Q: What does the Board have to do?

A: The Board of directors oversees the operations of a cooperative. The Board’s job is to make policy and major decisions about the direction of the cooperative’s development. The Board is responsible for guiding the cooperative towards sustainable operations (net income) and achieving its mission, so decisions should be made towards those goals. 

The Board does not have to make every decision. Usually there are management roles filled by staff. Those managers make the decisions in their realm of authority. Boards should expect managers to manage the cooperative’s operations. The Board reviews how well things are working, and makes changes if needed.

Some specific responsibilities of the Board are:

• Making sure that the cooperative follows required legal formalities, like filing annual reports and tax returns;
• Making sure the cooperative gives an annual report to members, if required;
• Making sure board meetings and member meetings happen, including elections for directors.

Q: Do directors have a duty of loyalty?

A: Yes. Directors must exercise their decision-making power in a manner they believe to be in the best interests of the cooperative. In a cooperative, directors are usually members, and as members, they do patronage business with the cooperative. This is not considered a conflict of interest. (See more detail at Corporations Code s. 12373.)

Q: What is a director’s standard of care?

A: To act reasonably. To act as carefully as an ordinary person would. A director may rely on committees and professional advisors if they seem knowledgeable, but if there is a reason to doubt them, the director has a duty to inquire, not turn a blind eye to something that seems like a problem. (See more detail at Corporations Code s. 12371.)

Q: Is it risky to be a director? Can I be held liable?

A: This is usually addressed with indemnification clauses and directors’ and officers’ insurance. “Indemnification” means that if a director is named as a defendant in any lawsuit because of their action in their role as a director, the cooperative must pay the costs of that defense. There is likely an indemnification clause in the articles of incorporation or the bylaws. Read it to find out how your cooperative distinguishes between situations in which the cooperative will pay all costs of defense, and situations in which the behavior was too bad for the cooperative to pay for the harm.

Directors’ and officers’ insurance can be purchased to help a cooperative be able to afford the cost of indemnification.

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This is a discussion of the legal mechanism for using a general business corporation as the legal entity for a cooperative. (This is a long nerdy post for my colleague-friends.) If you just want someone to do this for you, let us know.

First, the goal is to have one member = one vote, and, after any dividends on any preferred shares, which dividends should be limited, remaining net income should be allocated to an undivided reserve and then to members and any other patrons on the basis of patronage.

1. First try with just my own ideas:

In 2019, I converted an Illinois general corporation into a cooperative by amending the articles of incorporation. My strategy was to use the provision of law that says you can determine dividends based on an ascertainable fact outside of the articles. I decided that the ascertainable fact would be the shareholders' patronage. So I amended the articles to say that dividends on common stock would be calculated based on the patronage of the shareholder. In this case, the shareholders' patronage was their labor, and patronage was to be measured by their wages during the applicable time. (This is consistent with the definition of "patronage" = the quantity or value of business done with the cooperative, from Section 1388 of the Internal Revenue Code.)

Here's the language in the amendment describing the common stock:

a. Common Stock: The corporation shall issue not more than one share of Common Stock to any individual. Common Stock shall not be transferable except to the corporation, unless otherwise required by law. Holders of Common Stock shall be entitled to one vote per share. Holders of Common Stock are entitled to receive distributions to shareholders as authorized by the corporation's board of directors, as authorized by Section 9.10(a) of the Business Corporation Act of 1983 or its successor, subject to the following restriction: Amounts distributed to each holder of a share of Common Stock shall be in proportion to the holder's Patronage relative to the total Patronage of all shareholders. For the purpose of this paragraph, "Patronage" means the number of hours worked for the corporation by the shareholder, as recorded in the corporation's official records, multiplied by the shareholder's hourly pay rate in effect at the time the work was performed.

I spoke about this idea later with my friend, Therese Tuttle. Her first reaction was that this would not work! Because patronage dividends are not a return on capital! And they are treated differently for tax purposes. However, even after thinking about Therese's feedback, I think this approach will work, as long as the co-op works with a CPA to prepare a tax return consistent with this strategy. Here's why:

The corporate mechanism is that the return on stock is a dollar amount based on patronage. This is permitted by corporate law. Normally, dividends on stock come out of the corporation's after-tax income, but Subchapter T of the Internal Revenue Code provides an exclusion for "patronage dividends." Anything that is a "patronage dividend" does not need to be included in a cooperative's taxable income. Allocations to members have to meet certain requirements to qualify as a "patronage dividend," and none of that has to do with the legal mechanism of making the allocation. More simply, even if this is legally a dividend on a share, if it is calculated based on the shareholder's patronage, then it is in reality a patronage dividend, not a return on capital. And this does not conflict with Subchapter T, so it can meet all of the requirements of a patronage dividend and be treated as such. The cooperative just needs to know to ask for this treatment, and the tax return preparer needs to know the requirements of Subchapter T.

