III. IS THERE A CORPORATE DUTY TO HEDGE?
In light of the preceding section it is clear that when derivatives are properly and cautiously used they create benefits to a busines. Current US case law is unclear in establishing whether or not directors of a corporation should consider at least the use of derivatives to hedge a material market risk, in other words, whether the fiduciary duties owned by directors to the shareholders of a corporation impose an implicit obligation to hedge.
The conclusion reached by the Court of Appeals of Indiana in Brane v. Roth[1] offers important clues as to the scope of the use of derivatives in companies dealing with agricultural commodities.
A. The Point of Departure
In Brane v. Roth[2] the Court of Appeals of Indiana was confronted with a derivative lawsuit involving a dispute between a group of shareholders and the directors of a rural grain elevator cooperative (Co-op). [3] Pursuant to the facts of the case, approximately 90% of Co-op’s business was devoted to the purchase and sale of grain.[4] Since Co-op had economic difficulties, the directors decided to implement a new strategy.[5] Under the new strategy, Co-op would hedge its grain position to protect itself from the volatility of the grain market. Although Co-op’s directors authorized the manager to hedge, only a minimal amount was effectively hedged (US$20,500 out US$7,300,000 of Co-op’s total grain sales)[6]. Shareholders brought a suit alleging that director’s failure to adequately hedge in the grain market had caused the losses to Co-op.[7]
The lower court found in favor of the shareholders and stated that Co-op’s directors had breached their fiduciary duty by retaining an inexperienced manager, by failing to maintain reasonable supervision over him, and by failing to attain knowledge of the fundamentals of hedging to be able to direct the hedging activities and supervise the manager.[8]
The Court of Appeals reaffirmed the lower court’s decision stating that Co-op’s losses resulted from the failure to hedge.[9] The position taken by the court was corroborated by both a witness and an outside expert in the grain market who testified that grain elevators cooperatives should engage in hedging activities to protect themselves from the fluctuations of the gain industry. [10]
B. Aftermath of Brane v. Roth, delimitations of the obligation to hedge
The conclusions of the court in Brane v. Roth highlight that speculation is not welcomed at a corporate level since shareholders are by principle, risk averse[11]. Since Co-op’s hedging strategy was only limited to a small portion of Co-op’s total grain sales, it is argued that the large non-hedged portion was used by Co-op for mere speculative purposes and therefore such speculation should be actionable at the corporate level. Accordingly, the case suggests that given the existence of price protection in the market, directors of a corporation have a duty to at least explore the use of derivatives to protect risk exposure because otherwise, they would be speculating on the future price of such commodity.
The decision of the court, although innovative in the derivatives market, reflects the general common law standard of care developed by US courts. Pursuant to such standard, a director wishing to invoke the protection of the business judgment rule is in the obligation to inform himself prior to making any business decision.[12] Once informed, said director has the additional duty to act with requisite care in the discharge of their duties.[13] Directors who comply with their duty of care (and with their duty of good faith and loyalty) are protected by the benefit of the business judgment rule.[14]
This article posits that the obligation to hedge is intimately attached to the standard of care developed by US courts and therefore, should not be seen as a complete stranger. Putting it bluntly, the liability of Co-op’s directors resulted from failing to comply with their duty of care by not properly hedging in the grain market. Nonetheless, the duty to hedge should be seen as a sub-category of the duty of care. For that reason, the extension, implementation and scope of the obligation to hedge should not only be circumscribed by the duty of care parameters but also, should be bounded by narrower conditions of applicability, three of which are identified in this article: level of information; level of sophistication, and level of risk.
1. Level of Information:
U.S. courts have long stated that in order to determine if directors’ decisions fall within the protection granted by the business-judgment rule a fact finder must analyze the type of information available to such directors at the time the decision was taken.[15] While directors are not required to be informed of every fact, especially those deemed immaterial or out of director’s reasonable reach, they are responsible for considering all material information reasonably available to them prior to making a business decision.[16]
Determining the type of information that is deemed to be material depends in turn on the industry standards required for directors in the field where the company undertakes its activities.[17] Industry standards provide minimum levels of skill and expertise that directors must have when presiding a business in a specific industry.[18] Industry standards are, thus, quintessential in establishing if directors are properly informed and if they have an obligation to hedge.
While courts have not imposed liability on directors for failure to follow specific standards; there are various examples where other fiduciaries have been held liable for failure to comply with industry regulations.
In Gilbert v. EMG Advisors,[19] the court, highlighting that the ERISA fiduciary duties were the highest known to the law, held that an investment manager had breached his fiduciary duties for failing to conduct a thorough investigation before investing certain assets belonging to a retirement fund in a complex derivatives scheme.[20] Similarly, in Evanston Bank v. Commodity Services Inc,[21] the district court held that a broker could be liable for speculative trading conducted in a client’s hedge account where those trades resulted in a violation of federal banking policy.[22]
These are but two examples that illustrate the general view of the courts as to the importance of the industry standards in assessing the type of information directors should consider when taking a business decision. These cases are instrumental in showing that: (1) The standard to which directors may be found accountable differs greatly from one industry to another. Therefore, such differences should be taken into consideration when deciding whether or not directors have to consider the use of derivatives to reduce risk exposure; (2) When directors or fiduciaries analyze and gather information they are compelled to fulfill the requirements imposed by industry standards; (3) Expectations as to the knowledge and expertise of fiduciaries differ depending on the industry in which the company operates.
