Protecting Member Loan Programs

Karen Zimbelman: Can you summarize the main issues in securities laws that co-op directors need to consider vis-a-vis their member loan programs?

Kathryn Sedo: Securities laws were set up basically to protect investors from unscrupulous practices in encouraging investment. In particular, the laws strive to ensure that investors are protected from being defrauded, cheated or encouraged to invest in activities without full knowledge ofthe risks and where promises are being made that aren't realistic or truthful. The major securities laws were passed in 1933 and 1934 at the height of the Depression, after the stock market collapse of 1929. The laws were designed to address concerns that a contributor to the stock market collapse was the unsubstantiated pie-in-the-sky promises made to investors and that when those promises didn't materialize, people lost confidence.

KZ: What are the areas of compliance that co-ops need to be aware of when taking loans from members?

KS: Basically, there are two areas of compliance for co-ops that want to take loans from members. First, co-ops need to consider federal securities laws and the securities laws of the state or states in which they expect to make loans (that is, the states where the members reside). This could mean that co-ops have to meet the securities laws of more than one state. Here, the primary focus will be on the following issues: Is this note a security? If it's found to be a security, does it need to be registered at the federal and/or state level? Or, is there some exemption that allows it to be distributed or sold without registration?

Secondly, regardless of whether the member loan is determined to be a security and has to be registered, the co-op must meet and comply with anti-fraud statutes. Whether or not a security has to be registered, anti-fraud laws apply both at the federal and state levels. Basically, anti-fraud laws say that you (the co-op) must provide potential investors with truthful and accurate information about the risks involved, about the health of the co-op, and about what the funds are to be used for. Otherwise, directors and officers face potential liability related to the issuance of notes and distribution of securities.

At some level, this disclosure requirement isn't as difficult or complicated for co-ops, because of the very public way co-ops conduct business -- holding annual meetings, reporting on a regular basis on the operations and performance of the business, distributing financial statements to members, etc. Meeting anti-fraud regulations will entail providing somewhat more disclosure than is provided to members at this level, but the issue of financial disclosure is less onerous to co-ops because they tend to do that more than many other companies do.

However, if a co-op is issuing notes to help fund an expansion or move, for example, the store will often have some projections -- budgeted costs and sales forecasts -- that wouldn't necessarily be passed along to members in the normal course of business. This is the type of information and disclosure that should be provided to potential investors to make sure that they understand what assumptions the co-op is making about their ability to repay those loans.

KZ: What issues determine if a member loan or note is, indeed, a security?

KS: With regard to notes, the recent Supreme Court case -- Reves v. Ernst and Young -- set out some very specific standards. The Supreme Court determined that even though federal law says that notes are securities, there are certain times when notes aren't securities. It set out four factors that need to be examined to make that determination.

These four factors -- the motivation of the lender and borrower, the plan of distribution, the reasonable expectations of the investor, and factors related to risk -- basically outline the ways courts will determine if a note is being made in a way that has the features of a security or not. In general, if the borrower is using the money for general purposes, if the lender reasonably expects that this investment will generate a profit, if the notes are marketed commonly and widely as an investment, and if they carry a relatively large amount of risk, a note will be more likely to be considered a security. On the other hand, if the risk is mitigated, for example by the assignment of security, and the transaction has more of the features of a commercial type of transaction (e.g., a bank lending money to a business), then it is less likely to be considered a security. And, if the co-op is subject to state laws controlling and governing these issues, a member loan would be less likely to be viewed as a security and typically viewed as less risky.

In reviewing these factors and the motivations involved, interest rates obviously are an important indicator. When the interest rate is very low, it would be hard to argue that the lender is making the loan purely for purposes of making a profit. But interest rates are somewhat volatile; it will be hard to fix an absolute value to what is a "market" interest rate -- especially over a period of time. Interest rates are really only one factor.

KZ: What advice do you have for co-ops wanting to structure a loan program in compliance with these laws and issues?

KS: A co-op wanting to set up or maintain a proper member loan program would have basically three options. The first, and most prudent option, would be to assume that notes will be considered securities and act accordingly. In other words, structure the notes to meet securities laws, and then register them with the proper state and/or federal authorities. Most co-ops prefer not to follow this method, primarily because of the costs and complexities involved. However, since the Reves case many larger agriculture co-ops are going this way.

