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"To hedge or not to hedge? Directors liable for losses" 28 Apr. 93, IFR Swaps, London
This article forms the basis for a chapter in "Key Financial Instruments: understanding innovation in the world of derivatives" 4 February 2000, Commissioned by Financial Times Prentice Hall ISBN 0273 63300 7 London link
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by Warren Edwardes
¿To hedge or not to hedge? Esta es la cuestión Viernes 16 de Julio de 1993, Cinco Días, Madrid link
The recently uncovered Billion Dollar "Shell Shock" in Japan and consequent resignations following misadventures by Allied Lyons and Volkswagen have led to increased scrutiny of derivative activity within Treasury operations.
Avoidance of derivatives is, arguably, no longer a soft option. Last year a Court of Appeal ruled that "directors breached their duty in failing to supervise (the) manager and become aware of essentials of hedging to be able to monitor business .... the primary cause of the gross loss was the failure to hedge."
Without wishing to pore over troubled oil nor water down the implications for Treasury management, Corporate and Bank Boards of Directors and Central Bankers are rightly concerned about their firms' exposure to risk management instruments. The court case, however, suggests that throwing the baby out with the bath-water can be equally dangerous.
The US legal journal, North Eastern Reporter, related the ruling on 1 June 1992 by the Courts of Appeal of Indiana on the case of Brane v Roth. The case did not involve another "Blue-Chip" corporate or Investment Bank. It related to the activities of a small rural grain co-operative and shareholders' action against its directors for losses the Co-op suffered in 1980 as a result of the directors' failure to protect its position adequately. The firm could have hedged in the Chicago Board of Trade grain futures market.
Nearly ninety percent of the Co-op's business was buying and selling grain. The directors met monthly reviewing the report of the manager who handled the grain transactions and the financial reports produced by the Co-op's book-keeper. Profits had fallen in successive years since 1977 and after a substantial loss in 1979 the firm's accountant recommended that the directors hedge the Co-op's grain position to protect itself against future losses. The directors did in fact authorise the manager to hedge but despite grain sales totalling $7,300,000 only $20,050 in futures contracts were effected. The fall in the grain price resulted in a gross loss for the co-operative business in 1980 of $424,039.
What could send shivers down many a Directorial spine is the court thinking behind its finding that the Co-op's directors breached their duty of care. They breached their duties by retaining a manager inexperienced in hedging; failure to maintain reasonable supervision over him; and failing to attain knowledge of the basic fundamentals of hedging to be able to direct the hedging activities and supervise the manager properly; and that their gross inattention and failure to protect the grain profits caused the resultant loss. The directors argued that they relied upon their manager and should be insulated from liability, the court ruled that "the business judgement rule" protects directors from liability only if their decisions were informed ones.
The Indiana case could turn out to be the first of many. The ruling is likely to prove an irresistible precedent for the Legal and Management Consultancy professions. Furthermore, publicity surrounding derivatives losses in Corporations which might have tempted Boards of Directors to adopt the ostrich-like approach of "let's leave everything uncovered and blame losses on the Bundesbank" could well rebound.
The Building Societies Commission has laid down strict guidelines regarding the use of hedging instruments. The BIS and Central Banks regularly express their fears over the burgeoning market in derivatives. Boards have in the past blamed unforeseen "adverse exchange rate movements" at their AGMs to explain away their losses. Equal attention must be paid to the management of "natural" exposures generated by on-balance-sheet assets or liabilities. Will, for example, the Non-Executive Directors of a Building Society or Savings Bank be comfortable in allowing their Treasurers to offer a tranche of fixed rate mortgages without a swap to hedge interest rate exposure?
Ignorance of derivatives is, perhaps, no longer an excuse for failing to use them.
Warren Edwardes, CEO Delphi Risk Management Limited