Governance During and After Conversion

Introduction

There are potentially infinite ways to design a company’s governance, and a wide variety of ways to transition governance in the process of converting to a cooperative. There is an art to governance design, with many policies, practices, roles, and rules than can be arranged into place to produce a desired outcome. One desired outcome of cooperative conversion is to give power to workers. The transfer of power may or may not implicate an immediate change in the day to day life of a business, but it will create the conditions for the evolution of a company that, in the long run, focuses on the concerns of its employees.

A Few Basic, But Powerful, Governance Rights

At their legal core, cooperatives are obligated to give members only a few basic governance rights, including:

  • The right to an equal vote in the election of the Board,
  • The right to request and vote in an action to remove Board members,
  • The right to take part in at least one member meeting per year,
  • The right of access to information about the cooperative, its members, its Board meetings, and finances, and
  • The right to approve/disapprove dissolution, merger, and other major decisions.

When a company converts to a cooperative, these are sometimes the primary new governance powers that the worker-owners will give themselves as members. These rights may not sound like they amount to much, but they are quite powerful, in that they give members the ability to alter the direction of a cooperative through Board elections, helping to keep cooperatives ultimately accountable to members. While these powers may sound simple enough to grasp, a new worker-owner may not be familiar with strategies and opportunities for exercising their rights, which calls attention to the need to train workers on how to exercise their new rights. In particular, companies that did not previously have a Board of Directors may need training to understand the potential roles of a Board. Democracy is powerful when people are informed and active participants in the democratic process, and educating new worker-owners about the process can bring more genuine democracy.

In some cooperatives, workers will choose to give themselves a much wider variety of opportunities and processes to shape the direction and day-to-day work of the cooperative. Whether it’s through participation in committees, collective management structures, distributed governance, rotating management positions, consensus processes, or other strategies, workers may grow more intimate with the company’s governance in the process of converting to a cooperative.

The Transition to Workplace Democracy

In some cases, the cooperative buy-out may happen gradually and may involve multiple intermediate steps. The transition of governance may, likewise, be gradual, particularly in companies where workers must complete the buy-out over time and borrow money from multiple sources – including, quite possibly – the selling owners. Full worker control may be an ultimate goal, but the intermediate governance structures may take many forms.

How Much Will Governance and Management Change?

When companies change ownership, whether or not to become a cooperative, the workers, customers, and a wide variety of stakeholders often worry about the changes to be brought by new owners. Sometimes new owners bring dramatic changes (even closing the business), and other times, the transition is made to feel as seamless as possible.

On one hand, stability is a highly valued quality of a business, and it offers a very good reason to continue core governance and operational structures during ownership transition. Such structures may be key to the company’s success and profitability, and it’s not necessarily wise to shake things up in the moment where many parties are taking a great financial risk. Employees, in particular, have their livelihoods at stake during a transition. They may wish to retain the status quo in governance, even if they find management structures to be stifling.

On the other hand, new governance structures may be the primary incentive for workers to buy their employer’s business, and worker control could unleash widespread innovation in a company. In many companies, workers tend to be an undiscovered treasure trove of information. They sense the needs and impact of a company’s work and operations at nearly every level of the system, and their experiences and insights – if tapped – could perpetually refine a company’s efficacy and performance. This potential has been acknowledged in business management texts for nearly a century, but top-down approaches to management have left decentralized governance models at the margins of the mainstream business world.

Legal Governance Requirements

The entity a cooperative forms at the state level and the tax status it chooses at the federal level will dictate certain limits and possibilities for how the cooperative may operate. For example, corporations must have boards of directors, and must follow certain election and meeting notice procedures; business taxed as cooperatives under Subchapter T must have democratic voting.

Laws Governing Cooperative Corporations

The statutes governing cooperative corporations generally function to create:

  • Due process for the group, so that an individual doesn’t have too much power over the group,
  • Due process for an individual, so that the group doesn’t have too much power over the individual,
  • A Board of Directors with the ultimate legal duty to make decisions in the best interest of and to ensure proper operation of the company, and
  • Fallback rules in case the group doesn’t adopt clear rules.