2. Level of Risk:
In addition to the information factor, the level of risk to which a company is exposed determines whether or not a director has the duty to consider the implementation of hedging strategies. This article posits that directors should consider hedging strategies only in cases where lack of hedging results in a material risk to the company[23].
In the context of the duty of care, the Delaware Supreme Court has defined materiality as any event that is relevant and of such magnitude that directors must take into account in performing their fiduciary duties.[24]
A perfect example of a material risk can be found in Brane v. Roth. The risk exposure of a grain elevator cooperative, like Co-op, was so material that implementing hedging trough derivatives seemed necessary for the business (approximately 90% of Co-op’s business was buying and selling grain).[25] By contrast there are a handful of examples where such materiality may not be present, for instance, when the risk is not closely related to the main purpose of a corporation but instead is secondary and insubstantial to the business. In these latter cases there should not be an obligation to hedge.
A hypothetical may be useful to illustrate this point: ALFA is a corporation that produces furniture. 85% of ALFA’s furniture derives from wood. ALFA cuts trees in Region A and transports its trees to Region B. The cost of gasoline for the transportation of the wood from A to B is marginal and amounts to less than 0,01% of the total costs of production of the furniture. ALFA has learned that a group of environmentalists are lobbying a law that would prohibit the cutting of trees in certain regions where ALFA and most of its competitors operate. Though it is not certain that the environmentalist would be successful, there is a potential risk that the price of wood would increase. Parallel to this, the government is drafting a preliminary decree that would raise the gasoline tax with the aim of financing the construction of a hospital in Region C. Assuming that ALFA’s board of directors has taken the necessary steps to analyze the above situations, is ALFA’s board obliged to hedge (i) the price of gasoline; (ii) the potential passage of the law (ii) both? It is argued that while ALFA should enter into a derivative contract (e.g. a forward) to hedge the negative effects the law may on the price in wood; ALFA’s board should not be obliged to hedge the price of gasoline because the increase of such price does not represent a material risk to its business.
3. Level of Sophistication:
Another factor that conditions the applicability of the duty to hedge as a sub-category of the duty of care is the level of sophistication. The sophistication factor stems from the right of the shareholders of a corporation to elect the members of the board of directors. Presumably, when the shareholders of a corporation are sophisticated, the members of the board of directors will also be sophisticated and should be capable of understanding the sometimes complex world of derivatives. Conversely, when the shareholders of a corporation are not sophisticated it is likely that the members of the board would not have the same qualities and understanding of derivatives than that of the sophisticated board. It is therefore argued, although not in absolute terms, that the shareholders of the latter board (non-sophisticated) may not imply in its elected directors a complete understanding of derivatives. 4. Other limitations
In addition to the delimitations exposed in this section, the business judgment rule constitutes an additional delimitation of the duty to hedge. Since it is argued that the duty to hedge is a sub-category of the duty of care, to hold a director liable for failure to use, or at least consider the use of derivatives it is necessary to follow the tortuous steps of the business judgment rule. This means that a plaintiff would have to assume the burden of providing evidence that directors, in reaching their business decision, breached any one of the triads of their fiduciary duties.[26] Failing to meet this evidentiary burden implies that the courts will concede full authority to the decision reached by the directors and grant the protection of the business judgment rule.
Furthermore, plaintiffs must show that the losses sustained are attributed to the failure of directors to use derivatives due to their gross negligence.[27] Since the duty of care focuses on the procedures taken by directors rather than the results, directors would not be held liable for mere errors of judgment in their decision-making but instead, they would be liable for losses occurring due to their gross inattention to the business or their willful violation of their duties.
IV CONCLUSION
The duty of directors to consider the use of derivatives is limited by various elements. First, the question as to whether directors should or should not use derivatives should revolve only around the hedging rather than the speculative practices. While speculation plays an important role in the derivative market, it is argued that such practices should be limited, at least theoretically, to corporations whose corporate purpose is to speculate in the market. Accordingly, the obligation to consider the use of derivatives by directors should be narrowed to the hedging activities. Highly publicized scandals serve as evidentiary support of this argument.
Second, the use of derivatives to hedge is in turn restricted by at least three factors that condition its applicability and scope. Departing from the assumption that the obligation to hedge is a sub-category of the duty of care, this article shows that the levels of information, risk and sophistication play a major role in determining whether or not directors have an obligation to hedge. Even when all the conditions of applicability of the duty to hedge are fulfilled; a plaintiff must still overcome the requirements of the business judgment rule. Since the obligation to hedge is a sub-category of the duty of care, a plaintiff must sustain the burden that in reaching a business decision the directors failed to comply with their fiduciary duties. Thus, while this article argues in favor of the existence of an implied obligation to hedge, it shows that its applicability, extension and scope is restricted and will depend upon on the applicability of the business judgment rule.