George Crawford..Stanford..Fiduciary Duties to hedge ESOs with call sales,
1 Stan. J.L. Bus & Fin. 307Stanford Journal of Law, Business & FinanceSpring, 1995Symposium: Regulation of Financial DerivativesCase Studies*307 A FIDUCIARY DUTY TO USE DERIVATIVES?George CrawfordCopyright (c) 1995 by the Board of Trustees of the Leland StanfordJunior University; George Crawford
Does the pervasive use of derivatives within the investment andfiduciary communities compelfiduciaries to learn how to apply them inappropriate instances? This article approaches this question byexamining a fictitious scenario in which, in the midst of daily headlinesdemonizing derivatives, a trustee is sued for breach of fiduciary duty forfailing to use derivatives to hedge the trusts investment portfolio. Thisarticle addresses the merits of such a claim by first reviewing thecurrent uses of derivatives in the banking industry. It then examinessome of the recent headline-grabbing derivatives-related disasters andcontrasts the conservative use of derivatives as a hedge against losswith their risky use for highly leveraged investment. Next, it presents anoverview of the rules the courts have applied to trustees, and theevolution of those rules over the years. The use of derivatives is thenexamined in the context of the most traditional and contemporaryformulations of the Prudent Investor Rule. This article concludes byarguing that fiduciaries may now have a duty to understand uses ofderivatives to achieve the most appropriate mix of risk and return fortheir beneficiaries, and to use derivatives when they offer the bestmeans of achieving that mix.I. The Trustees Dilemma and the Rejected Derivative SolutionThe ticking of the antique clock was the only sound in Franks wood-paneled bank office as he stared open-mouthed at the papers he hadjust received. Sued! Over derivatives! This despite the fact that hisdepartment had never used derivatives, and indeed had little
understanding of what derivatives were. In fact, that seemed to be thebasis for the suit.Frank was being sued for failing to use options to reduce the risk of hisclients investment portfolio. How could this be happening? Derivativesin general, and options in particular, are “dangerous” and“unpredictable” things–arent they? After all, the business pages arefull of stories about derivatives-related disasters. How could a prudenttrustee even consider using option derivatives in a trust?Frank picked up the phone. Within the hour he was sitting in the officeof the banks attorney giving his account of the facts leading up to thesuit.A. A Simple TrustThe trust had seemed so simple, so routine. Barbara had come into thebank with her sister Alice. Barbara was in her 80s and had beendiagnosed with Alzheimers*308 disease. Barbara had given her sisterAlice a power of attorney to handle her affairs. Alice didnt have anyfinancial expertise, and came to the bank for help. She wanted the bankto manage Barbaras stocks and bonds, and make investment decisionsfor Barbara, who could no longer depend on her own financial andinvestment acumen. At the time, Barbara had accumulated an estate ofover $2,000,000.Naturally, Frank suggested placing Barbaras assets in a trust, with thebank as trustee. He called the banks legal department, and it drew up asimple trust agreement (the “Trust”). Two weeks later, Alice returnedto the bank to sign the Trust agreement under the power of attorneyBarbara had given her. Under the Trust agreement, all investment
decisions and management of Barbaras financial affairs would becarried out by the bank. The Trust also provided that on Barbarasdeath the assets would be distributed to Barbaras estate, whichincluded Alice and other siblings. Alice could terminate the Trust, oroverride the banks decisions, but this was unlikely since it was heruncertainty about handling the administration of Barbaras funds andmaking such decisions that brought Alice to the bank in the first place.Together, Alice and Frank opened Barbaras safety deposit box andmade an inventory of the contents. There were bonds totaling about$200,000, thirty different stock certificates totaling $700,000, and stockcertificates for Philip Morris Company totaling $1,500,000. Alice signedthe stock certificates over to the bank as trustee for the Trust. Now, alldividend and interest payments, and proceeds from the sale of stocksor bonds, would be made directly to the bank, which would hold themin a separate account in the name of the Trust. The bank sent a checkfor $3,000 each month to her small town nursing home, and also paidany of Barbaras medical bills and other incidental expenses.The total income of the Trust amounted to $80,000 per year from theinvestments (3% of the $2,400,000 total value of the investments), plus$10,000 a year from Social Security, for a total of $90,000 per year.After paying $25,000 per year in taxes, $45,000 per year for Barbarasliving expenses, and $12,000 per year for the banks fees, the Trust wasleft accumulating $8,000 per year. There certainly seemed to beenough money to support Barbara for the rest of her life–providedthere were no major investment losses.B. The Need for Diversification
Frank knew that diversification was the key to any portfolios safety. Aportfolio of many assets whose values do not rise and fall together ismuch less risky than a portfolio of only one asset, or of several assetswhose values tend to rise and fall together. The banks own commontrust fund was well diversified, containing short, intermediate, andlong-term bonds of varying credit quality, domestic stocks in companiesof varying size and active in many different industries, and even someforeign stocks and bonds. Frank knew this was typical of bank trustfunds and of the pension funds the bank managed as well.Aside from the fact that diversification made good business sense,Frank knew that a lack of diversification involved legal risks. The banksattorney had explained to him that federal law specified that pensionfunds be diversified, and *309 she had given him a copy of the newversion of the Prudent Investor Act, recommended to state legislaturesby the American Bar Association, which states: “The long familiarrequirement that fiduciaries diversify their investments has beenintegrated into the definition of prudent investing.” *FN1+With over sixty percent of Barbaras assets tied up in a single stock,Philip Morris, Frank understood that Barbaras portfolio was exposed toconsiderable risk. He also knew that at Barbaras age she needed safety,not risk. Any additional money she made through risky adventureswould be of little practical use to her, but loss of the money she neededto pay medical expenses and bills at the nursing home could bedisastrous. Frank wanted to diversify Barbaras portfolio, andconsidered selling most of the Philip Morris stock and investing theproceeds in high quality bills and bonds. This would give her greatersafety of principal, less exposure to the volatile stock market, andincreased diversification as between stocks and bonds. As to the
portion of her portfolio remaining in stocks, the companies were welldiversified in size and across industries. If her income from interest anddividends was not sufficient to keep up with inflation in nursing homeand medical costs, Frank calculated that he could spend some of theprincipal for Barbaras needs and the Trust would still be left withample funds for her remaining years.C. The Obstacle to Diversification: TaxesAs he pondered diversifying Barbaras portfolio, Frank considered thetax consequences. He knew that taxes should be considered as a matterof prudent business practice, even though very few courts have heldtrustees liable for mismanaging the tax planning of their beneficiaries.[FN2] The new model Prudent Investor Act provides that “the Trusteeshall consider in investing and managing trust assets ... the expected taxconsequences of investment decisions or strategies.” *FN3+Barbara began investing in the early 1930s, some sixty years before heraffairs were turned over to the bank. She bought stocks and held them,and used dividend reinvestment plans to increase her holdings. Thestocks had appreciated greatly in value over the years; her total costbasis for all her stocks was only $150,000, [FN4] including her PhilipMorris stock, whose basis was only $50,000. Consulting the tax tables,Frank calculated that if all her stocks were sold, the total bill in federaland state income taxes would have come to 40% of the $2,050,000gain, or $820,000, thereby reducing the size of her estate from$2,400,000 to $1,580,000. [FN5] If she received 3% in income on thereinvested proceeds, her income from investments would be cut from$80,000 a year to $47,400 a year. Combined with her $10,000social*310 security income, this probably wouldnt cover her annual
expenses. Still, the plan would leave her investments risk-free, [FN6]even though Frank would have to dip into principal to pay expenses andthe trust would be more vulnerable to high medical and living expensesshould she live for many years.Frank also realized that whatever remained of Barbaras estate wouldbe taxed upon her death. However, if the stock remained in her estateuntil after her death, the cost basis of the stock could be automaticallyadjusted upward to its value on the date of her death. Then, it could besold the next day with no income tax payable at all. Thus, the $820,000income tax bill that would be incurred by selling the stock now could becompletely avoided. The net saving to her estate would beconsiderable. [FN7]More important the principal from which Barbarawas receiving income would not be reduced during her lifetime.Furthermore, Philip Morris paid a good dividend, which would alsodisappear after selling the stock and reinvesting the proceeds in shortterm bonds.Frank believed that the size of Barbaras estate after her death wasprobably of little importance to Barbara. Barbara had no children, andshe had not made any substantial gifts to her brothers and sisters whileshe was alive. True, she had left her money to them in her will, but shehad not indicated to Frank that she wanted to put her own security atrisk during her lifetime in order to leave a larger inheritance behind.As Frank thought it all over, selling the Philip Morris stock now wouldpermit diversification of the trust assets, but payment of income taxeswould considerably reduce the income on which Barbara depended;less importantly it would reduce the after tax value of her estate upon
her death. The question appeared to be whether diversification wasworth the tax cost, now and later.Frank decided to talk the situation over with Alice, who held Barbaraspower of attorney. Alice came to the bank and Frank met with her toexplain things. Alice understood that if the stock were sold now,Barbaras income would fall, and there would probably be less moneyfor Alice and her siblings after Barbaras death. [FN8] If the stock werekept, Barbara would have more money now, and Alice and her siblingswould have more money after Barbaras death. That was in Barbarasinterest as well as her own, Alice thought, and she wasnt going toquarrel with that. Still, she saw that Philip Morris stock could fall invalue, and if it did, there could be less money for Barbara now, and lessfor her later. It would be nice to have it both ways, but she didnt knowhow to do this, and Frank didnt seem to *311know either. Faced with adifficult choice, she and Frank did nothing. Frank was happy enoughwith this, since he had involved Alice in the decision, and it would beharder for her to blame him if it proved to be the wrong one.D. The Proposed Solutions: Options, Hedges and SwapsAfter Alice went home from the meeting, she couldnt help thinkingabout the issues the banker had posed to her-portfolio risk,diversification, and tax considerations. She mentioned the meeting toher sister Edna, who subscribed to several investment magazines, ashad Barbara. Edna noticed a simple explanation of options by the WallStreet Journal, [FN9] which seemed to offer a solution to the issueraised by the banker. [FN10] She wrote Frank a note, in which shesuggested that the bank consider buying puts as a means of insuringagainst a big drop in the value of the Philip Morris stock.
