Foreword

All boards of directors are under increasing pressure to perform well and justify their decisions. Cooperative boards are no exception. But increasing scrutiny of director behavior is not always accompanied by better information about exactly what directors are supposed to do and how they are to perform their many duties.

The series of articles reprinted here originally appeared during 2002 as Management Tip articles in three issues of USDA's "Rural Cooperatives" magazine. These articles lay out fundamental guidelines for cooperative directors. Along with practical guides, the articles explain underlying principles and give suggestions for specific actions cooperative boards and directors can take to improve their service to cooperatives.

Cooperative members can use this well-received series to assess board and individual director performance and make informed choices about directors. Directors can apply the information to carry out the full range of their responsibilities with the assurance that they are satisfying the high standards of conduct required of them.

Questions about cooperatives?

E-mail: coopinfo@wdc.usda.gov, or call (202 720-7558.

This and other USDA co-op publications are posted on the USDA/RD website: www.rurdev.usda.gov.

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If you wish to file a Civil Rights program complaint of discrimination, complete the USDA Program Discrimination Complaint Form (PDF), found online at http://www.ascr.usda.gov/complaint_filing_cust.html, or at any USDA office, or call (866) 632-9992 to request the form. You may also write a letter containing all of the information requested in the form. Send your completed complaint form or letter to us by mail at U.S. Department of Agriculture, Director, Office of Adjudication, 1400 Independence Avenue, S.W., Washington, D.C. 20250-9410, by fax (202) 690-7442 or email at program.intake@usda.gov.

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Persons with disabilities who wish to file a program complaint, please see information above on how to contact us by mail directly or by email. If you require alternative means of communication for program information (e.g., Braille, large print, audiotape, etc.) please contact USDA's TARGET Center at (202) 720-2600 (voice and TDD).

USDA Rural Development Rural Business Cooperative Service Cooperative Information Report 61 Reprinted April 2014

Rural Cooperatives / July / August 2002 3

C o - o p b o a r d s ’ c i r c l e o fr e s p o n s i b i l i t i e s

M A N A G E M E N T T I P

By James BaardaUSDA/RBS Ag Economist james.baarda@usda.gov

Editor’s Note: This is the first of athree-part series about cooperative boards ofdirectors. This article identifies the sources ofauthority for boards and describes sevenbasic responsibilities imposed on every coop-erative board of directors. The next articlediscusses the legal standards directors mustmeet and outlines practical ways directorscan protect themselves as well as the cooper-ative. The last article describes the numer-ous special difficulties faced by cooperativedirectors and shows why a cooperative direc-tor’s task is more difficult than for directorsof other organizations.

eing a director of a coop-erative isn’t easy. In fact, itis harder to be a goodcooperative director than

a director of almost any other organiza-tion, including the largest corporationsin the country. Cooperative directorsmake decisions that aren’t required in anon-cooperative corporation, and baddecisions can hurt the cooperative and allof its members.

Frequently, directors just have toolittle information about what they needto do as directors. Information that isavailable to help them become excellentdirectors is often not appropriate forcooperative directors. Often, advice isso general it isn’t applicable and some isso specific that it cannot be applied easi-ly. Advice and information may notfocus on the real issues and sometimesthe advice is conflicting.

The three articles in this series cer-tainly don’t give all the answers. Howev-er, existing information related to coop-erative directors, as well as the directorsof other kinds of organizations, can bedistilled and focused for cooperativedirector use. Concise guidelines are giv-en that can be tailored to the needs ofindividual directors on the boards of aspecific cooperative.

This article identifies authority thatgives directors the rights and responsi-bilities to carry out their work as direc-tors on behalf of the cooperative and itsmembers. Then it describes the sevenbasic responsibilities imposed on alldirectors of all cooperatives: the “circleof responsibilities.”

Board authorityWhat gives a board of directors its

authority? The basic authority, and theultimate statement of responsibility, isimposed by law. Statutes under whichcooperatives are incorporated identifythe board of directors as the key institu-tion responsible for the direction andmanagement of the cooperative. A typi-cal cooperative statute says: “The affairsof the association shall be managed by aboard of not less than five directors,elected by the members or stockholdersfrom among their own number.” Varia-tions exist, of course, among statutesand states, but the theme is always thesame: the law places a cooperative’smanagement and guidance in the handsof its board of directors.

The statutory mandate is broad butisn’t described in further detail by moststatutes. This is one reason that furtherexplanation is needed to make the direc

tive meaningful. An added source ofguidance is a cooperative’s own bylaws.The bylaws are not the place to givedetailed descriptions of what the board issupposed to do, and bylaws typically donot. However, in describing certainprocesses and actions of the cooperative,bylaws often identify decisions the boardmust make on specific issues. Some ofthese will be described when board func-tion and personal responsibilities are not-ed in the next article in this series and—even more so—when special issues aredescribed for directors in the final article.The problem faced by directors (whorepresent members) when members wantsomething that will be detrimental totheir cooperative (to whom directors alsoowe a duty) is also noted in the final arti-cle.

Finally, the board will establish its owninternal structure, rules and operations tosupplement the broader statements in thestatutes and the bylaws. These cannotremove or diminish the responsibilitiesimposed by statute, but can create aframework in which the overall responsi-bilities and authority are useful in theeveryday work of the board.

These are the technical sources ofauthority. The ultimate authority,though, comes from the cooperative’smembers. The cooperative is theirs, andwithout members’ desire to create andperpetuate the cooperative, the boardwould not exist. Members place theirtrust, their needs, and authority in aboard of directors of their own choosing.

Circle of seven responsibilitiesDespite significant differences among

cooperatives in the United States in

B

4 Rural Cooperatives / July / August 2002

size, function, complexity, organiza-tional form, financing methods andmembership makeup, it is possible tosummarize a “circle” of seven responsi-bilities applicable to all cooperative

boards of directors. Of course, each ofthe responsibilities will be carried outdifferently depending on the coopera-tive, but fundamentally the circle ofseven responsibilities describes allcooperative boards of directors.

