omaha-based Green Plains Renewable Energy, Inc. Guardian Energy LLC, based in Shakopee, Minnesota, purchased the Janesville, Minnesota plant. And the Dyersville, Iowa plant was purchased by River Valley Energy, LLC, a wholly owned subsidiary of Wisconsin-based United Cooperative.

Sources: Dan Campbell, AgStar buys six VeraSun plants; hopes to re-sell to farmer co-ops, Rural Cooperatives, May/June 2009. Melissa Loth, AgStar Sells Michigan Ethanol Plant, Twin Cities Business Magazine online, May 2009. Kristin Holtz, Shakopee corporation buys Janesville ethanol plant, Shakopee Valley News online, Aug. 4, 2009. AgStar Financial Services to Sell Former VeraSun Plant in Dyersville, IA to River Valley Energy LLC, BioFuels Journal online, Aug. 7, 2009.

2. Effingham-Clay Service Co. and Illini FS buy fuel business

In October, 2008, Effingham-Clay Service Co., GROWMARK, Inc.’s Illini FS division, and Lanman Oil Co. announced an agreement under which the two agricultural cooperatives purchased Lanman Oil’s farm fuel delivery, lube oil and non-branded transport fuel businesses. Details of the transaction were not disclosed. Effingham-Clay, founded in 1944, provides farm-related inputs, including feed, seed, plant food, crop protection, fuel, lubricants and grain marketing services to farmers and rural residents in east- central Illinois. Illini FS, a division of GROWMARK, Inc., provides ag-related products and services to farmers and rural residents in east-central Illinois.

Source: Dan Campbell, Midwest local co-ops buy fuel business, Rural Cooperatives, Nov/Dec 2008.

3. Two electric co-ops purchase assets of Allegheny Energy Virginia

Greensburg, Pa.-based Allegheny has agreed to sell its Virginia distribution business, Potomac Edison (PE), to a pair of electric cooperatives. By getting out of Virginia, Allegheny says it can focus on Pennsylvania, West Virginia, Maryland and its generating plants.

Allegheny says it will net about $340 million from the sale to Fredericksburg, Va.-based Rappahannock Electric Cooperative and Mt. Crawford, Va.-based Shenandoah Valley Electric Cooperative. Allegheny says the cooperatives have agreed to offer jobs to 102 Allegheny employees affected by the deal. Allegheny says the sale should close by the end of the year, pending regulatory approval. The company has about 102,000 customers in northern Virginia.

Currently, Shenandoah Valley Electric Cooperative serves over 39,000 members with over 5,239 miles of electric lines in Augusta, Rockingham and Shenandoah and Hardy Counties. REC provides electricity to 103,000 connections and maintains over 12,500 miles of power lines in parts of 16 counties. After the expansion, REC will be the third largest electric utility in the state. Source: Associated Press, Allegheny Energy pulls plug on Virginia operations, nbc29.com, May 5, 2009.

4. Humboldt Creamery files for Chapter 11 and Foster Dairy Farms bids on assets

Humboldt Creamery filed for Chapter 11 bankruptcy protection April 21 in U.S. Bankruptcy Court in Santa Rosa, Calif. Humboldt Creamery’s bankruptcy filing listed assets of $50 million to $100 million, with liabilities in the amount of $3.7 million owed to members and $54 million in secured debt in the form of a term loan and a revolving line of credit. As of the time of this report’s writing Foster Dairy Farms was set to bid on Humboldt Creamery’s facilities at auction for $20.5 million.

Humboldt Creamery is the oldest independent dairy cooperative in California and specializes in pasture- based and organic dairy farming. It is owned and operated by about 50 family farmers and produces high- quality fluid milk products, ice cream and milk powder shipped nationally and internationally. Based in Fernbridge in Humboldt County, it has additional facilities in Stockton, Calif., and Los Angeles.

Source: Thadeus Greenson, Humboldt Creamery's iconic run ends Tuesday, The Times-Standard online, Aug. 8, 2009.

5. AgSource Cooperative acquires Agri-Check testing business

AgSource Cooperative Services announced that it has acquired Agri-Check, Inc., an agricultural testing business located in Umatilla, Oregon. Founded in 1976, the laboratory provides soil, plant, water and forage testing with a diverse clientele throughout the Pacific Northwest. Based in Verona, AgSource is a subsidiary of Cooperative Resources International and a member-owned cooperative that provides agricultural and environmental laboratory analysis and management information services to members and clients from North America and overseas from eight locations in the Midwest and Northwest.

Source: AgSource Co-op acquires Agri-Check testing tusiness, Wisconsin Ag Connection, Jan. 26, 2009.

6. Foremost Farms USA sells milk processing plants to Dean Foods

Foremost Farms USA, a Baraboo-based dairy cooperative, has sold its milk-processing plants in Waukesha and De Pere, Wisconsin so that it can focus on wholesale markets and get out of the retail milk business. The plants have been sold to Dean Foods Co., of Dallas, the nation's largest processor of milk and other dairy products. With 282 employees, the plants will continue operating and buying milk from Foremost Farms, according to Dean Foods. The sale includes the Golden Guernsey and Morning Glory brands. Terms were not disclosed, but the result of the sale means that Foremost will concentrate on its wholesale businesses of cheese, butter and dairy-product ingredients.

Foremost Farms is a dairy cooperative owned by about 3,760 dairy farmer-members in Illinois, Indiana, Iowa, Michigan, Minnesota, Ohio and Wisconsin. In 2003, they supplied nearly 5 billion pounds of milk. Foremost Farms is among the top 10 dairy cooperatives in the United States in terms of milk volume, with sales over $1.2 billion in 2003.

Source: Rick Barrett, Dean Foods acquires Waukesha, De Pere milk-processing plants, Milwaukee- Wisconsin Journal Sentinel online, April 2, 2009.

7. United Farmers of Alberta Cooperative Ltd. acquires 15 Sportsman’s Warehouse locations

Amid deteriorating economic conditions, Utah-based outdoors retailer Sportsman’s Warehouse has sold 15 of its store locations to the United Farmers of Alberta Cooperative, Ltd., a Canadian agricultural supply cooperative based in Calgary. With more than $2 billion in annual revenues and 120,000 active members, UFA is one of Canada’s largest co-operatives.

Source: Jenny K. Boone, Outdoors retailer to close Roanoke store, The Roanoke Times online, Mar. 10, 2009.

8. Mountain States Lamb and Wool co-op buys out partner

Mountain States Lamb and Wool Cooperative, based in Douglas, Wyoming, has purchased the remaining interest in Mountain States Rosen, according to a report in the “Casper Star-Tribune.” The cooperative markets lamb throughout the United States and in some foreign markets. The co-op, which has 140 family producers in 13 states, says Mountain States Rosen is the nation’s largest fully integrated lamb and veal company.

Source: Dan Campbell, Lamb co-op buys out partner, Rural Cooperatives, January/February 2009.

9. Tree Top Acquires Sabroso

Tree Top Inc. acquired the Sabroso Company in an October, 2008 transaction. Sabroso is based in Medford, OR, with manufacturing facilities in Medford and Woodburn, OR, and Oxnard, CA. Sabroso was the nation’s leading manugacutrer and seller of fruit purees, including apple, pear and peach. Sabroso was also a leader in dried fruit flakes and fruit preparations for the ingredient and foodservice channels. Sabroso’s products compliment Tree Top’s product lines and the acquisition allowed Tree Top to offer a broader spectrum of products to customers, and provides Tree Top’s growers with additional outlets for their processing fruit.

Source: Tree-Top News Release, October 27, 2008.

10. Agropur Acquires US Dairies

Agropur, Canada’s largest dairy cooperative, acquired several US dairy operations in 2008 and 2009, including Green Meadows Foods, a recently completed cheese factory located in Iowa, Farmland Dairies’ Grand Rapids, Michigan, milk processing facilities, and the operations of Schroeder Milk, based in Minnesota.

Source: Agropur Press Releases, February 11, 2009, September 29, 2009, and December 3, 2009.

II. Merger and Consolidation News

1. Country Horizons Cooperative and Valders Cooperative approve merger

Members of Country Horizons Cooperative and Valders Cooperative in eastern Wisconsin have approved a merger, which became effective Oct. 1, 2008. The new cooperative will have eight locations and 200 employees, with sales of more than $85 million annually. The combined operations will be 40 percent ag- services, 30 percent retail-based and 30 percent energy. About 75 percent of Valders Cooperative members approved the merger, while 68 percent of Country Horizons Cooperative members approved it. Voting was done both by mail and at a membership meeting.

The newly formed cooperative selected the name Country Visions Cooperative. It will be governed by a nine-person board, with five directors from Country Horizons and four from Valders Cooperative. Robert Lowe, general manager of Country Horizons, has been named CEO/general manager of the combined company. He has more than 30 years of experience as a cooperative general manager. The stock or equity held by members in each cooperative was transferred Oct. 1 for equal value for equity in the new cooperative.

Source: Dan Campbell, Wisconsin Co-ops approve merger, Rural Cooperatives, November/December 2008.

2. Associate Pharmacies, Inc. and United Drugs merge pharmacy cooperatives

Associated Pharmacies, Inc. (API) of Scottsboro, Ala., and United Drugs of Phoenix have merged their independent pharmacy cooperatives. Following the closing, API and United Drugs became wholly owned subsidiaries of American Associated Pharmacies (AAP), a cooperative incorporated in Minnesota and representing approximately 2,000 independent pharmacies. “API is recognized for its member-owned warehouse and United Drugs is well known for its managed-care program, so there’s a lot of compatibility with regard to our corporate cultures,” said Bruce A. Semingson, CEO of United Drugs.

Executives from both API and United Drugs are initiating a series of educational meetings for members in late July, starting with a “United-API University” held in Washington, D.C. Discussions and details will be announced later about future plans for the corporate structure, merger combination timeline, and other details of the new company’s future.

Source: Two success stories become one as Associated Pharmacies, Inc. and United Drugs announce their proposed corporate merger, United Pharmacies Press Release, Feb. 24, 2009. 3. Montana co-ops to merge

Laurel Town & Country Supply has announced a merger with Farmers Union Association of Big Horn County, according to a report in the Laurel (Montana) Outlook. Big Horn County members approved the merger by the required two-thirds majority at a November meeting. The businesses will operate under the Town & Country Supply name. The merger became effective February 1.

The merger adds another farm store, convenience store, agronomy plant and bulk fuel and propane plant to the Town & Country Supply operation. Besides its farm store in Laurel, it also operates a convenience store/casino and a bulk fuel and propane plant. It also has agronomy plants in Bridger and Edgar, a convenience store in Bridger, a convenience store in Billings and a farm store in Bridger.

Source: Dan Campbell, Montana co-ops to merge, Rural Cooperatives, Jan/Feb 2009.

4. Historic merger of two Montana electric co-ops

On Jan. 1, 2009, the first merger of two Montana electric cooperatives took effect. Northern Electric Cooperative and Valley Electric Cooperative, both Basin Electric Class C members located in Northeast Montana, agreed to merge their two cooperatives following informational meetings and a vote of their respective memberships in early October 2008. The new co-op will be called NorVal Electric Cooperative and will maintain offices in both Opheim and Glasgow, MT. It is hoped that the merger will eliminate duplication of effort, reduce costs, and help the cooperative remain competitive As a newly merged cooperative, NorVal will have approximately 3,200 meters, 2,000 members and 23 employees. The new board will have 12 directors, which is simply a combination of the six board members from each cooperative.

Source: Historic merger of two Montana co-ops, Basin Electric Power Cooperative, Jan. 9, 2009.

III. Miscellaneous Transactions and News

1. G&T co-ops support Iowa wind farm

Six generation and transmission cooperatives across the United States are supporting a renewable energy project, culminating with the commercial operation of the 150-megawatt (MW) Story County Wind Energy Center in Story County, Iowa. The project is owned and operated by a subsidiary of FPL Energy and began commercial operation last November. This is believed to be the first time several G&T cooperatives operating in different regions of the country have banded together to reap the benefits of a large-scale wind project.

Participating co-ops are: Buckeye Power Inc. (Ohio); PowerSouth Energy Cooperative (serving Alabama and Florida); Wabash Valley Power Association (serving several Midwest states, including Indiana); Hoosier Energy (serving Indiana and Illinois); Central Iowa Power Cooperative (CIPCO); and North Carolina Electric Membership Corporation. Joint participation enables each G&T co-op the ability to spread any risks associated with the project, and to participate on a pro-rata basis (taking only the megawatt quantity desired) in a sizeable and viable project with a highly regarded developer in a wind- rich region. Source: Dan Campbell, G&T co-ops support Iowa wind farm, Rural Cooperatives, January/February 2009.

2. Meadowbrook Farms files for Chapter 7 bankruptcy

Meadowbrook Farms, an Illinois hog cooperative that opened in 2002, announced plans in March to file for Chapter 7 bankruptcy. It said its assets will be liquidated, including a processing plant in Rantoul, Illinois. The co-op once had 200 members, but was down to less than half that number, according to press reports. Its 600 employees were laid off in December. It had for many months been paying below-market rates for hog deliveries, leading to steady erosion in member business.

Source: Dan Campbell, Hog co-op files for bankruptcy, Rural Cooperatives, May/June 2009.

3. Norbest reopens turkey-processing plant in Utah

A company that laid off nearly 400 employees last year has brought many of them back. In March, the Moroni Feed Company, which produces Norbest Turkeys, resumed operations after being forced to shut down because of high corn prices.

Moroni Feed Company, headquartered in the community of Moroni, Utah, is a fully integrated turkey producing and processing cooperative. All of Utah's five million commercially grown turkeys are raised by the 55 independent turkey producer-members of the co-op.

Incorporated in 1938, Moroni Feed Company has gross sales in excess of 125 million dollars. In addition to the independent growers and their employees, Moroni Feed has 675 employees.

Source: Sam Penrod, Moroni turkey processing plant reopens its doors, ksl.com, Mar. 24, 2009

4. North Dakota Natural Beef opens new grind facility, offices

In mid-March, North Dakota Natural Beef LLC completed its move into new offices in north Fargo, N.D. following the opening of its grind facility in December 2008. The largest shareholder in the new venture is the North American Bison Cooperative of New Rockford, N.D. The co-op currently processes 14,000 bison a year and nearly 4,000 beef, and it hopes to go to 25,000 beef a year. Established in 1993, the bison co-op today has some 330 members, including some newer ones. About 70 percent are in the U.S. and 30 percent are Canadian.

Source: Mikkel Pates, Venture should be boost for N.D. meat animal industry, Agweek, May 18, 2009.

5. Basin Electric discusses proposed wind farm

In early 2008, the directors of Basin Electric Power Cooperative approved the creation of a subsidiary, named PrairieWinds ND 1 (“PWND 1”) Inc. The for-profit subsidiary was formed to develop a new $240 million, 115 megawatt (MW) wind project in central North Dakota near Minot, ND. PrairieWinds ND 1 will initially be the largest wind project owned and operated by a cooperative in the United States. Before construction can begin, Basin Electric needs regulatory approval from North Dakota Public Service Commission. A public hearing was held on May 26 in Minot to hear testimony on the wind project, including its effect on wildlife.

Basin Electric Power Cooperative is one of the largest electric generation and transmission cooperatives in the United States. Its members' service territory spans 430,000 square miles from the Canadian to the Mexican border and distributes electricity to 2.6 million customers in the Midwest and Plains states.

Source: Basin discusses proposed wind farm, KFRY-TV.com, May 27, 2009.

6. Dairy farmers and Niagara Milk cooperative reach settlement

Following the May 2006 merger between Niagara Milk and Upstate Farms, seven members of Upstate Farms filed a lawsuit against Niagara alleging that they had not been offered enough money for their shares of the co-ops assets. In February 2009, a settlement agreement was reached between the dairy farmers and Niagara, the terms of which were kept confidential by the New York state court.

Source: Matt Gryta, Farmers, milk co-op reach deal, Buffalo News online, Feb. 27, 2009.

NATIONAL COUNCIL OF FARMER COOPERATIVES Legal, Tax and Accounting Committee Report of Subcommittee 6: Calculating Patronage Dividends

NEW DEVELOPMENTS The Subcommittee reports no significant legal or accounting development within the scope of the Subcommittee's topic during 2009. This statement is conditioned on the Subcommittee Chair's perception of the scope of the Subcommittee's topic. This leaves the Subcommittee report to discuss other issues within the scope of the Subcommittee's topic. There follow discussions of two related topics prepared by the Subcommittee Chair and Vice Chair:

I. THE NATURE OF A PATRONAGE DIVIDEND Why should we be interested in the nature of a patronage dividend? And what do we mean by "nature"? For the purpose of this section, we will consider underlying economic and corporate law theory for patronage dividends. Economic theory and corporate law are important to an examination of patronage dividends because they determine why and how a cooperative calculates its patronage dividends, and how this is (or should be) described in the patronage contract found in either the cooperative's bylaws or in a separate written patronage agreement. While Subchapter T of the Code has become a dominant force in defining what it means to do business on a cooperative basis, the current tax law applicable to patronage dividends is derived from economic and corporate law theories of what it means to allocate and distribute the fruits of a commercial enterprise on a cooperative basis. It is said that a cooperative is not a pass-through entity (as that term is understood by tax practitioners) and this is true. There are many things that a cooperative is not. For example, a cooperative is not really a nonprofit corporation, and yet we often find it helpful to analogize a cooperative as nonprofit. Many state cooperative statutes (which are definitely not tax statutes) specifically designate cooperatives as nonprofit for certain applications of corporate, tax, and regulatory law. This is because cooperatives have attributes of nonprofit entities (principally, governance and subordination of capital interests) that for certain corporate and tax law purposes, justify lumping them with other nonprofit entities.

To say that a cooperative is not a pass-through entity, or even that it is a nonprofit corporation does not help us describe a cooperative's patronage dividends. Because Subchapter T of the Code and many features of cooperatives are different from anything else in corporate law and tax codes, we are left with the need to describe these features as being "like" more familiar items. This can be helpful in describing how cooperatives work, but that is not the same as describing what these features actually are. For example: • Cooperatives pass certain profits, losses and tax credits through to their Patrons as patronage dividends – but not at all in the same manner or for the same reason as partnership-style entities ("S" corporations, LLC's, LLP's, etc.); • Allocation and distribution of a patronage dividend is like a price or cost adjustment with respect to a Patron's patronage transactions but it is neither a price discount or rebate; • The cooperative is a conduit for Patron-earned profits that are distributed to the Patrons in the form of patronage dividends; • The cooperative is an agent acting on behalf of the Patrons with respect to patronage dividends; or • The cooperative allocates and distributes its profits as patronage dividends to its Patrons, just as other corporations distribute their profits as dividends to their shareholders. All of these are descriptions of what happens when patronage dividends are distributed to Patrons, but they do not truly describe what patronage dividends are from the standpoint of corporate or tax law or under relevant economic theory. It is the unique nature and purpose of the cooperative business model that gives substance to a description of patronage dividends. This is why cooperative taxation and accounting are derived from the corporate law and economic theories of the cooperative business model. Through much of the last century the battle lines for describing the true nature of a patronage dividend were drawn over economic and corporate law theory. Cooperatives maintained that their Patrons are the real actors in the cooperative enterprise and that the cooperative is a facilitator in the collective economic and property interests of the Patrons. This resulted in a federal income tax policy that the cooperative is not a taxpayer with respect to its net margins to the extent those net margins are allocated to the Patrons as patronage dividends.

The opposing position – most strenuously voiced by the National Tax Equality Association – is that Patronage dividends are: • Merely a distribution of the cooperative's profits; • No different than the dividends that other corporations distribute to their shareholders; and • Should be taxed at the corporate level the same as other corporate dividends. In short, opponents of the prevailing tax treatment of cooperative patronage dividends insisted that there is nothing distinctive about cooperatives and the cooperative business model in corporate law or economics that justifies different treatment (tax or otherwise) of patronage dividends. A prominent example of the competing theories are the opposing positions of the pre- Subchapter T cooperative community and the National Tax Equality Association laid out in an article by Albert W. Adcock, General Counsel for the National Tax Equality Association in 19481. Adoption of Subchapter T of the Code (which became effective in 1963) eventually took the wind out of the sails of the National Tax Equality Association, but it did not precisely settle the nature of a patronage dividend. Subchapter T begins with: "(b) Patronage Dividends and Per unit Retain Allocations. – In determining the taxable income of an organization to which this part [Subchapter T] applies, there shall not be taken into account amounts paid during the payment period for the taxable year – (1) as patronage dividends (as defined in section 1388(a)) ****" 26 USC Section 1382(b) This suggests that the cooperative principles of "operations at cost" and cooperative as a "conduit" or "agent" are in play; that cooperative net margins belong to the patrons and are not corporate profits of the cooperative as such. But, subchapter T concludes with a definition of patronage dividend (Section 1388(a)). Of course "dividend" is a well recognized corporate law concept for the distribution of corporate profits. NCFC has occasionally invited IRS officials to address cooperative tax theory at NCFC- LTA Committee Annual Meetings. On at least one occasion in the 1980's, the LTA Committee heard a Service analysis of patronage dividends in terms of the cooperative as "agent" and a

"conduit" for the Patrons. And yet, it is well settled that IRS pronouncements and tax forms treat patronage dividends as deductions from the cooperative's adjusted gross income, not exclusions from gross receipts as stated in Subchapter T. So, why does any of this matter? It may not matter for federal income tax reporting by the cooperative. But it does matter for drafting corporate documents such as bylaws and patron contracts. The distinction between a "conduit" or "agency" theory of patronage dividends and a "distribution of corporate profits" theory (a true corporate dividend) has come into focus for: • Worker cooperatives currently being audited with respect to alleged employer liability for withholding and FICA contributions on patronage dividends allocated and distributed to employee patrons; and • Patronage dividend as a "rebate" in cooperative insurance arrangements.

A PROBLEM OF PATRONAGE DIVIDENDS CHARACTERIZED AS REBATES From time to time it is advantageous for a cooperative to advocate one or another of apparently opposing theories of patronage dividend characterization. Recently, it was necessary to assert that a cooperative who acquired an interest in a crop insurance agency could allocate and distribute net margins from this enterprise as patronage dividends to Patrons of the enterprise without violating state anti-rebate statutes. Competitors claimed that these patronage dividends were illegal rebates under applicable state insurance law. The cooperative argued that a patronage dividend is a distribution of its corporate net profit and that a rebate is something else entirely. There is a thorough analysis of the distinction between a patronage dividend and a rebate in a 2007 Tax Court decision, Affiliated Foods, Inc. v. Commissioner2. If Mr. Adcock of the National Tax Equality Association were alive today, he would probably applaud the decision and its reasoning because it comes down on the side of patronage dividends as a distribution of the cooperative's net profit. This analysis makes perfect sense when comparing patronage dividends to rebates in a commercial transaction, but is it dispositive as to the nature of a patronage dividend and the cooperative that allocates and distributes the patronage dividend? Referring back to the

1 "Patronage Dividends: Income Distribution Or Price Adjustment" 13 Law & Contemporary Problems 505 (1948). 2 128 T.C. 62 (March 29, 2007).

beginning of this discussion, we analyze and describe cooperatives and what they do – calculate, allocate, and distribute patronage dividends – using more familiar terms borrowed from other entities and their income distributions. In various respects, patronage dividends are like something else that the observer, unfamiliar with cooperatives, can understand. Perhaps cooperatives, like certain other objects in nature, cannot be understood by direct observation, but only by observing their leavings. One can learn something of the nature of cooperatives and their patronage dividends by reading Subchapter T, state cooperative statutes, the Capper- Volstead Act, and a cooperative's articles of incorporation and bylaws, but these alone do not describe why patronage dividends and the cooperative that allocates them are so distinctive under corporate and tax law. The nature of patronage dividends is elusive. Those who defend the distinctive treatment of patronage dividends (and cooperatives) in various contexts must be prepared to argue one or another theory of their nature depending on the context.

December 22, 2009 Mark C. Stewart Shumaker, Loop & Kendrick, LLP 1000 Jackson Street Toledo, OH 43604-5573 (419) 321-1456 [email protected]

II. 2009 Practice Notes on Computing Patronage Dividends

1. Patronage dividend basics

Agricultural cooperatives are formed to create value for their farmer-patrons by creating economies of scale through horizontal and vertical integration into the markets for their production inputs and outputs. The patronage dividend system is the contractual device unique to cooperatives for measuring value created in terms of annual net earnings, and distributing it to patrons in proportion to their participation. For patrons of a marketing cooperative, the patronage dividend is considered additional sales proceeds; for patrons of a purchasing cooperative it’s considered a reduction in the cost of inputs. Consistent with their economic effect, patronage dividends are considered deferred and corrective price adjustments. Farmers join marketing and purchasing cooperatives to gain the economic benefit of patronage dividends, so patrons must be satisfied that their patronage dividends represent an accurate measure of each year’s economic income. Cooperative principles are the framework for the legal relationships necessary to bind a group of unrelated farmers together to operate on a cooperative basis and were established long before our federal income tax system was enacted.

Consistent with general income tax principles, Subchapter T was designed to apply the corporate income tax law to the economic reality of a cooperative. Accordingly, cooperative operating principles were adopted by Congress as the framework for the tax principles governing patronage dividends at both the cooperative and patron levels. Specifically, Congress based the definition and taxation of a patronage dividend on its economic reality as a contractual price adjustment determined with reference to annual net earnings from business done with or for patrons.3

Historically, cooperatives have either used GAAP or tax accounting principles to compute patronage dividends because each offers a widely-used, objective set of rules for computing net earnings. However, both GAAP and tax accounting principles were developed to serve broad investor and government policy objectives that often come in conflict with reaching an accurate measure of a cooperative’s economic performance on behalf of its patrons

3 S. Rept. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 822 (“patronage dividends represent price adjustments”); H. Rept. 1447, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 405, 485-486 (similar).

for a given year. Thus, cooperatives have always been in the position of striking a balance between the objective results of GAAP or tax accounting and the need to justify to their patrons (and to the various constituencies within the patron group) that each year’s patronage dividend is a reasonable and fair measure of their economic income, and that an item of income or expense is not being shifted to patrons of past or future years due to an arbitrary policy-driven accounting adjustment that distorts the final price they receive for their crops or the amount they pay for their inputs.

2. What problems do cooperatives face today when computing patronage dividends?

GAAP accounting and tax accounting rules are continually being revised in significant ways to serve evolving national and, increasingly, international policy objectives. This makes it increasingly difficult for cooperatives to reconcile their annual GAAP or tax net earnings to a reasonable measure of economic income. Where patronage dividend bylaws provide that net earnings are equal to current year GAAP earnings (book basis) or taxable income (tax basis), a significant policy risk is created that the patronage dividend may vary materially from what the cooperative and its patrons believe is true economic income. For example, the policy risk to a patronage program based on taxable income is subject to tax policies that create major tax deductions like bonus depreciation or the section 199 deduction; the policy risks to GAAP basis patronage programs include changes in acceptable financial accounting principles requiring direct charges or credits to equity rather than to current net income, or dramatic changes to the timing of income or expense items that happen to be significant in the cooperative’s business. As a result, many cooperatives, especially the larger and more complex businesses, are either considering or have already amended their patronage dividend bylaw to adjust the formula for computing patronage net earnings to provide an alternative accounting treatment for specified items where the GAAP or tax method could otherwise materially distort their patronage dividend and compromise their ability to make good on the cooperative’s obligation to return a realistic patronage dividend to its patrons.

Here are a few examples of adjustments cooperatives have made to their patronage dividend bylaw to better match the GAAP or tax accounting computations to the economic reality of their business:

A. A book basis cooperative amended its bylaws and now determines overall net earnings in accordance with GAAP with exceptions for alternative non-GAAP accounting treatment for its hedging operations and certain rebates. The bylaws also provide authority and criteria for other exceptions to GAAP if: 1. GAAP accounting for a particular item will not reflect the year in which the item should be recognized for patronage accounting purposes as accurately as an alternative method of accounting would; 2. The effect of using GAAP for the item over a period of years on the sharing of patronage dividends is expected to be material; and 3. Using the alternative method results in a more fair and equitable patronage accounting system. B. A cooperative’s patronage bylaw contract provided for a patronage dividend based on taxable income. As the distortion caused by its non-cash section 199 deduction grew in significance, the cooperative amended its patronage bylaw to provide that the section 199 deduction would no longer be taken into account in arriving at tax basis patronage net earnings. C. A book basis cooperative eliminated the distortion caused by an extraordinary GAAP deduction for merger costs by amortizing the costs into patronage net earnings over a term of future years. Clearly, providing alternative accounting treatment for selected items as exceptions from GAAP or tax basis patronage accounting is not a step cooperatives are willing take without careful consideration. The objectivity gained by conforming completely to the cooperative’s financial statement GAAP or its tax return accounting in computing patronage dividends unfortunately carries with it the risk of significant distortions if FASB financial accounting or U.S. federal tax policies create income or expense amounts or timing differences that conflict with fair and equitable patronage dividend accounting, i.e., policy risk. Reducing policy risk by authorizing alternative accounting treatment for selected items in order to preserve the integrity of a cooperative’s patronage dividend system is consistent with cooperative operating principles and with the Subchapter T rules based on cooperative principles.4

4 It shouldn’t be forgotten that Congress struggled with its own version of tax policy risk in the form of tax incentives that distorted (and often eliminated) taxable income, until it passed the alternative minimum tax as an

3. Taking another look at amending bylaws to avoid the dividend allocation rule. The American Jobs Creation Act of 2004 included an amendment to section 1388(a)(3) allowing cooperatives to amend their bylaws or other contract with patrons to provide that dividends on capital stock or equity capital will not reduce patronage net earnings for purposes of computing deductible patronage dividends. Specifically - “…net earnings shall not be reduced by amounts paid during the year as dividends on capital stock or other proprietary capital interests of the organization to the extent that the articles of incorporation or bylaws of such organization or other contract with patrons provide that such dividends are in addition to amounts otherwise payable to patrons which are derived from business done with or for patrons during the taxable year.” Without the required bylaw provision, ordinary dividends paid during the year are allocated and charged against patronage and nonpatronage earnings, thus reducing the pool of patronage net earnings available to distribute as deductible patronage dividends. This allocation is known as the "dividend allocation rule". Our anecdotal observation is that many cooperatives have not amended their bylaws to take advantage of this 2004 relief provision, probably because a large number of cooperatives aren’t authorized or don’t intend to pay dividends on capital. However, the downside of making this amendment is probably negligible, and it may have a welcome value for tax planning in the future even if no ordinary dividends are contemplated. One situation that could arise is where patronage dividends paid in the form of qualified written notices of allocation are deducted but turn out to be defective for some reason and the deduction is later disallowed. The patrons holding these notices after paying tax on them still expect the cooperative to redeem them at some point, and if it does, the distribution might be considered an ordinary dividend in the year of distribution. If the dividend allocation rule is applied to this distribution because the bylaw was not amended, it would be allocated between patronage and nonpatronage income. The amount allocated to patronage income would then reduce the deductible patronage dividend pool for the year of distribution. Another risk of not amending the bylaw is that circumstances often change, and cooperatives with no current plans to pay dividends may change their plans, or they may adopt a

attempt to define and tax economic income. If nothing else, this experience should help the IRS understand why cooperatives and patrons would also prefer to compute patronage dividends in terms of economic income.

strategy to use expiring patronage losses by substituting ordinary dividends, taxable to patrons at lower rates, for patronage dividends.5 Finally, it is very likely that a number of cooperatives that do pay significant dividends just aren’t aware of this fairly recent change in the law and need to be made aware of it. Cooperative tax advisors should consider revisiting this law change with their clients to make sure they’re fully informed.

Daniel R. Schultz, CPA Cooperative Consulting, LLC [email protected] (763) 360 – 7160

5 This is complex planning and involves tax and nontax considerations beyond the scope of this Note.

2009 LTA REPORTING SUBCOMMITTEE

COOPERATIVE ISSUES SPECIFIC TO MARKETING ORDERS

Kendall L. Manock, Chair BAKER MANOCK & JENSEN, PC 5260 N. Palm Avenue, Suite 421 Fresno, California 93704

Julian B. Heron, Jr., Vice-Chair TUTTLE, TAYLOR & HERON 1025 Thomas Jefferson St., NW Suite 407 West Washington, DC 20007

Richard Emde SUN-MAID GROWERS OF CALIFORNIA 13525 S. Bethel Avenue Kingsburg, California 93631

Clayton Galarneau MICHIGAN MILK PRODUCERS ASSOCIATION 41310 Bridge Street Novi, Michigan 48376-8002

2009 SUBCOMMITTEE ON COOPERATIVE ISSUES SPECIFIC TO MARKETING ORDERS

In 2009, a number of courts decided cases concerning various procedural and substantive aspects of marketing orders for milk, raisins, almonds and fresh grapes.

FREE SPEECH AND MARKETING ORDERS

One California case involving constitutional free speech and mandatory assessments for a state marketing order was decided in 2009. However, the issues raised in the three Supreme Court decisions on constitutional free speech and mandatory assessments6 for federal and state marketing orders are still being resolved in several other California cases. The pending cases involve mandatory assessments for marketing orders regulating apples, cherries, cut flowers, dates, and grape root stock. These cases were stayed pending the final decision in Gallo Cattle Co. v. Kawamura, 15 Cal.App.4th 948 (2008). As this Committee previously reported, the decision was issued in 2008, but the trial court handling most of the pending cases has not lifted the stay.

In 2009, the Ninth Circuit Court of Appeals decided Delano Farms Company v. The California Table Grape Commission, __ F.3d __ , 2009 WL 3925053 (9th Cir. 2009), in which it upheld assessments used for generic marketing of table grapes by the California Table Grape Commission. The issue before the Court was whether generic advertising by the California Table Grape Commission to promote table grapes, is the government’s own speech and thereby exempt from a First Amendment compelled speech challenge. The three judge panel of the Ninth Circuit recognized that under Lebron v. National Railroad Passenger Corp., 513 U.S. 374 (1995)7 the Commission would be considered a governmental entity, making its speech government speech for First Amendment purposes.

6 Glickman v. Wileman & Elliot Inc., 52 US 457 (1997) (assessments constitutional as part of a broad regulatory scheme). United States v. United Foods Inc., 533 U.S. 405 (2001) (assessments used only for advertising not constitutional); Johanns v. Livestock Marketing Association, 544 U.S. 550 (assessments for government speech were constitutional).

7 Holding “[W]here…the Government creates a corporation by special law, for the furtherance of governmental objectives, and retains for itself permanent authority to appoint a majority of the directors of that corporation, the corporation is part of the Government for purposes of the First Amendment.” Delano Farms Company ___ F.3d at ___; 2009 WL 3925053 at page 8, citing Lebron, 513 U.S. at 400.

Two of the judges in the Delano case also considered whether the Commission’s activity was controlled by the government.8 In making their determination regarding government control the majority utilized the factors set forth in Johanns v. Livestock Marketing Association, 125 S.Ct. 2055 (2005),9 which were subsequently analyzed in Paramount Land Co. LP v. California Pistachio Commission, 491 F.3d 1003 (9th Cir. 2007).10 The Ninth Circuit held that the State of California exercised effective control over commission activities to make the Commission’s message “from beginning to end that of the State” based on the following:

• Establishment of the Commission: The Commission was established by an act of the Legislature, the Ketchum Act (Cal. Food & Agric. Code §§ 65500 et seq.), to enhance the image of and demand for California agricultural products through expressive conduct.

• The Commission’s Message: The Legislature provided an overriding directive for the sort of messages the commission should promote, declaring that the Commission should focus on “the promotion of the sale of fresh grapes for human consumption by means of advertising [and] dissemination of information....”

• State Involvement and Oversight: The Secretary of the California Department of Food and Agriculture possesses the power of nomination over all table grape commissioners and the State possesses additional oversight powers over the Commission to keep accurate books, records, and accounts which must be open to review by the State.

Finally, the Court recognized a number of differences between the case at hand and the situations in Johanns and Paramount, but held such differences legally insufficient to justify invalidating the Commission’s activity on First Amendment grounds.

8 The other judge wrote: “I would simply conclude that the Commission is a government entity and its speech is therefore government speech.” ___ F.3d at ___; 2009 WL 3925053 at page 10.

9 In Johanns, the Supreme Court considered the constitutionality of the Beef Promotion and Research Act of 1985, which gave the Secretary of Agriculture the Authority to issue a Beef Promotion and Research Order and to appoint an Operating Committee to design promotional campaigns, which are approved by the Secretary before their release. The Court held that that Operating Committee’s promotional activities constitute the government’s own speech because the message is effectively controlled by the federal government.

10 In Paramount, the Ninth Circuit decided a First Amendment challenge to the California Pistachio Commission’s advertising. Following the holding in Johanns, the Court held that because the Pistachio commission’s message was dictated by the state legislature and was effectively overseen by the Secretary of the California Department of Food and Agriculture, the Commission’s message was “from beginning to end the message established by the State.”

FEDERAL MILK MARKETING ORDER: STANDING

In Arkansas Dairy Cooperative Ass’n, Inc. et al. v. United States Department of Agriculture 573 F.3d 815 (C.A.D.C. July 24, 2009), the Court of Appeal for the D.C. Circuit reversed and remanded the lower court’s holding that milk producers did not have standing to challenge the Federal milk marketing orders (7 U.S.C. § 608 c(7)) (“FMMO”) because no definite personal right was offended. In the case, the Secretary of Agriculture issued an Interim Rule increasing allowances for milk. Producers challenged the rule arguing that the increase directly affected their blend price. The court held that the producers had standing to sue because they were aggrieved within the meaning of the Administrative Procedures Act (“APA”) (5 U.S.C. § 702 et. seq.), by the alleged diminution of their personal rights secured under the Agricultural Marketing Agreement Act of 1937 (7 U.S.C. §§ 601 et seq.) (“AMAA”). However, despite this, the District Court affirmed the lower court’s denial of an injunction sought by plaintiff-handlers. The court noted that the producers had failed to show a likelihood of success on the merits on their contention that the Secretary exceeded his power by failing to consider their costs for feed and fuel in deciding whether or not to amend allowances.

FEDERAL MILK MARKETING ORDERS: PROCEDURE

In Hettinga v. United States 560 F.3d 498 (C.A.D.C. 2009) the United States Court of Appeals for the District of Columbia held that complainants are neither judicially nor prudentially required to exhaust their AMAA administrative remedies before bringing suit against the United States, where the challenge is to the constitutionality of the AMAA statute itself. The Hettingas challenged two amendments to the AMAA as being invalid as a bill of attainder and a violation of equal protection and due process. The amendments subjected certain large producer- handlers of milk to contribution requirements applicable to milk handlers. The District Court dismissed the Hettingas’ complaint, ruling that they were required to exhaust administrative remedies under the AMAA before filing a suit. The Court of Appeals, however, reversed and remanded, holding that the AMAA’s exhaustion requirement is aimed only at challenges to marketing orders and attendant obligations, not at challenges to the statute itself.

In White Eagle Cooperative Ass’n. v. Conner 553 F.3d 467 (7th Cir. 2009) the Seventh Circuit Court of Appeals upheld summary judgment rulings against White Eagle who challenged the United States Department of Agriculture’s (“USDA”) rulemaking process and resulting change to the Mideast Milk Marketing Order. First,

the court held that White Eagle’s bias claim against the USDA for allowing its dairy program employees to partake in the decision making process at issue was untimely under 5 U.S.C. Section 556(b)(3), because it was brought well after White Eagle knew of their participation. Next, the court held that White Eagle’s challenge to the Regulatory Flexibility Act (5 U.S.C. §§ 601 et seq.) (“RFA”) was barred because it was not directly affected by the amendment. The court noted that “only small entities directly regulated by the proposed statute whose conduct is circumscribed or mandated, may bring a challenge to the RFA analysis or certification of an agency.” Additionally, the court held that the USDA’s issuance of a final decision on an emergency basis did not violate the APA because the agency had provided a notice accompanying its decision describing its reasons for the emergency basis and provided additional opportunities for comment on the issue after issuing the order. The court maintained that under the APA a subordinate employee may both issue the interim decision and be responsible for issuing the final decision. Finally, the court found that the government did not violate the AMAA when it considered the classification of milk as a condition for eligibility to receive the market blend price and rejected White Eagle’s argument that the USDA failed to consider relevant evidence in adopting the amendment.

FEDERAL MILK MARKETING ORDERS: LIABILITY FOR REPORTING

In Carlin v. DairyAmerica, Inc. a California cooperative, 2009 WL 1518058 (E.D.Cal. May 29, 2009) four plaintiffs seeking to be named as the Class representatives of all dairymen in the United States subject to federal milk marketing orders, filed a motion to consolidate cases and appoint Interim Class and Liaison Counsel. The court granted the motion to consolidate and appointed both an Interim Class and Liaison Counsel. The Plaintiffs alleged that defendants negligently and incorrectly reported nonfat dry milk prices to the National Agricultural Statistics Service, which resulted in artificially depressed minimum raw milk prices for the various federal milk marketing orders. They also named as a defendant, California Dairies, Inc., claiming DairyAmerica was its agent, but without naming the other eight members of DairyAmerica. A motion to dismiss is pending in the Federal Court.

FEDERAL MILK MARKETING ORDERS: EXEMPT STATUS

In re Hein Hettinga and Ellen Hettinga, d/b/a Sarah Farms, 2009 WL 248416 (U.S.D.A. January 15, 2009) involved a petition by the Hettingas for a determination that they should be refunded a $324,211.60 assessment they paid in protest for the month of April 2006, because they had been exempt from making pool payments until May 1, 2006. From 1994 and continuing until April 1, 2006, the Hettingas, as producer-handlers of milk, had been exempt from the minimum pricing provision of FMMOs. On

February 24, 2006, the Administrator issued a final rule, effective April 1, 2006, that subjected producer-handlers operating in the Arizona-Las Vegas and Pacific Northwest milk marketing area to the pricing and pooling provision of their respective milk marketing orders if they had in area route distributions of class I milk in excess of 3,000,000 pounds per month. The Hettingas’ in-route distribution exceeded this amount in April 2006. On April 11, 2006, Congress enacted the Milk Regulatory Equity Act (“MREA”) which amended and supplemented the AMAA and affirmed the Secretary of Agriculture’s determination to place volume limits on the applicability of producer- handler exemption. On May 1, 2006 the Administrator issued a final rule amending the FMMOs to implement the MREA. The Judicial Officer (“JO”) held that the definition of “producer-handler” allowing an operation to be exempt had been changed by final rule, effective April 1, 2006 and requires that to be exempt (1) the operator has to apply to be a producer-handler, and (2) the market administrator has to designate a qualified dairy operation as a producer-handler. Noting that the Hettingas had not applied for exemption under the new definition, the JO held that because the Hettingas’ in-area route distribution of class I milk exceeded 3,000,00 pounds in April 2006, they were ineligible for producer-handlers status, even if they had applied. The JO further held that the Hettingas were not entitled to notice of cancellation of their status as producer- handlers because they had never been designated as such under the new rule. The fees assessed for April 2006 were, therefore, upheld as proper.

RAISIN MARKETING ORDER: HANDLERS

An issue that has been heavily litigated over the past few years is whether producers who store and process their own raisins are considered “handlers” such that they become subject to the AMAA and the Raisin Marketing Order.

In the latest chapter of the ongoing battle between the USDA and Marvin and Laura Horne and their partners, the Hornes filed a complaint in the United States District Court for the Eastern District of California. (Marvin D. Horne, et al. v. United States No: 08-01549 (E.D.Cal., filed October. 14, 2008.).) In their complaint, the Hornes asked the court for (1) declaratory relief and a declaratory judgment that the final USDA administrative decision below was arbitrary, capricious, and an abuse of discretion, (2) a trial de novo, (3) a declaration by the court that the Hornes’ prior administrative petition was filed in good faith and should preclude the Hornes from having to pay USDA and Raisin Administrative Committee penalties, (4) a declaration that the Hornes are not “handlers” subject to the AMAA or the Marketing Order for Raisins Produced from Grapes Grown in California (7 C.F.R. pt. 989.) (“Raisin Marketing Order”) or, in the alternative, a declaration that the USDA has not proved that their status as handlers by substantial evidence, (5) that the penalties imposed upon

them thus far are cruel and unusual and excessive fines under the US Constitution, (6) a declaration by the court that the they were treated in an arbitrary manner when they were denied a right to file a petition by the USDA because they were not “handlers,” but then assessed penalties for not paying handler fees, and (7) attorneys’ fees pursuant to the Equal Access to Justice Act. The USDA filed an answer on December 12, 2008 denying essentially all of the causes of action. The Hornes filed a motion for summary judgment on August 28, 2009 and the USDA submitted a brief in opposition on October 6, 2009.

RAISIN MARKETING ORDERS: TIME TO APPEAL

In a separate action, the Hornes have now appealed the District Court’s November 13, 2008, decision denying their appeal from a USDA administrative order described in this Committee’s 2008 report. (Marvin D. Horne, et al. v. United States No: 09-15071 (9th Cir., filed June 12, 2009.) The Hornes had filed an appeal with the District Court to the adverse decision of the JO after the statutory 20-day appeal period had expired, arguing that their untimeliness was not their fault, but due to the court clerk’s delayed mailing of the decision and their subsequent late receipt (they received the decision after the 20-day appeal period had expired). The District Court refused to hear the appeal as untimely. The Hornes have now appealed to the Ninth Circuit and filed an opening brief contending: (1) that even if they are statutorily precluded from appealing, they have a constitutional due process right to appeal, which requires adequate notice of the decision before an appeal right is lost; and (2) that the District Court erred in holding that the APA did not provide a separate jurisdictional standing argument for appellants. The briefing is now complete and the case is awaiting oral argument.

In addition, the Hornes have filed a complaint in the United States District Court requesting declaratory and injunctive relief and a review of USDA actions. (Marvin D. Horne, et. al. v. United States No: 09-01790 (E.D.Cal., filed October 8, 2009.) Specifically, the Hornes are requesting an injunction to make the USDA engage in rule making and change the rules regarding service of administrative decisions, whereby non-USDA parties would be notified of USDA administrative decisions by facsimile or email on the date that a Judicial Officer’s (“JO”) or administrative law judge’s (“ALJ”) decision is made or on the day immediately following that date.

The Horne group is also involved in California v. Raisin Valley Farms, et al., Superior Court, Fresno, originally brought by the state to collect assessments. They have now filed a cross-complaint challenging the California Raisin Marketing Order on the grounds that the bloc voting allowed for cooperatives under California law violates

their constitutional rights of equal protection, association, free speech and due process. The case is now set for trial in April 2010.

RAISIN MARKETING ORDER: DISCOVERY

The owners of Lion Raisins, Inc., are another group who seem dissatisfied with the federal and state restrictions and assessments in the California Raisin Industry, over the years adding almost unlimited knowledge to the law of marketing orders.

This year in Lion Raisins, Inc. v. United States Department of Agriculture 636 F.Supp. 1081 (E.D.Cal. 2009), the court ruled on cross-motions for summary judgment on nine separate counts involving discovery. Counts four through eight were resolved with the parties’ voluntary concessions and the court’s decision focused on counts one through three and count nine. In the first three counts Lion challenged the adequacy of the USDA’s search for documents relating to the disposition of inspection records requested by Lion under the Freedom of Information Act (5 U.S.C. §§ 522 et. seq.) (“FOIA”). The court noted that “[i]n cases where the agency’s search for responsive records is at issue, the agency must demonstrate that it has conducted a search reasonably calculated to uncover all relevant documents…In a FOIA case, sufficient declarations [supporting a reasonable search] describe what records were searched, by whom, and through what process.” The USDA failed to meet this standard when describing the extent of attempt to locate the records requested. The court granted Lion limited discovery, but refused to grant summary judgment on this issue to either party. In the ninth and final count, Lion asserted a claim for violation of the APA on grounds that the USDA’s actions were arbitrary and capricious. The court held that because the FIOA contains a citizen-suit provision, Lion was precluded from bringing an action under the APA, because such action would be duplicative.

On November 3, 2009, Lion Raisins, Inc. filed another suit in the United States District Court for the Eastern District of California seeking disclosure, release, and physical access to agency records allegedly withheld from it by in the USDA and the United States Department of Justice. (Lion Raisins, Inc. v. United States Dept. of Ag. and United States Dept. of Justice No: 09-01900 (E.D.Cal., filed November 3, 2009.)

RAISIN MARKETING ORDER: DEBARMENT

In re Lion Raisins, Inc., 2009 WL 1064498 (U.S.D.A. April 17, 2009), In re Lion Raisins, Inc., 2009 WL 2368706 (U.S.D.A. May 4, 2009) and, In re Lion Raisins, Inc., 2009 WL 1513252 (U.S.D.A. May 4, 2009) are proceedings brought by the USDA to debar

Lion Raisins, Inc., and certain of its officers and two affiliated corporations from receiving USDA inspection and grading services.