Frank called and thanked Alice for the note, but did nothing about it,considering the cost of buying the puts too high. Several months laterEdna saw another article in Forbes, which specifically used Philip Morrisstock as an example of derivative hedging with options. [FN11] Alicethought that such a hedging strategy *312 sounded sensible, but shewasnt sure she understood it completely. It involved buying puts, butreducing their cost by selling calls at the same time. She also sawanother article in Business Week entitled “When Your Eggs Are All inOne Stock,” *FN12+ which suggested the use of an equity swap to avoidunderdiversification without paying taxes. She clipped out both articlesand sent them to Frank. The publication of these articles in majorfinancial magazines convinced her that it was something that manypeople were doing, and she hoped the bankers would consider it.As was explained in detail in the materials Edna had read, there werethree basic possibilities, and a number of ways they could be carriedout. The trust could buy puts, or it could buy puts and sell calls, or itcould swap the returns on the Philip Morris stock for the returns of adiversified portfolio of stock, such as the Standard & Poors 500. Thefirst two strategies might be implemented on the public exchanges. Anyof the three could be implemented through a private contract with abank or other derivative dealer.If the trust bought puts, this would insure against loss, but involvepaying a substantial time premium, just like other insurance. Buyingputs would leave open the possibility of gains from upward movementin the stock, and protect against loss at a price.If the trust bought puts and sold calls, this would greatly reduce thecost of the options, but it would foreclose the possibility of gains from
any increases in value of the stock. If the price of Philip Morris stockdeclined, the loss would be offset by gains in the value of the puts. Ifthe price of Philip Morris stock increased, the profit would be offset byincreased liability under the put option which had been sold.Either of the first two strategies could involve tax complications-inparticular, if the options expired before Barbara died, and had to bereplaced with new options. The exact tax consequences would dependon which way the price of the stock moved and when. For most stocks,options expire only a few months after they are purchased, and Barbaracould live for years. In the case of Philip Morris, however, and the stockof a few other very large companies, special options are traded *313 onthe exchanges, called LEAPs, which expire several years in the future.Even so, Barbara might outlive them, so the tax consequences could beunpredictable.As an alternative to exchange-traded options or LEAPs, some bankswrite private options tailored to the buyers needs. A contract could bewritten which would not expire during Barbaras lifetime. Bankers Trustadvertised this service in a full page advertisement in Barrons whichEdna had seen. [FN13] Of course, the cost of this alternative wouldhave to be compared to that of publicly available alternatives. The thirdalternative, swapping the Philip Morris stock for a stock index, hadbeen seen by Barbara inBusiness Week, where the strategy wasdescribed in detail. [FN14]In sum, several derivatives strategies were available to reduce Barbarasrisks without incurring the tax disadvantages of selling the stock. Thesestrategies differ in their consequences, and the cost of each strategywould have to be carefully weighed. Their execution involves
complexities beyond the scope of this paper, and not central to thepoint. The important thing is that such strategies exist, and that theyoffer a resolution of the trusts dilemma-suffer the risks ofunderdiversification, or pay large taxes now-at varying costs, butwithout adding new risks of the magnitude of those being avoided. Thatis, the risks of underdiversification could be avoided, and the large taxcost of the most obvious solution (selling the Philip Morris stock now)could be avoided, at costs subject to negotiation and management.Moreover, these strategies were explained not only in finance journalsand other technical forums, but were available in the publicly tradedoptions market quoted every day in the newspaper, explained inmainstream business publications such as Forbes and Business Week,and even advertised by large banks in full page advertisements inBarrons.E. The Rejection of the SolutionDespite a follow-up letter from Alice, the bank never implemented anyof the strategies that were so clearly presented to it. Frank simplychecked on the banks view of Philip Morris stock and wrote Alice anote thanking her for the articles, stating that the banks investmentdepartment was still positive on Philip Morris stock, reminding her ofthe adverse tax consequences of a sale, and concluding that the bankbelieved it was imprudent to use derivatives. In fact, Frank simplythought that derivatives were dangerous and that there might be riskshe didnt fully understand, and didnt want to take the trouble to checkout the possibilities. Given the pervasive public presence of thesestrategies, Frank was running serious risks by taking this attitude.F. The Loss and the Lawsuit
Philip Morris stock was selling at about $78 per share at the time Alicesent the articles to the bank. Upon Barbaras death, Philip Morris stockwas selling at about $52. Now that there was no longer any tax reasonto continue to hold the stock, Alice demanded that it be sold now, andthe sale was executed at $52 per share. *314 The next thing Frankknew, he was holding in his hands the papers filed by the attorneyprobating Barbaras estate. The suit charged the bank with breach oftrust by reason of imprudent investment, lack of due care in failing topreserve the principal of the Trust, and negligently wasting the assetsof the Trust.After listening to Franks capsulization of the events leading up to thesuit, the banks attorney told Frank that she had never heard of atrustee being held liable for failure to use derivatives, and that sheknew of only one case that held a board of directors liable for failing tohedge sufficiently with derivatives. [FN15] However, she informedFrank that trustees could be held liable for failure to diversify, and thatFranks reasoning for not doing that–adverse tax consequences–mightnot be an adequate defense, since the bank had, without investigation,rejected a proposed method for reducing the risk of the undiversifiedportfolio without adverse tax consequences. The banks attorneysummarized her understanding of Franks situation by noting that theapplicable law is in a process of change, and that it was currentlyunlikely that Frank could safely ignore the possible use of derivatives toreduce the risks faced by his beneficiaries, whether or not thebeneficiaries themselves suggested the solution. Use of derivatives wasbecoming too common in the financial world to be safely ignored.
II. Can A Trustee Use Derivatives?A. Derivatives in Banking TodayIn light of the recent disaster stories about derivatives, [FN16] the bankmight argue, as Frank seemed to believe, that derivatives such as LEAPsare too risky for prudent trustees even to consider. Indeed, aproclaimed refusal to use derivatives in a trust might actually be aneffective marketing tool, considering the fact that many people whocreate trusts are rather conservative. The bank might even argue thathad it attempted to follow one of the derivatives strategies that Alicesuggested, it would have been even more susceptible to a lawsuit thanit was now.A complete condemnation of derivatives by a bank may be difficult todefend, however, given the current use of derivatives by many banks ina variety of banking contexts-including trusts. In many cases, banks usederivatives, such as the options proposed by Alice, to reduce risk. Giventhe opprobrium which has recently attached to the term “derivatives,”used as a blanket description for a variety of very dissimilar strategies,the average bank customer might be shocked to learn that banks suchas J.P. Morgan, Citibank, Bank of America, Wells Fargo, and manyothers have been using derivatives effectively and successfully foryears. [FN17]*315 At present, however, the term “derivatives” is a pejorative, giventhe outcry in the press over prominent losses and lawsuits involvingderivatives at General Electric (“GE”), *FN18+ Proctor & Gamble(“P&G”), *FN19+ Metallgesellschaft (“MG”), *FN20+ Orange County,
[FN21] and Barings. [FN22] Indeed, some state legislatures are talkingabout banning derivatives altogether as public investments. The meremention of the word “derivatives” raises a red flag for federal bankregulators, Congress, the Securities Exchange Commission (the “SEC”),the Commodities Futures Trading Commission (the “CFTC”), the FederalReserve Board (the “Fed”), and various international agencies. *FN23+Even newspapers warn the public to check for derivatives beforeinvesting, as if a derivative were some kind of an infectious disease.[FN24]In spite of the disasters and fears, however, derivatives are here tostay, for at least one very good reason: in many cases they provide alow cost way for banks, money managers, corporate treasurers, andeven bank trust officers to reduce risk.B. Using Derivatives to Reduce Risk in the Foreign Currency MarketBanks often help their customers reduce currency risk by writingforeign-currency-forward contracts. For example, imagine that a client(“Client A”) has recently ordered a shipment of parts from Japan, withpayment due in six months. Payment will be in Japanese yen.Understandably, Client A would be concerned that the cost of buyingyen might rise before payment is due.Client A could go to the currency-forward department of his bank(“Bank One”) for help in solving this problem. Bank Ones currencyforward department could enter into a contract with Client A to sell tohim the exact amount of yen he will need in six months at a rate ofexchange that is fixed as of the date of the contract.*316 This contractinsulates Client A from any changes in the exchange rate of the dollarrelative to the yen. Thus, Client A can calculate the exact amount of
payment he will have to make, without any risk that changes in theprice of yen will require him to come up with more money. [FN25]Payment and delivery of the yen typically occur when the yen areneeded. [FN26]Bank One has, through its contract with Client A, assumed the risk thata rise in the value of the yen relative to the dollar will force it to take aloss when it delivers the yen to Client A at the agreed price. Toeliminate this risk, Bank Ones currency-forward department cancontract with another banks (“Bank Two”) currency-forwarddepartment to buy yen in the future at a fixed exchange rate. Thus,Bank Ones obligation to sell yen to Client A is exactly offset by its rightto buy yen from Bank Two. This contract does not pose a risk for BankTwo if it has a client (“Client B”) who was going to receive the sameamount of Japanese yen in six months from a sale of equipment to aJapanese customer. By entering into a contract with Client B to buy heryen at a fixed rate, Bank Two assures itself that it can meet itsobligation to Bank One while also assuring Client B that the profitmargin on her sale of equipment will remain constant despite anyfluctuation in the currency markets.Both banks build in a profit margin for themselves in writing thesecontracts and so are able to earn an assured profit while providing avital service to their clients. Through a simple hedge, the two clientshave removed the risk of currency fluctuations from their business withforeign customers and suppliers who deal in a different currency.The worlds currency-forward business amounts to over $1 trillion aday. Some of this business is carried out on the futures exchangeswhere standardized contracts are traded, but by far the greatest part is
