Skip to main content

B-159292, Jul 7, 1988

B-159292 Jul 07, 1988
Jump To:
Skip to Highlights

Highlights

Only way in which B stockholders can obtain cash from their stock is through stock redemption. While matter is not free from doubt. Cash dividends on Class B stock are prohibited by section 406(d) of Act. AFMD: This memorandum addresses legal questions which have arisen in connection with your July 23. We have been asked whether the Act permits the Bank to pay patronage refunds on its Class B stock in cash. We have been asked whether redemption by the Bank of its Class B stock in cash would impair vested rights of the Government as Class A stockholder. These issues are addressed in the context of an April 1987. To include in that retirement both the Class B stock issued at the end of that year as a deferred patronage refund and the amount which was placed in the Bank's Reserve for Contingencies for the year in which that Class B stock was issued.

View Decision

B-159292, Jul 7, 1988

MISCELLANEOUS TOPICS - Finance Industry - Financial institutions - Stocks - Refunds DIGEST: 1. Under section 406(d) of Rural Electrification Act of 1936, as amended (REA Act), 7 U.S.C. Sec. 946(d), patronage refunds on Class B stock of Rural Telephone Bank (Bank) may only be made in B stock of Bank. Only way in which B stockholders can obtain cash from their stock is through stock redemption. While matter is not free from doubt, such redemptions may be viewed as constructive dividends. Cash dividends on Class B stock are prohibited by section 406(d) of Act. MISCELLANEOUS TOPICS - Finance Industry - Financial institutions - Stocks - Retirement 2. Current Bylaws of Bank established vested right of prior redemption for Bank's Class A stock which would be impaired by proposal to amend Bylaws to permit retirement of Class B stock before retirement of Class A stock. 3. Neither Secretary of Agriculture nor Administrator of Rural Electrification Administration has authority under section 403(a) of REA Act, 7 U.S.C. Sec. 943(a), to consent to Bank's amendment of its Bylaws to change government's right of prior redemption for its Class A stock. Any such consent should be specifically authorized by the Congress. Authority of Rural Telephone Bank to Amend Bank's Bylaws to Redeem B Stock In Cash (File B-159292; Code 916947)

Director, AFMD:

This memorandum addresses legal questions which have arisen in connection with your July 23, 1987, testimony on the interest rate policies of the Rural Telephone Bank (Bank) before the Subcommittee on Government Information, Justice and Agriculture, House Committee on Government Operations.

We have been asked whether the Act permits the Bank to pay patronage refunds on its Class B stock in cash. Also, we have been asked whether redemption by the Bank of its Class B stock in cash would impair vested rights of the Government as Class A stockholder.

These issues are addressed in the context of an April 1987, proposal by the Bank's staff to its board of directors (Board) to establish a patronage refund system for retirement of Class B stock. Under the proposal, the Bank's Bylaws would be amended to allow the Board to retire patronage capital accumulated for a particular year, and to include in that retirement both the Class B stock issued at the end of that year as a deferred patronage refund and the amount which was placed in the Bank's Reserve for Contingencies for the year in which that Class B stock was issued. Thus, each year's addition to the Reserve for Contingencies would, at a future date, first be converted to Class B stock and then redeemed along with the Class B stock issued as a deferred patronage refund for the same year. On August 4, 1987, the Board considered and failed to pass this proposal.

Since we began addressing the issues presented, Congress passed the Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203, enacted December 22, 1987. Section 1413 of the Reconciliation Act replaces the Bank's Reserve for Contingencies with a new reserve for interest rate fluctuation and directs GAO to study and make recommendations with respect to the Bank's operations, including the appropriate level of funding of the new reserve and the disposition of the excess reserves.

Section 1413 of the Reconciliation Act would have preempted much of the Bank's proposal to convert unexpended amounts in the Reserve for Contingencies to Class B stock by limiting the availability of those funds for use as proposed by the Board. Subsection 1413(a) of the Reconciliation Act, adding subsection (h) to section 406 of the Rural Electrification Act, provides that the interest rate fluctuation reserve may be used to cover operating losses of the Bank, only.

Subsection 1413(b) of the Reconciliation Act directs GAO to study the Bank's operations and report on its recommendations in 6 months to the House Committee on Agriculture and Government Operations and the Senate Committee on Agriculture, Nutrition, and Forestry. The GAO study must make recommendations with respect to (1) the appropriate level of funding for the reserve for losses due to interest rate fluctuations, (2) the circumstances under which amounts in this new reserve should be expended, (3) the circumstances under which amounts should be added to this new reserve, and (4) the disposition of excess reserves. Under this statutory directive, your staff is considering proposing a recommendation for retirement of the Bank's Class B patronage stock which is similar in essential respects to the Board's proposal. Therefore, the legal issues presented and our analysis of those issues are applicable to both the Board's proposal and your staff's proposed recommendations.

It is our conclusion that the Secretary of Agriculture needs specific and new legislative authority to implement any proposal to redeem with cash Class B stock paid as patronage refunds and to retire Class B patronage stock before all Class A stock is retired. While the Board has voted down the Bank's proposal to retire patronage refunds, further consideration of this matter awaits the recommendations of the GAO study. In this regard, the significance of our analysis is the adequacy of the authority of the Secretary of Agriculture and the Board to effectuate changes administratively to the Bank's operations regarding retirement of its patronage capital.

