The easy case for derivatives use: advocating a corporate fiduciary duty to use derivatives.

Author:Adams, Edward S.
 
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In the 1990s, derivatives left their mark in newspaper headlines, financial statements of corporations, and the minds of brokers, CEOs, shareholders, lawyers, regulators, legislators, and investors worldwide. Two very distinct perceptions of derivatives have emerged, depending on one's level of sophistication and personal experience with derivatives. To victims of misused derivatives, with inadequate, information, they can be seen as a herd of stampeding zebras: terrifying and destructive. Containing their power can be a mystery. From this perspective, avoidance is the only safe harbor. To the savvy investor, derivatives are more akin to a team of horses. Harnessed and used appropriately, they are productive, efficient tools that maximize resources and reduce risk; however, when inadequately harnessed or misused, they have the ability to deliver a painful bite or even a fatal kick.

In all fairness to the "derivaphobes," good reason exists to be wary. During the 1990s, derivatives were blamed for major financial losses across every sector of the economy. They spared no industry and chose indiscriminately between large and small, new and old companies. From 1983 to 1993, the total reported monetary loss attributed to derivatives was about $2.1 billion.(1) In 1994 alone, however, this loss mushroomed to $10 billion.(2) Some of the most notable publicly reported or acknowledged derivatives losses include:(3) Gibson Greetings ($20.7 million);(4) Proctor & Gamble ($157 million);(5) MG Corp., the U.S. subsidiary of Germany's Metallgesellschaft AG ($1.5 billion);(6) Dell Computer ($43 to $53 million);(7) Atlantic Richfield Co. ($22 million);(8) Marion Merrell Dow Inc. ($11.1 to $13.9 million);(9) Mead Corp. ($7.4 million);(10) Paramount Communications ($20 million);(11) Caterpillar Financial Services Unit ($11.5 million);(12) City Colleges of Chicago (approximately $48 million);(13) Odessa College ($10 million to $22 million);(14) Escambia County, Florida ($25 million);(15) and Wisconsin's investment fund ($95 million).(16)

Two of the most infamous and devastating derivatives catastrophes ended in bankruptcy. One of England's oldest banks, Barings PLC, founded in 1763,(17) could not survive an estimated $1 billion loss attributed to derivatives.(18) Orange County, California, one of the wealthiest counties in the country, filed for Chapter 9 bankruptcy after suffering a loss of almost $2 billion as a result of derivative misuse.(19) According to their broker, Merrill Lynch, however, the portfolio could have rebounded to its full $21 billion value, plus $300 million in interest, if Orange County had ridden out the losses for a few more months.(20) A flurry of investigation and litigation, both civil and criminal, has surrounded Merrill Lynch ever since the county's bankruptcy filing.(21) The brokerage firm recently agreed to pay a $2 million penalty to settle SEC charges of negligence in the company's dealings with Orange County.(22) The settlement closed the door on over three years of controversy and litigation concerning Merrill and the Orange County debacle. Previously, Merrill settled with the county for $437.1 million in a civil suit and agreed to pay $30 million to resolve a criminal investigation.(23) Merrill consistently denied any wrongdoing throughout all legal proceedings.(24)

The Asian currency crisis of early 1998 renewed skepticism about the safety of derivatives.(25) In February 1998, J.P. Morgan & Co. filed suit against a large South Korean bank and a South Korean securities firm, SK Securities Co., for their inability to fulfill obligations on swap contracts involving exchange of U.S. dollars for various Southeast Asian currencies.(26) SK Securities filed its own lawsuit against J.P. Morgan in Korea for failing to adequately inform SK Securities and other local investors about the risks involved in the derivatives transactions.(27)

The sharp devaluation of the Russian ruble in mid-August of 1998 continues to shake investors' confidence in the foreign market and the use of derivatives.(28) In addition to allowing the rubble's value to drop thirty-four percent, the government also issued a ninety-day moratorium on payments of foreign debt.(29) Western banks will experience substantial losses if the Russian banks refuse to honor the over $10 billion worth of currency deals with foreign lenders.(30) Although most American banks can absorb the losses of the ruble devaluation, some have experienced severe losses.(31) The Republic New York Corporation reported losses in Russia equal to its total third-quarter earnings for 1998.