In the April 17, 2009 order, (In re Lion Raisins, Inc., 2009 WL 1064498 (U.S.D.A. April 17, 2009),) the JO adopted the ALJ’s decision and order holding that Lion Raisins, Inc. and certain officers had willfully violated the AMA when they issued “Lion certificates” which looked deceptively similar to and appeared to provide the same information as USDA certificates. The JO held that the Lions impermissibly used U.S. Grade designations and USDA terms in Lion certificates, which conduct amounted to “a pattern of misrepresentation or deceptive or fraudulent practices or acts in connection with the use of inspection certificates and/or inspection results….” While the Administrator sought a 15 year debarment, the JO debarred the Lions for 5 years, holding the requested 15-year period as being excessive.

In the May 4, 2009 orders, In re Lion Raisins, Inc., 2009 WL 2368706 (U.S.D.A. May 4, 2009) and In re Lion Raisins, Inc., 2009 WL 1513252 (U.S.D.A. May 4, 2009), the ALJ found that the corporate respondents and certain of its officers were responsible for “unauthorized and unlawful alteration or fabrication of official USDA inspection certificates…thereby attributing to USDA unfounded statements of quality and conditions” and that the USDA Agricultural Marketing Service (“AMS”) “has good cause to be outraged” by the alteration of USDA inspection certificates. AMS sought a 36 month debarment. The ALJ ordered a 36 month debarment for the corporation and the officers he found to be responsible. No civil penalties are authorized by statute; criminal penalties are authorized but none have been imposed in this case. The ALJ’s decision is currently on appeal to the JO.

In re Lion Raisins, Inc. 2009 WL 1064499 (U.S.D.A. April 16, 2009), also involves the debarment proceedings. After the ALJ had issued a decision on June 6, 2009, in which he concluded that petitioners violated the AMA and were debarred from receiving inspection services, the JO heard petitions to reopen the hearing. Petitions to reopen the hearing by Lion Raisin Company, Lion Packing Company, Isabel Lion, and Larry Lion were denied, because the JO held that he lacked jurisdiction to hear the petitions. The JO further held that although he had jurisdiction to hear the petitions of Lion Raisins, Inc, Alfred Lion, Jr., Daniel Lion, Jeffrey Lion, and Bruce Lion, they sought to adduce evidence that was cumulative or inadmissible. Lastly, the JO dismissed petitioners’ other petitions to reopen the matter, holding that the Rules of Practice do not provide an automatic right to multiple petitions to reopen a hearing.

RAISIN MARKETING ORDER: CHALLENGE TO AUTHORITY

In re Lion Raisins, Inc., No 09-0050 2009 WL 2762657 (U.S.D.A.) is yet another Lion petition to the USDA. This time, the ALJ refused to dismiss Lion’s challenge of “the authority of the RAC President to suspend handlers from participation in the export program, the attempted suspension imposed on October 3, 2008, and the authority of the RAC to enact binding regulations with a circular.” The ALJ concluded that the USDA’s motion to dismiss was premature because factual issues raised in the petition needed to be resolved first. The ALJ noted that “the relationship between Lion and the AMS of Agriculture may easily be characterized as having been more than a little acrimonious at times during recent years, with numerous actions being brought by one party or the other both at the administrative level and before the federal courts.”11

ALMOND MARKETING ORDER: JURISDICTION

In Koretoff v. Vilsack 601 F.Supp.2d 238 (D.D.C. 2009) the court granted the USDA’s motion to dismiss based on lack of subject matter jurisdiction. In Koretoff I almond growers, handlers, grower-handlers, and retailers, subject to the Almond Marketing Order (7 C.F.R. §§ 981.1 et seq.) sued the Secretary of Agriculture for adopting rules requiring mandatory treatment of almonds to reduce the potential for Salmonella bacteria prior to shipment. Among the claims asserted were that the treatment regulation exceeds the authority granted by the almond marketing order to establish quality control requirements and that the rule was created in violation of the formal rulemaking requirements of the AMAA. The Federal District Court held that it lacked subject matter jurisdiction because parties involved were suing as “handlers” and, therefore, were obligated to exhaust their administrative remedies before pursuing a civil suit against the Secretary. Furthermore, the court noted that a narrow exception, allowing growers to bring suit if they assert definite personal rights, did not apply because no such rights were at issue.

In Koretoff v. Vilsack 626 F.Supp. 2014 (D.D.C. 2009) , following the court’s decision in Koretoff I, four grower-retailers and the plaintiff growers in that case moved for reconsideration and to alter and amend the court’s judgment under Federal Rules of Civil Procedure 59(e) and 60(b)(3). The District Court dismissed the motions of both parties. The grower-retailer plaintiffs argued changed circumstances, noting that they had refrained from engaging in certain retail activities that the USDA defines as

11 To that understatement he then added in a footnote “which may not be exhaustive” citations to four petitions brought by Lion against the USDA, three separate debarment actions brought by the USDA to prevent the use of the federal inspection service by Lion and six reported decisions by District Courts, the Court of Claims and the Federal and Ninth Circuit Courts of Appeal.

handling, and should therefore not be classified as handlers. The court rejected this logic and held that grower-retailers would be subject to the exhaustion requirements if they chose to engage in handling activities. The court also found that because the grower plaintiffs presented no new arguments they were not entitled to prevail on their motion to dismiss.

DMS: 775707_1.DOC

NATIONAL COUNCIL OF FARMER COOPERATIVES

LEGAL TAX & ACCOUNTING COMMITTEE

Report of Subcommittee on Litigation Between Cooperatives and Their Members, Including Member Insolvency

Chair: David M. Hayes, Esq. Bond, Schoeneck & King, PLLC One Lincoln Center Syracuse, NY 13202 Phone: (315) 218-8188 Fax: (315) 218-8100 [email protected]

Vice-Chair: Terry D. Bertholf, Esq. Kansas Farmers Service Association 1515 East 30th Avenue P.O. Box 2560 Hutchinson, KS 67504-2560 Phone: (620) 663-5453 Fax: (620) 663-1653 [email protected]

Vice-Chair: William P. Hutchison, Esq. Roberts Kaplan LLP 601 SW 2nd, Suite 1800 Portland, OR 97204 Phone: (503) 219-8133 Fax: (800) 600-2138 [email protected]

Dated: November 23, 2009

TABLE OF CONTENTS

1. Enforceability of a Liquidated Damages Clause

(A) Bybee Farms, LLC et al v. Snake River Sugar Company, et al.

(B) United Dairymen of Arizona v. Rawlings

2. Stark Packing Corporation v. Sunkist Growers, Inc.

3. Andrews Farms, et al. v. Calcot, Ltd., et al.

4. Walnut Producers of California, et al v. Diamond Foods, Inc.

5. Affiliated Foods Southwest, Inc. Bankruptcy.

6. Rural Electric Cooperatives Litigation

7. Antitrust Litigation.

Appendix A. Liquidated Damages Clause – Practice Tips

59 1604834.8

1. Enforceability of a Liquidated Damages Clause

In this Committee’s 2008 Report, we reported on three pending legal actions addressing the issue: Whether a liquidated damages12 clause in a cooperative’s marketing agreements with its members is legally enforceable? In this Report, we provide updates on these three legal matters.

(A) In Bybee Farms, LLC v. Snake River Sugar Co. United States District Court, Eastern District of Washington, CV-06-5007-FVS, 563 F.Supp 2d 1184 (E.D. Wash. 2008), the Court considered the enforceability of a liquidated damages provision in the defendant cooperative’s marketing agreement which establishes penalties in the event that the member does not fulfill his contractual obligations as follows: “In the event Grower has failed to plant or deliver all or any portion of the Grower’s full Quota, the Grower will pay to the Cooperative 100% of the Distributable Cash Per Acre Decrease for each acre which was not planted or delivered”, and “In the event that Grower does not pay the Distributable Per Acre Decrease (within 90 days but not later than the following February 1) the Grower’s Patron Preferred Stock in an amount equivalent to the number of acres to which said payment failure applies shall immediately revert and transfer to the Cooperative”. Id.

The Court in Bybee reviewed the law of the State of Washington, which would apply a two part test to determine whether a contractual liquidated damages clause is enforceable. “First, the amount fixed must be a reasonable forecast of just compensation for the harm caused by the breach. Second, the harm must be such that it is incapable or very difficult of ascertainment” as in Walter Implement, Inc. v Focht 107 Wash. 2d 553, 559, 730 P. 2d 134. In Bybee Farms the federal court further noted that the Washington test would be applied at the time the contract was executed, and is therefore “prospective” citing Watson v Ingram 124 Wash. 2d 845, 851, 881 P. 2d 247. Under the Washington State common law, the liquidated damages must have been a “reasonable forecast of just compensation at the time that the contract was executed, and ignores the damages actually suffered, except as evidence of the reasonableness of the estimate of potential damage.” Id, Watson. In view of today’s volatile commodity prices, Washington law, as interpreted by the federal court, would encourage inappropriate seller speculation as risk of unforeseeable price increase is transferred to the buyer of farm commodities if damages must be reasonable at the time that the contract was executed.

The marketing agreement with Snake River Sugar Co. contained a choice of law clause and designated Idaho law. Id, FN4. The U.S. District Court noted that the Idaho Supreme Court would apply a different test, stating “In Idaho parties to a contract may agree upon liquidated damages in anticipation of a breach, in any case where (accurate) determination of damages would be difficult or impossible” and the fixed liquidated damages “bear a reasonable relation to actual damages” referring to Graves v. Cupic 75 Idaho 451, 456, 272 P.2d 1020, 1023. By considering the non-breaching party’s actual damages, the Idaho test is at least partially retrospective in nature.

12 In 1992, the U.S. Department of Agriculture published Cooperative Marketing Agreements – Legal Aspects (USDA, ACS Research Report 106). Pages 40-44 of the USDA Report discuss liquidated damages.

Under Idaho law, the test of reasonableness of damages relates to the actual damages that were sustained by the non-breaching party. The Bybee Court held that the plaintiffs/producers had the burden of proving that the forfeiture (of stock) provision was unenforceable. The Court noted that plaintiffs do not dispute that an accurate determination of damages would have been difficult, but they focused on the second part of the Graves test, arguing that they paid $400 per share for the stock, and that the forfeiture of the stock vastly exceeds the cooperative’s actual damages.

In April 2009, a jury returned a verdict of more than $800,000 against the cooperative. The cooperative contended that forfeiture of the plaintiff farmers’ shares was justified by their failure to plant and grow their sugar beet acreage. The jury concluded that the cooperative had dealt unfairly with its members and did not have the right to take back their shares or collect fees from them. The context included an apparent effort by the cooperative to curtail acreage in light of an oversupply of sugar.

The cooperative’s motion for new trial filed in April is pending. Among lessons learned may be the importance of a cooperative treating members equitably (not necessarily equally) and establishing corporate policies and procedures which are grounded in business judgment properly memorialized.

(B) In United Dairymen of Arizona v. Rawlings, 217 Ariz. 592, 177 P. 3d 334 (Feb. 2008), the cooperative, United Dairymen of Arizona, brought suit for breach of the cooperative marketing agreement against a dairy farmer member, Rawlings. The Arizona Court of Appeals held that the statute providing that liquidated damages clauses in cooperative marketing agreements between cooperative marketing associations and their members “shall be valid and enforceable in the courts”, A.R.S. § 10-2016(D). The statute reflects the legislative intent that such clauses are not subject to common law principles limiting the enforceability of liquidated damages clauses, e.g., a requirement of reasonableness agreed to by parties or difficulty in calculating actual damages. The cooperative marketing statutes of many states include similar provisions permitting liquidated damages clauses in cooperatives’ marketing agreements. The Court upheld liquidated damages in the cooperative’s marketing agreement requiring the dairy farmer to pay the cooperative 40 percent of the gross sales price of milk not sold to the association when the farmer breached his contract obligation to deliver all milk to the cooperative. In United Dairymen of Arizona v. Rawlings, Id, the Court held that the liquidated damages clause was enforceable by the cooperative against the member.

Rawlings’ petition for review with the Arizona Supreme Court was denied.

(C) In September 2008, shareholders of The Western Sugar Cooperative (“Western Sugar”) filed a class action suit against their cooperative, Luft Farms, LLC v. The Western Sugar Cooperative, U.S. District Court, D. Colo 08-CV-0214 (2009 WL 42640). The developing case was not included in the 2008 LTA Report, but Mr. Dan Mott did report the case to the entire LTA Committee at the 2009 NCFC Annual Meeting.

In April, 2008, Western Sugar initiated lawsuits to enforce grower agreements and collect liquidated damages from shareholders/members who failed to meet their delivery obligations for

the 2007 crop year. Luft Farms, LLC and other members responded with a class action complaint against Western Sugar on behalf of a class of sugar beet growers.

The case centers on two provisions in the shareholder grower agreement for liquidated damages and the “evergreen” term provision. Western Sugar was organized (evolved from Rocky Mountain Growers Cooperative’s acquisition of Western Sugar Co.) as a closed cooperative model. Members purchased shares ($185 per share) and signed grower agreements that included the right and obligation to deliver one acre per share, which was an “evergreen” obligation. The grower agreement prescribed liquidated damages for failure to deliver.

After the creation of Western Sugar, the sugar industry changed dramatically. Alternate crop prices increased while sugar beet prices and payments to members declined and some growers wanted out.

These class action members assert that:

They did not understand that they would be committed to deliver.

No ability to exit is coercive and violates the Agricultural Fair Practices Act of 1967, 7 U.S.C.A. § 2303(a) (“AFPA”).

The perpetual, “evergreen” provision violates state law and is not enforceable.

Western Sugar argues in defense that:

The delivery obligation was clear.

The offering statement disclosed that the sale of shares would be required to exit (which is a characteristic of many closed cooperatives).

Members voluntarily “signed up” and were not coerced.

These members benefited for several years without objection, and are, therefore, barred by laches.

Members rely upon mutuality of membership.

This case has potential serious implications for cooperative membership agreements in general and especially for closed cooperatives, which rely upon the enforceability of grower agreements. The use of the AFPA to avoid membership obligations is a disconcerting trend.

Liquidated damages provisions are critical terms of many grower agreements. Plaintiffs have requested the Court to declare that the cooperative has never been empowered to impose liquidated damages. Last year’s LTA Litigation Subcommittee report focused on the use of liquidated damages provisions.

In 2003, Western Sugar created a new uniform growers’ agreement (“Agreement”) which renewed year to year unless terminated by the Cooperative after one year’s notice, and imposing liquidated damages for failing to plant and deliver the quota of sugar beets. In 2007 to 2008, liquidated damages were $380 per acre.

The class action plaintiff’s alleged violations of the AFPA Act for the “abrupt substitution” of an onerous contract to replace the prior more reasonable agreement, and Plaintiff’s asked the Court to enjoin the Cooperative from enforcing the shareholder agreements.

In February 2009, the Court denied the preliminary injunction and the Court found that the Cooperative had not violated the AFPA by “coercing any producer to enter into, maintain, breach, cancel, or terminate a membership agreement with an association of producers”. Act §2303(c). The Court rejected Plaintiffs’ allegations that the unilateral insertion of the liquidated damages provisions and automatic renewal provisions constituted such coercion.

The case continues. Plaintiffs have amended their complaint continuing to allege violation of AFPA coercing growers by (a) imposing a contract on growers that purports to be terminable or transferable only at the discretion of the cooperative, (b) asserting unfettered discretion to modify Agreement, (c) failing to meet with the Shareholder Advisory Committee to discuss contract modifications as required by the Agreement, (d) refusing to call shareholders’ meetings, (e) refusing to provide growers with meaningful financial disclosures, (f) threatening to impose liquidated damages in excess of amounts permitted by the Agreement, (g) imposing liquidated damages, (h) the indefinite term was always void “ab initio”, and (i) the cooperative has violated its duty of good faith and fair dealing.

On September 10, 2009, Western Sugar filed its Memorandum in Opposition to Plaintiff’s Motion to file Second Amended Complaint. Plaintiffs continue to allege violation of AFPA.

Bybee Farms LLC v Snake River Sugar Company, discussed above, similarly involves members relying upon AFPA to challenge their cooperative’s grower agreements.

* * * * * * * *

In Big V Supermarkets, Inc. v Wakefern Cooperative, 267 BR 71 (Bankr.D.Del.2001) U.S. Bankruptcy Court, District of Delaware, Case no 00-4372 September 14, 2001, the member, Big V Supermarkets, sought a declaratory judgment that the withdrawal payment (or adherence to a minimum patronage requirement) under the cooperative’s agreements with its stockholders was unenforceable. The Court ruled for the cooperative and enforced the requirement that the member-stockholder was obligated to satisfy the minimum patronage requirement in its purchases from the cooperative or to pay the withdrawal payment (liquidated damages) to the cooperative. The Court relied on general corporate and contract law principles, not on a cooperative marketing statute.

The reported cases that Big V, Id. refer to in the Court’s determination that the party requesting the relief (restraining order/injunction) bears the burden of proof:

In re National Forge Co., 344 B.R. 340, 347

In re Foxmeyer Corp., 286 B.R.546, 574

In re Convenience USA, Inc., 2003 WL 21459559 (Bankr.M.D.N.C. Jun 17, 2003)

In re Moore, 2009 WL 1066135 (Bankr.S.D.Tex. Mar 27, 2009)

In re Rollings, 2009 WL 152322 (Bankr.S.D.Tex. Jan 16, 2009)

* * * * * * * * * * *

Attached as Appendix A is Liquidated Damages Clause –Practice Tips.

2. Stark Packing Corporation v. Sunkist Growers, Inc.

On December 20, 2006, a jury in the Superior Court of California, Tulare County, returned a verdict of $13.5 million against Sunkist Growers, Inc. in favor of former Sunkist for-profit licensed packinghouses, Stark Packing Corporation and Millwood Packing, Inc. The packinghouses are not producers and are not members of Sunkist. After the U.S. Supreme Court’s decision in Case-Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967), Sunkist changed its organizational structure in 1968 and eliminated for-profit packinghouses as members.

The jury verdict was based upon the alleged breach by Sunkist of an implied term in the packinghouse license agreements. During the trial, at the close of the plaintiffs’ evidence, the trial judge ruled that there was an implied term in the agreements: “that all packers be provided equal marketing opportunity, but not equal results.” The judge may have derived this implied new term in the packinghouse license agreements from a Sunkist Marketing Equity Policy which applied to Sunkist members. The plaintiff-packinghouses were not growers or Sunkist members, and Sunkist did not intend or provide that the Marketing Equity Policy applied to Sunkist’s dealings with non-member packinghouses. The jury verdict rested on breach of contract – on Sunkist’s alleged breach of the implied term.

On July 23, 2009, the Court of Appeal, Fifth Appellate District, issued a 56 page opinion affirming the judgment against Sunkist (with a small reduction in the damages awarded because of the applicable statute of limitations).

Sunkist filed a petition for review with the California Supreme Court on September 15, 2009, which the Supreme Court denied on October 28, 2009.

3. Andrews Farms, et al. v. Calcot, Ltd., et al.

A lawsuit was first filed January 2007 in the Superior Court of California, Kern County, by two members, Andrews Farms and Greg Palla, seeking class action status, against Calcot, Ltd., a cotton marketing cooperative in Bakersfield, CA. Also named as defendants were Eadie and Payne, LLP, the cooperative’s auditors. The legal action was removed to U.S. District Court, Eastern District of California.

The complaint alleged breach of fiduciary duty; constructive fraud and deceit based upon fiduciary relationship; accounting; fraud and deceit – intentional misrepresentation of material fact; negligent misrepresentation against the auditors; and, violations of the federal RICO (Racketeer Influenced and Corrupt Organizations) statute, 18 U.S.C. § 1962.

According to the suit, Calcot improperly charged its members more than $23 million in interest expenses during the last two decades to pay for a commercial real estate development. The plaintiffs claimed that interest costs were incurred for a real estate venture unrelated to marketing Calcot members’ cotton, but the interest was deducted from the amounts due members for their cotton. The plaintiffs alleged that the interest deductions were concealed from members and from the Board of Directors. The suit relates to the accounting treatment of interest and the disclosures related to interest. The plaintiffs seek treble damages under RICO as well as punitive damages.

The original complaint was dismissed with leave to amend the complaint. In July 2007, the plaintiffs filed an amended complaint in federal court containing similar allegations. In October 2007, the U.S. District Court denied Calcot’s motion to dismiss the amended complaint in its entirety. On motions to dismiss by Calcot’s auditors, Eadie and Payne, LLP, the Court denied both the auditors’ motion to dismiss and its motion to strike the plaintiffs’ request for punitive damages; but, the Court did grant the auditors’ motion to strike plaintiffs’ request for attorneys’ fees and granted, in part, the auditors’ motion for a more definite statement.

In August 2009, the District Court granted the plaintiffs’ request for class certification.

4. Walnut Producers of California et al v. Diamond Foods, Inc.

In March 2008, a walnut grower and a cooperative bargaining association named Walnut Producers of California filed suit against Diamond Foods, Inc., the publicly traded successor entity to Diamond Walnut Growers, Inc., a California cooperative, in San Joaquin County Superior Court, California, for breach of contract relating to the alleged underpayment for walnuts delivered to Diamond Foods for the 2005 and 2006 crop years. The plaintiffs brought the suit individually, on their own behalfs, and as a class action of walnut growers who entered into contracts with Diamond Foods.

As background, in 2005, the members of Diamond Walnut Growers, Inc. voted to approve the conversion of the agricultural cooperative into a stockholder-owned corporation, Diamond Foods, Inc. The corporation is a branded food company specializing in processing, marketing and distributing culinary, snack, inshell and ingredient nuts under the Diamond of California and Emerald of California brands. Products include walnuts, pine nuts, pecans, peanuts, macadamia nuts, hazelnuts, cashews, Brazil nuts and almonds. Diamond Foods is a publicly owned company with its common stock trading on the NASDAQ Exchange.

In the lawsuit, the growers allege that they have not been paid a “competitive price” for their products since the conversion of the organization from an agricultural cooperative to a publicly owned company.

The plaintiffs filed an amended complaint on September 19, 2008. The underlying theory is breach of contract for failure of the defendant to pay the growers the competitive price (sometimes referred to as reasonable, market, or competitive price) for walnuts they have delivered. Since the conversion of the cooperative to a stockholder-owned corporation, the defendant has paid the growers a price that is reported to be significantly less than the market price. Apparently, the contract itself includes a commitment by Diamond Foods to establish the price in good faith. Historically, the cooperative paid growers above market prices for their walnuts. The contract between Diamond Foods and its former members does not include a price, which may be contrary to California law. (California Food and Agriculture Code section 62801.) It appears that plaintiffs may rely upon a promissory estoppel theory and the practices that pertained at the time of the execution of the contracts.

Counsel for plaintiffs has observed the so-called “horizon problem” that is inherent in conversion from a member-owned cooperative to a stockholder-owned corporation. The older members desire an exit strategy to realize the value that has accumulated over the years while the younger generation is more interested in assuring a continuing market for their products.

Plaintiffs filed their original complaint in March of 2008 and have been seeking from the Court a class designation. There may be as many as 1,600 growers involved. The plaintiffs include an individual and the Walnut Producers of California, a bargaining association.

Upon motion by Diamond Foods, the trial court summarily struck the class action allegations from the plaintiffs’ amended complaint, appearing to reject plaintiffs’ contention that the mandatory arbitration clause was unconscionable and, therefore, unenforceable. The plaintiffs

have appealed the class action denial to the California Appellate Court, Sacramento, California. Oral argument is expected to occur in the near future.

5. Affiliated Foods Southwest, Inc. Bankruptcy

In July 2009, Affiliated Foods Southwest, Inc. of Little Rock, AR (Affiliated) filed a motion in U.S. Bankruptcy Court, AR, to convert its Chapter 11 reorganization to Chapter 7 liquidation. Affiliated is a wholesale grocery cooperative owned by its member retail grocery stores. According to a published article, about $34 million in subordinated certificates of indebtedness issued by Affiliated are held by members and employees. Two holders of certificates of indebtedness have commenced a lawsuit in Pulaski County Circuit Court against the former CEO and the former Secretary alleging that the certificates of deposit were unregistered securities issued in violation of the Arkansas Securities Act. The plaintiffs are seeking class action status.

6. Rural Electric Cooperatives

In recent years, class action lawsuits have been filed against rural electric cooperatives in Texas, South Carolina, Georgia and Arkansas. While there are important legal differences between rural electric cooperatives and agricultural cooperatives, the claims against rural electric cooperatives by their members may be of interest. A “Rural Coop Litigation News” website has been created www.coop-litigation.com.

The lawsuits contain different allegations against the rural electric cooperatives, their directors and officers. A common claim involves patronage capital, also known as capital credits (equity of the cooperative).

The suits allege:

Equity • Failure to revolve equity • Refusal to redeem equity upon a member’s cessation of membership • Discounting equity by the cooperative • Maintenance of unreasonably high equity

Other • Excessive compensation paid to directors and management • Restrictive director nomination procedure • Low attendance by members at members’ meetings • Refusal to provide the membership list

A class action suit against Pedernales Electric Cooperative, Inc. (PEC), Johnson City, TX is illustrative. The class action suit was commenced in Texas state court in July 2007 against PEC and its individual directors and officers. The plaintiff-members claimed negligence, gross negligence, breach of contract and breach of fiduciary duty based on various allegations of mismanagement, self-dealing and excessive compensation.

PEC is the largest electric cooperative in the U.S. serving 24 counties in Texas. The plaintiffs alleged that the cooperative and the individual defendants concealed excessive officers and directors compensation; and, breached their fiduciary duties by purchasing a wholly owned subsidiary, without proper due diligence, failing to require competitive bidding for software billing services provided by the subsidiary and funneling millions of dollars of PEC capital into the subsidiary without proper due diligence or justification. They also alleged that the cooperative’s general manager failed to provide notice of Board meetings, called Board meetings at the last minute, conducted telephonic Board meeting without disclosing the call-in number, and claimed to have no email accounts or direct telephone numbers in an attempt to conceal material information regarding the use of the cooperative’s funds. Importantly, the plaintiffs took issue with the cooperative’s handling of surplus funds representing its accumulated excess retained revenue over expenses. As an important distinction between PEC and most agricultural cooperatives, under Texas law, PEC is required to periodically return patronage capital to its members. Electric Cooperative Corporation Act, Tex. Util. Code. Ann. § 161.059(d). From its

organization in 1938 until the suit was filed in 2007, PEC had never returned patronage capital to its members.

While the suit was pending, PEC took steps to remedy some issues raised by the plaintiffs, including:

• Amending the PEC bylaws to make the director nomination/election process more open and democratic • Posting federal income tax returns on PEC’s website • Creating a mechanism to begin returning patronage capital to its members In addition, PEC’s general manager resigned and forfeited $600,000 in deferred compensation. The PEC Board President also resigned, and his additional position of “Coordinator” at PEC, which paid approximately $200,000 per year, was eliminated.

On March 5, 2009, the Texas Court of Appeals, Third District, at Austin, affirmed the trial court’s judgment approving a settlement of the class action lawsuit.

Under the terms of the class action settlement, PEC agreed to:

• Return $23 million in patronage capital by bill credits to current members over a future period of 5 years • Undergo and pay for a comprehensive review of financial and management operations by an independent consulting firm • Pay the class representatives’ attorneys’ fees and other court costs of up to $4 million

In additional to civil legal actions, criminal prosecutions and investigations of rural electric cooperatives have been commenced.

In June 2009, the former PEC general manager and its top outside lawyer were indicted. They are charged with three felonies – misapplication of fiduciary property, theft and money laundering.

The Cobb County (Georgia) District Attorney executed search warrants at 5 locations related to Cobb Electric Membership Corp. in April 2009. Local and state law enforcement agencies stated that they were seeking evidence of theft and racketeering at the rural electric cooperative.

7. Antitrust Litigation.

The Antitrust Subcommittee’s report contains a summary of antitrust litigation.

Appendix A

Liquidated Damages Clause – Practice Tips

It is suggested that a cooperative’s marketing agreements should:

• Avoid use of the words “penalty,” “forfeiture” and the like to reinforce that the liquidated damages provision is a legally enforceable liquidated damages clause and not an unenforceable penalty clause.

• Provide for liquidated damages that reasonably relate to the cooperative’s potential actual damages.

• State that the actual damages are difficult or impossible to determine.

• State that the parties agree that the specified liquidated damages are reasonable under the circumstances.

• State that the cooperative has the right to bring successive claims for each breach of contract.

• State that the cooperative may pursue, in addition to liquidated damages, all other legal and equitable remedies available to the cooperative. (Liquidated damages are not the cooperative’s exclusive remedy.)

• When possible, prescribe application of the law of a state specifically authorizing liquidated damages in cooperatives’ marketing agreements by statute or court decision. (If the cooperative’s marketing agreement does not specify application of the law of a cooperative friendly state (with respect to liquidated damages), then, the cooperative should attempt to bring the action first in a cooperative friendly state, or in a state which allow the retrospective (at the time of trial) test of reasonableness, if jurisdictional requirements can be met.)

Report of LTA Subcommittee

Alternative Minimum Tax, Tax Accounting and State and Local Tax Issues Affecting Agricultural Cooperatives

Chair: David R. Simon [email protected] Farleigh Wada Witt 121 SW Morrison Street, Suite 600 Portland, Oregon 97204

Vice Chairs: Wayne E. Sine [email protected] Southern States Cooperative, Inc. 6606 West Broad Street Richmond, VA 23230

Brett V. Huston [email protected] KPMG LLP 400 Capitol Mall Suite 800 Sacramento, California 95814

The subcommittee wishes to report on the following issues of relevance to agricultural cooperatives. Those issues include:

Issue # 1: Increased activity by state tax authority regarding nexus and state income tax filings.

Issue # 2: Section 199 Deduction for States.

Issue # 1 State Income Tax Filing

During the past few years there has been increased activity by states in regards to income tax filing requirements. Local state taxing authorities have regularly been contacting out-of-state companies to determine whether out-of-state companies have income nexus in the local state. Most commonly, local state taxing authorities send nexus questionnaires to out-of-state companies if the local state finds an out-of-state company’s product being sold in a local grocery store or supermarket. Cooperatives should regularly review their state tax nexus analysis to ensure they are properly filing returns in the local states where they have nexus. Cooperatives should also review internally who and how state tax nexus questionnaires are being completed. The questionnaire should be completed only by individuals working for the cooperative who

understand each local states’ tax nexus rules. An incorrectly completed questionnaire can end up not only compromising a cooperative’s tax advocacy position, but could result in costly corrective audits or a state asserting that an out-of-state cooperative must file local state income tax returns and pay local state income taxes. . In addition to the increased activity by state authorities, cooperatives should also be reviewing their state tax exposure for FIN 48 purposes. For private companies, FIN 48 is required to be implemented for years beginning after December 15, 2008. For many cooperatives, FIN 48 will be required to be implemented on this year’s financial statements. A full review of state tax nexus and state tax exposure should be completed and documented for FIN 48 purposes. This review should include current state tax filings and state tax exposure for previous tax years if state tax returns have not been previously filed.

The FIN 48 analysis may also entail the review of whether states offer voluntary disclosure agreements (VDA’s). A VDA is an agreement made with a state for proactively disclosing prior period tax liabilities in accordance with a binding agreement. Most states offer VDA’s to encourage companies to comply with a state tax laws and in turn generate revenue for the state that it may not have had if the company did not come forward and disclose it tax liabilities. The benefits of a VDA are the following:

Limitations of the prior look-back period – Usually the look-back period is limited to between 3 and 5 years as opposed to having no statute of limitations if no return has ever been filed. In some cases prospective agreements can be reached in which the taxpayer is forgiven of all past liabilities, but agrees to future compliance.

Abatement of Penalties - Most states will waive penalties on any prior period taxes that are remitted in connection with a VDA.

Full or Partial Interest Abatement – A limited number of states will abate interest in full. Many states apply a reduced interest rate to prior period taxes remitted in connect in with a VDA.

Brings Closure to Prior Periods – The company will be comfortable knowing that prior period liabilities are closed and will be able to concentrate its compliance efforts on current and future periods.

State VDA’s can assist a company in determining their state tax exposure when implementing FIN 48.

Issue # 2 Section 199 Deduction for States

Many states have not adopted the Section 199 provisions allowed for federal tax purposes. A number of states require taxpayers to add back the federal Domestic Production Activities Deduction (DPAD) to arrive at state taxable income. For an agriculture cooperative that chooses to pass its patronage DPAD through to its patrons, IRC Section 199(d)(3)(B) requires the

cooperative to reduce its deduction under IRC Section 1382 by the amount of the DPAD that is passed through to its patrons. The reduction of the deduction under Section 1382, combined with the disallowance of the DPAD deduction at the state level, can ultimately result in taxable income at the state level even though the cooperative did not receive an overall deduction at federal level due to the pass-through of the DPAD deduction. Agriculture cooperatives need to be aware of the negative state tax impact this pass-through of the DPAD to its patrons may have at the cooperative level. Cooperatives in states that require the DPAD deduction to be added back for state tax purposes should consider working with local state legislators and lobbyists to change state law, as the state tax consequences described above were not contemplated under the federal tax regime.

H:\Client\Drs\Report of LTA Subcommittee 2009REV.doc

2009 ANNUAL REPORT OF THE ANTITRUST SUBCOMMITTEE OF THE NATIONAL COUNCIL OF FARMER COOPERATIVES

William L. Sippel (Chair) Michael Lindsey (Vice-Chair) Donald Barnes (Vice-Chair)

Antitrust Subcommittee Report

Both the government and private litigants have been active in the last year on the antitrust front. Some of the activities are just beginning, while others are working their way through the courts. All told, if private litigants do not make the Antitrust Committee busy writing about their activities, the government will.

This report provides an update of public antitrust legislative, governmental and litigation activities.

I. Administrative and Legislative Developments

a. Antitrust Division and USDA Public Workshop on Competition Issues in

Agriculture (Bill Sippel and Marlis Carson)

This summer, the Antitrust Division and the USDA announced that they will be holding public workshops to explore competition issues in the agriculture industry early next year.

(Antitrust Division Press Release August 5, 2009 at http://www.usdoj.gov/atr/public/press_releases/2009/248797.htm)

The DOJ/USDA workshops will address, among other issues, buyer power (monopsony) and vertical integration in agriculture. The USDA/DOJ invited input on additional topics that might be discussed at the workshops, including the impact of agriculture concentration on food costs, the effect of agricultural regulatory statutes or other applicable laws and programs on competition, issues relating to patent and intellectual property affecting agricultural marketing or production, and market practices such as price spreads, forward contracts, packer ownership of livestock before slaughter, market transparency, and increasing retailer concentration.

Staff of the National Council met with the Department of Justice and the Department of

Agriculture along with representatives from agriculture groups and other interested parties to

offer more details on the upcoming workshops on competition in agriculture. According to the

Administration, the workshops reflect a renewed interest in antitrust enforcement, both in

Congress and in the Administration.

Phillip Weiser, Deputy Assistant Attorney General, Antitrust Division, said the

workshops will be designed to give the Justice Department “systematic and comprehensive

exposure” to the agricultural sector and will bring “sunlight” to areas that are not always

understood. He explained that the workshops – five are scheduled throughout 2010 – will consist

of roundtable discussions featuring producers and others involved in agriculture. The

participants will be “representative spokespersons who can speak in an upscale manner,”

according to Weiser.

Each workshop will be an all-day session. The first workshop, scheduled for March 12 in

Iowa, will feature a key note address by Secretary Vilsack and Assistant Attorney General

Christine Varney, followed by panel discussions and ending with an open microphone

session. Comments on the workshops are due December 31, but the workshop records will be

open indefinitely and additional comments are encouraged. Interested parties may submit

questions for the panelists in advance of the workshops or during the workshop sessions.

When asked about the goal of the workshops, the officials said there are no preconceived

outcomes. Doug O’ Brien, Chief of Staff to USDA Deputy Secretary Kathleen Merrigan, said

the Departments are seeking to “heighten the conversation across a spectrum of issues of

importance to a lot of folks.”

The National Council of Farmer Cooperatives submitted comments for the hearings in late December. See, National Council of Farmer Cooperatives, “Agriculture and Antitrust

Enforcement Issues in Our 21st Century Economy,” attached as Exhibit A. The NCFC comments included summaries of studies on the effectiveness and value of farmer cooperatives in improving competition in agricultural markets.

Some statements made by the Antitrust Division may signal their positions and interest.

Preceding the hearings, three Antitrust Division officials have given speeches on topics identified in the Press Release announcing the Workshops. These statements elaborate on the competitive issues of interest to the Antitrust Division.

Speaking to the American Farm Bureau, outgoing Antitrust Division Special Counsel for

Agriculture Doug Ross did not discuss Capper-Volstead extensively other than to reiterate the importance of Capper-Volstead to farmers. Ross also indicated there could be prosecutions for concerted activity hindering the creation of a cooperative:

As I mentioned, this law [Capper-Volstead] allows producers of agricultural

commodities to form processing and marketing cooperatives -- in effect to engage in joint

selling at a price agreed to by the producer members of the co-op -- subject to certain

limitations enforced in the first instance by USDA. There have been efforts in recent

years by some cattle producers to organize cooperatives to slaughter and process their

own beef for the wholesale market. Not only would such a cooperative, or a similar one

in another agricultural commodity, most likely be protected under the Capper-Volstead

Act; but if established packers or processors attempted to drive it out of business by

cutting off access to transportation or to wholesale markets, that would raise serious

antitrust issues and we would certainly want to investigate.

He then went on to discuss Division enforcement efforts involving, primarily, mergers and acquisitions, and how the Division assesses competition in procurement markets in addition to competition in output markets.

These same themes were carried forward in a speech by the new Deputy Assistant

Attorney General for Antitrust whose responsibilities include Agriculture. In a speech before the

Organization for Competitive Markets, a farm group focused on seed pricing and procurement practices in the pork and beef industries, Deputy Assistant Attorney General Philip Wieser, described the Division’s renewed attention to competition in procurement markets and described the scope of the Workshop as including:

1. evaluating the state and nature of competition in a range of agricultural markets;

2. the impact of vertical integration;

3. concerns about "buyer power";

4. relevant regulatory regimes; and

5. questions about the nature of transparency in the marketplace.

For a copy of the speech, see http://www.usdoj.gov/atr/public/speeches/248858.htm

The scope of the DOJ/USDA hearing also came up most recently a hearing of the Senate

Antitrust Subcommittee in Vermont in a statement by Assistant Attorney General Varney.

According to reporter Marlis Carson, who attended the meeting, “Varney said the workshops will focus on two issues – buyer power (monopsony) and vertical integration. She noted that exclusive arrangements between processors and cooperatives can lead to lower prices, but may alter the incentives of the parties involved. She said such arrangements are an area of focus for

the Antitrust Division and will warrant careful review.” For a fuller description of the hearing, see the summary of the hearings in the next section of this report below.

Finally, the issues identified in the announcement itself, and subsequent statements about the Workshop match some areas for study proposed by the American Antitrust Institute (AAI) to the Obama administration. The AAI is likely to be submitting comments to the Antitrust

Division/USDA and it is worth looking at their recommendations to get a picture of what might be on the horizon. The AAI recommendations to the Obama administration can be found at http://www.antitrustinstitute.org/archives/files/Food%20Chapter%20from%20%20AAI%20Tran sition%20Report_100520082051.pdf. These include more detail on the issues of their concern, especially about activities in pork and beef industries which are regulated by the Packers and

Stockyards Administration. The AAI comments also include recommendations regarding possible abuses of or appropriate standards for federal marketing orders.

b. Senate Antitrust Committee Hearings (Marlis Carson)

At a September 19 Senate Judiciary Committee field hearing, Assistant Attorney General

Christine Varney, the top antitrust enforcement official at the Department of Justice, said the

Capper-Volstead Act was intended to bring small producers together, but that coops have grown beyond what was imagined when the statute was enacted. She noted that some activity is exempt from the antitrust laws, but said if coops act outside the scope of Capper-Volstead they will be subject to review and potential prosecution.

Varney testified in St. Albans, Vermont, at a hearing led by Committee Chairman Patrick

Leahy (D-VT) and Senator Bernie Sanders (I-VT).

Senator Leahy asked Varney if she agreed that Congress could revoke the Capper-

Volstead Act if they determine its intent has been violated. Varney said Congress might conclude that the Capper-Volstead Act “might not be the right law for the state of the industry at this time” and could revoke it. However, she noted that Congress “does not act lightly” when granting antitrust exemptions and said she is looking forward to working with Congress on the scope of the immunity.

In his opening remarks, Chairman Leahy noted that consolidation in the agriculture industry has had a tremendous impact on local and regional markets and has caused a breakdown in competition. He said the result is that dairy farmers are not getting their fair share of the price

for their milk and corporate processors are reaping record profits. Nearly 200 people attended the

hearing, including dairy producers, state representatives, and local citizens. St. Albans is the

home of St. Albans Cooperative Creamery.

Varney repeated her recent statements regarding concerns with vertical integration in

agriculture. She said some changes in agriculture may promote needed efficiencies, but

cautioned that where there are antitrust violations, “we will not hesitate to prosecute.” Varney said her division is also aware of the economic upheaval in the dairy industry. She said the recently announced workshops, to be held jointly by the Department of Justice and USDA early next year, will be an opportunity to learn about the effects of vertical integration, including contractual relationships between producers and retailers.

Varney said the workshops will focus on two issues – buyer power (monopsony) and vertical integration. She noted that exclusive arrangements between processors and cooperatives can lead to lower prices, but may alter the incentives of the parties involved. She said such arrangements are an area of focus for the Antitrust Division and will warrant careful review.

Varney stressed that the upcoming workshops will be conducted evenhandedly, but

promised that the Department of Justice “will take whatever action we find warranted.” She later

noted that the Department “will not hesitate to prosecute” if antitrust violations are found, a

statement that produced applause from many in attendance at the hearing.

Chairman Leahy noted that vertical integration is a problem where cooperatives rely on

one company to process their milk. Varney said she wants to understand how cooperatives could

become captive to one distributor. “How did we get there, and how do we reinvigorate” the

competition in that region, Varney asked.

Dr. Joseph Glauber, the USDA’s Chief Economist, testified on a panel with Varney. A

second panel consisted of three dairy producers and Robert Wellington, economist for Agri-

Mark, Inc.

The official hearing record will be open until September 30; NCFC will submit testimony

on the limited antitrust immunity provided by the Capper-Volstead Act and its importance for the continued viability of farmer cooperatives.

A copy of Varney’s testimony can be found at: http://www.usdoj.gov/atr/public/testimony/250178.htm

[Ed. Note: Preceding the hearings, Vermont Senator Sanders issued a statement which contained

more specifics about issues being complained of by Vermont and other northeastern dairy

producers. For more details, see http://sanders.senate.gov/newsroom/news/?id=fcc5095e-72cc-

4f99-a35f-be295f2fc6fc]

c. Oregon Blackberry Legislation (Michael Lindsay)

The Oregon legislature passed a statute (which the governor signed in June 2009) that uses

the “state action” doctrine to try to provide antitrust immunity for collective pricing by

blackberry growers and cooperatives (the “Blackberry Act”).13 This is the third statute that

Oregon has adopted to substitute a state regulatory structure for competition. The others apply to

ryegrass seed14 and Oregon seafood,15 and the Blackberry Act is patterned after the ryegrass

statute.16

The state action doctrine provides that a state can displace federal competition policy and

achieve antitrust immunity for private actors if (and only if) the private conduct (1) is pursuant to

(and conforms with) a “clearly articulated” state policy, and (2) is “actively supervised” by the

state. The first requirement ensures that the state have made a conscious and deliberate decision

to use a regulatory structure to displace competition. The second requirement ensures that the

conduct is in fact advancing the state policy (rather than the private interests of the private

actors).17

The Blackberry Act was intended to “create . . . antitrust immunity for Oregon blackberry

cooperatives and other participants negotiating price of blackberries under state regulatory

program actively supervised by Director of Agriculture.”18 In other words, the statute is

designed to permit blackberry buyers to organize a negotiating committee to collectively

negotiate prices with growers. The Oregon Department of Agriculture has described its role as

13 The text of the Blackberry Act is available at http://www.leg.state.or.us/09reg/measures/sb0400.dir/sb0409.intro.html. 14 O.R.S. § 62.848. 15 O.R.S. § 62.849. 16 An article published by the Oregon Department of Agriculture in 2001 noted that “Many observers in the agriculture industry were watching to see if this process succeeded and whether it can be used with other commodities.” Brent Searle (Oregon Department of Agriculture), Price Negotiations -- A Historical Development in Oregon Agriculture (2001), available at http://www.oregon.gov/ODA/docs/price/grass/bg_2001.perspective.doc. 17 See generally Parker v. Brown, 317 U.S. 341 (1943); Office of Policy Planning, Federal Trade Commission, Report of the State Action Task Force (Sept. 2003), available at http://www.ftc.gov/os/2003/09/stateactionreport.pdf.

“supervising negotiations of blackberries,” stating that “[t]he process is called ‘State Action

Immunity’ [and] enables multiple buyers/packers to come together with a grower's bargaining

cooperative to discuss prices without violating antitrust laws.”19 An article published by the

Oregon Department of Agriculture shortly after the first state-supervised negotiations under the

ryegrass law described the purpose of the act (which is presumably similar to the purpose of the

Blackberry Act):

But grower cooperatives have to negotiate with buyers individually

— anti-trust laws prevent more than one buyer jointly meeting

together with growers to discuss prices — this becomes price

collusion. The only way around this situation is to have a state

supervised price negotiation process.20

This premise is not entirely correct, because buying groups can make collective

purchasing decisions, as long as they follow certain reasonably clear guidelines.21 Nevertheless,

a regulatory structure using the state action doctrine provides an additional defense (assuming

that the elements of that doctrine are satisfied). Indeed, this structure may well have been

necessary if the Oregon blackberry buyers represented more than 35% of blackberry purchasers.

The Blackberry Act expressly and clearly articulates a policy to supplant competition

(and provide antitrust immunity) by imposing a state regulatory structure:

18 Legislative summary, available at http://www.leg.state.or.us/09reg/measures/sb0400.dir/sb0409.intro.html. 19 See Oregon Department of Agriculture, Blackberry Price Negotiations, available at http://www.oregon.gov/ODA/blackberry_price.shtml. 20 Brent Searle (Oregon Department of Agriculture), Price Negotiations -- A Historical Development in Oregon Agriculture (2001), available at http://www.oregon.gov/ODA/docs/price/grass/bg_2001.perspective.doc. 21 See generally Michael A. Lindsay, Antitrust and Group Purchasing, ANTITRUST, Vol. 23 No. 3, at p.66 (Summer 2009), available at http://www.dorsey.com/files/upload/antitrust_group_purchasing.pdf.

[I]t is the intent of this section and ORS 646.535 (2) and

646.740 (10) to displace competition with a regulatory program in

the Oregon blackberry industry to a limited degree. The regulatory

program is intended to grant immunity from federal and state

antitrust laws to Oregon blackberry producers and dealers for the

limited purpose of allowing the producers and the dealers to

bargain collectively and to arrive at a negotiated price for the sale

of Oregon blackberries by the producers to the dealers. The

activities of any party that comply with this section may not be

considered to be in restraint of trade, a conspiracy or combination

or any other unlawful activity in violation of any provision of ORS

646.705 to 646.826 or federal antitrust laws.22

Like the original ryegrass statute, the Blackberry Act provides that the Director of Agriculture

“shall actively supervise the conduct of a party in establishing the price of Oregon blackberries to be produced and sold to dealers at a future date,” and “shall supervise the negotiations between the parties, review the prices established by the negotiations and approve the prices proposed by the parties before the prices take effect.”23 Neither prices nor adjustments to previously approved prices can be implemented until the Director approves them. The

Blackberry Act gives the Director power to “compel the parties to take whatever action the director considers necessary” to ensure that the parties engage in conduct authorized under the

Act and that the policies of the Act are being fulfilled, as well as to enjoin conduct that the

22 Blackberry Act, § 2(2).

Director has not authorized or that the Director finds does not advance the State’s interest in carrying out the “blackberry regulatory program.”24

One interesting aspect of the Blackberry Act is its potential role in supply management.

In 2001, the Oregon Department of Agriculture had described the motivation for the ryegrass law on which the Blackberry Act is modeled: a collapse in ryegrass seed prices. “Overproduction” led to low prices – prices that were below the producers’ cost of production:

The Bargaining Council agreed that the primary problem was

excess inventory in stock and too many acres in production. The

question became: what price level is appropriate to clear excess

inventory and discourage excess production so that demand and

supply reach a better balance?