In conducting our analysis, we examined the positions presented by the Department of Agriculture's General Counsel as to the legal validity of the Board's proposal to retire the Bank's Class B stock.

A detailed discussion is attached.

QUESTION 1: Does the Rural Electrification Act, as amended, 7 U.S.C. Sec. 941 et seq., permit the Bank to pay patronage refunds on its Class B stock in cash?

ANSWER: No. Section 406(d) of the Act, 7 U.S.C. Sec. 946(d), allows the payment of patronage refunds only in B stock of the Bank. The only way in which Class B stockholders can obtain cash from their stock is through a stock redemption. However, while the matter is not entirely free from doubt, such redemptions could be viewed as constructive dividends. Cash dividends on Class B stock are prohibited by section 406(d).

QUESTION 2: May the Bank redeem its Class B stock in cash before retiring Class A stock without impairing vested rights of the Government as Class A stockholder?

Answer: We do not believe the Board may redeem its Class B stock in cash before retiring Class A stock without impairing vested rights of Class A stock. The current Bylaws appear to establish a contractural, vested right of prior redemption for the government's Class A stock. Such rights would be unlawfully impaired by the Board's proposal to amend the Bank's Bylaws to permit retirement of Class B stock before retirement of Class A stock.

A detailed analysis is attached.

Attachment

cc: Mr. Kepplinger, OGC

Mr. Bedrick, OGC

Mr. Duquette, AFMD

Mr. Jackson, OGC

Mr. Stoltz, AFMD

ATTACHMENT

ANALYSIS

I. BACKGROUND

In 1971, Congress created the Rural Telephone Bank ("Bank") as a corporate body and agency and instrumentality of the United States to meet the growing capital needs of rural telephone systems. Pub. L. No. 92-15, 85 Stat. 29 (1971) (codified at 7 U.S.C. Sec. 941 et seq.). The Bank's purposes are to obtain funds through the sale of stock and debentures to supplement the Rural Electrification Administration's (REA) telephone loan program, and to make loans to providers of telephone service in rural areas which either have received REA loans or loan commitments or have been certified eligible for such loans by the Administrator of REA.

The Act provides for three (3) distinct classes of stock: A, B, and C. /1/ Class A stock may only be held by the Administrator of REA on behalf of the United States, 7 U.S.C. Sec. 946(c). As originally chartered, Congress provided that the United States would purchase $300,000,000 of Class A stock and accordingly authorized an annual appropriation of $30,000,000 for such purposes. In 1981, the amount of Class A stock the United States was authorized to purchase was changed to $600,000,000. See 7 U.S.C. Sec. 946(a). The bank must begin redeeming its Class A stock in 1995.

Class B stock may be issued only to borrowers of the Bank. This stock is obtained under two (2) circumstances. First, borrowers are required to purchase Class B stock in amounts equal to 5 percent of any loan obtained from the Bank. 7 U.S.C. Sec. 946(d). Second, after certain expenditures are made each year, patronage refunds may be allocated from patronage capital assignable in the form of Class B stock under terms and conditions specified in the Bank's Bylaws. Under the Bylaws, patronage refunds in Class B stock are paid in the proportion that the amount of interest earned on the loans of each borrower bears to the total interest earned on the loans of all borrowers during the fiscal year. /2/

Section 2.2(b) of the Bylaws currently provides that Class B stock can be redeemed and retired only after all shares of Class A stock have been redeemed and retired. In addition, section 8.2 of the Bylaws provides that the Board may establish procedures for the full or partial retirement of Class B stock at any time after all Class A stock has been retired.

In April 1987, Bank staff presented to the Board a proposal to establish a patronage capital retirement plan. Under the proposed plan, the Bylaws would be amended to allow Class B stock issued as patronage refunds to be retired before some or all of the Class A stock is retired. The proposal would require the Board, whenever it decided to retire Class B stock issued as patronage refunds, to reduce the Reserve for Contingencies by any unexpended amounts placed in that reserve during the year or years the Class B stock being retired was issued, and transfer these amounts to patronage capital assignable. These additions to patronage capital assignable would be distributed in shares of Class B stock and also redeemed in cash with the B stock initially issued as patronage refunds for the same year or years. Thus, the retirement of patronage capital for a particular year would include both the Class B stock issued initially as deferred patronage refunds and the amount which was placed in the Reserve for Contingencies for the same year. Although the proposal does not specifically address the source of funds from which cash redemptions would be made, an REA official has stated that such cash would come from the Bank's future income or margins. /3/

In addition, the Bylaw amendments would authorize the Class B stock issued as patronage refunds to be retired sooner than those Class B shares required to be purchased in conjunction with loans under section 406(d) of the Act (7 U.S.C. Sec. 946(d)). The amendment would make other changes to the Bylaws not relevant for this analysis. On August 4, 1987, the Board considered and failed to pass the proposal.

