Article by George Crawford on Fiduciary required use of derivatives to manage risk of holding employee stock options by hedging.

1. 1 Stan. J.L. Bus & Fin. 307
Stanford Journal of Law, Business & Finance
Spring, 1995
Symposium: Regulation of Financial Derivatives
Case Studies
*307 A FIDUCIARY DUTY TO USE DERIVATIVES?
George Crawford
Copyright (c) 1995 by the Board of Trustees of the Leland Stanford
Junior University; George Crawford

2. Does the pervasive use of derivatives within the investment and
fiduciary communities compelfiduciaries to learn how to apply them in
appropriate instances? This article approaches this question by
examining a fictitious scenario in which, in the midst of daily headlines
demonizing derivatives, a trustee is sued for breach of fiduciary duty for
failing to use derivatives to hedge the trust's investment portfolio. This
article addresses the merits of such a claim by first reviewing the
current uses of derivatives in the banking industry. It then examines
some of the recent headline-grabbing derivatives-related disasters and
contrasts the conservative use of derivatives as a hedge against loss
with their risky use for highly leveraged investment. Next, it presents an
overview of the rules the courts have applied to trustees, and the
evolution of those rules over the years. The use of derivatives is then
examined in the context of the most traditional and contemporary
formulations of the Prudent Investor Rule. This article concludes by
arguing that fiduciaries may now have a duty to understand uses of
derivatives to achieve the most appropriate mix of risk and return for
their beneficiaries, and to use derivatives when they offer the best
means of achieving that mix.
I. The Trustee's Dilemma and the Rejected Derivative Solution
The ticking of the antique clock was the only sound in Frank's wood-
paneled bank office as he stared open-mouthed at the papers he had
just received. Sued! Over derivatives! This despite the fact that his
department had never used derivatives, and indeed had little

3. understanding of what derivatives were. In fact, that seemed to be the
basis for the suit.
Frank was being sued for failing to use options to reduce the risk of his
client's investment portfolio. How could this be happening? Derivatives
in general, and options in particular, are “dangerous” and
“unpredictable” things–aren't they? After all, the business pages are
full of stories about derivatives-related disasters. How could a prudent
trustee even consider using option derivatives in a trust?
Frank picked up the phone. Within the hour he was sitting in the office
of the bank's attorney giving his account of the facts leading up to the
suit.
A. A Simple Trust
The trust had seemed so simple, so routine. Barbara had come into the
bank with her sister Alice. Barbara was in her 80's and had been
diagnosed with Alzheimer's*308 disease. Barbara had given her sister
Alice a power of attorney to handle her affairs. Alice didn't have any
financial expertise, and came to the bank for help. She wanted the bank
to manage Barbara's stocks and bonds, and make investment decisions
for Barbara, who could no longer depend on her own financial and
investment acumen. At the time, Barbara had accumulated an estate of
over $2,000,000.
Naturally, Frank suggested placing Barbara's assets in a trust, with the
bank as trustee. He called the bank's legal department, and it drew up a
simple trust agreement (the “Trust”). Two weeks later, Alice returned
to the bank to sign the Trust agreement under the power of attorney
Barbara had given her. Under the Trust agreement, all investment

4. decisions and management of Barbara's financial affairs would be
carried out by the bank. The Trust also provided that on Barbara's
death the assets would be distributed to Barbara's estate, which
included Alice and other siblings. Alice could terminate the Trust, or
override the bank's decisions, but this was unlikely since it was her
uncertainty about handling the administration of Barbara's funds and
making such decisions that brought Alice to the bank in the first place.
Together, Alice and Frank opened Barbara's safety deposit box and
made an inventory of the contents. There were bonds totaling about
$200,000, thirty different stock certificates totaling $700,000, and stock
certificates for Philip Morris Company totaling $1,500,000. Alice signed
the stock certificates over to the bank as trustee for the Trust. Now, all
dividend and interest payments, and proceeds from the sale of stocks
or bonds, would be made directly to the bank, which would hold them
in a separate account in the name of the Trust. The bank sent a check
for $3,000 each month to her small town nursing home, and also paid
any of Barbara's medical bills and other incidental expenses.
The total income of the Trust amounted to $80,000 per year from the
investments (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 Barbara's
living expenses, and $12,000 per year for the bank's fees, the Trust was
left accumulating $8,000 per year. There certainly seemed to be
enough money to support Barbara for the rest of her life–provided
there were no major investment losses.
B. The Need for Diversification

5. Frank knew that diversification was the key to any portfolio's safety. A
portfolio of many assets whose values do not rise and fall together is
much less risky than a portfolio of only one asset, or of several assets
whose values tend to rise and fall together. The bank's own common
trust fund was well diversified, containing short, intermediate, and
long-term bonds of varying credit quality, domestic stocks in companies
of varying size and active in many different industries, and even some
foreign stocks and bonds. Frank knew this was typical of bank trust
funds 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 bank's
attorney had explained to him that federal law specified that pension
funds be diversified, and *309 she had given him a copy of the new
version of the Prudent Investor Act, recommended to state legislatures
by the American Bar Association, which states: “The long familiar
requirement that fiduciaries diversify their investments has been
integrated into the definition of prudent investing.” *FN1+
With over sixty percent of Barbara's assets tied up in a single stock,
Philip Morris, Frank understood that Barbara's portfolio was exposed to
considerable risk. He also knew that at Barbara's age she needed safety,
not risk. Any additional money she made through risky adventures
would be of little practical use to her, but loss of the money she needed
to pay medical expenses and bills at the nursing home could be
disastrous. Frank wanted to diversify Barbara's portfolio, and
considered selling most of the Philip Morris stock and investing the
proceeds in high quality bills and bonds. This would give her greater
safety of principal, less exposure to the volatile stock market, and
increased diversification as between stocks and bonds. As to the

6. portion of her portfolio remaining in stocks, the companies were well
diversified in size and across industries. If her income from interest and
dividends was not sufficient to keep up with inflation in nursing home
and medical costs, Frank calculated that he could spend some of the
principal for Barbara's needs and the Trust would still be left with
ample funds for her remaining years.
C. The Obstacle to Diversification: Taxes
As he pondered diversifying Barbara's portfolio, Frank considered the
tax consequences. He knew that taxes should be considered as a matter
of prudent business practice, even though very few courts have held
trustees liable for mismanaging the tax planning of their beneficiaries.
[FN2] The new model Prudent Investor Act provides that “the Trustee
shall consider in investing and managing trust assets ... the expected tax
consequences of investment decisions or strategies.” *FN3+
Barbara began investing in the early 1930's, some sixty years before her
affairs were turned over to the bank. She bought stocks and held them,
and used dividend reinvestment plans to increase her holdings. The
stocks had appreciated greatly in value over the years; her total cost
basis for all her stocks was only $150,000, [FN4] including her Philip
Morris stock, whose basis was only $50,000. Consulting the tax tables,
Frank calculated that if all her stocks were sold, the total bill in federal
and state income taxes would have come to 40% of the $2,050,000
gain, 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 the
reinvested proceeds, her income from investments would be cut from
$80,000 a year to $47,400 a year. Combined with her $10,000
social*310 security income, this probably wouldn't cover her annual

7. expenses. Still, the plan would leave her investments risk-free, [FN6]
even though Frank would have to dip into principal to pay expenses and
the trust would be more vulnerable to high medical and living expenses
should she live for many years.
Frank also realized that whatever remained of Barbara's estate would
be taxed upon her death. However, if the stock remained in her estate
until after her death, the cost basis of the stock could be automatically
adjusted upward to its value on the date of her death. Then, it could be
sold the next day with no income tax payable at all. Thus, the $820,000
income tax bill that would be incurred by selling the stock now could be
completely avoided. The net saving to her estate would be
considerable. [FN7]More important the principal from which Barbara
was receiving income would not be reduced during her lifetime.
Furthermore, Philip Morris paid a good dividend, which would also
disappear after selling the stock and reinvesting the proceeds in short
term bonds.
Frank believed that the size of Barbara's estate after her death was
probably of little importance to Barbara. Barbara had no children, and
she had not made any substantial gifts to her brothers and sisters while
she was alive. True, she had left her money to them in her will, but she
had not indicated to Frank that she wanted to put her own security at
risk during her lifetime in order to leave a larger inheritance behind.
As Frank thought it all over, selling the Philip Morris stock now would
permit diversification of the trust assets, but payment of income taxes
would considerably reduce the income on which Barbara depended;
less importantly it would reduce the after tax value of her estate upon

