Maximizing Cooperative Value Through Equity Management

Transcription

1 Maximizing Cooperative Value Through Equity Management Executive Summary and Acknowledgements The following document provides a high-level description of the significant issues associated with managing electric cooperative patronage capital. The report focuses on the retirement of patronage capital, and describes various methodologies, implications, and factors to consider. The primary impetus for the report is to provide Texas electric cooperatives with equity management alternatives that support minimizing the amount of member dollars that are currently being lost through the escheatment process. While all phases of the capital credit cycle are important, the value to most cooperatives members comes from the retirement policies. A multitude of retirement options exist, and carefully considering and evaluating the impact of each option is where the opportunity for value lies. Many cooperatives may already have policies that are performing as intended. However, others may find opportunities to enhance their existing practices and provide even greater value to member-owners. Acknowledgements I would like to express my appreciation to those who contributed to this report, including our team at Texas Electric Cooperatives who shared their unique talents. A special thanks goes to Bill Miller with Bolinger, Segars, Gilbert & Moss, Ty Thompson with NRECA, Rod Crile and several TEC members, each of which generously provided their expertise and valuable input. Jeff Marshall, CPA CFO, Texas Electric Cooperatives

2 Maximizing Cooperative Value Through Equity Management Having a sound equity management policy is critical because the cooperative s approach to equity management decisions can impact members actual and perceived value of the organization. There is no one-size-fits-all answer to managing equity each situation is unique. Among other things, an equity management policy should address the cooperative s desired financial position, funding of growth in infrastructure, and compliance with debt requirements. The policy should also fully support the operation-at-cost cooperative principle under federal cooperative tax law by ensuring fair and equitable economic participation through the management of capital credits. It should serve as the cooperative s road map for making informed equity management decisions and address: 1) What amounts are allocated; 2) How they are allocated; 3) What amounts should be retired; and 4) How they should be retired. Maximizing Members Perceived Value Cooperative members expect certain things, primarily safe, affordable and reliable electricity, and high-quality member service. Some cooperatives, particularly those near fast-growing areas, have encountered changing member demographics. Fewer members refer to the cooperative as the REA and most have no recollection of life without electricity or what the electric cooperatives did to improve their members quality of life 80 years ago. Therefore, many cooperatives struggle to demonstrate what sets them apart from other utilities the cooperative business model and, in particular, the allocation and retirement of capital credits to the member-owners. Patronage capital is often thought of as a revolving fund. New equity is rotated in (allocated) as older equity is rotated out (retired). Effort and expertise go into the decisions that generate a margin. Equal effort should go into how margins are allocated to the member-owners of the cooperative. These guidelines should be clearly identified in the equity management policy. The latter phases of the cooperative equity cycle the retirement of allocated equity is when the cooperative business model becomes more tangible to members. An effective policy should minimize the impact of unclaimed property, and maximize the real and perceived value of the cooperative to the membership. Proper Patronage Allocation and the Effect on Cooperatives Tax-Exempt Status The tax-exempt and cooperative status under Internal Revenue Code 501(c)(12) is predicated on the operation at cost principle by properly allocating margins, and maintaining the capital credits records of current and former cooperative members. The allocation process is the cornerstone for managing the cooperative s necessary equity while operating at cost. When discussing equity management, the conversation often begins with issues related to generating margins and their allocation. It is crucial that cooperatives not overlook this step. However, the allocation process itself is not the root cause of most present-day problems facing the industry. Most cooperatives understand and adhere to the cooperative core principles, typically avoiding problems by allocating margins fairly.

