Derivatives, Corporate Hedging and Shareholder Wealth: Modigliani-Miller Forty Years Later
Corporate America considers risk management vitally important and considers derivative financial products an indispensable tool for managing many types of financial risk regularly faced by today's corporations. Not content with criticizing derivatives speculation as undesirable, however, some academics have begun to question the seemingly more benign use of derivatives as hedging devices, arguing that, under the irrelevance theorem developed by Franco Modigliani and Merton Miller, such hedging by corporations harms diversified shareholders. This has led some legal commentators to conclude that current corporate law norms fail to provide adequate guidance to management in a world characterized by derivatives and other new financial innovations. In this article, I demonstrate that a broad rethinking of the basic principles of corporate law as applied to corporate derivatives hedging is neither necessary nor warranted. In fact, such arguments raise a severe danger, if adopted by future courts judging management decisions regarding corporate hedging, of undermining the business judgement rule as applied to management hedging decisions. I demonstrate, through both a theoretical and empirical analysis, that because many potential benefits may flow to corporate shareholders due to firm-level hedging, the corporate hedging decision is a business decision just like many other decisions impacting shareholder welfare that are commonly made by corporate management. Accordingly, the decision of whether and how much to hedge should be protected by the business judgement rule, so long as that decision is made in good faith by fully informed and disinterested corporate managers.