1. Board represents cooperativemembers

Cooperatives are created and oper-ated to serve members’ needs. Mem-bers invest in the cooperative, theypatronize it and they exercise ultimatecontrol of the cooperative. The boardof directors is the means by which theneeds and desires of individual cooper-ative members are incorporated intothe cooperative. In some circum-stances, of course, members votedirectly on a cooperative issue. But forthe most part, members are represent-ed by the board of directors.

Directors are elected by membersand directors’ role is to represent thosemembers. To represent members effec-tively, directors must know what mem-bers need. They also assess the cooper-ative’s capabilities to meet those needs.Directors must understand thestrengths and weaknesses of the coop-erative and make judgments based on a

thorough understanding of the cooper-ative’s resources and its employees sothey can be used to the members’ bestadvantage in a successful cooperative.

2. Board establishes cooperativepolicies

Directors put theirmember representationrole into effect by mak-ing policy. Indeed, manydiscussions about coop-erative directors summa-rize the board’s job asestablishing cooperativepolicy. Policies may bebroad and long-range orthey may be specific andimmediate. Both arenecessary. If the boardfails to establish cooper-ative policy, either some-one else will establish thepolicy or the cooperativewill operate withoutdirection and control. In

either case, the cooperative cannot besuccessful and disaster is likely to follow.

3. Board hires and supervises man-agement

Directors do not run the cooperativethemselves. Employees are used to dothe work necessary, given policies theboard has established about the purpos-

es of the cooperative and specific poli-cies guiding cooperative operations.The board hires and supervises manage-ment. Normally, direct involvement byboard members is limited to only topmanagement, but the board’s responsi-bility does not end with the employ-ment of a chief executive officer. Super-visory responsibilities vary according tostructure and circumstances.

4. Board is responsible for acquisi-tion and preservation of cooperativeassets

Cooperatives acquire and use assets

to serve patrons in one way or another.An overall responsibility of the board isto establish policies with respect toacquisition and preservation of thecooperative’s assets. Cooperatives areentrusted with other people’s moneyand must account for it at all times. Theassets of a cooperative were purchasedwith member money, and the coopera-tive is obligated to those members.

This board responsibility is shownin two specific obligations. First, theboard is responsible for guaranteeingthat the cooperative establish and useaccounting systems that keep track of all aspects of the cooperative’sfinances and resources. The account-ing system must also accuratelyreflect the true financial condition ofthe cooperative.

The second obligation is that theboard monitor the cooperative’s finan-cial performance and establish policiesthat protect the cooperative fromfinancial shocks and risky situationsthat undermine its financial health.Proper audits and careful boardresponse to audit reports is the firststep towards meeting this responsibili-ty, but a range of board decisions canspell financial success or failure.Whether financially related policies areshort-term or long-term, the board of

directors has the ulti-mate responsibility forthe cooperative’s finan-cial affairs.

It is clear that theseresponsibilities requirea great deal of care,attention, and skill by

each member of the board. Boardmembers must understand what afinancial reporting system is, what itmust do, and what financial informa-tion can and cannot tell directorsabout the performance of the coopera-tive and its management.

5. Board preserves the cooperativecharacter of the organization

The board, as the policy-makingbody and representative of the cooper-ative’s members, is responsible formaintaining the special character of thecooperative. If the cooperative is

General definitions:Responsibilities: What boards of directors must do tomeet their obligations to the cooperative under lawsand other guiding sources.

Standards of conduct: Sometimes called duties, stan-dards specify how the responsibilities must be carriedout. They impose standards of conduct on the boardand individual director board members.

Liabilities: These are consequences when directorsfail to carry out required responsibilities with therequired standards of conduct. Liability may beimposed on the cooperative or individual membersof the board.

Boards of directors and management often strugglewith the division of duties, supervision, and opera-tional detail between the board and management.This issue can be detrimental to the cooperative ifconflicts are not resolved satisfactorily.

Rural Cooperatives / July / August 2002 5

allowed to deviate from principles tothe extent that it is no longer a cooper-ative, the directors have failed in thisresponsibility. This can be a breach ofthe trust that members have placed inthe board, and in some cases it can be aviolation of law.

At the same time, the board appre-

ciates that a wide rangeof operating methodsand structures is avail-able to cooperatives.Preserving cooperativeprinciples doesn’t meanthat the cooperative iseither small or simple.It only means that thefundamental characterof the organization isthat of a cooperativeregardless of size orcomplexity.

The responsibility imposed on theboard to preserve the cooperativecharacter of the organization meansthat the directors must know what thatcharacter is, how it operates in thestructure of their organization, andwhat kinds of events and actions mayundermine cooperative fundamentals.

6. Board assesses the cooperative’sperformance

Every organization evaluates its per-formance to assess the policies andactions taken during the year and to planeffectively for the future. For coopera-tives, performance rules are not identicalto those that generally apply to othertypes of businesses, although they aredeceptively similar. A cooperative isindeed concerned with the “bottom line”and its success as measured by financialcriteria, but it is not organized to simplybenefit itself. The cooperative’s perfor-mance is ultimately measured by thebenefit it confers on those who use it.Performance is judged by the coopera-tive’s fundamental objectives.

This may be accomplished in differ-ing ways, as no single standard of mea-sure is available to the board. The boardis faced with multiple criteria, and somemay be conflicting. Some criteria maybe measured in numbers, and some can-not be measured by any financial docu-ments. Despite the variations, the boardmust keep its eye on the cooperative’sultimate goals, make careful assessmentsof performance and strategies, establishappropriate policies, and make harddecisions on behalf of the members.

7. Board informs membersCooperative boards of directors

inform members about the cooperativeorganization—the members’ own busi-ness. This duty is rather unique amongbusinesses in its importance and impli-cations for member control.

Without accurate information,members cannot make decisions abouttheir cooperative and will not be pre-pared to make decisions imposed onthem as cooperative members. Mem-bers will not be able to understandwhether their cooperative is successful,or whether basic changes must be madeto correct problems identified by theboard. And without accurate and com-plete information, members will not beable to make judgments about coopera-tive management or about the board’sown performance.