handled by bankers, creating custom-made contracts to accommodatethe needs of individual customers. [FN27] Competition among banksdrives the banks profit margins down to competitive levels, and in thetransactions described here, each party is reducing risk by usingderivatives. [FN28]The currency-forward market is no new invention;banks have been using it for years, and its origins trace back at least asfar as the Medici banking family.C. Using Swaps to Reduce the Risk of Interest Rate VolatilityInterest rate swaps and basis swaps represent other uses of derivativesthat can considerably reduce risk. In fact, a bank could hedge its entireloan portfolio with such swaps. Simply put, an interest rate swap can bean arrangement between banks to “trade” the interest payments eachreceives on loans it has issued. For example,*317 one bank may swapthe fixed rate payments it receives on a fixed rate loan for the variablerate payments another bank receives on a variable rate loan. Theadvantage of interest rate swaps is that they allow the bank portfoliomanager to match the duration of the banks assets (loan payments)with the duration of its liabilities (demand deposits, CDs, and the like).[FN29]Banks use another type of swap, called a basis swap, to fix the spreadbetween the cost of funds to the bank (the rate it pays on deposits) andthe rate that the bank receives on its loans. For example, suppose abank has lent money at the prime rate plus two percent. At the sametime, the bank has promised to pay depositors the six month TreasuryBill rate plus two percent. As long as the prime rate exceeds the sixmonth Treasury Bill by a constant percentage, the bank can predict itsprofit on this spread. If the spread between these two rates narrows,
however, the banks profit is at risk. Thus, a bank may enter into a basisswap in which it agrees to pay the prime rate to a third party (usually aderivatives dealer) in return for that third partys agreement to pay thesix month Treasury Bill rate to the bank. [FN30]Unlike the currency market, where futures are traded daily and pricescan be found in the newspaper, the swaps market largely takes place inprivate transactions involving banks. Nevertheless, swaps trading isanother huge segment of the derivatives market. [FN31]D. Investment-Fund Managers Use of Unleveraged Derivatives toImprove Portfolio DiversificationStock indexes and options are commonly used by investment-fundmanagers as an inexpensive way to buy or sell a diversified portfolio ofstocks. The price of a stock index fluctuates with the price of theunderlying basket of stocks that it represents. For example, the S&P500 index represents the aggregate value of the 500 stocks making upthat index. When the total price of those stocks rises, the index rises. AJune 1996 S&P 500 stock index future represents a commitment to payon a date in June, 1996 an amount based on the value of the index onthat date. [FN32]For example, suppose a pension manager has $100,000,000 in cash thathe wants to invest in various stocks within a few weeks. [FN33] Whenthe money comes in, the manager may not necessarily have a long listof stocks ready to buy that day. However, depending on the guidelinesfor the fund, the manager may have an obligation to be “in the market”immediately. Certainly, the manager doesnt want to go out and buy agroup of stocks without sufficient analysis. Therefore, the managerbuys stock index futures with a face amount of $100,000,000 as a proxy
for a well diversified portfolio. This purchase does not require theentire $100,000,000. Rather, *318 it may require only that $5,000,000be deposited with the broker as security for the purchase of the stockindex futures. The fund earns interest on the $5,000,000 and can leavethe remaining money on deposit with the bank, where it also earnsinterest. Then, as the manager studies the markets, and picks just theright time to buy particular stocks, he can buy the stocks, and sell anequal face amount of the index futures at that time. Through thisprocedure, $100,000,000 is invested in stocks at all times. Moreimportant, at no time is the portfolio leveraged. In fact, this particularuse of index futures is no more risky than buying the individual stocks.The purchase of index futures is a cost effective way to achieve thediversity of a large portfolio without the need to make hastyinvestment decisions in individual stocks. [FN34]E. Concerning Derivatives DisastersA brief analysis of some recent derivatives disasters sheds valuable lighton possible causes of such disasters, and on the reasonableness ofusing derivatives in a bank trust account. Derivatives-related disasterscan be caused by the same traditionally inappropriate investment-management practices that would have led to financial disaster even inthe absence of derivatives. These practices include the use of leverageto multiply risk and reward beyond levels suitable for the investor,inadequate monitoring of traders, and a failure to match the timeframe of an investment to the investors liquidity requirements. Thecomplexity of derivatives may add to these problems by making themharder to identify. [FN35]Nevertheless, the size of the losses incurredand the unexpected swiftness with which the losses mount, suggests
that derivatives involving leverage need closer management scrutinythan other investments.Leverage helped cause nearly all of the recent derivatives disasters,including the losses in bond trading at Kidder Peabody, [FN36] thelosses on interest rate swaps incurred by P&G, [FN37] the losses in thebond market that drove Orange County *319 into bankruptcy, [FN38]and the losses in the Nikkei stock index and Japanese interest ratefutures trades that bankrupted Barings. [FN39] While some of thetrading in these situations may have begun with an attempt to hedgeother obligations, such as corporate interest rate obligations at P&G, allultimately involved large, unhedged, leveraged positions which moveddecisively against the investor.Leverage multiplies risk and potential return. The principle is simple. If abond purchased for $1,000 cash fluctuates 10% in value, a $100 gain orloss is incurred, equal to 10% of the investment. Now suppose the$1,000 bond is purchased for $200 in cash and the balance of thepurchase price in some form of credit. This is five-to-one leverage, sincethe price of the bond is five times the amount of cash used to buy it. A10% fluctuation in the price of the bond still results in a $100 gain orloss, but this is now 50% of the $200 investment in the bond. The use offive-to-one leverage has multiplied the gain or loss percentage by five.A conservative investment has become a very risky investment.The bankruptcy at Barings is a stunning example of the disastrouspotential of leverage. Barings Singapore trader was apparentlyauthorized to engage in fully hedged arbitrage trades. For example, hewould buy the Japanese stock index in the Singapore market, and sellexactly the same index in the Osaka market, profiting from small
differences in the price of that index which would temporarily existbetween the two markets. Given the fully hedged nature of hispositions, large use of leverage was justifiable. It appears that he tiredof this safe trade, however, and made very highly leveragedinvestments, which were not hedged, *320 believing that he knewwhich way the index would move. He was wrong, and an investmentfirm old enough to help finance the Louisiana purchase and theNapoleonic wars was bankrupt in little over a month; thus illustratingthe speed with which highly leveraged investments can unravel, as wellas the need for close supervision of traders.F. MG: A Failed Hedge Against Long Term ContractsMGs losses present a different problem. The losses at MG illustrate (i)the way in which business risks unrelated to derivatives are oftenblamed on derivatives, (ii) the importance of matching the timing andamount of a hedge with the underlying business obligation beinghedged, and (iii) the importance of anticipating the possible short-termcosts of financing a hedging strategy.As part of its regular business, MG entered into contracts to supplycustomers with petroleum at fixed prices in the future. MGs futurestrading was intended to hedge against these long-term contracts tosupply petroleum at fixed prices. [FN40] The logic behind the futurescontracts was that any increase in the price of oil would be offset by again in the value of the futures contract, which would offset losses onthe long term supply contracts, and vice versa. In fact, the price of oilfell, so that there were losses on the futures position, and potentiallyhigh profits under the long term supply contracts. The problemhowever, was that the losses in the futures contracts occurred in the
present while the profits that MG hoped to make on its petroleumsupply contracts did not. Indeed, those profits would only accrue overtime, as the petroleum supply contracts were fulfilled. Ultimately, thepresent losses were so large and notorious that the company decidednot to maintain the hedged position. It took its losses in the futuresmarket and extricated itself from its long term supply contracts, all atgreat expense. [FN41]The MG hedge created new risks, [FN42] rather than eliminatingexisting business risks, because of a timing mismatch between thehedge and the business obligations MG was trying to limit by thehedge. MG bought short-term futures contracts even though its supplycontracts were long-term. As an alternative to the hedge into whichMG entered, it might have contracted with one of the large derivativesdealers for a long-term custom-made hedge against the market risk ofoil prices. For its part, the derivative dealer could then have limited itsown risk on the contract either by entering short-term futures contracts(with adequate financing in place to *321 carry adverse short term-price movements) or perhaps by entering into a long-term contract topurchase oil from someone with large oil reserves who wanted to besure of selling oil at a fixed price in the future, such as an oil company.This would have been much like the currency-forward contractsdiscussed above, in which the timing of the obligation would match thetiming of the hedge.In any case, MGs original risk was created by entering into long-termpetroleum supply contracts at a fixed price when MG knew that theprice of oil remained very volatile. Long-term, fixed-price supplycontracts inherently involve speculation on future prices, which cancause disasters even without derivatives. For example, several years
