Corporate governance and derivatives end users

Paul Ali University of Melbourne

1. Introduction

The basic function of a derivative is to transfer risk. Derivatives can be used to replicate the entire economic incidents of particular assets, as well as to break assets down into their component risks and transfer individual risks. There is, in principle, no reason why a derivative cannot be crafted for each of the risks to which particular assets are subject – a point that is well borne out by the rapid rate of innovation in the derivatives markets. Beyond the 'plain vanilla' derivatives linked to interest rate and currency risk that continue to dominate the over-the-counter (OTC) markets, it is now possible to transact derivatives linked to credit risk, currency convertibility risk, equity risk, macro-economic indicia (including inflation and unemployment rates), market access risk, volatility and weather risk, as well as derivatives replicating real estate investments and dynamic portfolios of securities and derivatives.

There are, however, certain factors common to all derivatives transactions, regardless of their complexity and innovative qualities. One such factor is corporate governance. This is a matter that has assumed considerably more importance in the wake of the global financial crisis. It is commonly the case that when an end user of derivatives suffers losses – particularly where the derivatives in question are complex and the user has significantly less expertise in transacting derivatives than the dealer that it booked the derivative with – the focus is on how the dealer has conducted itself towards the user. A critical issue is whether the dealer owes a duty of care to the end user to ensure that the derivative is suitable for the end user, in the context of the end user's personal circumstances and risk tolerance. This focus on the sell side of derivatives transactions tends, however, to obscure the fact that the buy side of the transaction – the end user – may itself be subject to a legal duty to ascertain for itself the suitability of the derivative, and that failure to do so may render the end user liable to its own shareholders or investors. Corporate governance encompasses inquiries of that nature. Thus, while the management of an end user may be mulling over whether they can recover derivatives-related losses from a swap dealer, their own investors could well be contemplating bringing a class action against them to recover those losses. That prospect confronts both end users that are corporations – which are transacting derivatives for their own account – and those end users that are institutional investors which are transacting derivatives using funds entrusted to them by their investors.

Corporate governance may be described as a system of principles governing the interaction between the management of a corporation, its owners and other parties with a financial stake in the corporation. The objective of these principles is to reduce the agency costs inherent in the separation of management from ownership and assure the owners and providers of finance of a return on their stake in the corporation. A key concern of corporate governance is therefore the rules that govern the management of corporations.

This chapter examines the corporate governance aspects of derivatives transactions from the perspective of corporations, as well as institutional investors. These two categories make up the principal end users of derivatives. The former are business enterprises that use derivatives, typically, for the purposes of reducing the volatility of their earnings by hedging particular risks; the latter are professional investors that manage assets on behalf of others and use derivatives for the purpose of hedging, as well as for creating exposure by replicating all or a discrete portion of the economic incidents of physical investments. The institutional investor category includes:

• pension funds;

• insurance companies;

• mutual funds;

• hedge funds;

• not-for-profit organisations; and

• charitable endowments.

The chapter outlines the duties to which the management of corporate end users are subject when entering into derivatives transactions and the analogous duties that apply to institutional investors. In both instances the relevant duty holders have been entrusted with the management of assets for the benefit of other parties: the officers of a corporation have vested in them the power to manage the corporation's business assets for the benefit of the corporation as a whole, while the institutional investor has been appointed to manage assets entrusted to it by its investors.

2. Corporate end users

Derivatives are typically used by corporate end users to reduce or extinguish their exposure to discrete risks and thus reduce the volatility of their earnings. A corporation can, for example, hedge the risk of an increase in interest rates by putting in place an interest rate swap under which it receives a floating-interest rate in exchange for paying a fixed-interest rate. Similarly, other derivatives can readily be transacted to protect the corporation against an adverse change in exchange rates or even the financial consequences of inclement weather.

2.1 Use of derivatives for non-hedging purposes

Corporations also use derivatives not to reduce or extinguish exposure to an existing risk, but to create or magnify exposure. In this situation, derivatives are used to establish investment positions reflecting the corporation's view of, for instance, future interest rates or exchange rates. However, corporations are less likely to treat their treasury departments as profit centres in the current economic environment, given the sharply reduced tolerance for derivatives-related losses on the part of shareholders, especially where the losses are not attributable to hedging.

2.2 Legal capacity of corporate end users

Corporate end users are relatively unconstrained in their ability to enter into derivatives...