Member information completes thedirectors’ “circle of responsibility”leading to member representation. ■

This may be one of the most misunderstood andneglected of directors’ responsibilities. In most situa-tions, it does not require specific action on the part ofthe board, but only if the proper safeguards have beenestablished and are in place for all to see. A periodicreview of the cooperative along with established poli-cies and rules requiring operation on a cooperativebasis are essential. But nothing gives the cooperativeas much protection as an articulated dedication tocooperative principles understood by the board, themembers, and management.

Implementing exerciseAt your next board meeting, consider conducting a complete assessment of

sources of the board’s authority, including statutory requirements, bylaw provi-sions, policies, board structures or another source of board authority.

• What is the source of the authority?• What does it mean for the everyday operation of the board?• Does the board fully appreciate its authority—and its limits?• How can the board respond better to the authority it is assigned?

At each of the subsequent seven board meetings, thoroughly consider oneof the responsibilities listed.

• What specifically does the board currently do to meet the responsibility?• What are the weaknesses in the board regarding its responsibility?• Does each director have the skill, interest, and time to consider and respond to the

responsibility?• Does the board have the knowledge and information necessary to meet each

responsibility?• What specific steps can be taken to make the board meet every responsibility?• Is there a consensus on the board’s performance?• Would members agree with the board’s self-assessment?

The most effective way to make the responsibilities “up close and personal”is to have each director individually address the issue and propose his or her ownsolution to problems perceived about the responsibility under discussion. Boardmeetings or ancillary sessions to board meetings can then provide the forum fordiscussion within the board. These sessions may be more effective if managementis not present.

6 Rural Cooperatives / September / October 2002

Co-op d i rec to rs he ld to h igh s tandards

M A N A G E M E N T T I P

By James BaardaUSDA RBS Economistjames.baarda@usda.gov

Editor’s note: In the last issue we exam-ined the circle of seven responsibilities thatall directors have. This second article in aseries of three discusses standards of conductapplied to directors and the sources of legalliability imposed on directors when theydon’t meet the standards. It concludes witha discussion of protections for individualdirectors against personal liability. Just asresponsibilities can be divided into sevendistinct, yet related, items, standards ofconduct, liabilities and responses can beviewed in seven steps.

Directors’ roles inperspective

A number of responsi-bilities are imposed on acooperative board of

directors, but where do individual direc-tors fit in? Four perspectives of direc-tors’ roles help identify board and indi-vidual director responsibilities. Startingwith the broadest perspective and nar-rowing the view to the individual direc-tor gives the following breakdown.

The cooperative is a business orga-nization, almost always a corporation.All of the substantial rules governingcooperative directors come from cor-porate law.

The cooperative is a very specialkind of corporation. Cooperatives oper-ate according to appropriate coopera-tive rules or principles. These uniquecooperative attributes define coopera-tives’ unique objectives, they requirespecialized income distribution and

financing techniques, they imposeunusual decisions on the board of direc-tors and they give cooperative directors“something else to think about.”

Narrowing the perspective further,the board of directors acts as a body.The power to act on behalf of thecooperative is given to the board ofdirectors as a body, not to individualdirectors. No special power is given toan individual board member to act offi-cially. As an individual, a board mem-ber has no greater authority than anordinary cooperative member. Theboard derives its authority from theincorporation statutes, articles of incor-poration, bylaws, and the members.These all identify the board of direc-tors as the governing body.

This perspective further defines an

individual director’s participation in thecooperative. Decisions are board ofdirector decisions, so an individualdirector must be able to work effectivelywithin the dynamics of the board toinfluence board decisions. The board asa whole will be effective only if proce-dures, committee structures and interac-tion is conducive to good decision-mak-ing. If a director objects to a decision, itis imperative that a negative vote berecorded, otherwise the director will beheld to have agreed with the decision.

Responsibilities, standards of con-duct and possible liabilities fall onboard members as individuals. If thestandards of conduct are not met, indi-vidual directors may be liable to share-holders and members, to the coopera-tive, to creditors, to patrons and to thepublic through civil or criminal laws.What are the standards of conduct bywhich directors are measured?

2. Standards of conductStandards of conduct for corporate

directors have been developed overmany years by judicial decisions andlegislative action. Although cooperativedirectors face numerous special prob-lems, no separate set of standards hasever been developed for cooperativedirectors. Therefore, corporate rulesgenerally apply to cooperative directors.

Standards applicable to cooperativedirectors (as is the case with corporatedirectors) are usually divided into three“duties.” These are summaries of manydecisions and statutes and are stated ingeneral terms in this article. The threeduties are “duty of obedience,” “duty ofcare” and “duty of loyalty.”

1.

The Circle of SevenResponsibil it ies(As described in the previous articlein this series, see July-August 2002issue, page 30.)

Directors:1. Represent members2. Establish cooperative policies3. Hire and supervise management4. Oversee acquisition and preserva-

tion of cooperative assets5. Preserve the cooperative charac-

ter of the organization6. Assess the cooperative’s perfor-

mance7. Inform members

Rural Cooperatives / September / October 2002 7

3. Duty of obedienceThe term “duty of obedience”

sounds odd but is logical whenexplained. The duty means first thatdirectors must perform their roles inconformity with the statutes and termsof the cooperative’s documentedrequirements for the directors. Theauthority given to the board of direc-tors is defined, as is the purpose of thecooperative. Acts beyond those limitsare “ultra vires” and are not autho-rized.

Neither may the board make deci-sions that are either themselves illegalor that will cause the cooperative to dosomething illegal. The duty of obedi-ence also implies that the board shouldmandate necessary records and record-keeping, internal procedures, policiesand compliance programs, then super-vise the process to the extent necessaryto protect the cooperative from illegalor improper actions.

4. Duty of careThe duty of care, also called the duty

of diligence, has developed in judicialdecisions but is also found in many cor-porate statutes. Statutes typicallydescribe the duty of care in three parts:good faith, prudence and judgment.

Directors are required to act ingood faith in all circumstances. Direc-tors must also exercise care that anordinary person in a like positionwould in similar situations. Finally, adirector must make decisions for thecooperative in a manner that he or shereasonably believes to be in the bestinterests of the cooperative. Directors

have the highest obligation to thecooperative and stand in a relationshipof trust—a fiduciary relationship.Good faith, conscientious care and bestjudgments are expected of each andevery director.