. . . .

Both sides recognize the price is substantially below the cost of

production and the difficulty this creates for producers. The intent

is to create a signal that production needs to be reduced.

. . . .

The signal to reduce acreage is clear. With other crop options

limited at the present, that may be difficult. Some growers may

23 Blackberry Act , § 2(4). 24 Blackberry Act, § 2(5).

choose to fallow land; others are watching the price of wheat. But

acreage must be reduced to turn the price around.25

choose to fallow land; others are watching the price of wheat. But

acreage must be reduced to turn the price around.26

The Department of Agriculture has created a website to provide information regarding

the Blackberry Act and the resulting program.27 The site has not yet been populated, but it

provides a placeholder for a report on 2009 price negotiations. A similar site for the ryegrass

program includes information on past price negotiations.28 The 2007 price-negotiation minutes noted various factors that went into the pricing negotiation: the general decline in perennial ryegrass acreage, and the relatively more favorable pricing on other crops that farmers can plant instead of ryegrass.29

II. Pending Litigation

a. Dairy Antitrust Litigation: Allen, et al. v. Dairy Farmers of America, Inc., et al., (Vt.); In re

Southeastern Milk Antitrust Litigation (Tenn.) (Don Barnes)

At present, ten (10) antitrust class action lawsuits are pending against Dairy Farmers of

America, Inc. (“DFA”), Dean Foods Company (“Dean”) and various alleged co-conspirators in federal courts in Vermont and Tennessee.

25 Brent Searle (Oregon Department of Agriculture), Price Negotiations -- A Historical Development in Oregon Agriculture (2001), available at http://www.oregon.gov/ODA/docs/price/grass/bg_2001.perspective.doc. 26 Brent Searle (Oregon Department of Agriculture), Price Negotiations -- A Historical Development in Oregon Agriculture (2001), available at http://www.oregon.gov/ODA/docs/price/grass/bg_2001.perspective.doc. 27 The site is available at http://www.oregon.gov/ODA/blackberry_price.shtml#Introduction#Introduction. 28 See http://www.oregon.gov/ODA/price.shtml. 29 Minutes of the May 7, 2007 Perennial Ryegrass Bargaining Council (prepared by Brent Searle, Oregon Dept. of Agriculture), available at http://www.oregon.gov/ODA/docs/price/grass/2007minutes.5.7.07.doc.

The Vermont lawsuit, Allen, et al. v. Dairy Farmers of America, Inc., et al., was filed on

October 8, 2009.

There, a class consisting of all dairy farmers (including DFA members) who produced

Grade A milk in the Northeast (Order 1) and sold it through DFA’s affiliate, Dairy Marketing

Services (“DMS”) from October 9, 2005 to present allege a conspiracy among DFA, Dean

Foods, DMS and H.P. Hood which reduced the mailbox price to the dairy farmer members of the class. The producers are seeking damages, injunctive relief and divestiture of dairy plants for alleged violations of the Sherman Act § 1 and § 2 (conspiracy to monopolize and monopsonize attempt to monopolize and monopolization) and the Agricultural Fair Practices Act (coercion of dairy farmers to join DFA/DMS).

In addition, nine previously filed antitrust lawsuits have all been consolidated as In re

Southeastern Milk Antitrust Litigation, No. 08-1000 (E.D. Tenn.) in the Eastern District of

Tennessee.

In July of 2007, two antitrust class action lawsuits were filed against Dean Foods, Dairy

Farmers of America, National Dairy Holdings, and others in federal court in Tennessee. Shortly thereafter, five additional “tag along” dairy farmer class actions were filed along with two direct purchaser suits, including one by the Food Lion supermarket chain. More recently, in June of

2009 yet another class action antitrust lawsuit was filed on behalf of “indirect purchasers” (i.e., milk consumers) residing in thirteen (13) states. This lawsuit seeks injunctive relief and damages for the alleged overcharges paid by the indirect purchasers as a result of the alleged antitrust violations.

All of the cases have been consolidated before Judge Ronnie Greer in the Greeneville

Division, Eastern District of Tennessee.

In a consolidated amended complaint the Dairy Farmer Classes alleged that the

Defendants conspired and refused to compete for raw Grade A milk, thereby causing reduced pay prices to members of the Class. In addition, a sub-class of DFA members had additional claims for “breach of contract,” i.e., the duty of DFA management to use corporate resources for the benefit of the members.

Various preliminary motions to dismiss the complaint pursuant to Rule 12(b)(6) have been denied, including one motion based upon alleged Capper-Volstead Act immunity.

On July 29, 2008 the court entered an extensive Order directing the parties to participate in a mediation effort. The mediation efforts were not successful and discovery in the litigation has continued. Class certification motions have been filed and are currently pending. All of the class certification filings, including virtually everything else filed to date in the case, remain under seal. The New York Times and National Public Radio filed motions to unseal the record.

A hearing on those motions (among others) took place on September 10 and await a ruling by the

Court.

At present, the Court set a discovery cut-off date of December 15 except for any expert witnesses who might be used by the parties in support of, or in opposition to summary judgment motions. Under the current schedule, summary judgment motions are due to be filed in March of

2010. Responses to those motions will be due sometime this summer.

In view of: (1) the extensions of prior deadlines; (2) the numerous pending motions;

(3) the current schedule for the filing and resolution of summary judgment motions; and (4) the recent filing of yet another class action by Indirect Purchasers, it is likely that any trial will not take place until early 2011 -- unless the case is previously resolved by summary judgment or settlement.

A chronological outline of the various complaints and claims is set out below:

Date Case name

10/08/09 Allen et al. v. Dairy Farmers of America, Inc., et al., No. 2:09-CV-230 (D. VT.)

• Antitrust class action complaint filed by:

o Plaintiffs Alice and Laurence Allen, d/b/a Al-lens Farm and Ralph and Garrett Sitts (former DFA members)

o Against Defendants Dairy Farmers of America, Inc., Dean Foods Company, Dairy Marketing Services LLC and H.P. Hood, Inc. • Antitrust case alleging a conspiracy to monopolize the sale of Grade A milk to bottling plants in Federal Order No. 1 (for DFA’s benefit) and monopsonize the market for the purchase of Grade A milk in Order 1 (for the benefit of the handler co-conspirators and DFA plants). In return for full supply arrangements, DFA allegedly held the price of raw Grade A milk below the market value. Violations of the Sherman Act §§ 1 & 2, and the Agricultural Fair Practices Act, 7 U.S.C. § 2302(a) et. seq. are alleged. • Class consists of: o All dairy farmers who produced Grade A milk in Federal Order No. 1 and who sold their milk through DMS in Order 1 at any time from October 9, 2005 to the present. 7/5/2007 Sweetwater Valley Farm, Inc., et al., v. Dean Foods Company, et al., No. 07- 00051 (M.D. Tenn. filed Jul. 5, 2007).

• Antitrust class action complaint filed by:

o Plaintiffs Sweetwater Valley Farm, Inc., Harrison Dairy, Inc., D.L. Robey Farms, Barbara and Victor Atwood d/b/a Vba Dairy, John M. Moore, Jeffrey P. Bender, Randel E. Davis, Mountain View Farms of Virginia, LC, Sam Smith, and Thomas R. Watson.

o Against Defendants Dean Foods Company, National Dairy Holdings, LP, Dairy Farmers of America, Inc., Dairy Marketing Services, LLC, Southern Marketing Agency, Inc., James Baird, Gary Hanman, and Gerald Bos.

• Antitrust case alleging that defendants conspired to operate a cartel that refuses to compete for the purchase of Grade A milk and fixes the prices of milk paid to dairy farmers in the Southeast United States in violation of Sections 1 and 2 of the Sherman Act.

• Class consists of:

o All independent dairy farmers, whether individuals or entities, who produced Grade A milk within Orders 5 or 7, and, either directly through Dairy Marketing Services, LLC, sold Grade A milk to Defendants in Orders 5 and/or 7 during any time from January 1, 2001 to the present.

o All dairy farmer members of Maryland & Virginia Producers Cooperative Association, Inc., whether individuals or entities, who produced Grade A milk within Orders 5 and/or 7, and, through Southern Marketing Agency, Inc., sold Grade A milk to Defendants in Orders 5 and/or 7 during any time from January 1, 2001 to the present.

7/5/2007 James D. Baisley and Eva C. Baisley, et al., v. Dean Foods Company, et al., No. 07-00052 (MD. Tenn. filed Jul. 5, 2007).

• Antitrust class action complaint filed by:

o Plaintiffs James D. Baisley and Eva C. Baisley d/b/a Baisley Farms, Stephen J. Cornett, William C. Frazier and Branson McCain d/b/a McCain Dairy, Jerry L. Holmes, Rocky Creek Dairy, Inc., and Van Der Hyde Dairy, Inc.

o Against same Defendants as Sweetwater Valley Farm, Inc., et al., v. Dean Foods Company, et al., No. 07-00051 (M.D. Tenn. filed Jul. 5, 2007) above.

• Class consists of:

o All DFA members, whether individuals or entities who produced and sold Grade A milk in Orders 5 or 7 during any time from January 1, 2001 to the present.

8/9/2007 Fidel Breto, d/b/a Family Foods, v. Dean Foods Company, et al., No. 07-188 (E.D. Tenn. filed Aug. 9, 2007).

• Antitrust class action complaint filed by:

o Plaintiff Fidel Breto, d/b/a Family Foods, a grocery store.

o Against same Defendants as Sweetwater Valley Farm, Inc., et al., v.

Dean Foods Company, et al., No. 07-00051 (M.D. Tenn. filed Jul. 5, 2007) above.

• Class consists of:

o “Direct milk purchaser” class, defined as All Direct Purchasers of Grade A milk in the States of Alabama, Arkansas, Florida, Georgia, Indiana, Kentucky, Louisiana, Mississippi, Missouri, North Carolina, South Carolina, Tennessee, Virginia, and West Virginia, whether individuals or entities, from January 1, 2001 to the present.

8/27/2007 Scott Dairy Farm, Inc., et al., v. Dean Foods Company, et al., No. 07-208 (E.D. Tenn. filed Aug. 27, 2007).

• Antitrust class action complaint filed by:

o Plaintiff Scott Dairy Farm, Inc., William H. Price, Highland Dairy Farm, LLP, Jeff Whatley, and Robert D. Stoots.

o Against Defendants Dean Foods Company, National Dairy Holdings, LP, Dairy Farmers of America, Inc., Mid-Am Capital LLC, Dairy Marketing Services, LLC, and Southern Marketing Agency, Inc.

• Class consists of:

o All independent dairy farmers (whether individuals or entities) who produced Grade A milk within Orders 5 or 7, and sold Grade A milk directly or through an agent to Defendants or their co-conspirators in Orders 5 or 7 during any time from January 1, 2001 to the present.

10/3/2007 George C. Aker, et al., v. Dean Foods Company, et al., No. 07-248 (E.D. Tenn. filed Oct. 3, 2007).

• Antitrust class action complaint filed by:

o Plaintiff George C. Aker, a dairy farmer.

• Defendants, type of action filed, and class definition same as Scott Dairy Farm, Inc., et al., v. Dean Foods Company, et al., No. 07-208 (E.D. Tenn. filed Aug. 27, 2007).

11/15/2007 James Farrar and Farrar & Farrar Dairy, Inc., et al., v. Dean Foods Company, et al., No. 07-272 (E.D. Tenn. filed Nov. 15, 2007).

• Antitrust class action complaint filed by:

o Plaintiff James Farrar and Farrar & Farrar Dairy, Inc., and Fred Jaques, dairy farmers.

• Defendants, type of action filed, and class definition same as Scott Dairy Farm, Inc., et al., v. Dean Foods Company, et al., No. 07-208 (E.D. Tenn. filed Aug. 27, 2007).

1/7/2008 Transfer order from Judicial Panel on Multidistrict Litigation, granting defendants’ motion for coordinated or consolidated pretrial proceedings. The panel granted the motion, pursuant to 28 U.S.C. § 1407, and transferred the actions pending in the Middle District of Tennessee to the Eastern District of Tennessee, creating MDL No. 1899. The litigation was renamed In re: Southeastern Milk Antitrust Litigation, No. 1899.

2/13/2008 Ernest Groseclose & Sons, Inc., et al., v. Dean Foods Company et al., No. 08- 00053 (E.D. Tenn. filed Feb. 13, 2008).

• Antitrust class action complaint filed by:

o Plaintiff Ernest Groseclose & Sons, Inc., and Virgil C. Willie, dairy farmers.

o Against Defendants Dean Foods Company, National Dairy Holdings LP, Dairy Farmers of America, Inc., Dairy Marketing Services LLC, Maryland and Virginia Milk Producers Cooperative Association, Inc., and Southern Marketing Agency, Inc.

• Type of action filed and class definition same as Scott Dairy Farm, Inc., et al., v. Dean Foods Company, et al., No. 07-208 (E.D. Tenn. filed Aug. 27, 2007).

3/28/2008 Food Lion, LLC, and Fidel Breto, d/b/a Family Foods, et al., v. Dean Foods Company, et al., No. 07-188 (E.D. Tenn. filed Mar. 28, 2008).

• Antitrust class action complaint filed by:

o Plaintiffs Food Lion LLC and Fidel Breto, d/b/a Family Foods.

o Against Defendants Dean Foods Company, National Dairy Holdings, LP, Dairy Farmers of America, Inc., Dairy Marketing Services, LLC, and Southern Marketing Agency, Inc.

• Antitrust case alleging that Dean Foods Company monopolized the market for the sale of processed milk in the Southeast and entered into exclusive agreements with Dairy Farmers of America and National Dairy Holdings, LP to lessen competition for sales and processed milk, in violation of Section 1 and 2 of the Sherman Act and Section 3 of the Clayton Act. Plaintiffs allege that the defendants’ actions compelled Food Lion, Breto, and the Class to pay unlawfully inflated prices for processed milk.

• Class consists of:

o All persons, other than schools and school districts, within the Southeast United States who have purchased, at any time from January 1, 2002 until the present, directly from any Defendant, Grade A milk which has been pasteurized and processed for human consumption and then packaged into containers which are sold to retail outlets and other customers.

6/6/2008 In re: Southeastern Milk Antitrust Litigation, MDL No. 1899 (E.D. Tenn. Jun. 6, 2008) denying motion to dismiss by Southern Marketing Agency (“SMA”) and James Baird (“Baird”).

• SMA and Baird argued, inter alia, that the court should grant their motion to dismiss for failure to state a claim because the Capper-Volstead Act, 7 U.S.C. § 291, immunizes them from antitrust liability.

• The court, however, denied the motion finding that the defendants’ claim of Capper-Volstead immunity was “largely conclusory” and ultimately holding that the competing arguments on this issue necessitated a fact-intensive inquiry which the court could only conduct after proper discovery had been completed. The court concluded that an affirmative defense, such as one of Capper- Volstead immunity, could not be resolved through a 12(b)(6) motion.

6/20/2008 Consolidated amended complaint filed as Sweetwater Valley Farm, et al., v. Dean Foods Company, et al., No. 08-1000 (E.D. Tenn. filed Jun. 20, 2008).

• Antitrust class action complaint filed by:

o Plaintiffs Sweetwater Valley Farm, Inc., Barbara and Victor Atwood d/b/a VBA Dairy, Jeffrey P. Bender, Randel E. Davis, Farrar & Farrar Dairy, Inc., Fred Jaques, John M. Moore, D.L. Robey Farms, Robert D. Stoots, Virgil C. Willie, James D. Baisley and Eva C. Baisley d/b/a

Baisley Farms, Stephen J. Cornett, William C. Frazier and Branson McCain d/b/a McCain Dairy, and Jerry L. Holmes.

o Against Defendants Dean Foods Company, National Dairy Holdings, LP, Dairy Farmers of America, Inc., Dairy Marketing Services, LLC, Southern Marketing Agency, Inc., Mid-Am Capital LLC, James Baird, Gary Hanman, and Gerald Bos.

• Antitrust case alleging that the defendants conspired to refuse to compete for raw Grade A milk marketed, sold, or purchased in the Southeast United States, fixed prices paid to dairy farmers for that milk, and unlawfully acquired and maintained monopoly power in order to reduce the price paid by defendants for Grade A milk bought from plaintiffs and other class members in violation of Sections 1 and 2 of the Sherman Act.

• Class consists of:

o All dairy farmers, whether individuals or entities, who produced Grade A milk within Orders 5 and/or 7, and sold Grade A milk directly or through an agent to Defendants or Co-Conspirators in Orders 5 and/or 7 during any time from January 1, 2001 to the present.

o The plaintiffs also sought certification of two subclasses, claiming that that DFA member dairy farmers (as opposed to all dairy farmers) had additional claims for breach of contract:

. Independent dairy farmer and independent cooperative member subclass—All independent dairy farmers and independent cooperative members (whether individuals or entities) who produced Grade A milk within Orders 5 or 7 and sold Grade A milk directly or through an agent to Defendants or Co- conspirators in Orders 5 or 7 during any time from January 1, 2001 to the present. The terms “independent dairy farmer” and “independent cooperative member” refer to Southeast dairy farmers who were not members of DFA at the time of their Grade A milk sales.

. DFA member dairy farmer subclass—All DFA members (whether individuals or entities) who produced Grade A milk within Orders 5 or 7 and sold Grade A milk directly or through an agent to Defendants or Co-conspirators in Orders 5 or 7 during any time from January 1, 2001 to the present. The term

“DFA member dairy farmer” refers to Southeast dairy farmers who were members of DFA at the time of their Grade A milk sales.

7/29/2008 Mediation order filed in In re Southeastern Milk Antitrust Litigation, MDL No. 1899 (E.D. Tenn. filed Jul. 29, 2008).

• The court ordered the parties to participate in mediation pursuant to LR 16.4(a) of the Local Rules of the United States District Court for the Eastern District of Tennessee and also ordered that the mediation should occur simultaneously with discovery and pretrial litigation. The court appointed the mediator and instructed counsel for the defendants to meet with him to develop, among other things, a comprehensive plan and framework for the mediation. The mediation efforts have not been successful.

6/29/09 Charles Benson, et al. v. Dean Foods Company, et al., No. 2:09-cv-00128 (E.D. Tenn., filed 6/29/09)

• Antitrust class action filed by Indirect Purchasers Charles Benson, et al. • Against Defendants Dean Foods Company, Dairy Farmers of America, National Dairy Holdings, L.P.; Dairy Marketing Services, LLC, Southern Marketing Agency, Inc. • Plaintiffs allege Defendants entered into a continuing conspiracy in restraint of trade which artificially raised the price of Grade A milk in Alabama, Arkansas, Florida, Georgia, Indiana, Kentucky, Louisiana, Missouri, North Carolina, South Carolina, Tennessee, Virginia and West Virginia (“Damage States”). • Class consists of:

o All individuals and businesses in the Damage States who indirectly purchased Grade A milk, processed and sold for human consumption from January 1, 2002 through present.

b. Report on In Re Mushroom Antitrust Litigation (Chris Ondeck)

The mushroom antitrust case continues to proceed, from its beginnings in February, 2006.

After completing limited discovery, the parties in the In re Mushroom Direct Purchasers

Litigation filed cross-motions for summary judgment on the question whether Capper-Volstead immunity covered the claims at issue. On July 8, 2008, NCFC also filed an amicus brief in those proceedings. Without taking a position regarding the facts, NCFC argued that (1) vertical integration does not preclude a grower from membership in a Capper-Volstead cooperative; (2)

the “50% rule” – requiring at least 50% of the products a cooperative deals in to be products of

its members – applies only at the level of the cooperative; and (3) when a cooperative engages in

predatory conduct, its members are not liable for that conduct.

In a March 26, 2009 decision, the Court denied defendants’ motions and granted

plaintiffs’ cross motion. The court did not address the issues raised by the NCFC brief. Instead,

the court focused primarily on the composition of the membership in the cooperative. The court

determined that one of the members of the mushroom cooperative was not a producer, and thus

the requirements of the Capper-Volstead Act were not met. The producer in question was a

processor entity named M. Cutone Chelsea, Co., Inc., a non-grower. Mario Cutone, his wife, and

three adult sons owned both the processing entity, and a related growing entity. Regardless, the

court held that despite the processor and grower entities having “the same owners,” the court

insisted the membership of the processor entity violated the Act. The court also rejected the

argument that this was a mere “technical, de minimis violation.”

The Court also held that even if defendants had satisfied all structural requirements of the

Capper-Volstead Act, immunity would still have been destroyed by a price-fixing conspiracy between members and affiliated distributors that were not agricultural producers. This involved similar issues of cross-ownership of growers and processors. Here, the defendants asserted

Copperweld immunity (Copperweld Corp. v. Independence Tube Corp., 467 U.S. 742 (1984)).

The Court found that the “single economic entity” theory did not apply because there was more than a de minimis deviation from complete ownership between the distributors and the member-

growers and they thus were not under common control. Finally, the Court stated clearly that

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“[t]he involvement of family relationships in these varying ownerships is immaterial to determining common ownership or control” and that “[t]o hold otherwise would … create an untenably blurry test in which courts must investigate the degree of the entities’ family connections to determine whether they qualify as a single entity unable to engage in conspiracies.”

In light of these conclusions, the Court found it unnecessary to reach the plaintiffs’ other arguments and NCFC’s related brief. The defendants thereafter filed a motion for a certificate of appealability pursuant to 28 U.S.C. § 1292(b), moved to stay the proceedings in the district court pending appeal, and filed a notice of appeal. On April 29, 2009, however, the court denied these motions and ordered the parties to move forward and confer to establish a pretrial schedule.

c. Report on In Re Processed Egg Products Antitrust Litigation (Chris Ondeck)

Beginning in late September 2008, a series of class action antitrust lawsuits was filed against approximately 16 companies engaged in producing raw shell eggs and processed egg products, as well as against an agricultural cooperative, United Egg Producers (“UEP”) and two related entities. These cases followed media reports beginning September 23, 2008 regarding a

Department of Justice antitrust investigation into the pricing and marketing of certain processed egg products. Approximately 20 separate lawsuits were filed, listing both direct and indirect purchasers as plaintiffs. On December 2, 2008, the Judicial Panel on Multi District Litigation consolidated the cases into a single matter in the United Stated District Court in the Eastern

District of Pennsylvania, titled In re Processed Egg Products Antitrust Litigation.

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The complaints allege violations of Section 1 of Sherman Act; specifically, that

defendant egg producers and alleged co-conspirators engaged in a continuing combination and conspiracy in unreasonable restraint of trade. The conduct alleged by the complaints to be anticompetitive falls into two primary categories: (1) that UEP and its members engaged in pretextual animal husbandry guidelines (involving, e.g., cage-sizes, molting practices and schedules, delaying and reducing chick hatching) and (2) that UEP, its affiliates, and their respective members reduced supply by selective exportation of eggs at a loss to increase domestic price.

The defendants collectively filed multiple motions to dismiss the direct and indirect class plaintiffs’ complaints in their entirety on April 30th. These included 12(b)(6) motions to dismiss the direct and indirect complaints, as well as a motion to dismiss the direct purchasers’ fraudulent concealment claim, and a Rule 8 motion. These motions are pending, and the plaintiffs originally had a deadline of July 22 for their oppositions (that deadline has been extended).

On June 8, the direct purchaser class plaintiffs entered into a proposed class settlement with one of the defendants, Sparboe Farms, Inc. At the end of June, both the class plaintiffs and

Sparboe moved for preliminary approval of the class settlement and preliminary certification of a settlement class. On July 8, the non-settling defendants filed a response to the motions asking the court to refrain from certifying the settlement class defined in the class plaintiffs’ motion or, if that request was not granted, to order that any preliminary class certification decision was without prejudice to the non-settling defendants (i.e., that any such decision has no bearing on

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the issue of certification of a litigation class in the case). The court held a hearing on the motions on July 14. Two days later, on July 16, the court entered an order directing the class plaintiffs and Sparboe to submit additional briefing by July 29 regarding the issue of class certification.

The parties are now waiting on the court’s ruling regarding the proposed preliminary class settlement involving Sparboe; all briefing deadlines now hinge on the date of that ruling.

Discovery continues to be stayed in the case.

III. Other Activities of the Committee

Members of the Antitrust Committee have gathered and posted on a NCFC

password protected website cases, legislative history, and briefs on the agricultural

producer issue.

In addition, in response to recent activity the Justice Department Antitrust

Division, members of the Antitrust Committee prepared a white paper on supply

management (see Exhibit B) and submitted it to the Justice Department in December,

2009.

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2009 ANNUAL REPORT OF THE ANTITRUST SUBCOMMITTEE OF THE NATIONAL COUNCIL OF FARMER COOPERATIVES

EXHIBIT A

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NATIONAL COUNCIL OF FARMER COOPERATIVES

December 30, 2009 Legal Policy Section Antitrust Division U.S. Department of Justice 450 5th Street, NW, Suite 11700 Washington, DC 20001 RE: Response to Request for Comments on “Agriculture and Antitrust Enforcement Issues in Our 21st Century Economy,” 74 FR 43725 (08/27/2009).

To Whom It May Concern:

The National Council of Farmer Cooperatives (NCFC) is pleased to submit the attached comments in response to the request for comments on agriculture and antitrust enforcement issues.

NCFC is the national trade association representing America’s farmer cooperatives. There are over three thousand farmer cooperatives across the United States, whose members include a majority of our nation’s two million farmers.

We appreciate the opportunity to comment on this important topic and would be happy to provide witnesses for the upcoming workshops and to answer any questions you may have regarding the nature and role of farmer cooperatives in American agriculture.

Please direct your questions to Marlis Carson, General Counsel and Vice President, Legal, Tax and Accounting, at 202-879-0825 or [email protected].

Sincerely,

Charles F. Conner President and CEO

50 F STREET, NW • SUITE 900 • WASHINGTON, DC • 20001 • 202-626-8700 • fax 202-626-8722 • Web site www.ncfc.org

Serving America’s Farmer-Owned Cooperative Businesses Since 1929 National Council of Farmer Cooperatives Comments Regarding Agriculture and Antitrust Enforcement Issues in Our 21st Century Economy, 74 FR 43725 (08/27/2009)

Executive Summary

x American agriculture is a modern-day success story, providing abundant and safe food to American consumers at the lowest prices in the world.

x Farmer cooperatives are an important part of the success of the nation’s food and agricultural supply system. Farmer cooperatives handle, process and market almost every type of agricultural commodity, furnish farm supplies, and provide credit and related financial services, including export financing, to their farmer members.

x The limited antitrust immunity provided by the Capper-Volstead Act and other federal statutes enables farmers to join together to collectively process and market their products through farmer cooperatives, and thereby helps to level the playing field for farmers in an environment characterized by increasing concentration at the food wholesale and retail levels.

x Buyer power in the agricultural marketplace is as strong or stronger than it was in 1922, when the Capper-Volstead Act was enacted – the Capper-Volstead Act’s protections are as critical today as they were nearly 100 years ago.

x Any action to eliminate or dilute the Capper-Volstead Act or other similar federal statutes would harm the success and effectiveness of farmer cooperatives, damage American agriculture and competition in the agricultural marketplace, and harm rural communities.

x Farmer cooperatives increase competition; provide a guaranteed home for their members’ products; lower farmers’ production costs; and increase farmers’ incomes.

x The activities and earnings of farmer cooperatives are vital to the economies of the rural communities they serve.

x While cooperatives may help farmers countervail the market power of buyers and processors, cooperatives are subject to numerous practical constraints that prevent them from achieving monopoly power.

2 Introduction

American agriculture is a modern-day success story. American farmers produce the world’s safest, most abundant food supply for consumers at prices that are the envy of the world. Innovative planting, fertilizing, harvesting, storage, and processing are the hallmarks of American agriculture and ensure a safe and affordable food supply for the nation’s citizens.

According to the Department of Agriculture, United States households spend an average of 5.7 percent of household final consumption expenditures on food, the lowest percentage in the world.1 A 2009 study by the United States Government Accountability Office determined that, while per capita food expenditures have increased since 1982, households now spend a smaller percentage of disposable income on food than they did more than 25 years ago.2

Farmer cooperatives -- businesses owned and controlled by farmers, ranchers, and growers -- are an important part of the success of American agriculture. Cooperatives differ from other businesses because they are member-owned and are operated for the mutual benefit of their members. Cooperative earnings are distributed on the basis of the quantity or value of business the cooperative conducts with the member, also known as “patronage.” There are over 3,000 farmer cooperatives across the U.S., whose members include a majority of our nation’s two million farmers.

Farmer cooperatives handle, process and market almost every type of agricultural commodity, furnish farm supplies, and provide credit and related financial services, including export financing, to their farmer members. Earnings from these activities are returned to their farmer members on a patronage basis, helping improve their income from the marketplace. In addition, farmer cooperatives are a vital part of the rural communities they serve, providing nearly 200,000 jobs in the United States, with net business volume of $165.3 billion,3 and contribute significantly to the economic well-being of rural America.

Farmer cooperatives enhance competition in the agricultural marketplace by acting as bargaining agents for their members’ products; providing market intelligence and pricing information; providing competitively priced farming supplies; and vertically integrating their members’ production and processing.

For farmer cooperatives that market their members’ products, the Capper-Volstead Act provides limited antitrust immunity that allows them to continue to operate effectively. Without this immunity, marketing cooperatives would not be able to function in today’s challenging marketplace, which is characterized by relatively few, large buyers of agricultural products. The Act’s limited immunity does not cover (among other things) illegal conspiracies or combinations with non-cooperative entities, or so-called “predatory” conduct of any kind.

1 USDA Economic Research Service, Table 7—Food expenditures by families and individuals as a share of disposable personal income, 2007, available at: http://www.ers.usda.gov/Briefing/CPIFoodAndExpenditures/data/Table_97/2007table97.htm 2 Concentration in Agriculture, 2009, GAO-09-746R. 3 USDA Rural Development Cooperative Statistics 2008, Service Report 69 (November 2009).

3 Since 1929 the National Council of Farmer Cooperatives (NCFC) has represented the business and policy interests of America’s farmer cooperatives. As you explore the impact of market concentration in agriculture, NCFC asks that you recognize the unique and important role that farmer cooperatives play in the success of American agriculture and in providing farmers the best opportunity to compete in an increasingly challenging marketplace. We also ask that you recognize the importance both for farmers and consumers of preserving the Capper-Volstead Act’s protections for cooperatives.

I. Overview of Capper-Volstead Act and Other Federal Statutes

Acting independently, individual farmers are too small and too numerous to deal effectively with larger agribusinesses in the supply, processing, and marketing sectors of agriculture. Consequently, in the late 19th and early 20th centuries, farmers joined forces to form cooperative associations to market their products and purchase farm-related supplies and services.

Contrary to the likely intentions of Congress, early court decisions held that these associations fell within the broad reach of the Sherman Act of 1890, which made “[e]very contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce . . . illegal.”4 To address this problem, Congress later enacted Section 6 of the Clayton Act, which exempted agricultural organizations from antitrust laws if they were established for mutual help, did not have capital stock, and were not operated on a for-profit basis.5

The language of Section 6 of the Clayton Act made it clear that forming a cooperative was not a violation of the Sherman Act, but Section 6 did not clearly specify the types of activities in which a cooperative could engage, nor did it apply to cooperatives organized on a stock basis. The shortcomings of the Clayton Act led to the passage of the Capper-Volstead Act in 1922.6 The Supreme Court has noted: “From the standpoint of agricultural cooperatives, the principal defect in that exemption [Clayton Act Section 6] was that it applied only to non-stock organizations. The Capper-Volstead Act was intended to clarify the immunity for agricultural organizations and to extend it to cooperatives having capital stock.”7

The Capper-Volstead Act gives agricultural producer organizations limited antitrust immunity “in collectively processing, preparing for market, handling, and marketing” their products and permits such organizations to have “marketing agencies in common.” 8 The Capper-Volstead Act also gives the Secretary of Agriculture authority to prevent cooperatives from using their market power to unduly enhance the price of the products they market.9

4 15 U.S.C. § 1. 5 15 U.S.C. § 17. 6 7 U.S.C. §§ 291-292. 7 Case-Swayne Co., Inc. v. Sunkist Growers, Inc., 389 U.S. 384, 391 (1967). 8 7 U.S.C. § 291. In 1926, following American Column & Lumber Co. v. U. S., 257 U.S. 377 (1921), Congress enacted the Cooperative Marketing Act of 1926, 7 U.S.C. §§ 451-457, which further clarified that cooperatives may exchange marketing and other economic information as part of their immunity. 9 7 U.S.C. § 292.

4 Without limited antitrust immunity for cooperatives, family farmers would find it virtually impossible to compete in a business economy in which farmers lack bargaining power in dealing with relatively few, large buyers, and would lack the ability to integrate into agricultural processing to compete with those entities. In addition, limited antitrust immunity promotes efficient integration in farming production and allows farming operations to survive in the market. As the Supreme Court has stated: “By allowing farmers to join together in cooperatives, Congress hoped to bolster their market strength and to improve their ability to weather adverse economic periods and to deal with processors and distributors.”10 The limited antitrust immunity for agricultural cooperatives provided by the Capper-Volstead Act and other federal statutes is essential to the economic well-being of American farmers because it enables farmers to more efficiently market their agricultural products and integrate into agricultural processing. This limited immunity introduces more competitors into agricultural processing than would exist absent the immunity. It also permits local cooperatives to obtain the benefits of specialization by permitting them to join together in a federated cooperative that may carry out specialized functions not performed by the local cooperative. These functions include manufacturing production supplies, exporting, and large-scale advertising, activities that may be too complex and expensive to perform at the local cooperative or individual farmer level. Congress also has declared its support for agricultural production and cooperatives through the Agricultural Marketing Act of 1929. In that Act, Congress declared the policy of Congress to be:

[T]o promote the effective merchandising of agricultural commodities in interstate and foreign commerce so that the industry of agriculture will be placed on a basis of economic equality with other industries, and to that end to protect, control, and stabilize the currents of interstate and foreign commerce in the marketing of agricultural commodities and their food products . . . by encouraging the organization of producers into effective associations or corporations under their own control for greater unity of effort in marketing and by promoting the establishment and financing of a farm marketing system of producer-owned and producer-controlled cooperative associations and other agencies.11

Congress further supports associations of agricultural producers through the Agricultural Marketing Agreement Act of 1937,12 which grants the Secretary of Agriculture authority to enter into marketing agreements with associations of producers and to thereby help stabilize market conditions and assure consumers of adequate supplies of commodities. Marketing orders for dairy, poultry, fruits, vegetables, and livestock are currently in place. The terms of orders are developed through public hearings held by the Department of Agriculture, providing an opportunity for the public and other government agencies to comment prior to issuance. A recent study determined that orders do not prevent entry into the industry and “do not allow producers to set prices directly or even to set limits on pricing such as price floors.”13

10 National Broiler Mktg. Ass’n v. United States, 436 U.S. 816, 826 (1978). 11 12 U.S.C. § 1141(a). 12 7 U.S.C.§ 608b-c. 13 Sexton, Richards, and Patterson, Retail Consolidation and Produce Buying Practices, Giannini Foundation Monograph Number 45, p. 32 (December 2002).

5 The Agricultural Fair Practices Act of 1967 further illustrates Congressional support for associations of producers. The Act states that “the marketing and bargaining position of individual farmers will be adversely affected unless they are free to join together voluntarily in cooperative organization . . .” and prohibits discrimination against a farmer because of membership in a cooperative.14

II. Farmer Cooperatives Promote Competition and Improve Farmers’ Income

Farmer cooperatives are an essential component of American agriculture, providing their farmer- members an alternative for marketing products and procuring goods and services. They also offer a method for farmers to store raw and finished products in order to increase market favorability, bargain collectively over prices, and share in profits from the processing and marketing of products.

Farmer cooperatives by their very nature enhance competition in farm products and farm supply markets. They are neither formed nor operated to provide a return on investor capital. Instead, their purpose is to provide valuable products or services to their patrons at a competitive cost. Joint action among farmers originated as a defensive mechanism to combat exploitation and abuse from buyers and has expanded to include entry into agricultural processing, thereby increasing competition. Trends in farming – increased farm size, mechanization, and improved managerial and operational skills of farmers – have not changed the basic market structure of farmers, that of individual producers with relatively little bargaining power.

The bargaining power achieved by farmer cooperatives helps to offset a number of unique and challenging conditions experienced by farmers:

1) Thousands of small-scale farm firms sell to and buy from only a few large-scale nonfarm firms, resulting in inequality in bargaining power; 2) Farmers must make production decisions long before demand for the product is known; 3) Once production decisions are made, they cannot be easily or quickly changed because of the long transition times between planting and harvest; 4) Weather, disease, insects, and other conditions may impact farming plans; 5) Due to the perishable nature of most farming products, farmers have few opportunities to delay selling and must sell at a time when many farmers in the region are bringing their product to market; and 6) Capital investments cannot be easily transferred to alternative production choices.

The Supreme Court has recognized the inherent and unique difficulties faced by farmers. In a 1929 opinion, Justice Sutherland, acknowledging the special treatment of cooperatives, wrote: “It is settled that to provide specifically for peculiar needs of farmers or producers is a reasonable

14 7 U.S.C. §§ 2301-2305.

6 basis of classification.”15 And in a case reviewing the constitutionality of a Texas antitrust law, Justice Frankfurter acknowledged that:

[f]armers were widely scattered and inured to habits of individualism; their economic fate was in large measure dependent upon contingencies beyond their control. In these circumstances, legislators may well have thought combinations of farmers and stockmen presented no threat to the community, or, at least, the threat was of a different order from that arising through combinations of industrialists and middlemen.16

In finding that Kentucky cooperative marketing statutes promoted the common interest, Justice McReynolds cited the lower court’s finding that the statutes were enacted because producers were “at the mercy of speculators and others who fixed the price of the selling producer and ... the final consumer through combinations and other arrangements, whether valid or invalid, and that by reason thereof the [producer] obtained a grossly inadequate price for his products.” 17

The processors, distributors, manufacturers, and other buyers to whom farmers sell their products today have grown increasingly concentrated and integrated. The USDA has described the squeeze this concentration has put on farmers and their cooperatives:

Consolidation of firms at the processing, wholesale, and retail levels of the U.S. food marketing system continues unabated. Market influence and bargaining strength of even the largest cooperatives are limited as a consequence. Food retailers flex their market muscle by imposing coordination mechanisms that demand strict discipline and conformity from suppliers. Food processors exert greater control over distribution channels by integrating back into the production of raw materials through a variety of ownership and contractual arrangements. Such arrangements rob producers of decision-making authority and market choices.18

Indeed, one major, concentrated segment of farmers' buyer base has developed in recent decades -- the national or regional grocery store chain. To a large and increasing extent, the grocery industry is concentrated into large chains, such as Walmart and Costco, that exert enormous buying power. Industry estimates by Supermarket News indicate that the top ten grocery retailers and wholesalers account for more than two-thirds of U.S. grocery sales.19

The USDA has taken note of this trend:

Consolidation among U.S. retail food marketers is continuous. It is augmented by the entry of foreign firms into the U.S. market through aggressive acquisition

15 Frost v. Corporation Com’n of State of Okla., 278 U.S. 515, 535 (1929). 16 Tigner v. State of Texas, 310 U.S. 141, 145 (1940). 17 Liberty Warehouse Co. v. Burley Tobacco Growers’ Co-Op. Marketing Ass’n, 276 U.S. 71, 93 (1928). 18 Dunn, Agricultural Cooperatives in the 21st Century, USDA Rural Business Cooperative Service, Cooperative Information Report 60 (2002), p. 4; and see, e.g., Harris, The U.S. Food Marketing System, 2002, USDA Economic Research Service, Agricultural Economic Report No. 811 (2002), at pp. 2, 6, 15, 17-19, 26-28, 32-33. 19 Supermarket News Top 75 Retailers for 2009, see: http://supermarketnews.com/profiles/top75/2009-top-75/

7 strategies . . . Retailers are positioned to dictate product requirements, prices, and other terms of trade to suppliers. Purchasing is centralized for logistical and pecuniary advantage as retailers seek to purchase as many products as possible from the fewest number of suppliers. Moreover, suppliers must be substantial enough to carry not only a nationwide presence, but also global networks of stores. As traditional supermarkets expand in size and scope, volume discounters and warehouse clubs are entering food retailing and becoming dominant market participants.20

Moreover, cooperatives face large-scale concentration and integration not only on the part of the businesses that buy farmers' products, but even among their direct competition at the producer level. Investor-owned firms are increasingly integrating vertically, operating at the levels of initial production, processing and marketing, and distribution and retailing. The USDA study concludes:

As part of their response to the growth of consumer power, food processors and retailers are extending their influence over associated market channel activities. Firms that control key elements of the distribution and marketing system are attempting to control each level of the process, up to and including delivery to the consumer . . . Competition gives way to coordination, as large consolidated firms internalize transactions through ownership or other coordination mechanisms that give them greater control of variables affecting profitability. It also results in thinner markets where the disparity in bargaining power among the parties becomes even more pronounced.21

Cooperatives enable farmers to reduce the risks associated with price and income volatility. A Giannini Foundation study notes:

Everyone knows farming is a risky business. Prices fluctuate from year to year, and production levels can be similarly volatile. These factors often combine to make farm income very unstable. … Thus, if marketing through a cooperative can reduce this risk, we have an additional benefit of integration through a marketing cooperative.22

Cooperatives also help farmers to reduce risk through diversification. A USDA report on dairy cooperatives explains:

…[C]ooperatives have adapted to the situation and hedged the price risks by diversifying into multi-product and multi-plant operations, expediting inventory turnover, integrating and diversifying into consumer-product and niche markets, forming marketing agencies in common to share

20 Agricultural Cooperatives in the 21st Century at p. 6. 21 Id. at p. 5. 22 Sexton and Iskow, “Factors Critical to the Success or Failure of Emerging Agricultural Cooperatives,” Giannini Foundation Information Series No. 88-3, 1988, at p. 5.

8 market information or coordinate dairy product marketing, and entering joint ventures with other firms to shift away some of the risks.23

Farmer cooperatives are the primary instrument to raise farm income and to improve farmers’ well-being by correcting or alleviating such market or competitive weaknesses. It is the structural imbalance referred to above that originally spurred the formation of farmer cooperatives. Without the freedom to act in association with other producers, the farmer has almost no bargaining power and is at a competitive disadvantage.

Cooperatives play a vital role in reducing price fluctuations and other uncertainties by pooling, collecting, analyzing, and disseminating information on market conditions. For example, the California Citrus Growers Association establishes quality standards and shares information, and the Wine Service Cooperative “provides storage and shipping services, as well as inventory control and government reporting services. Similar cooperative ventures focused on services such as cotton ginning, prune drying, citrus packing and storage, are continuing to provide California producers with economies of scale.” 24 By pooling information from farmers and from other levels of the supply and product chain, cooperatives can assist farmers in predicting future input and product prices. Cooperatives also can provide an assured market for member farmers’ products when the cooperative stores and/or processes those products.

Cooperatives also reduce fluctuations in members’ incomes by diversifying into new product and geographic markets in order to mitigate fluctuations in supply and demand. For example, Sunkist Growers, Inc. markets its products extensively abroad. Rather than selling only products of its members, Sunkist has purchased citrus from other countries in order to be a year-round supplier of a full line of citrus products.25

Another example of diversification exists in the fresh berry market, where cooperatives Naturipe and MBG/Michigan Blueberry Growers Association have joined a privately held company in Chile to ensure a year-round supply of fresh berries under the Naturipe brand. The arrangement gives the two cooperatives’ members a more secure and broader customer base.26

By pooling the resources of their farmer-members, cooperatives also promote innovation and the creation of new products and packaging. Such innovation allows farmers to compete against major food and beverage manufacturers and to benefit from patronage generated by new revenue streams.

23 Ling and Liebrand, “Dairy Cooperatives’ Role in Managing Price Risks,” USDA Rural Business Cooperative Service Report 152, September 1996, at p. i. 24 Shermain D. Hardesty and Vikas D. Salgia, “Comparative Financial Performance of Agricultural Cooperatives and Investor-Owned Firms,” n. d. (2002 or later), unpublished paper, research supported by a Rural Cooperative Development Grant from USDA, p. 2. 25 Hardesty, 2005, p. 238. 26 Hardesty, 2005, p. 240.

9 Cooperatives serve another important function in allowing farmers to band together when dealing with large suppliers in oligopolistic markets for agricultural products.27 Michael Cook, agricultural economics professor at the University of Missouri, notes that individual farmers acting alone may be the victims of market holdup and opportunism on the part of larger suppliers and buyers, but supply cooperatives allow farmers to work together “…to avoid monopoly power.”28

Supply cooperatives can realize substantial savings in input procurement through volume discounts for consolidated purchases. Supply cooperatives provide more dependable supplies of high-quality input materials (crop protectants, feed, fertilizer, petroleum, seed, and other supplies) than would otherwise be available to their member farmers:

Farmers [who belong to coops], especially those producing fruits and vegetables, have realized substantial savings in buying containers and packaging supplies. Savings of up to 10 percent of sales have been realized from volume discounts, brokerage allowances, or negotiated prices from consolidated purchases.29, 30

USDA researchers have found that the activity of cooperatives in supply markets increases the competitiveness of prices in these markets to the benefit of all, not just their members:

Cooperatives inject competition into the system by providing services at cost to members. This leads to pricing adjustments by other organizations; thus the real benefit may be their day-to-day impact on market prices. Based on the competitive influence of cooperatives since they began operations, many leaders report that these economic benefits greatly exceeded the annual net margins of the cooperatives. 31

Researches find similar outcomes in the “yardstick of competition theory,” which assumes that farmers compare the prices charged by cooperatives for farm inputs and the prices paid by cooperatives for farm products to the prices offered by investor-owned firms. This analysis indicates that cooperatives may constrain the prices offered by investor-owned firms.32 One economic model predicts that cooperatives involved in processing have lower processor-farmer

27 Caves and Petersen, “Cooperatives’ Shares in Farm Industries: Organizational and Policy Factors,” Agribusiness, Vol. 2, No. 1, 1986, pp. 1–19 at p. 11 (“Cooperatives may be formed to avert the monopsony power of IOE [“investor-owned enterprises”] processors….”). 28 Cook, “The Future of U.S. Agricultural Cooperatives,” American Journal of Agricultural Economics, Vol. 77, 1995, pp. 1153–1159, at p. 1155. 29 Biser, “Cooperative Supply and Equipment Operations,” Cooperative Information Report, USDA, 1989, at p. 17. 30 See also Deller et al. (2009): “Many farmers purchase basic inputs such as seed, fertilizer, and farm chemicals from a cooperative. In other words, farmers collectively establish a firm to negotiate better terms of purchase for basic agricultural production inputs.” Deller, Hoyt, Hueth, and Sundaram-Stukel, “Research on the Economic Impact of Cooperatives,” University of Wisconsin Center for Cooperatives, 2009, at pp. 16-17. 31 J. Warren Mather and Homer J. Preston, “Cooperative Benefits and Limitations,” Cooperative Information Report, USDA, 1990, at p. 3. 32 See Richard J. Sexton, “The Role of Cooperatives in Increasingly Concentrated Agricultural Markets,” in Cooperatives: Their Importance in the Future Food and Agricultural System, Proceedings of a January 1990 Symposium sponsored by the National Council of Farmers Cooperatives and The Food and Agricultural Marketing Consortium, 1997, pp. 31-47 at p. 38. (“[I]f cooperatives are providing better services and prices to farmers than are competing for-profit firms, these firms must follow suit or lose patrons to the cooperative.”)

10 price spreads than rival processors. The model suggests that open membership cooperatives are pro-competitive forces whose presence mitigates for-profit firms’ opportunities to exercise monopoly or monopsony power.33

In some cases, cooperatives vertically integrate into production of farm inputs or the processing, and sale of food products. Such vertical integration allows cooperative members to eliminate the margin between the revenues and costs of an investor-owned processor and avoid transaction costs that arise when vertically related enterprises have different owners.

