University of Wisconsin Center for Cooperatives

UWCC Occasional Paper No. 3 - February, 1980


APPENDIX II

Alternative Equity Redemption Programs

The member-patron equity redemption plans which are described in this section are of two types: (1) those that have been attempted by a number of local cooperatives in their desire to avoid the inherent problems which accompany the policy of not redeeming member equities within a reasonable time period, and (2) formulations of a rather abstract or vague nature that must be made more operative before being pragmatically incorporated into an actual farmer cooperative member-patron equity redemption policy.

Before presenting a list of these alternatives it is important to state that only the financial impacts of these policies are discussed or evaluated in this and the following chapter. Whether member-patron equity redemption policies increase the demands for a cooperative association's services is beyond the scope of this study. That is left to the cooperative management team involved in comparing and studying alternative equity redemption policies.

Utilized Alternatives

Generally, four basic programs have been most popular among those local farmer cooperatives adopting member-patron equity redemption policies:
(a) a net savings percentage program,
(b) a program of increasing cash refunds combined with estate settlement,
(c) a shortening of the revolving fund period combined with an estate settlement program, and
(d) the policy of settling estates when a member-patron dies.

Net Savings Percentage Plan

Under this plan the cooperative allocates a specific percentage of the net savings for the purpose of retiring estates and other member- patron equities. The following examples demonstrate how this is accomplished.

"Settlement of Estates: Notwithstanding any other provisions of these bylaws, the board of directors, at its discretion, shall have the power at anytime to pay off , or retire, or secure a release or satisfaction of any common stock, preferred stock, participation certificates, stock or deferred patronage ledger credits for the purpose of facilitating the settlement of an estate. The settlement of estates shall be made in the following manner:
a) Estates will be settled in the same order as requests for settlement are received by the association.
b) Estate settlements in the current year tn which the association is operating shall be limited to thirty-five percent (35%) of the allocated net savings of the prior year's allocated net savings, the balance of such requests shall have first priority in the following fiscal year and such estate settlements will again be made but limited to thirty-five percent (35%) of the allocated net savings of the prior fiscal year." 1

Cash Refund Plans

The objective of this plan is to increase the percentage of cash refunds from the obligatory 20 percent to a figure that covers the tax bracket of the member-patrons associated with the cooperative. When implemented, this plan also reduces the amount of allocated patronage refunds that must be returned in the future. The disadvantage of this program is that it favors the active member rather than the inactive member who has accumulated equity in the cooperative but no longer utilizes its services. The impact of increasing the percentage of cash returned on the financial structure of a farmer cooperative must be analyzed before implementation.

Shorter Revolving Period

Usually this policy alleviates the problem of retiring older equities, but if this plan is not combined with an increase in the percentage of cash refund it aggravates the tax problem mitigated by the aforementioned cash refund plan. A cooperative usually attempts to shorten its revolving fund period by restring several years of allocated equities for several continuous years. The impact of this type of plan on the financial structure of a farmer cooperative must also be analyzed before implementation.

Less Proven Alternatives

The following programs have seldom been incorporated into farmer cooperative member-patron equity redemption programs. They are being offered as topics for generating hypotheses rather than programs that have weathered the test of time.

Insurance

The basic idea behind this plan is to provide a basic service to member-patrons and at the same time increase the amount of permanent capital ln a cooperative association. An insurance member-patron equity redemption program might work like the following:
a) The cash refund to the member-patron might cover his tax obligations on the allocated patronage refund.
b) A small proportion of the remainder would be utilized to purchase a life insurance policy for the member-patron -- the rest becomes permanent equity. The insurance might be one of several types, a policy which sets up an annuity program that begins when the member- patron reaches a certain age, or an annual renewal term policy.

The fact that the farmer is underinsured has often been cited as in the following quotation:

". . . the farmer owns far too little in the way of life insurance protection. Almost every insurance expert recommends that a man should own the insurance equal to 6 to 10 times his annual income. But the average breadwinner in America owns less than $20,000 of life insurance, and among the farm population this figure is even lower." 2

Why does the farmer need more insurance than anyone else?

"Because Federal Estate Tax and State Inheritance Tax have a particularly strong impact on a farmer's estate. Many farmers go through a lifetime of hard work without realizing the devastating impact on their families when they are faced with a large demand for cash for Uncle Sam." 3

Mutual Fund

In this plan a number of cooperatives join together (possibly under the coordinatton of a regional affiliate) in setting up a mutual fund whereby each local cooperative invests a certain percentage of net margins (sinking fund) into a joint investment fund. The earnings from this mutual fund are then used to retire member equities. The advantages of this program are two: it's an expilcit method of setting aside funds for the member-patron equity redemption program and secondly, if the mutual fund is earning a higher return on its capital investment the program will retire equity at a faster rate than accumulated and, therefore, allow for shortening of the revolving fund period. The disadvantage is if the opposite is true; the mutual fund having a lower return on its invested capital, then the cooperative will encourage the lengthening of the revolving fund.