8. her death. The question appeared to be whether diversification was
worth the tax cost, now and later.
Frank decided to talk the situation over with Alice, who held Barbara's
power of attorney. Alice came to the bank and Frank met with her to
explain things. Alice understood that if the stock were sold now,
Barbara's income would fall, and there would probably be less money
for Alice and her siblings after Barbara's death. [FN8] If the stock were
kept, Barbara would have more money now, and Alice and her siblings
would have more money after Barbara's death. That was in Barbara's
interest as well as her own, Alice thought, and she wasn't going to
quarrel with that. Still, she saw that Philip Morris stock could fall in
value, and if it did, there could be less money for Barbara now, and less
for her later. It would be nice to have it both ways, but she didn't know
how to do this, and Frank didn't seem to *311know either. Faced with a
difficult choice, she and Frank did nothing. Frank was happy enough
with this, since he had involved Alice in the decision, and it would be
harder for her to blame him if it proved to be the wrong one.
D. The Proposed Solutions: Options, Hedges and Swaps
After Alice went home from the meeting, she couldn't help thinking
about the issues the banker had posed to her-portfolio risk,
diversification, and tax considerations. She mentioned the meeting to
her sister Edna, who subscribed to several investment magazines, as
had Barbara. Edna noticed a simple explanation of options by the Wall
Street Journal, [FN9] which seemed to offer a solution to the issue
raised by the banker. [FN10] She wrote Frank a note, in which she
suggested that the bank consider buying puts as a means of insuring
against a big drop in the value of the Philip Morris stock.

9. Frank called and thanked Alice for the note, but did nothing about it,
considering the cost of buying the puts too high. Several months later
Edna saw another article in Forbes, which specifically used Philip Morris
stock as an example of derivative hedging with options. [FN11] Alice
thought that such a hedging strategy *312 sounded sensible, but she
wasn't sure she understood it completely. It involved buying puts, but
reducing their cost by selling calls at the same time. She also saw
another article in Business Week entitled “When Your Eggs Are All in
One Stock,” *FN12+ which suggested the use of an equity swap to avoid
underdiversification without paying taxes. She clipped out both articles
and sent them to Frank. The publication of these articles in major
financial magazines convinced her that it was something that many
people were doing, and she hoped the bankers would consider it.
As was explained in detail in the materials Edna had read, there were
three basic possibilities, and a number of ways they could be carried
out. The trust could buy puts, or it could buy puts and sell calls, or it
could swap the returns on the Philip Morris stock for the returns of a
diversified portfolio of stock, such as the Standard & Poor's 500. The
first two strategies might be implemented on the public exchanges. Any
of the three could be implemented through a private contract with a
bank or other derivative dealer.
If the trust bought puts, this would insure against loss, but involve
paying a substantial time premium, just like other insurance. Buying
puts would leave open the possibility of gains from upward movement
in the stock, and protect against loss at a price.
If the trust bought puts and sold calls, this would greatly reduce the
cost of the options, but it would foreclose the possibility of gains from

10. any increases in value of the stock. If the price of Philip Morris stock
declined, the loss would be offset by gains in the value of the puts. If
the price of Philip Morris stock increased, the profit would be offset by
increased liability under the put option which had been sold.
Either of the first two strategies could involve tax complications-in
particular, if the options expired before Barbara died, and had to be
replaced with new options. The exact tax consequences would depend
on which way the price of the stock moved and when. For most stocks,
options expire only a few months after they are purchased, and Barbara
could live for years. In the case of Philip Morris, however, and the stock
of a few other very large companies, special options are traded *313 on
the exchanges, called LEAPs, which expire several years in the future.
Even so, Barbara might outlive them, so the tax consequences could be
unpredictable.
As an alternative to exchange-traded options or LEAPs, some banks
write private options tailored to the buyer's needs. A contract could be
written which would not expire during Barbara's lifetime. Banker's Trust
advertised this service in a full page advertisement in Barron's which
Edna had seen. [FN13] Of course, the cost of this alternative would
have to be compared to that of publicly available alternatives. The third
alternative, swapping the Philip Morris stock for a stock index, had
been seen by Barbara inBusiness Week, where the strategy was
described in detail. [FN14]
In sum, several derivatives strategies were available to reduce Barbara's
risks without incurring the tax disadvantages of selling the stock. These
strategies differ in their consequences, and the cost of each strategy
would have to be carefully weighed. Their execution involves

11. complexities beyond the scope of this paper, and not central to the
point. The important thing is that such strategies exist, and that they
offer a resolution of the trust's dilemma-suffer the risks of
underdiversification, or pay large taxes now-at varying costs, but
without adding new risks of the magnitude of those being avoided. That
is, the risks of underdiversification could be avoided, and the large tax
cost 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 journals
and other technical forums, but were available in the publicly traded
options market quoted every day in the newspaper, explained in
mainstream business publications such as Forbes and Business Week,
and even advertised by large banks in full page advertisements in
Barron's.
E. The Rejection of the Solution
Despite a follow-up letter from Alice, the bank never implemented any
of the strategies that were so clearly presented to it. Frank simply
checked on the bank's view of Philip Morris stock and wrote Alice a
note thanking her for the articles, stating that the bank's investment
department was still positive on Philip Morris stock, reminding her of
the adverse tax consequences of a sale, and concluding that the bank
believed it was imprudent to use derivatives. In fact, Frank simply
thought that derivatives were dangerous and that there might be risks
he didn't fully understand, and didn't want to take the trouble to check
out the possibilities. Given the pervasive public presence of these
strategies, Frank was running serious risks by taking this attitude.
F. The Loss and the Lawsuit

12. Philip Morris stock was selling at about $78 per share at the time Alice
sent the articles to the bank. Upon Barbara's death, Philip Morris stock
was selling at about $52. Now that there was no longer any tax reason
to continue to hold the stock, Alice demanded that it be sold now, and
the sale was executed at $52 per share. *314 The next thing Frank
knew, he was holding in his hands the papers filed by the attorney
probating Barbara's estate. The suit charged the bank with breach of
trust by reason of imprudent investment, lack of due care in failing to
preserve the principal of the Trust, and negligently wasting the assets
of the Trust.
After listening to Frank's capsulization of the events leading up to the
suit, the bank's attorney told Frank that she had never heard of a
trustee being held liable for failure to use derivatives, and that she
knew of only one case that held a board of directors liable for failing to
hedge sufficiently with derivatives. [FN15] However, she informed
Frank that trustees could be held liable for failure to diversify, and that
Frank's reasoning for not doing that–adverse tax consequences–might
not be an adequate defense, since the bank had, without investigation,
rejected a proposed method for reducing the risk of the undiversified
portfolio without adverse tax consequences. The bank's attorney
summarized her understanding of Frank's situation by noting that the
applicable law is in a process of change, and that it was currently
unlikely that Frank could safely ignore the possible use of derivatives to
reduce the risks faced by his beneficiaries, whether or not the
beneficiaries themselves suggested the solution. Use of derivatives was
becoming too common in the financial world to be safely ignored.

13. II. Can A Trustee Use Derivatives?
A. Derivatives in Banking Today
In light of the recent disaster stories about derivatives, [FN16] the bank
might argue, as Frank seemed to believe, that derivatives such as LEAPs
are too risky for prudent trustees even to consider. Indeed, a
proclaimed refusal to use derivatives in a trust might actually be an
effective marketing tool, considering the fact that many people who
create trusts are rather conservative. The bank might even argue that
had it attempted to follow one of the derivatives strategies that Alice
suggested, it would have been even more susceptible to a lawsuit than
it was now.
A complete condemnation of derivatives by a bank may be difficult to
defend, however, given the current use of derivatives by many banks in
a variety of banking contexts-including trusts. In many cases, banks use
derivatives, such as the options proposed by Alice, to reduce risk. Given
the 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 such
as J.P. Morgan, Citibank, Bank of America, Wells Fargo, and many
others have been using derivatives effectively and successfully for
years. [FN17]
*315 At present, however, the term “derivatives” is a pejorative, given
the outcry in the press over prominent losses and lawsuits involving
derivatives at General Electric (“GE”), *FN18+ Proctor & Gamble
(“P&G”), *FN19+ Metallgesellschaft (“MG”), *FN20+ Orange County,