On April 23 and July 23, 1987, the Government Information, Justice, and Agricultural Subcommittee of the House Committee on Government Operations held hearings to investigate the interest rate policies of the Bank. /4/ Based on the hearings, the Committee found that the Bank, in its view (but not ours), had adopted and implemented a series of policies and procedures for setting interest rates that have resulted in rates that are higher than the statutorily required rate of the Bank's average cost of moneys. The Committee specifically found that the Bank had accumulated over $179 million in excess profits as a result of its interest rate policies and procedures. The Committee further found that he Bank's Reserve for Contingencies was funded at a level significantly higher than justified and represents excess profits and that the Bank's patronage refunds are virtually worthless to borrowers and also represent excess profits. /5/

The Committee recommended, among other things, that the Bank take immediate steps to eliminate the further accrual of profits from all loans, and that the Board immediately initiate a study of alternative methods of returning to rural telephone systems and ratepayers the $179 million in profits it had accrued. The Committee also recommended that the disposition of Bank profits be addressed and resolved before any consideration is given to privatization of the Bank. The Committee further recommended that the Bank take action to reduce the risk of interest rate fluctuations both to the Bank and its customers, and that the House Committee on Agriculture consider making changes to the Rural Electrification Act that would direct the Bank to reduce these risks further.

On December 23, 1987, Congress passed the Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203, to provide for agricultural reconciliation. Section 1413 of the Reconciliation Act establishes in the Bank a new "reserve for losses due to interest rate fluctuations," and requires the Bank's Governor to transfer all amounts currently in the Reserve for Contingencies into this new reserve. 7 U.S.C. Sec. 947(h). Amounts in this new reserve may be expended only to cover operating losses of the Bank, after taking into consideration any recommendations made by the General Accounting Office under subsection 1413(b) of the Reconciliation Act. Id. /6/ The authority of the Bank to establish reserves is limited by the Reconciliation Act to the preexisting reserve for loan losses authorized under 7 U.S.C. Sec. 946(g) and the new reserve for losses due to interest rate fluctuations.

Your staff has determined that the Bank's risk due to interest rate fluctuations will diminish and disappear over the next 6 years as the Bank's fixed commitment loans expire. Because of this low risk, your staff has determined that reserve for losses due to interest rate fluctuations of $10 million appears sufficient, and intends to recommend this amount as the appropriate level of funding for the new reserve. of September 30, 1987, $109.5 million of the Bank's earnings has been designated for the Reserve for Contingencies. Your staff intends to make a series of recommendations that would result in the excess $99.5 million being transferred back to the Bank's borrowers. First, your staff intends to recommend that the excess $99.5 million be converted to Class B patronage stock. Your staff further proposes that the distribution of this Class B patronage stock should be made proportional to the interest payments made over the years in which accumulated profits were placed in the Reserve for Contingencies, consistent with the Bank's current Bylaws for yearly patronage refunds. Further, additional accrued profits earned after the excess reserve distribution would be distributed annually as Class B patronage stock based on a borrower's interest for that year. Finally, your staff would propose that funds be made available for the retirement of the Class B patronage stock gradually over time by using the margin generated from the Bank's current year's operations as well as the margin represented by principal payments on loans. /7/

As of September 30, 1987, the Bank has accumulated $188 million in profits (after dividends) since its inception in 1971. The Bank has converted $78.5 million of these profits to Class B patronage stock as subscriber refunds and has designated the remaining $109.5 million for the Reserve for Contingencies.

II. AUTHORITY OF BANK TO PAY PATRONAGE REFUNDS IN CASH

Section 406(d) of the Act provides in part that:

"... (all) holders of Class B Stock shall be entitled to patronage refunds in Class B stock under terms and conditions to be specified in the bylaws of the telephone bank." 7 U.S.C. Sec. 946(d).

In applying the provisions of a statute, we are ordinarily bound to follow the settled rule of statutory construction that provisions with unambiguous language and specific directions may not be construed in a manner that will alter or extend their plain meaning. See 2A Sutherland, Statutes and Statutory Construction, Sec. 46.01, 46.07 (4th ed. Sands 1973). And if persons and things to which a statute refers are specifically and unambiguously designated, it is generally to be inferred that all omissions were intended. See 2A Sutherland, cited above, Sec. 57.10.

The plain language of section 406(d) specifically and unambiguously provides that the patronage refunds to which holders of the Bank's Class B stock are entitled is "in Class B stock." The language makes no provision whatever for entitlement of patronage refunds in any other form, e.g., cash. Our review of the legislative history of section 406(d) uncovered nothing to contradict this view. Hence, we have no basis to construe that provision as permitting patronage refunds to be paid in cash. Indeed, the purpose of the third sentence of 7 U.S.C. Sec. 946(d)-- "No dividends shall be payable on Class B stock"-- is to prevent cash patronage refunds which are in all respects material here, equivalent to cash dividends.

Although the Act does not allow cash to be paid as patronage refunds on Class B stock, an argument can be made that with an appropriate amendment of the Bank's Bylaws, cash can be obtained for redemption of such stock, since the Act does not expressly prohibit cash redemption of that stock. In support of this view, we note that various provisions of the Act grant the Board broad discretion in dealing with Class B stock.