ago Westinghouse was selling nuclear power plant equipment, andoffered the utility companies which bought the equipment long-term,fixed-price uranium supply contracts. The price of uranium rose, andWestinghouse found itself faced with potentially disastrouscommitments. Westinghouse reneged on the contracts, and defendeditself by asserting that the price increases were unforeseeable and aproper basis to void the contracts. It settled the resulting litigation atgreat but not disastrous expense. [FN43]The really big risk was undertaken by Westinghouse and by MG wheneach entered a long-term supply contract at a fixed price, which wouldhave to be fulfilled by purchases on the open market, at anunforeseeable price. Westinghouse didnt hedge, and avoided disasteronly by succeeding in high-risk litigation.Recognizing its business risk, MG entered into a hedging program.Rather than paying the cost of a hedging program designed to fullyoffset the business risk, like any other insurance cost, MG apparentlythought it could implement a hedging program that involvedspeculative trading of the market on a short-term basis-profiting fromthis short-term trading to reduce the cost of the hedge. [FN44] Thestrategy backfired; the anticipated short-term trading profits becameshort-term trading losses; and both the hedging program and theunderlying supply contracts were abandoned. [FN45]As in the case of Barings and MG, hedgers often meet with unexpectedlosses when they stray from pure hedging to outright, unhedged, andoften highly leveraged, investments. By definition, hedges decreaserather than increase risk. However, each hedging transaction must becarefully examined to determine the extent to which it strays from
being a pure hedge: whether it incorporates elements which create,rather than eliminate, risk; the magnitude of those risks; and theireffects on the transaction and the organization if they become a reality.Unfortunately, whether this straying is fully understood by thecompany personnel implementing the program, whether it has been orshould have been fully explained to them by the brokers through whichthe program is implemented, and whether top *322management knewwhat was happening are often questions which can only be resolved bylong and painful litigation.G. Summary: Three Uses of DerivativesAs discussed above, banks can use derivatives conservatively in twoways. They can hedge, or they can use derivatives as a proxy foranother investment.In the first case, they (or their clients) can use them to hedge againstfluctuations in the prices of underlying commodities (like petroleum) orfinancial instruments (like currencies or interest rates) as to which thehedger has a business commitment to buy or sell. When hedging, it iscritical that the investor match the time frame and amount of thederivative contract with the time frame and amount of the supply orpurchase contract.In the second case, a fund manager within the bank can use derivativesas convenient proxies for the underlying investments from which theyare derived, as in the case of a pension fund manager buying a futurescontract on the Standard & Poors 500 stocks. As long as the pensionfund has allocated to this position as much cash as it would require tobuy the stocks represented by the futures contract, this use of
derivatives is unleveraged and no more speculative than buying thestocks themselves.Banks can also use derivatives for leveraged investment. Like any othermethod of leveraging an investment (such as buying stock on margin)this multiplies risk just as it multiplies potential reward. As the recentderivatives disasters indicate, the risks associated with high leverageare not always fully appreciated by those making the investment at thetime it is made. Use of high leverage requires expertise and attentionon the part of the investor and bank management. The banksmanagement commit to closely monitoring both the positions held, andthe traders entrusted with the use of derivatives. Even then, there maybe substantial losses.In any case, Franks argument that derivatives are simply inappropriatefor banks in general or trust officers in particular, simply flies in the faceof the widespread, conservative uses of derivatives in banking today.III. A Trustees Fiduciary DutiesAlthough the use of derivatives as a hedge may be permitted in a trust,Frank may argue that he was under no duty to use them and, therefore,cannot be held liable. This argument implies that Franksfiduciary dutydid not require him to adjust his investment strategy to accommodateinnovations in the financial markets. Evaluation of such an argumentrequires a careful examination of both (i) the Prudent Investor Rule,which defines generally a trustees duties, and (ii) the way that courts
have interpreted afiduciarys duties when confronted with “new”investment choices.A. The Prudent Investor RuleThe job of a trustee is not getting any easier. The courts have beenlooking over trustees shoulders for a long time now, and even the bestclients sometimes sue their trustees. The traditional formulation of thePrudent Investor Rule is found in *323 the 1830 case of Harvard Collegev. Amory, [FN46] where the court asserted that fiduciaries should“observe how men of prudence, discretion and intelligence managetheir own affairs, not in regard to speculation, but in regard to thepermanent disposition of their funds, considering the probable income,as well as the probable safety of the capital to be invested.” *FN47+ Thisstatement of the “Prudent Investor Rule” has been quoted ever since.Various forms of it have been enacted in many state and federalstatutes, and form the basis of many court decisions. [FN48]In this respect, the traditional test is timeless, and as valid today as itwas in 1830. By referring the fiduciary to the conduct of others who areregarded as “of prudence, discretion and intelligence,” the courtexpressed a standard which automatically updates itself tocontemporary standards of commercial conduct, of which evidence canbe introduced in the normal course of judicial proceedings.Defining the current standard of conduct, however, can be quitechallenging. For example, the emphasis on “permanent” disposition offunds seems almost quaint in an era where many customers seem tothink that a trustees management is no better than the last quartersresults. In our hypothetical scenario, Barbara was an old-fashioned,long-term investor who profited greatly from buying and holding good
companies over the years. Frank may try to use her successful, long-term strategy as a justification for keeping the investments she made,but Barbaras heirs can counter that this strategy no longer made sensegiven the relative size of Barbaras Philip Morris position, the volatilityof the stock market in general and Philip Morris in particular, andBarbaras age, health, and projected needs.1. Stocks and the Prudent InvestorThe propriety of investing in stocks provides an example of theredefinition over time of the standard of prudent conduct. The originalformulation of the Prudent Investor Rule condemned “speculation,”which could be understood to include stock investments. [FN49] Toquote a New Jersey court as recently as 1934:The stock market is not a playground for trustees. The ethics oftrusteeship is not to be found in the code of the speculator. Anexecutors function is to conserve, not to venture. It is no less a breachof trust to speculate with securities of an estate than to gamble with itsmoney, though the motive be to advance its interests. [FN50]Fifty-two years later, however, a Washington court held that a banktrustee acted imprudently byfailing to include stock in a portfoliootherwise comprised *324 exclusively of tax-free bonds. [FN51] Thecourt ordered the bank to pay damages based on what the trust wouldhave earned if the trustee “had prudently diversified between tax-exempt and equity securities” by investing forty percent of the trustsassets in stocks, which would have appreciated twenty to twenty-two
percent during the time of the trusts administration, as measured bythe broad stock indexes. [FN52]Today, the easiest way to purchase a widely diversified portfolio ofstocks is to buy a futures contract on the Standard & Poors 500. For aninvestor with $250,000, this is no more risky than buying $250,000worth of stock, and it provides a much more diversified portfolio thanan investor could buy for $250,000 at much lower transaction costs.True, the futures contract doesnt pay dividends, but the investorreceives interest on the $250,000, which today pays more thandividends. Indeed, many pension funds routinely use futures as atemporary substitute for stocks. So long as no leverage is employed andthe investor keeps cash on hand equal to the total face value of thefutures contract, the substitute is no more or less risky than buying thestock itself. [FN53]2. Tax Planning and the Prudent InvestorTax planning provides another example of changes in the standards ofconduct under the Prudent Investor Rule. Trustees have rarely beenheld liable for bad tax planning. In fact, one court recently noted that atrust officer would not be held liable even if she had openly admittedthat she was “unaware of some of the tax consequences” of herinvestment decisions. [FN54]Even so, Franks concern about adverse tax consequences is hardlymisplaced. A recent, authoritative restatement of the Prudent InvestorRule observes that:
[T]ax consequences within the trust and the tax positions of the variousbeneficiaries have come to have considerable importance in themanagement of trust funds, and the trustees investment decisionsoften affect different beneficiaries quite differently in this respect. Forthese reasons trustees must recognize that the traditional insistence onpreservation of principal includes a consideration of the real value ofthe corpus and a need to balance this concern against a lifebeneficiarys typical interest in the production of income, withattention to the after-tax worth of each. [FN55]In the same vein, the model Prudent Investor Act provides that “theexpected tax consequences of investment decisions or strategies” are“*a]mong the circumstances*325 that the trustee shall consider ininvesting and managing trust assets.” *FN56+ Frank is justified in hisconcern over the tax consequences of selling Philip Morris. Thatconcern is not enough to justify inaction, however, if both the taxobjective and the diversification objective can be achieved throughderivative strategies being used by other fiduciaries. Under bothtraditional and modern concepts of the Prudent Investor Rule, notrustee can safely ignore investment strategies other fiduciaries areusing to protect their beneficiaries. [FN57]3. Diversification and the Prudent InvestorUnder the current legislative model, the primary duty of the trustee isto strike an appropriate balance between risk and reward in a portfolio,[FN58] and diversification is the principal method of reducing risk
without reducing potential rewards. [FN59] In todays financialenvironment, derivative vehicles-including options, futures, and swaps-offer opportunities for diversification, sometimes at lower costs or risksthan other alternatives. Under the legislative model, “a trustee mayinvest in any kind of property or type of investment” as long as it fitsinto a portfolio which is prudent when taken as a whole. [FN60] Thislegislation has only recently been endorsed by the American BarAssociation and Uniform Law Commissioners, but it reflects modernportfolio theory and practice, as expressed in the restatement of thePrudent Investor Rule by the American Law Institute. It is now underconsideration by state legislatures, and a judge might well apply itsprinciples under the traditional rule of Harvard College v. Amory, torequire fiduciaries to emulate the practices of other prudent fiduciarieswho are already using derivatives.Indeed, pension funds are not only using futures, swaps, and otherderivatives, but also investing in venture capital, short-term technicaltrading schemes, and other types of investments that have traditionallybeen regarded as too speculative for fiduciaries. [FN61] Pensionmanagers justify their engaging in such investments under pension laws[FN62] and modern portfolio theory. [FN63] They explain that while anyone investment taken alone might be regarded as too speculative, acombination of these investments can produce a prudent portfolio inthe aggregate. That is, some *326 individual assets in the portfolio maybe very volatile, with widely varying returns and the possibility of largelosses, but such investments also offer the possibility of very highreturns. Since gains on some of these investments are expected tomore than offset the losses on the others, and since the losses are notlikely to occur in all the investments at the same time, the portfolio as a