14. [FN21] and Barings. [FN22] Indeed, some state legislatures are talking
about banning derivatives altogether as public investments. The mere
mention of the word “derivatives” raises a red flag for federal bank
regulators, Congress, the Securities Exchange Commission (the “SEC”),
the Commodities Futures Trading Commission (the “CFTC”), the Federal
Reserve Board (the “Fed”), and various international agencies. *FN23+
Even newspapers warn the public to check for derivatives before
investing, as if a derivative were some kind of an infectious disease.
[FN24]
In spite of the disasters and fears, however, derivatives are here to
stay, for at least one very good reason: in many cases they provide a
low cost way for banks, money managers, corporate treasurers, and
even bank trust officers to reduce risk.
B. Using Derivatives to Reduce Risk in the Foreign Currency Market
Banks often help their customers reduce currency risk by writing
foreign-currency-forward contracts. For example, imagine that a client
(“Client A”) has recently ordered a shipment of parts from Japan, with
payment due in six months. Payment will be in Japanese yen.
Understandably, Client A would be concerned that the cost of buying
yen 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 One's currency
forward department could enter into a contract with Client A to sell to
him the exact amount of yen he will need in six months at a rate of
exchange that is fixed as of the date of the contract.*316 This contract
insulates Client A from any changes in the exchange rate of the dollar
relative to the yen. Thus, Client A can calculate the exact amount of

15. payment he will have to make, without any risk that changes in the
price of yen will require him to come up with more money. [FN25]
Payment and delivery of the yen typically occur when the yen are
needed. [FN26]
Bank One has, through its contract with Client A, assumed the risk that
a rise in the value of the yen relative to the dollar will force it to take a
loss when it delivers the yen to Client A at the agreed price. To
eliminate this risk, Bank One's currency-forward department can
contract with another bank's (“Bank Two”) currency-forward
department to buy yen in the future at a fixed exchange rate. Thus,
Bank One's obligation to sell yen to Client A is exactly offset by its right
to buy yen from Bank Two. This contract does not pose a risk for Bank
Two if it has a client (“Client B”) who was going to receive the same
amount of Japanese yen in six months from a sale of equipment to a
Japanese customer. By entering into a contract with Client B to buy her
yen at a fixed rate, Bank Two assures itself that it can meet its
obligation to Bank One while also assuring Client B that the profit
margin on her sale of equipment will remain constant despite any
fluctuation in the currency markets.
Both banks build in a profit margin for themselves in writing these
contracts and so are able to earn an assured profit while providing a
vital service to their clients. Through a simple hedge, the two clients
have removed the risk of currency fluctuations from their business with
foreign customers and suppliers who deal in a different currency.
The world's currency-forward business amounts to over $1 trillion a
day. Some of this business is carried out on the futures exchanges
where standardized contracts are traded, but by far the greatest part is

16. handled by bankers, creating custom-made contracts to accommodate
the needs of individual customers. [FN27] Competition among banks
drives the banks' profit margins down to competitive levels, and in the
transactions described here, each party is reducing risk by using
derivatives. [FN28]The currency-forward market is no new invention;
banks have been using it for years, and its origins trace back at least as
far as the Medici banking family.
C. Using Swaps to Reduce the Risk of Interest Rate Volatility
Interest rate swaps and basis swaps represent other uses of derivatives
that can considerably reduce risk. In fact, a bank could hedge its entire
loan portfolio with such swaps. Simply put, an interest rate swap can be
an arrangement between banks to “trade” the interest payments each
receives on loans it has issued. For example,*317 one bank may swap
the fixed rate payments it receives on a fixed rate loan for the variable
rate payments another bank receives on a variable rate loan. The
advantage of interest rate swaps is that they allow the bank portfolio
manager to match the duration of the bank's assets (loan payments)
with the duration of its liabilities (demand deposits, CD's, and the like).
[FN29]
Banks use another type of swap, called a basis swap, to fix the spread
between the cost of funds to the bank (the rate it pays on deposits) and
the rate that the bank receives on its loans. For example, suppose a
bank has lent money at the prime rate plus two percent. At the same
time, the bank has promised to pay depositors the six month Treasury
Bill rate plus two percent. As long as the prime rate exceeds the six
month Treasury Bill by a constant percentage, the bank can predict its
profit on this spread. If the spread between these two rates narrows,

17. however, the bank's profit is at risk. Thus, a bank may enter into a basis
swap in which it agrees to pay the prime rate to a third party (usually a
derivatives dealer) in return for that third party's agreement to pay the
six month Treasury Bill rate to the bank. [FN30]
Unlike the currency market, where futures are traded daily and prices
can be found in the newspaper, the swaps market largely takes place in
private transactions involving banks. Nevertheless, swaps trading is
another huge segment of the derivatives market. [FN31]
D. Investment-Fund Managers' Use of Unleveraged Derivatives to
Improve Portfolio Diversification
Stock indexes and options are commonly used by investment-fund
managers as an inexpensive way to buy or sell a diversified portfolio of
stocks. The price of a stock index fluctuates with the price of the
underlying basket of stocks that it represents. For example, the S&P
500 index represents the aggregate value of the 500 stocks making up
that index. When the total price of those stocks rises, the index rises. A
June 1996 S&P 500 stock index future represents a commitment to pay
on a date in June, 1996 an amount based on the value of the index on
that date. [FN32]
For example, suppose a pension manager has $100,000,000 in cash that
he wants to invest in various stocks within a few weeks. [FN33] When
the money comes in, the manager may not necessarily have a long list
of stocks ready to buy that day. However, depending on the guidelines
for the fund, the manager may have an obligation to be “in the market”
immediately. Certainly, the manager doesn't want to go out and buy a
group of stocks without sufficient analysis. Therefore, the manager
buys stock index futures with a face amount of $100,000,000 as a proxy

18. for a well diversified portfolio. This purchase does not require the
entire $100,000,000. Rather, *318 it may require only that $5,000,000
be deposited with the broker as security for the purchase of the stock
index futures. The fund earns interest on the $5,000,000 and can leave
the remaining money on deposit with the bank, where it also earns
interest. Then, as the manager studies the markets, and picks just the
right time to buy particular stocks, he can buy the stocks, and sell an
equal face amount of the index futures at that time. Through this
procedure, $100,000,000 is invested in stocks at all times. More
important, at no time is the portfolio leveraged. In fact, this particular
use of index futures is no more risky than buying the individual stocks.
The purchase of index futures is a cost effective way to achieve the
diversity of a large portfolio without the need to make hasty
investment decisions in individual stocks. [FN34]
E. Concerning Derivatives Disasters
A brief analysis of some recent derivatives disasters sheds valuable light
on possible causes of such disasters, and on the reasonableness of
using derivatives in a bank trust account. Derivatives-related disasters
can be caused by the same traditionally inappropriate investment-
management practices that would have led to financial disaster even in
the absence of derivatives. These practices include the use of leverage
to multiply risk and reward beyond levels suitable for the investor,
inadequate monitoring of traders, and a failure to match the time
frame of an investment to the investor's liquidity requirements. The
complexity of derivatives may add to these problems by making them
harder to identify. [FN35]Nevertheless, the size of the losses incurred
and the unexpected swiftness with which the losses mount, suggests

19. that derivatives involving leverage need closer management scrutiny
than other investments.
Leverage helped cause nearly all of the recent derivatives disasters,
including the losses in bond trading at Kidder Peabody, [FN36] the
losses on interest rate swaps incurred by P&G, [FN37] the losses in the
bond market that drove Orange County *319 into bankruptcy, [FN38]
and the losses in the Nikkei stock index and Japanese interest rate
futures trades that bankrupted Barings. [FN39] While some of the
trading in these situations may have begun with an attempt to hedge
other obligations, such as corporate interest rate obligations at P&G, all
ultimately involved large, unhedged, leveraged positions which moved
decisively against the investor.
Leverage multiplies risk and potential return. The principle is simple. If a
bond purchased for $1,000 cash fluctuates 10% in value, a $100 gain or
loss is incurred, equal to 10% of the investment. Now suppose the
$1,000 bond is purchased for $200 in cash and the balance of the
purchase price in some form of credit. This is five-to-one leverage, since
the price of the bond is five times the amount of cash used to buy it. A
10% fluctuation in the price of the bond still results in a $100 gain or
loss, but this is now 50% of the $200 investment in the bond. The use of
five-to-one leverage has multiplied the gain or loss percentage by five.
A conservative investment has become a very risky investment.
The bankruptcy at Baring's is a stunning example of the disastrous
potential of leverage. Baring's Singapore trader was apparently
authorized to engage in fully hedged arbitrage trades. For example, he
would buy the Japanese stock index in the Singapore market, and sell
exactly the same index in the Osaka market, profiting from small