Section 405(g) of the Act provides that:

"The telephone bank board shall prescribe bylaws, not inconsistent with law, regulating the manner in which the telephone bank's business shall be conducted, its directors and officers elected, its stock issued, held and disposed of, its property transferred, its bylaws amended, and the powers and privileges granted to it by law exercised and enjoyed." 7 U.S.C. Sec. 945(g).

Section 406(b) provides, in part, that:

"The capital stock of the telephone bank shall consist of three classes, Class A, Class B, and Class C. The rights, powers, privileges, and preferences of the separate classes to be as specified, not inconsistent with law, in the bylaws of the telephone bank." 7 U.S.C. Sec. 946(b).

On their face, the above-quoted provisions arguably may be broad enough to grant the Board discretion to redeem the Bank's Class B stock in cash.

These provisions authorize the Board to regulate the manner in which all the Bank's stock is issued, held and disposed of.In addition, the Board is expressly authorized to establish stock "rights," "privileges" and "preferences."

However, it must be determined whether the redemption of Class B stock in cash would violate the prohibition in section 406(d) of the Act that "No dividends shall be payable on class B stock," and therefore be "inconsistent with law" as that term is used in sections 405(g) and 406(b). Cash redemptions of Class B stock arguably could be viewed as constructive dividends in violation of the statutory proscription.

Basically, a dividend is a pro rata distribution of property by a corporation out of earnings and profits. Walker v. C.I.R., 544 F.2d 419, 421 (9th Cir. 1976); Wright v. United States, 482 F.2d 600, 604 (8th Cir. 1973). The crucial concept in a finding that there is a constructive dividend is that the corporation has conferred a benefit on the stockholder in order to distribute available earnings and profits without expectation of repayment. Telefsen v. Commissioner of Internal Revenue, 431 F.2d 511, 513 (2d Cir. 1970), cert denied, 401 U.S. 908, 91 S.Ct. 867, 27 L.Ed. 2d 806 (1971); See Miller v. United States, 404 F. Supp. 284 (E.D. N.Y. 1975).

In Murray Co., Inc. v. Commonwealth, 401 A.2d 412 (Pa. 1979), a cooperative distributed to a shareholder-patron property, including cash, from the excess of the cooperative's gross margins in operations, less expenses and reserves. The distribution was held to qualify as a "dividend" for purposes of state income taxation, even though it was treated as "patronage" by the cooperative. The court construed the term "dividend" according to its common and approved usage, and reasoned that the cooperative's distributions qualified as dividends since the distributions were paid out of the cooperative's earnings and profits in proportion to the amount of merchandise and services purchased by the stockholder-patron. See also Mississippi Valley Portland Cement Co. v. United States, 408 F.2d 827 (5th Cir. 1969) (purported patronage dividend otherwise excluded from income, held to be ordinary corporate dividend, and hence income).

Under its current Bylaws, the Board determines how much of the Bank's patronage capital assignable is to be set aside in the Reserve for Contingencies and how much should go toward deferred patronage refunds in the form of Class B stock. Under its proposal to amend the Bylaws, the Board would retire the patronage capital for a particular year by including in that retirement both the Class B stock issued initially as deferred patronage refunds and the amount of patronage capital assignable which was placed in the Reserve for Contingencies for the same year. The proposal would require that each year's addition of patronage capital to the Reserve for Contingencies would, at a future date, be converted to Class B stock and be redeemed with the Class B stock issued initially as patronage refunds for the same year. As noted earlier, an REA official has indicated that redemptions of Class B stock would be made from the Bank's future income or margins.

Your staff's proposed recommendation for retirement of Class B patronage stock, as noted earlier, would have the excess of the Reserve for Contingencies and any additional annual profits earned after distribution of the excess reserve converted to Class B patronage stock, distributed in proportion to interest payments made. Retirement of Class B patronage stock would be accomplished by using margins from both the Bank's current year's operations and principal payments on outstanding loans.

The margins which would be used to retire the Class B stock under both the Board's proposal and your staff's proposed recommendation are clearly the profits of the Bank, since they consist of all revenues in excess of operating expenses. /8/ Since the Class B stock would be issued as patronage refunds in proportion to the amount of interest income the Bank derives from Class B stockholders, we are inclined to the view that cash payments out of the Bank's profits to retire the Class B patronage refund stock would constitute a constructive dividend. A similarly strong argument can be made for such payments to retire any Class B stock converted from yearly additions to the Reserve for Contingencies, or otherwise from any additional annual profits earned after distribution of the excess reserve, since such payments would also constitute distributions of the Bank's profits in proportion to the amount of business conducted by the Class B stockholders with the Bank.

We believe the view that both cash patronage refunds and cash redemptions of Class B stock are prohibited by section 406(d) of the Act is supported by other provisions of the Act. In this regard, we note that the Act requires the Bank to be self-sustaining and eventually to achieve independent status in which the Bank's ownership, control, and operation converts to private ownership. 7 U.S.C. Secs. 941(b) and 950. To assist the Bank in achieving its independence, the Act requires the Bank to repay the government's investment by starting to redeem Class A stock by 1995, and to pay, annually, from the Bank's income, a cumulative 2 percent return on that stock. 7 U.S.C. Sec. 946(c). In addition, the Act provides that upon liquidation or dissolution of the Bank, Class A stock shall receive priority over Class B and C stock, and shall share equally with Class B stock any surpluses. 7 U.S.C. Sec. 950a.

