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Congressional hearing focuses on possible need for more flexible co-op business model.

Are structural changes needed in the cooperative business model to help co-ops remain a vital cog in the engine of America's rural economy? That was the central question addressed during a five-hour hearing held by the House Agriculture Committee on Oct. 16 in Washington, D.C.

A wide array of co-op leaders, government officials, lenders, academics and others testified. A common theme was that the late of U.S. agriculture, the nation's farmer-owned cooperatives, rural lenders and the rest of rural America is inextricably linked, and that for each of them to thrive, they must all be strong and prepared to work together to adapt to change.

But a wide diversity of opinion was expressed as to exactly what changes should be made and how far to go in altering the co-op business model.

New state co-op laws at center of debate

Throughout the day, numerous references--pro and con--were made to the new Minnesota and Wyoming cooperative incorporation laws. Some said those laws go too far in expanding the co-op model and that co-ops organized under those statutes are vulnerable to takeovers by outside investors who may have little real interest in the fate of producers or rural communities. Further, they said if the nation winds up with 50 different definitions of what a cooperative is, it will lead to chaos.

"When is a cooperative no longer a cooperative?" was asked several times. One committee member noted that under the new Minnesota law, 99 percent of the equity and 85 percent of the profits of a co-op could be controlled by non-producers.

But others said that these new state laws are at least a step in the right direction, and that without changes such as they encourage, producers will be locked in a downward spiral. They will continue to lose the control in ag industries that they and their predecessors fought so hard to establish during the past century. They predicted that increasing numbers of co-ops will reluctantly have to change their business structure to Limited Liability Corporations (LLC), or some type of hybrid LLC-co-op.

The announced purpose of the hearing was to focus the attention of Congress and the nation on trends being seen among new-generation cooperatives--particularly regarding why some of them are finding it more advantageous to change their business structure to LLCs. In reality, the focus of the hearing was broader than that, breaking down into three primary areas: 1) Should cooperative law be modified to allow for greater flexibility in business and governance structure--particularly in ways that will allow co-ops to raise more equity capital?; 2) Should the charter of CoBank be modified so that it can finance a broader array of farmer-owned enterprises than is currently permitted?; and 3) What is the status and future of USDA's cooperative programs?

In his opening remarks, Committee Chairman Bob Goodlatte of Virginia noted that "The real subject of our hearing today may just as well be how we can assist the financing of U.S. agriculture." He said producers are increasingly looking "to attract outside, passive investors who may have an interest in the community where the operation is located, but who otherwise are looking for a reasonable return on that investment. That calls for new business structures that may abandon the traditional cooperative model."

Goodlatte noted that the House Ag Committee last conducted a thorough examination of the Farm Credit Act during the Farm recession of the 1980s--a crisis period for farmers and ranchers. Changes enacted in the Farm Credit System at that time have proven successful, Goodlatte said, but the time may be right for a more deliberative review process "now that the system is adequately capitalized and relatively prosperous."

High stakes

"Today, we are laying the foundation for the future of agriculture," said Rep. Charles Stenholm of Texas, the ranking minority member on the Ag Committee. "We're not pouring the concrete yet--just putting up the forms; we'll pour the concrete later."

He spoke of the importance of farmer and utility cooperatives in the West Texas district he represents and to his own family. Stenholm noted that he and Iris son are members of the Plains Cotton Cooperative Association (PCCA) in Lubbock, and that he once managed a rural utility cooperative in Texas.

"PCCA is an excellent example of how things have changed, and also why there is a need to review and modernize federal cooperative law," Stenholm said. To make his point, he noted that in the 1970s, PCCA built a $25-million plant that spins cotton into denim. "Since 1976, PCCA's denim mill alone has provided its members with $300 million in added-value for their cotton. However, building that same mill today would cost between $100 million and $150 million." With rural economies starved for capital and far fewer producers than 30 years ago, he said it is unlikely PCCA could construct the same denim mill.

Stenholm said efforts such as USDNs new Value-Added Producer Grant program and the new Agricultural Innovation Centers established in 10 states are steps in the right direction. But he said "there is much more work for this committee and USDA to do to ensure that farmer and rancher cooperatives have the means to compete in an area of rapid consolidation and technological innovation."

Rep. Collin Peterson of Minnesota expressed concerns about the new coop law in his state, and said it could allow non-farmer equity owners to take over co-ops, which he said has already occurred. Peterson said co-ops are getting into industries "controlled by just 3-4 entities, and they can squash you like a bug in these commodity areas. When they (large corporations) control so much, they can run down prices and force you to sell out." Peterson said that perhaps co-ops would find more success pursuing niche markets, and that care has to be taken not to lure farmers into commodity areas where they have little real chance of making money.

