Derivatives at Bankruptcy: LifesavingKnowledge for the Small Firm

(ProQuest: ... denotes formulae omitted.)I. The Importance of DerivativesSince Jacob had fallen in love with Rachel, he said, "I'll serve you for seven years in exchange for your younger daughter Rachel."1Over four-thousand years ago, Jacob entered into a derivatives contract granting him the option to marry Rachel, the youngest daughter of Laban.2 Although Jacob paid for the marriage right with seven years of labor, the actual value of the option correlated directly with his ability to marry Rachel at the close of the term. Had Rachel died prior to the close of the seven-year term, for instance, the option would have been worthless. Accordingly, the value of his contract with Laban was derived from Jacob's underlying ability to enter into marriage with Rachel.Although Jacob upheld his end of the agreement, Laban deceived Jacobsecretly substituting Rachel with his firstborn daughter Leah on the couple's wedding night.3 Regrettably, Jacob sits in history as the first known holder of an option contract,4 as well as the first known victim of a default.5 After marrying Leah according to his custom, and subsequently purchasing another option with an additional seven years of service, Jacob finally earned the right to marry his true love, and with both women he fathered the twelve tribes of Israel.6 In some respects, the entire nation of Israel owes its genesis to a series of derivatives.While modem derivatives contracts are no longer used to arrange marriages and found nations, their importance is undiminished. Today, derivatives are significant financial tools that provide opportunities to "measure, manage, distribute, and transfer risk."7 The President's Working Group on Financial Markets (PWG) states:One of the most dramatic changes in the world of finance during the past fifteen years has been the extraordinary development of the markets for financial derivatives. Over-the-counter varieties have transformed the world of finance, increasing the range of financial products available to corporations and investors and fostered more precise ways of understanding, quantifying, and managing risk.8A recent survey conducted by the International Swaps and Derivatives Association (ISDA) concluded that over 92% of the world's 500 largest companies use derivatives to manage and hedge risk.9 Of the 196 U.S. companies included in the survey, 94% use derivatives-a percentage only surpassed by companies in the United Kingdom.10 According to Robert Pickel, Executive Director and Chief Executive Officer of ISDA, "[t]he survey demonstrates that derivatives today are an integral part of corporate risk management among the world's leading companies."11 Additionally, finance professors from top business schools overwhelmingly agree that "derivatives help companies manage financial risk more effectively," thereby facilitating continued growth in their use and application.12Today, derivatives penetrate geographic regions and industry sectors, with the vast majority of the world's most financially successful companies relying on derivatives "to hedge a range of risks to which they are exposed in the normal course of business."13 Derivatives permit companies "to focus on their primary business or core competence instead of worrying about fluctuations in financial markets."14 By using derivatives, firms can "eliminate those risks that they do not control" while taking "additional risks that they believe contribute^ to their firm's values."15Despite a cloud of legal uncertainty that hangs over the derivatives market in the United States, derivatives show no sign of slowing.16 Widespread use of these instruments has led to an exponential growth in the worldwide derivatives market. In the first half of 2006 alone, the total notional value of global derivatives contracts grew by an estimated 20.1% from $235.8 trillion to $283.2 trillion.17 These figures dwarf the modest total notional value of $0. …