Model Rules for an FCA Accepted FairShares Cooperatives

Congratulations! Love your work and always mention in Barcelona events I or go Big hug

Álvaro Solache

[email protected]
@asolache
00 34 629 86 77 15

This is great news as I am currently going down the route of getting LocoSoco FCA approved...this would be a massive help and save on costs so would very much like to be part of the trial. We also have an FCA regulated person working with us who I am sure would like to be a part of this.

This is great news.

All the best,

Christine

This is really good news.

Great to hear

Congratulations on your new model - a number of really smart innovations here, and I'm sure this will be a valuable addition to the family of Co-op Societies.
... but I do have some concerns. As a test, I generated some rules, and while not all options would cause the issues I found, I think you might want to exclude some of the more extreme possibilities.
The two concerns I am concentrating on are the distribution of profits and the accountability of the board.
The 3rd co-op principle requires that profit distributions are for 'benefiting members in proportion to their transactions with the cooperative'. Clearly, the 'qualifying contribution' is meant to achieve this, and in common with most co-op rulebooks you don't spell out the formula in detail. However, unlike most other co-op rulebooks, you don't use the word 'equitable' either, or relate proportionality directly to transactions: so a qualifying contribution could be set at such a high level (eg earnings in the top tax bracket; use of premium services) that only a small proportion of the stakeholder group benefit. Of more concern is the ability to distribute profits to founder members irrespective of whether or not they have (or ever had) qualifying contributions. That's up to 5% of profits each for the founders, even if the business was dysfunctional until they hired staff to run it properly. I note also that you carefully refer to investor returns as 'interest' and not 'dividend', but they look awfully like dividend to me - directly proportional to profits up to a generous 10%, and not paid at all if the business makes a loss (and potentially paid at a very stingy level if the other members grabbed the maximum 75% from a modest profit).
Then there's the accountability of the board. I generated a set of rules in which until the co-op had 2 million members, the whole enterprise was run by the founders and their handpicked mates. Yes, I know you've given a bunch of extra powers to the GM - but the user members might well not be able to change the rules (founder and a few investors can block), can't propose their own choice of directors and, although they might be able to sack them, can never get past the founder members being the only people who can replace them. Having to put large contracts to the GM is onerous if you are honest, easily evaded if you're not.
Even if my rigged co-op gets over 2 million members, those elected by users could still be a minority, with founders and appointees always able to outvote them.
What I'm saying is: although you could generate perfectly co-operative rules within your template, you could also generate very unco-operative rules that I would hope the FCA would refuse to register. Could I suggest:
- no dividend allocation to founder shares (no reason they couldn't get interest, mind you - but justifying the initial allocation could be a can of worms. Should there be some evidence for the value of their initial contribution?)
- break the fixed link between profit and investor interest; it's a dividend in all but name
- make absolutely clear that the qualifying contribution should always be defined in a way that is 'fair', 'equitable', 'inclusive' or otherwise ensures 'proportionality to transactions'.
- cap the number of members for which the board is unelected at a low figure (20?).
- even an unelected board should always include some workers or users (all of them is typical!)
- it shouldn't be possible for less than half of an elected board to be elected by users or workers (see principles 2 and 4).

Alex - we can add default settings that prevent extreme iterations. However, you forget that the FCA will seek sponsor approval for any use of the rules and there is no way your version would get signoff by Sheffield Hallam University. You also ignore all the embedded links and guidance in the FairShares Wiki (directly accessible from the rules generated) which advise strongly against many of the abuses that you playfully attempt.

You also ignore that there is an option with settings preset to options that would be most favourable to a bone fide coop model.

Rewarding founders is necessary to generate interest in the coop model generally, and would enable coops to found other coops and be rewarded for their sweat equity (the Founder Share can be held by a legal person).

I will see what we can do (without compromising innovation) regarding limits on options. Personally, I’m for maximum innovation and minimum limitations.

Okay - I've rechecked the rules and think that Alex's suggestions need further comment because some of his points are misleading about the practical application of the rules. Before responding to suggestions, I want to clarify that there is no circumstance in which Founder/Investor members can walk off with most of the surplus. The rules state that even if there are no qualifying contributions for Labour/User members, the surplus must be placed in trust for the benefit of workers and users. In v3.1 (under development) this is even clearer.

Here are responses to each of his suggestions.

a) no dividend allocation to founder shares (no reason they couldn't get interest).