Diligence and care raise two particu-lar challenges for cooperative directors.Directors may fail in their duty if theboard does not adequately supervisemanagement. The board must devisesome way to be sure that managementand employees conduct themselves inthe cooperative’s affairs in an ethical andlegal manner. The board also establishesthe cooperative’s strategic direction andevaluates management’s progress towardthe cooperative’s goals. In addition toselecting top management (usually themanager or CEO), the board’s duty ofdiligence requires that the board evalu-ate management’s performance, estab-lish succession plans and, if necessary,dismiss top management.

Often, questions about a director’sperformance revolvearound what the direc-tor knows. Generally,ignorance does notexcuse a director fromliability. Directors mustknow what they aredoing or they cannotsatisfy their duty of care.The knowledge requirement is usuallydivided into two important parts.Directors will be held accountable forwhat they know and what they shouldknow. A director who is actually igno-rant of a fact is not excused if the lawrequires that the fact should have been

known by the director.How is a director to

gain this knowledge?Directors are sometimessaid to have a duty toinquire about factswhich are required forthem to carry out all oftheir responsibilities.Directors have a right toinspect all books andrecords. They have theadditional duty to

understand the financial condition ofthe cooperative and its business opera-tions. Directors are presumed to knowwhat is in the cooperative’s books andrecords. As a general statement, direc-tors will be charged with knowledge ofwhat it is their duty to know.

5. Duty of loyaltyLoyalty is perhaps the most trouble-

some area of liability in corporate law,including cooperative law. It is trouble-some because it is not well understood,and the presence of disloyalty or conflictsof interest is devastating to a director’spersonal position of trust in the coopera-tive. As has been mentioned, directorsoccupy a position of highest trust andconfidence upon which the cooperativeand the entire membership relies. Thatposition must be protected in any actiontaken and in any decisions made.

Several kinds of behavior are prohib-ited by the duty of loyalty. Self-dealing,where the director makes a special prof-

it by doing business with the coopera-tive, is a breach of the duty of loyalty.

As discussed in the previous article,directors of cooperatives are placedalmost automatically in a position ofdealing with the cooperative. This isnot a problem if handled properly. Infact, a common statutory provisiondescribes permissible situations. A typi-cal provision states “No director, duringthe term of his office, shall be a party toa contract for profit with the associationdiffering in any way from the businessrelations accorded a regular member orholders of common stock of the associ-ation or others, or differing from termsgenerally current in that district.” Con-flicts of interest situations always posespecial challenges.

Do corporate statutes applyto cooperative directors?

Generally yes, for two reasons. Cooperative incorpo-ration statutes usually state that corporate law appliesto cooperatives unless corporate law conflicts. Coop-eratives are incorporated bodies that have all of thebasic characteristics of corporations; directors’ roles,duties and responsibilities are no exception.

Conflicts of interestConflicts of interest involving directors are unavoid-able and can have serious consequences if not handledproperly by the board and the cooperative. This topicwill be further examined in the third part of this series.

8 Rural Cooperatives / September / October 2002

The duty of loyalty imposes otherrestrictions on directors. A directorwill violate the duty of loyalty by deal-ing with someone directly who couldhave otherwise dealt with the coopera-tive. This is called “appropriating thecooperative’s opportunity.” Loyaltyalso requires the highest degree ofhonesty and fair dealing with the coop-erative and on the cooperative’s behalf.

Directors are often in a positionwhere they could violate the final aspectof the duty of loyalty: that of confiden-tiality. Directors are privy to informa-tion about the cooperative that may notbe public. This is particularly the casewhere directors have access to informa-tion about the affairs of other membersof the cooperative. Directors are understrict prohibitions about eitherdivulging confidential information toanyone else or using it for their ownbenefit regardless of the harm to thecooperative.

Generally, a violation of the duty ofloyalty, typically in situations referredto as conflicts of interest, is the quick-est and surest way to make a directorliable for wrongdoing.

6. The business judgment ruleDirectors constantly exercise judg-

ment on behalf of the cooperative, andsometimes that judgment does not leadto the best outcomes for the coopera-tive. Unexpected events can turn agood plan bad. Or directors may simplymake a mistake in judgment. Whathappens when directors’ actions lead tolosses or other detriment to the cooper-ative?

Normally, courts will not interferewith the internal operations of a busi-ness to replace the judgments of thedirectors with the court’s own judgmenton business matters after the fact. Thebusiness judgment rule says that, absentfraud or self-dealing, business judg-ments made by directors will not beoverturned by the courts and will notlead to director liability. Directors donot and cannot guarantee the success ofthe cooperative or each decision made.

Courts have generally given threereasons for the business judgment rule.

Few members would be willing toserve as cooperative directors if theyfaced personal liability for good faitherrors in judgments that results inharm to the cooperative. Courts alsorecognize that courts themselves areill-equipped to make business judg-ments for directors and that second-guessing board decisions is not an effi-cient way to monitor directors. Finally,a cooperative cannot be managed effi-ciently if directors are not given widelatitude in law to handle the coopera-tive’s affairs.

It is important to understand the lim-its of the business judgment rule. Courtsusually say that the authority of directorsis absolute when they act within the law,and questions of policy and internalmanagement are—in the absence of non-feasance, misfeasance or malfeasance—left wholly to their discretion. The rule isnot a protection if the offending actionwas an abuse of the board’s discretion,was tainted with board member conflictsof interest or was a result of the directors’abdication of their duties to the coopera-tive. Courts will step in and hold direc-tors liable for their actions when direc-

tors are guilty of willful abuse of theirdiscretionary powers, or bad faith, or ofneglected duty, or of perversion of thepurposes of the corporation, or whenfraud or breach of trust is involved. Oth-erwise, directors are not personally liablefor mistakes while exercising theirinformed, best judgment.