The second option would be to try to structure the program so that notes won't be considered securities. This method involves a fair bit of judgement, but would basically entail using such features as very low interest rates, a very limited offering or marketing of the notes to just co-op members, promoting them as a "social" investment, rather than an investment for profit, and probably making the notes pretty short term with options for renewing. And, the co-op that really wants to be cautious would go the additional step and assign co-op assets as collateral for the notes.

Using this approach, a co-op could argue that such loans are commercial notes and not member investments. Loans made in the ordinary course of business, not for investment purposes, are commercial notes. Banks don't make loans to businesses for the purpose of investing in that businesss but, instead, for a commercial purpose.

This second strategy -- to structure the notes so they won't be considered securities -- is by far the most risky way to proceed. Especially since the Reves case, people have been uncomfortable with this approach, since there are more "grey" areas regarding the definition of a security, and it's unclear whether a particular approach would hold up under legal scrutiny.

KZ: And the third option?

KS: The third approach is to find a federal exemption from securities laws that fits -- in other words, to structure a member loan program in such a way that it will fall under the clearly defined categories of exemption from federal securities laws. Basically, there are two possible methods of exemption practically available for co-ops. The first is an exemption for short-term notes -- notes for a period of 270 days (9 months) or less. Using this strategy, a co-op could set up a loan program to take member loans for six months and, as a result, be exempted from federal securities regulations. However, it's important to note that demand notes -- notes that have no defined term but are due any time on demand of the borrower -- were found in the Reves case not to be short term notes.

KZ: In your experience, is such a program of short-term notes generally workable for the co-op's purposes?

KS: Many co-ops don't find this very workable or practical, given the amount of recordkeeping required. They find such short-term notes to be not worth the paperwork demands and/or they need the funds for longer than 9 months. However, one strategy some co-ops have used is to take notes of terms up to 9 months and make them renewable. This would mean that the co-op would contact the lender some time before the due date and ask the lender if they would like to renew the note for another term (up to 9 months). In that case, it's best for the papers to clearly reflect that the note is renewable and the procedure that will be followed to renew a note.

KZ: What is the second "exception" approach?

KS: This approach holds the most promise for co-ops. There is an exemption from federal securities laws for co-ops taking only intra-state loans. In other words, if all your members/lenders reside in one state, federal law allows these notes to be exempt from registration. The idea here is that federal laws are set up to regulate inter-state commerce and transaction; when the commercial activities are limtied to one state, federal law will generally not be involved.

Most co-ops should be able to qualify for this exemption. The exemption has some specifications -- the co-op has to be doing the majority of its business in the same state as the members: at least 80 percent of the co-op's gross revenues are generated in the state, the co-op has 80 percent of its assets in the state, its principal office is in the state, and it intends to use at least 80 percent of the proceeds of these notes in the state. The idea is to provide local financing for local industries carried out through local investment. But it only takes one loan from one member in another state to disqualify the co-op from this exemption; resales by the original lenders to non-residents would also destroy the exemption. However, most consumer co-ops should be able to qualify for exemption from federal securities registration by structuring an intra-state member loan program.

KZ: Does qualifying for a federal exemption take care of all legal concerns?

KS: That's just the first step. Then a co-op would need to comply with the securities laws of that state -- which may entail registration, or addressing other issues related to the member loan program.

KZ: What are the general issues in state securities laws?

KS: In general, state securities laws address the same or similar issues as federal securities laws. In some cases, state laws specifically address co-op member loans programs and clearly outline what is required for securities compliance. And in some states, Minnesota, for example, there is an exemption specifically in the statute for member loans taken by co-ops, and co-ops don't have to register member loans as securities. Naturally, each state law will be different, but meeting state laws is likely to be more workable for most co-ops.

KZ: That summarizes the issues in securities laws. What about the anti-fraud issues?

KS: Right. Regardless of which strategy a co-op uses to design its member loan program -- whether or not the program qualifies for a federal or state exemption -- the co-op will still need to meet anti-fraud regulations ifthe loan is a security. In other words, whether or not the co-op is required to register the security, the co-op will still have to comply with federal and state anti-fraud laws.

Again, the anti-fraud laws are mainly concerned with the disclosures made to the potential lender -- making sure that truthful information is provided to potential lenders. Co-ops have to actively disclose the co-op's financial condition, its plans for the funds, its financial projections to people before taking loans from them -- so the potential lender can determine the level of financial risk they are assuming.

