A Perfect Storm

Farmland trustee sues ex-officers, directors
for ‘gross negligence’ in co-op’s collapse

By Dan Campbell, Editor


n its final years, Farmland Industries was trapped in a “death spiral of debt,” made worse by a series of business blunders that evidence reckless and negligent behavior by the co-op’s managers and board, according to a lawsuit filed in February by the estate trustee for Farmland.

The lawsuit accuses the co-op’s former managers and directors of “gross negligence and acts of corporate waste” in carrying out their duties, resulting in the largest co-op bankruptcy in the nation’s history. The board was little more than “a rubber stamp” for management’s high-risk ventures, the lawsuit says, and directors repeatedly failed to demand that other obvious alternatives be explored.

The 34-page lawsuit reads a bit like a “how-not-to-run-a-cooperative” primer, complete with lessons in “throwing good money after bad.” That impression could, of course, change markedly when the defendants file their response (which was due in March, after the copy deadline for this magazine). The pre-trial hearing has been slated for May 10.

The lawsuit, filed in U.S. Bankruptcy Court in Kansas City by J.P. Morgan Trust Co., does not paint a pretty picture of how the ship of state was being guided in the final years of Farmland. It provides a detailed look into how Farmland tried to grow its way out of debt by taking on even more debt as it constructed major new facilities and acquired another failing farm supply business. In the end, Farmland succeeded only in swamping itself in an everdeepening sea of red ink, which led to its bonds being downgraded to “junk” status.

That resulted in the co-op having to pay higher interest rates. A “run on the bank” by panicked bondholders ensued when press reports picked up on the co-op’s intensifying financial troubles. Farmland filed for Chapter 11 (reorganization) bankruptcy in 2002. Since then, the assets of the one-time Fortune 500 company — with $11.8 billion in annual sales and 600,000 members — have been sold off.

The suit builds its case on a series of seemingly self-destructive actions the co-op took, or didn’t take, primarily during the tenure of CEO Harry Cleberg from 1992 until 2000. The suit also names his successor, Robert Honse, along with 27 former board members.

Ben Mann, a Kansas City attorney representing Cleberg and former Chairman Al Shively, says the lawsuit “is nothing but second guessing” by the trustee, and that none of the claims have merit. He declined further comment pending his clients’ formal response to the lawsuit.

Fertilizer plant:
a co-op killer?
Perhaps the handwriting on the wall for Farmland Industries appeared in 1999, when CHS members voted down a proposed merger with Farmland. In turning it down, CHS members cited their concern over the massive debt levels Farmland had assumed and displeasure with the big pay checks management of the two co-ops would have collected as part of the deal.

The biggest nail in Farmland’s coffin, according to the lawsuit, was the decision to build a $300-million nitrogen fertilizer plant close by its petroleum refinery in Coffeyville, Kan. The new fertilizer plant was to use a commercially unproven technology from Texaco that used petroleum coke (produced as a byproduct of refining petroleum) instead of natural gas as a fuel source for anhydrous ammonia-based fertilizer. This technology was not being used commercially anywhere in the United States at the time and in very few places globally.

Farmland relied on fertilizer sales for up to 70 percent of its income in the 1990s, the lawsuit says. However, in the early ‘90s, management had recommended that Farmland exit the highly volatile fertilizer business. Fluctuating demand caused by changes in cropping patterns and government farm programs, weather conditions and competition from imports were making the fertilizer trade seem like an endless rollercoaster ride. Natural gas prices also fluctuate widely, but Farmland believed the long-term out- look was for steadily rising gas prices, hence its decision to seek an alternative energy source for the manufacture of anhydrous ammonia.

Inadequate research alleged
“Farmland never hired any third party or outside consultant to advise [it] on the completeness and accuracy of Texaco’s representation,” the suit says. The co-op’s main research consisted of a single trip by Honse and one other co-op employee (a former Texaco employee) to a small plant in Japan that was using the technology. No board members made the trip, and no contacts were made with customers of the plant, which had experienced start-up problems.

Gasification technologies other than Texaco’s were available in the United States at that time, and the Tennessee Valley Authority had built a gasifier that used petroleum coke to produce ammonia. None of these options were investigated by Farmland, the suit says.

