Practical Derivatives: A Transactional Approach, Third Edition - Hardcover

Hardcover

ISBN 10: 1911078178 ISBN 13: 9781911078173

Publisher: Globe Law and Business Ltd, 2016

Synopsis

Since the near-collapse of the global financial system back in 2008, the derivatives industry has come a long way. As derivatives were blamed for causing, or contributing to, the crisis, the politicians and regulators on both side of the Atlantic (and in most other developed jurisdictions) decided to take action. In September 2009 the G20 leaders at their meeting in Pittsburg resolved the following: "All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end of 2012 at the latest." Even though it is now 2016, the regulators continue to work on the detailed rules, which still won't be fully implemented for a while. Nonetheless, the derivatives markets have already changed almost beyond recognition, and continue to evolve. Featuring updated chapters, this third edition of Practical Derivatives: A Transactional Approach shows how derivatives are used in a variety of transactions, how the documentation works, and why boards need to be aware of the derivatives market.It also analyses the impact of the recent regulatory changes on derivatives transactions and related documentation. With contributions from leading law firms, investment firms and academics, this accessible book takes a transactional approach and features coverage of product innovations. This latest edition includes chapters on established markets such as equity and energy derivatives, but it also discusses the expansion of derivatives into new markets such as credit risk, weather risk and property. It features topical analysis on corporate governance and directors' duties; it includes an overview of the documentation produced by the International Swaps and Derivatives Association, the International Capital Markets Association and the German banking association; and it discusses related issues such as close-out netting. This edition would not be complete without an analysis of the recent derivatives regulation, and the transactional documentation that helps to implement the new rules. Whether you are at a bank or financial institution or from a company or organisation looking to invest or manage your

About this title

Excerpt. © Reprinted by permission. All rights reserved.

Practical Derivatives

A Transactional Approach

By Edmund Parker, Marcin Perzanowski

Globe Law and Business Ltd

Copyright © 2017 Globe Law and Business Ltd
All rights reserved.

ISBN: 978-1-911078-17-3

Contents

Preface, 
Part I: The regulatory and governance aspects of derivatives, 
Corporate governance and derivatives end users, 
Regulation of OTC derivatives, 
Close-out netting, 
Part II: Documenting and designing derivatives transactions, 
Overview of industry standard documentation, 
Introduction to German derivatives documentation, 
Documentation for cleared OTC derivatives, 
Designing derivatives structures, 
Part III: Derivatives asset classes and corresponding industry documentation, 
a) Commodity derivatives, 
Introduction to commodity derivatives, 
Overview of the 2005 ISDA Commodity Definitions, 
Emissions trading, 
Weather derivatives, 
Energy derivatives and hedging strategies, 
b) Equity derivatives, 
Introduction to equity derivatives, 
Overview of the 2002 ISDA Equity Derivatives Definitions, 
c) Credit derivatives, 
Introduction to credit derivatives, 
Overview of the 2014 ISDA Credit Derivatives Definitions, 
d) Other derivatives classes, 
Interest rate derivatives, 
FX derivatives, 
Property derivatives, 
About the authors, 

CHAPTER 1

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 transactions. The doctrine of ultra vires, which makes void any acts by a corporation that are beyond the scope of its stated powers, has been rendered otiose as regards UK corporations. Accordingly, UK corporations face no explicit constraints on their legal capacity to enter into derivatives transactions. Similar steps to reduce the operation of that doctrine or to abolish it altogether have been taken in other markets whose laws are derived from English law.

While the governing laws and constituent documents of corporate end users may be silent on the issue of derivatives (with the legal capacity to transact derivatives being found in the general powers of the corporation), corporations usually assume voluntary limitations on their use of derivatives. These limitations are expressed in their internal hedging polices and are an incident of the duty of care that applies to the directors and senior management of corporations.

2.3 Duty of care

The only legal fetters on the use of derivatives by corporations are the duties owed by the corporation's officers (the directors and senior management) to the corporation itself – in particular, the duty of care.