whole may produce a fairly steady, fairly high rate of return. [FN64] Inthis way, a portfolio containing a combination of speculative andconservative investments can produce higher returns with less volatilitythan the traditional prudent portfolio containing only conservativeinvestments.B. Emerging Rules for Prudent Investors1. Changes in the Prudent Investor RuleSupporting the new fiduciary investment standards, five changes havebeen made in the new model Prudent Investor Act. These changesreflect the evolution of current financial theory and practice whichunderlie the changes in fiduciary behavior and standards discussedabove.First, “*t+he long familiar requirement that fiduciaries diversify theirinvestments has been integrated into the definition of prudentinvesting.” *FN65+ There is no question that Barbaras trust wasinadequately diversified. As discussed above, the requirement fordiversification has been in the law for a long time. Its inclusion in theRestatement Third of Trusts and the new Prudent Investor Act onlyserves to emphasize this duty.Second, “*t+he tradeoff in all investing between risk and return isidentified as the fiduciarys central consideration.” *FN66+ Since theprimary focus of a hedging strategy is to improve this tradeoff, futuretrustees may expect that a failure to hedge could lead to liability when
hedging is necessary to protect the portfolio from risks which wouldotherwise be judged excessive, such as those of underdiversification.Third, “*a+llcategoric restrictions on types of investments have beenabrogated; the trustee can invest in anything that plays an appropriaterole in achieving the risk/return objectives of the trust and that meetsthe other requirements of *327 prudent investing.” *FN67+ This makesit clear that derivatives may be used in trust investing, provided thatthe particular use made of the derivatives is prudent.Fourth, “*t+he standard of prudence is applied to the portfolio as awhole, rather than to individual investments.” *FN68+ In evaluating thetrustees performance, this change allays any concerns that gains onthe options, such as Philip Morris LEAPs, puts, or swaps, would not beoffset against losses on the Philip Morris stock, and vice versa.Fifth, “*t+he much criticized former rule of trust law forbidding thetrustee to delegate investment and management functions has beenreversed. Delegation is now permitted, subject to safeguards.” *FN69+Ifa trustee is unfamiliar with a particular investment vehicle the use ofwhich would benefit his beneficiary, nothing prevents the trustee fromdelegating that investment task to a more knowledgeable expert,carefully selected, instructed, and monitored, at costs reasonablyrelated to the purposes to be served.2. The Fiduciary Duties of Pension Fund Investors
Over one-third of the common stock of American companies is ownedby pension fund fiduciaries on behalf of those who depend on it fortheir retirement. The conduct of these fiduciaries, and the standards bywhich they are judged, cannot be disregarded in determining what aprudent investor must do. The investment strategies of pensionmanagers may tend to set standards for all fiduciaries. Under currentpension plan regulations:A fiduciary shall discharge his duties with respect to a plan with thecare, skill, prudence, and diligence under the circumstances thenprevailing that a prudent man acting in like capacity and familiar withsuch matters would use in the conduct of an enterprise of a likecharacter and with like aims. [FN70]This version of the Prudent Investor Rule not only emphasizescontemporary practices in the financial community; it also holdsfiduciaries to the standard of a person “familiar with such matters.”[FN71]Ignorance is no excuse.The fiduciary has met the standard if he or she “has given appropriateconsideration to those facts and circumstances that ... the fiduciaryknows or should know are relevant to the particular investment” and“has acted accordingly.” *FN72+ Consideration shall include the “risk ofloss and opportunity for gain,” *FN73+ “the composition of the portfoliowith regard to diversification” *FN74+ and “anticipated cash *328 flowrequirements.” *FN75+ In this formulation, the tradeoff between riskand reward, and the emphasis on diversification, are as central topension law as they are to the laws regarding private trusts. The abilityto delegate investment authority to others, and ways of allocating
responsibility among those with such authority, are spelled out in thesame regulation.As they relate to our hypothetical scenario, both pension law and thenew version of the Uniform Prudent Investor Act reflect the latestthinking in the field, and lead to the same conclusion as the 1830traditional rule: current financial practice is the touchstone forevaluating Franks investment decisions with regard to Barbaras trust,and answering the question whether his failure to hedge withderivatives was a breach of his fiduciary duty.Derivatives are simply one of the tools a fiduciary has available toconstruct a portfolio with risk and return characteristics which aresuitable for the people whose money is being invested. This tool is nowso widely used that it should be in every fiduciarys tool kit, even if usedonly carefully and sparingly. Like any other tool, it can be used, ormisused.IV. Did Frank Have A Fiduciary Duty to Use Derivatives?There are currently no cases holding a trustee liable for failing to usederivatives, but there is a great deal of authority for the propositionthat trustees should not run the risks of an undiversified portfolio. Anycourt dealing with the issue as a matter of first impression may beinfluenced by this authority, as well as the changes in contemporarystandards and practices discussed above. Frank will have to explain whyhe maintained so large an investment in Philip Morris stock in the faceof diversification requirements. His explanation that a sale would have
incurred onerous tax burdens will be met with the argument that therewere many ways to use derivatives to diminish the risk withoutincurring the tax burden. A general condemnation of the use ofderivatives as a means to “get rid of the risk, not the stock,” asadvertised, seems unlikely to impress a court without a detailed inquiryinto the costs and risks of each strategy. [FN76] Failure to make thisinquiry at the time might well be a basis for imposing liability on Frank.Frank never held himself out to be an expert at every kind ofinvestment vehicle available, but he was a trustee. Under thetraditional formulation of the Prudent Investor Rule in Harvard College,*FN77+he had a duty to “observe” how others manage their affairs, andany such observation would have disclosed the articles andadvertisements seen by Edna in the public press, as well as morespecialized financial journals. Frank might at least have contacted otherinvestment managers to find out if, and how, they were usingderivatives. At a minimum, Frank could have contacted his own bankstreasurer and fund managers, as well as trust officers *329 at otherbanks. [FN78] Through such an inquiry, Frank could have learned theextent to which this use of derivatives was an accepted practice.A. Hedging vs. SpeculatingGiven the recent disaster stories about derivatives, Frank could arguethat any use of derivatives would be improper for a trustee. However,as Part II indicates, these disasters cannot simply be blamed onderivatives, and banks currently use derivatives in a variety of prudentways. Furthermore, long experience of courts and regulators withderivatives, even before their current prominence, reflects a distinctionbetween their use as a hedge and their use for speculation, a
distinction which is recognized by the regulators of the futuresexchanges and in the tax laws.The courts have recognized a “hedge” as “a form of price insurance,”*FN79+ and a hedger as one with “an interest in the cash market ... whodeals as a means of transferring risks he faces in the cash market. ...”[FN80] The Tax Court provides another definition of a hedge:[I]n order to have a bona fide hedge, there must be (1) a risk of loss byunfavorable change to the price of something expected to be used ormarketed in ones business; (2) a possibility of shifting to someone else,through the purchase or sale of futures contracts; and (3) an intentionand attempt to so shift the risk. [FN81]A speculator, on the other hand, is one “with no underlying interest inthe cash market ... [who takes] on the risks which the hedgers want toshift.” *FN82+ Thus speculators are taking on risk with a view togenerate profits.With Barbaras large investment in Philip Morris stock, the use ofderivatives to reduce that risk should clearly be regarded as a hedge ineconomic substance. Furthermore, given the fact pattern in Barbarascase, it is clear that Frank was being asked to hedge, not to speculate.Of course, there is a cost to engage in a hedge, analogous to aninsurance premium. Balancing benefits against costs is part of the dutyof the trustee to balance risk and reward, and if not carried out in atimely and careful manner, a basis for imposing liability.B. Relevant Precedent
The hypothetical suit is one of first impression. No cases have beenfound imposing a duty on a trustee to use derivatives. The recentoutbreak of derivatives *330 litigation thus far has involved claims thatderivatives were used to effect unsuitable investments; or hedgeswhich were ill conceived, ill understood, badly implemented, orincluding elements of highly leveraged outright investment.There is one case, however, holding a board of directors liable forinsufficient use of derivatives. InBrane v. Roth, [FN83] the board ofdirectors of an Indiana grain co-operative used the futures market tohedge against the risk of a collapse of grain prices while the grain wasbeing held in the co-ops elevator pending eventual sale. [FN84] Thetrial court held the co-ops hedging efforts insufficient, since the hedgewas in too small an amount to protect the bulk of the grain from theprice collapse which occurred. [FN85] The court held the directors liablefor failing to understand and supervise the hedging practices whichthey had delegated, and a court of appeals affirmed. [FN86]The Brane case may be a particular source of discomfort for bank orpension trustees, since corporate directors are held to a less stringentstandard than the Prudent Investor Rule discussed above. In fact,corporate directors are often shielded from liability by the “BusinessJudgment Rule” which protects them from liability for their decisions solong as they act in good faith, free of conflict of interest, and with atleast a minimal level of attention to the corporations affairs. [FN87] Itis true that in Indiana hedging grain inventories may be a commonpractice with which co-op directors are or should be familiar, and thatthis is not a financial center case involving much larger sums. However,the same logic may influence courts deciding cases in areas of thefinancial community where particular derivatives are now widely used.
