Commentary: The Merc's Bad Example

When CBOT and NYSE go public, will they also opt for dubious corporate governance?

Just what is "independence"? Advocates of good governance and most of Corporate America differ with the Chicago Mercantile Exchange on the subject (CME ). Objectively, the notion seems clear: Independent directors hail from companies, law firms, accounting firms, or universities that have little or no link to the outfits they help govern. They are truly disinterested.

Not so at the Merc, the giant market for futures contracts, where all but a handful of directors are so enmeshed in the exchange that even industry insiders are appalled. Where independent governance is concerned, charges Futures Industry Assn. head John M. Damgard, the Merc "doesn't meet the laugh test."

This could soon become a front-burner issue. As the New York Stock Exchange and Chicago Board of Trade (CBOT) make plans to go public this year, will they mimic the Merc? Or will they tap truly independent directors? "Public companies must have a preponderance of directors whose interests are only in serving the public shareholders," says Gregory P. Taxin, chief executive officer of institutional adviser Glass, Lewis & Co. When most directors "have potentially other interests at heart," he adds, "the public shareholders can no longer rely on that board."

Faced with potential conflicts of interest, the Merc's leaders adopted a novel approach when the exchange went public in 2002: They cooked up a definition of independence that is, well, exceptionally flexible. Their CEO is not independent, but traders on the exchange floor can be. The Merc's auditor is not; executives at firms that have done business there for 25 years are. An exchange consultant can't be independent. But a past chairman who draws $200,000 a year, plus fees, as a special board adviser can. The Merc figures he has "no material relationship" with it.

Why take such liberties with common sense and Merriam-Webster? Because to comply with NYSE listing standards, the Merc's board must have a majority of independent directors. But most of the directors -- among those in office when the Merc went public and the 10 elected on Apr. 27 -- are not independent by real-world standards. Of the 20 directors, 13 earn their livings from the exchange as employees, paid advisers, or execs of me mber firms. Only seven are outsiders, including a former member and another whose company is a big user of Merc futures. Argues Merc Chief Executive Officer Craig S. Donohue: "The industry knowledge on our board has helped guide us and insured harmony, trust, and confidence as we've gone through dramatic changes."

For most of its 107-year history, the Merc was a club run by and for members; its older, crosstown cousin, the CBOT, still is. When the Merc went public, members still wanted to run the show. As electronic trading loomed, many also wanted the floor to survive -- and the member-friendly board has obliged, even while allowing 70% of the Merc's trading to go electronic. Clearly, the Merc is thriving, but one can only wonder whether the floor could survive without such backing.

So far, regulators have let the Merc have its way. Thanks to its definitional sleight of hand, the outfit meets the NYSE's listing standards. The Merc's regulator, the Commodity Futures Trading Commission, hasn't yet finished a study expected to touch on board composition. The Securities & Exchange Commission doesn't oversee the Merc, and a rule it has proposed requiring true independence wouldn't affect futures markets -- though the CFTC might adopt something like it.

As other exchanges go public, standards could tighten. Since 2003, the NYSE's board has only bona fide independent directors (except for the CEO). A panel of exchange members advises them. NYSE may keep that model when it merges with the publicly traded electronic exchange, Archipelago Holdings Inc. -- though it hasn't said so yet.

The signs at the CBOT are less encouraging. In a February regulatory filing, it says it will create a 17-member board with nine independents. But its definition of independence seems as loose as the Merc's. The CBOT declined to comment because it is in a pre-IPO quiet period.

Even if it doesn't go whole hog like the Big Board, the CBOT should at least opt for a board with a majority of true independents. And the Merc needs to follow suit.

By Joseph Weber

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