If a court finds that negligent corporate acts or omissions generate unnecessary and preventable losses what are the potential sanctions? loss of reputation? fines? Jail? The conclusion of this article is that senior management has a positive duty to protect (hedge) the value of the firm against any material risk that it knows or ought to know; or, at a minimum, directors or senior officers (collectively, “Directors”) must provide a fully informed, fully reasoned, reasonably justified, basis for not hedging.
Context: Market Risks and Losses
“If it be not now, yet it will come—the readiness is all.” (Hamlet: Act 5, Scene 2)
Market risks include all risks that attach to production inputs or outputs controlled by world markets; those risks that a company does not control. Material corporate losses can accrue from market moves in interest rates, commodities, or currencies (“risk factors”). These losses are coming; the question is when. How does the law address decision-making when corporate losses are predictably unpredictable? In other words, are Directors legally immune from foreseeable mitigable losses simply because the risk of those losses come from international markets?
Consider moves in the dollar. Importers fear a weak dollar; exporters fear a strong dollar. Directors know which moves are detrimental to earnings. All else being equal, if the dollar takes a 25% unfavourable move the result is a dollar for dollar assault on corporate income. Costs for the importer increase by 25%; sales revenue of the export decreases by 25%. Unless a corporation can pass on the pain, the damage is certain and quantifiable.
Directors know when risks to the company are material. But in many cases market risk is not properly addressed.
Hedging, the Indefensible Position, Speculation and the Leveraged Play
Many corporate decision-makers have, paradoxically, confused hedging with derivatives as gambling with the treasury. Maxims include the following: “doing nothing” to mitigate market risk is the safe course; using hedging instruments is speculative; fluctuations in market risk factors are certain, uncontrollable business risks that even out in the long run. Relevantly and unfortunately, as Lord Keynes explained, “in the long run we are all dead”.
These positions are not defensible.
The indisputable fact is that not hedging market risks is speculating with corporate cash flow. Speculating with cash flow is speculating with income, and speculating with income is speculating with firm value.
A director’s paramount goal is to optimize firm value (E. M. Iacobucci, “Directors’ Duties in Insolvency: Clarifying What Is at Stake” (2003), 39 Can. Bus. L.J. 398, at pp. 400 1). Maximizing firm value is in fact a fiduciary duty owed to the company. However, firm value optimization becomes a roll of the dice if managers roll the dice with risk optimization.
The materiality of firm risk is commensurate with enterprise operational structure. If a company is a pure exporter—all costs in native currency and all revenues in foreign currencies–this is a leveraged play. The higher the risk-associated percentage of revenues or costs to total revenues or costs, the higher the sensitivity to fluctuations in firm value. In other words, for a pure exporter, there is a direct relationship between a corporation’s percentage foreign revenues (100%), its net profit rate, and a percentage change in the relevant foreign exchange rate. That calculable profit sensitivity to market risk can be applied to firm value. Significant changes in exchange rates can result in big losses.
Big Losses: The Certain and Not-So-Certain Reactions
The job of a CFO is difficult. That person often wears many hats: adding the “risk manager” role to those of audit, accounting, staffing, tax, fund-raising etc. may be challenging. While some larger firms employ a Chief Risk Officer (CRO), many who should, have not.
However, when the company takes a 25% stab from international markets the result can be catastrophic depending on the company’s market risk sensitivity to earnings and ultimately firm value. Directors and shareholders may, for over-lapping reasons, express concern.
Director’s general concerns are several, but they all stem from losing money. This is especially so when losses may be preventable. Likewise, stakeholders can be outraged if losses were preventable.
The point is this: blame for losses will search for a home. The board may blame the CFO; the CFO may blame the board; stakeholders of all sorts may blame the company generally. However, eventually all roads lead to one potentially fatal barb to the relevant players:
“Don’t we pay you to protect us from this?”
Shareholders or creditors—anyone with legal standing–can, and do, sue companies and Directors who do not prudently protect corporate earnings. Directors are vulnerable to a variety of career-altering penalties.
