Why you should care CME plans to cut B shareholder reps on board by half

March 19, 2014 11:12 AM

In the latest CME Group(NASDAQ:CME) proxy statement, CME management is asking B-shareholders to decrease their representation on the CME Board of Directors by 50%.  We intend to vote no on this question, and desire to keep the B share representation at the current six board members. 

It’s not because we own a B share and are holding out for a buyout.  It pays to understand how and why the B share directors were placed on the board in the first place.  It was intentional, and the reasons haven’t changed.

The B share can be one of CME’s most valuable assets if they utilize them correctly.  However, CME’s management has always looked at the B share with disdain.  In the discussion of risks to the enterprise on the documents CME filed for its IPO, a portion dealt with the perceived risk B shares could have to the value of publicly traded A shares.

Currently, a B share owner/leasee receives preferential treatment on fees, board representation, and clearing members are required to buy and hold them as collateral with the CME clearinghouse. 

You can find the issue on the CME proxy under “To approve an amendment to our Certificate of Incorporation to modify the director election rights of certain of our Class B shareholders to reduce the size of the board."  It is Item 6.


When the Chicago Mercantile Exchange (CME) started down the road to demutualization, the exchange asked the Internal Revenue Service (IRS) for an opinion on what to do with the memberships.  In an ideal world, CME would have been able to simply issue stock for memberships in a tax-free transaction.

However, the IRS wouldn’t allow that. 

This is one of the reasons there is exactly one publicly traded A share stapled to the value of the B share.  Not due to governance, or structure, but because of a bad IRS ruling.   However, B share representatives were an integral part of the thought process behind having good corporate governance at a publicly traded exchange.

When the CME Board was drafting its demutualization referendum, we debated the structure of the future CME Group Board.  At the time, CME had 40 board members.  This was not good governance, and unwieldy for a publicly traded company.  In the demutualization referendum, we proposed cutting the board down to 19 members. 

The CME Board knew that regulatory organizations like the commodity Futures Trading Commission (CFTC), Futures Industry Association (FIA) and National Futures Association (NFA) would want to see independent directors on the board.  The new public board couldn’t be made up of former members exclusively because of existing regulations.   That structure wasn’t a hallmark of good governance.  However, to get the referendum to pass, CME needed to give comfort to its membership that they would have a voice in the new public company.  That was the conundrum we were confronted with prior to sending the referendum out for ratification.

There are other considerations when designing a good board. It was important to the designers of demutualization that there were members from the industry on the board.  The futures industry isn’t a typical industry.  It changes quickly, and there are a lot of intricate parts that require deep understanding before a rule is passed or decision is made.  Having industry participants on the board is essential to operate a well-run exchange. 

When we arrived at 19 members, the board agreed six of them with industry experience would provide enough input for good board governance.  Our investment banking advisors also thought having 31%  member representation on the board was a good idea. Having that representation also created credibility with the investing community.  We had skin in the game.

The proposed board structure also aligned with the “3-2-1” profit sharing CME had established for Post Market Trade (PMT) back in 1987.  The six members would always be in the minority.  This gave safety to A shareholders that the B shareholders couldn’t dominate policy making so there was economic disadvantage brought to publicly traded shares in favor of privately traded B shares. 

The board also needed six members to oversee continuing operations that existed on the trading floor as well.  In 2001, CME still had a large open outcry presence, even though everyone knew things would change in the future.  We knew the six board members with experience on the floor would eventually become six board members with experience in electronic markets.  CME needs six board members with market experience to help guide it through the choppy waters of today.

It’s important to note, CME is still in the midst of a massive transition, which has happened on the floor, but has not happened in the ownership of the B share memberships. It most certainly will eventually.

The demutualization referendum put forward passed almost unanimously.  CME Board members were to engage in run off elections over the next couple of years that would thin the board from 40 to 19.  That only happened for some of the former members, not all.  Many members of the board from 2000 are still on the board, and have never had to face a run off.  They have been on the A slate.

Corporate executives currently leading CME (except for the Executive Chairman) were not a part of the debate that took place prior to demutualization.  They are out of touch when it comes to the historical parts of the structural debate.

Evolution of CME Board size

In 2002, then CME CEO James McNulty wanted a seat on the board.  It is proper to have a CEO on a public board.  Instead of replacing a board member, CME management asked to add one member in the proxy statement.  It passed, and CME became a 20-member board.  CME avoided the hard decision of replacing an existing board member that could have run for a B slot with Mr. McNulty.  An “even” number of board members is not ideal for good board governance.

When CME acquired the Chicago Board of Trade (CBOT) and New York Mercantile Exchange (NYMEX), instead of trimming board members it simply added them until it got to a high of 34 board members.  This was also poor governance.  What other company engaged in M+A “staples” on board members in this manner?

Prior to demutualization, a board term was two years.  Directors had to run competitive elections and earn their spot on the board. Similar to a democratic republic, running every two years made board members accountable to their constituency.  In the ensuing years, CME Group has monkeyed with the terms of the B share directors. 