[FN88] The likelihood of such a development is underlined by a recentBarrons editorial arguing that “companies ... that dont use derivatives... are, on the whole, much riskier than companies that do.” *FN89+ Thesame editorial quotes Wharton professor Richard Marston, whorecently completed a study of the extent of derivative use, as saying:“Any firm that has an exposure and doesnt use derivatives is gamblingwith the shareholders money.” *FN90+*331 V. ConclusionSince 1830, investors of other peoples money have been subject to thelegal requirement that they “observe” current financial practices andapply them in the management of the money entrusted to their care.Today the colossal scale and widespread use of derivatives requires“observation” of their potential uses by fiduciaries.The newest restatements of the Prudent Investor Rule, as formulated inthe federal regulations governing pension fund investment, [FN91] andin the Uniform Prudent Investor Act [FN92] propounded for statelegislation, make it clear that every category of investment ispermitted, including derivatives, so long as it plays an appropriate partin a diversified portfolio whose potential returns are balanced against alevel of risk suitable for the beneficiaries. Construction of such aportfolio is facilitated by (i) emphasizing investment strategy andperformance of the portfolio as a whole, rather than each particularinvestment, offsetting losses against profits which are part of the samestrategy, and (ii) permitting delegation to carefully selected, instructed,
and monitored experts in situations where a trustee lacks the expertiseto carry out a strategy that would advance the interests of thebeneficiaries.Banks and other prudent trustees can consider the use of derivatives inthree ways. First, they can be used as a hedge, reducing risk at a price,as with Barbaras Trust. Second, as in the case of a pension fund buyinga futures contract on the Standard & Poors 500, they can be used asproxies for the underlying investments from which they are derived. Aslong as the pension fund has allocated to its position cash equal to thatwhich would be required to buy the stocks represented by the futurescontract, this use of derivatives is unleveraged and no more or lessspeculative than buying the stocks themselves. The third use ofderivatives involves the use of leverage to multiply the potential return,and the risk, of a particular investment. Any use of leverage carries withit the multiplication of risk which can render the investment extremelyrisky. Especially close monitoring of highly leveraged investmentstrategies is necessary, and even then there may be substantial losses.In the context of fiduciary investing, fiduciaries such as bank trustofficers can use derivatives as a pure hedge. Because some complexderivative products include elements of all three uses, however, it iseasy for a fiduciary (perhaps misled by an overeager broker) to slipfrom one of the first two “conservative” uses of derivatives, as hedgesor proxies, into their much more risky use for highly leveragedinvestment. Accordingly, each use of a complex derivative product orstrategy must be carefully analyzed to determine the extent, if any, towhich it exposes the user to risk, and the extent to which it guards theuser from risk. [FN93]
*332 Fiduciaries may even be required to use derivatives to hedgeagainst risk in cases where the best result for the beneficiaries can beachieved in no other way. The second use of derivatives, as anunleveraged proxy for the underlying investment, is in widespread usetoday, has not resulted in notorious disasters and litigation, and iscertainly permitted to fiduciaries. The third use, as a highly leveragedinvestment, helped cause many of the recent financial disasters andlawsuits, and poses many risks to trust managers when applied to anysubstantial part of a trust portfolio without the express mandate of thegrantor.Derivatives are part of todays financial world, in newly colossal size.They can be used to great advantage, or misused with disastrousconsequences. We can learn from the current wave of litigation anddisputes how to avoid similar problems in the future, and intenseefforts are underway within the derivatives industry and among itsregulators to that end. Meanwhile, fiduciaries may now have a duty tounderstand enough of this great, new fact of life to make safe use ofderivatives to obtain advantages otherwise unavailable to theirbeneficiaries, as well as to avoid their risky use for highly leveragedinvestment where those risks are unauthorized, undisclosed, andunsuitable.[FNa1]. Lecturer, Stanford Law School; Visiting Scholar, HooverInstitution; occasional lecturer in risk management, Economic Systems,Operations Research, Stanford University; J.D., Harvard Law School,1968. I would like to thank Mark Eisenhut for his research assistance inpreparing this article.
[FN1]. UNIF.PRUDENT INVESTORS ACT, prefatory note at 1 (Natl Conf.of Commrs on Uniform State Laws, Feb. 1995) [hereinafter UPIA].[FN2]. RESTATEMENT (THIRD) OF TRUSTS, introduction at 7 (1990)(Prudent Investor Rule); see infratext accompanying notes 54-57.[FN3]. UPIA § 2(c)(3).*FN4+. The “cost basis” in the case of Barbaras stocks is the price atwhich she purchased them. The profit on which she would have to paytax, if the stocks were sold, is the difference between the amount shereceives for the stock and the cost basis.[FN5]. For a precise calculation of the applicable federal and statetaxes, consult tax tables and tax schedules in reporters such as the CCHSTANDARD FEDERAL TAX REPORTER (1995) and the CCH STATE TAXREPORTER, CALIFORNIA (1994).[FN6]. There is, in reality, no true risk-free investment. U.S. dollars, U.S.government bills, notes, and bonds held to maturity are often called“risk free,” but even these investments risk loss of real principal due toinflation.
[FN7]. Some rough estimates show that in the absence of dramaticprice changes in the value of Barbaras investments, her estate wouldbe about $450,000 larger if the stock were held until her death, ratherthan sold before her death. If the stock were sold before her death, thevalue of the portfolio after income taxes would be $1,580,000; anestate tax of $592,000 (roughly 40%) would be due on this amount atBarbaras death, leaving $988,000. If the stock were sold after Barbarasdeath, in contrast, $976,000 in estate taxes would be due on the$2,400,000 estate, but, after basis adjustment, no income tax would bepayable on the sale of the stock leaving $1,424,000 for her heirs.[FN8]. Often, trustees are reluctant to change the investment decisionsof those who have made the money which funded the trust, but herethe case for change was strong.[FN9]. See RICHARD S. WURMAN ET AL., THE WALL STREET JOURNALGUIDE TO UNDERSTANDING MONEY & MARKETS 92-95 (1990).[FN10]. A put option gives the option holder the right, but not theobligation, to sell the corresponding stock at a fixed price at any timebefore the expiration date. Id. at 92-93. A more comprehensive butreadily understandable explanation of these markets is found inGLOBAL DERIVATIVES STUDY GROUP, GROUP OF THIRTY, DERIVATIVES:PRACTICES AND PRINCIPLES (1993).
[FN11]. An abbreviated version of the article reads as follows:The tripling of the stock market over the past decade may have left you... sitting on some very big paper gains, sure that a correction is aroundthe corner, yet unwilling to sell the stocks because of the taxes youdhave to pay. If youve got low-cost-basis stock and live in a high-taxstate, selling the stock could erase almost a third of your capital.For investors in this fix, there are escape hatches. One that you shouldlook at closely involves the options market. ... Suppose you own PhilipMorris at a cost of 5. Recent price, 78. You sell a call, exercisable at 80,against your position. Then you use the option premium you collect tobuy a put, also with a strike price of 80. Net outlay: pretty close to zero.But dont you get hit for capital gains tax on the Philip Morris when theoptions expire? Not if you dont want to. Instead of delivering yourPhilip Morris, you can close out your option positions for cash-gainingon one, losing on the other. You still own Philip Morris.If your Morris stock has in fact fallen, say to 65, then you will have apaper loss there ... and a cash profit in the options. That option gain of$15 a share will be immediately taxable. But better to owe tax on $15than tax on $73, the gain you would have reported had you sold thestock outright. The bottom line is that your stock is worth $13 a shareless on paper, but you have made a profit of $15 a share on youroptions.And if Philip Morris keeps shooting up, say to 95? Then you haveanother $17 of paper gain on your stock, and that gain remainsuntaxed. Offsetting most of this gain, you will have an out-of-pocket$15 loss on the options.