Based on these provisions, one may perceive a statutory scheme to protect the government's investment in the Bank, and that Congress did not want the Bank's funds depleted before the government could recoup its interest and privatization of the Bank was completed. A reading of the statutory requirement in 7 U.S.C. Sec. 946(d) that patronage refunds be paid in Class B stock, rather than cash, either in the form of dividends or redemptions, is, in our view, consistent with these provisions and the underlying congressional purpose.

III. VALIDITY OF BOARDS'S PROPOSAL TO AMEND ITS BYLAWS TO REDEEM CLASS B STOCK BEFORE CLASS A STOCK

The Department of Agriculture's General Counsel (Agriculture) questions whether the proposal to amend the Bylaws impairs vested rights of the government as Class A stockholder. Agriculture presents several arguments in support of the view that the Board's proposal does not impair those vested rights. We have examined Agriculture's position on this issue, and believe that the proposal poses a greater risk of impairing those vested rights than Agriculture's analysis suggests.

Agriculture correctly notes that applicable statutes and bylaws in force when stock is issued become part of the contract between the stockholder and the corporation.

Agriculture goes on to state that the general statements of the powers to amend in section 405(g) of the Act, quoted above, and Article X of the Bylaws do not seem to be sufficiently specific to authorize the proposed amendment. /9/ However, after citing a provision in the Bank's stock certificate which makes the "rights, powers, privileges and preferences" of all Bank stock subject to amendment of its Bylaws, Agriculture concludes that "credible arguments" can be made that the Board possesses authority to change the Bylaws to modify the prior right of redemption for Class A stock. /10/ In arriving at this conclusion, Agriculture places considerable reliance on dictum in a state court case, Black v. Glass, 438 So. 2d 1359, 1367 (Ala. 1983), to the effect that provisions of a stockholder's share certificate are also part of his contract with the corporation.

A. The Government Has a Vested Right Under the Current Bylaws

A "vested right" is the power to do certain actions or possess certain things lawfully, and is substantially a property right; it may be created either by common law, by statute or by contract and once created it becomes absolute. Oklahoma Water Resources Bd v. Central Oklahoma Master Conservancy Dist., 464 P.2d 748, 755 (1969). It may also be defined as an immediate fixed right of present or future enjoyment; a property interest so substantial in character that its destruction or deprivation cannot be justified by the objective in view. Adelman v. Adelman, 296 N.Y.S. 2d 999 (1969). The term has been used to designate a right which has become so fixed that it is not subject to being divested without the consent of the owner as distinguished from rights which are subject to being divested without his consent. In re Adoption of Graham, 377 P.2d 275 (1962).

Article 2.2(b) of the Bylaws provides that Class B stock can be redeemed and retired only after all shares of Class A stock have been redeemed and retired. Article 8.2 of the Bylaws provides that at any time after all Class A stock has been retired, the Board may establish procedures for the retirement of Class B stock in full or in part.

Courts have held that a right of stock redemption is a vested right of a stockholder which cannot be impaired by a subsequent amendment of the corporation's articles or bylaws. Vanden Bosch v. Michigan Trust Co., 35 F.2d 643 (6th Cir. 1929); Sutton v. Globe Knitting Works, 267 N.W. 815 (1936). With regard to the undertaking of the corporation to redeem its stock as conferring a vested right, the court in the Sutton case stated:

"By virtue of the quoted provision contained in the certificate of stock held by plaintiff, he certainly had, immediately upon receiving it from defendant, a vested or accruing right to have it redeemed at par on the 25th of January, 1932. This was a liability that the corporation assumed incident to issuing this stock ... the redemption right is something more and different in character than an ordinary incidental right of a stockholder, such as voting for the election of a director of the company, and that his right is contractual in nature ... The redemption provision was a definite undertaking on the part of the defendant corporation to redeem at a given time and on given terms the stock plaintiff agreed to purchase ... the provision for redemption was something more than a mere incident to corporate relationship; it was a definite contractual undertaking, the proposal for which antedated and consummation of which coincided with the purchase of the stock ..." 267 N.W. 815 at 818. believe the Government's prior right of redemption of its Class A stock is a vested right. The redemption requirement in Article 2.2(b) of the Bylaws appears to be as much of a contractual undertaking as that in the Sutton case. While Article 2.2(b) itself does not specify a date on which the Class A stock is to be redeemed, section 406(c) of the Act, which is clearly a part of the government's contract with the Bank as shareholder, provides that the Bank shall begin to redeem such stock beginning in 1995. This undertaking was a liability that the Bank assumed incident to its issuance and the government's purchase of the Class A stock.