Another promising alternative would have been to expand the co-op’s joint venture with Mississippi Chemical on the Caribbean island of Trinidad, where Farmland was then securing natural gas for only 40 percent of the cost of domestic natural gas. But that option was given “only a cursory consideration,” the lawsuit says. Other off-shore suppliers also could have been tapped as low-cost gas suppliers, but again, such options were not explored.

Ultimately, the co-op spent less than $2 million investigating the merits of the Coffeyville fertilizer plant, and allotted only 25 minutes of its agenda to the topic before approving it in April of 1997, the suit says. The entire Coffeyville complex — fertilizer plant and refinery — were eventually sold for just $11 million, leaving it with a $300 million loss on the fertilizer plant alone.

Farmland’s decision to enter some major joint ventures — with ADM for grain marketing and with other co-ops in Agriliance for fertilizer — caused it to lose control over the ability to set prices for those commodities, the lawsuit says.

SF Services acquisition
J.P. Morgan Trust contends that Farmland’s leaders failed to perform due diligence when it decided in April 1998 to acquire SF Services, a faltering, federated farm-supply co-op with $100 million in debt. SF Services was not only losing money and burdened with debt, it had “a significant problem with its pension plan” and was locked in a dispute with the IRS. Farmland “hired no outside consultant to advise it regarding the merger,” the lawsuit says.

SF Services — which did business in Arkansas, Louisiana and Mississippi — never made money for Farmland. “All the money was lost. These losses were foreseeable and completely avoidable,” the lawsuit alleges.

These types of actions, it continues, reflected Cleberg’s philosophy that “Farmland needed to grow ever bigger. During his tenure as CEO, the focus was on growing sales volume and diversifying operations, not on the bottom line — profitability. From 1996 to 2000, the co-op took on an additional $400 million in debt, boosting total indebtedness to $1.3 billion.”

The lawsuit alleges that accounting tricks were used to mask its true financial condition. “Gross revenues increased significantly until 2002, giving the appearance that Farmland was a growing company, when its profitability was in truth steadily declining.” Expansion, including the Coffeyville fertilizer plant, “was funded through the use of off-balance sheet financing.” Furthermore, Farmland “changed certain accounting practices that added billions of dollars in revenue to the company,” masking how leveraged it was, the suit alleges.

Rubbing salt in the wound was a $700,000 “sweetheart bonus” Cleberg received in 1999, during a year in which his primary focus was on securing approval for the merger with CHS. Having failed to accomplish this goal, the suit questions why he was given a bonus equal to more than his annual base salary. Cleberg and Honse reached a settlement with the creditors last September which allowed them to collect $7.4 million and $3.6 million (respectively) in deferred compensation and retirement benefits.

A perfect storm
While the defense attorneys aren’t saying much at this point, some others who have followed the case say a number of negative factors converged to bring down Farmland. The Coffeyville plant was “located in just about the worst place it could be,” says David Barton, director of the Arthur Capper Cooperative Center at Kansas State University. “It was located in an ‘oversupplied’ market with limited marketing flexibility resulting in relatively low prices and needed major environmental updating.”

And while he agrees that it was a major negative for the co-op, Barton cites three primary reasons for Farmland’s failure: There was also “a sea change” occurring in the grain business which worked against Farmland. Less grain volume was being shipped to its traditional inland grain terminals and instead was moving to smaller, high-speed train load-out facilities dispersed throughout the grain belt.

“Recklessness” hard to prove
Farmland had shown strong intentions of wanting to transition from being a farm supply and grain business to being a producer of processed meats. It had been moving in that direction and was operating successful pork and beef operations when the roof began to fall in.

Had Farmland started sooner in making the transition to a food coop, perhaps today we would be hailing it as a model of a co-op that successfully reinvented itself for the 21st century, rather than as the biggest co-op failure in history.

But the good performance of the meat processing businesses was not directly serving the needs of its primary owners and patrons, the Farmland local co-op members, who wanted the co-op to perform better as a source of farm supplies and as a grain marketer, says Barton.

There also may have been a method to what the lawsuit paints as madness regarding the money spent on the Coffeyville fertilizer plant. Farmland had been trying for years to sell the Coffeyville petroleum refinery, but without success. Had the fertilizer plant been successful in using byproducts from the refinery to produce fertilizer, it might have made that entire operation marketable.