Directors, Shareholders and other Stakeholders have Legal Options
Legal actions are available to litigants when senior management take or omit actions that damage the value of the company or the interests of specific stakeholders. These actions can take several forms. Inter alia disgruntled agents can bring “derivative” actions, actions for “oppression”, actions for “breach of fiduciary duty”, or actions for “breach of a duty of care”. These actions can be brought by shareholders, employees, or creditors. In fact, others may be granted standing.
Going back as far as 1994, when I began working in this area, Commissioner J. Carter Beese of the U.S. Securities and Exchange Commission wrote:
But even while some of the press paints derivatives as accidents waiting to happen, some companies are getting hammered if they do not use derivatives to hedge risk. Compaq Computer, which derives over half of its revenues from overseas markets has two shareholder suits currently pending against it in federal and state court. Compaq is being sued for failing to disclose that it did not have sufficient and adequate foreign exchange hedging mechanisms to protect the company from substantial foreign exchange risk.
A much-cited U.S. case is that of Brane v. Roth (590 NE 2d 587 – Ind: Court of Appeals, 1st Dist. 1992). The shareholders sued the directors of a grain co-operative for losses incurred for inadequate hedging in the grain market. The directors authorized the manager to hedge, but the quantum of grain actually hedged was insufficient to protect cash flow. The court found the following breaches by directors:
1. They did not hire a manager experienced in hedging;
2. They did not supervise the manager’s activities;
3. They failed to acquire the requisite knowledge and skills to enable them to direct and supervise the manager adequately.
The court found that Directors’ negligence in protecting grain co-operative profits resulted in $424,000 in losses.
Some commentators seem to minimize the principles and holding of Brane, supra. Their arguments are based in economic theory and are neither supported with experiential data nor common sense. (this may be worthy of an additional post) Any lawyer who counsels a corporation to avoid hedging based on arcane economic theories may find themselves on the business end of a negligence complaint.
These early harbinger opinions and cases matter. In the past 20 years stakeholders have taken a shellacking through the misdeeds of corporate decision-makers. The debacles (Enron, WorldCom, Barings Bank, Orange County, the 2007 meltdown etc.), the academic papers, the media, the new legislation (Dodd Frank etc.), and the movies (The Big Short etc.) conspire to educate stakeholders, regulators and law-makers about risk. In numerous cases the result was criminal and civil proceedings. These days, arguably, stakeholders, regulators, and law-makers have little appetite for questionable corporate acts or omissions. Media headlines support that contention.
“When sorrows come, they come not single spies, But in battalions.” (Hamlet 4.5.78)
The Law
It is all about Corporate Governance.
“The Crises” of 2007 and 2008 gave birth to a legislative spasm, notably the U.S. Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR). At the heart of this near-calamitous-collapse-inducing-compulsory-reflex is the control of market risk. Regulation backed by legal and moral suasion was aimed decisively at responsible corporate governance. Of course, Dodd-Frank enacted margin rules on OTC derivative just in case corporate actors do not get the message. But what are the legal tests that bring Directors in view of legal sanction.
The Legal Test: Ultimately a Corporation Must Satisfy the “Business Judgment Rule”
“Use every man after his desert, and who shall scape whipping (Hamlet, Act 2, Scene 2)
As mentioned above, stakeholders can take legal action against senior management. Here, however, I will focus on the ubiquitously cited and cross-jurisdictionally agreed upon, “duty of care”.
While Directors have a “duty of loyalty”, a fiduciary duty where they must act honestly and in good faith with a view to the best interests of the corporation, this duty is tangentially relevant to the focus of market risk. We implicitly assume that Directors are acting loyally to the company.
The “duty of care” imposes a legal obligation upon directors and officers to diligently supervise and manage corporate affairs. Generally, Directors should identify all material company risks (legally, those risks that are known or ought to be known), inform themselves of all material information reasonably available to them, and do their best to mitigate those risks; or, justify them. Therefore, where risks are material, corporate decision makers must act on a “fully informed” basis. In most jurisdictions the duty of care is legislated (see Peoples Department Stores Inc. (Trustee of) v. Wise, 2004 SCC 68 (CanLII); Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
Under the common law (judge made law) Directors must avoid “grossly negligence” with respect to the affairs of the corporation. Decision makers were judged according to their own personal skills, knowledge, abilities and capacities. In most jurisdictions, however, statutory requirements have tended to stiffen these standards and consequently put pressure on corporations to improve the quality of board decisions.