7. Minimizing riskAn easy but inadequate suggestion

for avoiding problems as a cooperativedirector is to understand and appreci-ate the responsibilities listed in the firstarticle in this series, know and adhereto all standards of conduct in this arti-cle and make no mistakes that may bedetrimental to the cooperative. Thefirst two suggestions are in the controlof each director and are, in fact, thebest defenses to legal challenges todirector performance.

Protection is best when a proactiveattitude is adopted by each director toknow the responsibilities and standards,understand what it means for the direc-tor’s performance and identify particu-larly sensitive issues in the cooperative,for the board of directors and regarding

Implementing exerciseEstablish a schedule to consider—at board meetings or ancillary meetings—

each of the standards of conduct imposed on directors. Systematically considereach standard and its requirements. At each meeting, thoroughly examine oneof the standards outlined in this article.

• What specifically does the board currently do to meet the standard?• What are board’s weaknesses regarding the standard?• Does each director have the skill, interest and time to consider and respond

to the standard’s requirements?• Does the board have the knowledge and information necessary to meet the

standards?• What specific steps can be taken to make the board meet every standard?• Is there consensus on the board’s performance?• Would members agree with the board’s self-assessment?Even more than the board’s responsibilities, the standards are personal to each

director. Each director should individually address the issue and propose his orher own solution to problems perceived about the standard of conduct under dis-cussion. These sessions may be more effective if management is not present.

The board should also consider the mechanisms the cooperative has in placeto protect directors, such as indemnification provisions and D & O insurance.Assessment of state law applicable to the cooperative and directors will be partof the analysis.

Rural Cooperatives / September / October 2002 9

the director’s own personal performance.Directors may also give attention to

several other actions and practices thatare beneficial to their performance.Board structure, proper use of commit-tees, effective board discussions andleadership, flows of information frommanagement to the board and goodboard-management relations can avoida number of problems. Directors mayrely on experts, advisors, employees,and board committees, within certainlimits. Reliance does not relieve direc-tors of their responsibilities but doesshow care and diligence.

Reliance on others must, of course,be justified and cannot amount to abdi-cation of responsibilities and duties.Director training is key to effectivedirectorship. Effective training pro-grams must go far beyond indoctrina-tion by management about the cooper-ative’s business from management’sviewpoint.

Compliance programs can be help-ful, and in some cases are necessary, toimplement directors duties of care andmanagement monitoring. Complianceprograms are formalized internal pro-grams to monitor certain types ofbehavior to be sure neither the cooper-ative nor employees violate some law orfail to take a required action. Theseprograms are typically designed aroundlegal requirements such as environmen-tal issues, antitrust and securities laws,financing issues, or special problemsthat may be sensitive for a particularcooperative. To be effective, the boardmust insist on workable programs, mustmonitor their implementation andinsist on full support by management atall levels. In some cases, a poor compli-ance program is more likely to causeproblems than no program at all.

Legal audits are another techniquedirectors may use to assist them intheir duties. A legal audit can includereview of the cooperative’s legal struc-ture and documents that govern thecooperative internally as well as itsrelationships with members and oth-ers, analysis of assets and liabilities,evaluation of potential claims againstthe cooperative, a thorough examina-

tion of procedures in place and recom-mendations for changes needed toaddress weaknesses.

Whatever action is taken, the overallattitude of directors should be active,positive, creative and dynamic. Thegreat responsibilities imposed on coop-erative directors and the associatedpotential for liability should not lead toa defensive posture.

IndemnificationLegal challenges to cooperative

directors and litigation involving direc-tors cannot always be avoided. Thetrauma of such actions against directorsis significant. In one regard, the bur-dens can be relieved somewhat in mostcircumstances.

Legislation has been used in manystates to allow a corporation (and pre-sumably a cooperative) to indemnifydirectors who are subject to legalaction that requires expenditures ofsometimes substantial sums in defense.Indemnification in this context simplymeans that the cooperative pays forcosts incurred by a director who isresponding to legal actions for someact as a director.

In addition to authorizing indemni-fication and describing procedures forindemnification, statutes usually estab-lish standards of conduct permittingindemnification. A cooperative may notbe permitted to indemnify a directorwhere the director’s conduct in ques-tion fails to meet certain standards ofconduct. For example, directors whocause harm to the cooperative by self-dealing or fraud against the cooperativecannot demand indemnification whenthey are sued for such actions. Whencontemplating indemnification, a boardconsiders not only the applicable statu-tory requirements and restrictions, butalso determines under what circum-stances the cooperative should orshould not indemnify a director.

InsuranceCooperatives can purchase insurance

to protect the cooperative and its direc-tors in case costs are incurred defendinglitigation against directors. Usually

called D & O insurance because it cov-ers both directors and officers, theinsurance is often in the form of twopolicies. One covers directors to theextent the cooperative does not fullyindemnify them for their costs. Theother covers the cooperative itself forthe indemnification made to directors.

As with nearly any insurancearrangement, each policy will be tai-lored to the needs of the cooperative.Terms will be negotiated that include:level of coverage, exclusions, claims oroccurrences methods, deductibles andgeneral claims procedures. ■

10 Rural Cooperatives / November / December 2002

By James Baarda, USDA/RBSEconomistjames.baarda@usda.gov

Editor’s Note: This is the third ofthree articles dealing with issues facingcooperative directors. The first installmentappeared on page 30 of the July-August2002 issue while part two was on page 15of the September-October 2002 issue.These and other past issues of this maga-zine can be assessed via the Internet at:http://www.rurdev.usda.gov/rbs/pub/openmag.htm

ooperative directors regu-larly face problems thatdirectors of even thelargest and most complexcorporations need not

even think about. The tough issues don’tdepend entirely on cooperative size

either. Directors of smallcooperatives face manydecisions as difficult asany confronted by thelargest cooperatives.

Special cooperativedirector challenges require personalwisdom and good collective decision-making abilities. In some ways, coop-erative directors need to knowmore—and think about issues morecarefully—than directors of otherkinds of businesses. Cooperativeboards certainly demand more timeand work. In addition, the dual role ofa director in a cooperative—as both adirector and a member—puts everydirector in a sensitive position.

This article, the last in a series aboutcooperative directors, identifies someunique issues that cooperative directorsmust consider on a regular basis. Itfocuses on issues that are “in additionto” the responsibilities expected ofdirectors of all businesses.