This misses the point. Founders may expend lots of time and energy even when they do not invest financial capital. If they invest financial capital, this is an Investor Share holding, not a Founder Share holding. If they do not not invest financial capital, they are still entitled to a reward proportional to their entrepreneurial labour prior to the formation of the cooperative. The literature on cooperatives, particularly worker cooperatives, is that Founders do not recover (or even recognise) their sweat equity. Founder Shares provide for sweat equity. The level is capped at 15%.

In v2.1 Model Rules we set this at 0%, but early adopters insisted that they receive compensation for their efforts, so we changed it in v3.x and capped it at 15% (typically people assign 10%). Having researched this (see http://www.fairshares.coop/publications/), the number of benefits from having Founder Shares substantially outweighs the disadvantages. The FCA were happy once we clarified that the combined fraction (voting power) of founder/investor shareholding (the Share Fractions) cannot exceed those of Labour/User members combined.

b) break the fixed link between profit and investor interest; it's a dividend in all but name

Investor shares are held by Labour and User members, and they acquire them in proportion to the generation of surpluses historically. The FCA were satisfied, and we convinced them on this point, that the allocation of Investor Shares is proportional to participation of Labour and User members (and therefore is a reward for participation). There is the possibility that they'll invest financial capital outside of this, but that is clearly not the norm in this model. Once the 10% cap was in place, the FCA were happy to accept the model rules.

FYI - Clause 15 describes how half of the capital gain (not the surplus) is allocated to Labour/User members as Investor Shares in proportion to their Labour/User share holding (which are proportional to their Labour/User participation).

c) make absolutely clear that the qualifying contribution should always be defined in a way that is 'fair', 'equitable', 'inclusive' or otherwise ensures 'proportionality to transactions'.

Equity is already written into the rules. 5(a) (Objects) states that the purpose of the cooperative is:

"to meet the economic, social and cultural needs of the Cooperative’s primary stakeholders (Founder, Labour and User members) by engaging in commerce and social activities that spread wealth and power equitably amongst them;

5(e) states that the cooperative will:

"abide by the internationally recognised values and principles of cooperative identity as defined by the International Cooperative Alliance (ICA), in particular the values of self-help, self-responsibility, democracy, equality, equity and solidarity and the ethical values of honesty, openness, social responsibility and caring for others;"

10(a)(ii) states that Labour Shares will be "issued in proportion to their labour contribution"

Put it all together, and equity runs right through the FairShares Model.

d) cap the number of members for which the board is unelected at a low figure (20?).

Absolutely not - but you can choose to do this if you want to (I've added 20 as an option just for you Alex :). Research shows that local democracy in collectives is generally okay up 40 people (I've just examined a doctorate that reaffirms this point). We only need to be concerned above 40.

I have now removed the 'Other' option - the threshold is capped at 5,000 (so no more rules with a threshold of 2,000,000)!

Any enterprise with a qualifying contribution for User Members could exceed 20 (or even 1,000) within days of incorporation and force elections before there is a stable business model. This matters. I'm supervising doctoral research by Jules O'Dor at Sheffield Hallam. He has found that co-operative entrepreneurs can deeply regret not being able to maintain a stable business/stable board whilst the business model of their cooperative is evolving. Some said that the election process, initiated too soon, destroyed their cooperative venture.

In short, there is a balance to be struck - this is the difference between communitarian idealism and communitarian pragmatism - we are encouraging pragmatism. We are not ideologues - we are pragmatists.

e) even an unelected board should always include some workers or users (all of them is typical!) +
f) it shouldn't be possible for less than half of an elected board to be elected by users or workers (see principles 2 and 4).

In an ideal world, we would agree. However, the provisions as they stand provide for the widest possible set of configurations (including cooperatives that want to observe the UK Code of Corporate Governance - as has now happened at the Coop Group). Our guidance advises AGAINST this, but we do not want to be too prescriptive.

We are satisfied that the social audit provisions (Clause 47) are a sufficient block for any resolution by the board or a member class that disrupts the balance of power between stakeholders. It reads that the social audit committee's purpose is:

"To approve or withhold approval of the text of resolutions proposed by members or the Board. Approval may be withheld until the audit committee is satisfied that adequate consultations on the matters to be resolved have taken place with and within member classes"

This is an extremely powerful check on the power of the board to go against the interest of any group (much stronger than anything available in the Cooperative Group, I believe). As all four groups MUST elect members to the social audit committee if there is a proposed special resolution, the multi-stakeholder model always remains intact. I think Alex must have missed the significance of the social audit provision.

Please do post further comments and questions if you have any.