William Baldwin, Take a LEAP, FORBES, Jun. 22, 1992, at 230.[FN12]. Pam Black, When Your Eggs are All in One Stock, BUS. WK., Mar.27, 1995, at 194. The article reads in part as follows:[Y]ou want to diversify your holding without having to sell and realize ahuge capital gain. An equity swap meets these requirements. You pay afee to a commercial or investment bank and enter a contract agreeingto pay the bank the total return on [Philip Morris] shares in exchangefor the return on a diversified basket of issues such as ones listed onthe Standard & Poors 500 index. ... Some tax professionals believe thatthe Internal Revenue Service will make swaps taxable. Other expertssay that isnt likely.[FN13]. See Too Much Money In Just One Stock? Get Rid of the Risk,Not the Stock, BARRONS, Aug. 1, 1994, at 7 (advertisement).[FN14]. See supra note 12.[FN15]. See Brane v. Roth, 590 N.E.2d 587 (Ind. Ct. App. 1992) (holdinga board of directors liable for failing to sufficiently hedge againstchanges in grain prices). See infra text accompanying notes 83-90.[FN16]. See Lauren A. Teigland, Derivatives, Disputes, andDisappointments, 64 BNA BANKING REP. 703 (1995).
[FN17]. See Books of Revelations, RISK, Sept. 1994, at 93. A list of thecommitments of the 10 largest derivatives dealers totaled over $16trillion. The list was comprised mostly of banks each with commitmentsover $1 trillion. Chemical Bank had the largest commitments ($2.5trillion) while J.P. Morgans commitments exceeded $1.6 trillion. J.P.Morgan actually publishes a market risk management system over theInternet daily. See also Barbara D. Granito, Assessing the Size of theMarket, WALL ST. J., Aug. 25, 1994, at A4 (“The ‘notional’ value of thederivatives market ... is a mind-boggling $35 trillion, equal to nearlythree-quarters of all the worlds stocks, bonds, money-marketsecurities and currencies put together.”); Randall Smith & Steven Lipin,Beleaguered Giant: As Derivatives Losses Rise, Industry Fights to AvertRegulation, WALL ST. J., Aug. 25, 1994, at A1.[FN18]. See infra note 36.[FN19]. See infra note 37.[FN20]. See discussion infra part II.F.[FN21]. See infra note 38.[FN22]. See infra note 39.
[FN23]. See, e.g., COMMODITY FUTURES TRADING COMMISSION, OTCDERIVATIVE MARKETS AND THEIR REGULATION (Oct. 1993); Lee Berton,FASB Requires More Disclosure on Derivatives, WALL ST. J., Oct. 6,1994, at A4; Randall Smith & Steven Lipin, Beleaguered Giant: AsDerivatives Losses Rise, Industry Fights to Avert Regulation, WALL ST. J.,Aug. 25, 1994, at A1; J. Carter Beese, Jr., Testimony before theCommittee on Banking, Finance & Urban Affairs, U.S. House ofRepresentatives (Oct. 28, 1993) (unpublished hearing on file with theStanford Journal of Law, Business & Finance); Richard Y. Roberts,Remarks at Spotlight on Derivatives Conference (Sept. 13, 1994) (“TheCommission has been and continues to be very concerned with thecurrent state of the disclosure by mutual funds ... of their derivativesactivities.”) (on file with the Stanford Journal of Law, Business &Finance).[FN24]. See, e.g., AdrinaColindres, State Investment Pool Safe:Treasurer Says State Wont Repeat Wisconsins Losing Investments,PEORIA J. STAR, Mar. 25, 1995, at C5; Help the BuyerBeware,PORTLAND OREGONIAN, Nov. 29, 1994, at D8; Dick Marlowe,Investing Safeguards Not Everywhere,ORLANDO SENTINEL, Dec. 19,1994, at 3.[FN26]. Meanwhile, the bank relies on Client As line of credit forassurance that the client will buy the yen as agreed, even if theexchange rate has fallen below the level set in the agreement.
[FN27]. See GLOBAL DERIVATIVES STUDY GROUP, GROUP OF THIRTY,DERIVATIVES: PRACTICES AND PRINCIPLES 42 (1993).[FN28]. Speculators who trade currencies without offsetting obligationsto buy or sell goods in the same amounts of the currencies in questionare taking risks, sometimes large risks, in the hope of large profits. Theirpresence adds liquidity to the market, and makes it easier for hedgersto place the trades which will protect them from their business risks.[FN29]. ZVI BODIE ET AL., INVESTMENTS 461-464 (1989) (discussinginterest rate swaps as a means of minimizing risk associated withinterest rate fluctuations).[FN30]. Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of Swaps,ECON. REV., Mar./Apr. 1991, at 12, 17-18.[FN31]. See GLOBAL DERIVATIVES STUDY GROUP, GROUP OF THIRTY,DERIVATIVES: PRACTICES AND PRINCIPLES 28, 31, nn. 2-4 (1993).[FN32]. See WURMAN ET AL., supra note 9, 86-87 (1990).
[FN33]. See generally Joan Ogden, Pension Funds New Appetite forDerivatives, GLOBAL FIN., Aug. 1993, at 42.[FN34]. Of course, if a pension trustee had only $10,000,000 in his trust,and used stock index futures to buy the equivalent of $100,000,000worth of stock, the risks would be entirely different. This wouldrepresent 10 to 1 leverage, and would risk loss of the entire trust if themarket declined only 10%. The fund manager who uses $100,000 tobuy $100,000 face amount of stock index futures, however, is nottaking on any more risk than he would be accepting if he bought aproportionate amount of the stocks individually. In short, as long as theuse of derivatives does not involve leverage, it can be just as safe as theunderlying asset.[FN35]. For example, it may be hard to tell to what extent a giventransaction is a hedge, insuring against a business risk that has alreadybeen undertaken, and to what extent it constitutes a leveragedinvestment in its own right, creating new risks. The FinancialAccounting Standards Board is currently grappling with the properaccounting for derivatives, and these issues are not easy to resolve.[FN36]. See Laura Jereski& Michael Siconolfi, On the Ropes: KidderPeabody Gets Infusion From GE, But Problems Mount, WALL ST. J., June15, 1994, at A1 (reporting on the large losses suffered by GeneralElectrics 80% owned subsidiary, Kidder Peabody, as a result of a pricedecline in its $12 billion inventory of mortgage-backed bonds and
suggesting that the price decline was primarily the result of a sharp risein interest rates which was exacerbated by a lack of liquidity due toother traders unwillingness to engage in active trading in themortgage-backed bond market).[FN37]. See Gabriella Stern & Steven Lipin, Proctor & Gamble to Take aCharge To Close Out Two Interest-Rate Swaps, WALL ST. J., Apr. 13,1994, at A3. P&Gs problems involved a one-time, pretax charge of$157 million to close out two highly leveraged interest-rate-swapcontracts. P&G had swapped its fixed-rate obligations for floating-rateobligations. When interest rates rose in the U.S. and Germany, thevalue of these swap contracts dropped precipitously. See also StevenLipin et al., Portfolio Poker: Just What Firms Do With ‘Derivatives IsSuddenly a Hot Issue, WALL ST. J., Apr. 14, 1994, at A1 (reporting thatsome corporate treasurers engage in speculative derivativestransactions because their corporations treat the treasurers office as aprofit center rather than a vehicle for financing the companysoperations).[FN38]. See Andrew Bary, Peter Pan Portfolio: Orange County Bet ThatInterest Rates Would Stay Low Forever, BARRONS, Dec. 5, 1994, at 17;Bitter Fruit: Orange County, Mired in Investment Mess, Files forBankruptcy Decision, Following Default on Reverse-Repo Deals, MayPut Assets in Limbo, WALL ST. J., Dec. 7, 1994, at A1; G. Bruce Knecht,Californias Orange County Has Lost $1.5 Billion in Aggressive Strategy,WALL ST. J., Dec. 2, 1994, at A3. For several years Robert Citron,treasurer of Orange County, had been reporting extraordinary earnings
on leveraged investments in high quality bonds including U.S. Treasurybonds and U.S. Government Agency debt, such as Federal NationalMortgage Association obligations. As long as interest rates did not rise,this strategy worked. When rates increased, however, this strategy ledto bankruptcy. See also Laura Jereski, Orange County Fund Loses Put at$2.5 Billion,WALL ST. J., Dec. 12, 1994, at A3.[FN39]. See Sara Webb et al., A Royal Mess: Britains Barings PLC Betson Derivatives-And Cost is Dear,WALL ST. J., Feb. 27, 1995, at C6.(reporting that 27 year old Nicholas Leesons trading in huge volumes ofJapanese stock-index futures led to an estimated loss of $950 millionand drove Barings into bankruptcy). See also, Jeremy Mark et al., Lossesat Barings Grow to $1.24 Billion; British Authorities Begin Sale of Assets,WALL ST. J., Feb. 28, 1995, at A3 (reporting that although the actualfacts in the Barings incident were not fully known, it appeared thatLeeson entered into a series of speculative options and futurescontracts involving the Nikkei 225 stock index, Japanese governmentbonds and short-term euro-yen securities and that the apparent lack ofcontrols over Leesons activities was uncharacteristic of sound bankingpractices).[FN40]. See, e.g., Silvia Ascarelli& Peter Truell, German Firm FacesInquiry in New York, WALL ST. J., Sept. 14, 1994, at A14; Jack Reerink,Inside the MG Trading Debacle, FUTURES, Apr. 1994, at 58. As in theother cases considered, the full facts are not currently known, aresubject to gradual revelation in discovery and trial of the pendinglitigation, and indeed may never be known if the case is settled, or, as
in the instance of Metallgesellschaft, if it is submitted to privatearbitration.[FN41]. See also Christopher L. Culp & Merton H. Miller,Metallgesellschaft and the Economics of Synthetic Storage, 7 J. OFAPPLIED CORP. FIN. 4 (forthcoming Winter 1995) (arguing that thelosses may have been unnecessary, and that the hedged position couldprofitably have been maintained). In any case, it is clear that theorganization was not prepared for the large present cash outflow whichmaintenance of the hedge involved.[FN42]. At least in the short term, as prices of its futures positionsfluctuated. In the long run, the losses on the futures positions mighthave been recouped by profits either on futures contracts or the longterm supply contracts.[FN43]. See In re Westinghouse Elec. Corp. Uranium Contracts Litig.,436 F.Supp. 990 (1977); TVA v. Westinghouse Elec. Corp., 429 F.Supp.940 (1977).[FN44]. This market has typically permitted a hedger to profit whenrolling over a short term hedge to more distant delivery months, sincefutures prices are usually lower than “spot” prices in todays market.MG apparently thought it could capture this profit. However, themarket unexpectedly moved to a condition where spot prices were
lower than futures prices, creating losses for MG each time it rolledcontracts forward, buying future months at higher prices.[FN45]. See Reerink, supra note 40, at 58.[FN46]. 26 Mass. (9 Pick.) 446 (1830).[FN47]. Id., at 461.[FN48]. See RESTATEMENT (THIRD) OF TRUSTS § 227 reporters notes,at 60-67 (1990) (Prudent Investor Rule).[FN49]. Stocks were regarded as too speculative for trustees by manycourts for over a hundred years after the 1830 Harvard decision. A fewstates still prohibit their pension funds from making any stockinvestments at all. See Leslie Wayne, Where Playing the Stock Market isReally Risky, N.Y. TIMES, May 1, 1995, at C4.[FN50]. In re Westfield Trust, 172 A. 212, 214 (N.J. Prerog.Ct. 1934).