The character of the cooperativeCooperatives are unique kinds of

businesses. Members justifiably expecttheir cooperative to operate on a coop-erative basis with the appropriate mixof rights and obligations for everyone.Members trust the board to fully sup-port those expectations.

Sometimes cooperative characteris-tics are defined by law. In other situa-tions they are just an inherent part ofthe cooperative that members’ under-stand and expect. In any case, directorshave the ultimate responsibility to pre-serve the cooperative character of theorganization.

This responsibility presents some

hard questions for the board. Is theorganization truly operating on a coop-erative basis? How do directors know itis? What observable criteria can beestablished to guarantee the integrityof a cooperative’s implied promise to bea cooperative? Are measures taken—either on a periodic basis or in prepara-tion for significant business changes—to be sure that basic cooperativeprinciples are preserved? Has the boardestablished policies, operating proce-dures and internal controls to guaran-tee operation as a cooperative? Doesthe cooperative have danger points inits operations that require special mon-itoring and attention?

Although difficult, the directors’role in maintaining the ability of thecooperative to serve members in auniquely beneficial manner can be arewarding professional and personalexperience for directors. Each directoris a gatekeeper of the principles andpractices that empower members tocooperate to create true value forthemselves and others.

Cooperative-based decisionsCooperative boards of directors

make decisions not made by boards ofany other kinds of business. Thesedecisions are, for the most part, unusu-ally difficult. They require directors tohave a clear understanding of financialdocuments, performance measures andthe short- and long-term consequences

Cooperat ive d i rec to rs face un ique cha l lenges

M A N A G E M E N T T I P

C

The Circle of SevenResponsibil it ies(As described in the previous articlein this series, see September-October2002 issue, page 15.)

Directors:1. Represent members2. Establish cooperative policies3. Hire and supervise management4. Oversee acquisition and preserva-

tion of cooperative assets5. Preserve the cooperative character

of the organization6. Assess the cooperative’s performance7. Inform members

Cooperative directors are responsible formaintaining the cooperative character of theorganization.

Rural Cooperatives / November / December 2002 11

of decisions made and actions taken.Situations may make the board a con-flict-resolution body that balancesdivergent and often deeply held inter-ests among members. Some of theseinvolve business and financial issues,while others are emotional in nature.

Operating within proper authority wasmentioned in a previous article. Thecooperative’s authority and limitationson that authority may be found in sev-eral places. The board’s authority maybe defined by the cooperative’s charter,including the applicable incorporationstatute. The board of a cooperative

considers incorporation statutes, thearticles of incorporation and bylaws todetermine the obligations and limita-tions of the cooperative.

Laws that apply generally to allbusinesses apply to cooperatives aswell, but sometimes in a different man-ner. Such laws mean that cooperativeboards must make decisions for thecooperative based not only on general-ly applicable laws, but laws that areespecially applicable to cooperatives.Examples include special tax laws thatapply to cooperatives, cooperativeantitrust laws that mandate or prohibitcertain business structures and behav-ior, and state cooperative incorporationstatutes that contain special require-ments for cooperatives.

A cooperative’s charter, its bylaws, itscontracts, membership agreements andother binding agreements are all sub-ject to review by directors as they estab-lish policies and procedures to guaran-

tee that the cooperative adheres to lawsand other legal obligations. Directorsmay, of course, rely on counsel andaccountants to identify the rules, butdirectors themselves make the decisionsand bear the responsibility for decisionsmade.

Determining and allocating patronagerefunds is one of a cooperative board’smajor concerns. Of course, the boarddoes not make decisions about refundson the spur of the moment each year.The system used to determine and cal-culate refunds should have been estab-lished in the bylaws and in written

policies, all ofwhich are subjectsof careful directorstudy and periodicreview. Decisionsabout allocationsand distributionsare complicated byshort-term andlong- term implica-tions as well as bal-ances among thosewho use the coop-erative for differentpurposes. All thisleads to possibleconflicts among

cooperative members. The cooperative may also face cir-

cumstances that weren’t contemplatedwhen the policies were established.The board must decide what modifica-tions can be made in response to spe-cial circumstances to recognize thecooperative’s purposes.

Any patronage refund system hasmany implications for the cooperativeand its members. These include fairness,operation on a true cooperative basis, taximplications, rules in state laws, inter-pretations of bylaws, members’ expecta-tions and desires, and the very healthand survival of the cooperative. Success-ful solutions to sensitive issues ultimatelyrest in the hands of an informed, delib-erative board of directors.

Member qualification is important to acooperative, whether the qualificationsof applicants for new membership areat issue or continued qualification ofexisting members is in question. Direc-

tors should recognize the importance ofkeeping good membership roles andpurging those who no longer deal withthe cooperative. The behavior of somemembers may harm the cooperativeand therefore other members. Direc-tors have the unenviable task of takingappropriate action to protect the coop-erative. Predetermined, neutral rulesthat avoid ad hoc decisions about indi-vidual members will help avoid confu-sion and hard feelings.

Decisions with federal income tax conse-quences are pervasive. Directors are notexpected to be tax experts, but they doneed to appreciate the implications ofall of their decisions. Examples of deci-sions with direct tax implicationsinclude use of qualified or nonqualifiednotices of allocation, per-unit retains,allocation of margins and losses andmost issues regarding calculating mar-gins and distributions.

Patron or non-patronage businessand the allocations and payment ofrelated net margins have direct incometax implications. Added to the directeffect on the cooperative is the impactthat any such decisions have on mem-bers or other patrons. A seeminglysimple business decision by cooperativedirectors becomes one of balancingmany interests.

Conflict of interestLike other members, directors use

the services of the cooperative. Thismeans that directors deal personallywith the cooperative. They have theirown obligations toward the cooperativeand their own expectations of benefitsfrom it. Decisions that directors makeabout the cooperative will affect themas member-users just as they affect thecooperative and other members.

The previous discussion of “duty ofloyalty” pointed out that the single actionmost likely to impose personal liabilityon a director is a conflict of interest. Thepersonal dealings that a director has withthe cooperative places the director in aprecarious position. What appears to beinnocent when done may in hindsightlook very bad for the director.