20. differences in the price of that index which would temporarily exist
between the two markets. Given the fully hedged nature of his
positions, large use of leverage was justifiable. It appears that he tired
of this safe trade, however, and made very highly leveraged
investments, which were not hedged, *320 believing that he knew
which way the index would move. He was wrong, and an investment
firm old enough to help finance the Louisiana purchase and the
Napoleonic wars was bankrupt in little over a month; thus illustrating
the speed with which highly leveraged investments can unravel, as well
as the need for close supervision of traders.
F. MG: A Failed Hedge Against Long Term Contracts
MG's losses present a different problem. The losses at MG illustrate (i)
the way in which business risks unrelated to derivatives are often
blamed on derivatives, (ii) the importance of matching the timing and
amount of a hedge with the underlying business obligation being
hedged, and (iii) the importance of anticipating the possible short-term
costs of financing a hedging strategy.
As part of its regular business, MG entered into contracts to supply
customers with petroleum at fixed prices in the future. MG's futures
trading was intended to hedge against these long-term contracts to
supply petroleum at fixed prices. [FN40] The logic behind the futures
contracts was that any increase in the price of oil would be offset by a
gain in the value of the futures contract, which would offset losses on
the long term supply contracts, and vice versa. In fact, the price of oil
fell, so that there were losses on the futures position, and potentially
high profits under the long term supply contracts. The problem
however, was that the losses in the futures contracts occurred in the

21. present while the profits that MG hoped to make on its petroleum
supply contracts did not. Indeed, those profits would only accrue over
time, as the petroleum supply contracts were fulfilled. Ultimately, the
present losses were so large and notorious that the company decided
not to maintain the hedged position. It took its losses in the futures
market and extricated itself from its long term supply contracts, all at
great expense. [FN41]
The MG hedge created new risks, [FN42] rather than eliminating
existing business risks, because of a timing mismatch between the
hedge and the business obligations MG was trying to limit by the
hedge. MG bought short-term futures contracts even though its supply
contracts were long-term. As an alternative to the hedge into which
MG entered, it might have contracted with one of the large derivatives
dealers for a long-term custom-made hedge against the market risk of
oil prices. For its part, the derivative dealer could then have limited its
own 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 to
purchase oil from someone with large oil reserves who wanted to be
sure of selling oil at a fixed price in the future, such as an oil company.
This would have been much like the currency-forward contracts
discussed above, in which the timing of the obligation would match the
timing of the hedge.
In any case, MG's original risk was created by entering into long-term
petroleum supply contracts at a fixed price when MG knew that the
price of oil remained very volatile. Long-term, fixed-price supply
contracts inherently involve speculation on future prices, which can
cause disasters even without derivatives. For example, several years

22. ago Westinghouse was selling nuclear power plant equipment, and
offered the utility companies which bought the equipment long-term,
fixed-price uranium supply contracts. The price of uranium rose, and
Westinghouse found itself faced with potentially disastrous
commitments. Westinghouse reneged on the contracts, and defended
itself by asserting that the price increases were unforeseeable and a
proper basis to void the contracts. It settled the resulting litigation at
great but not disastrous expense. [FN43]
The really big risk was undertaken by Westinghouse and by MG when
each entered a long-term supply contract at a fixed price, which would
have to be fulfilled by purchases on the open market, at an
unforeseeable price. Westinghouse didn't hedge, and avoided disaster
only 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 fully
offset the business risk, like any other insurance cost, MG apparently
thought it could implement a hedging program that involved
speculative trading of the market on a short-term basis-profiting from
this short-term trading to reduce the cost of the hedge. [FN44] The
strategy backfired; the anticipated short-term trading profits became
short-term trading losses; and both the hedging program and the
underlying supply contracts were abandoned. [FN45]
As in the case of Baring's and MG, hedgers often meet with unexpected
losses when they stray from pure hedging to outright, unhedged, and
often highly leveraged, investments. By definition, hedges decrease
rather than increase risk. However, each hedging transaction must be
carefully examined to determine the extent to which it strays from

23. being a pure hedge: whether it incorporates elements which create,
rather than eliminate, risk; the magnitude of those risks; and their
effects on the transaction and the organization if they become a reality.
Unfortunately, whether this straying is fully understood by the
company personnel implementing the program, whether it has been or
should have been fully explained to them by the brokers through which
the program is implemented, and whether top *322management knew
what was happening are often questions which can only be resolved by
long and painful litigation.
G. Summary: Three Uses of Derivatives
As discussed above, banks can use derivatives conservatively in two
ways. They can hedge, or they can use derivatives as a proxy for
another investment.
In the first case, they (or their clients) can use them to hedge against
fluctuations in the prices of underlying commodities (like petroleum) or
financial instruments (like currencies or interest rates) as to which the
hedger has a business commitment to buy or sell. When hedging, it is
critical that the investor match the time frame and amount of the
derivative contract with the time frame and amount of the supply or
purchase contract.
In the second case, a fund manager within the bank can use derivatives
as convenient proxies for the underlying investments from which they
are derived, as in the case of a pension fund manager buying a futures
contract on the Standard & Poor's 500 stocks. As long as the pension
fund has allocated to this position as much cash as it would require to
buy the stocks represented by the futures contract, this use of

24. derivatives is unleveraged and no more speculative than buying the
stocks themselves.
Banks can also use derivatives for leveraged investment. Like any other
method of leveraging an investment (such as buying stock on margin)
this multiplies risk just as it multiplies potential reward. As the recent
derivatives disasters indicate, the risks associated with high leverage
are not always fully appreciated by those making the investment at the
time it is made. Use of high leverage requires expertise and attention
on the part of the investor and bank management. The bank's
management commit to closely monitoring both the positions held, and
the traders entrusted with the use of derivatives. Even then, there may
be substantial losses.
In any case, Frank's argument that derivatives are simply inappropriate
for banks in general or trust officers in particular, simply flies in the face
of the widespread, conservative uses of derivatives in banking today.
III. A Trustee's Fiduciary Duties
Although 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 Frank'sfiduciary duty
did not require him to adjust his investment strategy to accommodate
innovations in the financial markets. Evaluation of such an argument
requires a careful examination of both (i) the Prudent Investor Rule,
which defines generally a trustee's duties, and (ii) the way that courts

25. have interpreted afiduciary's duties when confronted with “new”
investment choices.
A. The Prudent Investor Rule
The job of a trustee is not getting any easier. The courts have been
looking over trustees' shoulders for a long time now, and even the best
clients sometimes sue their trustees. The traditional formulation of the
Prudent Investor Rule is found in *323 the 1830 case of Harvard College
v. Amory, [FN46] where the court asserted that fiduciaries should
“observe how men of prudence, discretion and intelligence manage
their own affairs, not in regard to speculation, but in regard to the
permanent disposition of their funds, considering the probable income,
as well as the probable safety of the capital to be invested.” *FN47+ This
statement of the “Prudent Investor Rule” has been quoted ever since.
Various forms of it have been enacted in many state and federal
statutes, and form the basis of many court decisions. [FN48]
In this respect, the traditional test is timeless, and as valid today as it
was in 1830. By referring the fiduciary to the conduct of others who are
regarded as “of prudence, discretion and intelligence,” the court
expressed a standard which automatically updates itself to
contemporary standards of commercial conduct, of which evidence can
be introduced in the normal course of judicial proceedings.
Defining the current standard of conduct, however, can be quite
challenging. For example, the emphasis on “permanent” disposition of
funds seems almost quaint in an era where many customers seem to
think that a trustee's management is no better than the last quarter's
results. In our hypothetical scenario, Barbara was an old-fashioned,
long-term investor who profited greatly from buying and holding good

26. companies over the years. Frank may try to use her successful, long-
term strategy as a justification for keeping the investments she made,
but Barbara's heirs can counter that this strategy no longer made sense
given the relative size of Barbara's Philip Morris position, the volatility
of the stock market in general and Philip Morris in particular, and
Barbara's age, health, and projected needs.
1. Stocks and the Prudent Investor
The propriety of investing in stocks provides an example of the
redefinition over time of the standard of prudent conduct. The original
formulation of the Prudent Investor Rule condemned “speculation,”
which could be understood to include stock investments. [FN49] To
quote a New Jersey court as recently as 1934:
The stock market is not a playground for trustees. The ethics of
trusteeship is not to be found in the code of the speculator. An
executor's function is to conserve, not to venture. It is no less a breach
of trust to speculate with securities of an estate than to gamble with its
money, though the motive be to advance its interests. [FN50]
Fifty-two years later, however, a Washington court held that a bank
trustee acted imprudently byfailing to include stock in a portfolio
otherwise comprised *324 exclusively of tax-free bonds. [FN51] The
court ordered the bank to pay damages based on what the trust would
have earned if the trustee “had prudently diversified between tax-
exempt and equity securities” by investing forty percent of the trust's
assets in stocks, which would have appreciated twenty to twenty-two