According to a March 11 report in Kansas City Star, the Coffeyville complex, which some called an albatross, is now paying off for Pegasus Capital, which paid only $22 million in cash (plus some other considerations) for the refinery and fertilizer facilities. In its first year running the plant, Pegasus says it will earn $100 million in operating income, making it what the owners call "the lowest-price producer of fertilizer in the world." So perhaps the technology was not flawed, but only in need of fine-tuning.

The business, now operating under the name Coffeyville Resources, has announced that it is going public and hopes to raise $300 million.

It is the job of the trustee to get as much as he can for the debtors in a bankruptcy, but proving recklessness may be an uphill battle in this case, according to some legal experts. It is important to note that this lawsuit does not allege fraud, nor that actions were taken for the personal enrichment of the defendants. And while the suit certainly alleges that some very poor business decisions were made by management and the board, the court may not agree that this constitutes negligence or failure to perform due diligence. That is a heavy burden to prove. If it does, most companies and co-ops carry liability insurance to protect the directors from any personal liability.

In essence, the lawsuit poses the question: at what point do (alleged) bad business decisions cross the border into the realm of failure to perform due diligence?

The closest the lawsuit comes to alleging fraud is when it makes allegations of “off-balance-sheet financing” and “changing accounting practices” to mask indebtedness.

In this environment, management and directors more than ever need to do their homework, properly research major business moves and make sure all accounting and financial statements are above board and accurate.



Why wasn’t Farmland reorganized?

Heads have been turned and eyebrows raised in coop circles by reports of the unusually high payouts creditors are receiving from the estate of bankrupt Farmland Industries. Secured creditors (essentially the co-op’s lenders) have been paid in full, about $500 million. The 60,000 unsecured creditors (including about 20,000 bondholders) have been paid 95 cents on the dollar, or more than $800 million, with prospects for getting even more.

Those are remarkable payback figures, considering that the average in bankruptcy cases is closer to 10 cents on the dollar for unsecured creditors and 80 cents on the dollar for secured creditors.

Holders of $100 million in Farmland preferred stock have not fared as well, with an estimated payback of only about $4 million at this time. Local co-ops lost all of their equity investment (or common stock) in Farmland.

So why wasn’t Farmland reorganized, as are so many other companies that file for Chapter 11 Bankruptcy? The case seems to have been handled as a Chapter 7 liquidation almost from the start — and it seems there was never any real intent to save the business, some former co-op members have complained. Some have also questioned whether Smithfield Foods was able to exert pressure to steer the case toward liquidation because it wanted to gain control of Farmland’s highly coveted pork operations.

Larry Frazen of the Kansas City law firm of Bryan Cave, Farmland’s attorney, says he understands why former members and others are doing a double take when they read reports of how well creditors have fared, but he does not share the belief that this is an indication that Farmland should have, or could have, been successfully reorganized.

“Sometimes the assets of a co-op may be worth far more when it is broken up than when whole, as in this case,” Frazen says. In the case of Farmland, it operated numerous divisions and joint ventures — fertilizer, petroleum, grain, pork, beef, feed, transportation — which did not necessarily complement each other well, he notes. Furthermore, no one anticipated the very big sale prices many of the co-op’s best assets fetched.

The management team did make an offer to reorganize the co-op, Frazen says, but the two unsecured creditors’ committees (one for bondholders and one for trade creditors) wanted to liquidate. “They wanted cash.”

While Smithfield did indeed buy up some creditors’ claims against Farmland, Frazen said it was never to the extent that the Virginia-based pork company could have blocked a reorganization had the creditors’ committees decided to go that route. But Smithfield did gain standing on the creditors’ committees, he noted.

The creditors included banks that were adamant about being repaid, and many bondholders who were equally eager to get their cash out. It was many of these same small bondholders who were spooked by press reports of Farmland’s growing debts that sparked a “run on the bank” in 2002.

The resulting “cash crunch” was the culmination of what Frazen also calls “a perfect storm” of events that doomed the co-op. Farmland had been greatly weakened by three successive years of poor planting conditions, causing fertilizer sales to plunge just when the coop could least afford it.

David Barton, director of the Arthur Capper Cooperative Center at Kansas State University (KSU), cites two main reasons for Farmland’s inability to reorganize under bankruptcy: 1) bondholders would have had to agree to convert their bonds into preferred stock in the co-op, and few had any interest in doing so; and 2) members would have had to invest more money in the co-op, and few showed a willingness and interest to do so.

