A Corporate Duty to Hedge? Distinguishing between Speculation and Hedging

I.          Introduction  

In 1992, a group of shareholders brought a derivative lawsuit against the directors of a grain elevator cooperative for their failure to properly hedge the risk associated with the grain industry. Finding for the plaintiffs, the Court of Appeals of Indiana held: “we find that there was probative evidence that [cooperative’s] losses were due to a failure to hedge.” [1]  

 Inexplicably the cited holding has not being subject to detailed analysis by legal scholars. Having passed almost eighteen years since it was decided, the case now faces the risk of being forgotten without ever being the subject of legal discussion.  

This article seeks at determining whether, under the basis of this holding, there should be a corporate duty for directors to hedge. In other words, should directors, at the very least, consider the use of derivatives to hedge the risks of a corporation?  

To answer this question, this paper is divided as follows. Part II stresses that derivatives should not be seen as inherent losers. First, derivative-related scandals do not result from the inherent risk of these instruments but are rather due to other factors that would have made a company collapse, even in the absence of derivative. Second, derivatives are used for two separate purposes: speculation or hedging. Since the use of derivatives for speculation generally leads to a different outcome from the use of derivatives to hedge, the duty of directors to consider the use of derivatives should be limited only to the hedging alternative.  Part III stresses that under current U.S. law directors should have a duty to hedge. Said duty to hedge should not be understood as an absolute duty. It should be circumscribed by the limits established by U.S. case law on the duty of care, and as such, should be seen as a subcategory of the latter. Also, the duty to hedge should be dependent on directors’ level of information, sophistication and the level of risk a company faces. This section concludes by pointing out that even when such factors suggest the presence of an obligation to hedge, to hold a director liable for failure to implement hedging strategies is conditioned on overcoming the lengthy steps of the business judgment rule. Part IV presents a general conclusion.  

II.        Are Derivatives Inherent Losers? The fine line between hedging and speculation   

For those not familiar with the derivatives market, the word “derivatives” is synonymous with corporate scandals, Wall Street opulence, or highly risky investments that often lead to bankruptcy. The negative view of derivatives has been promoted by newspapers around the globe that tend to highlight catastrophes involving derivatives that devastate companies. Scandals such as Barings Bank, Metallgesellschaft, Orange County [2] and the recent credit-default swap crisis, would suggest to a non-savvy investor that derivatives are synonymous with evil and hence, should be kept out a business’ door.  

Despite the above, the amount of losses resulting from derivative-related scandals is minimal when contrasted with the total amount of money invested by companies in the derivatives market. In 1993, the Swaps Monitor, an industry newsletter, reported that the derivatives market amounted to a total of US$24 trillion, representing approximately four times the size of America’s domestic product by that time. [3] Just recently, the International Swaps and Derivatives Association reported that at the end of 2006 the derivatives market amounted US$283 trillion, an exorbitant amount when compared with the US$34 trillion resulting from the sum of the gross domestic product of the United States, the European Union, Canada, Japan and China. [4] The size of the derivatives market keeps growing and growing. By December 2008, Newsweek reported that the size of the market amounted to US$600 trillion [5], an exponential increase when compared with the size the market had in 1993 and 2006.  

In the US, the use of derivatives takes place every day and constitutes a fundamental business tool for both blue chip corporations and relatively small companies aiming at reducing their risk. Nearly 75% of US largest companies use derivatives and nearly 94% of Fortune 500 CEOs are satisfied with their firm’s use of these instruments. [6] 

These figures suggest that derivatives play a major role in today’s financial market. In the words of William McDonough, former president of the Reserve Bank of New York, “the existence of derivatives increases the level of investment and makes possible greater economic growth.” [7] 

The figures also suggest that the negative bias of some lay investors towards derivatives is wrong. A careful analysis of the derivatives-related scandals mentioned above show that the source of the problem does not merely emerge from the use of the derivatives but instead, from either a failure to properly use such instruments, or from other externalities such as poor corporate governance mechanisms. The Barings scandal is a clear example. Baring’s chief Singapore trader, Nick Leeson, bought several exchange-traded futures contracts based on the Nikkei average and traded on the Tokyo Stock Exchange. Leeson, believing that the Nikkei would rise, took speculative positions in order to increase his and the Bank’s gains. [8] When the Nikkei index fell, the Bank was not able to cover the losses and collapsed. [9] The cause of the collapse was not the use of the derivatives per se, but rather, inadequate investment management practices that would have led to financial disaster even in the absence of derivatives. [10] 

In contrast to the Barings Bank scandal, when derivatives are properly used they tend to be very effective in reducing risk. By using futures, oil companies reduce their exposure to price volatility in a specific transaction and plan future purchases and sales of its inventory. Pharmaceutical companies operating around the world use option contracts to hedge foreign currency transactions and equity investments in non-US subsidiaries. Mega companies employ interest rate swap agreements to change interest rate of a specific debt issuance. [11] 

Since the above analysis shows that derivatives are not inherent losers by nature, the following question arises: Why is it that in some cases the use of derivatives is beneficial while in others result in a catastrophe? The answer to this question depends greatly on the way derivatives are used. Although there is a broad spectrum on how derivatives may be used, the financial literature has identified two general categories: hedging and speculation. [12] 