Initially, B-share directors’ term mimicked the old pre-IPO style, two-year terms.  B directors had to appear before a nominating committee elected by the B-share membership, and continued to run in competitive elections.  Then, for reasons unknown, the CME board decided to extend the terms of the B directors to three years.  Today, it’s a one-year term.  A democratically elected and independent B Share Nominating Committee nominates B directors.  B share directors still have to run in competitive elections.

When CME purchased both the CBOT and NYMEX, they paid the existing members for their rights.  CME is seeking to strip away core rights that were enshrined in the referendum that passed back in 2000, and in the Articles of Incorporation without paying for them

Back in 2006, if one did a conservative discounted cash flow analysis and looked at how CME could buy out the B shares, and adjust the fee schedule to be rational, they would have found CME could have paid for the whole transaction within five years.  In the ensuing years, that analysis has only gotten more positive with the precipitous decline of B share value and increase in exchange volume. 

Economic and strategic rationale for B share board members

The B share directorship is the most open and democratically elected directorship in all of corporate America.  Anyone can run.  All they need is ownership of a B share, to lease a B share, or to be assigned a B share by a clearing firm or individual. Anyone can appear before the nominating committees. Anyone that isn’t nominated can run on petition, provided they get enough signatures to run. If they campaign well, and get enough votes, they are elected to the board.  There are no insider deals, or cronies that are guaranteed spots.

CME B-share directors are extremely qualified to serve on a public company board. The current directors are capable and can run or serve on the audit committees, and other board governance committees. Many of the A share directors, and the CME Executive Chairman came from the same place as existing B-share directors.  They have similar qualifications.

Who owns B shares? It is a who’s who of the futures industry. The shareholders have many highly qualified people who would make great board members.  Some of the existing directors on the A slate own B shares.  Many B shareholders own A shares. This referendum is not about having qualified people.

Here is an older example (circa 2000) showing the value a B share director brings to the table.  The new management team that came in was looking for ways to increase revenues easily.  One of the ways they proposed was charging $100 per out trade. The projected revenue stream was very large, and having a lot of out trades cost CME a lot of man-hours in the clearinghouse.  Floor traders didn’t like them, and did all they could not to have them.  Seemed like there was a good business school case for enacting the new policy.

Of course, not understanding floor trading or keypunch errors, the new management team didn’t comprehend that they would create an adverse economic incentive that would have put most floor traders out of business! We killed the proposal. The management team did eventually find new streams of revenue that were economically efficient. If there weren’t B share directors, maybe that ill-conceived proposal would have passed.

Contrast that prior example to the decisions the board and CME management have recently made.  Recall CME’s initial response to the MF Global debacle.  It was B share board members that were able to respond first. Recall the recent increase in data fees CME recently passed?  It’s difficult to see that measure passing with a board made up of 31% independent industry persons. The industry’s voice would have been heard, not drowned out or watered down.

The B-share directors provide an independent voice from a group whose primary interests are the long-term health of the organization. The B-share directors aren’t worried about this quarter's earnings or their current year-end bonus.  Management of public companies must pay close attention to current earnings. That is how the public markets measure their success. Other appointed board members do not have the same interests as the B members, since they are not daily users of the futures markets. The B class owners might have a point of view, which can conflict with management.

Shareholders and company management can move on to other entities with little regard for the long-term health of a company. B class owners tend to be very long-term participants with the exchange. Diminishing this independent voice violates the spirit of the original agreement with the members and risks the future of the exchange.

This is why having people on the board with experience in the industry is vitally important. B-share board members provide immediate color to decisions being debated at a board level on strategy and policy. They tend to take the long view and prefer sustainability. Codifying that industry experience with the B share board representation is the only way to secure that the industry has a voice in a monopsony like CME.  No other exchange has it, and we believe they are lesser because of it. 

Why we intend to vote NO on the proxy solicitation from CME

If the measure is passed, the B-share directors will melt away. The industry can look forward to never having a voice, and potential bad policy from CME down the road. Not voting is ignoring an economic interest. 

The B-share board representation right has an economic worth. That economic worth is buried among other rights that are reflected in B share values. B shares don’t impair the value of A shares.  Since January 1, 2008 CME stock is down 44%.  B-1 shares are down 59.7%.

Shrinking the board by getting rid of B-share directors is a bad idea. The B directors have held their fiduciary responsibility to A shares more closely than their fiduciary responsibility to the B! 

We agree that CME’s current board is not an example of good public governance. CME should cut the board back to a manageable size, but the cuts should come from the bloated A-share director slate.  When they were acquiring exchanges, CME avoided the tough decisions that it takes to integrate. 

We hope you agree with our opinion. It is important to discuss this with business associates and friends in person.  We also think discussion can and should take place in transparent social media circles.  Given what has happened in the past, what seems like a minor issue is actually a major one to industry participants. 

Endorsed by former CME Board members:

Jeffrey Carter, Yra Harris, Jeff Silverman, Tom Bentley, Patrick Mulchrone and Robert “Buck” Haworth



About the Author

Jeffrey Carter is an angel investor and independent trader. From 1988-2011 he was an independent floor trader at the CME.  He served on the CME Board of Directors.