Changing rural landscape

Thomas Dorr, under secretary for USDA Rural Development, which houses the Cooperative Services program, painted a picture of a rapidly changing rural landscape in which farmers must find new ways to invest in modern, value-added processing Facilities. Otherwise, they face the risk of becoming ever more marginalized as producers of basic commodities in a world economy where other nations have huge advantages in low-cost labor and land.

"Farmers and ranchers still retain a high level of confidence in cooperatives and this business model is still one of the most trusted tools of business development in rural America," Dorr said. "While many producers have substantial assets that are minimally leveraged, their numbers are declining. The amount of funds needed to finance a potentially lucrative agriculture-related business may be more than potential member-patrons can, or should, prudently invest in. Steps should be taken to make investing in a cooperative attractive to local non-producers, and, when advantageous to the producers and the community, non-producer outside investing interests."

Dorr said that impediments to attracting non-producer equity to co-ops can be found in federal and state laws enacted several decades ago. "If non-producer outsiders are to invest in a cooperative, they may well expect to have a voice in its affairs and the opportunity to earn a return on their investment commensurate with the success of the cooperative," Dorr said. "Good governance and increased transparency could also help improve the cooperative model."

Tax issues key

There are numerous examples of value-added cooperatives that have converted to LLCs or formed LLC joint ventures with other co-ops or investor-owned corporations, said Doug Flory, chairman of the Farm Credit System Insurance Corporation, who testified on behalf of Farm Credit Administration Chariman Michael Reyna. Flory said LLCs offer advantages in their ability to attract outside investors by giving them a say in management and a proportional return on their investment. They also may do "a significant amount of business with farmers who are not willing, of able, to acquire an ownership interest in the enterprise," Flory said.

While some large, well-established co-ops have been successful in raising outside equity capital, most outside investors are not farmers and thus cannot be members nor vote in a co-op's elections or share in patronage payments, he said. The Wyoming and Minnesota laws attempt to address this situation by allowing the creation of a hybrid between a traditional cooperative and an LLC, with separate membership classes for farmer-patrons and investors.

Flory said these state co-op laws each require that farmers have at least 50 percent voting control, and that Minnesota requires that 60 percent of financial returns go to farmers, unless they vote as a block to accept a lesser amount, but never less than 15 percent. Both laws are too new to determine whether many traditional co-ops will convert to the new hybrid co-op businesses, Flory said, adding that other states are considering similar legislation.

"The success of hybrid cooperatives will depend on whether farmers and investors can work together. Potentially the two groups have different objectives," which, he stressed, "could be a source of conflict." Whether the hybrids are successful "ultimately depends on their ability to reconcile potential conflict between farmers and investors."

CoBank seeks changes

Doug Sims, CEO of CoBank, part of the cooperatively owned Farm Credit Bank system, said provisions of the Farm Credit Act make it "increasingly difficult for a new generation of farmer-owned cooperatives ... to obtain financing from CoBank." Farmer cooperatives are increasingly turning to value-added activities to bolster their members' farming operations, and many are turning to new business models to raise equity capital from non-producers, to minimize tax liabilities and gain added operational flexibility, Sims said. "These new structures will often make the cooperative ineligible for financing by CoBank," which provides about 80 percent of all credit extended to farmer cooperatives.

Sims cited the role of co-ops in the rapidly expanding ethanol industry as an example of this situation. CoBank has loaned $200 million to finance 20 farmer-owned ethanol plants in the Midwest and Great Plains states. To date, return on equity has been a highly favorable 10 to 15 percent annually. But some of these co-ops are turning to outside investors to build plants.

Tall Corn Ethanol in Coon Rapids, Iowa, recently altered its corporate structure to an LLC to attract more equity from outside investors, Sims said. Even though farmers still control the business, it is no longer eligible for financing from CoBank. The same scenario holds true for South Dakota Soybean Processors, which had been a CoBank customer since its inception in 1996 but recently converted to an LLC for tax and equity reasons.

"This current situation is putting the farmer-owners of cooperatives in a very difficult position by choosing the most advantageous corporate structure, the cooperative may be forced to forgo access to the lender created specifically to meet the needs of farmer-owned cooperatives," Sims testified.

CoBank is requesting legislation that would change its charter to:

* Allow it to continue lending to producer associations with both a producer and investor class, provided that the producer class holds at least 50 percent of the voting control and that it operates on a cooperative basis;

* Permit ag co-ops organized consistent with state cooperative laws to be eligible for CoBank financing;

* Allow co-op customers adopting new business structures to continue to be eligible for CoBank financing, as long as the customer maintains at least 50 percent farmer control or continues to operate under co-op state law;

* Provide that co-ops that are CoBank customers but restructure as non-co-ops would remain eligible for CoBank financing for a five-year transition period.