3 How Much To Retire? Determining how much equity to retire to the member-owners is an important step in the retirement cycle process. Retiring capital credits provides the cooperative the opportunity to demonstrate the value of the cooperative model to member-owners. For many, the answer is part science and part art, incorporating general guidelines contained in an equity management policy. By having a current policy in place that utilizes appropriate practices, the cooperative has stated goals and objectives as they relate to maintaining the desired level of equity (financial), the targeted retirement cycle (ownership) and how to address special early retirements. The cooperative also has guidelines if ever questioned. Determining the amount to retire in conjunction with an equity management policy should be guided by cash flow impacts, financial ratio effects, debt covenant requirements, regulatory issues, work plans and the corresponding effect on how current rates will need to perform to achieve their stated objectives. It should also be noted, however, that under general cooperative law, capital credits retirements are at the board of directors discretion, and maybe prohibited to the extent they adversely impact the cooperative s financial condition. What Methodology To Utilize? Once a cooperative determines how much to retire and the impact of the decision is fully assessed, the next step is determining the methodology for retiring the capital credits. This step involves who within the membership base is providing equity. Many cooperatives have implemented strategically designed criteria for retirements. For some cooperatives, this is the result of recent changes in policies and procedures, while others might have successfully maintained the same approach for years. The key is to periodically review and assess the methodology in place for its effectiveness. It is important to understand that the retirement criteria impacts the member-owners and the relationship between the cooperative and the member-owners. In many cases, the retirement method addresses a blend of member longevity and current member value. Recently, the fair and equitable treatment of past or former members has been at issue in industry-related capital credits litigation. Cooperatives must be mindful of the risks accompanying the methodology decision. Choosing whether to issue retirements as bill credits or check disbursements, along with thoughtful timing should be considered. Bill credits are often an efficient and less costly means to distribute the retirement; however, checks may provide a more tangible demonstration. Also, issuing retirements at a time when members most appreciate the money, such as around the holiday season, can also maximize impact. Common Retirement Methods First-In-First-Out (FIFO) manages the cooperative s equity based on longevity (pays off the oldest equity first). The advantage of this method is its relative simplicity in matching the paying off of capital credits with the members who initially provided the equity. However, it fails to provide tangible value

4 to the newest members, eliminating their exposure to some of the value of the cooperative business model. It also increases the likelihood that more of the retired amounts are escheated to the state of Texas because of the difficulty of locating older members who might have relocated or died. First-In-First-Out/Last-In-First-Out (FIFO/LIFO) Hybrid manages equity by retiring a combination of the oldest and newest years, providing value to new and long-time members of the cooperative. A disadvantage of this plan is that it adds time to the retirement cycle for the oldest members (as will all methods other than FIFO). Another potential disadvantage is that members between the oldest and the newest are squeezed out, making the percentage assigned to each method critical. It is essential that the rationale for the methodology be clear and explainable to inquiring members or third parties, and that it be fair and equitable. Percentage of Total Equities manages equity by member (amount of equity provided) rather than by longevity (when equity was provided). This method provides some value to all equity holders by paying a pro rata share of the total retirement to everyone, but it should not be used by itself because no equity would ever become fully retired. This approach is often blended with FIFO to maintain a targeted retirement cycle to ensure that older members are fully retired upon reaching a minimum equity threshold. Special Early Retirements manage equity based on specific events that occur and are generally discounted to avoid unfairly advantaging members receiving their retirement earlier than the normal retirement cycle. Examples include retirements for estates or former members. Retirement Method Has Implications Choosing a method or combination of methods will affect retirement cycles, member perceptions and the volume of unclaimed capital credits. Unclaimed capital credits are an inherent byproduct of the cooperative business model, particularly with a continually changing demographic, and can present certain challenges and opportunities for electric cooperatives. Attributes: Provides a retirement to all members Ensures former members become fully retired Only active members own cooperative Functions to minimize future unclaimed property Lack of perceived value relative to new members (only oldest members receive payments) Lengthens retirement life cycle Could prevent a general retirement to membership

5 Texas Laws and Unclaimed Property Chapter 74 of the Texas Property Code is the primary statute governing how cooperatives handle unclaimed property, but multistate filing issues should also be considered when a former member has an out-of-state, last-known address. Under the current Texas Property Code, when a capital credits check is returned undeliverable (i.e., the recipient cannot be located, so the payment comes back to the cooperative), a three-year waiting period begins during which the cooperative must hold the funds. Once the three-year holding period expires, the funds are escheated to the Texas Comptroller of Public Accounts (other states have different laws), which takes on the burden of locating the lawful recipient. Each year, millions of dollars (more than $14 million in 2016) are paid to the Comptroller s Office by electric cooperatives related to unclaimed property, but only $2 million of that can be retained by cooperatives collectively and must be used for specific purposes scholarships, economic development projects or energy-efficiency programs. With continually increasing financial demands on the state budget, the likelihood of an increase in the statewide cap on the amount that can be retained is doubtful. A more effective approach includes exploring the various retirement methodologies that support your cooperative s objectives to help create an equity management strategy that minimizes what is escheated to the state, allowing members to more fully benefit from cooperative membership. Utilizing a FIFO-only approach will likely result in a higher percentage of unlocatable former members, and consequently more funds going to the state. This is a significant issue for large cooperatives with greater membership turnover. Conversely, for a small cooperative with little membership turnover and accurate records, the FIFO-only approach likely achieves the cooperative s goals. If the annual amount of unclaimed dollars is significant to your cooperative, an alternative special retirement approach could be explored. Consider Special Retirement Strategies That Target Capital Credits Before They Become Unclaimed Unclaimed property is usually a result of a member leaving the service area and not providing the cooperative with new contact information, making it difficult for the cooperative to locate them in the future. By fully retiring a member s capital credits account through a special retirement when the member leaves the system, the cooperative can retire that member s balance, potentially create permanent equity through the applied discounts and prevent escheating the former member s funds to the state. This approach addresses multiple issues from several angles, but begs the question, Why pay a member who is leaving our cooperative? The answer: Because they are leaving and no longer contributing. They no longer provide revenue or equity, and by paying them off at a discount, the cooperative has not disadvantaged current members. Once accounts of former members are retired, this approach should result in an outstanding allocated equity balance generated solely by current members. This means those who own the cooperative (members with existing equity) are also those who pay the rates and receive the service. This special retirement approach helps minimize future unclaimed property, but does not take into consideration the current outstanding equity of former members. To address that issue, a cooperative should consider assessing the amounts of the cooperative s current former patronage capital