These devastating losses did not have to occur. Properly used, derivatives have more advantages than disadvantages. Derivatives offset business risks, such as fluctuating interest and foreign exchange rates and commodity prices. In fact, the costs of not using derivatives vastly outweigh the costs of using them. Despite high profile losses, derivatives use has exploded throughout the 1990s.(32) Between 1995 and 1996, the use of interest rate swaps, currency swaps, and interest rate options contracts grew by 37.1%.(33) This statistic indicates that derivatives are an indispensable tool in corporate investment portfolios.

This Article hypothesizes that directors have a duty to shareholders to investigate and evaluate how derivatives could minimize risk to their organization. Even more, corporations have a duty to use derivatives if overall portfolio risk will thereby be reduced. Part I of this Article defines and describes the major types of derivatives and explains how and why they are used.(34) Part II investigates the risks of derivatives, comparing these risks to other investment instruments.(35) Part III introduces a new conceptualization of derivatives through exploration of three issues surrounding their use: (1) brokers' liabilities to investors when financial losses result; (2) corporate liability to shareholders for losses; and (3) the possibility that in certain contexts, a corporation has a duty to its shareholders to use derivatives to manage business risk.(36) Part IV proposes a risk management strategy designed to minimize the inherent risks of derivatives and to maximize their advantages in managing ordinary business risk.(37) Part V concludes with a look to the future of derivatives.(38)

  1. WHAT IS A DERIVATIVE?

    Peter Hancock, head of Global Derivatives at J.P. Morgan, explains rather inaccurately that "derivatives ... seem to have come to mean anything that lost money."(39) A more formal definition of a derivative is: a financial instrument, or contract, between two parties that derives its value from some other underlying asset or underlying reference price, interest rate, or index.(40) Although there are over 1200 different types of derivatives in existence,(41) many of which can be combined in complex ways,(42) almost all of them fall into one of four major categories: forwards, futures, options, and swaps.(43) These categories can be further divided into exchange-traded(44) and over-the-counter (OTC) derivatives.(45) All futures and many options contracts have been standardized and are traded on established exchanges.(46) Other derivatives, such as forwards, swaps, and some options, are custom-tailored contracts.(47) These derivatives are referred to as OTC derivatives because they are not traded on exchanges, but rather typically are negotiated between counterparties.(48)

    1. How and Why Derivatives Are Used

      Prior to the 1990s, knowledge about derivatives was uncommon outside of the most sophisticated investment circles. Today, approximately seventy-five percent of the largest companies in the United States use derivatives.(49) The market for derivatives has been estimated to be in the trillions of dollars.(50) According to the United States General Accounting Office, the surge in derivative use within the past two decades is due to "fundamental changes in global financial markets."(51) Those changes have led to increased demand for cost-effective protection against the risks known to result from movements in foreign exchange rates, interest rates, equities, and commodity prices.(52)

      The recent "Group of Thirty Survey" reported that ninety-four percent of Fortune 500 CEOs are satisfied with their firm's use of derivatives.(53) How are these derivatives being used? Although new uses for derivatives are being created continuously, most fall within two broad categories: hedging and speculation. Although most corporations use derivatives to hedge against adverse changes in the value of assets or liabilities, many investors, including some corporations, use derivatives to speculate in an attempt to profit by anticipating changes in market rates or prices.

      Eighty-two percent of the corporations recently surveyed use derivatives to hedge against market risks arising from new financing arrangements.(54) Seventy-eight percent use derivatives to manage or modify the characteristics of their existing assets and liabilities, and thirty-three percent use derivatives to hedge against foreign currency exposure.(55) When properly used as a means of hedging against existing risk, derivatives minimize rather than create risk. In fact, the Economist Intelligence Unit reported that despite "press coverage of so-called risky financial derivatives ... [their use] is a critical factor in reapportioning and reducing companies' overall risks."(56) "Hedging" refers specifically to the activity of mitigating economic risk or loss through the use of a counterbalancing or negatively correlated investment.(57) Hedging requires an end-user to identify specific business assets that are subject to price fluctuations and then to purchase derivatives that offset or counteract the effects of a change in the price of those assets.(58) Hedging ensures compensating gains for losses caused by underlying market movements.(59) Importantly, hedging is not designed to increase an investment's return, but...

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