Many examples exist of directors’dealings with the cooperative that will

Cooperative principles should befamiliar to every cooperativedirector.1. The User-Owner Principle: The people who own and

finance the cooperative are those who use the cooperative.

2. The User-Control Principle: The people who controlthe cooperative are those who use the cooperative.

3. The User-Benefits Principle: The cooperative’s solepurpose is to provide the distribute benefits to its userson the basis of their use.

12 Rural Cooperatives / November / December 2002

affect both the director and the cooper-ative and pose possible conflicts ofinterest. These include:

• Price differentials or special con-cessions for large producers andpatrons.

• Directorship in both a local cooper-ative and the federated cooperative.

• Extension of credit to member-patrons.

• Methods of obtaining capital.• Allocation of patronage refunds,

especially when the cooperative is amulti-functional cooperative and thefunctions are not totally separated.

• Cash or non-cash patronagerefunds related to patron taxbrackets.

• Equity redemption decisions,including when to redeem, financ-ing methods and equity- buildingprograms.

Directors must make these and allother decisions regardless of the sharedinterests of directors and the coopera-tive. Cooperative incorporation statutesrecognize the problem, at least withrespect to the patronage relationship. A

typical provision says that “no director,during his term of office, shall be partyto a contract for profit with the associa-tion differing in any way from the busi-ness relations accorded regular mem-

bers or holders of common stock of theassociation or others, or differing fromterms generally current in that district.”

Directors should not have problemsif the conflict is clearly recognized,decisions are made solely with theinterests of the cooperative foremostand all questions are addressed openlyand honestly.

Financial mattersDirectors must give careful attention

to the effective financial structure andstrong financial condition of the cooper-ative. Directors are entrusted with theultimate responsibility for the care ofthe funds and property of the coopera-tive and its members. Although similargeneral rules apply to non-cooperativecorporations, a cooperative’s directorshandle unusual issues because coopera-tives have special techniques to financethe organization. Because cooperativesoperate for the mutual benefit of themembers and not as purely profit-seek-ing organizations, they have financialneeds, opportunities and limitations notfound in other businesses. Ultimately,

the most difficult finan-cial decisions are in thedirectors’ hands.

Patronage refund distri-butions are closely relatedto equity allocations inmost cooperatives.Directors are involved inthe balance between cur-rent monetary returns tomembers and additionsto the cooperative’s equi-ty structure. For exam-ple, patronage refundsmay be paid in a combi-nation of cash and writ-ten notices of alloca-tions. The choice carriesmajor implications forthe long-term financialhealth of the coopera-tive. At the same time,members may expect

high cash payout as a return for theirinvolvement in the cooperative andtheir own tax considerations. Alloca-tions and choices of the income to allo-cate, equity vs. debt financing and

patronage-based vs. non-patronage-based sources of financing, are all partof plans and strategies that boards ofdirectors establish.

Equity redemption is an integral partof a cooperative financing system. Itcan also be a source of dispute. Deci-sions about equity redemption areoften assigned specifically to theboard’s discretion. How is the board ofdirectors to exercise that discretion?Do short revolving periods jeopardizethe cooperative’s financial health androbustness? Do long revolving periodsshow poor planning, do cooperativesuse former members’ money to gener-ate benefits for the current users, anddoes slow revolvement present fairnessissues? Courts usually support directordecisions on equity redemption in alegal dispute, but the major challengefor a board is to meet obligations ofpast, present and future members withfairness and forthrightness to avoidunresolvable problems.

Special eventsDirectors bear added responsibilities

when the cooperative considers a majorchange in its organization or in its rela-tionships with other businesses. Merg-ers or establishing long-term, signifi-cant joint-venture arrangements withother businesses are examples of eventswhere directors have a major responsi-bility for decisions that are of criticalimportance to the cooperative. Suchevents affect members’ interests in theshort run and in the long run.

Decisions affect benefits that all par-ties involved will receive, includingfinancial obligations (past and future),differential impacts among membersand planning horizons for all parties.Directors not only assess overall costsand benefits of such actions, they willbe required to address conflicts amongmembers about the action.

A decision to dissolve a cooperativeis, of course, among the most difficultthe board will make. The process notonly occurs under typically unpleasantcircumstances; it challenges the abili-ties and dedication of all involved.

Directors will be well served bymaking every effort to recognize how

Standards of conduct applicable to cooperativedirectors include:1. Duty of Obedience. Directors must ensure that they

or the cooperative do not engage in illegal orimproper actions.

2. Duty of Care. Directors are expected to act ingood faith at all times, exercise prudence, andapply their best judgments for the benefit of thecooperative.

3. Duty of Loyalty. Directors have a position ofhighest trust and must avoid conflicts of interest,self-dealing, actin in any other than the best inter-ests of the cooperative or divulging confidentialinformation.

Rural Cooperatives / November / December 2002 13

standards of conduct discussed in pre-vious articles in this series can guidethem. Adequate information about theimplications of the action, the mechan-ics of the process, impacts on membersand the future of the cooperative are allcritically important. Balancing memberinterests and measuring the financialand other needs of the cooperative willguide directors’ decisions.

Assessing the cooperative’s successImportant decisions about the per-

formance of management, success orfailure of strategic plans or specificprograms, and designing plans for thefuture are all based on an accurate andrealistic assessment of the coopera-tive’s current performance. Such anassessment is not necessarily easyunder any circumstances.

As with any business, the “bottomline” is critical. But unlike other busi-nesses, for cooperatives the bottomline is only the beginning of an assess-ment of its true success. Every directorneeds to understand financial state-ments, organizational growth, projectplans, overall strategies and levels ofservice offered. But more is required.

Difficult questions require addi-tional board consideration. What wasthe net benefit of an action to members,including their share of savings andmargins? What was the tradeoffbetween benefits distributed to mem-bers and the net income of the coopera-tive? What is the financial condition ofthe cooperative and what are the trendsand expectations for future capitalneeds?