27. percent during the time of the trust's administration, as measured by
the broad stock indexes. [FN52]
Today, the easiest way to purchase a widely diversified portfolio of
stocks is to buy a futures contract on the Standard & Poor's 500. For an
investor with $250,000, this is no more risky than buying $250,000
worth of stock, and it provides a much more diversified portfolio than
an investor could buy for $250,000 at much lower transaction costs.
True, the futures contract doesn't pay dividends, but the investor
receives interest on the $250,000, which today pays more than
dividends. Indeed, many pension funds routinely use futures as a
temporary substitute for stocks. So long as no leverage is employed and
the investor keeps cash on hand equal to the total face value of the
futures contract, the substitute is no more or less risky than buying the
stock itself. [FN53]
2. Tax Planning and the Prudent Investor
Tax planning provides another example of changes in the standards of
conduct under the Prudent Investor Rule. Trustees have rarely been
held liable for bad tax planning. In fact, one court recently noted that a
trust officer would not be held liable even if she had openly admitted
that she was “unaware of some of the tax consequences” of her
investment decisions. [FN54]
Even so, Frank's concern about adverse tax consequences is hardly
misplaced. A recent, authoritative restatement of the Prudent Investor
Rule observes that:

28. [T]ax consequences within the trust and the tax positions of the various
beneficiaries have come to have considerable importance in the
management of trust funds, and the trustee's investment decisions
often affect different beneficiaries quite differently in this respect. For
these reasons trustees must recognize that the traditional insistence on
preservation of principal includes a consideration of the real value of
the corpus and a need to balance this concern against a life
beneficiary's typical interest in the production of income, with
attention to the after-tax worth of each. [FN55]
In the same vein, the model Prudent Investor Act provides that “the
expected tax consequences of investment decisions or strategies” are
“*a]mong the circumstances*325 that the trustee shall consider in
investing and managing trust assets.” *FN56+ Frank is justified in his
concern over the tax consequences of selling Philip Morris. That
concern is not enough to justify inaction, however, if both the tax
objective and the diversification objective can be achieved through
derivative strategies being used by other fiduciaries. Under both
traditional and modern concepts of the Prudent Investor Rule, no
trustee can safely ignore investment strategies other fiduciaries are
using to protect their beneficiaries. [FN57]
3. Diversification and the Prudent Investor
Under the current legislative model, the primary duty of the trustee is
to strike an appropriate balance between risk and reward in a portfolio,
[FN58] and diversification is the principal method of reducing risk

29. without reducing potential rewards. [FN59] In today's financial
environment, derivative vehicles-including options, futures, and swaps-
offer opportunities for diversification, sometimes at lower costs or risks
than other alternatives. Under the legislative model, “a trustee may
invest in any kind of property or type of investment” as long as it fits
into a portfolio which is prudent when taken as a whole. [FN60] This
legislation has only recently been endorsed by the American Bar
Association and Uniform Law Commissioners, but it reflects modern
portfolio theory and practice, as expressed in the restatement of the
Prudent Investor Rule by the American Law Institute. It is now under
consideration by state legislatures, and a judge might well apply its
principles under the traditional rule of Harvard College v. Amory, to
require fiduciaries to emulate the practices of other prudent fiduciaries
who are already using derivatives.
Indeed, pension funds are not only using futures, swaps, and other
derivatives, but also investing in venture capital, short-term technical
trading schemes, and other types of investments that have traditionally
been regarded as too speculative for fiduciaries. [FN61] Pension
managers justify their engaging in such investments under pension laws
[FN62] and modern portfolio theory. [FN63] They explain that while any
one investment taken alone might be regarded as too speculative, a
combination of these investments can produce a prudent portfolio in
the aggregate. That is, some *326 individual assets in the portfolio may
be very volatile, with widely varying returns and the possibility of large
losses, but such investments also offer the possibility of very high
returns. Since gains on some of these investments are expected to
more than offset the losses on the others, and since the losses are not
likely to occur in all the investments at the same time, the portfolio as a

30. whole may produce a fairly steady, fairly high rate of return. [FN64] In
this way, a portfolio containing a combination of speculative and
conservative investments can produce higher returns with less volatility
than the traditional prudent portfolio containing only conservative
investments.
B. Emerging Rules for Prudent Investors
1. Changes in the Prudent Investor Rule
Supporting the new fiduciary investment standards, five changes have
been made in the new model Prudent Investor Act. These changes
reflect the evolution of current financial theory and practice which
underlie the changes in fiduciary behavior and standards discussed
above.
First, “*t+he long familiar requirement that fiduciaries diversify their
investments has been integrated into the definition of prudent
investing.” *FN65+ There is no question that Barbara's trust was
inadequately diversified. As discussed above, the requirement for
diversification has been in the law for a long time. Its inclusion in the
Restatement Third of Trusts and the new Prudent Investor Act only
serves to emphasize this duty.
Second, “*t+he tradeoff in all investing between risk and return is
identified as the fiduciary's central consideration.” *FN66+ Since the
primary focus of a hedging strategy is to improve this tradeoff, future
trustees may expect that a failure to hedge could lead to liability when

31. hedging is necessary to protect the portfolio from risks which would
otherwise be judged excessive, such as those of underdiversification.
Third, “*a+llcategoric restrictions on types of investments have been
abrogated; the trustee can invest in anything that plays an appropriate
role in achieving the risk/return objectives of the trust and that meets
the other requirements of *327 prudent investing.” *FN67+ This makes
it clear that derivatives may be used in trust investing, provided that
the particular use made of the derivatives is prudent.
Fourth, “*t+he standard of prudence is applied to the portfolio as a
whole, rather than to individual investments.” *FN68+ In evaluating the
trustee's performance, this change allays any concerns that gains on
the options, such as Philip Morris LEAPs, puts, or swaps, would not be
offset against losses on the Philip Morris stock, and vice versa.
Fifth, “*t+he much criticized former rule of trust law forbidding the
trustee to delegate investment and management functions has been
reversed. Delegation is now permitted, subject to safeguards.” *FN69+If
a trustee is unfamiliar with a particular investment vehicle the use of
which would benefit his beneficiary, nothing prevents the trustee from
delegating that investment task to a more knowledgeable expert,
carefully selected, instructed, and monitored, at costs reasonably
related to the purposes to be served.
2. The Fiduciary Duties of Pension Fund Investors

32. Over one-third of the common stock of American companies is owned
by pension fund fiduciaries on behalf of those who depend on it for
their retirement. The conduct of these fiduciaries, and the standards by
which they are judged, cannot be disregarded in determining what a
prudent investor must do. The investment strategies of pension
managers may tend to set standards for all fiduciaries. Under current
pension plan regulations:
A fiduciary shall discharge his duties with respect to a plan with the
care, skill, prudence, and diligence under the circumstances then
prevailing that a prudent man acting in like capacity and familiar with
such matters would use in the conduct of an enterprise of a like
character and with like aims. [FN70]
This version of the Prudent Investor Rule not only emphasizes
contemporary practices in the financial community; it also holds
fiduciaries 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 appropriate
consideration to those facts and circumstances that ... the fiduciary
knows or should know are relevant to the particular investment” and
“has acted accordingly.” *FN72+ Consideration shall include the “risk of
loss and opportunity for gain,” *FN73+ “the composition of the portfolio
with regard to diversification” *FN74+ and “anticipated cash *328 flow
requirements.” *FN75+ In this formulation, the tradeoff between risk
and reward, and the emphasis on diversification, are as central to
pension law as they are to the laws regarding private trusts. The ability
to delegate investment authority to others, and ways of allocating