So I think this is an OK approach.....

2. and then I learned about an even better-fitting approach.

​I recently learned that Equal Exchange, a large, well-established worker cooperative that imports and sells coffee, chocolate, and other foods, is not organized as a cooperative corporation! It is organized as a general business corporation. The provisions in its articles about patronage dividends are there under the statutory authority to include "provisions not inconsistent with law regarding: ... (ii) managing the business and regulating the affairs of the corporation;" and/or "(iii) defining, limiting, and regulating the powers of the corporation, its board of directors, and shareholders or any class thereof[.]" See Section 2.02 of the Massachusetts Business Corporation Act. It had not occurred to me to use that general authority to authorize allocations that were neither compensation nor dividends on stock, but that is a good idea.

Massachusetts makes its corporate filings available online. The following is quoted from Equal Exchange's restated articles filed in 2020:

Article IV
There are two classes of shares with preferences, limitations and relative rights as defined in the By-laws. Those classes are as follows:

1. Class A Common Stock (Membership Shares)
a. Membership. The Corporation shall have a single class of voting stock, known as Class A Common Stock or a Membership Share(s). Membership Shares may only be acquired and held by those eligible persons as set forth in the Corporation's By-laws.
....
b. Ownership. Each Member shall own one and only one Membership Share, and only Members (as defined in the Corporation's By-laws) may own shares of Class A Common Stock. [....]

c. Rights and Privileges.
i. Voting. .... Each share of Class A Common Stock shall entitle the holder thereof to one vote.
ii. Patronage Rebates. No dividends are paid on shares of Class A Common Stock, but a portion of net earnings or losses of the Corporation shall be allocated to Members on the basis of each Member's patronage, as defined in the Corporation's By-laws.

I have no information about whether this would hold up to a challenge in court, or what level of review it is given by the Massachusetts Secretary of State before filing. I know only that it was filed in 2020.

3. Then I tried to do this for an S-corp, and it didn't work.

Next, I tried to do something similar, but for allocations to shareholders of an S-corp--they want unequal share ownership (with voting and dissolution preferences following share ownership), but equal allocations of profit. So I tried to use this idea for that client in California. Here's what I submitted:

ARTICLE VI: Provisions for the Conduct of the Corporation’s Affairs
Whenever the corporation allocates and distributes its net income to shareholders, which shall be in the discretion of the corporation’s board of directors, the corporation shall make such allocations and distributions equally among the shareholders, without regard to the number of shares owned. Equal rights of shareholders to distributions of net income under this paragraph will be deemed the controlling provision solely for the purpose of determining shareholder ownership percentages for the purpose of Subchapter S of the Internal Revenue Code. Relative ownership interests for all other purposes including shareholder voting rights will be determined based on number of shares owned.

This got rejected. I wanted the tax preparer to be able to rely on the corporation's organizing documents to make equal allocations for the purpose of Subchapter S of the tax code. This language did not successfully frame the allocations as *not* dividends on stock. Because every share of the same class has to have equal rights as every other share of that class, these articles had to be changed (by removing this section) before resubmitting.

4. Alix used this strategy for a Washington co-op, and it did work.

Meanwhile, my friend Alexandra at https://aligned.law/ used this strategy in Washington State.
[I am going to ask Alix for the language that did get accepted in Washington. Coming soon, hopefully.]

5. Delaware Corporation for a start-up ... as a cooperative.

I am now working on this for a client that wants to organize as a Delaware corporation for other reasons, but wants to be a worker cooperative. So here's what we're going to submit:

Article 5: Additional provisions for the management of the corporation’s business and the conduct of its affairs:
a. One Member One Vote. The stock of the corporation may only be acquired and held by those persons who are eligible according to the corporation's bylaws. Each shareholder may hold one and only one share of common stock.

b. Allocations. At least once per fiscal year and at any time and from time to time as determined by the corporation’s board of directors (the “Board”), after the Board has provided for a reasonable reserve, the corporation’s net earnings or losses from Patronage Net Income (as that term is used in Subchapter T of the Internal Revenue Code or its successor (“Subchapter T”) shall be allocated to the shareholders in proportion to the shareholders’ relative Patronage, as “Patronage” is defined herein and as that term is used in Subchapter T. “Patronage” shall mean the quantity of labor or service done with or for the corporation by the shareholder, as measured by [insert client's way of measuring, e.g. hours worked], provided that such measurement may be modified by any bylaw or policy of the corporation under which the Patronage of the shareholders may be determined without ambiguity. Such allocations are not dividends on stock, and may take the form of Patronage Dividends or Non-Qualified Written Notices of Allocation, as those terms are used in Subchapter T. Net income not from Patronage may be allocated as dividends on stock.