B. The Government's Vested Right May Not Be Divested By Subsequent Amendment of the Bank's Bylaws

Having established that the government's right of prior redemption of Class A stock is a vested right, the next issue to be determined is whether the Board's exercise of authority in its share certificate to amend the Bylaws is "consistent with law," as that term is used in section 405(g) of the Act, 7 U.S.C. Sec. 945(g).

It is generally recognized that corporate bylaws are divided into two classes: those that are mere regulations governing the conduct of the internal affairs of a corporation which may be repealed, altered or amended without the consent of the parties whose rights are affected, and provisions in the nature of a contract which are designed to vest property rights in shareholders which cannot be repealed or changed without the consent of the affected parties. Swanson v. Schockley, 364 N.W. 2d 252 (Iowa 1985); Black v. Glass, 483 So. 2d 1359 (Ala. 1983). It is equally recognized that a general reservation of power to amend bylaws is more naturally applied to those bylaws which are mere regulations governing the conduct of a corporation's internal affairs and should be naturally construed to avoid making the contract subject to change in an essential particular at the election of one in whose favor the reservation is made. Black v. Glass, supra. Therefore, the explicitness of the right to amend is crucial; specificity must be considered along with the nature of the interest being affected by the amendment. The more significant the interest being infringed upon, the more explicit the right to affect it must be stated, if it is to affect previously issued stock. B&H Warehouse, Inc. v. Atlas Van Lines, Inc., 490 F.2d 818 (5th Cir. 1974).

The share certificate issued by the Bank for each class of stock provides:

"The rights, powers, privileges and preferences of each class of stock authorized to be issued by the Rural Telephone Bank shall be as specified in, and the share or shares represented hereby are issued and shall be held subject to (the Act) and the bylaws of the Rural Telephone Bank, as said Act and bylaws may from time to time be amended."

Section 2.2(b) of the Bylaws provides, in part:

"Prior to dissolution or liquidation of the Bank, Class B stock may be redeemed and retired only after all shares of Class A stock shall have been redeemed and retired ..."

Section 8.2 of the Bylaws provides, in part:

"... If, at any time after all Class A stock has been retired, the Board should determine that the Bank's financial condition will not be impaired thereby, it may establish procedures for the retirement of Class B stock in full or in part or its conversion to Class C stock in addition to the conversion authorized in section 2.2(b) hereof."

We believe the terms of the share certificate provision are too general to override the specific language of sections 2.2(b) and 8.2 of the Bylaws, and therefore fail the criterion of specificity. The language of the share certificate provides only a general right to amend the Bylaws so as to affect the "rights, powers, privileges and preferences" of Bank stock. Such language fails to indicate specifically that at some future time Class A stock might lose its prior right of redemption. In this respect, the share certificate is no more specific than the general reservations of power in section 405(g) of the Act and Article X of the Bylaws. Conversely, the provisions of sections 2.2(b) and 8.2 of the Bylaws explicitly give a prior right of redemption to Class A stock. Section 406(c) of the Act expressly provides that such redemption shall start beginning in 1995. 7 U.S.C. Sec. 946(c). We note that in Sutton v. Globe Knitting, supra, the court rejected the contention that a statutory reservation of power to amend "rights ... privileges or preferences" overrode more specific language in a corporation's articles of incorporation establishing a specific redemption date for the corporation's preferred stock. See 267 N.W. at 816-817.

Based on these considerations, we do no believe the language of the Bank's share certificate is sufficiently specific to authorize the Board to change the prior redemption rights of the Class A stock. For the Board to do so would be "inconsistent with law."

Moreover, as section 405(g) of the Act and the reservation in the stock certificate require the Bank to act consistent with law, we note that sections 2.2(b) and 8.2 of the Bylaws, as currently written, reflect no more than the statute, tracking various provisions of the Act, i.e., dividend restrictions and limitation of patronage refunds to stock refunds (7 U.S.C. Sec. 946(d)), privatization provisions (7 U.S.C. Sec. 950), and priority of Class A over Class B stock in dissolution, plus equal sharing of surpluses between Class A and Class B stock (7 U.S.C. Sec. 950a). These provisions suggest that Congress did not want the funds held by the Bank depleted until after the process of privatization provided for in the Act was completed. Section 1413 of the Reconciliation Act of 1987 does not require any contrary conclusion. Thus, any change in the Bylaws altering the prior redemption rights of Class A stock would be "inconsistent with law" as reflected in the above-mentioned statutory and Bylaw provisions. /11/

C. The Secretary and Administrator Lack Authority to Consent to Bank's Amendment of Bylaws So As To Affect Government's Vested Rights

Notwithstanding its position regarding its authority under the share certificate's reserved power to amend, Agriculture argues that the Secretary may exercise his discretion under section 403(a) of the Act to direct that the Board either reject the proposed amendment or determine that the government did not rely on any rights to prior redemption. suggesting that the government may not have relied on that right as established in the Bylaws, Agriculture notes that the Bylaws were not adopted until October 14, 1971, nearly five (5) months after passage of the Act creating the Bank on May 7, 1971. In this regard, Agriculture cites the case of Swanson v. Shockley, 364 N.W. 2d 252 (Iowa 1985), for the proposition that vested rights can be impaired if the holder did not act in reliance on those rights.