33. responsibility among those with such authority, are spelled out in the
same regulation.
As they relate to our hypothetical scenario, both pension law and the
new version of the Uniform Prudent Investor Act reflect the latest
thinking in the field, and lead to the same conclusion as the 1830
traditional rule: current financial practice is the touchstone for
evaluating Frank's investment decisions with regard to Barbara's trust,
and answering the question whether his failure to hedge with
derivatives was a breach of his fiduciary duty.
Derivatives are simply one of the tools a fiduciary has available to
construct a portfolio with risk and return characteristics which are
suitable for the people whose money is being invested. This tool is now
so widely used that it should be in every fiduciary's tool kit, even if used
only carefully and sparingly. Like any other tool, it can be used, or
misused.
IV. Did Frank Have A Fiduciary Duty to Use Derivatives?
There are currently no cases holding a trustee liable for failing to use
derivatives, but there is a great deal of authority for the proposition
that trustees should not run the risks of an undiversified portfolio. Any
court dealing with the issue as a matter of first impression may be
influenced by this authority, as well as the changes in contemporary
standards and practices discussed above. Frank will have to explain why
he maintained so large an investment in Philip Morris stock in the face
of diversification requirements. His explanation that a sale would have

34. incurred onerous tax burdens will be met with the argument that there
were many ways to use derivatives to diminish the risk without
incurring the tax burden. A general condemnation of the use of
derivatives as a means to “get rid of the risk, not the stock,” as
advertised, seems unlikely to impress a court without a detailed inquiry
into the costs and risks of each strategy. [FN76] Failure to make this
inquiry 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 of
investment vehicle available, but he was a trustee. Under the
traditional formulation of the Prudent Investor Rule in Harvard College,
*FN77+he had a duty to “observe” how others manage their affairs, and
any such observation would have disclosed the articles and
advertisements seen by Edna in the public press, as well as more
specialized financial journals. Frank might at least have contacted other
investment managers to find out if, and how, they were using
derivatives. At a minimum, Frank could have contacted his own bank's
treasurer and fund managers, as well as trust officers *329 at other
banks. [FN78] Through such an inquiry, Frank could have learned the
extent to which this use of derivatives was an accepted practice.
A. Hedging vs. Speculating
Given the recent disaster stories about derivatives, Frank could argue
that any use of derivatives would be improper for a trustee. However,
as Part II indicates, these disasters cannot simply be blamed on
derivatives, and banks currently use derivatives in a variety of prudent
ways. Furthermore, long experience of courts and regulators with
derivatives, even before their current prominence, reflects a distinction
between their use as a hedge and their use for speculation, a

35. distinction which is recognized by the regulators of the futures
exchanges 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 ... who
deals 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 by
unfavorable change to the price of something expected to be used or
marketed in one's business; (2) a possibility of shifting to someone else,
through the purchase or sale of futures contracts; and (3) an intention
and attempt to so shift the risk. [FN81]
A speculator, on the other hand, is one “with no underlying interest in
the cash market ... [who takes] on the risks which the hedgers want to
shift.” *FN82+ Thus speculators are taking on risk with a view to
generate profits.
With Barbara's large investment in Philip Morris stock, the use of
derivatives to reduce that risk should clearly be regarded as a hedge in
economic substance. Furthermore, given the fact pattern in Barbara's
case, 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 an
insurance premium. Balancing benefits against costs is part of the duty
of the trustee to balance risk and reward, and if not carried out in a
timely and careful manner, a basis for imposing liability.
B. Relevant Precedent

36. The hypothetical suit is one of first impression. No cases have been
found imposing a duty on a trustee to use derivatives. The recent
outbreak of derivatives *330 litigation thus far has involved claims that
derivatives were used to effect unsuitable investments; or hedges
which were ill conceived, ill understood, badly implemented, or
including elements of highly leveraged outright investment.
There is one case, however, holding a board of directors liable for
insufficient use of derivatives. InBrane v. Roth, [FN83] the board of
directors of an Indiana grain co-operative used the futures market to
hedge against the risk of a collapse of grain prices while the grain was
being held in the co-op's elevator pending eventual sale. [FN84] The
trial court held the co-op's hedging efforts insufficient, since the hedge
was in too small an amount to protect the bulk of the grain from the
price collapse which occurred. [FN85] The court held the directors liable
for failing to understand and supervise the hedging practices which
they had delegated, and a court of appeals affirmed. [FN86]
The Brane case may be a particular source of discomfort for bank or
pension trustees, since corporate directors are held to a less stringent
standard than the Prudent Investor Rule discussed above. In fact,
corporate directors are often shielded from liability by the “Business
Judgment Rule” which protects them from liability for their decisions so
long as they act in good faith, free of conflict of interest, and with at
least a minimal level of attention to the corporation's affairs. [FN87] It
is true that in Indiana hedging grain inventories may be a common
practice with which co-op directors are or should be familiar, and that
this is not a financial center case involving much larger sums. However,
the same logic may influence courts deciding cases in areas of the
financial community where particular derivatives are now widely used.

37. [FN88] The likelihood of such a development is underlined by a recent
Barron's editorial arguing that “companies ... that don't use derivatives
... are, on the whole, much riskier than companies that do.” *FN89+ The
same editorial quotes Wharton professor Richard Marston, who
recently completed a study of the extent of derivative use, as saying:
“Any firm that has an exposure and doesn't use derivatives is gambling
with the shareholders' money.” *FN90+
*331 V. Conclusion
Since 1830, investors of other peoples' money have been subject to the
legal requirement that they “observe” current financial practices and
apply 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 in
the federal regulations governing pension fund investment, [FN91] and
in the Uniform Prudent Investor Act [FN92] propounded for state
legislation, make it clear that every category of investment is
permitted, including derivatives, so long as it plays an appropriate part
in a diversified portfolio whose potential returns are balanced against a
level of risk suitable for the beneficiaries. Construction of such a
portfolio is facilitated by (i) emphasizing investment strategy and
performance of the portfolio as a whole, rather than each particular
investment, offsetting losses against profits which are part of the same
strategy, and (ii) permitting delegation to carefully selected, instructed,

38. and monitored experts in situations where a trustee lacks the expertise
to carry out a strategy that would advance the interests of the
beneficiaries.
Banks and other prudent trustees can consider the use of derivatives in
three ways. First, they can be used as a hedge, reducing risk at a price,
as with Barbara's Trust. Second, as in the case of a pension fund buying
a futures contract on the Standard & Poor's 500, they can be used as
proxies for the underlying investments from which they are derived. As
long as the pension fund has allocated to its position cash equal to that
which would be required to buy the stocks represented by the futures
contract, this use of derivatives is unleveraged and no more or less
speculative than buying the stocks themselves. The third use of
derivatives involves the use of leverage to multiply the potential return,
and the risk, of a particular investment. Any use of leverage carries with
it the multiplication of risk which can render the investment extremely
risky. Especially close monitoring of highly leveraged investment
strategies is necessary, and even then there may be substantial losses.
In the context of fiduciary investing, fiduciaries such as bank trust
officers can use derivatives as a pure hedge. Because some complex
derivative products include elements of all three uses, however, it is
easy for a fiduciary (perhaps misled by an overeager broker) to slip
from one of the first two “conservative” uses of derivatives, as hedges
or proxies, into their much more risky use for highly leveraged
investment. Accordingly, each use of a complex derivative product or
strategy must be carefully analyzed to determine the extent, if any, to
which it exposes the user to risk, and the extent to which it guards the
user from risk. [FN93]

39. *332 Fiduciaries may even be required to use derivatives to hedge
against risk in cases where the best result for the beneficiaries can be
achieved in no other way. The second use of derivatives, as an
unleveraged proxy for the underlying investment, is in widespread use
today, has not resulted in notorious disasters and litigation, and is
certainly permitted to fiduciaries. The third use, as a highly leveraged
investment, helped cause many of the recent financial disasters and
lawsuits, and poses many risks to trust managers when applied to any
substantial part of a trust portfolio without the express mandate of the
grantor.
Derivatives are part of today's financial world, in newly colossal size.
They can be used to great advantage, or misused with disastrous
consequences. We can learn from the current wave of litigation and
disputes how to avoid similar problems in the future, and intense
efforts are underway within the derivatives industry and among its
regulators to that end. Meanwhile, fiduciaries may now have a duty to
understand enough of this great, new fact of life to make safe use of
derivatives to obtain advantages otherwise unavailable to their
beneficiaries, as well as to avoid their risky use for highly leveraged
investment where those risks are unauthorized, undisclosed, and
unsuitable.
[FNa1]. Lecturer, Stanford Law School; Visiting Scholar, Hoover
Institution; 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 in
preparing this article.