"Without this action, CoBank will not be able to meet its mission of serving farmer-owned cooperatives," Sims warned. He noted that the proposal has received the endorsement of the National Council of Farmer Cooperatives (NCFC), the American Farm Bureau Federation, the Farm Credit Council and dozens of other farm organizations.

Community banking groups oppose CoBank proposal

Weighing in against the CoBank proposal were two banking industry trade groups, which testified that those changes would violate the very reason CoBank was formed while creating unfair competition for locally owned, community banks. As a government sponsored entity, CoBank has access to lower cost funds than do most community banks. They also raised numerous questions about the Wyoming and Minnesota state co-op laws, saying these statutes could have the opposite effect they were intended for, and could actually hasten the loss of producer control.

James Caspary, representing the Independent Community Bankers of America (ICBA), said those state laws would create a business model under which "outside investors could form LLCs labeled 'farmer-owned cooperatives,' even when farmers don't have majority ownership or voting control, and be eligible for cooperative benefits." ICBA, 75 percent of whose members are community banks located in towns of 10,000 or less, "opposes any fundamental rewrite of CoBank's lending charter because it would allow it to make loans to corporations that may have no farmer involvement and that may be unrelated to agriculture," Caspary testified.

"We do feel it is appropriate to explore ways to enhance the accumulation of equity capital within farmer-owned cooperatives and in rural America--but this should be done in a way that doesn't potentially lead to the loss of legitimate farmer control of their cooperatives or in ways that drastically depart from the bedrock principles of what makes a cooperative a cooperative."

Policies should not be enacted that would spur consolidation in agriculture and cooperatives "just for the sake of growth for some at the expense of survival for others," Caspary said. He presented the committee with a list of criticisms of the Wyoming state law, including a provision under which "one or more outside investors with two-thirds voting control can merge or consolidate the entity into another entity, or liquidate it without any support from the producer-patron members."

Caspary said Congress has recently adopted or updated several programs which could aid farmers and cooperatives pursuing new ventures. "Unfortunately several of these USDA authorities sit either idle today or have yet to be fully implemented."

Roger Monson, representing the American Bankers Association, offered similar testimony. He said the Wyoming and Minnesota co-op laws "will allow businesses to continue to be defined as farmer-owned cooperatives when ...(they) are neither owned by a majority of farmers or controlled by farmers."

Farmers Union urges careful study

Congress must take the lead in reexamining cooperative business structure, "rather than allowing events or other institutions to define a new cooperative model that may sacrifice the characteristics of cooperatives that distinguish it from other business structures," Doug Peterson testified on behalf of the 300,000-member National Farmers Union (NFU). Peterson, president of NFU's Minnesota state chapter, said that despite problems confronting farmers and their cooperatives, "we believe that a level of restraint must be exercised to provide the opportunity for a full discussion of potential alternatives and outcomes before engaging in a significant modification of the cooperative model." New state co-op laws may have worthy intentions, but "we are concerned about the longer term effects of these proposals on basic cooperative principles.

"In addition, schemes that blur the lines between cooperatives and other organizational structures may put at risk existing preferential public policy treatment for all cooperatives, including, but not limited to, the issues of partial anti-trust exemption and tax considerations."

"The old adage, 'he who pays the piper calls the tune,' could certainly apply to outside investors, who may in fact be able to qualify as farmers under the current definition," Peterson warned. These investors could persuade the co-op board to change traditional allocations of earnings away from patronage to return on investment. "They might also exert substantial influence on merger, consolidation, liquidation or other critical business decisions."

If Congress ultimately decides to allow more outside investors in co-ops, "it should establish strict guidelines and limitations on the level of influence these investors may exert over any cooperative business structure," he said. "At minimum, these rules should require diversification among investors, particularly those with interests in competing businesses...."

In its testimony, the National Council of Farmer Cooperatives (NCFC) urged that "the highest priority be given to strengthening USDA cooperative programs, including the re-establishment of a separate co-op agency within USDA. NCFC also said the Federal Farm Credit Act should be modernized to ensure farmers have access to a competitive source of credit capital for their cooperatives--including new generation cooperatives. It also called for the elimination of the so-called "triple tax" on farmer cooperative dividends.

John Henry Smith, board chairman of Southern States Cooperative (SSC), and CoBank CEO Douglas Sims both testified that their organizations "strongly support" NCFC's position on strengthening USDA's cooperative program. Smith said it needs to have resources not only to carry out existing programs, but new ones as well. He also asked that the loan guarantee limit on USDA's Business and lndustry Guaranteed Loan program be boosted from $40 million to $100 million.