Section 403(a) of the Act provides:

"(a) the telephone bank shall be an agency of the United States and shall be subject to the supervision and direction of the Secretary of Agriculture (hereinafter called the Secretary): Provided, however, That the telephone bank shall at no time be entitled to transmission of its mail free of postage, nor shall it have the priority of the United States in the payment of debts out of bankrupt, insolvent, and decedents' estates"; 7 U.S.C. 943(a).

It is a well established rule that without express or reasonably implied statutory authorization, the head of a federal department or agency is powerless to dispose of property of the United States. /12/ 65 Comp.Gen. 339, 341 (1986) and cases cited therein. It is equally well established that federal officers or agents have no authority to give away the money or property of the United States, either directly or by release of vested rights, without adequate legal consideration. 53 Comp.Gen. 574, 577 (1974); 51 Comp.Gen. 162, 165 (1971); 40 Comp.Gen. 309, 311 (1960). Specifically, no federal officer or employee can waive, modify, or otherwise change contractual obligations to the government without such consideration. 65 Comp.Gen. 563 (1986); B-193908, March 14, 1979.

Section 403(a) of the Act does not grant to either the Secretary or the Administrator of REA express authority to waive the government's right of prior redemption of its Class A stock. And while we recognize that section 403(a) grants the Secretary considerable discretion in the "supervision and direction" of the Bank's affairs, we do not believe that discretion is unlimited or so broad in scope as to authorize the waiver of specific vested rights of the government. A strong argument can be made that such authority cannot reasonably be implied form statutory language which appears only to grant a general duty of oversight and control over the Bank's operations.

Nonetheless, even if such authority could be implied under section 403(a), the Secretary could not consent to a waiver of the vested right of prior redemption unless there was some consideration or compensating benefit to the government, and unless the statutory prohibition in 7 U.S.C. Sec. 946(d) on the payment of dividends does not extend to stock redemptions. However, under the Board's proposal, we see no consideration flowing to the government to compensate for the anticipated loss of the right of prior redemption. In addition, we have noted earlier that a strong argument can be made that redemptions of the Bank's B stock as proposed would constitute payments of constructive dividends.

Further, we are not persuaded by Agriculture's specific arguments that the government did not rely on its prior right of redemption. We believe Agriculture's reliance on Swanson v. Shockley, 364 N.W. 2d 252 (Iowa 1985), for this proposition is misplaced. The court in Shockley had before it the question whether contractual rights which a minority shareholder had as a result of corporate bylaws granting such shareholder a first right of refusal, at a formula price, for shares sold by majority shareholders, could be defeated by an action of the majority shareholders amending those bylaws so as to abolish the right of first refusal. The minority shareholder contended that a sale of stock by the majority to a party not a shareholder in the corporation violated his vested contractual right of first refusal established under the original bylaw, which had been in effect at the time he acquired his stock. The court based its decision on a line of cases recognizing the rule that in order for vested contractual rights derived from corporate bylaws to be enforceable, the bylaw must be one upon which a shareholder has relied on by change of position or circumstances, or by parting with a valuable consideration, and enforcement of the right must not work an unreasonable hardship on the other shareholders. Regarding the criterion of reliance, the court held that the record did not show that the minority shareholder had relied in any way on the repealed bylaw in purchasing its shares; that it appeared that he was not even aware of the bylaw's existence at the time his shares were purchased.

Unlike the minority shareholder in Shockley, the government clearly had been aware of the existence of sections 2.2(b) and 8.2 of the Bank's Bylaws when it purchased the Class A stock. Although the initial $30 million was appropriated by the Congress for the government's initial annual purchase of Class A stock on August 10, 1971, the actual purchase did not take place until December 30, 1971, more than 2 months after adoption of the Bylaws (October 14, 1971). Obviously, subsequent annual appropriations and purchases were made after adoption of the Bylaws.

In addition, we believe it can be reasonably concluded that the government purchased Class A stock with an expectation that its interest would be protected. As we noted earlier, a strong argument can be made that the Act's statutory scheme was designed to protect the government's investment in the Bank, and the government relied on that protection in appropriating funds for the purchase of Class A stock, both before and after implementation of the Bylaws. The Bylaws are merely contemporaneous expressions of those provisions of the Act. See 7 U.S.C. Secs. 941(b), 946(c), 946(d), 950 and 950a. Based on these provisions of the Act, a reasonable inference can be drawn that the Act places the government's investment in Class A stock over the interest of Class B stockholders, and establishes a framework under which Class A stock is to be redeemed before Class B stock. In this regard, Congress, in its most recent amendments to the Act, did not disturb this statutory scheme. See Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203, enacted December 22, 1987.

Based on these considerations, we are not persuaded by Agriculture's argument that the Secretary may exercise his authority under section 403(a) of the Act to direct the Board to determine that the government did not rely on any rights to prior redemption of its Class A stock. Indeed, the Secretary of Agriculture and the Administrator of REA must act in conformance with the overall statutory scheme of the Act which provides for "priority" of the government's investment. It is doubtful that administrative officials could amend the Bank's Bylaws to provide the government less rights than the statute requires. In our view, therefore, any consent by the Secretary or Administrator to the proposed Bylaw amendments affecting the government's vested right of prior redemption should be specifically authorized by the Congress.