40. [FN1]. UNIF.PRUDENT INVESTORS ACT, prefatory note at 1 (Nat'l Conf.
of Comm'rs 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 Barbara's stocks is the price at
which she purchased them. The profit on which she would have to pay
tax, if the stocks were sold, is the difference between the amount she
receives for the stock and the cost basis.
[FN5]. For a precise calculation of the applicable federal and state
taxes, consult tax tables and tax schedules in reporters such as the CCH
STANDARD FEDERAL TAX REPORTER (1995) and the CCH STATE TAX
REPORTER, 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 to
inflation.

41. [FN7]. Some rough estimates show that in the absence of dramatic
price changes in the value of Barbara's investments, her estate would
be about $450,000 larger if the stock were held until her death, rather
than sold before her death. If the stock were sold before her death, the
value of the portfolio after income taxes would be $1,580,000; an
estate tax of $592,000 (roughly 40%) would be due on this amount at
Barbara's death, leaving $988,000. If the stock were sold after Barbara's
death, in contrast, $976,000 in estate taxes would be due on the
$2,400,000 estate, but, after basis adjustment, no income tax would be
payable on the sale of the stock leaving $1,424,000 for her heirs.
[FN8]. Often, trustees are reluctant to change the investment decisions
of those who have made the money which funded the trust, but here
the case for change was strong.
[FN9]. See RICHARD S. WURMAN ET AL., THE WALL STREET JOURNAL
GUIDE TO UNDERSTANDING MONEY & MARKETS 92-95 (1990).
[FN10]. A put option gives the option holder the right, but not the
obligation, to sell the corresponding stock at a fixed price at any time
before the expiration date. Id. at 92-93. A more comprehensive but
readily understandable explanation of these markets is found in
GLOBAL DERIVATIVES STUDY GROUP, GROUP OF THIRTY, DERIVATIVES:
PRACTICES AND PRINCIPLES (1993).

42. [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 around
the corner, yet unwilling to sell the stocks because of the taxes you'd
have to pay. If you've got low-cost-basis stock and live in a high-tax
state, selling the stock could erase almost a third of your capital.
For investors in this fix, there are escape hatches. One that you should
look at closely involves the options market. ... Suppose you own Philip
Morris 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 to
buy a put, also with a strike price of 80. Net outlay: pretty close to zero.
But don't you get hit for capital gains tax on the Philip Morris when the
options expire? Not if you don't want to. Instead of delivering your
Philip Morris, you can close out your option positions for cash-gaining
on 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 a
paper 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 $15
than tax on $73, the gain you would have reported had you sold the
stock outright. The bottom line is that your stock is worth $13 a share
less on paper, but you have made a profit of $15 a share on your
options.
And if Philip Morris keeps shooting up, say to 95? Then you have
another $17 of paper gain on your stock, and that gain remains
untaxed. Offsetting most of this gain, you will have an out-of-pocket
$15 loss on the options.

43. 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 a
huge capital gain. An equity swap meets these requirements. You pay a
fee to a commercial or investment bank and enter a contract agreeing
to pay the bank the total return on [Philip Morris] shares in exchange
for the return on a diversified basket of issues such as ones listed on
the Standard & Poor's 500 index. ... Some tax professionals believe that
the Internal Revenue Service will make swaps taxable. Other experts
say that isn't likely.
[FN13]. See Too Much Money In Just One Stock? Get Rid of the Risk,
Not the Stock, BARRON'S, 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) (holding
a board of directors liable for failing to sufficiently hedge against
changes in grain prices). See infra text accompanying notes 83-90.
[FN16]. See Lauren A. Teigland, Derivatives, Disputes, and
Disappointments, 64 BNA BANKING REP. 703 (1995).

44. [FN17]. See Books of Revelations, RISK, Sept. 1994, at 93. A list of the
commitments of the 10 largest derivatives dealers totaled over $16
trillion. The list was comprised mostly of banks each with commitments
over $1 trillion. Chemical Bank had the largest commitments ($2.5
trillion) while J.P. Morgan's commitments exceeded $1.6 trillion. J.P.
Morgan actually publishes a market risk management system over the
Internet daily. See also Barbara D. Granito, Assessing the Size of the
Market, WALL ST. J., Aug. 25, 1994, at A4 (“The ‘notional’ value of the
derivatives market ... is a mind-boggling $35 trillion, equal to nearly
three-quarters of all the world's stocks, bonds, money-market
securities and currencies put together.”); Randall Smith & Steven Lipin,
Beleaguered Giant: As Derivatives Losses Rise, Industry Fights to Avert
Regulation, 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.

45. [FN23]. See, e.g., COMMODITY FUTURES TRADING COMMISSION, OTC
DERIVATIVE 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: As
Derivatives Losses Rise, Industry Fights to Avert Regulation, WALL ST. J.,
Aug. 25, 1994, at A1; J. Carter Beese, Jr., Testimony before the
Committee on Banking, Finance & Urban Affairs, U.S. House of
Representatives (Oct. 28, 1993) (unpublished hearing on file with the
Stanford Journal of Law, Business & Finance); Richard Y. Roberts,
Remarks at Spotlight on Derivatives Conference (Sept. 13, 1994) (“The
Commission has been and continues to be very concerned with the
current state of the disclosure by mutual funds ... of their derivatives
activities.”) (on file with the Stanford Journal of Law, Business &
Finance).
[FN24]. See, e.g., AdrinaColindres, State Investment Pool Safe:
Treasurer Says State Won't Repeat Wisconsin's Losing Investments,
PEORIA J. STAR, Mar. 25, 1995, at C5; Help the Buyer
Beware,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 A's line of credit for
assurance that the client will buy the yen as agreed, even if the
exchange rate has fallen below the level set in the agreement.

46. [FN27]. See GLOBAL DERIVATIVES STUDY GROUP, GROUP OF THIRTY,
DERIVATIVES: PRACTICES AND PRINCIPLES 42 (1993).
[FN28]. Speculators who trade currencies without offsetting obligations
to buy or sell goods in the same amounts of the currencies in question
are taking risks, sometimes large risks, in the hope of large profits. Their
presence adds liquidity to the market, and makes it easier for hedgers
to place the trades which will protect them from their business risks.
[FN29]. ZVI BODIE ET AL., INVESTMENTS 461-464 (1989) (discussing
interest rate swaps as a means of minimizing risk associated with
interest 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).

47. [FN33]. See generally Joan Ogden, Pension Funds' New Appetite for
Derivatives, 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 $100,000,000
worth of stock, the risks would be entirely different. This would
represent 10 to 1 leverage, and would risk loss of the entire trust if the
market declined only 10%. The fund manager who uses $100,000 to
buy $100,000 face amount of stock index futures, however, is not
taking on any more risk than he would be accepting if he bought a
proportionate amount of the stocks individually. In short, as long as the
use of derivatives does not involve leverage, it can be just as safe as the
underlying asset.
[FN35]. For example, it may be hard to tell to what extent a given
transaction is a hedge, insuring against a business risk that has already
been undertaken, and to what extent it constitutes a leveraged
investment in its own right, creating new risks. The Financial
Accounting Standards Board is currently grappling with the proper
accounting for derivatives, and these issues are not easy to resolve.
[FN36]. See Laura Jereski& Michael Siconolfi, On the Ropes: Kidder
Peabody Gets Infusion From GE, But Problems Mount, WALL ST. J., June
15, 1994, at A1 (reporting on the large losses suffered by General
Electric's 80% owned subsidiary, Kidder Peabody, as a result of a price
decline in its $12 billion inventory of mortgage-backed bonds and

48. suggesting that the price decline was primarily the result of a sharp rise
in interest rates which was exacerbated by a lack of liquidity due to
other traders' unwillingness to engage in active trading in the
mortgage-backed bond market).
[FN37]. See Gabriella Stern & Steven Lipin, Proctor & Gamble to Take a
Charge To Close Out Two Interest-Rate Swaps, WALL ST. J., Apr. 13,
1994, at A3. P&G's problems involved a one-time, pretax charge of
$157 million to close out two highly leveraged interest-rate-swap
contracts. P&G had swapped its fixed-rate obligations for floating-rate
obligations. When interest rates rose in the U.S. and Germany, the
value of these swap contracts dropped precipitously. See also Steven
Lipin et al., Portfolio Poker: Just What Firms Do With ‘Derivatives' Is
Suddenly a Hot Issue, WALL ST. J., Apr. 14, 1994, at A1 (reporting that
some corporate treasurers engage in speculative derivatives
transactions because their corporations treat the treasurer's office as a
profit center rather than a vehicle for financing the company's
operations).
[FN38]. See Andrew Bary, Peter Pan Portfolio: Orange County Bet That
Interest Rates Would Stay Low Forever, BARRON'S, Dec. 5, 1994, at 17;
Bitter Fruit: Orange County, Mired in Investment Mess, Files for
Bankruptcy Decision, Following Default on Reverse-Repo Deals, May
Put Assets in Limbo, WALL ST. J., Dec. 7, 1994, at A1; G. Bruce Knecht,
California's 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