The due process rules generally specify minimum standards for how often meetings are held, how certain major decisions are made, how members and directors must receive notice of meetings, how members and directors can be expelled, how often elections are held, and so on. These rules prevent a complete tyranny of structureless-ness where members have no idea how to voice their needs and concerns. Even in a cooperative that has failed to prepare or follow Bylaws, a member can refer to the cooperative corporation statute to understand his or her basic rights, and even petition a court or attorney general to force the cooperative to follow the due process rules.

Laws Governing Cooperatives Taxed Under Subchapter T

To receive the benefit of pass-through taxation under Subchapter T of the Internal Revenue Code, a cooperative must adhere to the ways in which courts and the IRS have interpreted the requirement for democratic control by workers. In one case, Puget Sound Plywood, Inc. v. Commissioner of Internal Revenue (44 TC 305 – Tax Court 1965), the U.S. Tax Court described democratic control as follows:

“Implementation of the [principle] relating to democratic control is effected by having the worker-members themselves periodically assemble in democratically conducted meetings at which each member has one vote and one vote only, and at which no proxy voting is permitted; and these workers there deal personally with all problems affecting the conduct of the cooperative.”

Laws Governing Partnerships and LLCs Operating as Cooperatives

A cooperative that chooses to structure as a partnership or LLC will be subject to very few mandatory rules regarding governance and due process. Partnerships and LLCs will, however, be subject to statutory fallback rules if their Operating Agreements do not give enough specificity about how decisions are made and how finances are managed. Such companies are generally free to adopt highly customized governance and financial structures, if the partners/members agree to such structures. This flexibility can be a good thing in some cases, especially for cooperatives that are thoughtful about how they design governance. In other cases, a company that fails to establish basic procedures for the democratic process could devolve into a tyranny of structureless-ness where some members have very little control and no ability to meaningfully exercise rights of control.

The Critical Importance of Understanding and Adhering to Governance Documents

Beyond the basic governance rules applicable to cooperatives, regardless of chosen entity, there remains a good amount of flexibility in the details of the Bylaws and Operating Agreements. It is critically important that cooperatives adhere to rules they choose to adopt. Otherwise, actions can later be challenged and invalidated on the basis that they were taken without adherence to adopted procedures. It is very common for cooperatives to fall into habits of operating informally, without regard to the procedures they have adopted. Later, especially when there are disagreements, chaos can ensue as members seek to invalidate prior decisions.

The moral to this story is that members should become familiar with and practice their governance procedures with care. To facilitate this, it is very helpful to ensure that governance documents avoid legalese and are written in plain-English (and/or another primary language of workers). Additionally, in-person trainings and simulations for workers can greatly facilitate adherence to governance documents. Finally, it helps to designate one member or a committee of members responsible for regularly reviewing procedures to ensure that the cooperative is following its chosen roles. In some cooperatives, we have referred to this role as a “Cooperative Trustee,” meaning someone with a duty to ensure that the democratic principles of the cooperative are being faithfully upheld.

Some Basic Components of Governance

In most cases, conversion to a cooperative should involve learning and training about new ways to operate. Future cooperative members may wish to form a working group to examine questions of and possibilities for governance. When designing governance structures for a newly converted cooperative, here are some of the key considerations:

  • What are the governing bodies and what realms does each control? Board of Directors? Advisory Board? Bicameral governance? Role of committees?
  • How are governing bodies elected or appointed? Member-elected board? Board-appointed advisory council? Specific appointments by outside organizations (such as a nonprofit that has a right to appoint one board seat)? How long do people serve? If there are elections, what is the nomination process for candidates?
  • Who are the members? If applicable, what are criteria for membership? Who can become a member and participate in governance? Are there different classes of members with different powers?
  • What is the division of power between the board and members? What are the rights and responsibilities of directors? Of members? When can members invalidate board action?
  • What are avenues for member and stakeholder participation and influence? How can members and stakeholders take part in suggesting or dictating new directions for the organization?
  • Can the functions of the organization be delegated into semi-autonomous committees?
  • How are meetings held? Who can participate in meetings? How often are meetings and how do people receive notice of them? Are meetings in person or virtual? How is the agenda set? How is the meeting facilitated? Are there rules of order?
  • How are proposals brought, considered, and adopted? Who can bring a proposal, when, and about what? Is there a clear process for exploring the proposal? Is it adopted by a majority? Supermajority? Consensus? By Holacratic procedures?
  • Transparency and Communication? How can the organization efficiently and clearly communicate governance structure, rights, responsibilities, and activities to members and stakeholders?
  • Central organizations and outside governance: What could be the role of a centralized trust or federation of organizations that dictates some activities and decisions of the member organizations?

