In Defense of the B Shares

Thanks to the Co-op for granting my request to put the audited financial statements for 2015 on the Co-op web site.  They are available here.

[And if you are reading this, surely you're interested enough in the Co-op to vote here, between now and April 30.  Please consider making me one of your choices!]

Though the numbers comport entirely with what is reported in the 2015 “scorecard” and what was discussed on April 2 at the annual meeting, as usual the notes accompanying the financial statements contain some important and interesting information.  (That’s why there is a notation at the bottom of each page of the financial statements reading:  “The accompanying notes are an integral part of these statements.”)

Specifically, and elaborating on an issue briefly touched upon by General Manager Terry Appleby at the annual meeting, the notes at page 18 describe the following “contingency” (i.e., potential risk to the Co-op’s financial condition):

The Cooperative has been notified by the State of New Hampshire Bureau of Securities Regulation that the Bureau is evaluating the Cooperative’s capital structure for compliance with state law. The issue relates to the redeemability of common stock issued to satisfy patronage refunds declared. The Cooperative is in the early stages of addressing the matter with State authorities. Management believes that the matter is without merit and will be resolved favorably to the Cooperative without any unfavorable impact. Legal counsel for the Cooperative has advised that while they concur with management’s opinion, they are unable to conclude the likelihood of unfavorable outcome at this point. Therefore, the financial statements do not reflect any adjustments that might be required as a result of this matter.

Terry indicated at the annual meeting that this investigation began with a complaint by a member of the Co-op.  (Though Terry referred to an investigation by the Secretary of State, which registers co-ops and other corporations, it is this investigation by securities regulators to which he was clearly referring.)

Let me be clear:  As I said in my previous blog post about the Co-op’s financials, I am not a bystander with respect to this matter.  I was the Co-op’s treasurer when the capital structure at issue was invented, in the form of a package of bylaws amendments that I helped draft (and that the membership ultimately approved).  We created a new class of common stock – so-called B shares – as a vehicle by which the Co-op could issue patronage refunds in the form of stock rather than cash.  The B shares, issued for the first time in 2015, are the subject of the investigation.

This is important stuff.  I clamor for transparency at the Co-op because I think it’s vital for members to understand how their cooperative really works.  The rubber hits the road right here, because the issues implicated by this investigation go straight to the heart of what makes a cooperative different from an investor-owned business.  Terry made a similar point at the annual meeting.

Like any enteprise, the Co-op needs an adequate amount of stuff – buildings, equipment, inventory, cash reserves, etc. – to conduct its business.  It was obvious during my ten years on the Board (2003 to 2013) that the Co-op was wanting in that regard.  The Co-op simply lacked the assets it needed given the size and mission of the organization.  In other words, we needed more money to deploy as business assets.

There are only two kinds of money – yours and other people’s.  In financial terms, “your money” (“you” being the owners of the business) is called equity and other peoples’ money is referred to as debt, usually acquired from banks.  Since 2013, the Co-op has made a priority out of acquiring both kinds of money.

Specifically, there is new debt on the balance sheet in the form of about $3.5 million owed to the National Consumer Cooperative Bank and used to finance the recent renovation and expansion of the flagship Hanover store.  But that’s not enough.  A business cannot rely entirely, or even primarily, on debt to fund its assets.  So the Co-op needs to beef up the amount of equity on its balance sheet as well.

The easiest way to do that, at least in profitable years, is to retain earnings.  Nothing wrong with that except:  It’s taxable income.  And it would be imprudent for the Co-op to pay federal income taxes that it can avoid.  That’s where B shares come in – they are a tax-reduction strategy – and thus not a nefarious effort to commit securities fraud or anything close to that.

Cooperatives enjoy special treatment in the Internal Revenue Code.  (For those keeping score, the relevant provisions comprise Subchapter T of the Code.)  Specifically, the Co-op can avoid paying income tax on its earnings to the extent it can pay or allocate those earnings to members as a patronage refund.  “Allocate” is the key word:  Twenty percent must be paid out in cash; the Co-op can issue the remainder as shares and thus continue to have use of the money.  This is precisely what the Co-op did with the roughly $500,000 patronage refund from 2014, as declared a year ago.  One hundred thousand in cash; $400,000 in B shares.

You might wonder:  Why not just issue this non-cash refund as “A” shares – i.e., the old-fashioned membership shares the Co-op has always issued to people who become members?  The answer is that while the Co-op has traditionally redeemed A shares upon request, we wanted a separate class of shares that the Co-op would not ordinarily redeem.  Though I don’t know, I assume it’s this non-redeemability of B shares that is the focus of the investigation by the state securities regulators.  If you ask the Co-op to cash out your B shares, it will respectfully decline.

At the annual meeting, Terry defended this – and rightly so – with reference to the Cooperative Principle about member economic participation.  That principle has long included the notion of “indivisible” capital – that some of the economic value inherent in Co-op membership will lie in the commonly held property of the cooperative itself.  Even if you don’t buy such notion about wealth held in common with your neighbors, surely you would agree that the Co-op issuing B shares is a long way from the kinds of shady activities our securities laws are intended to prevent.  The Co-op, like every other food co-op, is very clear with members and prospective members:  Your shares are not an investment asset that will reap you financial gain . . . that’s not their purpose.  In that sense, they’re not even really a “security” (the relevant opinion of the U.S. Supreme Court is here) and thus I hope the securities regulators will beg off.

One final thing.  Since nobody likes to pay taxes, you might be wondering whether those patronage refunds you’ve been paid or allocated – the ones not taxable to the Co-op – are taxable income for you.  The answer, under section 1385 of the Internal Revenue Code, is “no.”  But it’s only “no” if you are an individual (not an entity) and, as here, the patronage refund in question is “attributable to personal, living, or family items.”