The Step Plan

This plan attempts to appease both younger and older members with respect to equity redemption. The plan would operate as follows: A certain percentage of cash is returned to the member-patrons (20% or more to comply with I.R.S. rules). Then a certain percentage of the previous year's allocated earnings are redeemed (for example 10%). Finally, a certain percentage of all outstanding equity is retired (for example 3%). This is called a 20-10-3 step plan. The advantage (the compromise) of this program Is that the older member-patron is having a portion of his equity retired while the younger member-patron is appreciating an early return on his investment.

Preferred Stock Plan

In this plan the cooperative pays 20 percent of the patronage refund in cash--the remaining 80 percent becomes part of a non-dividend bearing allocated equity base. After 5 years this allocated equity is converted into preferred stock with a dividend. The member-patron is permitted to cash in the preferred stock or maintain it and receive the annual dividend. The advantage of this program is that member-patrons who desire to support their cooperative or are in no need of liquidity will continue to invest in the cooperative by leaving their preferred stock in the association. The calling in of the preferred stock would be left to the discretion of the board of directors.

Midland's Plan

This plan, promoted by Midland Inc., has been described in a previous section, but it is worth repeating here with the other "ideal" alternatives. Under this plan a member-patron, upon reaching a certain age, would have his equity converted to a dividend bearing bond. The bond could be redeemed or the member could continue to earn the dividend until his death. Upon death the value of the bond is retired to the member-patron's estate.

The Paper Loss Plan

Under this plan the farmer member-patron would receive 20% of the patronage refund in cash; the remaining 80% would be issued as a non-interest bearing certificate. The member-patron then seeks out an investor in the high tax bracket who buys the certificate at lower than face falue upon which the member-patron takes a tax loss. The investor waits for the certificate to be revolved out and claims the earning as capital gains which are taxed at a lower rate than personal income.

Cooperatives Unlimited

Several cooperative finance authors (particularly Tubbs, Wilson and Henning and Laubis) have encouraged a system of equity capital acquisition that would also solve the equity redemption problem-- that is, marketability of cooperative securities. The following program-- Cooperatives Unlimited-- is an example (albeit more elaborate and ambitious than most) of one approach in which this goal might be accomplished. Two of Cooperatives Unlimited's objectives are:
To encourage the development of a Holding Company, controlled by a Cooperative Voting Trust, thus enabling cooperatives to participate in the benefits available to other types of private enterprise.
To provide the business mechanism, through the Holding Company, for cooperatives to gain control of successful profit companies, especially those selling to, or performing services for the regional cooperative owners of Cooperatives Unlimited or its subsidiaries thus obtaining access to capital, management and other resources which can result in more rapid cooperative growth.

The capital for the Holding Company would come from the regional's purchasing of its shares and through stock exchanges and public offerings. The Trustees of the Voting Trust would be the board of directors of Cooperatives Unlimited who would exercise effective control of the Holding Company while the stockholders retain their full property rights. This method of control would be disclosed in the prospectus for the sale of the stock. The control and endorsement by the regionals would enhance the sale of stock to the local cooperatives and to their individual members as well as the general public. Once the initial capital is raised, acquisitions of sources of supply, services and markets could begin. The outstanding stock of the Holding Company would have a market value established in the over-the-counter markets. When such a market value is established, unissued shares would be used to acquire more companies in tax free stock exchanges. 4

Aside from the complex problem of instituting such a system, the mayor disadvantage of a program that encourages cooperative securities marketability might originate from a securites regulation potnt of view. The element of doing business with your owners or stockholders is the critical factor that allows securities issued by cooperatives to be considered as substantially different from those issued by business corporations.5

This consideration of "uniqueness" might be viewed from a different point of view by the Securities and Exchange Commission if the "marketable cooperative securities" method of equity capital acquisition is implemented by farmer cooperatives.


Occasional Paper 3
Appendix I

Footnotes

l Copy received from Wilbur F. Klenke, Director of Services, Kansas Farmers Service Association, Hutchinson, Kansas.

2 W. L. Balilu, Chtef Operating Officer, FEMIC, Farmiand Life, and Farmiand Insurance Co., as quoted in Farmiand News. "New ServicP tn Fill Insurance Gap," March 15, 1974, p. 12. 3 Ibid. 4 Ellerbe' Thomas F. Jr., "Cooperatives Unitmited - A Concept for Cooperation," Blueprint for Cooperative Actton, American Cooperation 1972-73, American Institute of Cooperation 1972, pp. 149-154.

5 Weiss, Jerome P., "So You Think You're Exempt From Federal Securities Laws?", News h r Farmer Cooperatives, Farmer Cooperative Service, USDA, April 1Y75, pp. 6-9.



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