In addition to reducing production and processing costs, cooperatives may reduce marketing costs for their members. A USDA report notes that by pooling “sales, and handling and selling expenses, cooperatives can operate more efficiently—at lower costs per unit—than farmers can individually.”34 Accordingly, dairy cooperatives sometimes form marketing agencies to jointly market their milk, to achieve efficiencies, and to spread risk:

In 1995, three dairy cooperatives in California joined forces to create Dairy America, Inc., a marketing agency in common to market the powdered milk they manufactured. Besides taking advantage of scale economies in sales operations, the common agency can better coordinate marketing of the product and spread market risks over a very large volume.35

Cooperatives also assist farmers with branding and advertising, activities that are extremely difficult and expensive for individual farmers. Sunkist Growers, Inc. notes:

A cooperative of growers together can do many things that a grower alone cannot afford to do—develop a worldwide market, promote a brand name, access a global transportation system, develop comprehensive research capabilities, and gain governmental access to overseas markets—to name a few.36

Cooperatives may obtain better information about prevailing market conditions than farmers could obtain individually. Dairy cooperatives have formed marketing agencies in common as permitted under the Capper-Volstead Act. These marketing agencies provide a way for dairy cooperatives and their members to share market information on inventory levels and product movements of nonfat dry milk and whey powder. “This valuable information enables the cooperatives to make informed decisions on inventory management and marketing operations,”37 USDA experts note.

Bargaining cooperatives also play an important role in reducing the costs of transactions between farmers and processors to which the farmers sell their products. Bargaining cooperatives are

33 Sexton, “Imperfect Competition in Agricultural Markets and the Role of Cooperatives: A Spatial Analysis,” American Journal of Agricultural Economics, Vol. 72, No. 3, Aug. 1990, pp. 709–720 at p. 718. 34 Mather and Preston at p. 2. 35 Ling and Liebrand at p. 7. 36 “About Sunkist: The Sunkist Story,” http://www.sunkist.com/about/cooperative.aspx, Sunkist website, accessed 11/17/09. 37 Ling and Liebrand at p. 7.

11 active primarily in wholesale markets for agricultural products for which, prior to the growing season, a farmer and a processor enter into a contract setting the terms at which the farmer will supply its product to the processor and the processor will pay for that product. Such contractual relationships between farmers and processors are important for raw farm products for which storage and transportation are expensive or impossible.

Acting independently, producers of highly perishable or hard to transport products lack a competitive edge because there are few potential processors for any given farm’s output of raw farm products. Also, farmers and agricultural cooperatives have much less bargaining power in dealing with processors once the farmers have invested in production, and particularly once the crop has been harvested. As a result, farmers have a strong preference for contracting prior to the growing season. For these products there are typically benefits to both farmers and processors from coordinating to produce output to the processors’ specifications, in the quantities desired by the processors, and, insofar as possible, with the delivery dates desired by the processors.

Researchers at the University of Wisconsin Center for Cooperatives recently studied the negotiations between bargaining cooperatives representing growers of products such as fruits and vegetables and the processors that purchase their products in advance under contracts:

Bargaining can offer benefits to all parties when it results in enhanced price discovery (or “information sharing”). This is most likely to be important in markets where contracts are the primary farm-to-market coordination device. Without a substantial ‘spot market’ of some kind, there is limited opportunity for information transmission across the various market participants regarding uncertain supply and demand conditions, and a bargaining association can help overcome this problem.38

Cooperatives also can reduce risk through adjustment of production or sales as demand changes. “If the cooperative controls a significant share of the relevant market and the commodity is storeable, it can reduce price fluctuations by maintaining buffer stocks of the raw commodity.”39 Cooperatives may be able to coordinate production among farmers so as to reduce variability in production and thus prices.40

These various activities by farmer cooperatives help to achieve lower food prices. USDA researchers have concluded: “Lowered production costs on the farm and marketing efficiencies brought about by cooperatives help hold down food costs to consumers.”41

38 Brent Hueth and Philippe Marcoul, “An Essay on Cooperative Bargaining in U.S. Agricultural Markets,” Journal of Agricultural & Food Industrial Organization, Vol. 1, No. 10, 2003, p. 9. 39 Sexton and Iskow at p. 14. 40 This is not necessarily an easy task. Caves and Petersen (1980) explain the challenges facing cooperatives that, for example, try to exercise monopoly power through output restrictions. In particular, cooperatives may not be able to restrict output due to the fact that payments of net savings to its members is in direct proportion to the volume of product contributed by the member. Caves and Petersen, “Cooperatives’ Shares in Farm Industries: Organizational and Policy Factors,” Agribusiness, Vol. 2, No. 1, 1986, pp. 1–19 at p. 10. 41 Mather and Preston at p. 14.

12 One research study has found that where cooperatives sell products in retail markets in which brands sold by investor-owned firms have large market shares, the addition of the cooperative’s product may lead to a reduction in the prices of competitors. The study concluded that “the prices of all brands in a market are affected by the presence of a co-op brand. Brands in markets with at least one co-op are 6 cents cheaper than a similarly positioned brand where no co-ops compete.”42

While farmer cooperatives are able to reduce costs and thus reduce food prices, they also are able to increase incomes for farmers. A 2004 study indicated that when a farmer is a member of a supply cooperative, the farmer’s annual income is $5,678 higher on average.43 In fact, cooperatives increase farmer income in several ways, including raising the price paid to farmers for their products or lowering the level for supplies purchased; reducing per-unit handling or processing costs through economies of size or scale; distributing to the farmer-members the net savings made in handling, processing, and selling operations; and developing new markets for products.44

In addition, evidence shows that cooperatives may offer better investments for their members than some available alternatives. A USDA report measured the “extra value” of a cooperative by comparing its rate of equity return to a benchmark rate of return used by banks as a minimum threshold to make a loan. Over 30 percent of cooperatives beat the benchmark rate of return by over 5 percent in 1992-1996 and 27 percent exceeded the benchmark rate by over 5 percent in 2000-2004. More than 16 percent exceeded the benchmark rate by over 10 percent in those two time periods.45

III. Farmer Cooperatives Do Not Diminish Competition

While cooperatives may help farmers countervail the market power of buyers and processors, they are unlikely to achieve monopoly power.

As user-owned entities with a limited number of owner-investors, farmer cooperatives are subject to inherent practical constraints. Cooperatives typically do not seek capital from outside investors and their ability to raise additional capital from their producer members is limited, due to what one cooperative expert has identified as the “portfolio and horizon problems”:

42 Haller, “Branded Product Marketing Strategies in the Cottage Cheese Market: Cooperative versus Proprietary Firms,” Food Marketing Policy Center Research Report No. 16, January 1992, pp. 13–14. 43 Mishra, Ashok K.; Fisseha Tegegne, and Carmen L. Sandretto (2004) “The Impact of Participation in Cooperatives on the Success of Small Farms,” Journal of Agribusiness, 22, 1 (Spring 2004), pp. 31–48, at Table 2. 44 Mather and Preston at p. 2. 45 Liebrand, “Measuring the Performance of Agricultural Cooperatives,” Research Report 213, USDA, 2007, at p. 8.

13 investment. Since members are unable to recognize appreciation in their equity investment, they exert pressure on their cooperative to maximize current returns rather than investing for higher future returns.46

Such practical limitations on access to capital are a major hindrance to the activities of most cooperatives and make it difficult for such cooperatives to expand and approach significant market power, especially when operating and expansion expenses are increasing for such things as environmental compliance, expanding globalization, and corporate governance and accountability.

Further, the requirements for the favorable tax treatment of distributions of earnings by agricultural cooperatives to their members under Subchapter T of the Internal Revenue Code47 impose significant practical limitations on the activities of cooperatives. In order to distribute earnings as patronage distributions under the provisions of Subchapter T, such earnings must be from activities with or on behalf of the members and must be related to the agricultural activities of the members. These restrictions mean that agricultural cooperatives cannot expand or move away from a close connection with such agricultural activities without losing the benefits of Subchapter T.

In addition, the distribution of cooperative earnings to producer members may cause producers to view the distribution as a signal to produce more product. Increased production then forces the cooperative to expand output, thereby reducing prices. In contrast, corporations simply distribute dividends to shareholders who are not input suppliers to the enterprise and the dividend distribution does not encourage additional production. Numerous industrial organization economists have pointed out that, because of this feedback mechanism, cooperatives have a self- correcting supply enhancement in profitable times that makes it unlikely for cooperatives to achieve market power.48

Cooperatives also are unlikely to achieve market power because members can leave to compete against the cooperative, to form another competing cooperative, or to become a supplier to a proprietary firm – and, of course, farmers who were never members of the cooperative can do all of this, too.

Because of these inherent constraints and practical limitations, there is no need to eliminate or dilute the Capper-Volstead limited antitrust immunity. Such action could unintentionally result in purchases of the processing assets of marketing cooperatives by proprietary firms or the introduction of non-farmer stockholders into restructured agricultural enterprises. In addition, if cooperatives could not freely federate with other cooperatives to perform processing or marketing functions, they would be left with the stark choice of dealing only with proprietary

46S. Hardesty, Positioning California’s Agricultural Cooperatives for the Future, Agricultural and Resource Economics Update, Vol. 8, No. 3 (Jan./Feb. 2004). 47 26 U.S.C. §§ 1381, et seq. 48 Y. J. Youde and P.G. Helberger, Marketing Cooperatives in the U.S.: Membership Policies, Market Power, and Antitrust Policy, Journal of Farm Economics 48 (1966) and P. Helmberger and S. Hoos, Economic Theory of Bargaining in Agriculture, Journal of Farm Economics 45 (December 1963). See also, Mueller, Helmberger and Paterson, “The Sunkist Case: A Study in Legal-Economic Analysis” (Lexington Books, 1987).

14 firms. This would lead to the further consolidation of processing assets, as large proprietary firms would purchase the assets of cooperatives that could no longer compete efficiently.

Further, while other of the activities engaged in by agricultural cooperatives may be allowable under antitrust laws, the Capper-Volstead limited immunity provides a significant benefit to farmers. Without Capper-Volstead, marketing cooperatives would have to incur the substantial costs of proving that their activities do not violate antitrust laws in "rule of reason" proceedings, which often involve tremendous legal expense. The threat and actuality of such additional costs could be used by larger competitors to harass cooperatives with limited resources. In addition, loss of a bright-line Capper-Volstead immunity will result in additional lawsuits by plaintiffs’ law firms seeking treble damages under federal antitrust law. Removal of the limited immunity would result in a reduction in the number of competitors in the agricultural marketplace and reduced investment in agriculture.

IV. Farmer Cooperatives Enhance Rural Communities

In addition to improving competition and increasing farmers’ income levels, farmer cooperatives also provide essential economic and social benefits to rural communities. Cooperatives generate income, provide employment, and provide tax revenues across the United States. According to a USDA report:

Most of the additional income farmers get through cooperatives is spent with hometown firms for goods and services. Successful cooperatives also have substantial payrolls and their employees’ patronage of local businesses adds to the economic well-being of the community. The cooperatives also spend money for supplies, utilities, insurance, and local taxes.49

Cooperatives also provide a sense of community and are essential in helping rural communities remain viable:

In small towns, the cooperative often is the major or only business. Without it, people would have to go elsewhere for goods and services. A majority of the farmer cooperative plants and other facilities are located in rural areas—a plus value in stimulating home ownership and retaining rural industry. Participation in cooperatives often encourages participation in other community projects and in State and local government.50

A 2002 study collected survey data from 189 agricultural cooperatives in Minnesota reporting $5.4 billion in revenues.51 The researcher estimated that “[t]hese 189 cooperatives generate $8.4 billion in economic impacts” through “direct effects attributable to the firm, those [effects]

49 Mather and Preston at p. 10. 50 Id., at p. 11. 51 Joe Folsom (2003), "Measuring the Economic Impact of Cooperatives in Minnesota," RBS Research Report 200, Rural Business–Cooperative Service, USDA, December 2003, pp. 6, 8.

15 resulting from purchases made by the firm, and the induced effects as a result of local spending by firms attributable to the demand change resulting from a firm’s actions.”52 The study’s “best estimate of the total economic impact of agricultural cooperatives in the State [of Minnesota] using the USDA data is $17.2 billion with $647 million attributable to the cooperative business structure.”53

A second study presents similar statistics from 1999 for 42 agricultural cooperatives in Wisconsin. There, researchers found:

Agricultural marketing cooperatives employ 5,900 people, providing a significant source of employment in Wisconsin’s rural areas. Once the multiplier effect is considered, these cooperative businesses generate an additional 2,395 jobs. They produced $163 million in direct income, which when cycled through the local economy amounted to $263 million in income.54

A 2009 study surveyed about fifteen thousand cooperatives of different types operating in the U.S., including farm supply and marketing cooperatives.55 Extrapolating their sample to the total number of such cooperatives in the U.S., they calculate that farm supply and marketing cooperatives annually generate over $119 billion in revenue and directly employ nearly 150,000 people who earn over $6 billion in wages.56

Conclusion

America’s agricultural sector feeds the nation’s consumers at a fraction of the cost incurred by citizens in other countries. Farmer cooperatives play an essential role in the production of food and fiber and in the success and well-being of individual farmers and of rural communities. Any action that would limit the effectiveness and efficiency of farmer cooperatives would harm

52 Id, at pp. 8, 1. 53 Id, at p. 9. 54 Zeuli, Kimberly, Greg Lawless, Steven Deller, Robert Cropp, and Will Hughes (2003), "Measuring the Economic Impact of Cooperatives: Results from Wisconsin," RBS Research Report 196, Rural Business–Cooperative Service, USDA, August 2003, p. 6. 55 Deller et al. use “farm supply and marketing cooperatives” to refer to “cooperatives [that] perform a wide variety of functions in agricultural and food markets. Often these functions are grouped into two broad categories, ‘marketing,’ and ‘supply.’ …[Some marketing cooperatives] provide processing and marketing services to farmers, and also the necessary logistical support to aggregate farm supply. Other marketing cooperatives are much leaner organizations, providing only marketing services to assist farmers get product to market, to pool risk, or to negotiate sales as a group to a single buyer or a small number of buyers. Supply cooperatives provide service and inputs to farmers to help them produce their goods.” Deller, Hoyt, Hueth, and Sundaram-Stukel, “Research on the Economic Impact of Cooperatives,” University of Wisconsin Center for Cooperatives, 2009, at p. 16. 56 Deller, Hoyt, Hueth, and Sundaram-Stukel, “Research on the Economic Impact of Cooperatives,” University of Wisconsin Center for Cooperatives, 2009, at p. 16. The $119 billion revenue estimate appears to include total revenue for farm supply and marketing cooperatives measured at the stage at which the product leaves the coop. Thus, it seems to include revenue generated by selling farm inputs to farmers as well as revenue from selling farmers’ products to processors, etc.

16 American agriculture and rural communities and would result in a less reliable food supply and higher food prices.

The long-standing limited antitrust immunity provided by the Capper-Volstead Act and other federal statutes evidences the consistent recognition by Congress and our courts of the need to enable farmers to join together to collectively process and market their products and thereby to give family farmers bargaining power in an economy increasingly dominated by relatively few, large buyers. Congress has recognized the need for farmers to join together and has expressed its intent to promote associations of producers through the Clayton Act, the Capper-Volstead Act, the Agricultural Marketing Act, the Agricultural Marketing Agreement Act of 1937, and the Agricultural Fair Practices Act of 1967.

The Supreme Court also has recognized the importance of placing farmers in the same position as the purchasers of their products and their competitors:

We believe it reasonably clear from the very language of the Capper-Volstead Act, as it was in Section 6 of the Clayton Act, that the general philosophy of both was simply that individual farmers should be given, through agricultural cooperatives acting as entities, the same unified competitive advantage – and responsibility – available to businessmen acting through corporations as entities.57

Any action to eliminate or dilute the effectiveness of the Capper-Volstead Act would increase risk to farmer cooperatives and their farmer-members. Such action also would cause a decrease in the number of farmer cooperatives as farmers would be required to seek out other methods of marketing their products in a highly competitive environment dominated by large buyers such as Walmart, Costco, and others. The resulting damage to farmers and their ability to achieve bargaining power would damage American agriculture and would harm consumers.

57 Maryland and Virginia Milk Producers, 362 U.S. 458, 466 (1960).

2009 ANNUAL REPORT OF THE ANTITRUST SUBCOMMITTEE OF THE NATIONAL COUNCIL OF FARMER COOPERATIVES

EXHIBIT B

105 ______

SUPPLY MANAGEMENT WHITE PAPER:

The Capper-Volstead Act Authorizes Farmers Through Their

Cooperatives to Agree on Production Levels

______

December 30, 2009

I. Introduction...... 1

II. NCFC And Its Role In Speaking For Farmer Cooperatives ...... 3

III. Farmers Have Legitimate Needs To Engage In Supply Management...... 5 A. Individual farmers are forced to deal with large agribusinesses in supply, processing, and marketing ...... 5 B. Advance planning is even more important for farmers than for most businesses...... 11 C. Supply management is a response to consumer demand...... 14 D. Basic economics dictate that cooperatives should engage in supply management ...... 16 E. Supply management permits acreage and other assets to be put to the optimum uses, which include conservation purposes...... 17 F. Cooperatives currently engage in many forms of supply management...... 18 G. It would be inefficient to permit farmers to manage supply only after, but not before, a crop is grown ...... 20

IV. The Capper-Volstead Act Immunizes Cooperative Supply Management...... 21 A. Section 6 of the Clayton Act created the basic antitrust exemption for collective action by producers for the production and sale of agricultural products...... 21 B. The Capper-Volstead Act clarified and expanded the scope of legal cooperative activity...... 22 C. Congress intentionally used broad language...... 25 D. The Capper-Volstead Act’s legislative history reveals an intent to immunize supply management ...... 26 E. Courts also have held that cooperatives can engage in supply management...... 29 1. Holly Sugar v. Goshen County Cooperative Beet Growers Ass’n: Cooperatives can engage in pre-season price setting and supply management programs for their members’ production, just like any other corporation...... 30 2. The Dairy Cooperative Cases: Cooperatives can control, reduce, or withhold their members’ production ...... 31 3. Treasure Valley Potato Bargaining Ass’n v. Ore-Ida Foods, Inc.: Pre-season price setting and pre-season supply management are linked rights for cooperatives...... 34

i 4. State courts also have recognized the right to engage in supply management ...... 35 5. Government enforcement agencies have taken the position that farmers can legally agree to manage supply...... 36 6. There is no well-reasoned or persuasive countervailing precedent ...... 38 F. Supply management is a fundamental component of setting prices ...... 40 G. The Act already contains important protections ...... 41 H. Other sources of law and commentary also support farmers’ right to engage in supply management...... 43 1. Cooperative Marketing Act...... 43 2. Other agriculture statutes ...... 44 3. USDA policy support...... 46

V. To Exclude Supply Management From Immunity Is To Tie The Hands Of U.S. Farmers In International Competition...... 47

VI. Conclusion ...... 50

ii TABLE OF AUTHORITIES

Page

Cases Alexander v. National Farmers Organization, 687 F.2d 1173 (8th Cir. 1982), cert. denied, 461 U.S. 937 (1983)...... 32 Bergjans Farm Dairy Co. v. Sanitary Milk Producers, 241 F. Supp. 476 (E.D. Mo. 1965), aff’d, 368 F.2d 679 (8th Cir. 1966)...... 42 Burlington Northern Railroad Co. v. Brotherhood of Maintenance of Way Employees, 481 U.S. 429 (1987)...... 22 Case-Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967)...... 24 Ewald Bros., Inc. v. Mid-America Dairymen, Inc., 877 F.2d 1384 (8th Cir. 1989) ...... 32, 33 F.T.C. v. Superior Court Trial Lawyers Ass’n, 493 U.S. 411 (1990)...... 40 Fairdale Farms, Inc. v. Yankee Milk, Inc., 635 F.2d 1037 (2d Cir. 1980) ...... 26, 27, 33, 39 Frost v. Corp. Commission, 278 U.S. 515 (1929) ...... 7 Holly Sugar v. Goshen County Cooperative Beet Growers Ass’n, 725 F.2d 564 (10th Cir. 1984) ...... 30, 31 In re California Lettuce Producers Cooperative, 90 F.T.C. 18 (1977) ...... 39 In re Midwest Milk Monopolization Litigation, 510 F. Supp. 381 (D.C. Mo. 1981) ...... 32 In re Mushroom Direct Purchaser Antitrust Litigation, 621 F. Supp. 2d 274 (E.D. Pa. 2009)...... 36 In re Washington Crab Ass’n, 66 F.T.C. 45 (1964) ...... 37, 38 Kinnett Dairies, Inc. v. Dairymen, Inc., 512 F. Supp. 608 (M.D. Ga. 1981), aff’d, 715 F.2d 520 (11th Cir. 1983)...... 31 Liberty Warehouse Co. v. Burley Tobacco Growers’ Cooperative Marketing Ass’n, 276 U.S. 71 (1928)...... 7 Loewe v. Lawlor, 208 U.S. 274 (1908)...... 22, 23 Naional Broiler Marketing Ass’n v. United States, 436 U.S. 816 (1978)...... 22

iii North Texas Producers Ass’n v. Metzger Dairies, Inc., 348 F.2d 189 (5th Cir. 1965), cert. denied, 382 U.S. 977 (1966)...... 42 Northern Caifornia Supermarkets v. Central California Lettuce Producers Cooperative, 413 F. Supp. 984 (N.D. Cal. 1976)...... 25, 39 Oregon v. Mulkey, 1997-1 Trade Cases (CCH) ¶ 71,859 (D. Or. 1997)...... 36 Tigner v. Texas, 310 U.S. 141 (1940)...... 7 Treasure Valley Potato Bargaining Ass’n v. Ore-Ida Foods, Inc., 497 F.2d 203 (9th Cir. 1974), cert. denied, 419 U.S. 999 (1974)...... 25, 34, 35 United Dairymen of Arizona v. Schugg, 128 P.3d 756 (Ariz. Ct. App. 2006)...... 35, 36 United States v. Andreas, 216 F.3d 645 (7th Cir. 2000) ...... 41 United States v. Borden Co., 308 U.S. 188 (1939)...... 32 United States v. Dairymen, Inc., 660 F.2d 192 (6th Cir. 1981) ...... 25 United States v. Grower-Shippers Vegetable Ass’n of Central California, 344 U.S. 901 (1952)...... 38 United States v. Hinote, 823 F. Supp. 1350 (S.D. Miss. 1993) ...... 36 United States v. Hutcheson, 312 U.S. 219 (1941)...... 22 United States v. King, 250 F. 908 (D. Mass. 1916) ...... 23 United States v. Maryland & Virginia Milk Producers Ass’n, 362 U.S. 458 (1960)...... 22, 26, 37, 42 United States v. Socony-Vacuum Oil Co., 310 U.S. 150 (1940)...... 40 United States v. The Shade Tobacco Growers Agricultural Ass’n, Civ. A. No. 3992, 1954 U.S. Dist. LEXIS 3703 (D. Conn. 1954)...... 38 United States. v. Maryland Cooperative Milk Producers, 145 F. Supp. 151 (D.D.C. 1956)...... 42

Statutes Agricultural Marketing Act of 1929 (codified at 12 U.S.C. § 1141 et seq.)...... 45 Agricultural Marketing Agreement Act of 1937 (codified as amended at 7 U.S.C. § 601 et seq.) ...... 45

iv Capper-Volstead Act (codified at 7 U.S.C. § 291 et seq.)...... passim Clayton Act (codified as amended at 15 U.S.C. § 12 et seq.)...... 22, 23 Fisherman’s Collective Marketing Act (codified at 15 U.S.C. 521 et seq.) ...... 36, 37 Sherman Act (codified as amended at 15 U.S.C. § 1 et seq.) ...... 23

Legislative History 59 CONG. REC. 7852 et seq. (1920)...... 6, 11, 28, 29 60 CONG. REC. 313 et seq. (1920)...... 11, 27 61 CONG. REC. 1043 et seq. (1921)...... 7, 42 62 CONG. REC. 2049 et seq. (1922)...... passim 67 CONG. REC. 2775 (1926)...... 44 78 CONG. REC. 9175 (1934)...... 36 H.R. REP. NO. 116, 69th Cong., 1st Sess. (1926) ...... 44 S. Con. Res. 119, 109th Cong. (2006) ...... 29

Other Authorities 6 ABA SECTION OF ANTITRUST LAW, ANTITRUST LAW DEVELOPMENTS (6th ed. 2007)...... 40 Arie Reich, The Agricultural Exemption in Antitrust Law: A Comparative Look at the Political Economy of Market Regulation, 42 TEX. INT’L L.J. 843 (2007)...... 48, 49 CHESAPEAKE BAY FOUNDATION, A GUIDE TO PRESERVING AGRICULTURAL LANDS IN THE CHESAPEAKE BAY REGION: KEEPING STEWARDS ON THE LAND (2006) ...... 18 Chesapeake Bay Foundation, Agriculture, http://www.cbf.org/Page.aspx?pid=506 ...... 18 Competition Act 89 of 1998 s.10, as amended, Competition Second Amendment Act 39 of 2000 s.5 (S. Afr.) ...... 50 DENNIS W. CARLTON & JEFFREY M. PERLOFF, MODERN INDUSTRIAL ORGANIZATION (4th ed. 2005)...... 11 DOJ Business Review Letter from Edwin M. Zimmerman, Assistant Attorney General, Antitrust Division to Ray Obrecht, Master, Colorado Grange (Oct. 2, 1968) ...... 38 DONALD A. FREDERICK & GENE INGALSBE, USDA AGRICULTURAL COOPERATIVE SERVICE, WHAT ARE PATRONAGE REFUNDS?, COOPERATIVE INFORMATION REPORT NO. 9 (Jan. 1985)...... 4 DONALD A. FREDERICK, USDA RURAL BUSINESS-COOPERATIVE DEVELOPMENT SERVICE, TAX TREATMENT OF COOPERATIVES, COOPERATIVE INFORMATION REPORT 23 (revised May 1995)...... 4 DONALD A. FREDERICK, USDA RURAL BUSINESS-COOPERATIVE SERVICE, ANTITRUST STATUS OF FARMER COOPERATIVES: THE STORY OF THE CAPPER-VOLSTEAD ACT, COOPERATIVE INFORMATION REPORT NO. 59 (Sept. 2002)...... 22

v DONALD A. FREDERICK, USDA RURAL BUSINESS-COOPERATIVE SERVICE, DO YOURSELF A FAVOR: JOIN A COOPERATIVE, COOPERATIVE INFORMATION REPORT NO. 54 (Nov. 1996) ...... 47 EGERSTROM, MAKE NO SMALL PLANS: A COOPERATIVE REVIVAL FOR RURAL AMERICA (Lone Oak Press 1995) ...... 48 ETC Group, Global Seed Industry Concentration - 2005, COMMUNIQUÉ, Sept./Oct. 2005 ...... 10 ETC Group, Who Owns Nature? Corporate Power and the Final Frontier in the Commodification of Life, COMMUNIQUÉ, Nov. 2008 ...... 10 First Research, Farm Equipment Manufacture, available at http://premium.hoovers.com/subscribe/ind/fr/profile/basic.xhtml?ID=203 ...... 9 Gary D. Thompson, Retail Demand for Greenhouse Tomatoes: Differentiated Fresh Produce (paper presented at the American Agricultural Economics Association Annual Meeting Montreal, Canada, July 27-30, 2003) ...... 15 International Cooperative Agricultural Organisation, Members Directory, http://www.agricoop.org/directory/africa.htm...... 50 J. ISKOW & R. SEXTON, AGRICULTURAL COOP. SERV., BARGAINING ASSOCIATIONS IN GROWER-PROCESSOR MARKETS FOR FRUITS AND VEGETABLES, USDA-ACS RESEARCH REPORT NO. 104 (Mar. 1992)...... 41 J. MICHAEL HARRIS ET AL., THE U.S. FOOD MARKETING SYSTEM, 2002, USDA AGRICULTURAL ECONOMIC REPORT NO. 811 (June 2002)...... 8 JAMES J. WADSWORTH, USDA RURAL DEVELOPMENT, STRATEGIC PLANNING SYSTEMS OF LARGE FARMER COOPERATIVES, RESEARCH REPORT NO. 103 (Aug. 1992)...... 4 JOHN R. DUNN ET AL., USDA RURAL BUSINESS-COOPERATIVE SERVICE, AGRICULTURAL COOPERATIVES IN THE 21ST CENTURY,COOPERATIVE INFORMATION REPORT 60 (Nov. 2002) ...... passim KATHERINE C. DEVILLE ET AL., USDA RURAL DEVELOPMENT, COOPERATIVE STATISTICS 2008, SERVICE REPORT NO. 69 (Nov. 2009) ...... 3, 4 Kyösti Arovuori & Hanna Karikallio, Consumption Patterns and Competition in the World Fertilizer Markets (paper presented at the 19th Symposium of the International Food & Agribusiness Management Association, June 20-21, 2009, Budapest, Hungary) ...... 9 Letter from Keith Collins, Chief Economist, USDA, to Deborah A. Garza, Antitrust Modernization Commission (July 15, 2005) ...... 11, 13 National Council of Farmer Cooperatives, About NCFC, http://www.ncfc.org/about-ncfc.html ...... 4 National Council of Farmer Cooperatives, Cooperative Facts, http://www.ncfc.org/cooperative-facts.html ...... 4 Neil. E. Harl, The Age of Contract Agriculture: Consequences of Concentration in Input Supply, 18 J. OF AGRIBUSINESS (SPECIAL ISSUE) 115 (2000) ...... 10

vi Richard J. Sexton, Timothy J. Richards, & Paul M. Patterson, Retail Consolidation and Produce Buying Practices, Giannini Foundation Monograph No. 45 (Dec. 2002)...... 45 RICHARD SEXTON, MINGXIA ZHANG, & JAMES CHALFANT, USDA ECONOMIC RESEARCH SERVICE, GROCERY RETAILER BEHAVIORINTHE PROCUREMENTAND SALEOF PERISHABLE FRESH PRODUCE COMMODITIES, CONTRACTORS AND COOPERATORS REPORT NO. 2 (2003)...... 9 Shermain Hardesty, Positioning California’s Agricultural Cooperatives for the Future,AGRICULTURAL AND RESOURCE ECONOMICS UPDATE, Jan./Feb. 2005...... 13 THE FREEDONIA GROUP, WORLD AGRICULTURAL EQUIPMENT TO 2012 (2008) ...... 9 TRACEY L. KENNEDY, USDA RURAL DEVELOPMENT, U.S. COOPERATIVES IN INTERNATIONAL TRADE, 1997-2002, RESEARCH REPORT NO. 211 ...... 48

vii I. Introduction

This White Paper sets forth the position of the National Council of Farmer Cooperatives

(“NCFC”) that the Capper-Volstead Act, 7 U.S.C. § 291 et seq., authorizes farmers through their cooperatives to agree on the amount of product that they will produce, handle, and sell, from the pre-planting stage to the post-harvest stage. Agreeing on production levels or managing the supply of a product that the cooperative and its members produce is known as “supply management.” Any change in the interpretation of the Capper-Volstead Act’s scope to remove the ability to manage supply would contravene the intent of the Act and its eighty-seven years of judicial interpretation. Such a change also would be bad public policy, as it would disrupt the functioning and productivity of the cooperative sector of U.S. agriculture, and reduce the competitiveness of U.S. farmers who rely on the cooperative model.

Farmer cooperatives are a critical component of U.S. agriculture. Congress recognized this in 1922 when it enacted the Capper-Volstead Act. This law has been called the Magna Carta of agricultural cooperatives, and it is designed to permit farmers to cooperate with each other under a limited immunity from the antitrust laws. The Act’s key benefit provides farmers with the ability to join together and make decisions concerning the production and sale of their products as if they were a single corporation or enterprise, without fear of prosecution as a conspiracy under the antitrust laws. It is well accepted that a single corporation is entitled to determine its own levels of production, and farmers acting jointly in a cooperative have the same right and the same need. The Act recognizes this, and for that reason contains the right for farmers to set prices and the right to determine production levels. Courts and industry, moreover, have shared this understanding of the Act for the past eighty-seven years. Currently, the question has been raised as to whether the Capper-Volstead Act authorizes farmers through their cooperatives to agree on production levels, or whether the Act should be re-interpreted to exclude this ability. NCFC sets forth in this White Paper its position that the

Act authorizes supply management, and that any change in enforcement policy that seeks to strip cooperatives of the ability to manage supply would do harm in several ways. First, stripping cooperatives of the ability to engage in supply management would largely nullify the other benefits provided by the Capper-Volstead Act. The Act provides cooperative members with the right to determine their sales prices and to engage in collective bargaining. This is beyond dispute. But standard economic theory teaches that a business has no ability to determine pricing without the ability to set its own production levels. Thus the power of farmers to determine their prices through their cooperatives is nullified if they cannot also agree on their own production levels – the right to engage in joint selling must encompass the right to determine how much to produce, or it is no right at all.

Second, stripping farmers of the right to determine their production levels through their cooperatives forces them to “fly blind” in their advance planning and will foster instances of under- and over-production, uneconomic decision making, and waste of resources, investment, and labor. It will prevent or impede the advance planning that is so necessary for the survival of

U.S. farmers. Congress did not intend to deny farmers the ability to jointly plan their production levels when it enacted the Capper-Volstead Act.

Last, overturning protection for supply management would invalidate eighty-seven years of practice and precedent, and thus result in major upheaval in U.S. agriculture. In the short term, stripping farmers in cooperatives of the ability to engage in supply management would create immediate economic disruption and distress in the cooperative sector, as cooperatives

2 would be forced to halt many of their current supply management practices. And for the long term, depriving farmers of this ability would reduce their competitiveness domestically and worldwide, result in waste and inefficiency, and discourage U.S. farmers from making the new investments needed to compete in a globalized market. Foreign cooperatives, still possessing the ability to engage in supply management, would seek to fill that gap, to the great detriment of the

U.S. farming economy.

In summary, the Capper-Volstead Act rightly provides farmers with the ability to agree through their cooperatives on the amount they will produce, and it is the position of the NCFC that it would be bad law and bad policy to attempt to roll back this aspect of the Act.

II. NCFC And Its Role In Speaking For Farmer Cooperatives

Since 1929, NCFC has represented business and policy interests of America’s farmer cooperatives. NCFC’s members include regional and national farmer cooperatives, which in turn comprise nearly 3,000 local farmer cooperatives across the United States. NCFC membership also includes state and regional councils of cooperatives located throughout the country. A majority of the more than two million farmers in the United States belong to one or more farmer cooperatives.

America’s farmer-owned cooperatives provide a comprehensive array of services for their members. These diverse organizations handle, process, and market virtually every type of agricultural commodity.1 They also provide farmers with access to infrastructure necessary to manufacture, distribute, and sell a variety of farm inputs and provide credit and related financial

* NCFC notes its appreciation for the work of Christopher E. Ondeck, Timothy C. Carson, and Kathleen M. Clair, of Crowell & Moring, LLP in drafting this paper. 1 See, e.g.,KATHERINE C. DEVILLE ET AL., USDA RURAL DEVELOPMENT, COOPERATIVE STATISTICS 2008, SERVICE REPORT 69, at 2-3 (Nov. 2009), available at http://www.rurdev.usda.gov/rbs/pub/CoopStats2008.pdf.

3 services, including export financing.2 Earnings derived from these activities are returned by cooperatives to their farmer-members on a patronage basis, thereby enhancing their overall farm income.3

America’s farmer cooperatives generate substantial benefits that strengthen the U.S. national economy. They provide jobs for over 200,000 Americans with a combined payroll of over $8 billion.4 Many of these jobs are in rural areas where employment opportunities are often limited.5 With farmer-controlled boards of directors, cooperatives “encourage democratic decision making processes, [and] leadership development,” and allow individual farmers the ability to own and lead organizations essential for continued competitiveness in both domestic and international markets.6

NCFC represents the interests of these farmer cooperatives and their members before

Congress, administrative agencies, and in courts where cases of importance may affect farmer cooperative interests. NCFC is the primary voice of the agricultural cooperative system and its farmer members concerning the importance of the Capper-Volstead Act and its application across a wide variety of American farming practices.

2 E.g., Randall E. Torgerson, USDA Rural Development, Introduction to JOHN R. DUNN ET AL., USDA RURAL BUSINESS-COOPERATIVE SERVICE,AGRICULTURAL COOPERATIVES IN THE 21ST CENTURY,COOPERATIVE INFORMATION REPORT 60, at v (Nov. 2002), available at http://www.rurdev.usda.gov/RBS/pub/cir-60.pdf; JAMES J. WADSWORTH, USDA RURAL DEVELOPMENT, STRATEGIC PLANNING SYSTEMS OF LARGE FARMER COOPERATIVES, RESEARCH REPORT 103, at iii (Aug. 1992) . 3 DONALD A. FREDERICK, USDA RURAL BUSINESS-COOPERATIVE DEVELOPMENT SERVICE, TAX TREATMENT OF COOPERATIVES, COOPERATIVE INFORMATION REPORT 23 (revised May 1995), available at http://www.rurdev.usda.gov/RBS/pub/cir23/cir23.pdf; see generally DONALD A. FREDERICK & GENE INGALSBE, USDA AGRICULTURAL COOPERATIVE SERVICE, WHAT ARE PATRONAGE REFUNDS?, COOPERATIVE INFORMATION REPORT 9 (Jan. 1985), available at http://www.rurdev.usda.gov/RBS/pub/cir9.pdf. 4 See National Council of Farmer Cooperatives, Cooperative Facts, http://www.ncfc.org/cooperative-facts.html (last visited Dec. 11, 2009); National Council of Farmer Cooperatives, About NCFC, http://www.ncfc.org/about- ncfc.html (last visited Dec. 11, 2009). 5 DEVILLE ET AL., supra note 1, at i (“Cooperatives were a major employer in rural areas.”). 6 Torgerson, supra note 2, at v.

4 As the recognized leader in the legal, regulatory, and policy issues of farmer cooperatives, NCFC provides the industry viewpoint on the issue of supply management, which is ubiquitous and necessary throughout the U.S. agricultural sector. NCFC speaks for the agricultural cooperatives and their farmer members to explain to government policymakers and enforcers, and all interested parties, the importance, practical uses, and necessity of supply management – and to set forth its understanding of the Capper-Volstead Act’s protection of supply management under applicable principles of statutory interpretation and case law precedent.7

III. Farmers Have Legitimate Needs To Engage In Supply Management

A. Individual farmers are forced to deal with large agribusinesses in supply, processing, and marketing

Individual farmers, acting independently, are too small and too numerous to deal effectively with larger agribusinesses in the supply, processing, and marketing sectors of agriculture. Standing alone, farmers lack bargaining power and are subject to the uncertainties inherent in farming when they make decisions as to the amount of supply to produce and the consequent necessary decisions about purchasing seed, fertilizer, and other inputs. This is as true today as it was when the Act was passed in 1922.

These conditions apply throughout the entire farming process, from pre-planting, through harvest, to sale and delivery. At each of these stages, individual farmers face harsh economic and industry realities. Consequently, beginning in the late 19th and early 20th centuries, farmers

7 The views expressed herein are those solely of NCFC and not necessarily the views of each member. In addition, this paper does not create any legally enforceable obligations or duties for the members of NCFC. NCFC also does not purport to modify or change any legal, regulatory, or professional requirements of any company or individual by the positions set forth herein. The adoption or use of the positions set forth in this paper by any specific company or person is dependent on an assessment of their own specific facts and circumstances, and companies and individuals should interpret and apply NCFC’s positions accordingly. Lastly, this paper is not a commentary on the past, present, or future operations of any member of NCFC; and the application of the positions herein to NCFC members necessarily varies, and is appropriate only when taking their different factual and legal circumstances into account.

5 joined forces in the United States to form cooperative associations to work collectively in their farming endeavors.

Congress enacted the Capper-Volstead Act in 1922 to foster the development of these farmer cooperatives in recognition of the exposed position of individual farmers and their need to be able to act collectively in dealing with suppliers and purchasers that had much greater bargaining power. Speaking in support of the bill, as first introduced in 1920, Representative

Alben Barkley (D-KY) emphasized individual farmers’ unequal bargaining power as compared to that of the firms that sold them supplies and purchased their output:

[I]t is economically impossible for any individual farmer to compete with the conditions under which he must live. When he buys from a merchant he buys at the merchant’s price, and he has no power to compel the merchant to reduce the price. When he buys agricultural machinery from implement houses he has no power as an individual to exercise a voice in determining the price he pays for it.

…

When he sells his product … he must sell it at a price dictated not by himself but by others who have had no part in its production. For that reason I favor the passage of laws that will enable him and encourage him to cooperate with others similarly situated….8

Upon the bill’s reintroduction the following year, Representative Ira Hersey (R-ME) championed the importance of farmer cooperation through cooperative associations. The bill, by allowing cooperation among farmers, “does away with the middleman, the speculator, and the importer,” and instead:

creates a civic force in large farming communities which protects the farmers, both for the present and for the future. They can thereby operate together in buying seed, fertilizer, farm machinery, and everything needed for the conduct of the farm. They can work and act together in marketing their products, both in the local and

8 59 CONG. REC. 8034 (1920).

6 in all markets of the world. The small farmer is assisted in his efforts to hold or market his crops.9

Courts as well have recognized the inherent and unique difficulties faced by farmers. In a

1929 Supreme Court opinion, Justice Sutherland noted that U.S. policy is to recognize the special needs of farmers: “It is settled that to provide specifically for peculiar needs of farmers or producers is a reasonable basis of classification.”10 And in a case reviewing the constitutionality of a Texas antitrust law, Justice Frankfurter acknowledged that:

These “threats” included then, as now, the inequality of bargaining power described above. In finding that Kentucky cooperative marketing statutes promoted the common interest,

Justice McReynolds cited the lower court’s finding that the statutes were enacted because producers were “at the mercy of speculators and others.”12

These manufacturers, processors, buyers, and other third-parties from whom farmers must buy and to whom they must sell have grown increasingly concentrated and integrated up to the present day. The USDA has described the squeeze this concentration puts on farmers and their cooperatives:

9 61 CONG. REC. 1043 (1921). 10 Frost v. Corp. Comm’n, 278 U.S. 515, 535 (1929). 11 Tigner v. Texas, 310 U.S. 141, 145 (1940). 12 Liberty Warehouse Co. v. Burley Tobacco Growers’ Coop. Mktg. Ass’n, 276 U.S. 71, 93 (1928).

7 market muscle by imposing coordination mechanisms that demand strict discipline and conformity from suppliers. Food processors exert greater control over distribution channels by integrating back into the production of raw materials through a variety of ownership and contractual arrangements. Such arrangements rob producers of decision-making authority and market choices.13

Indeed, one major, concentrated segment of farmers’ buyer base has developed since 1922: the national or regional grocery store chain. When Capper-Volstead was enacted, the paradigm for retail grocery sales was the neighborhood store. To a large and increasing extent, however, the grocery industry is concentrated into powerful chains that exert enormous buying power. For example, the top eight retailers in the grocery sales rankings account for over 40 percent of total sales.14 The USDA has taken note of this trend:

Consolidation among U.S. retail food marketers is continuous. It is augmented by the entry of foreign firms into the U.S. market through aggressive acquisition strategies . . . Retailers are positioned to dictate product requirements, prices, and other terms of trade to suppliers. Purchasing is centralized for logistical and pecuniary leverage as retailers seek to purchase as many products as possible from the fewest number of suppliers. Moreover, suppliers must be substantial enough to carry not only a nationwide presence, but also global networks of stores. As traditional supermarkets expand in size and scope, volume discounters and warehouse clubs are entering food retailing and becoming dominant market participants.15

Accordingly, a recent USDA-published economic study of several produce products concluded that the evidence shows that retail grocery chains “are often able to exercise oligopsony power in procuring fresh produce commodities.”16 For example, in the purchase of

13 DUNN ET. AL., supra note 2, at 4; see also, e.g., J. MICHAEL HARRIS ET AL., THE U.S. FOOD MARKETING SYSTEM, 2002, USDA AGRICULTURAL ECONOMIC REPORT NO. 811 at 2, 6, 15, 17-19, 26-28, 32-33 (June 2002), available at http://www.ers.usda.gov/publications/aer811/aer811.pdf. 14 DUNN ET. AL., supra note 2, at 6. 15 Id. 16 RICHARD SEXTON, MINGXIA ZHANG, & JAMES CHALFANT, USDA ECONOMIC RESEARCH SERVICE, GROCERY RETAILER BEHAVIOR IN THE PROCUREMENTAND SALE OF PERISHABLE FRESH PRODUCE COMMODITIES,

8 iceberg lettuce, “retailers were able to capture the lion’s share (about 80 percent) of the market surplus, whereas under competitive procurement, the entire surplus would go to producers.”17 In contrast, producers of Florida mature-green tomatoes were able to retain more of the market surplus through collective action.18 This achievement “demonstrates the potential benefits to producers through the coordinated behavior allowed them under the law.”19 This well-illustrates one of the key benefits for farmers from the Capper-Volstead Act: the ability to gain competitive strength by acting jointly.

Farmers also face concentrations of power when they turn to purchase their supplies from fertilizer, equipment, agrochemical, and seed companies. “As buyers of inputs and ingredients, cooperatives feel the cost-price squeeze. They, like their members, face fewer, larger suppliers.”20 Indeed, a mere thirteen firms account for over half of fertilizer products sold worldwide, with the top five suppliers controlling 30 percent of the global market.21 As of 2007, the top six manufacturers of farm equipment, including Deere & Company, CNH, Agco, and others, controlled 41.2 percent of worldwide market share, and there is little price competition in the industry.22 The top ten producers of agrochemicals such as pesticides, herbicides, and fungicides – including Bayer, Syngenta, BASF, Dow, and Monsanto – control 89 percent of the

CONTRACTORS AND COOPERATORS REPORT NO. 2, at 45 (2003), available at http://ddr.nal.usda.gov/dspace/bitstream/10113/32806/1/CAT30930093.pdf. 17 Id. 18 Id. 19 Id. 20 DUNN ET AL., supra note 2, at 7. 21 See Kyösti Arovuori & Hanna Karikallio, Consumption Patterns and Competition in the World Fertilizer Markets 12-13 (paper presented at the Nineteenth Symposium of the International Food & Agribusiness Management Association, June 20-21, 2009, Budapest, Hungary), available at http://www.ifama.org/library.asp?collection=2009_budapest&volume=symposium/1035_paper.pdf. 22 THE FREEDONIA GROUP, WORLD AGRICULTURAL EQUIPMENT TO 2012, at 180-83 (2008); First Research, Farm Equipment Manufacture, available at http://premium.hoovers.com/subscribe/ind/fr/profile/basic.xhtml?ID=203 (last visited Dec. 11, 2009).

9 global agrochemical market, with the top six companies controlling 75 percent of the market.23

The world’s largest agrochemical manufacturers, the “gene giants,” also dominate the seed industry, where the top ten companies control half the world’s commercial seed sales.24 The seed industry is characterized by “fairly high” barriers to entry and increasing concentration not only in the firms themselves, but also in the ownership and control of seeds’ genetic material and the processes through which plant breeding is performed.25 Commentators who have studied the concentration in the market for agricultural supplies have expressly noted that as a result of this concentration, farmers need the ability to plan on a collective basis, through their Capper-

Volstead cooperatives, as a solution to improve their bargaining positions.26

Moreover, cooperatives face large-scale concentration and integration not only on the part of the businesses that buy farmers’ products and sell them supplies, but even among their direct competition at the producer level. Investor-owned firms are increasingly integrating vertically, operating at the levels of initial production (what farmers do), processing and marketing (what many farmer cooperatives do), and distribution and retailing (what much of farmers’ usual customer base does). A USDA study concludes:

23 ETC Group, Who Owns Nature? Corporate Power and the Final Frontier in the Commodification of Life, COMMUNIQUÉ, Nov. 2008, available at http://www.etcgroup.org/upload/publication/707/01/etc_won_report_final_color.pdf. 24 ETC Group, Global Seed Industry Concentration - 2005, COMMUNIQUÉ, Sept./Oct. 2005, available at http://www.etcgroup.org/upload/publication/48/01/seedmasterfin2005.pdf. 25 Neil E. Harl, The Age of Contract Agriculture: Consequences of Concentration in Input Supply, 18 J. OF AGRIBUSINESS (SPECIAL ISSUE) 115, 116, 118-20 (2000), available at http://www.jab.uga.edu/Library/M00-10.pdf. 26 See, e.g., id. at 123-25.

10 other coordination mechanisms that give them greater control of variables affecting profitability. It also results in thinner markets where the disparity in bargaining power among the parties becomes even more pronounced.27

The conditions that applied at the time of the Act’s passage thus apply equally today.

Individual farmers face large concentrations of power from their suppliers, from their corporate- farming competitors, and from their customers. The level of concentration at each of these levels is growing more acute. What is more, the unequal bargaining power that farmers face, and which motivated the Capper-Volstead Act, is not limited to “small” farmers. Larger farmers face the same conditions, and across the board, farmers are price takers.28 Even at the time the Act was drafted, large cooperatives existed, and legislators’ discussions reveal that they intended the benefits of the Act for these large cooperatives just as they did for small ones.29 Hence, the strength of the policy rationales set forth by Congress in 1922 has not diminished. If anything, farmers and their cooperatives need the Act more today than ever. And one of farmers’ greatest needs under the Act is to engage in advance planning through their cooperatives for how much they will produce.

