The year is 1859. Somewhere in pre-Great Fire Chicago, a man gestures somewhat obscenely to another gentleman and the nation’s very first futures contract is traded.
Chances are, this soon-to-be Cubs fan made the contract for a Midwestern farmer (or his grain elevator) to hedge against bad weather, bad luck or bad genes. A specific number of bushels of pretended grain were thereby created.
Odd, when you think about it. Here is a fellow who is worried about a glut of real wheat that will depress his selling price while, in response, he exacerbates the situation by inventing make-believe grain as well. Anyway, he has his price protection.
Now comes the bad news. “You owe me a commission,” says the trader to the farmer, “as well as a margin deposit of $1,200.”
Flummoxed, the reply is: “Your fee is fine but why do I have to put money down on something that hasn’t happened yet?”
The trader explains that, in this business, you never let the customer fall behind on his payments and, in fact, a surplus of funds is typically required.
“You don’t trust me to keep to the bargain?” asks the farmer. In response: “This is Chicago.”
And so it went for generations, a neat and tidy system where one pays to play, not the other way around. Eventually, the markets even grew a sugar daddy called a clearing house that piled more money on top of the existing dollars to assure against a worst case scenario.
And the business conducted through this system ran seamlessly, even in times of great crisis. That includes the 2008-2010 period when taxpayers became involuntary bankers for a time, though without bonuses or retention payments.
Too big to pay
Today, of course, there is much criticism of that regime. We hear companies that make billions of dollars in quarterly profits complain about proposals in Congress that would require them to post collateral for massive futures, options and derivatives positions – especially for market instruments that sank like the Titanic during the recent troubles.
“We are different,” they say. “Let those quaint farmers finance their hedges but our enterprises need an end user exemption from having to deposit real money. Otherwise, we are torn between two negatives: fund our hedges and grow our businesses more slowly, or don’t hedge in order to maintain our growth. We will threaten to adopt the latter choice. Maybe the system will blink.”
This debate might be averted entirely except for a flaw in the law. It has never been finally resolved whether shareholders can sue a company for suffering losses by deliberately failing to hedge.
A case can be made in favour of this ambiguity – after all, how much risk to take is a subjective decision. But an argument for accountability is supportable as well.
How much risk is careless?
So, while our lawmakers grapple with whether these new ‘end users’ should be spared the effrontery of having to post collateral, and whether the traditional clearing house protections should be waived in their case, someone should begin to address a standard of duty for decision makers in choosing between the competing goals of avoiding risk and maximising profits.
If inordinate business risks are taken in order to swell the executive bonus pool, serious fiduciary failings have probably occurred, which would warrant mega-lawsuits. But most of these decisions are less blatant than that.
The issue needs to be confronted whether failing to hedge is, is not, or presumptively is or is not, a breach of legal duty.
For a farmer who fails to hedge, the consequences can be ruinous for his family. But wealthier enterprises can take at least some losses without facing insolvency.
Anyway, it would be shareholders – not managers – that sustained any loss. Or that ultimately paid the regulatory penalty, should one be exacted.
As a general legal principle, situations like this which leave decision making to people who will not suffer the ultimate consequences impose a higher standard of care precisely for that reason.
Senator Christopher Dodd, are you listening?
The author is a former chairman of the CFTC and now heads the exchange-traded derivatives regulatory practice at Skadden, Arps, Slate, Meagher & Flom in Washington.