Thanks for taking the time to go into this in so much detail; I do realise that my nitpicking does involve obsessing about hypothetical outliers when the main thrust of the rules is clearly unimpeachable.
I'm happy to accept that the issue of how and when boards are elected, and when people other that the users should sit on them, should not be approached from too ideological or legalistic a point of view; the quality of decision making must come first. The co-op principles wisely leave a lot of options open, and while I may doubt the necessity of the more extreme solutions I won't pretend there are any moral absolutes here. Yes, the business should have a chance to bed in before being exposed to the bracing winds of democracy - but only within a reasonable timeframe, and I will always prefer to see that spelled out.
Similarly, the distinction between dividend and interest is a convention as much as a principle, and co-ops will always have the power to vary interest in the light of profitability. There is at least an upper limit of 10% on interest; though I still feel that may sometimes be more than is necessary to attract and retain investment, it isn't crazy high. I do think the use of investor shares for both user members and external investors is somewhat confusing (and no voting rights at all for external investors is maybe a little harsh), but that is I guess a matter of taste. The real issue here is that you have the opportunity to have two very different modes of compensation - dividend and interest - and by making them too similar in their operation you miss out on a chance to be more sophisticated in the delivery of returns.
As for founder members, I could not agree more that they have been poorly treated by co-ops in the past and that promises of sweat equity have been honoured more in the breach than in the observance. But as this is a co-op that has chosen to employ Fair Shares rules; the same problems aren't so likely to occur here. Distributing dividend in the absence of transactions seems to swing the pendulum way too far in the other direction (the arbitrary cut-off between the three founder members and other people who might have joined early, contributed as much if not more to the growth of the business, and worked unpaid for almost as long, does rather undermine the argument).
Dividend and interest have different jobs to do - best to keep dividend as a correction on excessive profits, and interest as the expense of obtaining investment in a given marketplace. Sweat equity should be available to more than just the three people who happened to be in the room when the registration forms were signed, and should not attract dividend years after the individual has ceased making any meaningful contribution to profits.

Alex - thanks for your thoughts. A couple of comments only.

Regarding - "I do think the use of investor shares for both user members and external investors is somewhat confusing (and no voting rights at all for external investors is maybe a little harsh)"

At FairShares, we conceive things differently - what matters is the relationships that you have. I could be founder, labour, user and investor member (and receive dividends in the first three roles, and interest in the fourth). The 'unit' is the relationship, not the person.

All an external investor has to do to obtain voting powers is become a Labour or User member (even if they leave, their previous participation means that they retain their voting rights when all they have left is Investor Shares). To clarify, read the 'Eligible Member' Definition in Clause 1. This clarifies what we mean by 'Eligible Investor members' elsewhere in the constitution.

This approach was suggested by FCA staff, and we happily implemented their suggestion. In non-FCA FairShares Companies and Cooperatives, Investor Members have the same voting rights as other member classes. The limitations on voting rights in FCA rules is because UK Co-operative Law does not support multi-stakeholding during special resolutions - it requires one-member, one-vote, without limiting the voting power of any member class.

In non-FCA FairShares Companies and Cooperatives, we can cap the voting power on Investors. We cannot do that in FCA Accepted FairShares Cooperatives - hence this suggestion by the FCA.

Regarding Founder shares - so far, quite few trialling the model rules have allocated 0% to founders - if this is their wish, that is what they can choose. Nor are Founder shares heritable - eventually they are cancelled. I do not begrudge reward to any person or enterprise creating a new viable enterprise that outlives them. Unlike private companies, shareholdings cannot be passed to next of kin, thus guaranteeing future ownership by the community as a cooperative.

We see entrepreneurial reward differently - my experience is that the job of starting an enterprise is the result of years of work (indirectly, because it takes that long to develop the skills/experience needed) plus many months - or even years of direct work - on the goods/services to be offered, and the constitution to be agreed. Whilst private companies typically give 100% of capital to founders (who then control all profit allocations and capital gains, at least until they dilute their holdings), FairShares enterprises only give a maximum of 15% of the future surplus and dilutes Investor holdings by sharing capital gains as well as surpluses over time. Capital gains are split 50/50 between Labour/Users and Investor members (Founders do not participate in capital gains unless they are Labour, User or Investor members).

This pragmatic arrangement is intended to take away the worse aspects of failing to award sweat equity, not enrich absentee founders. Once again, my experience is that the protection of voice rights (and temporary control of the board prior until the business model is stable and a growth in membership is secured) are much more important to founders than the promise of a (modest) future share of surplus.