B. Advance planning is even more important for farmers than for most businesses

In farming, as in all businesses, one of the centrally important decisions is: how much should the business produce? If the farmers in a cooperative produce too little, they can miss opportunities to fulfill market demands and thereby fall short of the returns they need to survive

27 DUNN ET AL., supra note 2, at 5. 28 See DENNIS W. CARLTON & JEFFREY M. PERLOFF, MODERN INDUSTRIAL ORGANIZATION 69 (4th ed. 2005); see also Letter from Keith Collins, Chief Economist, USDA, to Deborah A. Garza, Antitrust Modernization Commission, at 6 (July 15, 2005), available at http://govinfo.library.unt.edu/amc/public_studies_fr28902/immunities_exemptions_pdf/050715_Collins_USDA.pdf (“as ever growing processors and retailers increase their food marketing power, the market strength of even the largest farmers continues to pale in comparison to that of the firms buying agricultural products”). 29 62 CONG. REC. 2157 (1922) (statement of Sen. Thomas Walsh); 59 CONG. REC. 8024-25 (1920) (statement of Rep. Hugh S. Hersman); 60 CONG. REC. 313 (1920) (debate of Sens. William King and Porter McCumber).

11 another season. Producing too much can be worse; overproduction wastes the investment in raw materials, such as seed and fertilizer, and in the labor and equipment used for growing and harvesting. In addition, the acreage involved is neither put to its optimum use, such as growing a different product more in demand, nor used for competing purposes such as conservation and environmental preservation. Thus, as with any business or corporation that produces a product, the farmers in a cooperative frequently need to make decisions about how much to produce.

This is a reality that the drafters of the Capper-Volstead Act acknowledged when they permitted farmers in a cooperative to act as if they were a single corporation or business, and it is the reality of how cooperatives have operated up to the present day.

Farmers, moreover, have an even greater need than other businesses to engage in joint advance planning for their production. The immutable characteristics of farming – substantial initial investment made by farming families and small businesses, the unique caprices of weather, unequal bargaining power, inelastic demand – necessitate a cooperative approach to planning production levels. Many of these conditions are specific to farming, and they lie behind the rationale for the Capper-Volstead Act:

1) Farmers must make production decisions long before actual demand for the product is known;

2) Once production decisions are made, they cannot be easily or quickly changed;

3) Many farmers negotiate their purchases of seed, fertilizer, and equipment collectively through their cooperatives, and thus need to engage in advance planning on production levels;

4) Weather, disease, insects, and other conditions may impact farming plans;

5) Due to the perishable nature of most farming products, farmers have few opportunities to delay selling;

6) Capital investments cannot be easily transferred to alternative production choices; and

12 7) Thousands of small-scale farm firms sell to and buy from only a few large-scale, non-farm firms, resulting in inequality in bargaining power.30

As the USDA has recognized, these conditions – almost all relating to the management of supply

– make it “difficult for producers to consistently market their production on a profitable basis”31 without joint action through their cooperatives. Farmer cooperatives are the primary instrument for raising farm income and improving farmers’ well-being by correcting or alleviating these structural imbalances – the same imbalances that impelled the passage of the Act and continue to justify the protections it affords cooperatives.

In addition to these difficulties inherent in agriculture, farmer cooperatives themselves face practical constraints that place them in a more challenging situation than non-farmer owned businesses. Agricultural cooperatives are grower-owned and consist of a limited number of grower-investors. Cooperatives typically do not seek capital from outside investors and their ability to raise additional capital from their grower-members is limited, due to what one cooperative expert has identified as the “portfolio and horizon problems”:

The portfolio problem arises because producer-members are required to invest capital in an industry in which they already have significant investment in production capacity. The horizon problem occurs because, traditionally, cooperatives’ residual earnings are contractually tied to their producer-members’ current transactions, rather than to their investment. Since members are unable to recognize appreciation in their equity investment, they exert pressure on their cooperative to maximize current returns rather than investing for higher future returns.32

Such practical limitations on access to capital pose a major impediment to the activities of most agricultural cooperatives, and make it difficult for cooperatives to expand and to bargain on an

30 See also Letter from Keith Collins, supra note 28, at 2-3. 31 Id. at 3. 32 Shermain Hardesty, Positioning California’s Agricultural Cooperatives for the Future,AGRICULTURAL AND RESOURCE ECONOMICS UPDATE, Jan./Feb. 2005, available at http://www.agecon.ucdavis.edu/extension/update/articles/v8n3_4.pdf.

13 equal footing. This is particularly acute for advance planning by cooperatives that requires substantial capital investment or commitment of resources, such as planning for operating and expansion expenses, environmental compliance, expansion into the global market, or corporate governance and accountability. In these matters, cooperatives’ need to engage in advance planning with their members about production levels is greater than for non-cooperative businesses.

Thus, without the ability to determine their own production levels through their cooperatives, farmers cannot engage in effective advance planning, are at a competitive disadvantage, and have almost no bargaining power for their purchases and sales. Moreover, the gains from coordination and advance planning that the cooperative model allows “can be accomplished only with some decrease in the scope of decision making by the member.”33 In other words, for most farmers, a “go-it-alone” strategy simply is not an option for survival.

C. Supply management is a response to consumer demand

The primary means by which farmers respond to changing consumer demands is by determining what products to produce, and at what quality and volume. And for farmers who sell their products through a cooperative, the need to jointly discuss and agree on their production levels is an absolute requirement for addressing changes in consumer demand. When consumer demand for a specific product increases because, for example, a new product has been developed through breeding, horticulture, technology, or otherwise, farmers need the ability to engage in collective planning as to the amount to produce. Without this ability, some new products and technologies would never be implemented, or would be implemented at a slower pace, thus risking loss of a new market to competitors outside the United States. A single farmer

33 Lee F. Schrader, Economic Justification, in COOPERATIVES IN AGRICULTURE 121, 129 (David Cobia, ed., 1989).

14 typically cannot spearhead the implementation of a new technology or new product to respond to consumer demand; the risk is too great, and the scale too small.

Instead, farmers need the ability to make collective decisions to undertake such new production, both so that the investment in new processing and handling can occur, and so that increases in the underlying product can be planned in advance. These are the new products and technologies that keep U.S. agriculture on the cutting edge of competition and that respond to consumer demand, and they are generated specifically from the U.S. agricultural cooperative sector. Without the ability – afforded by the Capper-Volstead Act – to engage in advance planning as to production levels through their cooperatives, solo farmers cannot bear the risk of making the investments necessary to grow the products in question, to buy and develop the related processing requirements, and undertake the other labors involved in bringing a new product to market.

But joint advance planning is required not only for increases in demand and production.

Advance planning is required as well by decreases in consumer demand. As consumer preferences change over time, farmers must be nimble in response.34 But farmers cannot respond effectively if they are prohibited from agreeing with each other to reduce their production.

Instead, preventing farmers from managing their supply, in instances of decreasing demand, often will result in wasteful over-production and production of the wrong items for the demands of the market. Wreaking such harm on farmers and on the U.S. economy was not the intent of

34 Gary D. Thompson, Retail Demand for Greenhouse Tomatoes: Differentiated Fresh Produce 2-3 (paper presented at the American Agricultural Economics Association Annual Meeting, Montreal, Canada, July 27-30, 2003) (“Understanding retail demand for differentiated food products is important because substantial investments in research and development, production capacity, and marketing are necessary for making such products available at retail . . . . Without an understanding of the nature of retail demand for differentiated types of fresh tomatoes, . . . sizable investments in product development, production, and marketing may not yield future profits.”) (emphasis added).

15 the Act, nor has it been how Congress, courts, and cooperatives themselves have interpreted the

Act over the past eighty-seven years.

D. Basic economics dictate that cooperatives should engage in supply management

Basic economics dictate that cooperatives and their members should produce their products in the most efficient manner, using the fewest resources and generating the least waste.

If farmers were not permitted to engage in advance planning jointly through their cooperatives, instances of over- or under-production would result. Indeed, it might be said that prohibiting supply management encourages wasteful overproduction. Such a policy, however, would greatly harm the U.S. cooperative agriculture sector.

Overproduction has two layers of negative economic consequences. First, it adds to direct cost in the form of wasted resources. All the seed, fertilizer, chemicals, equipment, labor, and capital used to produce the surplus crop are wasted. Those costs must then be included in the cost of the products that actually are consumed, resulting in higher prices for the food products in question and harming all U.S. consumers. Alternatively, the direct cost is absorbed by farmers, thus defeating the purpose of the Capper-Volstead Act, which seeks to provide farmers with greater returns in order to ensure the continued survival and vibrancy of the cooperative farming sector.

A second negative result of overproduction – with perhaps even more far-reaching consequences – is opportunity cost, that is, the indirect costs resulting from loss of the benefits that wasted resources otherwise would have generated. When land, labor, and supplies are used for one crop (which is overproduced), they are not then used to produce other crops that society actually demands. When the U.S. economy loses the opportunity to produce these other products that are in greater demand, the result can be shortages or price spikes for those products, or

16 worse, loss of those markets to foreign competition. In short, if farmers are denied the ability under Capper-Volstead to engage in joint planning for production levels and thereby to attempt to avoid overproduction, they are unable to employ their resources in the best alternative uses.

E. Supply management permits acreage and other assets to be put to the optimum uses, which include conservation purposes

Overproduction that prevents acreage and assets from being put to the best uses not only prevents farmers from efficiently producing the most needed and profitable crops; it also prevents them from putting land to alternative purposes that would have positive externalities.

These alternative purposes include permitting land to lie fallow; planting it with holding materials or cover crops; implementing rotational grazing; or engaging in other management practices that limit runoff of nitrogen, phosphorus, and sediment pollution for purposes of soil conservation, water quality, and regeneration.35 The inability to engage in supply management and advance planning also prevents correct determinations being made as to when conservation purposes are the optimal use for land and assets. If farmers cannot engage in joint advance planning with their cooperatives, the resulting overproduction will mean land that should have either temporarily or permanently served as a conservation or environmental resource will not do so.

Worse, the overproduction itself may carry direct negative consequences. Farmers today often must pay to have surplus products and unused husks, stalks, leaves, rinds, and other remainders of agricultural production hauled away. In some instances, the only option is to landfill these remainders. Preventing farmers from controlling surpluses can only add to this waste. Clearly, it defies common sense to intentionally adopt a policy that prevents farmers from

35 See, e.g.,CHESAPEAKE BAY FOUNDATION, A GUIDE TO PRESERVING AGRICULTURAL LANDS IN THE CHESAPEAKE BAY REGION: KEEPING STEWARDS ON THE LAND 3-4 (2006), available at http://www.cbf.org/Document.Doc?id=138

17 controlling such surpluses, and instead to foster the growing of unnecessary products that will create further landfill burdens in the United States. Preventing farmers from engaging in collective planning as to the amount of their own product to produce thus would have a wide array of food supply, economic, and societal harms.

F. Cooperatives currently engage in many forms of supply management

Cooperatives currently engage in a wide variety of supply management activities. These practices are necessary to the continuing operations and viability of their members, as illustrated by the following examples of practices in use today:

In one program, a cooperative agrees with its farmer-members on the amount and quality they will produce prior to the planting season. The cooperative then accepts product only from contracted acres based on agreed-to quality standards. The cooperative and its members thereby agree in advance on the amount of acreage that will be deployed to grow the crop. This cooperative also has stabilized supply through improved horticultural practices.

A second cooperative manages supply by entering into agreements with its farmer- members on production levels prior to the growing season in which each member is issued a limited number of preferred shares. Each preferred share confers the right to deliver one acre, subject to a planting tolerance determined by the Board of Directors. Prior to planting, the cooperative will inform members of the planting range based on production capacity and government-imposed marketing allocations. If the crop is anticipated to be too large, the board will establish “at risk” acreage, and then later determine whether members can deliver the “at risk” amount. If not, members leave the product in the ground in order to avoid costs of harvesting, disposal, and related environmental costs.

(last visited Dec. 11, 2009); Chesapeake Bay Foundation, Agriculture, available at http://www.cbf.org/Page.aspx?pid=506 (last visited Dec. 11, 2009).

18 A third cooperative has instituted a fruit tree-pull program with the support of the USDA.

Members are paid to remove acreage and thereby reduce production. In the year before the program began, USDA spent tens of millions of dollars to purchase surplus product. In contrast, to support the supply management program, the USDA was able to make a much smaller payment, paid only once, and has brought its payments to purchase surplus to zero.

A fourth cooperative agrees in advance with its members to identify the acreage that each member is permitted to deliver to the cooperative. The member agrees to bring all product from acreage identified in the agreement, and the Board of Directors approves any new acreage, subject to a priority list. Members may deliver product from other acres, but will receive the spot market price and will not share in the cooperative’s profits on those deliveries.

In a fifth example, another cooperative engages in a herd retirement program to reduce the production assets of its members and thereby manage the levels of supply produced. The cooperative funds a pool for the program by charging members ten cents per hundredweight to participate. The program raises $120 million annually to fund herd reductions and buyouts, and has completed eight herd retirements since it began in 2003, removing a total of 451,000 animals that produced over 8.6 billion pounds of product.

A sixth cooperative and its members agree to regional base plans which determine the amount each member-producer in the region may produce, subject to penalties for overproduction. The cooperative and its members thus enter into agreements regarding production levels prior to the members investing resources and engaging in surplus production.

As a seventh example, one cooperative manages supply by determining a target price for its members’ products and then establishing a volume of production that would satisfy customer demand at that price. The cooperative then informs members of their allocations of volume to

19 produce according to a pro rata formula using their prior volumes on a pre-established base year.

As such, the cooperative agrees with its members prior to planting on the volumes of the crop that will be produced and seeks to avoid over-production. If the members produce beyond that level, the cooperative encourages them to discard or destroy the surplus product.

An eighth cooperative similarly manages supply by establishing a target price and calculating an associated production volume for members. In this program, if the market price drops below the target price, the cooperative and its members agree to a “trigger” mechanism whereby the members withhold production until and unless the price climbs back above the trigger price.

As the above examples illustrate, the historic and current operations of agricultural cooperatives in the United States include myriad supply management techniques. Any change in the application or interpretation of the Capper-Volstead Act would impact activities and planning throughout the agriculture sector, and could disrupt and lessen the competitiveness of a significant portion of the U.S. farming economy.

G. It would be inefficient to permit farmers to manage supply only after, but not before, a crop is grown

It has been suggested that the Capper-Volstead exemption could be artificially dissected, so as to permit management of supply by farmers after the product has been produced, but not permit such management prior to production. In practice, this means that farmers would be permitted to destroy crops already grown, instead of planning in advance to limit the amount of production. As discussed in the sections below, there is no basis in the statute, legislative history, or case law for such an artificial distinction.36 But even more important, such a

36 See infra Section IV.

20 distinction would be both illogical and harmful to the efficient functioning of the U.S. agricultural sector.

Congress enacted the Capper-Volstead Act to enable cooperatives to operate as efficiently as any corporate entity or business. No other business is limited in its ability to engage in advance planning and determine the amount to produce. As discussed above, forcing farmers to first grow their products, but then destroy them in the field or after they are produced is both uneconomic and unfair. This position encourages the unnecessary expenditures associated with producing the surplus product. It forces the farmers to go through the effort and process of creating a crop, only to then permit them to lift the curtain and communicate with one another to determine how much of their production is surplus, so they can then destroy the fruits of their labors. This artificial distinction violates a fundamental principle of economics –

“productive efficiency”: the principle that the production of goods should be done in the most cost-effective manner using the fewest resources. Last, the examples above in which production plans are linked to price demonstrate that this position also would contravene farmers’ right to set prices through their cooperatives – a right which is beyond dispute. Thus, such a position both runs counter to economic theory and offends principles of basic fairness. This position also contravenes the legislative purposes and case law interpretations of the Capper-Volstead Act.

IV. The Capper-Volstead Act Immunizes Cooperative Supply Management

A. Section 6 of the Clayton Act created the basic antitrust exemption for collective action by producers for the production and sale of agricultural products

While the Capper-Volstead Act is perhaps the most often cited source of statutory antitrust exemption for agricultural cooperatives, the Act itself is an outgrowth of the basic

21 exemption provided eight years earlier in Section 6 of the Clayton Act.37 Section 6 of the

Clayton Act, in the same breath, provides parallel exemptions for the existence, operation, and legitimate objects of “labor” – as well as – “agricultural, [and] horticultural organizations.”38 As such, the interpretation of the statutory agricultural cooperative exemption should be informed by the scope of the statutory labor exemption, created in the same statutory framework.

The statutory labor exemption created by the Clayton Act allows union members to act collectively with regard to the prices they charge (wages) and the amount of labor they supply, including agreements to limit output through peaceful strikes.39 The strike is a form of supply management in which a union agrees with its members to control – specifically, to limit – their supply of labor. Both practice and precedent make clear that the Clayton Act authorizes such supply management by labor – though neither “management of supply” nor “control of supply” is mentioned in that Act. Farmers stand in the same position as union members. Under the

Clayton Act, both may lawfully seek to manage or limit their output and production.

B. The Capper-Volstead Act clarified and expanded the scope of legal cooperative activity

Congress passed the Capper-Volstead Act to clarify and expand the limited immunity from the antitrust laws provided to farmers in the Clayton Act. Prior to those statutes, courts had held that the very nature of cooperatives violated the antitrust laws. Joint action by farmers was

37 Nat’l Broiler Mktg. Ass’n v. United States, 436 U.S. 816, 824 (1978); Md. & Va. Milk Producers Ass’n v. United States, 362 U.S. 458 (1960). 38 15 U.S.C. § 17. 39 See Burlington N. R.R. Co. v. Bhd. of Maint. of Way Employees, 481 U.S. 429, 438 (1987) (“The language of the Clayton Act was broad enough to encompass all peaceful strike activity . . . .”); United States v. Hutcheson, 312 U.S. 219, 233 (1941) (recognizing that the Clayton Act “plainly” allows strikes); see also DONALD A. FREDERICK, USDA RURAL BUSINESS-COOPERATIVE SERVICE,ANTITRUST STATUS OF FARMER COOPERATIVES: THE STORY OF THE CAPPER-VOLSTEAD ACT, COOPERATIVE INFORMATION REPORT 59, at 75 (Sept. 2002), available at http://www.rurdev.usda.gov/RBS/pub/cir59.pdf (“After Loewe v. Lawlor [208 U.S. 274 (1908) (applying Sherman Act to a labor union’s activities)] there was a widespread demand for an end to the threat of prosecution as unlawful combinations in restraint of trade that hung over labor and farm organizations. Section 6 of the Clayton Act is the result.”).

22 held to be a conspiracy to restrain trade and, along with labor unions, cooperatives were challenged under the Sherman Act as illegal conspiracies.40 Consequently, Congress first enacted Section 6 of the Clayton Act, which exempted agricultural organizations from certain antitrust laws if they were established for mutual help, did not have capital stock, and were not operated on a for-profit basis.41 But Section 6 did not specify the types of activities in which a cooperative could engage, nor did it apply to cooperatives organized on a stock basis. The shortcomings of the Clayton Act led to the passage of the Capper-Volstead Act in 1922.42

Section 1 of the Capper-Volstead Act, 7 U.S.C. § 291, provides as follows:

Persons engaged in the production of agricultural products as farmers, planters, ranchmen, dairymen, nut or fruit growers may act together in associations, corporate or otherwise, with or without capital stock, in collectively processing, preparing for market, handling, and marketing in interstate and foreign commerce, such products of persons so engaged. Such associations may have marketing agencies in common; and such associations and their members may make the necessary contracts and agreements to effect such purposes: Provided, however, That such associations are operated for the mutual benefit of the members thereof, as such producers, and conform to one or both of the following requirements:

First. That no member of the associations is allowed more than one vote because of the amount of stock or membership capital he may own therein, or,

Second. That the association does not pay dividends on stock or membership capital in excess of 8 per centum per annum.

And in any case to the following:

Third. That the association shall not deal in the products of nonmembers to an amount greater in value than such as are handled by it for members.

Congress enacted the Capper-Volstead Act in recognition of the problems faced by individual farmers, recognizing that as a segment of the American economy individual farmers

40 15 U.S.C. § 1; see, e.g., United States v. King, 250 F. 908 (D. Mass. 1916); Loewe, 208 U.S. at 301 (holding union’s activity to be a combination in restraint of trade in violation of the Sherman Act, in part because of the failure of legislative efforts to exempt “organizations of farmers and laborers” from the Sherman Act, thus signaling an understanding of agricultural cooperatives as subject to the Sherman Act’s prohibitions) (emphasis added). 41 15 U.S.C. § 17.

23 lack bargaining power and are exposed, often cruelly, to the vagaries of weather and other production conditions. The Act permits farmers to join together and make decisions concerning the production and sale of their products as if they were a single corporation or enterprise, without fear of prosecution as a conspiracy under the antitrust laws. This is the key function of the Act – to permit farmers to “act together in associations.”43

The Act is not merely a joint-selling law; it speaks broadly of “the production of agricultural products.”44 In addition, the Act contains language that covers the gamut of farming activities, including “collectively processing, preparing for market, handling, and marketing in interstate and foreign commerce, such products of persons so engaged.” Courts that have interpreted this language have noted that Congress’s intent was to speak broadly and to cover the entire scope of growing and selling agricultural products.45

Any re-interpretation of the Act so as to prohibit farmers from engaging in advance planning through their cooperatives on a joint basis would run directly counter to the specific grant of authority the Act provides. Determining how much to produce is a component of

“preparing [products] for market.” The Act also authorizes farmers to make joint decisions to

“handl[e]” product; that right also encompasses the right to determine how much they will handle. Last, and most important, the Act specifically grants farmers the joint right of

“marketing [their products] in interstate and foreign commerce.” Under principles of common sense, industry practice, and basic economic theory, the right to market includes the right to determine how much to market, and in fact, to determine whether to produce anything at all for such marketing.

42 See Case-Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967). 43 7 U.S.C. § 291. 44 Id.

24 C. Congress intentionally used broad language

Congress cast the protection provided to agricultural cooperatives in the broadest terms when it immunized collective “processing, preparing for market, handling, and marketing” agricultural products.46 This language encompasses the whole scope of farming activity, from pre-planting, through harvest and processing, to sale. Congress did not intend to narrowly limit the Act to specific farming activities, and then exclude all the rest in a form of legislative

“gotcha.”

For example, the Capper-Volstead nowhere includes the word “price.” Yet all authorities agree that the Act authorizes farmers to engage in joint pricing through their cooperatives. How so, if the word “price” is not used in the Act, and the statute does not specifically enumerate a right to engage even in joint sales or joint selling? The answer lies in the design of the Act – courts have stated that the broad sweep of activity described by “processing, preparing for market, handling, and marketing” includes joint pricing – the situation is similar for supply management.47 The Act covers the joint functions necessary for a cooperative on behalf of its members in their farming activities – and includes agreements by them on the amount of product to produce.

45 See infra Section IV.E. 46 7 U.S.C. § 291. 47 See, e.g., Treasure Valley Potato Bargaining Ass’n. v. Ore-Ida Foods, Inc., 497 F.2d 203 (9th Cir. 1974), cert. denied, 419 U.S. 999 (1974) (internal citations omitted); see also United States v. Dairymen, Inc., 660 F.2d 192, 194 (6th Cir. 1981) (extending Capper-Volstead immunity to pricing even though the Act does not explicitly reference prices) (citing, e.g., N. Cal. Supermarkets v. Cent. Cal. Lettuce Producers Coop., 413 F. Supp. 984, 992 (N.D. Cal. 1976)) (“[E]ven if [the cooperative] engaged in no other collective marketing activities, mere price-fixing is clearly within the ambit of the statutory protection. It would be ironic and anomalous to expose producers, who meet in a cooperative to set prices, to antitrust liability, knowing full well that if the same producers engage in even more anticompetitive practices, such as collective marketing or bargaining, they would clearly be entitled to an exemption.”), aff’d per curiam, 580 F.2d 369 (1978) (affirming “for the reasons stated by the trial judge”), cert. denied, 439 U.S. 1090 (1979).

25 D. The Capper-Volstead Act’s legislative history reveals an intent to immunize supply management

The legislative history for the Capper-Volstead Act is a key guide for interpreting the statute. The Supreme Court and lower courts often have cited to the statements of Congressional intent when interpreting and applying the Act, and it is well-established that courts consider the

Act’s legislative history when interpreting and applying the Act.48 That legislative history clearly indicates that Congress intended to provide farmers with the right to agree to set prices, and control, limit, and withhold production, i.e., to engage in supply management.

During the debates, several members of Congress explained that their intent was to put cooperatives on equal footing with corporations, and that this included the right to control their production. Senator Hitchcock pointed out that manufacturers could reduce production; however, the antitrust laws precluded farmers from joining together to respond in the same way, which necessitated the passage of the Capper-Volstead Act:

Not only that, but when there is a check in demand for the products which they are making, the [manufacturers] can reduce the production . . . discharge their men, cut down their forces, and run their factories upon what is called 25 to 30 percent capacity, and merely feed out to the market what it will consume at their prices. The farmer can not do that . . . . He is not in a position to do as a manufacturer does. He can not control his markets and he can not make his own prices, and he never ought to have been made subject to the provisions of the antitrust law.49

Senator Hitchcock stated that, as a consequence, farmers needed the protection of the Act.50

Senator Lenroot similarly stated that “from the standpoint of public benefit and public welfare alone, we are justified in enacting this legislation which will enable the farmers of this

48 See, e.g., Nat’l Broiler Mktg. Ass’n v. United States, 436 U.S. 816, 826-29 (1978) (looking to legislative history to interpret the Act); Case-Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967) (same); Md. & Va. Milk Producers Ass’n v. United States, 362 U.S. 458, 466-68 (1960) (same); Fairdale Farms, Inc. v. Yankee Milk, Inc., 635 F.2d 1037, 1043 (2d Cir. 1980) (same). 49 62 CONG. REC. 2262 (1922) (emphasis added).

26 country to put themselves somewhat nearer an equality of bargaining power and control of output in production that all other industries have today.”51 Senator Capper also confirmed that:

“The Capper-Volstead bill. . . was designed simply to give the growers or the farmers the same opportunity for successful organization and distribution of their products that the great corporations of America have enjoyed for many years.”52

Senator Capper’s unambiguous intent has been echoed and adopted by the Second Circuit

Court of Appeals:

As Senator Capper himself expressed it, when he successfully opposed Senator Walsh’s proposed amendment to Capper- Volstead that would have prohibited the creation of cooperative monopolies, see S. Rep. No. 236, 67th Cong., 1st Sess. (1921), “no association can efficiently operate that does not control and handle a substantial part of a given commodity in the locality where it operates.”53

As Senator Capper pointed out, prior to and without the exemption, farmers often were helpless – compelled to dump their product on a glutted or oversupplied market at prices below their cost of production with significant farmer attrition.54 Senator Kellogg also lamented farmers’ inability to join together so as to manage their production, explaining that there was no

“coordination, but each man proceeded to dump his stuff upon the railroads. Consequently the markets were glutted.”55

Congressional supporters of the Act agreed, and expressly stated that the Act was designed to remedy these supply-management issues. For example, Senator King noted that

50 Id. 51 Id. at 2225 (emphasis added). 52 Id. at 2058. 53 Fairdale Farms, 635 F.2d at 1043. 54 62 CONG. REC. 2058-59 (1922). 55 60 CONG. REC. 361 (1920).

27 “they shall not only be permitted to combine for the purpose of marketing their products, but for the purpose of holding them for an indefinite period in order to secure higher prices, even though such action might constitute a monopoly or restrain trade.”56 Senator Hitchcock seconded

Senator Capper and agreed with Senator King that a cooperative would be able to withhold and limit product from the market.57

Continuing in the same vein, Senator Lenroot stated during the debates:

If the farmers in the United States could, through cooperation, have some control and agreement as to production and as to prices, not for the purpose of making exorbitant profits, but so that they might at least secure back the cost of production, we would see in the United States immediately an upward turn toward prosperity.58

While some passages of the legislative history reference a goal to increase output in general or over the long term, the same passages also express a desire to allow farmers to make production “more uniform,” implying that production control is a goal of the Act.59 These statements in the legislative history that express hope the Act will result in increased production, moreover, must be read in context. First, such statements clearly acknowledge that the Act grants the right of supply management – with one possible result being increases in the food supply. Second, the Act was passed during a depression in the agricultural segment of the economy. At that time, low prices for agricultural products were causing farmers to leave their farms for the cities, and Congress feared that the decline in agricultural production could lead to food shortages.

56 Id. at 312 (emphasis added). 57 62 CONG. REC. 2277 (1922). 58 Id. at 2225 (emphasis added). 59 See 59 CONG. REC. 7852 (1920) (“prices will be stabilized, production will be more uniform and larger in the aggregate”).

28 The Act was intended therefore to provide farmers with the ability to generate greater returns by authorizing joint action that included advance planning on production, and in so doing to ensure reliable agricultural production for the future.60 That is in fact what has occurred. The food supply in the United States has been dependable since the Act’s passage, in part due to the ability granted to farmers to jointly plan for production increases and decreases, and for changes in consumer demand, economic conditions, technological innovation, and worldwide competition.

The legislative history of Congressional support for the cooperative model and its authorization of joint actions by farmers to control production levels did not end with the passage of the Act. Such support continues to the present day. As recently as 2006, the Senate reaffirmed its support for “the ability of farmers and ranchers in the United States to join together in cooperative self-help efforts.”61 It further noted that “farmer- and rancher-owned cooperatives also play an important role in providing consumers in the United States and abroad with a dependable supply of safe, affordable, high-quality food, fiber, and related products.”62

Congress thus recognized the important role that cooperatives serve in engaging in advance planning for agricultural supply. Such a statement would not have been made if Congressional policy had changed and now sought to disenfranchise farmers of the right to engage jointly in advance planning for their production levels.

E. Courts also have held that cooperatives can engage in supply management

All courts that have considered the Act’s treatment of supply management programs – including courts located in the Second, Eighth, Ninth, Tenth, and Eleventh Circuits, as well as

60 Id. 61 S. CON. RES. 119, 109th Cong. (2006).

29 the Federal Trade Commission – have ruled that farmers may enter into agreements through their cooperatives to control supply. The cases uniformly agree that supply management initiatives by farmers in cooperatives are limited only by the prohibitions against exclusionary and predatory conduct faced by any other single-entity actor under the antitrust laws. The specific circumstances and holdings of these cases are as follows:

1. Holly Sugar v. Goshen County Cooperative Beet Growers Ass’n: Cooperatives can engage in pre-season price setting and supply management programs for their members’ production, just like any other corporation

A cooperative confronted with excess capacity has the right to pursue the same business alternatives available to any corporate entity and reduce production or control supply in anticipation of and response to market conditions and demand.63 In Holly Sugar v. Goshen

County Cooperative Beet Growers Ass’n,64 members of a sugar beet cooperative entered into an agreement giving the cooperative exclusive control over marketing their crops. When the cooperative failed to reach a purchase agreement with the local sugar manufacturer, members of the cooperative voted to disallow members from contracting individually with the manufacturer, which had the effect of preventing farmers from planting sugar beets and thus reducing the supply of sugar beets in the market.65

The Tenth Circuit Court of Appeals held that such supply management was covered by the Capper-Volstead Act. Even prior to planting their crops, farmers are permitted to agree though their cooperative to manage supply. The court held that there was “no cause of action

62 Id. (emphasis added). 63 Holly Sugar v. Goshen County Coop. Beet Growers Ass’n, 725 F.2d 564, 569-70, 572 (10th Cir. 1984). 64 725 F.2d 564 (10th Cir. 1984). 65 Id. at 566. (“The negotiations have continued into the time when growers need to be and should be planting beets.”).

30 based on an antitrust violation by the association,” because this conduct did not fall outside the

“qualified exception … from the antitrust laws” created by the Capper-Volstead Act.66

2. The Dairy Cooperative Cases: Cooperatives can control, reduce, or withhold their members’ production

A line of cases in the dairy industry clearly demonstrates the judiciary’s familiarity with, and approval of, a host of supply management programs. These cases establish a cooperative’s right to control, reduce, or withhold production, as a means of facilitating lawful price fixing. In

Kinnett Dairies, Inc. v. Dairymen, Inc., fluid milk processors that bought raw milk from farmers complained that a cooperative’s program of “buying options” to keep surplus milk from entering the market violated the antitrust laws. The cooperative associations at issue in Kinnett Dairies also managed the day-to-day quality control of member milk producers, which can also impact supply.67 Moreover, the cooperatives shared market information in order to assist the coordination among members in managing their production.68

Directly relating lawful price fixing activity to supply management programs, the court upheld these activities under Capper-Volstead, explaining that the cooperatives may lawfully fix the price at which the milk will be sold, and in seeking to obtain the best price for the milk may exercise such market leverage as is afforded by managing the combined production of its members.69 The court went even further, noting that cooperative associations may manage the supply of their members’ products in the market through, for example, allocating certain territories or customers for the sale of certain members’ products.70

66 Id. at 569. 67 Kinnett Dairies, Inc. v. Dairymen, Inc., 512 F. Supp. 608, 613 (M.D. Ga. 1981), aff’d, 715 F.2d 520 (11th Cir. 1983). 68 Id. at 615. 69 Id. at 632. 70 Id.

31 In Alexander v. National Farmers Organization, the National Farmers Organization

(“NFO”) withheld milk deliveries from the market, including to another cooperative, Mid-

America Dairymen (“Mid-Am”), in order to effect more favorable contract terms for NFO and its members.71 Mid-Am complained that the activity had the sole purpose of eliminating NFO’s competitors, including Mid-Am.72 The trial court rejected Mid-Am’s claim, stating:

NFO’s sponsorship of a two-week milk withholding action was broad in scope and part of concerted demands for higher dairy prices. [N]o individual farmer’s decision to withhold milk was coerced by NFO or otherwise. When not directed at the elimination of competition, this type of activity, as a general matter, is within the scope of the Capper-Volstead exemption.73

The Eighth Circuit found the activity at issue to be nothing more than permissible supply management designed to obtain higher prices:

Capper-Volstead provides only limited immunity and co-ops have occasionally sought to extend their market power in ways not intended by Congress. Co-ops cannot, for example, conspire or combine with nonexempt entities to fix prices or control supply, even though such activities are lawful when engaged in by co-ops alone.74

Seven years later the Eighth Circuit again upheld a supply management program in

Ewald Bros., Inc. v. Mid-America Dairymen, Inc.75 There, a group of dairy cooperatives created a standby pool to provide its members with a reserve milk supply so they could meet demand during seasonal low periods. The cooperatives entered option agreements to purchase Grade A

71 Alexander v. Nat’l Farmers Org., 687 F.2d 1173, 1188 (8th Cir. 1982), cert. denied, 461 U.S. 937 (1983) “NFO encouraged dairy farmers who were NFO members to withhold their milk from the market and encouraged other dairy farmers to sign an NFO membership agreement and then withhold their milk from the market.” In re Midwest Milk Monopolization Litig., 510 F. Supp. 381, 394 (D.C. Mo. 1981). 72 Alexander, 687 F.2d at 1187. 73 Id. at 1188. 74 Id. at 1182 (citing United States v. Borden, 308 U.S. 188, 207-08 (1939)) (emphasis added). The court explained that the operation of the standby pool “served legitimate business purposes” and was important, at least in principle, to the stable supply of milk. Id. at 1206-07. 75 Ewald Bros., Inc. v. Mid-America Dairymen, Inc., 877 F.2d 1384 (8th Cir. 1989).

32 milk from members and non-members, and could thereafter exercise the options on short notice by paying the current minimum price of the Federal Milk Marketing Order.76 If the cooperatives did not exercise the option, then the milk would not be sold to handlers regulated by the Federal

Milk Marketing Order at issue. The plaintiff, a milk handler, complained that the option agreements illegally reduced the supply of, and raised the price of, Grade A milk.77

The Eighth Circuit held that the creation of the standby pool did not violate antitrust laws because there was no evidence that the cooperatives engaged in predatory practices or that the cooperatives formed the standby pool with any unlawful intent.78 Rather, the cooperatives formed the standby pool to stabilize supply, thereby stabilizing prices, during seasonal low periods.79 Moreover, milk’s perishable nature combined with the fact that “demand and supply cycles of milk are seasonal and do not correspond” supported the need for effective supply management,80 a concern faced by all of America’s farmers. Here, again, a court upheld the legality of management of supply and production by a cooperative and its members, as permitted and covered by the Capper-Volstead Act.

76 Id. at 1385-86. 77 Id. 78 Id. at 1392. (“the ‘overriding issue’ in determining the liability of . . . cooperatives under the antitrust laws ‘is one of tactics and intent’” (citing Alexander, 687 F.2d at 1206)). 79 Id. at 1394 (“while the options may have enhanced the cooperatives’ ability to set prices, the pool served the legitimate purpose of providing an adequate reserve supply to meet fluctuations in consumer demand for fluid milk”); see also Fairdale Farms, Inc. v. Yankee Milk, Inc., 715 F.2d 30, 31 (2d Cir. 1984) (holding that it is not predatory for an agricultural cooperative, acting alone, to cut off a portion of the supply of raw milk). 80 Ewald Bros., 877 F.2d at 1387-88.

33 3. Treasure Valley Potato Bargaining Ass’n v. Ore-Ida Foods, Inc.: Pre-season price setting and pre-season supply management are linked rights for cooperatives

In Treasure Valley, two associations of potato farmers fixed the price of pre-season contracts between their members and the potato processors.81 Individual farmer members of the associations were then prohibited from selling their potatoes under a pre-season contract unless the contract was approved by the association.82 The court held this pre-season price fixing to be

“marketing” within the meaning of the Act and therefore covered by its protection.83 While

Treasure Valley spoke directly to a cooperative’s right to fix the price of the product before the product is even planted, fixing prices and restricting supply are two sides of the same coin, and it would be incongruous to allow pre-season price fixing agreements, yet ban pre-season attempts to agree on volume.

In upholding the right of farmers to fix prices before the crop is planted, the court explained that the term “marketing” as used in the Capper-Volstead Act is far broader than the word “sell.”84 In particular, Treasure Valley recognized, as aspects of marketing, both

“standardizing” output and “supplying market information” – activities that normally constitute supply management programs within an industry.85 Moreover, the court recognized that producers and their associations may make the necessary contracts to carry out the legitimate objects of the producers and their associations.86 If a legitimate object of an association and its members is to fix prices, and one of the most effective ways to fix prices is to control supply,

81 Treasure Valley Potato Bargaining Ass’n v. Ore-Ida Foods, Inc., 497 F.2d 203, 206 (9th Cir. 1974), cert. denied, 419 U.S. 999 (1974). 82 Id. 83 Id. at 215. 84 Id. 85 Id. 86 Id. at 216 n.11.

34 then a contract between the association and its members to control supply in order to effectively fix prices must be protected under the Capper-Volstead Act.

In reaching its holding in Treasure Valley, the Ninth Circuit also pointed out that the exemption was buttressed by the Cooperative Marketing Act of 1926, which sanctions the dissemination among producers and cooperatives of prospective, past, present, crop, market, and statistical information to facilitate the collective handling and marketing of their products.87

While these activities would normally be suspect under a traditional antitrust analysis because of the strong likelihood that they would facilitate agreements regarding supply, the court’s discussion illustrates that Capper-Volstead and its companion legislation supports exactly this type of activity for producers of agricultural products.

4. State courts also have recognized the right to engage in supply management

In United Dairymen of Arizona v. Schugg,88 cooperative members argued that the cooperative’s “dumping” policy was anti-competitive.89 The cooperative marketing agreement provided that the cooperative would market all Grade A milk produced by its members, and would use its “best efforts” to market the milk to the best advantage of its members.90 Part of the cooperative’s strategy was to set minimum prices above the federal market order price.91 When the cooperative’s two largest customers refused to pay the higher prices, certain cooperative members, including the Shuggs, agreed not to sell them milk.92 As in Treasure Valley, the

87 Id. at 214, 216. 88 128 P.3d 756 (Ariz. Ct. App. 2006). 89 Id. at 764. 90 Id. at 762. 91 Id. 92 Id.

35 Arizona Supreme Court explained that the term “market” is broader than the term “sell.”93 In fact, the cooperative’s

contractual duty to “market” milk reasonably includes taking actions to protect its long-term ability to sell at prices beneficial to its members. UDA attempted to obtain long-term contracts and premiums from its primary customers by limiting the supply of milk from its members and from members of other cooperatives. In doing so, it was exercising its authority to “market” in a manner it deemed to be to the best advantage of its members.94

Thus, the cooperative’s “‘dumping’ policy was [not] part of an illegal anti-competitive scheme to limit milk supply in violation of federal and state antitrust laws.”95 Instead, it was part of the right to manage supply covered by the Capper-Volstead Act.

5. Government enforcement agencies have taken the position that farmers can legally agree to manage supply

Both the United States Department of Justice (“DOJ”)96 and the Federal Trade

Commission (“FTC”), in prior proceedings, have taken the position that farmers can agree to manage supply through their cooperatives. This is especially evident in their interpretations of the Fisherman’s Collective Marketing Act,97 which is the fishing industry’s equivalent to the

Capper-Volstead Act.98 In 1964, the FTC issued an administrative complaint against the

93 Id. at 763. 94 Id. 95 Id. at 764. 96 The DOJ Antitrust Division’s competitive impact statement and the consent judgment in Oregon v. Mulkey, 1997- 1 Trade Cases (CCH) ¶ 71,859, at ¶ 80,042 (D. Or. 1997) implicitly recognized the right of an association of fishermen to agree to fix prices and to reduce, eliminate, or limit production. 97 15 U.S.C. §§ 521-22 (1934). 98 “[T]hough there are some differences between Capper-Volstead and the Fisherman's Act, the two Acts provide exemptions from antitrust liability for essentially the same activities, the primary difference being the fact that one Act applies to the agricultural industry and the other to the fishing industry; [therefore] whether the conduct [of a cooperative] is exempt or not, it is the same under either Act.” United States v. Hinote, 823 F. Supp. 1350, 1353 n.4 (S.D. Miss. 1993). Further, courts have relied on case law interpreting the Fisherman's Collective Marketing Act to interpret the Capper-Volstead Act. See, e.g., In re Mushroom Direct Purchaser Antitrust Litig, 621 F. Supp. 2d 274, 285 (E.D. Pa. 2009) (citing Hinote, 823 F. Supp. at 1358); see also 78 CONG. REC. 9175 (1934) (statement of Rep. Schuyler Bland clarifying that the Fisherman’s Collective Marketing Act, then under consideration, “provides for

36 Washington Crab Association (“WCA”).99 The WCA was a cooperative of crab fisherman formed to obtain higher prices from crab processors. When processors refused to pay the higher prices, the WCA members agreed to refuse to fish. In other words, the members agreed in advance to set their production levels at zero. The boycott continued for one month, until the fisherman purchased their own processing plant, and the processors agreed to the price demanded by the WCA.100 The FTC held that the WCA’s effort to control supply by refusing to fish was lawful.

Taking issue with the over-breadth of the hearing examiner’s initial order, which would have prevented simple agreements among members and the Association to voluntarily control supply, the full Commission relied on Capper-Volstead’s analogous protections, explaining:

[The hearing examiner’s] provision would . . . be violated if these respondents agreed among themselves to reduce their catch, whether by “sitting on the beach” until the processors agreed to pay the price they were demanding, or by “rotating their boats” so as to divide equally among the members the business of supplying the first few processors that do accept their price demands. To be sure, this is a “limitation on production” and, except for the exemption afforded to these respondents by the Fisherman’s Collective Marketing Act, 15 U.S.C. 521, would be a per se violation of the Sherman Act and the Federal Trade Commission Act. But the Supreme Court has held, as noted above, that “the general philosophy of Capper-Volstead was simply that individual farmers should be given, through agricultural cooperatives acting as entities, the same unified competitive advantage – and responsibility – available to businessmen acting through corporations as entities.” Maryland & Virginia Milk Producers Ass’n, [362 U.S. 458, 466 (1960)]. Thus, so long as the members of a cooperative are acting pursuant to an agreement voluntarily entered into among themselves, they are to be considered as a single entity for antitrust purposes, the same as an ordinary the same relief for the fishermen that has already been given to the farmers. There is no change in the law except it is made applicable to fishermen.”). 99 In re Washington Crab Ass’n, 66 F.T.C. 45 (1964). 100 Id. The FTC found that the WCA had engaged in other predatory and coercive tactics to force non-members and processors to comply with the WCA’s demands.

37 business corporation with a number of “divisions.” There is no obligation on the single corporation to produce at capacity; it may produce in any volume that it likes, and allocate production among its several “divisions” in such proportions as it sees fit. . . . We see nothing unlawful in their limiting production by agreement among themselves, or in their “boat rotation.”101

Therefore, the cooperative was permitted to continue its supply management program.102

6. There is no well-reasoned or persuasive countervailing precedent

Despite the clear legislative history and strong judicial precedent interpreting the Act to permit and authorize supply management programs by farmers through their cooperatives, it has been suggested that other authority establishes limits on such supply management programs.

These sources, however, are either inapposite or lack any coherent analysis or rationale. For example, a 1968 DOJ Business Review letter issued to the Colorado Grange, which has been cited as disfavoring supply management by cooperatives, relies on cases that contain no analysis or rationale.103 One of the cited cases, United States v. Grower-Shipper Vegetable Ass’n,104 involved a request for a preliminary injunction that was dismissed as moot, and the case does not even involve a cooperative – the organization was described as a trade association in the government’s brief on appeal.105 The other cited case, United States v. Shade Leaf Tobacco

Growers Agricultural Ass’n,106 was a settled consent judgment. Neither case has any compelling precedential value or persuasive force.

101 Id. 102 Id. (This activity, absent coercion and threats or use of violence “would be nothing . . . to concern the [FTC].”). 103 DOJ Business Review Letter from Edwin M. Zimmerman, Assistant Attorney General, Antitrust Division to Ray Obrecht, Master, Colorado Grange (Oct. 2, 1968). 104 United States v. Grower-Shippers Vegetable Ass’n of Cent. Cal., 344 U.S. 901 (1952). 105 Brief of Petitioner-Appellant at 5 n.1, Grower-Shippers Vegetable Ass’n of Cent. Cal., 344 U.S. 901 (No. 461), 1952 WL 82103. 106 United States v. The Shade Tobacco Growers Agric. Ass’n, C.v. A. No. 3992, 1954 U.S. Dist. LEXIS 3703, (D. Conn. May 10, 1954).

38 Others have suggested that farmers possess solely the right to fix prices through their cooperative, but not the right to control production. But that suggestion is not persuasive because it lacks support in the statutory language and the legislative history, and is contrary to case authority and economic logic. For example, the FTC’s decision in In re California Lettuce

Producers,107 contains dicta implying that production control is not exempt. After recognizing that a cooperative had the right to fix prices, the FTC opined in a footnote that the exemption did not cover production controls even though that was not an issue in the case. The footnote cited inapposite legislative history in which Senator Capper noted that a cooperative which reduced production in one year would inevitably face overproduction in the following year because farmers would be incentivized to overproduce.108

The cited legislative history does not render the footnote true; it merely recognizes that, as a practical matter, an agricultural cooperative cannot charge inflated prices because that would inevitably invite overproduction in later growing seasons. Moreover, it is trumped by Senator

Capper’s clear statement, specific to the point at hand, that the exemption was designed to permit cooperatives to control production and plan ahead to produce in anticipation of projected demand.109 Thus, neither the 1968 DOJ Business Review letter issued to the Colorado Grange nor the FTC’s footnote in In re California Lettuce Producers overrides the clear legislative intent and the long line of judicial precedent squarely placing supply management programs within the broad immunity provided by the Act.

107 90 F.T.C. 18, 62 n.2 (1977). 108 62 CONG. REC. 2059 (1922). 109 62 CONG. REC. 2058-59 (1922); Fairdale Farms, Inc. v. Yankee Milk, Inc., 635 F.2d 1037, 1043 (2d Cir. 1980).

39 F. Supply management is a fundamental component of setting prices

It is well-established under traditional antitrust law that control of price and control of supply are two versions of the same conduct, with the same market impact. Output restrictions are tantamount to price-fixing agreements, and this is the very reason they implicate antitrust concerns. “Because economics teaches that an agreement to limit output is effectively an agreement to fix price, courts also have applied the per se rule to agreements to limit production or set quotas” or engage in other activities that set minimum or maximum output quantity under the Sherman Act.110 It would be incongruous to suggest that Congress intended to permit farmers to combine to fix prices without the correlative right to control or limit their production.