Speculation can be defined as the practice of theorizing about matters over which there is no certain knowledge. [13] Speculators are traders who enter into a derivative agreement with the intention to seek profits by accepting high levels of risk; they rarely have an inherent interest in the market they participate. [14] By contrast, hedging refers to the use of two compensating or offsetting transactions to ensure a position of breaking even. [15] Hedgers enter the market with the purpose of reducing or eliminating an existing risk. [16] Both hedging and speculation complement each other, and in a way, are necessary for the derivatives market to function. Hedgers mitigate their risk by transferring it to other investors (normally speculators). [17] Speculators ensure adequate liquidity in the market by taking risky positions that hedgers are not willing to take. [18] 

The negative stigma given to derivatives over the years corresponds more to their speculative use rather than to the use of these instruments to hedge. [19] Therefore, the question as to the scope of the duty of directors to use derivatives should revolve around hedging only and not speculation.  

From a policy perspective, this conclusion is nonetheless far more complex and controversial than what it appears. First, in Delaware the standard against which directorial decision-making is measured is gross negligence rather than mere negligence. This means that Delaware courts encourage directors to be business risk takers. [20] Second, since investors are by definition risk averse [21] it would not be necessary for directors, at least in theory, to avoid the use of derivatives for speculative purposes because (i) investors would diversify or modify their individual risk with less risky investment such as treasuries; or (ii) make their own hedges if they have not diversify or modify their risk.  [22] 

While the foregoing may be true, it is argued that since the fiduciary duties of a director impose on such director the obligation to act in the best interest of the corporation, the business and investment decisions taken by directors should be addressed to mitigate and reduce the corporation’s risk (hedging) rather than to create it (speculation).  

By principle, a company would expect to get more return if it is to assume more risk. Thus, if the same return is available at a lower risk, investing at a high risk for the same return would be irrational. Since future expected returns are uncertain (there is a risk that such returns would be lower than expected even when the same investment was made) directors are required by their own mandate to avoid risk-taking strategies and hence, to keep away from speculation. By the same token, if hedging avoids risks (and generally keeps the return expectations equal, at the very least), it is irrational not to hedge. In other words, not hedging would be speculating. This conclusion is circumscribed by the type of business a company undertakes. If the corporate purpose of a corporation tells its shareholders and the market that its goal is to sell grain (as in Brane v. Roth) and not to speculate an ordinary prudent board should protect itself from price fluctuations and be obliged to hedge. Conversely, if the purpose of the company is to speculate directors should follow such guidelines and carry out the activities that the company’s purpose mandates.  

 


[1]Brane v. Roth, 590  N.E.2d 587, 589 (Ind. Ct. App. 1992).  

[2] See generally Edward Adams & David Runkle, The Easy Case for Derivatives: Advocating a Corporate Duty to Use Derivatives, 41 Wm. & Mary L. Rev. 595 (2000) (stating, generally, the use of derivatives as a corporate duty requirement).  

[3] Saul Hansell, Derivatives as the Fall Guy: Excuses, Excuses, N.Y. Times, Oct. 3, 1994 at § 3.  

[4] Floyd Norris, Off the Charts; What’s a couple of Hundred Trillion When You’re Talking Derivatives, N. Y. Times, Sept. 23, 2006 at § C (stating that although the statistics show the nominal value of the derivatives market, the growth rate is real).  

[5] Barret Sheridan, 600,000,000,000,000?, Newsweek, Oct.18, 2008, http://www.newsweek.com/id/164591.  

[6] Kelly Holland et. al., Did Proctor & Gamble play with fire?, Bus.Wk., Apr. 25, 1994 at  38.  

[7] Saul Hansell, supra note 3.  

[8] Edward Adams & David Runkle, supra note 2, at 10. For a complete review of the Barings Bank case see Paul Stonham, Whatever happened at Barings? Part Two: Unauthorized trading and the Failure of Controls, 14 Eur. Mgmt. J., 3, 269–78 (1996) (analyzing the debacle of Barings Bank).  

[9] Id.  

[10] George Crawford, A fiduciary duty to use derivatives? 1 Stan. J.L. Bus. & Fin. 307, 318 (1995) (discussing the use of derivatives by directors).

 

[11] Edward Adams & David Runkle, supra note 2, at 4.

 

[12]  Id. at 3.  

[13] Lynn Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives,48 Duke L.J. 701,735 (1999) (discussing the impact of speculation in the derivatives market).  

[14] Robert Aalberts & Percy Poon, Derivatives and the Modern Prudent Investor Rule: Too Risky or Too Necessary?, 67 Ohio St. L.J., 525, 553 (2006) (contrasting hedging with speculation)  

[15] Black’s Law Dictionary, (8th ed. 2004).  

[16] Robert Aalberts & Percy Poon, supra note 14 at 536.  

[17] Id. at 14  

[18] Id.  

[19]Edward Adams & David Runkle, supra note 2, at  3.  

[20] Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).  

[21] William Bratton, Corporate Finance, Cases and Materials 120-21 (Foundation Press, ed. 2003).

[22] Joy v. North 692 F.2d 880 (2d. Cir. 1982) (“[G]iven mutual funds and similar forms of diversified investment, courts need not bend over backwards to give special protection to shareholders who refuse to reduce the volatility of risk by not diversifying.”).  

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