Rep. Stenholm urged that rural banks find a way to work together with CoBank and the rest of the Farm Credit System, noting that "the rural America we know is dying ... We must bring in capital and jobs in non-traditional ways. That's what this is all about."

Equity, tax issues prompt beef co-op to ponder switch

U.S. Premium Beef (USPB) recently completed a buyout of its former partner--Farmland Industries--in National Beef, the nation's fourth largest beef packer. But its co-op structure threw up barriers to raising the needed investment capital, co-op CEO Steve Hunt testified in October at the House Ag Committee hearing on new generation co-ops. The co-op is now weighing whether to convert its business structure to an LLC or reincorporate under the new Minnesota or Wyoming state co-op laws.

The main reasons would be to capture "the benefits of a pass-through tax structure," he said, and because this change would allow "unlimited earnings diversification and provide for recruitment of outside capital, while still maintaining control in the hands of the producer."

But even if the co-op converts its business structure, it faces hurdles, he said. Co-op members could be charged substantial taxes on the gain in their co-op stock value, which has risen sharply. As a new generation coop, USPB members purchase stock in the co-op which creates a right and requirement to deliver cattle to the co-op. Those shares can be sold to other producers.

Leaving the ranks of co-ops would also mean losing its relationship with CoBank, Hunt testified.

He proposed a number of changes to the tax coda which would provide relief for co-ops in such situations, including a one-time conversion tax exemption for cooperatives that convert to an LLC but still maintain producer control.

"Today, as we witness an acceleration of concentration among food industry participants, the need to achieve size, scale and market leverage is becoming paramount to their success," Hunt said. "These changes require vast amounts of capital."

"Under today's rules," he continued, "cooperatives have only to look to cash-strapped producers to secure equity. The alternative is to leverage their business through debt, a strategy that has resulted in numerous public failures."

Hunt said that when Farmland Industries filed for bankruptcy last spring, USPB was able to buy its interest in National Beef. That kept the beef operation under producer control, unlike Farmland's pork business, which was snapped up by Smithfield. Hunt said USPB was forced to form a venture outside of the cooperative and seek outside investors as partners in order to buy out Farmland's share in the partnership. "Had USPB been able to attract alternative sources of capital within the co-op, we would have owned a larger percentage of the beef business and increased our odds of maintaining producer control into an uncertain and very competitive future," Hunt said. "Additionally, in order to achieve a majority position, since equity capital was limited, we were forced to rely more heavily on riskier debt equity, thereby leveraging the company."

Wheat-to-pizza co-op recounts equity challenge

Keith Kisling, an 0klahoma wheat and cattle producer and former director of the Burlington Cooperative Association, recounted a similar challenge in raising equity capital in 1996 for Value Added Products, a new-generation cooperative in Alva, Okla. The 850-producer co-op processes 642,000 bushels of wheat annually into $20 million worth of pizza crusts. After just four years in operation, it is the largest pre-proofed and frozen dough plant in the nation, Kisling said.

"Our biggest challenge," he testified before the Ag Committee, "was collecting up-front capital to convince our lenders to buy into the deal." Some 40 producer meetings were held with the goal of raising $10 million of the $18 million needed. The most useful financial incentive the co-op had in attracting producer-members, Kisling said, was Oklahoma's 30-percent state credit, which can be used for seven years by new value-added ventures. "I was asked consistently in those 40 meetings if there was a similar federal tax credit, and my response had to be "no."

The co-op raised the additional capital needed with the help of a Business and Industry Guaranteed Loan and a Value-Added Producer Grant, both of which are programs of USDA Rural Development.

As a result, the co-op "now sells pizza crust to the world instead of railroad cars of wheat. More jobs are available for young people and more sales tax revenue is going into our community to provide basic infrastructure and technology."

Kisling said more programs are needed to encourage and promote these types of farmer-owned value-added efforts. He urged that USDA's Value-Added Producer Grant program be funded at no less than $40 million, and called for Congress to "expedite the implementation" of the Rural Business Investment Program (RBIP). He said RBIP was designed to encourage investments in rural enterprises through rural business investment companies created to raise capital, provide operational assistance to small businesses and participate in a government guaranteed debenture program.

The RBIP, coupled with other co-op development programs, "offers an important opportunity for smaller rural cooperatives to access the resources that are vital to their success," Kisling said. But Congress should review technical requirements of the enabling legislation to determine if they are too restrictive, he continued. He said the entire coop development process also needs to be streamlined, including shifting some guaranteed loan programs for farmers to USDA's Farm Service Agency, which he said is in a better position to encourage more farmer participation.

--By Dan Campbell
COPYRIGHT 2003 U.S. Department of Agriculture, Rural Business - Cooperative Service
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Author:Campbell, Dan
Publication:Rural Cooperatives
Date:Nov 1, 2003
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