/1/ Class C stock may be issued to borrowers who wish to invest additional amounts in the Bank. The bank is authorized to pay dividends on such stock in the manner specified in the Bank's Bylaws. 7 U.S.C. Sec. 946(e). For purposes of our analysis, it is not necessary to consider the possible effects of the Board's proposal on the rights of Class C stockholders.

/2/ Under Section 8.1 of the current Bylaws, patronage capital assignable in calculated by subtracting the Class C stock dividend from the Bank's net income after payment of the return on Class A stock to the U.S. Treasury. Section 8.2 of the Bylaws requires at least 10 percent of the patronage capital assignable to be placed in the Reserve for Contingencies for operating and other losses, as determined by the Board, and the remainder distributed to the Bank's borrowers as a deferred patronage refund in the form of additional shares of Class B stock. See Section 8.1 and Section 8.2 of the Bylaws of the Rural Telephone Bank, adopted May 14, 1978 (Reprinted August 1986).

/3/ Mr. Bob Ruddy, Director, Financial Accounting Division, REA, who also serves as Assistant Treasurer for the Bank, has stated that where future income or margins are used to redeem Class B stock, the Bank would have to borrow from Treasury to make new loans.

/4/ REA's Rural Telephone Bank: Have Rural Telephone Systems and Ratepayers Been Overcharged? Hearings before a Subcommittee of the House Committee on Government Operations, 100th Cong., 1st Sess. April 23 and July 23, 1987.

/5/ Section 1411 of the Omnibus Budget Reconciliation Act, Pub. L. No. 100-103, 101 Stat. 1330-22, reflects the congressional finding that the RTB's overcharging of its borrowers has resulted in $179 million in excess profits. H.R. Rep. No. 100-357, 100th Cong., 1st Sess. 2, 3 (1987).

/6/ Subsection 1413(b) of the Reconciliation Act directs GAO to study the Bank's operations and report its recommendations in 6 months to the House Committee on Agriculture and Government Operations and the Senate Committee on Agriculture, Nutrition, and Forestry. The GAO study must make recommendations with respect to (1) the appropriate level of funding for the reserve for losses due to interest rate fluctuations; (2) the circumstances under which amounts in this new reserve should be expended; (3) the circumstances under which amounts should be added to this new reserve; and (4) the disposition of excess reserves. 7 U.S.C. Sec. 947(h).

/7/According to your staff, the Bank will continue to generate margin under the new interest rate calculation provision at the historical rate of 6.5 percent. It states that the Bank will continue to generate annual profits on past loans at 8 percent under the old method, as well as on new loans at a slightly lower level under the new method. In this connection, your staff states that since 7 U.S.C. Sec. 946(c) provides that the minimum amount of Class A stock that must be retired each year after 1995 need only equal at least the amount of Class B stock sold during any such year, the proceeds from such sales of Class B stock can be used to retire the Class A stock. It reasons that the gradual retirement of Class B stock using margins from principal payments on outstanding loans and current yearly profits will have minimal, if any, impact on the retirement of Class A stock at the minimum amount that must be retired.

/8/ See Section 8.2 of Bylaws of Rural Telephone Bank, adopted May 4, 1978. (Reprinted August 1986).

/9/ Article X of the Bylaws provides:

"These bylaws may be altered or amended by a vote of two-thirds of the entire Board at any regular or special meeting of the Board provided the notice of the meeting shall contain a copy of the proposed amendment or alteration."

/10/ Your staff's proposed recommendation for disposition of the excess funds from the Bank's Reserve for Contingencies would allow some Class B stock to be redeemed before all Class A stock is redeemed.

/11/ Clearly, enactment of section 1413 of the Reconciliation Act of 1987 will require the Bank to amend its Bylaws to conform to the changes effected by that law with respect to creation of the new reserve for interest rate fluctuations and abolishment of the Reserve for Contingencies, as well as any recommendations made by BAO concerning the Bank's operations which Congress adopts. However, the Reconciliation Act does not specifically address the redemption of the Bank's Class B stock, but instead directs that GAO study and make recommendations to the appropriate congressional committees with respect to such matters. Thus the government's vested right of prior redemption of its Class A stock has not been abrogated by that statute, and therefore could not be changed by any subsequent amendment of the Bank's Bylaws allegedly to conform those Bylaws to the requirements of section 1413 of the Reconciliation Act.

/12/ Under section 402(d) of the Act (7 U.S.C. Sec. 942(d)), the bank is authorized to "acquire, ... hold, maintain, use, and dispose of property." We do not consider this general corporate power to "dispose of property" as an implied statutory authorization to waive the government's right to prior redemption of its Class A stock, since it does not appear broad or comprehensive enough to cover such vested rights. The proviso to section 402(d) indicates that the "property" subject to disposal under that provision refers to property of the Bank, acquired for purposes of conducting the Bank's operations, or property which is pledged or mortgaged to secure Bank loans.

GAO Contacts

Office of Public Affairs