“Local co-op members had other options where they could take their business, rather than investing more in Farmland,” says Barton, who has been tracking Farmland’s fate both as an academic whose work focuses on co-ops, and as an unsecured creditor himself (he was owed for some consulting he did for the co-op). The KSU Co-op Center was also an unsecured creditor.

Because so many of the co-op’s bondholders were relatively small investors living in rural areas and associated with local co-ops, some of whom had invested the majority of their retirement funds in the bonds, there was a strong sentiment at Farmland to strive to repay as much of the bond debt as possible, Barton says.

Once the co-op’s assets went on the block, some spirited bidding wars broke out, none keener than for Farmland’s pork operations, where Smithfield vs. Cargill bidding ran up the price to $481 million. Smithfield even picked up the obligation for Farmland employee pensions, a real stroke of good fortune for workers caught up in a bankruptcy, Frazen says.

“It is kind of funny that you can get criticized for doing your job almost too well — for getting as much as you can for the creditors — in a case like this,” Frazen says. “Farmland’s management worked very hard to make sure as few as possible were hurt by the co-op’s bankruptcy.”

Dan Campbell, editor



Farmland faced classic co-op dilemma

Thomas W. Gray, Ph.D
Rural Sociologist
USDA Rural Development


Agricultural cooperatives are at once democratic associations of member-producers as well as businesses. This dual function of democracy and business results in various trade-offs and tensions that become a basic part of cooperative structure. Embedded are values of equality, equity, participation and self-governance (the democracy function,) but also values of efficiency, performance and economic return (the business function.) In their operations, cooperatives struggle to meet both sets of needs, sometimes successfully dancing between them, sometimes falling to one side or the other.

Many cooperatives were formed to help empower farmers to compete with much larger business organizations. Farmland Industries, from its inception as Union Oil in 1929, was formed to oppose the market power of such giants as Standard Oil and Sunoco. Farmland sought to empower farmers by competing with Big Oil. This led the cooperative down a path (with much of the rest of U.S. agriculture) of energy-intensive, agricultural industrialization, and into big business operations.

Conglomeration has been the predominant organizational strategy of big business, commencing with the Depression and World War II. Spreading investments across several different activities, subsidiary firms and locations (conglomeration) can diversify organizational vulnerability and risk. In an era that has come to be dominated with multi- nationalized firms, Farmland Industries grew to operate in all 50 states and 60 counties, with 600,000 members and 1,700 local cooperative owners.

Cooperatives are organized with the member in mind. Members are to be the prime beneficiaries. However, in a multi-national cooperative such as Farmland, complexity rules. It can become unclear who the prime beneficiaries and critical decision makers are.

Do the primary benefits of cooperatives get lost in shifts between business management prerogatives vs. the democratic rights of the members? Do membership interests get lost to the investment interests of “outsiders” in joint ventures? What group of interests is making crucial decisions of the organization that shape future directions? Complexity “confuses” any easy answer to these questions.

Had Farmland taken a different, less extensive path of development, member participation in the organization may have been higher. Complexity always leads to losses of member involvement and, generally, to increases in centralized decision making. To the extent that centralization occurs, the cooperative is less member-oriented because members are less involved.

More member involvement allows for more input and can produce greater flexibility and creativity. We might wonder if a more active democracy (one closer to the members) could have led to different structures and operations (if more modest) and to better survival rates of farmers and, ultimately, of the organization.

However, the tension from the business side of the organization may claim that while democracy is central to cooperative organization, to act without recognition of market imperatives (e.g., the need for earnings, market innovation, and countervailing power in the market place) can very easily eliminate the cooperative all together.

Ultimately, the members of a cooperative can demand that: 1) those who own and finance the cooperative are those who use the cooperative; 2) those who control the cooperative are those who use the cooperative; and that 3) the cooperative’s sole purpose ultimately is to provide and distribute benefits to its users on the basis of their use of the organization (Dunn).

However, the ease with which these principles can be stated belies the complexity of responding to member needs and rights of use, in an environment of globalization, industrialization, multi-national competitors, and such everpresent needs as capitalization.




March/April Table of Contents