Differences in the legal test across jurisdictions are only gradients of the similarities. In other words, the elements that satisfy the duty of standard of care are largely the same everywhere; it is only the legal interpretation of the respective elements that may make a difference. For example, a couple of differences may be found in the following elements:
The Standard of Care. Where on the standard of care continuum does the skill test fall: “professional person”, “average person”, or “reasonable person”?
The Test of Negligence. Where on the standard of negligence continuum does this legal test fall: “gross negligence (U.S.) or ordinary negligence (Canada)? And does the level of negligence dictate the sanction by the courts?
Courts do not impugn all bad corporate decision-making. In fact, courts have developed a rule of deference to business decisions called the “business judgment rule”. Decisions, whose ex post facto results turn out to be detrimental to the company, will not attract legal reparations if the ex ante reasons for taking such action was reasonably defensible. Again, according to the standard of care test, Directors must employ a standard of skill, make fully informed decisions considering all circumstances Directors knew or ought to have known, in the best interests of the company.
To fall within the defensible protections of the business judgment rule a decision-maker must perform the requisite due diligence. Upper management actually must make a fully informed judgment based on a proper analysis of the relevant risk Kerr v. Danier Leather Inc., [2007] 3 S.C.R. 331, 2007 SCC 44 (CanLII). A fair corollary axiom would be the following: the more material an identified risk is to the company the deeper the duty to be fully informed.
In evaluating business decisions according to the duty of care and the business judgment rule, the courts will fairly address industry standards. Industries exhibit particular best practices. There are spectra of skill, spectra of available information, and, to some extent, spectra of expectations. It should be noted that the trend is toward uniformity across industries when assessing risk (see ISO 31000 from the International Organization for Standardization in Geneva; adopted as the national risk management standard in most developed countries).
For plaintiff stakeholders to succeed in challenging business decisions they must establish that the Directors acted as follows:
(i) in breach of the duty of care and
(ii) in a way that caused injury to the plaintiff.
(for a relevant discussion see W. T. Allen, J. B. Jacobs and L. E. Strine, Jr., “Function Over Form: A Reassessment of Standards of Review in Delaware Corporation Law” (2001), 26 Del. J. Corp. L. 859, at p. 892).
“And where the offence is let the great axe fall.” (Hamlet 4.5.219)
Do Directors have a Duty to Mitigate Market Risks?
If market risks are material, Directors must undertake responsible due diligence relating to those risks.
The duty of care decidedly burdens Directors with a duty to make market risk decisions on a fully informed basis. As discussed above, an exporter with 100% domestic costs, and 100% foreign currency revenues, has a large income and valuation risk; Directors know the risk exists (or legally ought to know). The process of being fully informed and making an informed decision must flow from that knowledge. The exposure to market risk and its potential to reduce firm value induces and drives of the duty of care. Quick-changing production functions of a firm ensconced in an increasingly standardized global environment, make reliance on out-dated industry standards a flimsy defence.
Hedging is tantamount to insurance. Insurance hedges against unlikely events, protecting at least in part, the value of a company. Imagine the folly of a company not insuring its buildings or equipment (part of the value of the firm) against the vicissitudes of fate. Analogously, in finance, not insuring a company’s future cash flows when it is possible to do so, must be tantamount to a measured (or foolish) dice roll. Hedging insures cash flows. Logically therefore, hedging insures against losses in firm value. The duty of care to protect firm value must be commensurate with the sensitivity of firm value to market risk.
Conclusion
“If it be not now, yet it will come—the readiness is all.” (Hamlet: Act 5, Scene 2)
Where a market risk exists, senior management must be fully informed on the extent of those risks to income and firm value. They then must explore the methods and costs of risk mitigation; or at the very least, they must provide a fully informed, fully reasoned, reasonably justified, basis of a decision not to hedge. This is fundamental to a defence under the business judgment rule.
Richard Storey is a British Columbia based lawyer who specializes in securities and related structures. He has an MBA and a law degree from Cambridge University. For 12 years he worked in the world of financial derivatives (futures, forwards, options, swaps etc.) managing risk for large Canadian and U.S. companies.