49. on leveraged investments in high quality bonds including U.S. Treasury
bonds and U.S. Government Agency debt, such as Federal National
Mortgage Association obligations. As long as interest rates did not rise,
this strategy worked. When rates increased, however, this strategy led
to 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: Britain's Barings PLC Bets
on Derivatives-And Cost is Dear,WALL ST. J., Feb. 27, 1995, at C6.
(reporting that 27 year old Nicholas Leeson's trading in huge volumes of
Japanese stock-index futures led to an estimated loss of $950 million
and drove Barings into bankruptcy). See also, Jeremy Mark et al., Losses
at Barings Grow to $1.24 Billion; British Authorities Begin Sale of Assets,
WALL ST. J., Feb. 28, 1995, at A3 (reporting that although the actual
facts in the Baring's incident were not fully known, it appeared that
Leeson entered into a series of speculative options and futures
contracts involving the Nikkei 225 stock index, Japanese government
bonds and short-term euro-yen securities and that the apparent lack of
controls over Leeson's activities was uncharacteristic of sound banking
practices).
[FN40]. See, e.g., Silvia Ascarelli& Peter Truell, German Firm Faces
Inquiry 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 the
other cases considered, the full facts are not currently known, are
subject to gradual revelation in discovery and trial of the pending
litigation, and indeed may never be known if the case is settled, or, as

50. in the instance of Metallgesellschaft, if it is submitted to private
arbitration.
[FN41]. See also Christopher L. Culp & Merton H. Miller,
Metallgesellschaft and the Economics of Synthetic Storage, 7 J. OF
APPLIED CORP. FIN. 4 (forthcoming Winter 1995) (arguing that the
losses may have been unnecessary, and that the hedged position could
profitably have been maintained). In any case, it is clear that the
organization was not prepared for the large present cash outflow which
maintenance of the hedge involved.
[FN42]. At least in the short term, as prices of its futures positions
fluctuated. In the long run, the losses on the futures positions might
have been recouped by profits either on futures contracts or the long
term 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 when
rolling over a short term hedge to more distant delivery months, since
futures prices are usually lower than “spot” prices in today's market.
MG apparently thought it could capture this profit. However, the
market unexpectedly moved to a condition where spot prices were

51. lower than futures prices, creating losses for MG each time it rolled
contracts 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 reporter's notes,
at 60-67 (1990) (Prudent Investor Rule).
[FN49]. Stocks were regarded as too speculative for trustees by many
courts for over a hundred years after the 1830 Harvard decision. A few
states still prohibit their pension funds from making any stock
investments at all. See Leslie Wayne, Where Playing the Stock Market is
Really Risky, N.Y. TIMES, May 1, 1995, at C4.
[FN50]. In re Westfield Trust, 172 A. 212, 214 (N.J. Prerog.Ct. 1934).

52. [FN51]. Boyer Nat'l Bank v. Garver, 719 P.2d 583 (Wash. Ct. App. 1986),
noted in RESTATEMENT (THIRD) OF TRUSTS § 211 (1990) (Prudent
Investor Rule).
[FN52]. Boyer, 719 P.2d at 591. It is worth noting that the court
rejected the Bank's defense that avoiding taxes by using tax-exempt
bonds 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.

53. [FN59]. A well-diversified portfolio is one invested in various assets
which do not tend to decline or rise together in a highly correlated way,
and none of which constitutes an undue percentage of the portfolio. A
highly diversified portfolio may be appropriate for those for whom
preservation of capital is more important than high returns, whereas a
less diversified, more risky mix of assets, may be appropriate for those
in need of high returns who can accept the likelihood of loss.
RESTATEMENT (THIRD) OF TRUSTS § 227(a-b) (1990) (Prudent Investor
Rule). See also infra text accompanying note 65.
[FN60]. UPIA § 2(e).
[FN61]. See, e.g., Bill Opening VC to Jersey Pensions Awaits Governor's
Ink, VENTURE CAP. J., Apr. 1, 1995, at 9; John Psarouthokis, Strategies
for Economic Growth, DET. NEWS, Feb. 23, 1995, at A13; Thomas T.
Vogel, Jr., Connecticut's State Pension Fund May Suffer Losses on
Derivatives, 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, § 227
reporter's notes at 58-67 (1990).

54. [FN64]. John Lintner, a Harvard Business School professor, argued that
adding a small amount of futures trading to a portfolio of stocks and
bonds can increase returns while actually reducing risk. Although this
hypothesis has not been empirically confirmed in a definitive study, he
provides the basis for an argument that trustees should invest in
derivatives for the purpose of increasing return. See John Lintner, The
Potential 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 the
Financial 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 1830
tradeoff between income on the one hand, and safety of principal on
the other, except that income taxes have blurred the distinction
between income and principal. Income taxes didn't exist in 1830, but
they now do, so companies now pay out less in taxable dividends, and
keep more money in the company, where it adds to the value of the
stock. The stock can be sold whenever the investor wants, and taxed
only then as capital gains. Since Barbara didn't sell until her death, no
income tax was ever paid on the capital gains, though income tax was
paid on the dividends.
[FN67]. Id.

55. [FN68]. Id.
*FN69+. Id. The “safeguards” include the trustee's exercise of
reasonable care, skill and caution in selecting an agent, establishing the
scope and terms of the delegation, and periodically reviewing the
agent's 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).

56. [FN76]. Too Much Money In Just One Stock? Get Rid of the Risk, Not
the Stock, BARRON'S, 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 “higher
standard of care for the trustee representing itself to be expert or
professional); UPIA § 9 (allowing the trustee to delegate duties).
[FN79]. Commissioner v. Farmers & Ginners Cotton Oil Co., 120 F.2d
772, 774 (5th Cir. 1941) (holding refined oil futures were not true
hedges against crude oil prices).
[FN80]. Leist v. Simplot, 638 F.2d 283, 287 (2d Cir. 1980) (holding
speculators in the commodities market could bring suit because they
were among the class for whose benefit the Commodity Exchange Act
was 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.

57. [FN83]. 590 N.E.2d 587 (Ind. Ct. App. 1992).
[FN84]. Id. at 589.
*FN85+. “Only a minimal amount was hedged, specifically $20,050 in
hedging contracts were made, whereas Co-op had $7,300,000 in grain
sales.” Id.
[FN86]. Although in Brane there was no suggestion that the directors
were attempting to advance their own interests at the expense of the
corporation, and they had given sufficient attention to the
corporation's affairs to retain someone to hedge the risks, the directors
were held liable for failing to adequately understand derivatives and
monitor 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 director's decision if it was made after reasonable
investigation, the director honestly and reasonably believed the
decision would benefit the corporation, and the five essential elements
of the rule existed: a business decision, due care, good faith, and no
abuse of discretion or waste. See DENNIS J. BLOCK ET AL., THE
BUSINESS JUDGMENT RULE: FIDUCIARY DUTIES OF CORPORATE
INVESTORS 2 (3rd ed. 1989).

58. [FN88]. Philip Johnson, a former Chairman of the CFTC, has called the
Brane case a compelling precedent for lawyers attempting to create a
hedging duty applicable to ordinary business and financial institutions.
Future Shock, ECONOMIST, March 13, 1993, at 94.
[FN89]. Gregory J. Millman, The Risk Not Taken, BARRON'S, May 1,
1995, at 46.
[FN90]. Id. The study itself shows that one third of nonfinancial
companies now use derivatives, most commonly to hedge foreign
currency exposure through forward contracts with banks, and interest
rate risks through swaps. See RICHARD MARSTON, SURVEY OF
DERIVATIVES USAGE AMONG U.S. NON-FINANCIAL FIRMS, EXECUTIVE
SUMMARY (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 someone
knowledgeable enough to do so. Much of the current litigation over
derivative losses turns on arguments over whether it was the broker or
the client who undertook the responsibility for making this analysis. In

59. the first instance, the legal responsibility is that of the fiduciary, and if
the fiduciary wishes to delegate the task to another, he is well advised
to create a clear written record of the scope of that delegation to an
appropriate expert, and require written reports from the expert to
document that the required monitoring function is being carried out.