Red Flags Rising At the Merc

The Chicago exchange is rife with conflicts and independent directors who aren't.

With so much ongoing drama at the New York Stock Exchange, little attention has been paid to that other great anchor of the U.S. markets -- the Chicago Mercantile Exchange. The Merc is a veritable island of corporate governance tranquility. The futures-trading bourse did some soul-searching before it became a public company last year, and found its corporate governance to be in fine shape. Still, the Merc's incoming chief executive, Craig S. Donohue, says the 105-year-old exchange -- like its East Coast brethren -- is about to undergo far-reaching changes. "There is no doubt that we are going to continue to evolve and change," says Donohue.

The Merc certainly will be changing -- if not voluntarily, then with a push from the Commodity Futures Trading Commission, which is delving into market governance. And for good reason. The Merc board -- including its compensation committee -- remains controlled by traders and floor brokers who are regulated by the exchange. Indeed, the Merc seems rife with the same conflicts of interest that tarnished the Big Board before CEO Richard A. Grasso self-destructed, including consulting deals for directors such as former Chairman Leo Melamed. Under the definition employed by the Merc, Melamed and brokers regulated by the exchange can become "independent directors" -- an oddity that conjures up memories of the attempt to name former Citigroup Inc. (C ) Chairman Sanford I. Weill to a "public" position on the NYSE board.

A review of public documents shows that the Merc shares the NYSE's tin ear on governance issues. The Merc's 20-member board is dominated by people who are anything but independent. Most make their living in or around the Merc's trading pits. Only 4 of the 20 directors have no current ties to the Merc or its trading floor. Fifteen are longtime exchange members, many still working as traders or brokers.

The Merc has insisted that its governance policies are more than adequate, and that all its directors are "independent" except for chief executive James J. McNulty, who will be succeeded by Donohue at yearend. With their diverse backgrounds, they offer "independent objective views," wrote board Chairman Terrence A. Duffy and former Chairman John F. Sandner, a paid adviser to the Merc board, in a letter posted on the exchange's Web site. And though Donohue says that the Merc expects to increase the number of board seats held by people with no ties to the Merc, he sees no problem with the current setup. Says Donohue: "Our board is absolutely and definitely independent from management. None of our so-called member-directors has a sufficient relationship with the institution to compromise their independence."

But such views are unlikely to sway regulators. Notes one top Securities & Exchange Commission official: "Member firms have always been considered insiders rather than public or independent members." One potential sore spot is the Merc board's compensation committee. It is chaired by William R. Shepard, founder and president of Shepard International Inc., a futures brokerage. He did not return phone calls. The other members are a floor broker, the head of a trading company, and former Agriculture Secretary Daniel R. Glickman. Compensation is a hot topic at the board, in light of McNulty's lucrative pay package, decided by a previous pay panel, in which he gets $1.8 million, plus an option package valued at over $66 million.


For critics, the fact that brokerage execs such as Shepard are considered independent directors is absurd. "It raises a lot of red flags," says Ann Yerger, deputy director of the Council of Institutional Investors. Also troubling to critics is that ostensibly independent directors seem burdened with glaring conflicts of interest. Former Chairman Melamed is paid $200,000, plus $150,000 for expenses, as a "senior policy adviser" to the exchange board. Likewise, board member Sandner is a "special policy adviser," for which he gets $200,000 a year, plus meeting fees.

Both men play big roles in governance at the exchange. Sandner chairs the Merc's governance committee, which also includes Melamed. The ex-Merc chairman, a renowned figure in Chicago's market, is in some hot water because of his conflicting roles. The Merc is being sued by a former executive, Lewis C. Ting, who says his governance recommendations were disregarded. In the suit, Ting says he was wrongly fired in part because he complained to Merc executives that board members routinely "engage in practices designed to compensate themselves and their friends at the expense" of the Merc. The suit cites Melamed's expense allowance as an example. Ting blames Melamed for his firing, saying Melamed resisted changes in corporate governance that were championed by Ting. The Merc declines comment on the suit as does Melamed, who says he trades only for his own account.


Such cozy practices may be in jeopardy. The CFTC, which oversees the Merc and other futures exchanges, has put all such self-regulatory organizations (SROS) under a microscope. Asked about the apparent conflicts at the Merc, a spokesman says CFTC Chairman James E. Newsome directed his staff, in May, to review "the roles, responsibilities, and capabilities of SROs." He added that SRO governance is one element of the review, which should be finished by yearend.

Even without pressure from the CFTC, the Merc's governance practices are ripe for scrutiny. "It's not a private club anymore," says Nell Minow, editor of The Corporate Library LLC, a research firm that tracks governance issues. She argues that a board that appears to be run by and for traders isn't serving the public. Donohue says changes are coming. He notes that the Merc board has already changed dramatically, that it is half its pre-IPO size, and that 13 directorships could be filled by completely unaffiliated folks over time. Adds Glickman: "The board is going to have to bring in more outside directors as time goes on."

Melamed insists that he and his fellow directors are already models of propriety. "We have been jealously independent," Melamed says. His job at the Merc, he says, is as a "thought leader." There's no denying that Melamed is one of the smartest men in the world of finance. But as an another bright man by the name of Dick Grasso can attest, it takes more than brainpower to satisfy the gods of corporate governance nowadays.

By Joseph Weber in Chicago, with Gary Weiss in New York and Amy Borrus in Washington

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