Were all members treated equitablyin distributions and financing obliga-tions? Did the cooperative serve somemembers at the expense of greaterreturns to others? If so, is that practicepart of the cooperative’s greater pur-pose? What was the trade-off betweenshort-run and long-run needs, obliga-tions and benefits? Are successes orfailures attributable to management,board decisions, the economic environ-ment or member actions? What can orcannot be corrected about the coopera-tive’s performance?

Directors balance members’ interestsThe cooperative’s fortunes are those

of its members, and if the cooperativeis not responsive to members’ needs,the basic principles of member controland user benefit are weakened. Thecooperative will simply cease to existand serve.

The membership of most coopera-tives is not homogeneous. Each mem-ber has an interest in the cooperative.These interests differ to some degree,sometimes dramatically from othermembers. Members may have differingplanning horizons, as would be the casebetween someone just starting in thefarming business and someone contem-

plating imminent retirement. Thesetwo members could have markedly dif-ferent interests in financing, revolvingperiods for patronage payments andcash vs. non-cash payments. Membersmay be in different tax brackets, whichhas implications for the amount andform of patronage refunds.

Some members may be more con-cerned with price while others may findcertainty of supply or a market moreimportant. Producers of different prod-ucts may have distinctly different needsfrom the same cooperative. Disparity ofbusiness volume among members maylead to calls for differential pricing.These and other variables make thedirectors responsibility to representmembers quite different from decisionsfor non-cooperative businesses.

Members, or prospective members,may want more from the cooperative

than the organization can provide andstill maintain its financial and opera-tional integrity. Directors may actuallybe put in a position of balancing somemembers’ needs against the interests ofthe cooperative itself. Diplomacy andgood communication are valuable, butno easy resolution may be possible.

Board-management relationsA good working relationship

between the board of directors andmanagement is very important forcooperatives. At the same time, therelative responsibilities of the boardand management create natural ten-sions about roles and responsibilities.The cooperative board has a distinctrole and make-up that places obliga-tions of independence and leadershipon the cooperative board of direc-tors that are not necessarily found inother boards.

Does the board defer excessively toa forceful manager? If so, what mightthe consequences be? Does the boardinterfere inappropriately in the coop-erative’s management and day-to-dayoperations? If so, what are the conse-quences? How does the board assessmanagement and what correctivemeasures are in place in case of diffi-

culties? Is there an effective chain ofcommunication and command betweenthe board and management? Whatdoes management think of the board ofdirectors? If necessary for the good ofthe cooperative, is the board of direc-tors capable of making and executing adecision to replace management?

The rewardsWith all of the responsibilities

placed on boards of directors outlinedin the first article in this series, thehigh standards of conduct required ofindividual directors discussed in thesecond article and the many difficultdecisions directors make as noted inthis article, why would anyone agree tobe a cooperative director? Individualscan point to at least five reasons toserve as a cooperative director.

The rules that apply to responsibili-ties, liabilities, duties and requirements

To be effective, board members must have a solidgrasp on co-op financial statements. Request tomeet with the co-op manager or accountant if youneed more background on how to read them.USDA Photo by Ken Hammond

14 Rural Cooperatives / November / December 2002

are pretty clear. With diligence and care,a cooperative director has guidance toavoid the many pitfalls suggested by acautious view of a director’s job. Thougha director may face unpleasant, and some-times unexpected circumstances, adher-ence to high personal standards of con-duct is excellent insurance againstpersonal problems.

Directors are part of a team. Thisteam is not only a source of support, it isa reward in itself. Difficult issues arediscussed within the board before deci-sions are made; information is generatedand shared, and decisions are made as aboard. Responsibilities are shared withothers in a similar position. The teamconcept includes not only the board ofdirectors, but management and, mostimportantly, the cooperative’s members.The opportunity to take an active rolein multiple constituencies is unusuallyvaluable for a cooperative director.

The sheer challenge of being acooperative director can be added as athird source of reward. Directors see aproblem from its discovery. Theydefine the issues it raises for the coop-erative and members, identify therange of possible solutions, gather andstudy the information needed to assessthe solutions, determine what the con-sequences of various courses of actionmight be, make a decision, create thepolicies and directives needed to imple-ment the chosen solution, and assessthe consequences of the board’s deci-sions. The more difficult the problem,the greater the rewards of finding ananswer. The more critical the issue isto the success of the cooperative, themore satisfying is the problem-solvingprocess.

Directorship presents an opportu-nity to serve others in direct andimportant ways. Beneficiaries of a suc-cessfully guided cooperative includemembers and patrons, the coopera-tive’s management and employees, theindividuals and businesses that dealwith the cooperative, the communitiesin which the cooperative and its mem-bers and employees are located, andthe marketing and supply systems in

which the cooperative operates. Indi-viduals considering being a directorshould consider the significantimpacts they can have beyond theboardroom and even on the coopera-tive.

Finally, board membership carriespersonal prestige despite the manyduties and difficulties. Serving on acooperative’s board of directors is a wor-thy personal and professional goal.Directorship should be a source of greatpersonal pride and satisfaction. ■

Implementing exerciseAs a board, review the character of your cooperative:

• What is the stated purpose of the cooperative?• What does this mean when balancing interests?• Identify the “stakeholders”—those who have an interest in what the coop-

erative does and how the cooperative performs.• Identify the principle things that make the organization a cooperative and

distinguish it from other kinds of businesses.

Revisit the cooperative’s vision statement, mission statement and objectives.• Are they adequate, realistic and up-to-date?• Did they come form the membership or were they devised as a board-

management exercise?• Are members familiar with their cooperative’s vision, mission and purposes?• What do the members think of them?

Set aside some time at a board meeting (after preparation) to discuss what mea-sure of success the board should use to assess the cooperative’s performance, itsmanagement, and the board of directors.

• Start with the broadest list and set priorities.• Are some measures incompatible with others?• If trade-offs are required, what decision rules can be devised?• What would members think of the trade-offs and decision rules?

Make it personal—it already is!• Identify the issues that you personally find to be the most uncomfortable,

those you’d really rather not have to make decisions about.• Make a plan to share the burdens of the decision.• List the factors you will consider in addressing the problem.• Do you think others share your discomfort?