Governance Transition Scenarios

This section offers a handful of scenarios and considerations for the transition of governance during cooperative conversion, although the transitions will play out in a wide variety of ways.

1. Simple Transition: Transfer Ownership / Retain Management

In companies where management and ownership are separate to begin with, it is possible that governance will not change very much upon conversion. In many companies, owners/shareholders hire managers and set the basic management structure, but may otherwise not involve themselves in the details of the business. Upon handing control to workers, a worker-elected board could very well choose to continue operating under the exact same management structure.

2. When Former Owner Becomes Worker Owner

In cooperative conversions where the original owners will become worker-owners alongside the employees, it will be critical to take steps to overcome what many people refer to as “founders’ syndrome.” It can be hard for an enterprise to break away from habits of relying on founders to take on certain responsibilities and make primary decisions. New worker-owners may be cautious about exercising their rights to influence the business, and the original owners may feel a stronger sense of entitlement to control of the business.

One strategy for overcoming founders’ syndrome is to adopt highly structured meetings and decision-making processes that demonstrate to workers their ability to voice their concerns, bring proposals to the enterprise, and influence the direction of the business. For example, at the Sustainable Economies Law Center, a nonprofit that functions as a democratic workplace, the eight employees make decisions using a proposal process very similar to that of Holacracy (see www.holacracy.org for more information). This has helped the Center move away from reliance on its founders for direction, and enables any employee to bring and respond to a proposal. Proposals are brought and considered by asking employees for feedback in a series of circles, meaning that everyone is given a space to be heard. Meetings are carefully facilitated so that people cannot speak out of turn and interrupt one another.

Other strategies for overcoming founders syndrome include: (1) Rotation of roles and responsibilities, so that workers don’t get pigeon-holed into a set of roles where they have very little power, (2) Equalization of pay so that everyone has a strong sense of ownership and a sense of equal status, and (3) Training workers on various aspects of running the business and on democratic processes.

Note that this can be difficult when the original owners retain a higher financial stake in the business, such as by holding a promissory note to be paid by the cooperative. A worker-owner that has more at risk than other worker-owners may have a greater sense of entitlement to influence decisions in order to protect the financial stake. As such, it can be a good idea for cooperatives to work toward equalization of the financial resources each member has at risk.

3. Transitioning to Collective Governance

We generally use the phrase “collective governance” to refer to a structure where all members participate in the management of the business. While many small worker cooperatives are managed collectively, it may be somewhat more difficult to transition a conventional business to collective governance than it would be to establish collective governance when starting a new business. It is hard to unravel management hierarchies that are already in place, and it requires a high degree of structure and process to break old habits. See the above paragraphs for tips on reducing hierarchies and creating more equal participation in governance.

Collective governance can be empowering to some workers, and overwhelming to others. Participating meaningfully in the management of the business requires a good deal of knowledge, time, and attention. Because of this, a cooperative that desires to transition to collective governance may choose to do so gradually over time.

4. Transitioning to Distributed Governance

Distributed governance can be achieved by breaking the functions of an enterprise into multiple semi-autonomous spheres of control. Doing so essentially creates multiple small collective governance circles within a larger organization, meaning that workers can exercise a great deal of influence over their immediate realm of work and responsibility, but do not necessarily need to participate in management of the company as a whole. This has been achieved in many large companies, some of which are profiled in the book Reinventing Organizations, by Frederick Laloux. Holacracy and Sociocracy are models for distributed governance, and have been adopted by large companies like Zappos, and recently by at least one worker cooperative, Three Stone Hearth in Berkeley, CA.

When Departing Owners Maintain Some Control

Even when a business converts entirely to worker-ownership and former owners cease active involvement in the business, there are some situations where the former owners wish to retain a certain amount of power temporarily or indefinitely. One of the core cooperative principles is that cooperatives should be autonomous, meaning that they are independent of outside control. As such, giving temporary or ongoing control to former owners can be seen as undermining of the cooperative principles. At the same time, there are some valid reasons, described below, to allow some degree of control by former owners.