The unmistakable economic reality is that one cannot set prices unless one has control of output or production. Otherwise, the right to fix prices would be illusory.

This fundamental principle – that supply control is a form of price fixing – is well- supported by case precedent. As the Supreme Court observed in F.T.C. v. Superior Court Trial

Lawyers Ass’n, a “constriction of supply is the essence of price-fixing, whether it be accomplished by agreeing upon a price, which will decrease the quantity demanded, or by agreeing upon an output, which will increase the price offered.”111 The Court has also condemned as per se illegal a conspiracy among companies to purchase one another’s excess supply, in a system of “quotas” or “allocations,” because these measures amounted to price fixing.112 As the Supreme Court reasoned in that decision, “the machinery employed by a combination for price-fixing is immaterial.”113

110 ABA SECTION OF ANTITRUST LAW, ANTITRUST LAW DEVELOPMENTS 86 (6th ed. 2007). 111 493 U.S. 411, 423 (1990) (internal quotation marks omitted). 112 United States v. Socony-Vacuum Oil Co., 310 U.S. 150, 179-84, 223-24 (1940). 113 Id. at 223.

40 Similarly, the court in United States v. Andreas rejected an argument that output and customer allocation agreements were not per se violations of Section 1 because “[a]t bottom, the

… cartel’s agreement was a conspiracy to limit the producers’ output and thereby raise prices.

Functionally, an agreement to restrict output works in most cases to raise[] prices above a competitive level.”114 And, as the cases discussed in Part IV.E, supra, make clear, this same understanding of cooperative price setting and cooperative supply management as two sides of the same coin has long been embraced by courts interpreting the Capper-Volstead Act.

That price and supply decisions are inextricably interrelated is also evidenced by cooperatives’ negotiating practices, as documented by the USDA. When farmers negotiate about price with processors that have the greater bargaining power, the farmers’ negotiation arsenal includes the ability to “leave crop in the field” in the short term, or to “discontinue or reduce production” or transition to different crops in the long term.115 And it has been documented that when growers negotiate with buyers before planting, the quantity they supply tends to be a function of the price they are able to negotiate in the pre-season period.116 And similarly, even when farmers negotiate with buyers after planting, price is a function of the projected supply.117

In either situation, cooperatives’ price and supply decisions are, from an economic standpoint, the same conduct based on the same decision-making process.

G. The Act already contains important protections

While Capper-Volstead immunity is inclusive, it is not unlimited. Congress carefully considered how to address the risk that the Act may allow associations to harm consumers with

114 216 F.3d 645, 667 (7th Cir. 2000). 115 J. ISKOW & R. SEXTON, AGRICULTURAL COOPERATIVE SERVICE, BARGAINING ASSOCIATIONS IN GROWER- PROCESSOR MARKETS FOR FRUITS AND VEGETABLES, USDA-ACS RESEARCH REPORT 104, at 11 (1992), available at http://www.rurdev.usda.gov/rbs/pub/rr104.pdf. 116 Id.

41 undue price enhancements, and Section 2 of the Act responds to this concern.118 Section 2 of the

Act grants the Secretary of Agriculture oversight and enforcement power for “[m]onopolizing or restraining trade and unduly enhancing prices.”119 The Act empowers the USDA Secretary to intervene and seek an injunction when the Secretary determines an association has monopolized or restrained trade to such an extent that the price of any agricultural product is unduly enhanced.120

Furthermore, courts have long since established two additional limitations on Capper-

Volstead immunity: First, a cooperative has no antitrust immunity when it combines or conspires with non-exempt entities, such as non-producers (other than an appropriate marketing agent), to monopolize or restrain trade.121 Second, a cooperative may not engage in monopolistic or predatory practices that are outside the legitimate purposes of a cooperative, such as attempting to force non-members to join or to punish or exclude them from the relevant market.122 These limits to the Capper-Volstead Act immunity are well-established and effective at controlling conduct outside the policy goals of the Act; there is no need to limit the Act’s protections with regard to supply management.

117 Id. at 13. 118 See, e.g., 62 CONG. REC. 2058 (1922) (statement of Sen. Arthur Capper); 62 CONG. REC. 2049 (1922) (statement of Sen. Frank Kellog); 61 CONG. REC. 1044 (1921) (discussion of Reps. Andrew Volstead and Hatton Sumners). 119 7 U.S.C. § 292. 120 Id. 121 Case-Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967); United States v. Borden Co., 308 U.S. 188, 204- 05 (1939); United States. v. Md. Coop. Milk Producers, Inc., 145 F. Supp. 151, 153 (D.D.C. 1956). 122 United States v. Md. & Va. Milk Producers Ass’n, 362 U.S. 458, 467-68 (1960); N. Tex. Producers Ass’n v. Metzger Dairies, Inc., 348 F.2d 189, 193-94 (5th Cir. 1965), cert. denied, 382 U.S. 977 (1966); Bergjans Farm Dairy Co. v. Sanitary Milk Producers, 241 F. Supp. 476, 483-84 (E.D. Mo. 1965), aff’d, 368 F.2d 679 (8th Cir. 1966).

42 H. Other sources of law and commentary also support farmers’ right to engage in supply management

1. Cooperative Marketing Act

The Cooperative Marketing Act of 1926 specifically provides for the exchange of information among producers, cooperatives, or federations of cooperatives:

Persons engaged, as original producers of agricultural products, such as farmers, planters, ranchmen, dairymen, nut or fruit growers, acting together in associations, corporate or otherwise, in collectively processing, preparing for market, handling, and marketing in interstate and/or foreign commerce such products of persons so engaged, may acquire, exchange, interpret, and disseminate past, present, and prospective crop, market, statistical, economic, and other similar information by direct exchange between such persons, and/or such associations or federations thereof, and/or by and through a common agent created or selected by them.123

While the CMA does not reference the Capper-Volstead Act, it borrows some of its language and embodies a Congressional policy favoring the types of information sharing that make supply management more effective and efficient. The CMA’s legislative history shows that Congress intended the Act to foster and permit data exchange and indicates that its purpose in doing so was to help producers address overproduction, prevent uninformed decision-making, and provide further means of collaboration by producers. The House Report from the Committee on Agriculture states:

123 7 U.S.C. § 455 (emphasis added).

43 The bill also provides for the acquisition and dissemination by associations of farmers, of crop and market information. It is highly important that associations should be allowed to keep their members fully informed in regard to all of the factors affecting the demand for their products. It is generally known that farmers, due to the large number of them and to their widely scattered geographical situation, proceed in many respects unintelligently in regard to the production and marketing of their products. The provision in question would tend to alleviate this condition.124

During the floor debate for the full House vote, Representative Barbour stated that until this bill “[t]here has been no way in which information could be gathered successfully and disseminated among the members of an association in a way that would prevent the overproduction of the farm products which these associations handle and market.”125 Thus, viewed along with the Capper-Volstead Act’s protections, the enactment of the CMA further reveals Congress’s intent that agricultural cooperatives be permitted to engage in the same type of supply management as any proprietary corporation.

2. Other agriculture statutes

The Capper-Volstead Act and the Cooperative Marketing Act are merely two of a number of federal statutes that embody a Congressional policy of supporting cooperatives in their activities, including supply management activities. The Agricultural Marketing Act of 1929

(codified as part of the Farm Credit Act, 12 U.S.C. § 1141 (1929)), confirmed the important public policy of promoting the economic efficiency of farmers in managing and limiting their production in order to avoid and prevent surpluses and overproduction:

(3) by encouraging the organization of producers into effective associations or corporations under their own control for greater unity of effort in marketing and by promoting the establishment and financing of a farm marketing system of producer-owned and

124 H.R. REP. NO. 116, 69th Cong., 1st Sess. (1926). 125 67 CONG. REC. 2775 (1926) (emphasis added).

44 producer-controlled cooperative associations and other agencies; [and]

(4) by aiding in preventing and controlling surpluses in any agricultural commodity, through orderly production and distribution . . . and prevent such surpluses from causing undue and excessive fluctuations or depressions in prices for the commodity.126

Thus, Congress again articulated in clear and unambiguous statutory language its intent to permit farmers to form cooperative entities to fix prices and control their production in order to efficiently operate and market their products.

Congress further supports associations of agricultural producers through the Agricultural

Marketing Agreement Act of 1937,127 which grants the Secretary of Agriculture authority to enter into marketing agreements with associations of producers and to thereby help stabilize market conditions and assure consumers of adequate supplies of commodities. Marketing orders for dairy, poultry, fruits, vegetables, and livestock are currently in place. The terms of orders are developed through public hearings held by the Department of Agriculture, providing an opportunity for the public and other government agencies to comment prior to issuance. A recent study determined that orders do not prevent entry into the industry and “do not allow producers to set prices directly or even to set limits on pricing such as price floors.”128

These statutes provide examples of Congressional policy to foster supply management planning and practices in U.S. agriculture. When necessary, Congress even authorizes direct action by U.S. agencies to assist the farming sector with supply management support and

126 12 U.S.C. § 1141(a)(3)-(4).

127 50 Stat. 246 (1937) (codified as amended 7 U.S.C. § 601 et seq.). 128 RICHARD J. SEXTON, TIMOTHY J. RICHARDS, & PAUL M. PATTERSON, RETAIL CONSOLIDATION AND PRODUCE BUYING PRACTICES, GIANNINI FOUNDATION MONOGRAPH NO. 45, at 32 (2002).

45 subsidies. This supports, and in no way preempts, the ability of agricultural cooperatives to engage in supply management as industry participants.

3. USDA policy support

The USDA has a long-standing history of supporting supply management practices by agricultural cooperatives. One USDA expert stated:

A cooperative, confronting declining demand or low prices, can, pursuant to the terms of the statutes and their legislative history, respond as does any corporate entity facing similar situations – with legitimate business options, which include closing plants, lowering, limiting or reducing production and cutting down its work force in order to attempt to efficiently confront the market demand presented.129

A USDA publication titled “Antitrust Status of Farmer Cooperatives: The Story of the

Capper-Volstead Act,” confirms the legality of producer agreements to control production through their cooperative:

It is uncontested…that a value-added cooperative can, just like its non-cooperative competitors, limit the amount of product it offers for sale. These precedents suggest that members of a cooperative may voluntarily agree among themselves to limit their production as well.130

Another USDA report states that:

129 See ISKOW & SEXTON, supra note 115, at 10-13. 130 FREDERICK, supra note 39, at 291.

46 “Supply chain management” is the term describing the tools consolidating control over “key elements of the distribution and marketing system [in an] attempt[] to control each level of the process, up to and including delivery to the consumer. These firms strive to assure: a) product quality that satisfies their customers’ specific preferences; b) minimum costs subject to meeting the quality specifications; and c) that the associated risks are managed within acceptable levels.”131

This report goes on to discuss the need for joint planning on supply in part due to “shortened planning horizons,” that are particular to agriculture.132

The USDA also has noted farmers’ purchasing needs as one of the key underpinnings for cooperatives’ advance planning on production levels.

By banding together and purchasing business supplies and services as a group, individuals offset the market power advantage of firms providing those supplies. You can gain access to volume discounts and negotiate from a position of greater strength for better delivery terms, credit terms, and other arrangements. Suppliers will be more willing to discuss customizing products and services to meet your specifications if the purchasing group provides them sufficient volume to justify the extra time and expense.133

Thus, the USDA has a track-record of advocating and supporting supply management practices by farmers through their cooperatives.

V. To Exclude Supply Management From Immunity Is To Tie The Hands Of U.S. Farmers In International Competition

In order to compete in global markets, U.S. farmers and their cooperatives need the same ability to manage supply that cooperatives in other countries possess. The cooperative format for agriculture is not unique to the United States, but exists in virtually all parts of the developed and

131 DUNN ET AL., supra note 2, at 5. 132 Id. at 6. 133 DONALD A. FREDERICK, USDA RURAL BUSINESS-COOPERATIVE SERVICE, DO YOURSELF A FAVOR: JOIN A COOPERATIVE,COOPERATIVE INFORMATION REPORT 54, at 4 (Nov. 1996), available at http://www.rurdev.usda.gov/rbs/pub/cir54.pdf.

47 developing world.134 These cooperatives compete in a global market and as direct competitors to

U.S. farmers for exports to the United States. U.S. cooperatives compete with these global cooperatives in foreign markets throughout the world, and U.S. cooperatives’ direct exports make up an important share of all U.S. exports.135 Yet, at the same time that slow growth in U.S. population and income are “requiring U.S. producers to look to the 96 percent of the world’s consumers outside the United States,” U.S. producers are being “particularly hard hit by globalization,” as the foreign producers against which they must compete have much lower labor, land, and other input costs.136 Thus, the importance of advance planning to U.S. cooperatives’ efforts to compete internationally cannot be overstated.137 To be sure, cooperatives overseas actively engage in rational, intelligent, and collective supply management as part of their growing competition with U.S. agriculture. To tie the hands of U.S. farmers would make the United States the odd-man-out, and would harm the competitiveness of U.S. farmers in cooperatives.

As in the United States, other countries’ legal regimes contain statutory antitrust exemptions that enable agricultural cooperatives to engage in supply management measures.138

In some instances, their statutes employ broad language of the kind typically used in U.S. antitrust statutes such as the Capper-Volstead Act, with the right of supply control included in their scope. In other instances, regulations specifically spell out the right to engage in supply

134 EGERSTROM, MAKE NO SMALL PLANS: A COOPERATIVE REVIVAL FOR RURAL AMERICA (Lone Oak Press 1995). 135 TRACEY L. KENNEDY, USDA RURAL DEVELOPMENT, U.S. COOPERATIVES IN INTERNATIONAL TRADE, 1997-2002, RESEARCH REPORT 211, at 7-10, available at http://www.rurdev.usda.gov/rbs/pub/RR211.pdf. 136 DUNN ET AL., supra note 2, at 7. 137 Id. 138 See generally Arie Reich, The Agricultural Exemption in Antitrust Law: A Comparative Look at the Political Economy of Market Regulation, 42 TEX. INT’L L.J. 843 (2007), available at http://tilj.org/journal/entry/42_843_reich/ (noting that between 1997 and 2002, cooperatives’ direct exports ranged from 8.6 percent to 13.8 percent of all U.S. exports). Moreover, the agricultural sector in general is twice as dependent on exports as the U.S. economy generally. KENNEDY, supra note 135, at 10.

48 control. But in both situations, it is clear that from an economic standpoint, and based on the simple realities of farming, cooperatives must possess the ability to manage supply.

For example, the European Community’s analogous exemption was intended to “allow the efficient functioning of associations of farmers in the form of agricultural cooperatives” and applies to producers of, rather than traders in, agricultural products.139 A complementary E.C. regulation, likewise intended “to strengthen the position of the producers in the market in the face of ‘ever greater concentration of demand,’”140 does so by:

encourag[ing] the establishment of such organizations by giving them a central role in the regulation of the market, entrusting them with special powers to intervene in the supply and demand side of the market.141

Israel’s analogous exemption also “grants a broad exemption to all types of arrangements made in relation to the growing and marketing of agricultural products, not only to collective arrangements between farmers, as in the U.S. exemption.”142 Under the Israeli exemption, there have been “several successful arrangements to eliminate surpluses” in the potato, carrot, banana, and milk industries, aimed at keeping domestic prices high through methods including destruction of excess supply and subsidized export.143

As another example, under Section 10 of South Africa’s Competition Act, the national

Competition Commission must grant exemptions from the Act’s restrictive-agreements and abuse-of-dominance prohibitions for either particular agreements or practices or general

139 Reich, supra note 138, at 849, 852, available at http://tilj.org/journal/entry/42_843_reich/. 140 Id. at 852 (quoting Council Regulation 2200/96, On the Common Organization of the Market in Fruit and Vegetables, 1996 O.J. (L 297) 1, at 2 ¶ 7 (EC)). 141 Id. (citing Council Regulation 2200/96, On the Common Organization of the Market in Fruit and Vegetables, 1996 O.J. (L 297) 1, at 3 ¶¶ 16-17, tit. IV, arts. 23, 25, 30, tit. V, art. 35 (EC). 142 Id. at 858. 143 Id. at 864-65.

49 categories thereof, when certain conditions are met.144 Specifically, Section 10 calls for exemptions for practices, even if otherwise violative of the Act’s per se prohibitions, if the practices contribute to, inter alia, the maintenance or promotion of exports or to change in productive capacity necessary to stop decline in an industry.145

These are a few examples of the legal frameworks governing the foreign cooperatives with which U.S. cooperatives must compete. Many other countries also employ the cooperative structure for agriculture, and they similarly foster their joint activities and hoped-for competition with U.S. agriculture. In addition to the countries discussed above, there are agricultural cooperatives in Egypt, Morocco, Tanzania, Uganda, Brazil, Canada, India, Japan, Korea,

Malaysia, Mongolia, Sri Lanka, Thailand, Cyprus, Bulgaria, Denmark, Finland, Hungary,

Norway, Poland, Slovak Republic, Turkey, the United Kingdom, and others.146 Cooperatives, and attendant joint supply control, are ubiquitous in the global marketplace. In light of this environment in which U.S. cooperatives must compete, any diminution of the Capper-Volstead

Act’s immunity for supply-control measures would tie the hands of U.S. farmers in the domestic and international marketplace.

VI. Conclusion

It is NCFC’s position that the Capper-Volstead Act authorizes farmers through their cooperatives to agree on the amount that they will produce, handle, and sell, from the pre- planting stage to the post-harvest stage. In the eighty-seven years since the passage of the Act, farmers have engaged in varied forms of supply control through their cooperatives. Supply management has enabled farmer cooperatives to respond to changing consumer demands,

144 Competition Act 89 of 1998 s.10, as amended, Competition Second Amendment Act 39 of 2000 s.5. 145 Id. s.10(3)(b)(i) & (iii). 146 International Cooperative Agricultural Organisation, Members Directory, http://www.agricoop.org/directory/africa.htm.

50 compete in a global economic environment, reduce waste and inefficiency, and promote efficient use of environmental resources. The language of the Act itself encompasses joint action on production, Congress sanctioned controlling production in the legislative history, and courts clearly have held that the Act enables farmers to agree on production levels. This is the status quo. Any change in enforcement policy that seeks to strip farmers of the ability to manage supply through their cooperatives would harm U.S. agriculture. Thus, it is NCFC’s position that such a change in enforcement is unwarranted, unwise, and not supported by law or by practice.

NATIONAL COUNCIL OF FARMER COOPERATIVES

Report of the Standing Subcommittee On Environmental Laws and Regulations For 2009

Legal, Tax and Accounting Committee

Chair: B. Andrew Brown DORSEY & WHITNEY LLP 50 South Sixth Street Minneapolis, MN 55402 [email protected] Tel: 612-340-5612 Fax: 612-340-8800

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National Council of Farmer Cooperatives

2009 Update on Environmental Laws

Climate Change Legislation ...... 107

Regulatory & Legislative Approaches ...... 107 Cap-and-Trade ...... 108 Agriculture Offsets...... 109 EPA Greenhouse Gas Reporting Rule ...... 110

Recent Developments Related to Genetically Modified Organisms ...... 111

Alfalfa ...... 111 Sugar Beets ...... 112 The Future of GM Crops...... 113

Clean Water Restoration Act ...... 113

Aquatic Pesticides & National Cotton Council v. EPA ...... 114

EPA National Enforcement Priorities ...... 116

Climate Change Legislation

In 2009, efforts increased to combat pollution and climate change by government agencies, Congress, and the public. The United States House of Representatives passed a bill that would establish a cap-and-trade system with the goal of reducing greenhouse gas (GHG) emissions. The Senate is currently debating its own version of the bill. The Environmental Protection Agency (EPA) also announced a final rule that requires large-quantity emitters of GHGs to annually report emission levels.

It remains to be seen whether the climate change legislation will pass the Senate and be signed into law. So far, the country has remained divided in its support for the legislation, and the debate on creating a new health care system has slowed progress on working on cap-and- trade. However, if a cap-and-trade system is passed, there will be major implications and major opportunities for the agriculture industry, especially in the area of agriculture offsets.

Regulatory & Legislative Approaches

Pollution and climate change may be regulated by any or some combination of three different policy approaches: 1) command and control regulations (e.g., Clean Air Act); 2) a

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carbon tax; or 3) a cap-and-trade system. In a command and control approach, the EPA would regulate GHGs by placing emissions limits on individual sources. Recent court action, specifically Massachusetts v. EPA, has given EPA the authority to control GHGs under the existing Clean Air Act. The EPA would decide how much emissions should be reduced and which entities would be covered. The second approach, a carbon tax, would apply a tax to all or some emitters of carbon. Although a tax would likely increase consumer costs, a carbon tax would also create an incentive to reduce the amount of carbon being emitted, spur innovative technologies to reduce pollution and avoid additional taxes, and generate revenue. A third approach is a cap-and-trade system. This would place caps on overall emissions from regulated entities in an effort to reduce emissions while lowering economic costs to achieve those reductions. A regulated entity could comply by reducing emissions, acquiring allowances, and/or purchasing offsets. Both the U.S. House and Senate have created legislation that outlines a cap-and-trade system, and the ability to purchase offsets could create market opportunities and generate revenue for agriculture.

Cap-and-Trade

Climate legislation passed the House (H.R. 2454) on June 26, 2009. The Senate originally introduced its own climate change legislation on September 30. The Senate is currently debating the provisions of its bill, and one alternate version has been published by the Senate Environment and Public Works Committee Chairwoman Barbara Boxer. Both the House bill and the originally published Senate bill would cap GHG emissions, require an allowance or offset for every ton of GHG emitted from covered entities, and establish a system of trading, selling, auctioning, and allocating emission allowances and offsets. Leora Falk, Climate Change: Senate, House Bills Differ on Key Provisions; Details on Senate Legislation Still to Come, Bureau of National Affairs (BNA), 189 DEN A-1 (10/02/2009).

The Senate will face many challenges while attempting to pass a climate change bill. After Massachusetts’s recent 2010 senate election, Democrats control the Senate 59-41 and 60 votes are needed to overcome a filibuster threat. Included in the 59 is Senator Joe Lieberman, who has been vocal about proposing changes to the existing legislation.

Although both the House and Senate have approached the reduction of GHG emissions through a cap-and-trade system, there are some provisions being debated in the Senate that differ markedly from the House bill. Both the House and originally released Senate bill would require an 83 percent reduction in emissions from 2005 levels by 2050. However, the House bill would mandate a 17 percent decrease by 2020, while the Senate mandates a 20 percent decrease by 2020. The bills also differ on how the trigger price of allowances should be calculated and how that price should change over time. The House bill generally remained quiet on the subject of nuclear power, but after much pressure from industry and individual senators, the Senate bill includes some language in support of increasing the country’s use of nuclear power. Another area of question is border measures and whether tariffs should be imposed. The House bill would allow the President to impose tariffs on imported goods from countries that do not have GHG restrictions. The Senate bill includes a general statement that a trade title would later be added that includes a border measure consistent with international obligations and that would allocate allowances to energy-intensive and trade-exposed industries. Id.

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These are just a few examples of the major issues that must be resolved before a cap-and- trade program can be established. One other area of debate, with particular interest to the agriculture community, is the area of offsets. Both the House and Senate would establish an Offsets Integrity Advisory Board which would recommend which types of GHG emissions- reducing projects would be eligible to produce offsets. The House bill directs the EPA to establish this Board, while the Senate assigns the President the task. The House and Senate both would limit the use of offsets to 2 billion tons annually, but the Senate bill would impose stricter limits on the number of international offsets that could be used. Id.

Agriculture Offsets

Under all three proposed cap-and-trade systems, the agriculture community will be able to generate revenue by selling offset credits to industries required to reduce their emission levels. A GHG offset is a reduction, removal, or avoidance of GHG emissions that is used to compensate for GHG emissions that occur elsewhere. Maintaining Carbon Market Integrity: Why Renewable Energy Certificates are Not Offsets, Offset Quality Initiative (June 2009). Offsets can be traded in the form of credits and typically one credit is equal to one metric ton of CO2 equivalent emission reductions. Id. Some examples of possible offsets specific to agriculture include: new methane capture systems installed over animal-waste lagoons, reforestation of grassland, alteration of cow diets to produce less heat-trapping methane, nitrous oxide reductions from fertilizer applications, and soil carbon sequestration.

The role of agriculture offsets has become increasingly debated as climate change legislation progresses. Although both the House and Senate climate change bills allow for offsets to be used, neither specifically address the role of the agriculture sector. At a hearing on Capitol Hill before the House Agriculture Committee this past June, Agriculture Secretary Tom Vilsack spoke in support of an expanded role for farming and agriculture in a comprehensive climate change plan. Christa Marshall, Agriculture Offsets – a Savior or a Boondoggle?, New York Times (June 12, 2009). Vilsack stated: “A viable carbon offsets market – one that rewards farmers, ranchers and forest landowners for stewardship activities – has the potential to play a very important role in helping America address climate change while also providing a possible new source of revenue for landowners.” Id.

The use of offsets is being championed as a way to control any increased costs to farmers as a result of a cap-and-trade program. The U.S. Department of Agriculture (USDA) has estimated that a cap-and-trade system will have modest short-term costs for agriculture and long- term net benefits. Robin Bravender, USDA Sees House Climate Bill Yielding Long-Term Benefits for Agriculture, New York Times (July 22, 2009). USDA has predicted the benefits from an agriculture offset market will rise over time and likely overtake costs in the medium term (years 2027-2033) and long term (years 2042-2048). Id. It has been estimated that the House bill’s program could create a domestic offset market valued at $2.7 billion to $3.4 billion or more annually within five years of the legislation’s implementation. The Value of a Carbon Offset Market for Agriculture, Agricultural Carbon Market Working Group, http://www.agcarbonmarkets.com/documents/TCG_White_Paper_Value_of_Offsets_Final_1.pdf Of course, not everyone agrees with this interpretation of the proposed climate change legislation, and many believe production costs to farmers will significantly increase.

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One area at issue is which agency should oversee agriculture offsets. In the House bill, the USDA has authority over offset projects in the forestry and agricultural sector, while the EPA would oversee all other types of projects. The Senate bill did not include language defining the roles of EPA and USDA, rather it directs the President to consult with “appropriate federal agencies.” Christa Marshall, The Senate Bill Tinkers with Touchy Issue – Carbon Offsets, New York Times (Oct. 1, 2009).

This past October, in a hearing before the Senate Committee on Environment and Public Works, the Presidents of both the National Farmers Union (NFU) and American Farm Bureau Federation (AFBF) testified about the climate change bills. NFU President Roger Johnson stated the Senate bill currently lacks a model for a robust and flexible agriculture offset program, which he deems necessary for American farmers to mitigate increased costs resulting from a cap-and- trade program. Johnson stated NFU would support a cap-and-trade system if, among other things, the system granted USDA control and administration of the agriculture offset program and no artificial cap is placed on domestic offsets. AFBF President Bob Stallman testified that cap-and-trade legislation would result in higher fuel, fertilizer, and energy costs to farmers and ranchers, in addition to higher energy costs for all consumers. Stallman said the Senate bill does not make economic sense for agriculture and that, unlike the House bill, the Senate bill does not specifically provide a place for agriculture and forestry in its offset program. While the Senate bill provides a pool of 1.5 billion tons of domestic offsets, the bill does not specify who is eligible to provide those. Instead, the bill places the use of forestry and agriculture offsets at the discretion of the President by allowing the President to choose which sector is eligible. Robert Pore, National Farm Organizations Differ on Climate Change Bill, The Grand Island Independent (Nov. 1, 2009).

A bill introduced on Nov. 4, 2009 by Senator Debbie Stabenow (D-Mich.), the Clean Energy Partnerships Act, would establish a domestic emissions offset program as part of any proposed cap-and-trade system. The Clean Energy Partnerships Act lists 15 categories of acceptable emission offset projects, including methane capture from landfills, reduced tilling of farmland, afforestation or reforesting of land, and carbon capture and storage. Leora Falk, Stabenow Introduces Bill to Establish Offset Scheme as Part of Cap-and-Trade Plan, BNA, 212 DEN A-3 (11/05/2009). Under this bill, USDA would oversee forestry and agriculture projects and EPA would oversee all other types of projects. The bill also ensures agriculture is not subject to any emissions cap. Additionally, on December 11, 2009, Senators Maria Cantwell (D- WA) and Susan Collins (R-ME) introduced another version of a cap-and-trade system called the CLEAR Act. Known as a “cap and dividend,” the 32 page bill would place a cap on emissions, require companies to buy permits for their carbon emissions in monthly auctions, and 75 percent of the auction revenue would be refunded back to consumers to compensate for higher energy costs, with the remaining 25 percent going to clean energy development. Ayesha Rascoe, Two U.S. Senators Unveil Alternative to Climate Bill, Reuters (12/11/2009). However, the “cap and dividend” system does not allow many offsets to be used.

EPA Greenhouse Gas Reporting Rule

On Oct. 30, 2009, EPA published a final rule that establishes a mandatory GHG emissions reporting program for sources that emit over 25,000 tons per year. EPA estimates the rule will require reporting from about 10,000 facilities, which accounts for nearly 85 percent of

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all U.S. GHG. Press Release, EPA Finalizes the Nation’s First Greenhouse Gas Reporting System/Monitoring to Begin in 2010, EPA (Sept. 22, 2009). The types of covered entities include suppliers of coal-based liquid fuel, petroleum products, natural gas, industrial GHGs, and carbon dioxide and facilities that use those resources, including stationary fuel combustion sites, electricity generators, manure management sites, waste landfills, and manufacturing plants (lime, iron, steel, lead, cement, and aluminum). Steven D. Cook, EPA Publishes Final Rule Reporting Greenhouse Gas Emissions Reporting, BNA, 209 DEN A-6 (11/02/2009). Reporting requirements go into effect on January 1, 2010 and the first reports must be submitted to EPA by March 31, 2011.

Recent Developments Related to Genetically Modified Organisms

In 1986, the White House Office of Science and Technology published the Coordinated Framework for the Regulation of Biotechnology. Since 1986, three principal agencies have had primary oversight of genetically modified (GM) organisms experimental testing, approval, and commercial release. First, USDA and the Animal and Plant Health Inspection Service (APHIS) is responsible for protecting agriculture from pests and diseases. Under the Plant Protection Act, USDA-APHIS has regulatory oversight over products of modern biotechnology. GM products are considered “potential plant pests” and are “regulated articles.” 7 C.F.R. §§ 340.0(a), 340.1. APHIS regulates the importation, interstate movement, and environmental release of GM plants through notification and permitting requirements. Developers may petition APHIS to “deregulate” a GM product. 7 C.F.R. § 340.6. The petition must include data proving the product is not a plant pest and information about the product’s potential environmental impacts. Second, EPA regulates GM plants under the Federal Insecticide, Fungicide and Rodenticide Act and microbial products of biotechnology under the Toxic Substances Control Act. Finally, the Food and Drug Administration must approve any food additive - a substance that is not a pesticide and not generally recognized to be safe under the conditions of its intended use - before a product can be marketed. This includes any food additive introduced into food or feed by way of plant breeding.

Under this regulatory backdrop, complex litigation has proceeded regarding GM alfalfa and sugar beets. The U.S. Supreme Court has granted certiorari in a case regarding Roundup Ready alfalfa. On October 22, 2009, Monsanto, Forage Genetics International, and two alfalfa farmers filed a cert petition to reverse a permanent nationwide injunction that prevents GM alfalfa from being sold or planted. Monsanto Co. v. Geertson Seed Farms, No. 09-475, 2009 WL 3420495 (U.S. Oct. 22, 2009). On September 21, 2009, a federal court in California held an Environmental Impact Statement (EIS) is required for the deregulation of GM sugar beets. The permanent injunction on alfalfa and the recent decision for sugar beets could result in many lost years where farmers are unable to grow these weed-resistant crops. (For disclosure: Dorsey & Whitney LLP represented Forage Genetics in the alfalfa case and Andy Brown was lead counsel.)

Alfalfa

The case going before the U.S. Supreme Court centers on a challenge to a nationwide injunction against Roundup Ready alfalfa that prevents its use and sale until the government performs an EIS. In 2007, the District Court held that APHIS’s environmental assessment was

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inadequate because it failed to explain why the possibility of cross-pollination of conventional and organic alfalfa with Roundup Ready alfalfa was not itself a “significant harmful impact” on the environment. Geertson Seed Farms v. Johanns, No. 06-01075, Docket No. 83, 2007 WL 518624 (N.D. Cal. Feb. 13, 2007). On this basis, the Court ordered APHIS to prepare a full EIS. The decision to require an EIS was not challenged on appeal, but APHIS, Monsanto (who owns the intellectual property rights to Roundup Ready alfalfa), Forage Genetics (the exclusive developer of Roundup Ready alfalfa) and three alfalfa growers appealed the court’s order which stopped the commercial use of Roundup Ready alfalfa until the EIS was prepared. The appellants argued the injunction was too broad, the court had effectively exempted the NEPA plaintiffs from showing irreparable harm to obtain the injunctive relief (only requiring the “possibility” of harm), and that the injunctive relief had been granted without an evidentiary hearing although there were genuinely disputed issues of fact and an evidentiary hearing had been requested.

The petitioners argue the Ninth Circuit misapplied the recent Supreme Court decision in Winter v. NRDC, 129 S.Ct. 365 (2008), which held a district court may not enter an injunction for a National Environmental Policy Act (NEPA) violation broader than necessary to prevent a likelihood of “irreparable harm” pending the government’s preparation of an EIS. Following this reasoning, petitioners argue the Ninth Circuit’s concern over the mere possibility of cross- pollination cannot be reconciled with Winter’s holding that irreparable harm must be likely. Petitioners also argue the Ninth Circuit erred in upholding an injunction sought to remedy a NEPA violation without first conducting an evidentiary hearing on genuinely disputed facts.

The issue of cross-pollination has become an increasingly important topic for the world of GM crops. According to the cert petition, cross-pollination can occur only if two fields produce flowers simultaneously and pollen is transferred between them. However, debates regarding isolation zones and whether farmers should fence-in or fence-out have not been resolved and are intensifying. The Roundup Ready alfalfa has been genetically modified to be resistant to Roundup, a broad-spectrum agricultural herbicide that controls nearly every weed species in alfalfa crops.

On Dec. 19, 2009, APHIS published a draft EIS that evaluates the environmental effects of deregulating Roundup Ready alfalfa. In the draft EIS, APHIS considered two alternatives: to grant nonregulated status to Roundup Ready alfalfa, or to maintain the products as regulated articles under the Plant Protection Act. In analyzing these alternatives, APHIS considered potential environmental impacts, socioeconomic impacts, as well as human health and safety impacts. Preliminarily, APHIS concluded there is no significant impact to the human environment due to deregulating Roundup Ready alfalfa. APHIS is seeking comments on the draft EIS until Feb. 17, 2010. The draft EIS is available on the APHIS website at http://www.aphis.usda.gov.

Sugar Beets

The Northern District of California, the same district court that decided the alfalfa case, ruled on September 21 that the government failed to require an EIS on GM Roundup Ready sugar beets. Center for Food Safety v. Vilsack, No. C 08-00484 (N.D. Cal. 2009). The plaintiffs sued after APHIS decided to unconditionally deregulate the sugar beets and allow them into U.S.

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agriculture. Over 95 percent of the U.S. sugar beet crop is now engineered to resist herbicide, so the effect of the District Court’s ruling could be extensive.

Once again, the District Court expressed its concern about the possibility of cross- pollination. Although APHIS, after conducting an environmental assessment, determined the likelihood of cross-pollination to organic fields is “unlikely,” the District Court found the “potential elimination of a farmer’s choice to grow non-genetically modified crops, or a consumer’s choice to eat non-genetically modified food” does have a “significant effect” on the environment because of the long distances pollen can travel by wind. The Court held APHIS did not demonstrate a “hard look” at this issue as required by NEPA.

The District Court planned a case management conference on October 30, 2009 to determine the remedies phase of the case. In addition to the original parties, other growers, sugar processors and seed companies like Monsanto were expected to be allowed to take part in the remedy phase. The results of the case management conference have not yet been published.

The Future of GM Crops

USDA and Agriculture Secretary Tom Vilsack are preparing to update the country’s regulations for GM crops in the spring of 2010 in order to create a better way for GM and conventional crops to coexist. Vilsack stated “[y]ou know, I think [regulations for GM are] an evolving process, which is why we’re doing this and probably should have done it more than 20 years ago.” Paul Voosen, Courts Force U.S. Reckoning With Dominance of GM Crops, New York Times (Oct. 8, 2009).

There are many issues USDA will have to debate in the upcoming months when creating new policies for GM crops, which are widely used throughout the country. At least 95 percent of sugar beets, 90 percent of soy and cotton crops, and 85 percent of the corn crop utilize GM seeds. Id. Whether the agency creates rules that compliment or correct the recent court rulings will be an important question, especially for sugar beet and alfalfa farmers.

Clean Water Restoration Act

In 2009, there was also spirited debate regarding who has jurisdiction over waters of the United States. In April 2009, Senator Russ Feingold (D-WI) introduced the Clean Water Restoration Act (S.787). This bill proposes to amend the Clean Water Act (CWA) to clarify jurisdiction over U.S. waters, which has become a muddled question due to recent court decisions. In 2006, the United States Supreme Court decided Rapanos v. United States, in which the Court addressed where the Federal government can apply the CWA, specifically by determining whether a wetland or tributary is a “water of the United States.” 126 S. Ct. 2208 (2006); Clean Water Act Jurisdiction Following the U.S. Supreme Court’s Decision in Rapanos v. United States & Carabell v. United States, EPA at 2 (Dec. 2, 2008) [hereinafter EPA Jurisdiction Memo].

The CWA prohibits the discharge of any pollutants into navigable waters. The term “navigable waters” means “the waters of the United States, including the territorial seas.” 33 U.S.C. § 1362(7). In Rapanos, the justices examined what constitutes “navigable” waters. Four

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justices in a plurality opinion decided that government agencies’ regulatory authority should extend beyond waters considered navigable in the traditional sense to “relatively permanent, standing or continuously flowing bodies of water” connected to traditional navigable waters and to “wetlands with a continuous surface connection to” such relatively permanent waters. EPA Jurisdiction Memo at 2. Justice Kennedy did not join the plurality opinion. Although he agreed regulatory authority should extend beyond traditional navigable waters, Kennedy rejected the plurality’s test and set forth his own standard. Under Kennedy’s standard, wetlands meet the definition of “waters of the United States” if “the wetlands, either alone or in combination with similarly situated lands in the region, significantly affect the chemical, physical, and biological integrity of other covered waters more readily understood as ‘navigable.’ When, in contrast, wetlands’ effects on water quality are speculative or insubstantial, they fall outside the zone fairly encompassed by the statutory term ‘navigable waters.’” EPA Jurisdiction Memo at 3. Because only a plurality opinion was issued, regulatory jurisdiction under the CWA exists over waters if either the plurality’s or Justice Kennedy’s standard is satisfied. Because two different standards may be used, many questions have arisen as to who has jurisdiction in specific cases.

In order to clarify the jurisdiction, the Clean Water Restoration Act proposes to remove the CWA requirement that waters be “navigable.” Instead, the bill would replace the term “navigable waters” with “waters of the United States,” which is defined to mean all waters subject to the ebb and flow of the tide, the territorial seas, and all interstate and intrastate waters and their tributaries (including lakes, rivers, streams, mudflats, sandflats, wetlands, sloughs, prairie potholes, wet meadows, playa lakes, natural ponds, and all impoundments and tributaries), the territorial seas, and all wetlands adjacent to any of the aforementioned waters.

The American Farm Bureau Federation argues that removing the term “navigable” “would bring about the largest expansion” of the CWA since its passage 40 years ago. Hembree Brandon, Updating the Clean Water Act: Potential for Broader Regulation?, Southeast Farm Press (Oct. 10, 2009). Groups opposed to the Clean Water Restoration Act argue government agencies would gain jurisdiction over all wet areas within a state – from farm ponds to roadside ditches. Additionally, those agencies would gain authority over all activities affecting U.S. waters, regardless of whether that activity occurs in the water or adds a pollutant. Id.

The Clean Waters Restoration Act has passed through the Committee on Environment and Public Works. Senator Blanche Lincoln (D-Ark), who is the Chairwoman of the Senate Agriculture Committee, has stated: “I appreciate the view that [the Act] could provide the Environmental Protection Agency with an expansion of its authority to regulate all U.S. water, including non-navigable waters. . . .We certainly don’t want to give the EPA the broad authority that would allow them onto your farms to regulate ponds, ditches, and gutters.”

Aquatic Pesticides & National Cotton Council v. EPA

On January 7, 2009, the Sixth Circuit Court of Appeals in National Cotton Council, et al, v. EPA, reversed EPA’s November 2006 Aquatics Pesticides rule and held that National Pollutant Discharge Elimination System (NPDES) permits are required for all biological pesticide applications that leave a residue in waters of the United States. 553 F.3d 927 (6th Cir. 2009). On August 3, 2009, the Sixth Circuit denied a request for rehearing. Many worry this decision will have significant impacts on agriculture operations and may greatly increase the

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number of permits required for the agriculture industry. EPA estimates that the ruling affects approximately 365,000 pesticide applicators that perform 5.6 million pesticide applications annually. National Pollutant Discharge Elimination System: Agriculture, EPA, http://cfpub.epa.gov/npdes/home.cfm?program_id=41. On November 3, 2009, several agricultural groups, including the American Farm Bureau Federation, National Cotton Council, CropLife America, and the American Forest and Paper Association filed a petition for certiorari to the U.S. Supreme Court seeking reversal of the Sixth Circuit decision.

The background for this recent court decision began in November 2006 when EPA issued a final rule clarifying the following two specific circumstances when NPDES permits are not required to apply pesticides to or around water: 1) the application of pesticides directly to water to control pests; and 2) the application of pesticides to control pests that are present over or near water, where a portion of the pesticides will unavoidably be deposited into waters. Id. This action confirmed EPA’s past operating approach that pesticides legally registered under the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA) for application to or near water, and legally applied to control pests, are not subject to NPDES permit requirements because EPA did not consider these pesticides “pollutants.” Id. EPA stated aquatic pesticides applied consistent with FIFRA were not “chemical wastes” because “they are products that EPA has evaluated and registered for the purpose of controlling target organisms, and are designed, purchased, and applied to perform that purpose.” 71 Fed. Reg. 68.486 (Nov. 27, 2006). While EPA may have considered residual material remaining after the pesticide application a “pollutant,” the pesticide itself was not a pollutant at the time of discharge.

Environmental and industry groups challenged EPA’s aquatic pesticide rule in January 2007. After two years of litigation, the Sixth Circuit held the final rule was not a reasonable interpretation of the CWA and vacated the rule. National Pollutant Discharge Elimination System: Agriculture, EPA, http://cfpub.epa.gov/npdes/home.cfm?program_id=41. The Court mandated that NPDES permits were required for all biological pesticide applications that leave a residue in water when such applications are made in or over, including near, waters of the U.S.

On April 9, 2009, the Department of Justice chose not to seek rehearing of the case and filed a motion to stay the issuance of the Court’s mandate for two years. This was to provide EPA time to develop, propose and issue a final NPDES general permit for pesticide applications, for States to develop permits, and to provide outreach and education to the regulated community. The Sixth Circuit granted the stay. Within two years, NPDES permits will be required for pesticides applied directly to water to control pests in most instances. Id. NPDES permits will not be required for application of chemical pesticides that leave no residue in the receiving waters. Irrigation return flows and agricultural runoff will also not require NPDES permits as they are specifically exempted from the CWA. Id.

EPA expects to propose its general permit by April 2010 and issue a final permit by December 2010. EPA plans to use the remaining four months until the Court’s mandate takes effect to provide outreach and education to the regulated community. EPA will develop and issue a general permit for the states of Massachusetts, New Hampshire, Idaho and New Mexico, and territories, tribal, and federal lands for which it has NPDES permitting authority. EPA will coordinate with the 45 NPDES-authorized states as they develop their proposed and final general

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permits. Pesticides NPDES Permit Program, Minnesota Pollution Control Agency, http://www.pca.state.mn.us/water/pesticidepermit.html.

EPA National Enforcement Priorities

EPA sets national enforcement priorities every three years in order to focus the department’s resources on high priority environmental and human health problems. EPA is in the process of determining national enforcement priorities for years 2011-2013. EPA accepted public comments on the potential priority candidates from January 4-19, 2010. EPA is considering the following issues for its 2011-2013 national enforcement priorities:

• Concentrated Animal Feeding Operations (CAFOs) • Air Toxics • Environmental Justice – Community Based Approach • Indian Country Drinking Water • Marine Debris • Mineral Processing • Municipal Infrastructure • New Source Review/Prevention of Significant Deterioration • Resource Conservation and Recovery Act (RCRA) Enforcement • Resource Conservation and Recovery Act (RCRA) Financial Assurance • Resource Extraction • Pesticides at Day Care Facilities • Surface Impoundments • Wetlands • Worker Protection Standards

Additional information about each of these priority candidates is available at EPA’s website, http://www.epa.gov/compliance/data/planning/priorities/index.html.

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NCFC LTA COMMITTEE

DIGEST OF CURRENT COOPERATIVE TAX DEVELOPMENTS 12/1/2008 – 12/28/2009

George W. Benson McDermott Will & Emery LLP Chicago, Illinois

This digest outlines the significant cooperative tax developments since December 1, 2008. The focus of this annual digest is primarily upon federal income taxes and upon issues of taxation that are peculiar to Subchapter T cooperatives. In addition, developments affecting the taxation of other kinds of cooperative or mutual organizations are included where those developments may have some interest to Subchapter T cooperatives. Also, some more general tax issues of potential interest to agricultural cooperatives are included.

Index and Capsule Summary Cases

1. Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Insurance Company, et al., 588 F.Supp.2d 919 (D. Ind. 2008), aff’d 582 F.3d 721 (7th Cir. September 17, 2009). Hoosier Electric, a rural electric cooperative that was involved in a SILO (sale-in, lease-out) tax shelter, obtained a preliminary injunction against creditors involved in the transaction who are seeking to enforce their rights after the credit rating of Ambac (who had been providing credit support to the transaction) declined placing Hoosier in violation of various covenants. The Seventh Circuit affirmed the decision, while casting doubts on the position of Hoosier Electric on the merits and instructing the District Court to review (and implicitly to increase) the security posted by Hoosier. Moreover, the Seventh Circuit placed a deadline of December 31, 2009, for Hoosier to replace Ambac, failing which, the creditors can enforce their rights. On remand, the District Court increased security to $140 million. See unreported decision dated October 5, 2009.

2. Community First Credit Union v. United States, 08-C-0057 (E.D. Wis. 5/15/2009). A jury concludes that credit life, credit disability and guaranteed auto protection insurance policies offered by Community First, a credit union exempt from taxation under Section 501(c)(14), to members in conjunction with loans do not give rise to unrelated business taxable income.

3. Bellco Credit Union v. United States, 2009-2 USTC ¶50,749 (D. Col. 2009). On cross motions for summary judgment, the District Court ruled in favor of Bellco, a credit union exempt from taxation under Section 501(c)(14), that certain financial services income

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from the provision of products and services to members was not unrelated business income. The District Court ruled in favor of the Government with respect to income from the provision of services and products to nonmembers and with respect to several other categories of income. On other issues, including the tax consequences of credit life insurance and accidental life and dismemberment insurance offered to members of Bellco and others, the Court held that summary judgment was not appropriate and that those issues should go to trial. In a subsequent order dated December 1, the District Court bifurcated issues of liability from computation issues and indicated that a scheduled December 7 trial would focus on issues of liability.

Private Letter Rulings

4. Ltr. 200845007 (July 30, 2008). A regulated investment company must figure the ten percent charitable contribution limitation after the dividend-paid deduction for distributions to investors. A contrary ruling previously issued to a REIT is found to be “incorrect.” This ruling parallels IRS position with respect to the patronage dividend deduction.

5. Ltr. 200849016 (September 11, 2008). The IRS provides guidance for an exempt rural electric cooperative that is acquiring an electric and natural gas distribution business and wants to operate that business as a separate division.

6. Ltr. 200852022 (September 17, 2008). Milk checks paid by a dairy cooperative are per- unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation.

7. Ltr. 200907014 (October 23, 2008). Gain realized by a rural telephone cooperative from the sale of a partnership interest in a cellular telephone company is patronage-sourced under pre-Subchapter T law.

8. Ltr. 200907040 (November 19, 2008). A rural electric cooperative’s capital plan (which involves a mandatory redemption of equities at a discount) will not jeopardize the cooperative’s tax exempt status under Section 501(c)(12).