The duty of care requires corporate officers to exercise the level of care and diligence that a reasonable person in the officer's position would display, having regard to the corporation's circumstances and the officer's responsibilities within the corporation. In terms of the use of derivatives, the officers of the corporate end user, in discharging their duty of care, must:

• clearly understand the general nature of the corporation's business and, in particular, the significant risks to which it is exposed (eg, currency risk in relation to inputs and sales, and interest rate risk in relation to borrowings and fundraising capacity);

• be able to formulate and monitor the implementation of a hedging programme (if required) to address those risks (which requires them to have a general understanding of hedging and the role of derivatives therein, and the risks associated with transacting derivatives; and

• be able to monitor the implementation of appropriate internal controls for transacting derivatives, in particular ensuring that the dealing role is separate from the settlement role.

The officers of a corporation will be personally liable for losses incurred on derivatives transactions if they fail properly to monitor the corporation's use of derivatives (whether this failure is due to the insufficiency of the corporation's internal controls or a lack of sufficient understanding of derivatives on the part of the officers). Moreover, these officers are unlikely, as regards these requirements, to be protected by the business judgement rule as a failure to ensure that one is familiar with the corporation's financial position or to monitor the corporation's policies and use of derivatives is not ordinarily considered to involve a decision by the officer to take or not take action.

The spectre of personal liability on the part of corporate officers for derivatives-related losses is well illustrated by one of the few cases from a major common law jurisdiction to deal specifically with the failure of a corporation's directors (and auditors) to monitor properly the corporation's use of derivatives: the Australian case of AWA Ltd v Daniels. AWA imported the majority of its inputs (electronic components) from Japan. AWA's board decided to implement an in-house hedging programme to reduce AWA's currency exposure. However, an employee with no training or experience in foreign exchange trading was placed in charge of the programme. Moreover, the managers to whom this employee was required to report had no training or experience in foreign exchange trading either. The employee was basically left unsupervised and was thus the person solely responsible within AWA for foreign exchange trading. The employee also had responsibilities in relation to the settlement of such trades and was in a position to circumvent any internal controls relating to the review of AWA's foreign exchange positions. The employee began to trade speculatively in foreign exchange forward instruments and ultimately caused AWA to incur losses of A$50 million. AWA's directors and senior management (as well as its auditors) were held by the Supreme Court of New South Wales and on appeal, the New South Wales Court of Appeal, to have breached their duty of care to AWA and were personally liable for the foreign exchange losses incurred by AWA.

2.4 A positive duty to hedge?

It is doubtful whether the duty of corporate officers to employ due care when their corporation enters into derivatives transactions can be extrapolated into a positive duty to use derivatives.

The closest case on point (and one often cited to justify the existence of a positive duty to use derivatives) is the US case of Brane v Roth, a decision of the Indiana Court of Appeals. The case involved a class action brought by the shareholders of La Fontaine Grain Cooperative against the cooperative's directors for losses suffered by the cooperative in its grain trading activities. The shareholders sought to recover those losses from the directors on the basis that the directors had failed to implement an adequate hedging programme to protect the cooperative's revenues.

Most of the cooperative's revenue (90%) was generated by its graintrading activities. The board of the cooperative decided to implement a hedging programme to protect the cooperative from fluctuations in grain prices. To that end, the cooperative entered into a number of grain futures contracts. These futures contracts covered less than 1% of the cooperative's grain sales and the cooperative suffered losses due to a deterioration in grain prices.

The court decided that the directors were personally liable for the losses suffered by the cooperative. However, rather than articulating a positive duty to use derivatives (or to hedge), the court's decision turned upon the failure of the directors to acquire a sufficient level of understanding of hedging and the impact of hedging or not hedging upon the cooperative's revenues. The directors were thus in no position to implement or monitor a suitable hedging programme for the cooperative and the court considered that this breach of duty was a direct cause of the trading losses suffered by the cooperative. Accordingly, it was the failure of the directors to attain the requisite level of understanding of derivatives and hedging that constituted a breach of their duty of care (as they could not then make a properly informed decision about whether to implement a hedging programme), not their failure to transact derivatives.