Reasons Former Owners Might Retain Some Control

The two most common reasons that former owners wish to retain some degree of control are:

  1. The owners helped finance the buyout, so they still have “skin in the game,” even if it’s in the form of a promissory note, and
  2. The owners want the business to retain a certain social/environmental mission or continue to serve a certain group of stakeholders.

Retaining Control to Protect Financial Stake

If a former owner wishes to retain some control in order to protect a financial stake, this brings up the big picture question: How much voice should we give to capital? Giving power to capital is almost antithetical to the concept of a worker cooperative, but giving people no means to protect their investment would prevent a flow of a capital to cooperative development. Thus, a balance generally needs to be struck.

To protect a former owners’ financial stake, it is not uncommon for the cooperative’s governing documents and/or loan agreements to give former owners the right to approve or veto any decision by the cooperative to:

  • Make a major expenditure,
  • Pay out dividends, bonuses, or patronage distributions,
  • Raise wages by a certain percentage,
  • Borrow money,
  • Restructure,
  • Expand the business, and/or
  • Dissolve.

Retaining Control to Protect Mission

Even when a former owner has no substantial financial stake left in the cooperative, the former owner may wish to retain control to ensure that the cooperative continues to serve a social or environmental mission, and/or to ensure that it remains a cooperative and does not sell out to a conventional business. This is especially common when a former owner forgoes the potential for financial gain in converting the business to a cooperative.

To protect the former owners’ vision, the cooperative’s governing documents or another contract could give the former owner the ability to approve or veto any decision by the cooperative to:

  • Change the mission or change certain socially responsible policies of the company,
  • Convert or sell the company to a conventional business,
  • Change the dissolution provisions of the business (which may require distribution of remaining assets to a nonprofit or another cooperative), and/or
  • Change the formula by which profits are allocated or distributed.

The former owner could also retain a right of first refusal to buy the company back, at a specified price or using a specified appraisal method, in the event that the cooperative desires to sell the company.

Specific Strategies for Giving Control to Former Owners

The list below offers specific strategies and legal documents wherein certain powers and rights can be allocated to former owners. Note that some cooperative entity statutes will not allow Bylaws to give power to non-members. In such a case, power can still be given through contract, such as through a loan agreement. Hybrid statutes and structures (cooperative LLCs) tend to afford a greater degree of flexibility in governance. This can be helpful, but also dangerous, since a company could call itself cooperative without actually adhering to the democratic principles of cooperatives.

Rights and powers can be given to former owners by:

  • Granting rights in a contract, such as a loan agreements, other financing contracts, or lease. These rights could require that the former owner be given notice whenever the cooperative takes a certain type of action or makes a certain kind of decisions, and the contracts could give the former owner the right to approve or veto certain decisions.
  • Giving the former owner one vote through retained membership, and requiring that certain decisions be made unanimously or by a supermajority, which gives the owner’s one vote significant power over those decisions.
  • Allowing one or more Board seats to be appointed by specific individuals or organizations. This may not be allowed under some cooperative corporation statutes, but in California it is allowed under Corporations Code Section 12360(d).
  • Allowing the former owner to nominate candidates for the Board, which would put the candidate on the ballot to be voted on by members. Many cooperative corporation statutes fail to address the procedure by which Board candidates should be nominated, which can leave space to give outside individuals the right to at least put someone on the ballot.
  • Having the former owner serve on the Board and on an “Empowered Committee” for a specified period of time after conversion. An empowered committee generally must consist of a minimum number of directors and it generally holds the same power as the Board with regard to realms of control delegated to it by the Board, except with regard to a few major decisions.
  • Allowing the former owner to appoint all or part of the initial Board, which will serve for a specified period of time, after which elections will be handed over to members.
  • Adopting Bylaws provisions that cannot be changed except if approved (or not actively vetoed) by specified individuals. For example, the Bylaws provisions related to dissolution, sale, and distribution of assets can be very important in preventing a cooperative from selling out to a conventional business. The former owner may want to retain a right to veto any attempted changes to those provisions of the Bylaws. This may not be allowed under many cooperative corporation statutes, but it is allowed in California under Corporations Code Section 12331.
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