9. Ltr. 200909016 (November 24, 2008). Milk checks paid by a dairy cooperative are per- unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation.

10. Ltr. 200909020 (November 26, 2008). Milk checks paid by a dairy cooperative are per- unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation. The cooperative was permitted to allocate a portion of the year’s Section 199 deduction to members before year end based on estimates, with a true- up after year end.

11. Ltr. 200910007 (December 2, 2008). A demonstration cellulosic ethanol plant qualifies for additional first year depreciation.

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12. Ltr. 200916004 (December 31, 2008). Gain (depreciation recapture) realized by a nonexempt rural electric cooperative upon the sale of an undivided interest in a nuclear power plant is patronage-sourced under pre-Subchapter T law. The gain may be split between member and nonmember “in accordance with their respective usage percentages of electricity generated by the station.”

13. Ltr. 200935019 (May 14, 2009). Gain realized by a cooperative in the process of liquidation upon the sale of its warehouse and office building is patronage-sourced. The IRS permitted the cooperative to allocate the gain only to persons who were members at as of the end of the fiscal year during which the sale occurred based upon patronage during the period the warehouse was owned.

14. Ltr. 200930035 (April 16, 2009). Beet payments (other than the final beet payment each year) paid by a sugar beet processing cooperative are per-unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation.

15. ILM 200935022 (May 11, 2009). Taxpayer qualified for the small ethanol producer credit during its first year of operation even though by the time it filed its return for the first year the taxpayer knew it would not qualify for the credit in the second year.

16. Ltr. 200942022 (July 9, 2009). Grain payments made by a local grain marketing cooperative are per-unit retain allocations paid in money (even though the cooperative does not pool) and thus can be added back in the cooperative’s Section 199 computation.

17. Ltr. 200946020 (August 13, 2009). This ruling addresses how a Section 199 computation should be done when two cooperatives are included in an expanded affiliated group, following Treas. Reg. §1.199-7 and allowing wages paid by the cooperatives to be aggregated in the computation along with QPAI and taxable income.

18. Ltr. 200946021 (August 12, 2009). Grain payments made by a federated grain marketing and soybean processing cooperative are per-unit retain allocations paid in money (even though the cooperative does not pool) and thus can be added back in the cooperative’s Section 199 computation.

19. Ltr. 200946057 (August 18, 2009). This ruling confirms that a rural electric cooperative will retain its exempt status if it enters into the business of distributing natural gas on a cooperative basis. For purposes of determining whether the 85% member income test is met, the test should be done considering its electricity and natural gas distribution businesses together.

20. Ltr. 200949018 (August 31, 2009). Crop payments paid by a marketing cooperative for its members crops are per-unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation.

21. FAA 20095001F (October 7, 2009). In this field attorney advice, Government Counsel concluded that a Section 521 cooperative did not qualify for the small ethanol producer credit during a taxable year because during part of the year the cooperative owned more than 50% of an LLC that had a productive capacity in excess of 60 million gallons. Under

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the aggregation rule in Section 40(g)(2), the cooperative and the LLC were treated as one person during the period the cooperative owned more than 50% of the LLC.

Miscellaneous

22. Rev. Proc. 2008-65, 2008-44 IRB 1082, Rev. Proc. 2009-16 IRB 449, and Rev. Proc. 2009-33, 2009-29 IRB 150. Guidance issued under Section 168(k) for claiming enhanced limitations on the use of alternative minimum tax and research credits in lieu of bonus depreciation.

23. Section 45 and Section 1603 of the American Recovery and Reinvestment Tax Act of 2009. Taxpayers (including cooperatives) are entitled to apply for a grant in lieu of a credit when they place in service specified energy property that is an electric production facility otherwise eligible for the renewable electricity production credit under code Section 45 or qualifying property otherwise eligible for the energy investment credit under Section 48.

24. Notice 2008-90, 2008-43 IRB 1000. For now, taxpayers (including cooperatives) who are limited by the 10% charitable contribution limitation may choose to forego the enhanced deduction for food contributions and treat food contributions as cost of goods sold adjustments to extent permitted by Section 170(e)(1) and Treas. Reg. §1.170A-1(c). Comments are requested as the IRS reviews this area.

25. Notice 2009-64, 2009-36 IRB 1. This notice released for comment a proposed revenue ruling which provides that going forward ethanol plants will be classified as in MACRS asset class 49.5 (Waste Reduction and Resource Recovery Plants), with a life of seven years, instead of in MACRS asset class 28.0 (Manufacture of Chemicals and Allied Products), with a life of five years.

26. LMSB-04-0808-041, LMSB Tier 1 Issue – IRS Section 118 Abuse Directive #5 (September 18, 2008), 2009 TNT 21-47. Bioenergy program payments from the USDA are intended to compensate the taxpayer for operating costs incurred as a result of purchases of commodities in the taxpayer’s bioenergy production process and thus must be included in income. They do not qualify for exclusion from gross income as a contribution to capital under Section 118.

27. Form developments. A few changes were made to the 2008 Form 1120-C and instructions, including the addition of Schedule K, question 3 (“Check the accounting method used to compute distributable patronage: book, tax, other (specify).”) and question 4 (“Enter the amount of outstanding nonqualified notices of allocation (attach schedule).”). No changes were made to the Form 1099-PATR.

28. Section 3402(t) and Prop. Treas. Regs. §§ 31.3402(t)-0 to 31.3402(t)-7. Efforts are being made to implement a new three percent withholding requirement applicable to Government payments (including payments under a “government commodity support program”). The effective date has been delayed to 2012.

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29. The USDA enlists support of the IRS to enforce the income limitations in the 2008 Farm Bill.

30. IRS Exempt Organizations Workplan for Fiscal 2009. This contains some language of interest to Section 501(c)(12) cooperatives.

31. Form 8-K from Sysco Corporation (August 25, 2009). Sysco concedes tax case that appears to have been the subject of ILMs 200729035 and 200826004, discussed in prior Digests.

32. The Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92. Section 13 of this act provides a taxpayer with a special up to 5-year carryback for net operating losses incurred in either its fiscal year beginning in 2008 or 2009 (including relaxation of the 90% limitation for alternative minimum tax purposes).

33. USDA Economic Information Bulletin Number 54 entitled “Federal Tax Policies and Farm Households” (May, 2009). This report evaluates the impact of federal income and estate tax policies on the tax burdens and financial well-being of farm households.

Articles

34. “IRS Blesses a Cooperative’s Allocation of Gain on Asset Sale,” by David J. Shakow, 2008 TNT 247-37 (December 22, 2008). This article discusses Ltr. 200842011.

35. “Maximize Tax Savings from the Agricultural Chemicals Security Act,” by Earl B Johnston III, Corporate Taxation (January/February 2009). Discusses Section 25O credit for qualified chemical security expenditures.

State Tax Developments

36. Washington Tax Determination No. 08-0301, 28 WTD 68 (October 28, 2008). A dairy cooperative is not acting as an agent for its members and thus is subject to the Washington Business and Occupation Tax.

37. Michigan Business Tax FAQ 08/26/2009 No. Mi42 (August 26, 2009). This FAQ provides a good summary of the Michigan Business Tax rules applicable to farmers and farmers cooperatives.

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Detailed Analysis

Cases

1. Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Insurance Company, et al., 588 F.Supp.2d 919 (D. Ind. 2008), aff’d 582 F.3d 721 (7th Cir. September 17, 2009).30

Although not technically a tax case, a recent decision in a civil suit brought by Hoosier Energy Rural Electric Cooperative, Inc. (“Hoosier”) against John Hancock Life Insurance Company provides ample commentary on a tax driven transaction, commonly know as a sale in – lease out or “SILO,” that has attracted significant IRS scrutiny over the past several years. See, Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Insurance Company, 588 F.Supp. 2d 919 (D. Ind. November 25, 2008). In 2005, the IRS declared that SILOs are abusive tax shelters. After a couple of courts issued opinions concurring in this judgment, the IRS last year provided settlement offers to taxpayers involved in these and similar transactions, pursuant to which the IRS would provide concessions on penalties in exchange for the taxpayers conceding most of the tax benefits.

Like many other transactions that the IRS has designated as tax shelters, SILOs require the participation of a tax-exempt or tax indifferent party, such as a foreign government, a local municipality or, in this case, a rural electric cooperative. The tax indifferent party generally will receive some form of compensation for its involvement, which is generally borne by the taxpayer who stands to receive the tax benefits from the transaction but without regard to whether the transaction actually yields the hoped for tax benefits. As such, the tax indifferent party’s involvement in a transaction of this sort might be viewed as entailing limited risk. This case focuses on a unique situation in which, due to the recent turmoil in the credit markets, the tax indifferent party stood to suffer a substantial and unanticipated monetary penalty for its involvement in the transaction. The prospect of this penalty spurred litigation between the parties. The Federal District Court condemned the SILO transaction and castigated the taxpayer that sought to reap the benefits of it, but largely spared the tax-exempt participant from its criticism.

Background

Hoosier is a rural electric cooperative exempt from income taxation under Section 501(c)(12). Hoosier owned and operated electric generating plants in Merom, Indiana. In 2002, Hoosier entered into a SILO transaction. Although the transaction was acknowledged to be quite complex, the court provided only a high level overview. As described by the court, the SILO involved Hoosier leasing certain assets of the Merom power plant to John Hancock for a term of 63 years. John Hancock made an up-from payment of $300 million for the 63-year lease. It then leased the same assets back for a term of 30 years. Of the $300 million payment, Hoosier kept approximately $20 million and deposited the balance with Ambac Assurance Corporation

30 This analysis of the case was prepared by Kevin J. Feeley, a partner in the Chicago office of McDermott Will & Emery LLP, and originally appeared in the Summer, 2009 TAXFAX Column in The Cooperative Accountant.

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(“Ambac”). The documents required Ambac to make rental payments to John Hancock on Hoosier’s behalf.

From a tax perspective, the key element was that the terms of the two leases were designed so as to allow John Hancock to take the position that it was the tax owner of the assets (i.e., possessor of the benefits and burdens of ownership). It would take this position even though Hoosier would likely continue to enjoy uninterrupted use and control of the Merom plant for its useful life. As the putative tax owner of the plant, John Hancock would be able to claim depreciation and related deductions for its full $300 investment in the property – deductions that were of little value to Hoosier by virtue of its exempt status.

A simple sale-lease back of property would expose John Hancock to the risk that Hoosier might default on the obligation to make lease payments. To mitigate its credit risk, the contracts required Hoosier to obtain a credit default swap (“CDS”) from Ambac for the benefit of John Hancock. Under the CDS agreement, if Hoosier defaulted on its lease obligations, John Hancock could demand a termination payment from Ambac. Under a separate CDS agreement, Ambac could then demand payment from Hoosier. Ambac also provided a surety bond for the benefit of John Hancock. In sum, Ambac assumed the risk that Hoosier might default on its lease obligations to John Hancock.

As a means of mitigating credit risk, a CDS is only as good as the entity that backs it. For this reason, sellers of credit protection (i.e., the party to whom to the credit risk is transferred) generally must possess a high investment grade credit rating. Under the SILO documents, John Hancock not only insisted that Hoosier obtain a CDS from a highly rated organization such as Ambac, but also that if the swap provider’s credit rating subsequently dropped below a specified threshold, that Hoosier would be required to obtain a substitute CDS from a financial institution with the requisite credit rating (a “qualified swap provider”). If it failed to do so, John Hancock could declare a default under the contracts, terminate the entire transaction, and demand an early termination payment from Ambac. Ambac, in turn, could seek a recovery of all or substantially all of this amount from Hoosier. The termination payment was determined by formula and appeared to approximate the net present value of all of the tax savings from the transaction, an amount in excess of $100 million.

It appears, then, that Hoosier’s exposure for participating in this SILO transaction was the risk (in 2002) that Ambac’s credit rating would deteriorate and that it would not be able to replace it with a qualified swap provider. Notably, Hoosier had no downside risk if the IRS were to successfully challenge John Hancock’s position that it was entitled to claim cost recovery deductions with respect to the plant. In this regard, a separate tax indemnity agreement expressly stated that Hoosier would be held harmless and have no liability for indemnification for loss resulting from “a determination that the transactions contemplated by the Operative Documents are a sham, lack a valid business purpose or have a substance different from their form.” Hoosier could also take comfort from the fact that its Federal regulator, the Rural Utility Service, approved the transaction (although apparently without considering any tax motivations on the part of the parties).

In June of 2008, Ambac’s credit rating was downgraded below the level specified in the CDS agreement. Hoosier was notified of the change, at which point it had 60 days under the CDS

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agreement to secure a replacement swap provider with the requisite credit rating. By that time the credit markets were just beginning their free fall. Hoosier notified John Hancock that conditions might make it impossible for it to find a substitute for Ambac within the 60-day period. In the summer of 2008, Hoosier twice requested and received extensions of the period, during which time it engaged in considerable negotiations with potential replacements for Ambac, keeping John Hancock apprised of all of its efforts. Meanwhile, Hoosier offered various alternative proposals to John Hancock, including waiving the credit rating requirement, restructuring or substituting other credit enhancements, and completely unwinding the transaction. John Hancock rejected these proposals.

After the expiration of a third extension period, John Hancock notified Ambac that an event of default occurred under the CDS agreement and demanded that a termination payment of $120 million be paid by October 31, 2008. Ambac informed John Hancock that it was ready, willing and able to make the termination payment, thus triggering Hoosier’s obligation to pay Ambac the same sum under the CDS between the two. To prevent this chain reaction, Hoosier filed suit in Indiana state court for a temporary restraining order seeking to enjoin Ambac from making the termination payment to John Hancock. The case was promptly removed to Federal district court, whereupon Hoosier filed a motion for preliminary injunction requesting the same relief.

The decision

In support of its motion, Hoosier’s principal argument was that the SILO transaction was an abusive tax shelter and, on this basis, the contract terms were contrary to public policy, void and unenforceable. As a back-up argument, Hoosier argued that the doctrine of commercial impracticability temporarily excused its performance under the governing documents. As to this defense, it argued that it should be provided an additional reasonable period of time to find a qualified swap replacement, at least until the credit markets begin to stabilize.

The Court accepted both of Hoosier’s arguments and granted the preliminary injunction. In so ruling, the court found that Hoosier would likely prevail in arguing that the contracts were illegal as contrary to public policy. While the judge acknowledged that the transaction documents were complex and he had limited time to render his ruling, his opinion left no doubt as to his distaste for the transaction. Actually, revulsion best describes the judge’s view of the transaction. The decision states that SILO transaction appears to have been “a pure, abusive tax shelter, with no economic substance at all”, citing an affidavit submitted by Hoosier’s expert witness which sought to show the similarities between the Merom SILO transaction and the one found unlawful in AWG Leasing Trust v. United States, 592 F. Supp. 2d 953 (N.D. Ohio May 28, 2008). John Hancock argued that even if the tax consequences of the leases were in question, the CDS agreement itself was legitimate and separable from rest of the SILO contracts, noting that the contracts had a standard severability clause. The court dismissed this argument, finding that the “[t]his deal was the attempted sale of tax deductions and no more than that; it appears to have been rotten to the core, so that the illegality affects every portion of the deal.”

The court was equally dismissive of John Hancock’s argument that Hoosier had contractually agreed to not challenge the tax treatment of the transaction or John Hancock’s efforts to claim the tax benefits that would flow from it. The court expressed indifference that Hoosier’s allegations that the SILO contracts were illegal may itself have breached such contracts. The

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court said it would not countenance an “oath of silence” to “defraud the taxpayers,” given that it is the taxpayers who support the very courts the parties assumed would protect their rights.

The court did acknowledge that Hoosier was a willing participant in a transaction that it now claims is a sham. However, the court did not believe that the theory of “unclean hands” should deny relief to Hoosier. Balancing the equities, the court saw that its ruling would likely elevate the credit risk above the level John Hancock thought it was assuming. However, the court was quick to point out that Hoosier was current on all payments due under the lease and had a reliable cash flow from its members, Ambac retained an investment grade credit rating, and it was protected by an over-collateralized mortgage and security interest in the Merom plant. By comparison, a denial of relief could force Hoosier into bankruptcy, potentially sticking Ambac with ultimate responsibility for the termination payment, while John Hancock would “walk[] away with the windfall of fraudulent tax benefits.” In sum, the potential harm to John Hancock paled to the irreparable harm that Hoosier would suffer if the court erroneously denied injunctive relief.

Since the court was granting only injunctive relief, a future court will have to make a final determination as to the rights of the parties and the granting of final equitable relief. This would include a determination of whether the SILO contracts are illegal and thus should be unwound. If they are not, the issue will be whether Hoosier should be given additional time to find a qualified swap replacement under the doctrine of commercial impracticability. And lastly, if the SILO contracts are found to be illegal, the question is whether and to what extent Hoosier should retain the $20 million up front benefit from the transaction.

Since the court’s role was to fashion a temporary equitable remedy and not to render a legal judgment on the core tax issue of whether the SILO conferred the desired tax benefits, the judge could feel less restrained in providing editorial comment on the tax motivations of the transaction. That said, the judge’s harsh treatment of the transaction will certainly be viewed as an endorsement of the IRS’s position on the legal merits and will fuel its efforts to pursue those taxpayers who did not take advantages of the IRS’s settlement initiative. The IRS will also likely point to this case to highlight the perils and unintended consequences of participating in these transactions, whether as the taxpayer or as the tax-exempt/indifferent party.

2. Community First Credit Union v. United States, 08-C-0057 (E.D. Wis. 5/15/2009).31

For some years, there has been a dispute brewing over whether state-chartered credit unions are subject to the unrelated business income tax (“UBIT”) when they sell credit life insurance, credit disability insurance, and guaranteed auto protection coverage (“insurance products”) to member borrowers. Historically, the credit union industry has not regarded the sale of insurance products to members as giving rise to UBIT, so long as the sales are made in conjunction with loans to members. Apparently for many years the Internal Revenue Service (“IRS”) accepted that treatment. However, in recent years, the IRS began sending signals that it was rethinking the

31 This description was prepared by Corey M. Wise, a law student from Northwest University, while serving as a summer associate at McDermott Will & Emery LLP, and appeared in the Fall, 2009 TAXFAX Column of The Cooperative Accountant.

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application of UBIT to the sale of insurance products and some other activities routinely carried on by credit unions.

In response, the credit union industry established a committee, referred to as the UBIT Steering Committee, to monitor the issue and to coordinate industry efforts. This committee is comprised of representatives from the Credit Union National Association (“CUNA”), the American Association of CU Leagues, the National Association of State CU Supervisors (“NASCUS”), and the CUNA Mutual Group

The issue was joined in 2006 and 2007 when the IRS National Office received a number of technical advice requests from IRS agents conducting audits of credit unions The agents asked whether various kinds of miscellaneous income routinely earned by credit unions, including income from the sale of insurance products, were subject to UBIT. The resulting IRS National Office technical advice memoranda were almost uniformly adverse to credit unions, concluding that the UBIT applied to most of the items, including the income from the sale of the insurance products. See, for example, TAM 200710019 (March 3, 2007).

The first of perhaps a number of cases arising from this dispute recently was tried in the U.S. District Court for the Eastern District of Wisconsin. After a several day trial, a jury rendered a verdict in favor of the credit union. See, Community First Credit Union v. U.S., 08-C-0057 (E.D. Wis. 5/15/09). While this case deals with a credit union, not a Subchapter T cooperative, this case and the credit union controversy should be of interest to Subchapter T cooperatives because there are parallels between the concepts of nonpatronage business and business subject to the UBIT.

Background A credit union serves as an alternative to other types of financial institutions, such as banks. A credit union is a cooperative financial association owned and controlled by its members (the individuals that maintain accounts at the credit union and use its services). Credit unions have a defined mission that separates them from other similar financial institutions. This defined mission is the promotion of thrift among members, providing credit at reasonable rates, and providing other financial services to its members. 12 U.S.C. §1752(1).

As a result of the quasi-charitable mission of promoting thrift and reasonably priced financial services, credit unions qualify for exemption from federal income taxation. However, credit unions are treated differently based on the origin of the charter. Federally-chartered credit unions are completely exempt from taxation as instrumentalities of the United States under Section 501(c)(1) of the Internal Revenue Code (all subsequent references to Section are to sections of the Internal Revenue Code). Federally-chartered credit unions are not subject to the UBIT. Rev. Rul. 89-94, 1989-2 C.B. 233. In contrast, state-chartered credit unions that are structured without capital stock and organized and operated for mutual purposes and without profit are exempt from taxation under Section 501(c)(14)(A). State-chartered credit unions are exempt with regard to income that is related to the credit union’s tax exempt purpose. However, state-chartered credit unions are subject to UBIT on income that is unrelated to the credit union’s tax exempt purpose under Section 511.

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Section 511 imposes a tax on the “unrelated business taxable income” of state-chartered credit unions. Section 512(a)(1) defines “unrelated business taxable income” as the gross income derived by an organization from any unrelated trade or business regularly carried on by it, less allowable deductions. An “unrelated trade or business,” as defined by Section 513(a), is any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its exempt function. Gross income is includable in the computation of unrelated business income if (i) it is income from a trade or business, (ii) the trade or business is regularly carried on by the exempt organization, and (iii) the conduct of such trade or business is not substantially related to the organization’s performance of its exempt functions. Treas. Reg. §1.513-1(a).

Gross income is derived from an “unrelated trade or business” within the meaning of Section 513(a), if the conduct of the trade or business which produces the income is not substantially related to the purposes for which exemption is granted. Treas. Reg. §1.513-1(d)(1). A trade or business is “related” to exempt purposes only if the conduct of the business has a causal relationship to the achievement of the exempt purposes. It is “substantially related,” for purposes of Section 513, only if the causal relationship is a strong one. Treas. Reg. § 1.513-1(d)(2).

Thus, for state-chartered credit unions, in order for activities like the sale of insurance products to escape the UBIT, the activities must contribute directly and importantly to the accomplishment of one or more of the credit union’s purposes – promotion of thrift, and providing low cost credit for its members through mutual and nonprofit operation.

The Community First case Community First, headquartered in Appleton, Wisconsin, is a Wisconsin state-chartered credit union that is a nonprofit, mutual, member-owned financial cooperative. Under Wisconsin Statutes section 186.01, a state-chartered credit union is defined as “a cooperative, nonprofit corporation incorporated to encourage thrift among its members, create a source of credit at a fair and reasonable cost, and provide an opportunity for its members to improve their economic and social conditions.”

Community First offers a wide array of financial products to members, including the three insurance products. Community First offers the insurance products in conjunction with loans to members to protect members in the event an unexpected occurrence affects their ability to repay their loans. Notwithstanding that fact, the IRS asserted that the sale of the insurance products was not substantially related to Community First’s exempt purpose, and that income from the sale was therefore subject to UBIT

Community First filed its 990-T tax return for the taxable year 2006, treating the sale of insurance products as subject to the UBIT. It then filed an Amended Form 990-T for the year, claiming a refund of the UBIT paid. The refund claim was not acted upon by the IRS, and so Community First filed a complaint on January 15, 2007 in federal court, asking for a jury trial. Community First claimed that it overpaid federal income taxes in the amount of $54,604 in relation to the sale of the insurance products in connection with loans extended to members in 2006. Community First claimed that the insurance products are “substantially related,” within

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the meaning of Section 513(a) and Treas. Reg. §1.513-1(d), to the exempt purposes and functions of Community First as a tax-exempt state-chartered credit union under Wisconsin law.

The credit union industry supported and closely watched Community First’s case. The day after Community First filed its complaint CUNA Executive Vice President and General Counsel Eric Richard said that the entire credit union movement owes Community First “a debt of gratitude” for taking on the UBIT issue in federal district court. CUNA News Now 1/16/07. In support of Community First’s legal action, NASCUS President/CEO Mary Martha Fortney said that “state regulators and state legislators have long recognized that credit unions must evolve their products and services to meet the needs of their members. The IRS must understand that credit unions offer certain products to their members in an effort to promote thrift and savings, as a part of the credit union’s purpose.” CUNA News Now 1/16/07.

There was considerable pre-trial sparring between the parties over a variety of matters during the year and one-half it took the case to come to trial. Community First seemed to come out ahead in most of the disputes. In one pre-trial ruling, Judge Griesbach wrote:

“The unstated, but apparent premise of the government’s argument is that credit life and GAP insurance could be substantially related to a credit union’s tax- exempt purposes if they were offered at lowered rates. That is, no one argues that credit and GAP insurance isn’t related to the business of credit unions – the argument is simply that the premiums charged are too high.” CUNA News Now 4/30/09.

Judge Griesbach expanded on his views by writing that “it would be one thing if there were allegations of lavish executives perks or waste, but it appears the bulk of the premiums is actually going into the pockets of the members who are depositors.” CUNA News Now 4/30/09.

The trial and verdict

The case came to trial in May. After a four day trial, the jury deliberated for less than two hours and delivered a verdict in favor of Community First. The jury entered a special verdict on May 14, 2009 that found that the sale of the insurance products to Community First’s members was substantially related to Community First’s purposes as a tax-exempt credit union and therefore Community First was entitled to a refund for the amount of UBIT paid in relation to those products. After the verdict was delivered, the government’s attorney filed a motion asking the judge to set aside the verdict and enter judgment for the Government as a matter of law. On July 14, Judge Griesbach denied the Government’s motion, observing:

“The government’s arguments are familiar ones. It highlights the testimony of its experts and other evidence presented at trial that showed that Community First ‘overcharged’ for the insurance products and failed to adequately educate its members about them. … The jury was not irrational in concluding otherwise. … In particular, the government’s case largely relied on the notion that the insurance products were a ‘bad deal,’ but the jury was not bound to accept that conclusion.”

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The Government has 60 days to appeal this decision.32

Community First argued in its closing statement that sales of the insurance products at issue were substantially related to its purposes under Wisconsin law; that the insurance products were a source of credit with fair and reasonable rates and were directly connected to the loans made; and that the credit union educated members about the products to improve their financial conditions. CUNA News Now 5/15/09.

Brett Thompson, the President/CEO of the Wisconsin Credit Union League, praised the jury verdict and described the future importance of the products that were at issue in the trial.

“These products provide credit unions’ member-borrowers with greater peace of mind and so can be instrumental in re-starting our economy. This decision ensures consumers won’t be denied this opportunity or be forced to pay more for the protection they want.” CUNA News Now 5/18/09.

Thompson further added that the

“… ruling clarifies that these loan-related products are part of the everyday mission and purpose of credit unions. The jury agreed that these services help mitigate losses to the credit union, enabling Community First to make more loans – a central task related to a credit union’s mission of serving members.” CUNA News Now 5/18/09.

And lastly, but perhaps most importantly, Thompson added that the Community First ruling “strengthens the credit union movement’s position in other pending litigation related to UBIT issues.” CUNA News Now 5/18/09.

A few days later Eric Richard, CUNA Executive Vice President and General Counsel said that “the ruling follows 12 years of effort to obtain clarity from the Internal Revenue Service on credit union tax liability. We hope this will lead the IRS to reconsider its entire position on UBIT for credit unions.” CUNA News Now 5/20/09.

Aftermath The Community First case has not resolved the dispute. Other cases are in the pipeline, including one involving Bellco Credit Union, a Colorado credit union. Bellco has brought suit in the U.S. District Court for Colorado, seeking a $199,000 refund from the IRS related to UBIT paid on similar insurance products. CUNA News Now 5/20/2009.

This continues to be an important issue by the credit union industry. As Community First CEO Catherine Tierney emphasized, “this is about the credit union mission. Unlike a traditional bank, credit unions are owned by their members and are not for profit financial cooperatives. This issue goes to the heart of preserving the unique services that credit unions provide to millions of members every day across the nation.” It will be interesting to see how it ultimately is resolved.

32 The Government chose not to appeal.

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3. Bellco Credit Union v. United States, 2009-2 USTC ¶50,749 (D. Col. 2009).

This is case similar to the Community First case described in Item 2. It deals with whether various ancillary activities of a credit union, exempt from taxation under Section 501(c)(14), are subject to UBIT. There are some parallels between the analysis of whether activities are subject to UBIT and whether activities of a cooperative are nonpatronage so these cases are being reported in this Digest.

On cross motions for summary judgment, the District Court ruled in favor of Bellco, concluding that certain financial services income from the provision of products and services to members was not unrelated business income. The District Court ruled in favor of the Government with respect to income from the provision of services and products to nonmembers and with respect to several other categories of income. On other issues, including the tax consequences of credit life insurance and accidental life and dismemberment insurance offered to members of Bellco and others, the Court held that summary judgment was not appropriate and that the issues should go to trial.

In a subsequent order dated December 1, the District Court bifurcated issues of liability from computation issues and indicated that the trial would focus on issues of liability.

The case went to trial on December 7. Fifteen witnesses testified, eleven for Bellco and four for the government. At the conclusion of the trial, the Government moved for summary judgment as a matter of law, arguing that Bellco had not met its burden of proof. That motion was denied. The judge then asked for post-trial briefs from both sides by February 1, 2010, reportedly indicating that some of the issues in the case are difficult. See, “UBIT case oral arguments end, briefs due Feb. 1,” CUNA News Now (December 15, 2009).

We will report on the outcome of this case in next year’s Digest.

Private Letter Rulings

4. Ltr. 200845007 (July 30, 2008).

Section 170(b)(2)(A) limits the deductions that a corporation may claim for charitable contributions in any year to “10 percent of the [corporation’s] taxable income.” Section 170(b)(2)(C) provides that the term “taxable income” means the corporation’s taxable income “computed without regard to” any charitable contribution deduction, any dividends-received deduction, any net operating loss or capital loss carryback and any Section 199 deduction. Unused charitable contributions deductions may be carried over five years. Section 170(d)(2)(A). If not used in that period, unused charitable contributions deductions expire.

For cooperatives, the Internal Revenue Service has consistently interpreted the reference to taxable income as applicable to a cooperative’s taxable income after the deduction for or exclusion of per-unit retain allocations and patronage dividends. See, for example, Ltr.

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5407286100A (July 28, 1954) and TAM 6507096300A (July 9, 1965). There is no provision permitting cooperatives to pass unused charitable contributions through to members.

The Internal Revenue Service position can reach anomalous results. For instance, a cooperative with book and taxable income (before patronage dividends) of $1 million, which distributes $900,000 as patronage dividends and makes a $100,000 charitable contribution, ends up taxed on $90,000 ($1 million – $900,000 – (10% x $100,000) = $90,000). If the charitable contribution limitation was based upon taxable income without regard to patronage dividends, there would be no tax due ($1 million – $900,000 – (10% x $1,000,000) = $0).

In the past, some cooperatives arguing against the Internal Revenue Service’s interpretation have cited by way of analogy Ltr. 8626065 (March 28, 1986), which concluded that a real estate investment trust could determine its charitable contribution deduction limitation based upon its taxable income determined without regard to any deduction for dividends paid permitted by Section 857(b)(2)(B).

However, in Ltr. 200845007 (July 30, 2008), the Internal Revenue Service declined to follow that ruling when asked to apply the same analysis to a regulated investment company, observing that it now believes that the conclusion reached in the 1986 private letter ruling is “incorrect.” The Internal Revenue Service went on to observe that the list of adjustments to taxable income contained in Section 170(b)(2)(C) is “an exclusive list of adjustments that must be made to a corporation’s taxable income as defined in §63 in order to calculate the amount of the corporation’s charitable contribution deduction under §170.”

5. Ltr. 200849016 (September 11, 2008).

A rural electric cooperative, exempt from tax under Section 501(c)(12), purchased electric and natural gas distribution accounts from a utility. The new customers were made members of the cooperative with full voting rights and with the right to share in patronage refunds. The cooperative reorganized its business into two operating divisions – one for electric energy distribution and the other for natural gas distribution.

In Ltr. 200849016 (September 11, 2008), the rural electric cooperative sought confirmation from the IRS that entering the natural gas distribution business would not jeopardize its Section 501(c)(12) status. The IRS readily concluded that natural gas distribution is a “public utility type service” and that it “fits squarely within the definition of a ‘like organization’ activity.” In so ruling, it relied upon prior published rulings identifying the distribution of gas as a public utility type service.

The rural electric cooperative also sought assurance from the IRS that operating through two divisions was “consistent with cooperative operating principles.” The IRS provided that assurance, observing:

“Further, we find no statutory or regulatory provisions which would discourage, much less prohibit, you from establishing separate operating divisions to manage your electric and natural gas delivery services, respectively. Creating the most

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appropriate structure to provide goods or services to consumers is generally a matter of business judgment.”

There is no analysis for this holding other than the paragraph quoted above. It is common practice for Subchapter T cooperatives to operate through multiple divisions (or allocation units), and perhaps the IRS relied upon its familiarity with the practice in reaching this conclusion.

Finally, the cooperative sought guidance as to whether, after it established two separate operating divisions, its compliance with the 85% member income test would be measured separately for each operating division or continue to be measured on a cooperative-wide basis. The IRS ruled that compliance “may be computed based on all approved ‘like organization’ activities in the aggregate, and not on each separate function or line of business.”

6. Ltr. 200852022 (September 17, 2008).

During the past two years, the IRS has issued a number of private letter rulings to marketing cooperatives confirming that payments made to members for farm products are per-unit retain allocations paid in money which should be disregarded (i.e., added back) in their Section 199 computation.

Last year’s digest described four private letter rulings issued to dairy cooperatives reaching this conclusion. Ltrs. 200838011 (June 19, 2008), 200843015 (July 21, 2008), 200843016 (July 21, 20008) and 200843023 (July 24, 2008). So far this year, the IRS has released seven additional rulings reaching the same conclusion, three to dairy cooperatives (Ltrs. 200852022 (September 17, 2008), 200909016 (November 24, 2008) and 200909020 (November 26, 2008)), one to a sugar beet processing cooperative (Ltr. 200930035 (April 16, 2009)), two to grain cooperatives (Ltrs. 200942022 (July 9, 2009) and 200946021 (August 12, 2009), and one to an unidentified marketing cooperative (Ltr. 200949018 (August 31, 2009)). Several other grain and other cooperative rulings have reportedly been issued, but have not yet been released to the public.

Most of the dairy cooperative rulings are similar. In Ltr. 200909020, in addition to asking for the basic rulings, the cooperative asked the IRS to approve an approach that involved allocating an estimated amount of Section 199 deduction among members prior to year end with a true-up allocation after year end. The purpose of this plan was to allow members to benefit from the pass-through deduction sooner that they would have if the cooperative had waited to pass it through until after year end. The IRS ruled:

“(3) Coop’s proposed method for identifying the amount of the section 199 deductions to be passed through to its members, employing an initial identification and a final identification, is consistent with the requirements of section 199(d)(3)(A) of the Code.”

The dairy, sugarbeet and unidentified marketing cooperative rulings all involve cooperatives that pool the proceeds of members. The cooperatives had never regarded their milk checks and beet payments as per-unit retain allocations paid in money, and had not reported them in that manner

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on their tax returns. Nevertheless, the IRS recognized that they were in fact per-unit retain allocations paid in money and allowed them to be added back in the Section 199 computation.

In an IRS legal memorandum discussed in last year’s Digest, the IRS National Office suggested that this conclusion was not limited to cooperatives that pool. See, ILM 200806011 (October 22, 2007). That memorandum indicated that payments made by marketing cooperatives to members for their products also met the definition of per-unit retain allocations paid in money. It is probably safe to say that prior to that statement no nonpooling cooperative had ever regarding crop payments as per-unit retain allocations paid in money, but the ILM encouraged several to file ruling requests.

The result is the two rulings issued to grain cooperatives listed above. The first of these rulings involved a local grain marketing cooperative whose operations are probably very similar to those of the thousand or more local grain marketing cooperatives in the United States. Grain cooperatives do not pool. Each member is paid a market price for his or her grain, determined based upon how and when the member chooses to deliver the grain to the cooperative. Net earnings of the cooperative (determined treating grain payments as a cost of product) are shared as patronage dividends on the basis of bushels delivered, but other proceeds are not. The ruling carefully described how the cooperative operated and the grain payments were determined. The IRS ruled that the grain payments are per-unit retain allocations paid in money because they meet the requirements set forth in Section 1388(f) of the Code, following the direction first taken in ILM 200806011. Thus, the payments can be added back in the Section 199 computation.

The second grain ruling deals with a federated cooperative and reached the same result.

These rulings indicate that the IRS thinks that, at least in most cases, the Section 199 computation is pushed up to the cooperative level. For instance, in the first grain ruling the IRS stated:

“The effect of the section 199 provisions is that a cooperative will compute the entire section 199 deduction at the cooperative level and that none of the distributions whether patronage dividends or per-unit retain allocations received from the cooperative will be eligible for section 199 in the patron’s hands. That is, the patron may not count the qualified payment received from the cooperative in the patron’s own section 199 computation whether or not the cooperative keeps or passes through the section 199 deduction. Accordingly, the only way that a patron can claim a section 199 deduction for a qualified payment received from a cooperative is for the cooperative to pass through the section 199 amount in accordance with the provisions of 199(d)(3) of the Code and the regulations thereunder.”

These rulings open the door for cooperatives and their members to enjoy significant tax benefits from Section 199, but there remain a number of unanswered questions with respect to the mechanics of implementing Section 199.

One question that has arisen is whether marketing cooperatives must report member payments to the IRS if those payments are treated as per-unit retain allocations paid in money. The Internal

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Revenue Code and regulations do not require such reporting, but the IRS has taken the position in the instructions to Form 1099-PATR that per-unit retain allocations paid in money must be reported on box 3 of that form. In the second grain ruling,33 the IRS stated:

“Such per-unit retains are to be reported in box 3 of Form 1099-PATR, ‘Taxable Distributions Received from Cooperatives.’”

Reportedly, the IRS plans to include that language in all future Section 199 rulings to cooperatives.

Another area where the rulings appear to be creating some confusion is in the area of inventory accounting. Many cooperatives that pool have historically treated per-unit retain allocations paid in money or certificates as proceeds distributions to members, not as a cost of product. Thus, to the extent that members’ crops remain in inventory at year end, payments to members related to those costs are not included in inventory. The IRS National Office is aware of that practice and has approved it.

Many of the cooperatives that have received Section 199 rulings have not accounted for crop payments in this manner, but rather have treated crop payments as purchase price for the crops being marketed, has deducted them as cost of goods sold (not as a per-unit retain allocation paid in money) and has included an appropriate amount in inventory at year end.34 This practice apparently has caused the IRS National Office concern that cooperatives treating crop payments as per-unit retain allocations paid in money for Section 199 purposes might attempt to claim a double deduction. Thus, the rulings have all contained language to the following effect:

“We note that to prevent a cooperative from deducting the per-unit retain allocations made in money or qualified certificates for the second time when the associated product is sold, the cost of goods sold mechanism associated with inventory must be adjusted to reflect the deductions allowable under subchapter T. Specifically, cooperatives need to include the PURs in inventory cost for purposes of making inventory and section 263A of the Code computations and then adjust either ending inventory and cost of goods sold to prevent double deduction of the PURs. The adjustments can be made to either the inventory or the line item deduction for the PURs. In other word, if the PURs are deducted on a deduction line in the cooperative’s tax return, they should be removed entirely from the ending inventory and cost of goods sold computed for the tax year. Alternatively, if the PURs are not deducted on a deduction line in the tax return, the PURs reflected in the ending inventory should be removed and included in the cost of goods sold amount for that tax year. This procedure will allow the cooperative to deduct the PURs once while also preserving the integrity of its section 263A calculation.” (from the second grain ruling).

33 This ruling was issued to a federated cooperative, all of whose members were cooperative corporations. Since Form 1099-PATRs need not be issued to corporate members (See Treas. Reg. §1.6044-3(c)(2)), one wonders why the ruling contains this language. 34 Some of these cooperatives value their inventories at market at year end, not at cost (or lower of cost or market), so for them there is no direct linkage between amount paid their members and the value of their year-end inventories.

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This language is likely to receive increased scrutiny in years to come. Some tax advisors for cooperatives that have historically treated crop payments as purchase price for the crops (reflecting them as cost of goods sold and inventory cost) appear to regard this language as an invitation to change how they have historically treated crop payments for inventory purposes.35

7. Ltr. 200907014 (October 23, 2008).

In recent years, the Internal Revenue Service has issued a number of private letter rulings confirming that gain realized on the sale of assets used by a cooperative in a patronage business is patronage-sourced.

Ltr. 200907014 is another of these rulings. The fact pattern in this ruling is similar to that of several prior rulings. A telephone cooperative, which historically had been tax exempt under Section 501(c)(12), obtained a cellular telephone license. Along with another telephone cooperative and an investor-owned telephone company, it developed a cellular telephone business. The cooperative now plans to sell its interest in the cellular telephone business to a third party. The sale will generate a gain large enough so that the cooperative will lose its Section 501(c)(12) status for the year of sale. The cooperative will then be taxed as a nonexempt cooperative under pre-Subchapter T law. Rev. Rul. 83-135, 1983-2 C.B. 149. The cooperative plans to treat the gain as patronage-sourced and to include the gain in patronage dividends paid to members.

In each of the prior rulings, the cellular telephone business was conducted in a corporate entity, and the Internal Revenue Service determined that the gain realized by the cooperative on the sale of stock in the corporate entity was patronage-sourced. In reaching that conclusion, the Internal Revenue Service looked to the principles developed under Subchapter T law for distinguishing patronage income from nonpatronage income, which it said were equally applicable to nonexempt cooperatives taxed under pre-Subchapter T law

In Ltr. 200907014, the cellular telephone business was conducted in a partnership, and so the rural telephone cooperative was selling a partnership interest, not shares of stock.

However, the Internal Revenue Service reached the same conclusion that it did in the past, namely, that gain realized would be patronage-sourced. Applying Subchapter T principles, the Internal Revenue Service observed that the cooperative’s “initial investment and subsequent divestment of its cellular partnership interest were both directly related to and facilitative of the cooperative’s overall patronage business purpose of providing telecommunications services.”

8. Ltr. 200907040 (November 19, 2008).

35 Any such change (if it is determined to make sense) should only be made after carefully considering all of its ramifications to the cooperative involved and obtaining the required consent from the Internal Revenue Service.

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In recent years, this Digest has reported on a number of private letter rulings approving capital plans involving the redemption of allocated equities at a discount adopted by exempt Section 501(c)(12) rural electric and telephone cooperatives.

Ltr. 200907040 (November 19, 2008) is the latest in this line of rulings. It involves a rural electric cooperative that historically has revolved its allocated equities on a cycle of approximately 25 years. The cooperative plans to adopt a mandatory early retirement plan using a discount rate equal to the prime rate as published in the Wall Street Journal plus one percent.

In this most recent ruling, the IRS reiterates the view that capital plans involving the redemption of allocated equities at a discount are consistent with operating on a cooperative basis and will not lead to the loss of exempt status. In particular, the IRS observes:

“The cooperative requirement that there is no forfeiture of former members’ rights to assets of the cooperative is not violated. Specifically, the redemption program permits members and former members to receive the present value of their capital credit accounts (i.e., patronage savings) at a date earlier than the 25- year holding period or cycle. The discount rate is in accordance with the prevailing market rate.”

The rulings have studiously avoided any discussion of whether the redemption at a discount results in income to the cooperative and whether that income jeopardizes the rural electric cooperative’s exempt status because of the 85% member income test. It appears that the IRS does not regard this as an issue when an exempt cooperative redeems capital credits at a discount. Several years ago, the portion of the Internal Revenue Manual dealing with organizations that are exempt under Section 501(c)(12) was revised to provide:

“b. Under the tax benefit doctrine, a recovered item that produced an income tax benefit in a prior year must be included in income in the year it is recovered. However, an exempt cooperative will not usually receive a tax benefit by redeeming capital at a discount, because there has not been a related deduction, such as an offset to unrelated business income. If there was no tax benefit, there is no income. Therefore, the redemptions are ignored for purposes of the 85- percent member income test.” IRM 4.76.20.10(1)(b) (last revised 12-01-2006).

The cooperative’s proposed capital plan also provides that amounts payable to former members in redemption of their capital credits that are unclaimed after three years (and reasonable attempts have been made to locate the former members) will revert to the cooperative as a contribution to capital and will be recorded as part of net savings. Under the plan such amounts will not be “reallocated for any current or former members [but will be] retained … to benefit current and former members.”

The ruling confirms that the proposed treatment of unclaimed amounts “does not violate the cooperative requirements of democratic control by members and non-forfeiture of a member’s right to assets because your directors are subject to and responsive to the control of the members.” It concludes that the treatment of the unclaimed amounts will not adversely affect the

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cooperative’s exempt status under Section 501(c)(12). The Service caveats this conclusion with the observation that it “does not supersede state escheat or abandoned property laws.”

9. Ltr. 200909016 (November 24, 2008).

Milk checks paid by a dairy cooperative are per-unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation. See item 6.

10. Ltr. 200909020 (November 26, 2008).

Milk checks paid by a dairy cooperative are per-unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation. The cooperative was permitted to allocate a portion of the year’s Section 199 deduction to members before year end based on estimates, with a true-up after year end. See item 6.

11. Ltr. 200910007 (December 2, 2008).

Section 168(l) was enacted as part of the Tax Relief and Health Care Act of 2006 to provide a 50-percent additional first-year depreciation deduction in the case of any “qualified cellulosic biomass ethanol plant property.” As originally enacted, the provision defined “cellulosic biomass ethanol” to mean “ethanol produced by enzymatic hydrolysis of any lignocellulosic or hemicellulosic matter that is available on a renewable or recurring basis.” Section 168(l)(3). It also provided that the property must be used “solely” to produce cellulosic biomass ethanol. Section 168(l)(2)(A).

In Ltr. 200910007 (December 2, 2008), the taxpayer is engaged in the business of commercializing the production of cellulosic ethanol using exclusive proprietary technology. It is in the process of building a demonstration plant which, if successful, will allow for commercial production of ethanol. The plant is designed so that it can use diverse feedstocks – energy crops (energy cane, switchgrass, hybrid poplar wood, and elephant grass), agricultural wastes (sugarcane bagasse, rice hulls, corn fiber, sugar beet pulp, citrus pulp, or citrus peels), forestry wastes (hardwood or softwood thinnings or residues from timber operations), wood wastes (saw mill waste or pulp mill waste) and urban wastes (the paper fraction of municipal solid waste, municipal wood waste and municipal green waste).

The plant will use a multistage process that is described in detail in the ruling. Hydrolysis is used in several steps of the process, but one of the critical steps is fermentation, using proprietary enzymes. That step is what produces the ethanol. In addition, the process will produce a lignin- rich residue which will be burned in a boiler yielding steam for the demonstration plant’s biomass ethanol production process.

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The ruling addressed several questions. First, it analyzed whether the process met the requirement of that the ethanol be “produced by enzymatic hydrolysis” given the role that fermentation using the proprietary enzymes played in the process. Second, it considered whether the “solely” to produce cellulosic biomass ethanol requirement was met, given the production of a lignin rich residue as a byproduct of the process.

The ruling concluded that both of these requirements would be met, and that, assuming all other requirements are met, the plant will qualify for additional first-year depreciation. The ruling observed:

“Section 168(l) should be interpreted in light of the purpose it was intended to serve. Section 168(l) was enacted as an incentive for taxpayers to invest in property that produces ethanol from economical and renewable lignocellulosic or hemicellulosic feedstocks. As indicated in the following DOE sources, both hydrolysis and fermentation are necessary to produce ethanol from cellulosic biomass. [citations omitted]. Further, a lignin-rich residue from distillation is a common by-product of the cellulosic biomass-to-ethanol process. [citations omitted]. Accordingly, the necessary use of a fermentation agent to convert sugars to cellulosic ethanol and the common by-product of lignin from the cellulosic biomass-to-ethanol process should not disqualify an otherwise eligible plant from the additional first-year depreciation deduction provided by section 168(l).”

Section 168(l) was amended as part of the Emergency Economic Stabilization Act of 2008 presumably in part to address one of the issues presented by this ruling. The section now applies to property used to produce “cellulosic biofuel,” not just “cellulosic biomass ethanol.” The definition of “cellulosic biofuel” (“liquid fuel which is produced from any lignocellulosic or hemicellulosic matter that is available on a renewable or recurring basis”) no longer mentions “hydrolysis.” The additional first-year depreciation applies to qualifying property placed in service after October 3, 2008 and before January 1, 2013. Property financed using tax-exempt financing does not qualify.

12. Ltr. 200916004 (December 31, 2008).

In Ltr. 200916004 (December 31, 2008), the Internal Revenue Service ruled on several issues arising from the sale by a taxable rural electric cooperative of its undivided ownership interest in a nuclear generating plant and supporting facilities.