[FN51]. Boyer Natl Bank v. Garver, 719 P.2d 583 (Wash. Ct. App. 1986),noted in RESTATEMENT (THIRD) OF TRUSTS § 211 (1990) (PrudentInvestor Rule).[FN52]. Boyer, 719 P.2d at 591. It is worth noting that the courtrejected the Banks defense that avoiding taxes by using tax-exemptbonds was a good justification for its undiversified investment strategy.Id. at 587-88.[FN53]. See discussion supra part II.E.[FN54]. Estate of Ames v. Markesan State Bank, 448 N.W.2d 250, 255(Wis. Ct. App. 1989).[FN55]. RESTATEMENT (THIRD) OF TRUSTS, introduction at 7 (1990)(Prudent Investor Rule) (emphasis added).[FN56]. UPIA § 2(c)(3).[FN57]. See supra text accompanying notes 46-48.[FN58]. See infra text accompanying note 66.
[FN59]. A well-diversified portfolio is one invested in various assetswhich do not tend to decline or rise together in a highly correlated way,and none of which constitutes an undue percentage of the portfolio. Ahighly diversified portfolio may be appropriate for those for whompreservation of capital is more important than high returns, whereas aless diversified, more risky mix of assets, may be appropriate for thosein need of high returns who can accept the likelihood of loss.RESTATEMENT (THIRD) OF TRUSTS § 227(a-b) (1990) (Prudent InvestorRule). See also infra text accompanying note 65.[FN60]. UPIA § 2(e).[FN61]. See, e.g., Bill Opening VC to Jersey Pensions Awaits GovernorsInk, VENTURE CAP. J., Apr. 1, 1995, at 9; John Psarouthokis, Strategiesfor Economic Growth, DET. NEWS, Feb. 23, 1995, at A13; Thomas T.Vogel, Jr., Connecticuts State Pension Fund May Suffer Losses onDerivatives, WALL ST. J., Mar. 28, 1995, at B4.[FN62]. See supra text accompanying notes 32 and 33.[FN63]. See RESTATEMENT (THIRD) OF TRUSTS, introduction at 4, § 227reporters notes at 58-67 (1990).
[FN64]. John Lintner, a Harvard Business School professor, argued thatadding a small amount of futures trading to a portfolio of stocks andbonds can increase returns while actually reducing risk. Although thishypothesis has not been empirically confirmed in a definitive study, heprovides the basis for an argument that trustees should invest inderivatives for the purpose of increasing return. See John Lintner, ThePotential Role of Managed Commodity-Financial Futures Accounts(And/Or Funds) In Portfolios of Stocks and Bonds, (May 16, 1983)(unpublished paper presented at the Annual Conference of theFinancial Analysts Federation, on file with the Stanford Journal of Law,Business & Finance).[FN65]. UPIA prefatory note at 1. See also UPIA § 3.[FN66]. UPIA prefatory note at 1. This is not too different from the 1830tradeoff between income on the one hand, and safety of principal onthe other, except that income taxes have blurred the distinctionbetween income and principal. Income taxes didnt exist in 1830, butthey now do, so companies now pay out less in taxable dividends, andkeep more money in the company, where it adds to the value of thestock. The stock can be sold whenever the investor wants, and taxedonly then as capital gains. Since Barbara didnt sell until her death, noincome tax was ever paid on the capital gains, though income tax waspaid on the dividends.[FN67]. Id.
[FN68]. Id.*FN69+. Id. The “safeguards” include the trustees exercise ofreasonable care, skill and caution in selecting an agent, establishing thescope and terms of the delegation, and periodically reviewing theagents actions. UPIA § 9(a)(1-3).[FN70]. 29 C.F.R. § 2550.404a-1(a) (1994).[FN71]. Id.[FN72]. 29 C.F.R. § 2550.404a-1(b)(1)(i) (1994).[FN73]. 29 C.F.R. § 2550.404a-1(b)(2)(i) (1994).[FN74]. 29 C.F.R. § 2550.404a-1(b)(2)(ii)(A) (1994)[FN75]. 29 C.F.R. § 2550.404a-1(b)(2)(ii)(B) (1994).
[FN76]. Too Much Money In Just One Stock? Get Rid of the Risk, Notthe Stock, BARRONS, Aug. 1, 1994, at 7 (advertisement).[FN77]. See supra text accompanying note 48.*FN78+. See, e.g., UPIA § 2(f) comment (stating that there is a “higherstandard of care for the trustee representing itself to be expert orprofessional); UPIA § 9 (allowing the trustee to delegate duties).[FN79]. Commissioner v. Farmers & Ginners Cotton Oil Co., 120 F.2d772, 774 (5th Cir. 1941) (holding refined oil futures were not truehedges against crude oil prices).[FN80]. Leist v. Simplot, 638 F.2d 283, 287 (2d Cir. 1980) (holdingspeculators in the commodities market could bring suit because theywere among the class for whose benefit the Commodity Exchange Actwas enacted).[FN81]. Sicanoff Vegetable Oil Corp. v. Commissioner of I.R.S., 27 T.C.1056, 1067-68 (1957).[FN82]. Leist, 638 F.2d at 288.
[FN83]. 590 N.E.2d 587 (Ind. Ct. App. 1992).[FN84]. Id. at 589.*FN85+. “Only a minimal amount was hedged, specifically $20,050 inhedging contracts were made, whereas Co-op had $7,300,000 in grainsales.” Id.[FN86]. Although in Brane there was no suggestion that the directorswere attempting to advance their own interests at the expense of thecorporation, and they had given sufficient attention to thecorporations affairs to retain someone to hedge the risks, the directorswere held liable for failing to adequately understand derivatives andmonitor the activities of their financial manager, their supposed expert.Id.[FN87]. Under the Business Judgment Rule, the court will not second-guess the merits of a directors decision if it was made after reasonableinvestigation, the director honestly and reasonably believed thedecision would benefit the corporation, and the five essential elementsof the rule existed: a business decision, due care, good faith, and noabuse of discretion or waste. See DENNIS J. BLOCK ET AL., THEBUSINESS JUDGMENT RULE: FIDUCIARY DUTIES OF CORPORATEINVESTORS 2 (3rd ed. 1989).
[FN88]. Philip Johnson, a former Chairman of the CFTC, has called theBrane case a compelling precedent for lawyers attempting to create ahedging duty applicable to ordinary business and financial institutions.Future Shock, ECONOMIST, March 13, 1993, at 94.[FN89]. Gregory J. Millman, The Risk Not Taken, BARRONS, May 1,1995, at 46.[FN90]. Id. The study itself shows that one third of nonfinancialcompanies now use derivatives, most commonly to hedge foreigncurrency exposure through forward contracts with banks, and interestrate risks through swaps. See RICHARD MARSTON, SURVEY OFDERIVATIVES USAGE AMONG U.S. NON-FINANCIAL FIRMS, EXECUTIVESUMMARY (Wharton School, March 1995).[FN91]. See discussion supra part III.B.2.[FN92]. See discussion supra part III.B.1.[FN93]. This task of evaluating risk must be carried out by someoneknowledgeable enough to do so. Much of the current litigation overderivative losses turns on arguments over whether it was the broker orthe client who undertook the responsibility for making this analysis. In
the first instance, the legal responsibility is that of the fiduciary, and ifthe fiduciary wishes to delegate the task to another, he is well advisedto create a clear written record of the scope of that delegation to anappropriate expert, and require written reports from the expert todocument that the required monitoring function is being carried out.