I am going to submit this for filing shortly, and we'll see whether it gets accepted or not by the Delaware Secretary of State.

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The prevailing wisdom is that for worker cooperatives owned by people who do not have employment authorization in the United States, their co-op should be organized as a limited liability company (LLC), with every member playing a meaningful role in management, and no probationary work time when they are not a member. (See this operating agreement--with cartoons!--re how this is put into practice, and check out this legal guide for a discussion.)

It is legal for any resident of any country to own a business in the US, and a business owner can work for their own business. It is not legal for a US company to hire as an employee someone without work authorization. This is why co-ops with undocumented worker-owners need to do what they can to make sure the law will see them as owners, not employees.

I used to hear this view stated repeatedly without citation to specific authority. So in 2020, when I was advising a co-op that expected that it might someday have undocumented worker-owners, I did a deep dive into the case law around when business-owners are considered owners, and when they considered employees.

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People who are starting a social enterprise sometimes ask if there is some special legal entity for social enterprises.

Their past experience in a nonprofit has left them disenchanted, and they want to do something different, and they also do not want to become an extractive for-profit corporation that is so profit-driven that it is willing to engage in harmful behavior.

So they wonder if there is something else.

There is no single “social enterprise” legal entity. Social enterprises choose one or more of the available legal entities under state law, and these are: cooperative, benefit corporation, general business corporation, limited liability company, low-profit limited liability company, or non-profit corporation. (Cooperatives can include general cooperative corporation, agricultural cooperative corporation, and limited cooperative association. Illinois has a limited worker cooperative association.) The choice among these depends on which goal is most important to you.

A cooperative prioritizes shared ownership. Cooperatives are owned and democratically governed by their members, and members are people who do some kind of business with the cooperative. Members share in profits or savings in proportion to their relative quantity or value of business done with the cooperative (their "patronage"). This could mean that workers democratically govern their workplace and share in profits on the basis of how much they worked. Or it could mean that all customers or users have a vote, and net income is returned to customers as a refund. Co-op founders often have the attitude that member ownership puts the entity in a right relationship with its workers, producers, customers, or users, and this is deeper and more important than being a benefit corporation.

A benefit corporation prioritizes the commitment to creating a social benefit or reducing a harm, and to being accountable for trying to create that benefit or reduce that harm. The legal meaning of a benefit corporation is that directors have a duty to consider many factors such as creating the benefit, and doing good rather than harm to employees, the community, the environment, etc. Directors are not supposed to make decisions based only on financial gain, and they are not liable to shareholders for making decisions in which the goal of creating profit is balanced against the attempt to do good. (Cooperatives are certainly also allowed to, and do, make decisions with the interests of workers, customers, the community, and the environment, in mind.)

The limited liability company (LLC) is a general-purpose, flexible entity. The financial and governance rights of owners can be customized in the operating agreement. An LLC can be a good fit for any profit-generating enterprise that has a small number of owners, or that wants customized ownership and financial rights that don’t fit corporate law requirements. An LLC is often used for small worker cooperatives.

Note: There is generally little harm done if a start-up founder forms their own LLC to start. The downside is the cost of having a partnership tax return prepared, and legal fees to convert to a corporation later if necessary. In contrast, if a founder starts forms their own corporation, and if the corporation has assets, you cannot "go back to" pass-through tax status without the assets being deemed distributed to owners for tax purposes.

A non-profit prioritizes being able to receive grants, if it has a charitable purpose and applies for charitable tax status with the IRS on Form 1023. Charitable organizations can pay salaries to employees, but cannot pay dividends or share profits with anyone. If receiving tax-deductible grants is most important, and if there is no need to distribute profits above salaries, then consider a non-profit corporation.

Let’s boil it down: Is receiving charitable gifts and grants important? If yes - consider a non-profit. If no, will you have a founder-owned company that is committed to creating a benefit, and willing to back up that commitment with public reports? That sounds like a benefit corporation. Or, will you have a worker-owned entity where all workers have a path to membership and share profit on the basis of how much they work? That is a worker cooperative. Or is this a cooperative to be owned by customers, or producers?  That is a consumer co-op or an agricultural co-op. Or maybe a general-purpose legal entity does the job, and you can carry on your social enterprise with your trusted business partners using an LLC or corporation.

There are layers of detail that don’t fit into a short blog post, so if you would like to discuss legal entity choice for a social enterprise, feel free to reach out.

This is general information, not legal advice.

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