Despite this, directors and other officers of corporations would be well advised to consider the use of derivatives to reduce the volatility of corporate revenues. Failure to do so may raise questions about whether the officers are sufficiently conversant with the corporation's business (and, more particularly, the material risks associated with that business) and are thus in a position to discharge their duty of care to the corporation. However, any such consideration of derivatives requires the officers to be sufficiently informed about (and understand) the nature of hedging, the role of derivatives in hedging and the risks attendant upon transacting derivatives.

In considering whether to use derivatives, the officers of a corporate end user should be cognisant of the risk that just as under-hedging may expose them to shareholder claims of dereliction of duty, so too may over-hedging. While it is obvious that hedging is not free, the officers of a corporation should be aware that hedging also necessarily involves the forgoing of returns. The stripping out of risk and the concomitant smoothing of corporate revenues may also reduce the prospects for outperformance by the corporation with a negative impact on shareholder wealth. Moreover, the shareholders of the corporation may, through their investment in the corporation, seek exposure to the markets in which the corporation conducts its business and the elimination, for instance, of all currency risk may not be what these shareholders perceive to be in their best interests. A balance must therefore be struck between the need to reduce or eliminate risks that are (or are perceived as likely to be) inimical to the financial health of the corporation and the desire to retain or create exposure to risks that are capable of contributing positively to the corporation's performance.

3. Institutional investors

Unlike the corporate end users of derivatives discussed above, institutional investors face two explicit legal constraints on their use of derivatives. The first relates to their actual legal capacity to enter into derivatives transactions – that is, whether an institutional investor is permitted to use derivatives (in the same way that the doctrine of ultra vires is used to limit the powers of corporations in the United Kingdom and other common law jurisdictions), while the second imposes prudential guidelines for any use of derivatives.

These two constraints are attributable to the more specialised or defined nature of the business enterprise of institutional investors compared to corporate end users of derivatives and the fact that, in contrast to the latter, institutional investors do not, by definition, invest for their own account. Neither of the two constraints is restricted in its application to derivatives. Instead, they are integral to defining the scope of the business enterprise of the institutional investor and the nature of the bargain between that institutional investor and the persons on whose behalf it makes investments (in particular, the two constraints establish the extent to which the persons for whom the institutional investor is acting have bargained for exposure to market-based or asset-specific risk).

In addition, the two constraints apply to institutional investors, regardless of the legal form selected to undertake their business enterprise. Thus, it is not relevant that pension funds are typically structured as trusts, while mutual funds may be structured as trusts or corporations, and hedge funds, private equity funds and venture capital funds may be structured as trusts, corporations or limited partnerships. The constraints do not arise as a result of the particular form chosen by the institutional investor for the management of assets on behalf of its investors, but are inherent in the relationship between the institutional investor and the investors.

3.1 Legal capacity of institutional investors

It is highly unusual for institutional investors to be given the same freedom to transact derivatives as corporate end users. Instead, the legal capacity of institutional investors to transact derivatives is ordinarily limited expressly by their governing laws, including the Occupational Pension Schemes (Investment) Regulations 2005 in the United Kingdom and the Employee Retirement Income Security Act 1974 in the United States, and constituent documents.

(Continues...)

Excerpted from Practical Derivatives by Edmund Parker, Marcin Perzanowski. Copyright © 2017 Globe Law and Business Ltd. Excerpted by permission of Globe Law and Business Ltd.
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Edition details

• Publisher: Globe Law and Business Ltd
• Publication date: 2016
• Language: English
• ISBN 10: 1911078178
• ISBN 13: 9781911078173
• Binding: Hardcover
• Edition number: 3
• Number of pages: 250