6 balances and implementing a phased-in approach to retire those accounts on a discounted basis. This achieves two outcomes: 1) eventual full retirement of all former accounts (thereby leaving the cooperative with only current active members as owners); and 2) reduction of the future unclaimed property burden (only the lesser discounted amounts would have to be escheated for members that the cooperative cannot locate). The timeframe of this phased-in approach would vary based on a cooperative s number of outstanding former members relative to the cash available to pay off these balances. Discounting equity has been a common practice for retiring patronage capital belonging to estates of deceased members. It can be effectively utilized in other situations, provided the cooperative treats similarly situated members in a consistent manner and applies a fair and equitable methodology. However, the discounting of equity is a method that has raised questions, even resulting in at least one instance of litigation filed against a cooperative. Since 2006, the IRS has issued more than 18 private-letter rulings regarding discounted patronage capital retirement programs. In each of these rulings, discounting was supported with particular attention paid to the authority granted to a board of directors in the bylaws, and whether the discount rate and discount period are fair and equitable to both the cooperative and its members. Revenue Rebates Another approach that minimizes unclaimed property is to utilize a revenue rebate. If margins are significantly above budgeted levels, a cooperative might want to consider giving the excess back immediately. Because margins can ultimately become potential unclaimed funds, immediately reducing the amount of a given year s margin reduces the pool of potential unclaimed funds. In addition, members see the cooperative s value on their bill immediately as opposed to waiting out the full retirement cycle. Common applications for this approach include years with weather anomalies that drive margins above budgeted levels or using a rebate to normalize the expected new margin levels during pending rate changes. Cooperatives need margins to generate cash, retire equity, expand facilities, fund operations and maintain an appropriate equity level. However, if it achieves those outcomes with a lower margin, then why not rebate those funds to the member-owners immediately? Rebates must be patronage based and require governance approval prior to the end of the fiscal year in which the revenue is rebated, so any decision to rebate must come within the year the rebate is recognized. Conclusion Any approach to managing capital credits may be challenged. Cooperatives should seek proper legal counsel and approval from their auditing/tax firms to ensure compliance with state and federal law, as well as accounting standards. By developing a detailed equity management plan that analyzes the individual situation of each cooperative, cooperatives can maximize value to their member-owners.

7 Glossary Allocation: The process of assigning a margin to the member-owners who generated such margin in a fair and equitable manner on the basis of patronage. Patronage of an electric cooperative can be measured by, including but not limited to, kilowatt-hours sold, revenue billed, revenue less cost of power, cost of service, or some combination thereof. Capital Credits: Credits to the individual capital accounts of member-owners of a cooperative based on their patronage (i.e., relative purchases from the cooperative). Discount: To calculate the net present value of an amount that would otherwise be received in the future (time value of money). Escheat: The reversion of property to the state. FIFO: First-In-First-Out methodology whereby the oldest or first equity received is the first equity paid back out. LIFO: Last-In-First-Out methodology whereby the newest or last equity received is the first equity paid back out. Margin: The excess of operating revenue over operating expenses. Patronage Capital: The allocated equity of a cooperative resulting from patronage. Retire or Retirements: To pay back capital credits, either through cash, bill credit or property, also known as redeeming of capital credits. Retirement Cycle: The length of time capital credits are held by a cooperative before being retired to members. Unclaimed Property or Capital Credits: Unclaimed or abandoned personal property that has been held by the cooperative for up to three years, or uncashed capital credit retirement disbursements.