Owners of nuclear power plants are obligated by law to establish a trust fund to provide for the ultimate decommissioning of the plant, including the dismantlement, clean up and final disposal of the plant’s components. The trust is funded from charges to customers as they purchase electricity from the plant. Plant owners have the option of qualifying the decommissioning fund under Section 468A, which allows the plant owner to deduct contributions to the fund. The cooperative’s fund was not qualified (which meant that the cooperative had not been permitted to claim a deduction for contributions to the fund). The fund was treated by the cooperative as a

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grantor trust for tax purposes (which meant that the cooperative was subject to tax on income earned by the fund).

When the cooperative sold its interest in the plant, it also transferred its decommissioning fund to the purchasers, and the purchasers assumed the cooperative’s decommissioning liability.

The first issue addressed in the ruling is the tax consequence to the cooperative of the purchasers’ assumption of the decommissioning liability. The ruling concludes that the nuclear decommissioning liability that was assumed by the purchasers should be included in the cooperative’s amount realized and taken into account in computing taxable income in the year of the sale of the plant. At the same time, the ruling concludes that the cooperative could accrue its nuclear decommissioning liability (which it previous had not been able to accrue because it had not met the economic performance test) at the time of the sale. The ruling states:

“Where the purchaser expressly assumes a liability arising out of the taxpayer’s trade or business that the taxpayer but for the economic performance requirement would have been entitled to incur as of the date of the sale, economic performance with respect to that liability occurs as the amount of the liability is properly included in the amount realized on the sale by the taxpayer.”

The second issue addressed by the ruling is the treatment of the gain realized by the cooperative on the sale of its undivided interest in the plant. The ruling indicates that all of the cooperative’s gain from the sale of the plant will be treated as depreciation recapture, taxable as ordinary income under Section 1245 of the Code.

While taxable rural electric cooperatives are taxable under the rules applicable to cooperatives prior to the enactment of Subchapter T, the IRS looks to the principles developed under Subchapter T to determine whether income realized by such cooperatives is patronage-sourced and, if so, how that income should be allocated.

Based on Subchapter T law, the IRS had no difficulty concluding the recapture gain is patronage- sourced. See, Rev. Rul. 74-84, 1974-1 C.B. 244.

“In the instant case, Taxpayer is disposing of its interest in the Station, which is used in Taxpayer’s business. Thus, the amounts at issue are realized in a transaction that is directly related to the cooperative enterprise.”

The ruling then considers how that gain should be split between members and nonmembers. It concludes that the gain should be so split “in accordance with their respective usage percentages of electricity generated by the Station” because depreciation expense had been split in that manner over the period the cooperative owned the plant.

“Taxpayer has made nonmember electric power sales on a kilowatt (kW) basis and allocated depreciation expense between members and nonmembers based on their percentage usage of the Station through their purchase of electricity measured on kilowatt hours (kWh) basis. At Taxpayer’s conference of right, Taxpayer’s representatives submitted and discussed information relating to the historic usage of the Station’s depreciable property by the members and

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nonmembers based on their respective usage percentages of the electricity generated by the Station. Based on Taxpayer’s representations and the submission, during Taxpayer’s period of ownership of Station, member usage of the Station has been FF percent, on a weighted basis, of electricity generated by the Station for members and nonmembers use.”

The ruling does not describe how the cooperative planned to allocate the member portion of the gain among its members, but presumably that was on the same historic basis used to determine the member/nonmember split.

13. Ltr. 200935019 (May 14, 2009).

This ruling concludes that gain realized by what appears to be a retailer-owed grocery cooperative upon the sale of its warehouse, adjacent office building and land as part of the winding down36 of its business is patronage-sourced. It then reviews the plan for allocating the gain among patrons and distributing it as a patronage dividend and concludes that the method “is practicable and a reasonable method of distributing the Proceeds to the persons who were patrons during the taxable years in which the Property was owned…”

The conclusion that the gain is patronage-sourced is consistent with the IRS’s treatment of similar gains in recent years.

What is different is that the cooperative appears to have historically regarded gains from asset sales as nonpatronage. It had a capital structure, common among grocery cooperatives, that contemplated that asset gains would be shared by members based on their stock ownership, not their patronage.

The cooperative had two classes of stock – Class A shares (membership shares) and Class B shares. Each member owned one Class A share, which was purchased and redeemed at par value, and whose voting power changed “annually based on the annual purchases of products by the Shareholder Member.” In the event of redemption, the Class B shares were entitled to receive book value (which would reflect the after-tax amount of retained gains from asset sales). The cooperative paid patronage dividends to its members each year, but “net gains resulting from the sale or exchange of tangible or intangible assets used in Taxpayer’s business are not included in Taxpayer’s rebateable net income” for patronage dividend purposes.

According to the ruling, the cooperative represented that its “Bylaws and Articles as well as State A law, require it to distribute the Gain related to the sale of Taxpayer’s Property to Taxpayer’s patrons.” The IRS appears to have accepted this representation – there is no discussion of just what in State A law, the Articles and Bylaws required that the gain be allocated on a patronage basis (satisfying the “pre-existing legal obligation” requirement). Perhaps because the first ruling is based in part on this representation, the ruling letter concludes that the gain “represents

36 The ruling indicates that the cooperative had entered into a transition agreement with another cooperative, which was purchasing certain of the cooperative’s “inventory and assets.” It further indicated that “most Members have signed agreements to become members of Coop upon the eventual winding down of Taxpayer’s operations.”

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patronage source income that may be eligible for a patronage dividend exclusion…” (emphasis added).

The method to be used to allocate the gain is described in the ruling as follows:

“Taxpayer proposes to distribute Proceeds to its current Members in good standing as of the end of Taxpayer’s fiscal year in which the Effective Date of the sale occurred (… the ‘Allocation Date’), based on Members’ patronage over Taxpayer’s approximate [number redacted]-year holding period of the Property (the ‘Holding Period’). Members who withdrew from the cooperative prior to the Allocation Date will not receive any distribution of Proceeds related to the property even if the Member had patronage activities during the Holding Period.”

Several things are notable about this method of allocating the gain. First, the cooperative was willing and able to allocate the gain based on patronage over the entire holding period of the property. Second, distributions are to be made only to persons who remained members in good standing through the date of the sale. Third, the portion of the proceeds that would have gone to former members is to be included in the amount allocated to members in good standing at the time of the sale.

The IRS summarized the arguments made by the cooperative in support of its proposed method of allocation:

“Taxpayer believes that its proposed allocation method is appropriate because: (i) Taxpayer has computerized records that accurately track membership and patronage for the last [Redacted Text] fiscal years, and can compile paper records and verify that the paper records accurately track membership and patronage with respect to current Members for the preceding fiscal years during the Holding Period; (ii) Taxpayer's membership has been relatively stable over the Holding Period; (iii) the majority of the current Members have been Members for many years prior to the Allocation Date, including many who have been Members throughout the Holding Period; (iv) the current Members that would be entitled to the largest allocations have been Members for many years prior to the Allocation Date, including many who have been Members throughout the Holding Period; (v) a number of patrons have withdrawn from the cooperative throughout the Holding Period, and the administrative burden of tracking down such former Members would be material; (vi) inclusion of former Members would significantly increase the amount of Proceeds that would be unclaimed, inasmuch as many former Members are no longer in business; (vii) under Taxpayer's organizational documents, former Member no longer have a current financial interest in Taxpayer; and (viii) Taxpayer expects to cease operations, and it would be inequitable to permit long departed Members that will not be required to bear any costs associated with winding down the business to share in Proceeds.”

As noted above, the ruling concludes that the method of distributing the gain “is practicable and a reasonable method of distributing the Proceeds to the persons who were patrons during the taxable years in which the Property was owned, and such amounts paid by Taxpayer to its

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Members will be deductible as patronage dividends…” There is very little legal analysis in the ruling as to the basis for this conclusion. The ruling does cite Treas. Reg. §1.1382-3(c)(3), which provides guidance as to how Section 521 should allocate capital gains to members. That section provides in pertinent part:

“… if capital gains are realized by the association from the sale or exchange of capital assets held for a period extending into more than one taxable year income realized from such gains must be paid, insofar as is practicable, to the persons who were patrons during the taxable years in which the asset was owned by the association in proportion to the amount of business done by such patrons during such taxable years.”

That, apparently, was the standard being applied by the IRS in this ruling.

14. Ltr. 200930035 (April 16, 2009).

Beet payments (other than the final beet payment each year) paid by a sugar beet processing cooperative are per-unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation. See item 6.

15. ILM 200935022 (May 11, 2009).

In ILM 200935022 (May 11, 2009), the IRS considered an issue related to the small ethanol producer credit provided by Section 40(a)(3). Small ethanol producers are allowed a credit of 10¢ per gallon on up to 15 million gallons of ethanol produced. Cooperatives are permitted to pass that credit through to patrons. A “small ethanol producer” is defined as “a person who, at all times during the taxable year, has a productive capacity for alcohol … not in excess of 60,000,000 gallons.” Section 40(g)(1).

ILM 200935022 does not indicate whether the taxpayer being examined by the IRS was a cooperative. There is some language in the memorandum that suggests that it may have been a partnership or limited liability company.

The issue presented is an unusual one. The year under examination was the first year of operation of a new ethanol plant. The engineered boilerplate capacity of the plant was less than 60 million gallons. The EPA permit governing production at the plant was for less than 60 million gallons. The actual production for the first year was less than 60 million gallons. However, during the second quarter of the second year of operation (and before the tax return was filed for the first year), the taxpayer determined that the actual capacity of the plant exceeded the engineered boilerplate and what was permitted in its EPA permit and, more importantly, exceeded 60 million gallons. The taxpayer then (in the second year) applied for and received a permit from the EPA allowing it to produce more than 60 million gallons of ethanol at the plant. The increase in the actual capacity of the plant was not attributable in an upgrade to

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the plant. Apparently the plant as designed and constructed always had a production capacity in excess of 60 million gallons. The taxpayer just did not realize that it did.

The taxpayer claimed the small producer credit for the first year of operation, but not the second. On examination, the IRS questioned whether it was eligible to claim the credit in the first year.

In the ILM, the IRS National Office observed that there was no evidence that the taxpayer had “actual knowledge at any point during [the first] Taxable Year that its actual capacity” could exceed 60 million gallons. It concluded that “during [the first] Taxable Year, despite its subsequent knowledge, Taxpayer did not have a productive capacity for alcohol in excess of 60,000,000 gallons…”

16. Ltr. 200942022 (July 9, 2009).

Grain payments made by a local grain marketing cooperative are per-unit retain allocations paid in money (even though the cooperative does not pool) and thus can be added back in the cooperative’s Section 199 computation. See item 6.

17. Ltr. 200946020 (August 13, 2009).

Over the last year and a half, the IRS has issued a number of private letter rulings to cooperatives concluding that payments they make for their crops qualify as per-unit retain allocations paid in money which can be added back in the Section 199 computation. The rulings released during the past year are discussed in Item 6, above.

A number of other questions can arise when applying Section 199 to cooperatives. Ltr. 200946020 (August 13, 2009) addresses one of the other questions.

Two nonexempt Subchapter T cooperatives are involved Ltr. 200946020, a parent cooperative (referred to in the ruling as the “Taxpayer”) and a wholly-owned, one-member cooperative subsidiary. The parent operates on a pooling basis, receiving and processing crops produced by its members. According to the ruling, the subsidiary “purchases b products such as d from Taxpayer and sells them in the retail market. Subsidiary pays a negotiated price under a contract to Taxpayer for its products.” The subsidiary operates as a non-pooling cooperative, distributing any net patronage-sourced income it has each year to its parent as a patronage dividend. The two cooperatives have not elected to file a consolidated return for federal income tax purposes, and thus they file separate federal income tax returns.

Section 199(d)(3) and Treas. Reg. §1.199-6 provide special rules for the application of Section 199 to “specified agricultural or horticultural cooperatives.”

Section 199(d)(4) and Treas. Reg. §1.199-7 provide special rules for the application of Section 199 to “expanded affiliated groups” (EAGs), which are defined as an affiliated group of corporations determined using a more than 50% ownership test rather than the normal 80%

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ownership test. For Section 199 purposes, Section 199(d)(4)(A) provides that all members of an EAG are “treated as a single corporation.”

In simple terms, the Section 199 deduction of an EAG is determined as if it were one corporation, by “aggregating each member’s taxable income or loss, QPAI, and W-2 wages, if any.” Treas. Reg. §1.199-7(b)(1). Treas. Reg. §1.199-7(c)(1) provides that the EAG group’s Section 199 deduction “is allocated among the members of the EAG in proportion to each member’s QPAI, regardless of whether the EAG member has taxable income or loss or W-2 wages for the taxable year. For this purpose, if a member has a negative QPAI, the QPAI of the member shall be treated as zero.”

The issue addressed in Ltr. 200946020 is a technical issue. If the two cooperatives were not included in an EAG and each had figured its Section 199 deduction separately, the parent apparently would have been subject to the W-2 wages limitation and the subsidiary would have had excess W-2 wages. Under the EAG rules, it is clear that the computation should be done on a combined basis, and the excess W-2 wages of one could be used in the combined computation. However, the two cooperatives were concerned that the regulations applicable to cooperatives might preclude them from achieving this result. In particular they were concerned with the language of Treas. Reg. Section 199-6(i):

“(i) W-2 wages. – TheW-2 wage limitation described in §1.199-2 shall be applied at the cooperative level whether or not the cooperative chooses to pass through some or all of the section 199 deduction. Any section 199 deduction that has been passed through by a cooperative to its patrons is not subject to the W-2 wage limitation a second time at the patron level.” (emphasis added).

Notwithstanding the underscored language, the IRS concluded that “Taxpayer should apply the W-2 limitation as if all members of EAG were a single corporation and allocate the section 199 deduction to the EAG members in proportion to their contribution to the EAG’s QPAI.” It based this conclusion on the following analysis:

“Section 1.199-6(i) prevents manipulation of the section 199 deduction by precluding the cooperative from aggregating W-2 wages of the individual patrons and by restricting the application of the W-2 limitation a second time at the individual patron level. Section 1.199-6(i) does not supersede the EAG rules in §1.199-7, rather both rules apply. Thus, cooperatives such as Taxpayer and Subsidiary aggregate their taxable income, QPAI, and W-2 wages (wages of the cooperative employees not of the individual patrons), compute their section 199 deduction, and apply the W-2 wage limitation to the EAG. Section 1.199-6(i) does not override the application of the EAG rules in §1.199-7.”

There is one odd aspect to Ltr. 200946020. In the discussion of how the subsidiary figures its Section 199 deduction, the ruling states that the subsidiary adds back “the patronage dividend but not the amount paid to its parent, Taxpayer, for the b products.” (emphasis added). This appears to be contrary to the position that the IRS has been taking in rulings with respect to grain cooperatives which do not pool, with respect to the payments they make to patrons for their

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grain. (One of the grain rulings was released by the IRS on the same day as the release of Ltr. 200946020.)

It does not appear that the IRS was specifically asked to address the treatment of the payments made by the subsidiary to its parent for purposes of the Section 199 computation of the subsidiary and there is no discussion of this aspect in the ruling.

Whether the subsidiary adds back payments to the parent or not should not affect the total amount of the Section 199 deduction earned by the parent and subsidiary, but it would affect the allocation of that deduction between the parent and the subsidiary. The ruling is silent as to whether the parent and subsidiary were able to use their respective shares of the Section 199 deduction or whether the subsidiary passed its Section 199 deduction up to the parent and the parent in turn passed its Section 199 deduction to its members. If the Section 199 deductions were passed through, it is possible that some portion of the patronage deduction could be lost if the IRS later followed the approach taken in the grain rulings and allocated more of the EAG’s deduction to the subsidiary. By the time that was done on audit, it would be too late for the subsidiary to pass the additional amount through to its parent.

18. Ltr. 200946021 (August 12, 2009).

Grain payments made by a federated grain marketing and soybean processing cooperative are per-unit retain allocations paid in money (even though the cooperative does not pool) and thus can be added back in the cooperative’s Section 199 computation. See item 6.

19. Ltr. 200946057 (August 18, 2009).

This ruling confirms that a rural electric cooperative will retain its exempt status if it enters into the business of distributing natural gas on a cooperative basis. For purposes of determining whether the 85% member income test is met, the test should be done considering its electricity and natural gas distribution businesses together. See item 5.

20. Ltr. 200949018 (August 31, 2009).

Crop payments paid by a marketing cooperative for its members crops are per-unit retain allocations paid in money and thus can be added back in the cooperative’s Section 199 computation. See item 6.

21. FAA 20095001F (October 7, 2009).

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In this field attorney advice, Government Counsel concluded that a Section 521 cooperative did not qualify for the small ethanol producer credit during a taxable year because during part of the year the cooperative owned more than 50% of an LLC that had a productive capacity in excess of 60 million gallons. Under the aggregation rule in Section 40(g)(2), the cooperative and the LLC were treated as one person during the period the cooperative owned more than 50% of the LLC.

This field attorney advice discusses and rejects a number of arguments made by the cooperative for avoiding the application of the aggregation rule in its particular situation.

Miscellaneous

22. Rev. Proc. 2008-65, 2008-44 IRB 1082, Rev. Proc. 2009-16 IRB 449, and Rev. Proc. 2009-33, 2009-29 IRB 150.

The Economic Stimulus Act of 2008 amended Section 168(k) to extend the 50% bonus depreciation provisions to cover certain new property acquired after 2007 and placed in service before 2009. The provision also applies to certain property with a long production period and certain aircraft placed in service before 2010. Taxpayers are, as in the past, permitted to elect out of this provision for all eligible property or for specific classes of eligible property. Section 168(k)(2)(D)(iii).

The Housing and Economic Recovery Act of 2008 further amended Section 168(k) to provide taxpayers who are unable to benefit from bonus depreciation an alternative. Such taxpayers may elect enhanced limitations on the use of alternative minimum tax (AMT) and research credits in lieu of bonus depreciation. See, Section 168(k)(4). The credits covered by the enhanced limitations are potentially refundable if they can not be used. Section 168(k)(4)(F).

The election to choose enhanced credit limitations in lieu of bonus depreciation applies only to property otherwise eligible for bonus depreciation acquired after March 31, 2008 and placed in service before 2009 (2010 in the case of some property). To benefit, a corporation must have AMT credits and research credits carrying over to its first taxable year ending after March 31, 2008 which arose in taxable years beginning before January 1, 2006 (“pre-2006 carryovers”). The corporation must also be willing to forego not only bonus depreciation on all eligible property acquired during the applicable period, but also accelerated depreciation.

The enhanced credit limitation equals 20% of the depreciation that would otherwise have been claimed on the eligible property for the year. However, the enhanced limitation may not exceed 6% of the “pre-2006 carryovers” or $30 million, whichever is less. Thus, a taxpayer with $10 million of “pre-2006 carryovers” could potentially be entitled to an enhanced limitation on use of the credit carryovers of $600,000, provided that the depreciation that could otherwise have been claimed on the eligible property for the year exceeds $3 million. To the extent that the taxpayer could not use the increased limitation on its tax return for the year, the $600,000 would be refundable.

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Cooperatives with “pre-2006 carryovers” which would not otherwise receive much benefit from bonus and accelerated depreciation should take a look at this provision. However, a careful analysis needs to be made based on the facts of each situation to determine whether waiving bonus depreciation makes sense. For instance, a cooperative with significant taxable nonmember and nonpatronage income may find that the waiver does not make sense because it could benefit from bonus and accelerated depreciation.

Some guidance has been released with respect to Section 168(k). See, Rev. Proc. 2008-65. More is promised. The guidance that has been released so far reinforces the need for careful study. For instance, if a cooperative makes an election under Section 168(k)(2)(D)(iii) to forego bonus depreciation on certain classes of eligible property, it appears that it will not able to make an election under Section 168(k)(4) with respect to that property. See, Section 4.04 of Rev. Proc. 2008-65.

23. Section 45 and Section 1603 of the American Recovery and Reinvestment Tax Act of 2009.

Taxpayers (including cooperatives) are entitled to apply for a grant in lieu of a credit when they place in service specified energy property that is an electric production facility otherwise eligible for the renewable electricity production credit under code Section 45 or qualifying property otherwise eligible for the energy investment credit under Section 48.

24. Notice 2008-90, 2008-43 IRB 1000.

For now, taxpayers (including cooperatives) who are limited by the 10% charitable contribution limitation may choose to forego the enhanced deduction for food contributions and treat food contributions as cost of goods sold adjustments to extent permitted by Section 170(e)(1) and Treas. Reg. §1.170A-1(c). Comments are requested as the IRS reviews this area.

25. Notice 2009-64, 2009-36 IRB 1.

In last year’s Digest, we reported on a dispute that has arisen between producers and the IRS over the proper MACRS category for ethanol plants. We described ILM 200814025 (December 14, 2007) in which the IRS National Office took the view that ethanol plants were seven-year property because they fell within MACRS Asset Class 49.5 (Waste Reduction and Resource Recovery Plants), not five-year property under MACRS Asset Class 28.0 (Manufacture of Chemicals and Allied Products). In addition, we reported on the industry’s side of the argument as presented in a letter from the Renewable Fuels Association. We described CCA 200835032 (August 27, 2008), where the IRS concluded that the issue “is better addressed through the published guidance process” and that the earlier chief counsel advice “is not to be followed for determining appropriate tax depreciation deductions.”

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In Notice 2009-64, 2009-36 IRB 1, the IRS released a proposed published ruling taking the position enunciated in ILM 200814025 that ethanol plants fall within the longer life category (Asset Class 49.5). Perhaps to limit opposition, the proposed ruling provides that it will be effective only for assets placed in service after the date of the publication of the final ruling. The IRS has requested public comments and stated that the final ruling “will not be issued until the comments have been considered.”

It is relatively unusual for guidance to be issued in this manner (e.g., by releasing a proposed revenue ruling and asking for public comments, a process normally employed when regulations are being promulgated). Perhaps this approach is being used in an effort to improve the IRS’s position in Court if the position enunciated in the ruling is someday challenged.

26. LMSB-04-0808-041, LMSB Tier 1 Issue – IRS Section 118 Abuse Directive #5 (September 18, 2008), 2009 TNT 21-47.

Last year’s Digest commented on the treatment of payments made to ethanol and biodiesel producers by the USDA under a program known as the Bioenergy Program. See the description of an IRS coordinated issue paper (Coordinated Issue Paper Agriculture Industry: Section 118 – Characterization of Bioenergy Program Payments, LMSB 04-0308-019 (April 8, 2008)) contained in last year’s Digest. Some producers apparently have taken the position that such payments can be excluded from income under Section 318 as nonshareholder contributions to capital. In the coordinated position paper, the IRS took the position that such payments must be included in income since (in the IRS’s view) they are intended to compensate taxpayers for operating costs incurred as a result of purchases of commodities in the taxpayer’s bioenergy production process.

This issue was made an LMSB Tier I Issue by an announcement titled “Tier I Issue – IRC Section 118 Abuse Directive #5,” LMSB 4-0808-041 (September 15, 2008). According to a Fact Sheet issued by the IRS Large and Mid-Size Business Division:

“Tier I issues are of high strategic importance to LMSB and have significant impact on one or more Industries. Tier I issues could include areas involving a large number of taxpayers, significant dollar risk, substantial compliance risk or high visibility, where there are established legal positions and/or LMSB direction. Tier I includes recognized abusive and listed transactions as well as other ‘high- risk’ transactions and issues that represent LMSB’s highest compliance priorities….

Elevation of an issue into Tier I or Tier II does not necessarily mean the issue will be automatically disallowed on all returns. Whereas listed transactions are automatically subject to examination, Tier I high-risk issues are not necessarily examined and/or disallowed. Determinations as to the allowability of particular issues are made as they are fully developed.”

In a subsequent release titled “Tier I Issue: I.R.C. §118 Abuse Directive #7,” LMSB 4-0509-023 (June 4, 2009)), LMSB announced that the issue “has been moved from active Tier I status to

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monitoring status: However it remains a Coordinated Issue…” According to the LMSB Fact Sheet, Tier I issues are assigned to monitoring status when they have been “fully researched, developed and resolved.” Apparently the bioenergy payment issue is now considered “well- defined, and published guidance in the Form of a Coordinated Issue Paper … has been issued.” Tier I issues that are in monitoring status “can be evaluated and resolved pursuant to guidance from the Issue Management Team,” which is this case is headed by the LMSB Agriculture Technical Advisor.

27. Form developments.

The 2008 Form 1120-C is almost identical to the 2007 Form 1120-C. There are only two changes.

• First, the IRS added a new question 3 to Schedule K. That question asks cooperative’s to “check the accounting method used to compute distributable patronage: (a) book, (b) tax, (c) other (specify).”

• Second, the IRS added a new question 15 to Schedule K. That question asks cooperatives to “enter the amount of outstanding nonqualified notices of allocation (attach schedule).”

Presumably, these additions were made to assist examiners in auditing cooperatives and to gather information about cooperative practices.

The cooperative aspects of the instructions to the 2008 Form 1120-C are substantially identical to the 2007 instructions.

28. Section 3402(t) and Prop. Treas. Regs. §§ 31.3402(t)-0 to 31.3402(t)-7.

The Tax Increase Prevention and Reconciliation Act of 2005 contained a provision that provides that the “Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies) making any payment to any person providing any property or services … shall deduct and withhold from such payment a tax in an amount equal to 3 percent of such payment.” Section 3402(t) of the Internal Revenue Code.

Section 3402(t) was not included in either the House or the Senate version of the 2005 legislation, but rather was tucked into the bill when it was in Conference. Tax provisions that do not get public scrutiny before enactment are often not well thought out, and Section 3402(t) is no exception. Section 3402(t)(1), which imposes the withholding obligation, is drafted very broadly. Given the magnitude of Government payments today, this provision has extremely broad potential impact. Section 3402(t)(1) then provides nine specific exceptions to the rule, but those exceptions do not begin to cover all the situations where withholding does not make sense.

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There is relatively little legislative history explaining the intended scope of the provision. The Conference Committee Report largely paraphrases what is contained in the section. It does, however, provide:

“Payments subject to the three-percent withholding requirement include any payment made in connection with a government voucher or certificate program which functions as a payment for property or services. For example, payments to a commodity producer under a government commodity support program are subject to the withholding requirement.” (emphasis added).

Section 3402(t) was originally to be effective for payments made after December 31, 2010. The American Recovery and Reinvestment Tax Act of 2009 extended that date by one year so that withholding is now scheduled to apply to payments made after December 31, 2011. No other changes were made to the provision.

If Section 3402(t) goes into effect in its present form, it will affect many governmental entities and taxpayers. Last year, the Government began the process of drafting regulations. In Notice 2008-38, 2008-13 IRB 683 (March 31, 2008), the Internal Revenue Service invited comments with respect to guidance under Section 3402(t). Many comments were received. In December, 2008, the Internal Revenue Service and Treasury released a set of proposed regulations intended to provide a framework for implementation of Section 3402(t). Prop. Treas. Reg. Sections 31.3402(t)-0 to 31.3402(t)-7. Comments were again solicited and a hearing scheduled.

Many comments were submitted. The hearing was held on April 16, and Tax Notes Today reported:

“Fifteen practitioners at an April 16 IRS hearing repeatedly called for repeal of a requirement in section 3402(t) that government entities withhold 3 percent from payments to vendors, despite the futility of calling for legislative action at the forum. … One after another, speakers at the hearing complained about how much it would cost to comply with the provision, what little impact it would have on tax compliance, and the disastrous effects it would have on business. Speakers called for exemption, delayed implementation, or money to cover the administrative costs of complying with the proposed provision. … Even a Treasury official has submitted negative comments on the proposed regs, complaining that the Treasury Department would incur new, unfunded costs that could offset any potential benefits, but the IRS was unable to answer speakers’ calls for repeal of the statute that it is charged with implementing.”

The new provision would potentially apply to a host of payments that farmers and cooperatives receive from the Government. The American Farm Bureau Federation has stepped forward to comment on the proposed rules as they may apply to farmers. In March, 2008 the Farm Bureau criticized the provision at a House Small Business Committee hearing. This year the Farm Bureau submitted comments with respect to the proposed regulations. See 2009 TNT 49-36. The Farm Bureau also participated in a broad-based coalition (Government Withholding Relief Coalition) which submitted comments pointing out many problems with the provision, including problems presented for farmers. See 2009 TNT 52-21.

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So far there is no evidence that anyone in the cooperative community has submitted comments with respect to Section 3402(t). Farmer cooperatives receiving Government payments should analyze the impact of potential withholding on them.

If this provision comes into effect and there are no special exemptions, a cooperative entitled to receive (in its own right) $100 million from a government commodity support program will in fact receive $97 million in cash, with $3 million withheld for taxes. Assuming that the $100 million is all member patronage income and is passed-through to members, the cooperative will owe no tax on that income. It seems senseless to impose withholding in such a case. There is no mechanism to attribute the withheld tax to the members who will owe tax with respect to that income.

The $3 million in tax withheld could, presumably, be applied against any other tax liability the cooperative might have for the year. Presumably, any excess would eventually be refunded. If the withheld tax is all refunded (which would be the case for a pure cooperative with no nonmember/nonpatronage income), one might wonder why withholding should apply in the first place. The withholding would effectively operate like an interest free loan from the cooperative to the Government. If the cooperative receives Government payments each year, the interest free loan would effectively be perpetual.

Given the outpouring of negative comments, if there is any rationality in the tax world (which may be a large assumption these days), it is likely that something will happen to Section 3402(t) before it becomes effective – e.g., its implementation will be further delayed, it will be repealed, it will be rewritten to be more limited in scope and targeted to areas where there is perceived underreporting. Stay tuned for future developments.

29. The USDA enlists support of the IRS to enforce the income limitations in the 2008 Farm Bill.

The 2002 Farm Bill for the first time placed a gross income limitations upon producers eligible to participate in various farm programs. A person with adjusted gross income (AGI) of over $2.5 million, averaged over 3 years, was not eligible for payments unless more than 75% of the AGI was from agriculture.

In the 2008 Farm Bill, Congress modified the gross income limitations, tightening up the requirements for eligibility.

Under the 2008 Farm Bill, a person with average adjusted gross nonfarm income in excess of $500,000 is not eligible for direct, counter-cyclical, average crop revenue election, marketing loan gain, loan deficiency, noninsured crop assistance, milk income loss contract program, or disaster assistance payments or benefits. A person with average adjusted gross nonfarm income in excess of $1 million is not eligible for disaster assistance, conservation, or agricultural risk management payments unless more than two-thirds of total average AGI is farm income. A person with averaged adjusted gross farm income in excess of $750,000 is not eligible for direct payments, but is eligible for other payments so long as nonfarm income does not exceed the nonfarm limits.

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The 2008 Farm Bill requires farm program participants to provide evidence of compliance with these requirements at least once every three years. The USDA has modified Form CCC-926 for this purpose. Besides certifying that his or her income does not exceed the applicable limits, a participant is required (among other things) to certify “that my income certifications are consistent with the tax returns filed with the Internal Revenue Service” and to agree “[i]f requested, … to authorize CCC to obtain tax data from the IRS for AGI compliance verification purposes and I will take all necessary actions required by the terms and conditions of the IRS disclosure laws so that CCC can obtain such data.”

The 2008 Farm Bill also directed the USDA to “establish statistically valid procedures under which the Secretary shall conduct targeted audits of such persons or legal entities as the Secretary determines are most likely to exceed the limitations...”

On November 24, 2008, not long after the 2008 Farm Bill was enacted, the Government Accounting Office released a report entitled “Federal Farm Programs: USDA Needs to Strengthen Controls to Prevent Payments to Individuals Who Exceed Income Eligibility Limits.” (October, 2008). The next day, President-elect Obama cited the report while introducing Peter Orszag as his new executive branch budget director, observing:

“We will go through our federal budget – page by page, line by line – eliminating those programs we don’t need, and insisting that those we do operate in a sensible cost-effective way.

Let me give you one example of what I’m talking about. There’s a report that from 2003 to 2006, millionaire farmers received $49 million in crop subsidies even though they were earning more than the $2.5 million cutoff for such subsidies. If this is true, it is a prime example of the kind of waste I intend to end as President.”

On March 19, 2009, in response to this attention, the USDA issued Release No. 0064.09 (“U.S. Department of Agriculture and Treasury Combine Forces to Combat Payment Fraud: Income Data Provided by IRS Will be Used by USDA to Validate Payment Eligibility”). That release began:

“In response to the discovery of nearly $50 million in payments to ineligible farmers, Agriculture Secretary Tom Vilsack today announced that the U.S. Department of Agriculture (USDA) and Internal Revenue Service (IRS) have begun efforts to ensure that high-income individuals and entities who request USDA payments meet income limits set forth in the 2008 Farm Bill.”

The joint program is in response to the requirement that the USDA develop procedures for targeted audits. It contemplates that all producers desiring to participate in a USDA program will be required to sign an IRS Form 8821 (Tax Information Authorization), or a similar form, allowing the IRS to share limited information with the USDA. Failure to provide the form will make a producer ineligible for program benefits.

The USDA plans to provide the IRS with a list of all 1.5 million FSA (Farm Service Agency) and NRCS (Natural Resource Conservation Service) customers, including only their taxpayer

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identification numbers. The IRS, in turn, will review the tax returns filed by the persons on the list, and will identify for USDA those persons who may potentially exceed the applicable income limitations. The IRS will not supply any actual tax return information to the USDA, but will be limited to identifying potential targets for further investigation. The IRS and USDA are working to assure that appropriate safeguards are established to safeguard any information the USDA receives from the IRS. The USDA then plans to further investigate the producers on the list, notifying them that additional information is needed concerning their average adjusted gross income and taking other appropriate action.

The proposed collaboration has been criticized by some (including eight members of Congress in a March 25 letter to the Secretary of Agriculture – see, 2009 TNT 57-54) as an unwarranted “invasion of privacy” and contrary to the intent of Congress. The USDA has responded observing:

“Some in the public have expressed concern that the collaboration is an unwarranted invasion of privacy and contravenes the intent of Congress. The process plans to keep sensitive information out of the local county office and would ensure compliance with the average AGI requirements imposed by statute. Individuals would not have to show sensitive financial information to their neighbors who may work in the local county office.

The collaboration would allow USDA to comply with statutory requirements while reducing the burden on producers. Producers may no longer be required to obtain verification from an attorney or CPA.”

30. IRS Exempt Organizations Workplan for Fiscal 2009.

The IRS Exempt Organizations Division released its Annual Report and Workplan for Fiscal 2009 in November. This document is available at the IRS website at http://www.irs.ustreas.gov/pub/irs-tege/finalannualrptworkplan11_25_08.pdf

Listed among the compliance initiatives is an item of interest to Section 501(c)(12) mutual organizations. In pertinent part, the Workplan states:

“In order to qualify for tax exemption, a mutual organization must be organized and operated on a cooperative or mutual basis, receive at least 85 percent of its income from its members, and use its member income for specific services. If, in any year, its member income falls below 85 percent of its total income for the year, the organization does not automatically lose its tax exemption, but is required to file a Form 1120, U.S. Corporation Income Tax Return, for that year.

In FY 2009, we will send compliance check letters to a number of organizations whose Forms 990 indicate they may have failed the member income test and we will take appropriate action, such as obtaining the delinquent tax Forms 1120 or conducting field examinations.”

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31. Form 8-K from Sysco Corporation (August 25, 2009).

Prior year’s Digests have described a controversy that arose between a large corporate taxpayer and the IRS over an elaborate cooperative structure that the corporate taxpayer had established. See ILM 200729035 (April 11, 2007), discussed in the 2007 Digest, and ILM 200826004 (February 26, 2008), discussed in the 2008 Digest.

While the ILMs did not indicate the taxpayer involved, it has become common knowledge in the cooperative community that the taxpayer was Sysco Corporation. The footnotes in the financial statements that Sysco filed with the SEC reported on the existence of the dispute, the magnitude of the dispute and the fact that the dispute was at Appeals.

On August 25, 2009, Sysco announced that it had “agreed with the Internal Revenue Service to a payment schedule related to a disputed tax deferral for its Baugh Supply Chain Cooperative.” In that announcement, Sysco indicated that it had agreed to pay some $952 million to the Internal Revenue Service over the next few years. Sysco’s Form 10-K for its fiscal year ended 6/27/2009 states:

“Sysco’s affiliate, Baugh Supply Chain Cooperative (BSCC), is a cooperative taxed under subchapter T of the United States Internal Revenue Code the operation of which has resulted in a deferral of tax payments. The IRS, in connection with its audits of our 2003 through 2006 tax returns proposed adjustments that would have accelerated amounts that we had previously deferred and would have resulted in the payment of interest on those deferred amounts. Sysco reached a settlement with the IRS on August 21, 2009 to cease paying U.S. federal taxes related to BSCC on a deferred basis, pay the amounts currently recorded within deferred taxes related to BSCC over a three year period and make a one-time payment of $41,000,000, of which approximately $39,000,000 is nondeductible.”

The announcement does not contain a more detailed description of the issues that were involved in the case.

This case should, obviously, be of interest to a corporation that established a captive cooperative to serve its subsidiaries and that has enjoyed a deferral of taxes as a result. Less obviously, it should be of interest to situations where a cooperative has a dominant member accounting for over half of its business. As the first ILM indicates, the IRS also argued that Treas. Reg. §1.1502-13 should have applied to Sysco and the cooperative and eliminated the deferral, even though they did not actually file a consolidated return. As indicated in the second ILM, the IRS sought to reallocate income between the cooperative and its members using the step transaction doctrine. Reportedly, the IRS also sought to argue that Section 482 and other sections of the Code applied.

The IRS has been systematically looking for situations where a cooperative has a dominant member. In the relatively new Form 1120-C, which must be filed by all Subchapter T cooperatives, there are a series of questions designed to ferret out control relationships. See

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questions 4, 5, 6 and 8 on Schedule K or the 2008 Form 1120-C.

32. The Worker, Homeownership, and Business Assistance Act of 2009, P.L. 111-92.

Section 13 of this act provides a taxpayer with a special extended carryback for net operating losses incurred in either its fiscal year beginning in 2008 or 2009 (including relaxation of the 90% limitation for alternative minimum tax purposes). A taxpayer is permitted to elect to have an extended carryback for the losses of one, but not both, years. The losses can be carried back three, four or five years (but may not offset more than fifty percent of the taxable income in the fifth preceding year.

Rev. Proc. 2009-52, 49 IRB 744, provides guidance as to how to go about claiming the benefits from this new provision.

33. USDA Economic Information Bulletin Number 54 entitled “Federal Tax Policies and Farm Households” (May, 2009).

This report evaluates the impact of federal income and estate tax policies on the tax burdens and financial well-being of farm households.

Set forth below are some of the more significant finding of the report with respect to income taxes:

• “[O]ver 99 percent of farmers are taxed under the individual rather than the corporate income tax.”

• The average tax rate of farm sole proprietors “dropped from 17.1 percent in 1994 and 17.8 percent in 2000 to about 14.8 percent in 2004.”

• “Since 1980, farm sole proprietors have reported negative aggregate net farm income for tax purposes. Over the years, both the share of farmers reporting losses and the amount of losses reported have increased. About half of all farm partnerships and small business corporations also report losses.”

• “Most federal income tax for farm households is paid on off-farm income.”

• “While there are limits on the ability to use [farm] losses to offset income from other sources, in most instances, losses from farming are fully used to reduce taxes on other income.”

• “Since rural residence and many intermediate farm households derive most of their income from nonfarm sources, these farm households are primarily affected by the changes in individual marginal income tax rates, standard deduction, and other exemption amounts and those policies affecting the tax treatment of income from nonfarm sources. In contrast, commercial farms [those with annual sales greater than $250,000] account for a disproportionate share of total U.S. farm

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sales and investment and report most of the farm profit. Thus, these farms are the primary beneficiaries of the tax changes affecting farm business income and investment. The most significant changes over the last decade include reduced capital gains tax rates, increased capital expensing and bonus depreciation, and the new manufacturer’s deduction. The increased deduction for self-employed health insurance and the availability of income averaging are also important changes to tax policy that affect farmers.”

• The current capital cost recovery system allows most investment to be expensed in the year of purchase. Less than 1 percent of farmers annually invest more than the current $250,000 expensing amount.

• About one in every five farm households directly benefit from the Section 199 deduction. “Commercial farm households [those with annual sales greater than $250,000] are the primary beneficiaries, with about two-thirds expected to benefit, compared with about 14 percent for all other farms. While commercial farms account for only about 8 percent of all farms, they will receive about 75 percent of all the farm sector’s benefits from the manufacturers’ deduction.”

Interestingly, the report does not comment upon benefits derived from the ability of farmers to use the cash method of accounting, including the ability to prepay costs and to defer income, which are significant tools used by farmers to manage their income for tax purposes. With respect to income averaging, the report observes:

“In 2004, an estimated 50,800 farmers saved an average of $4,434 with income averaging. The tax savings totaled $225.3 million and amounted to a 23-percent reduction in Federal income taxes for those taking advantage of the provision, compared with the amount that they would have owed without income averaging. A large share of the total tax reduction was realized by farmers with adjusted gross income over $1 million. These farmers saved an average of $264,000, for a total savings of $82.6 million, or about 37 percent of total tax savings from the income averaging provision.”

With respect to the federal estate tax, the report concluded:

“The estates of small business owners are about twice as likely as the typical estate to owe tax, and farm estates are even more likely to owe tax. The median wealth of farm households is about five times that of all U.S. households. As a result, a larger share of farm estates owes Federal estate tax, largely due to appreciation in land values, increases in the average size of commercial farms, and rising investment in farm machinery and equipment.”

Articles

34. “IRS Blesses a Cooperative’s Allocation of Gain on Asset Sale,” by David J. Shakow, 2008 TNT 247-37 (December 22, 2008).

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This article analyzes Ltr. 200842011 (July 11, 2008).

It focuses first on the conclusion of the ruling that the gain realized by a cooperative on the sale of a warehouse is patronage-sourced. The article then analyzes the ruling’s conclusion that “the Cooperative’s distribution of the gain recognized from the sale of its building to the Cooperative’s current and former members based on compound patronage (their respective average annual patronage percentages), for [a specified period], will be treated as a patronage dividend and will be deductible by the Cooperative for federal income tax purposes.”

35. “Maximize Tax Savings from the Agricultural Chemicals Security Act,” by Earl B Johnston III, Corporate Taxation (January/February 2009).

This article, written by the federal tax manager of FMC Corporation, discusses Section 25O credit for qualified chemical security expenditures and how FMC went about identifying and collecting the information required to claim that benefit.

State Tax Developments

36. Washington Tax Determination No. 08-0301, 28 WTD 68 (October 28, 2008).

The State of Washington has historically been troublesome from a tax perspective for cooperatives because it imposes a Business and Occupation Tax (“BOT”) based on gross receipts, not an income tax based on net income.

Washington Tax Determination No 08-0301 (October 29, 2008), arising from an appeal to the Appeals Division of the Department of Revenue, involves a dairy cooperative, organized and headquartered outside of Washington, operating processing plants outside of Washington, but selling products to customers in Washington. The cooperative either arranges to ship the products from its plants outside of Washington to its Washington customers using common carriers, or the Washington customers arrange for the transportation.

The cooperative had not been paying the wholesale BOT on its sales to Washington customers. On audit, the state of Washington asserted that it was liable for the tax. The cooperative appealed to the Appeals Division.

On appeal, the cooperative argued that it was acting as the agent of its members in making the sales in Washington and thus was not subject to the BOT.

The Appeals Division rejected this argument, concluding the “taxpayer, who sells products in its own name and whose records do not show it is an agent on behalf of its members, does not meet the requirements [of the Washington Department of Revenue rules and regulations] to be deemed an agent of its members.” Under those rules, a taxpayer has the burden of establishing that it is acting as an agent. Rule 159 provides that an agency relationship will be recognized only when:

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“[T]he contract or agreement between such persons clearly establishes the relationship of principal and agent and when the following conditions are complied with:

(1) The books and records of the broker or agent show the transactions were made in the name and for the account of the principal, and show the name of the actual owner of the property for whom the sale was made, or the buyer for whom the purchase was made.

(2) The books and records show the amount of gross sales, the amount of commissions and any other incidental income derived by the broker or agent from such sales.”

The cooperative did not have a contract showing that it was acting as the agent of its members. Its books and records did not reflect the information required by Rule 159. Consequently, the Appeals Division concluded that the taxpayer had not met its burden of proof to establish that it was acting as an agent for its members.

In addition, the Appeals Division rejected the argument of the cooperative that “department precedent and common law renders it an agent of its members,” concluding that “there is no presumption in Department precedent or common law which holds that taxpayer is an agent of its members.” In reaching that conclusion, the Appeals Division distinguished a 1987 ruling given to a cooperative which was structured in such a manner that it qualified as the agent for its members. The ruling concluded that the cooperative was not subject to wholesaling BOT on the gross receipts of sales, but only to service BOT on its agency fees. The Appeals Division distinguished the ruling on the ground that the dairy cooperative had not established it was acting as an agent for its members.

37. Michigan Business Tax FAQ 08/26/2009 No. Mi42 (August 26, 2009).

In August, Michigan released a short FAQ outlining the extent to which the activities of farmers and farmer cooperatives are exempt from the new Michigan Business Tax (“MBT”). Michigan Business Tax FAQ 08/26/2009 No. Mi42 (August 26, 2009). This FAQ does not add much to what is already contained in the Michigan statute, but it does provide a good summary of the rules applicable to farmers and farmers cooperatives.

1. For persons “whose primary activity is the production of agricultural goods” the portion of the tax base attributable to the production of agricultural goods is exempt from the MBT. That exemption does not extend to marketing agricultural goods at retail. See, MCL 208.1207(1)(d).

2. Section 521 cooperatives are exempt from the MBT. The blanket exemption also extends to cooperatives that would qualify as Section 521 cooperatives, but for either of the following activities:

“(i) The corporation’s repurchase from nonproducer customers of portions or components of commodities the corporation markets to those nonproducer

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customers and the corporation’s subsequent manufacturing or marketing of the repurchased portions or components of the commodities.

(ii) The corporation’s incidental or emergency purchases of commodities from nonproducers to facilitate the manufacturing or marketing of commodities purchased from producers.”

However, purchases under the second exception may not equal or exceed 5% of the corporation’s total purchases. See, MCL 208.1207(1)(e) and (2).

The first exception appears designed to permit cooperatives to enter into toll processing arrangements with nonproducers that involve transfer of title to the toll processor with a subsequent repurchase of the processed product, something that might technically lead to a loss of Section 521 status.

3. The “portion of the tax base attributable to the direct and indirect marketing activities” of certain marketing cooperatives is exempt from the MBT, whether or not the cooperative is a Section 521 cooperative. For products other than livestock, the marketing activities must “be related to the members’ direct sales of their products to third parties” and can not involve taking “physical possession” of the product. Livestock cooperatives are permitted to take physical possession of the product as part of their marketing activities.

This exception appears to be intended to cover bargaining cooperatives and livestock marketing cooperatives. MCL 208.1207(1)(f).

4. Finally, and of relevance to most nonexempt Subchapter T cooperatives, the MBT provides:

“(3) Except as otherwise provided in this section, a farmers’ cooperative corporation that is structured to allocate net earnings in the form of patronage dividends as defined in section 1388 of the internal revenue code to its farmer or farmer cooperative corporation patrons shall exclude from its adjusted tax base the revenue and expenses attributable to business transacted with its farmer or farmer cooperative corporation patrons.”

MCL 208.1207(3). CHI99 5160784-3.T00105.0010

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2009 Report of LTA Subcommittee on the IRS Industry Specialist

Marla Aspinwall, Chair Loeb & Loeb LLP 10100 Santa Monica Boulevard, Suite 2200 Los Angeles, California 90067-4164 Telephone: (310) 282-2377 Fax: (310) 282-2200 E-Mail: [email protected]

Our Industry Specialist, Tracy Holtslag is located in Dallas Texas at 4300 MSRO, 4050 Alpha Rd. Dallas, Texas 75244; phone: (972)308-1631; fax: (972)308-1545; e-mail: [email protected]. The Industry Specialist provides the Internal Revenue Service with an overview of the examinations in a particular industry and acts as a repository of knowledge and experience for auditors examining taxpayers in such industry.

Few of our members have reported any contact with Tracy this year. Tracy is known to have been involved behind the scenes in advising auditors on various cooperative audits. As always, we ask that you not contact Ms Holtslag directly without first discussing the nature of your contact with a member of this Committee. If Ms Holtslag attends your audit or otherwise makes contact with you, we would appreciate it if you notify us of such contact.

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