In general, it's advisable to include the following in such a disclosure: the history of the organization, its structure and capitalization system, financial statements and projections (including the assumptions being made), the management (directors and hired management), how much the co-op is planning to borrow, what the money will be used for, other financial obligations and debts, risks involved with this loan, etc. And, of course, specific information on the terms and conditions of the member loan should also be very clear and disclosed to the potential lender.

KZ: This sounds like a prospectus.

KS: Basically that's what this disclosure is -- but maybe without all of the technical language. Again, co-ops are somewhat unique because members automatically have access to things like the co-op's Articles and bylaws and get regular information regarding the financial health of the organization. So, these items don't need as much detail to be provided because it's assumed that members generally understand them.

KZ: What advice would you offer to a co-op that currently has a member loan program and wants to bring it into compliance with these issues?

KS: In that position, a co-op should definitely make the disclosure to all current and future lenders. To be absolutely safe, it would probably be a good idea to send this type of disclosure packet to all current lenders and ask them if they want to continue their loan. If they've been given the choice and choose to continue their loan, ask them to sign something that verifies that they have received this information and want to continue their loan with the co-op. In other words, bring members up to date and give them the option of taking their loan back; it takes more than just giving lenders the information to meet the spirit of the law. Certainly a co-op shouldn't go ahead and take loans now and go back and do the disclosure later.

KZ: And what is the prudent course of action for a co-op with member/lenders from more than one state?

KS: Technically, it's too late for such a co-op to qualify for the intra-state exemption from federal securities registration. However, one option would be for the co-op to prepare the disclosure information and provide it, per the procedure described previously, to all in-state lenders and, at the same time, cancel all out-state loans.

It's important to remember that a co-op will really only have a major problem if the co-op is financially troubled and can't meet its obligations to its member/lenders. In order for members to take any legal action against the co-op, they would have to suffer damages or a loss. Members can't sue the co-op alleging securities fraud unless they have suffered damages. So, as a matter of course, if the co-op is financially sound and meeting its obligations it will keep out of hot water. Perhaps the most important advice to co-ops with member loan programs is to keep payments up to date.

But, it is further advisable to terminate an old program that doesn't comply with the laws, start a new program that conforms with laws to meet the co-op's needs, and then actively give members the option to discontinue their notes under the new program. Until all ofthe co-op's member loans are written in conformity with the new program, the co-op and its directors will face potential exposure -- but generally not unless there is a loss.

KZ: We typically think of securities laws as dealing with member shares. This seems even more complicated than that.

KS: Yes, actually it is more complicated than member shares, because members don't buy member shares for investment purposes. There's no expectation that members are going to make a profit on that money based on the managerial activities of the board and management. Members purchase shares because they want to be a member, participate, and use the services of the co-op. Members don't buy shares because they want to get a return. The motivations behind acquiring member shares and member loans is very different.

Members are motivated to lend their co-ops money because they want their co-op to prosper. But co-ops must make it clear as a part of their disclosure information that if it's a problem for members to lose money, they shouldn't make the loan. It should be clear to potential lenders that there are risks involved in lending money to the co-op.

KZ: What about a non-voting share -- in other words, a second class of share that doesn't provide any votes -- instead of a member loan system?

KS: Actually the issues would be very similar with a non-voting share system. What is the member's motivation? If the member receives a dividend or interest, then the share looks similar to member loans. However, a non-voting share would probably be viewed as somewhat riskier to the member than a loan. The main advantage to this approach would be if the co-op is qualifying for the intra-state exemption and the state laws more clearly and spcifically exempt non-voting shares in a co-op; some states do have special regulations on non-voting shares. And, from the co-op's perspective, non-voting shares will be classified and viewed by creditors as equity.

KZ: Well, I think this will clarify a lot for our readers.

KS: I think, overall, the most important point is that co-ops can't just blithely go along assuming their member loans aren't securities. This most recent case has brought the issue to the forefront. People need to look carefully at what they're doing, consult with people knowledgeable about the federal and state laws, and then make decisions regarding the best course of action for their co-op and members. And, in summary, there are ways that member loans can be structured that aren't totally disadvantageous to the co-op.

KZ: Thank you very much for your comments and your insights.