MEMORANDUM

TO:          The Commission

FROM:     Division of Trading and Markets

RE:          The Chicago Mercantile Exchange’s Proposed Demutualization Plan

RECOMMENDATION:   That the Commission approve the proposed new Certificate of Incorporation  and By-laws of the Chicago Mercantile Exchange Inc., and proposed amendments to existing  Exchange rules and issue the attached Order in order to implement its proposed demutualization plan.

CONSULTED:      Division of Economic Analysis
                                   Division of Enforcement
                                   Office of the General Counsel

STAFF CONTACT: Riva Spear Adriance (x5494)

TABLE OF CONTENTS

I. Introduction

II. The Chicago Mercantile Exchange’s Proposed Demutualization Plan

A. Conversion of Existing Membership Interests into the Common Stock of New CME

B. Trading Rights

1. Floor and GLOBEX2 Trading Rights

2. Leasing of Trading Rights

3. Clearing Fees

C. Voting Rights

1. Election of the Board of Directors of New CME

a. Equity Directors

b. Class B Directors

2. Core Rights

3. Other Matters

D. Other Differences in Ownership Rights

E. Restrictions on the Transfer, Sale, or Lease of the Common Stock of New CME

F. Governance

1. Board of Directors

2. Executive Officers

3. Exchange Employees

4. Board Committees

III. Proposed Rules and Rule Amendments

A. Certificate of Incorporation and By-laws of New CME

B. Conforming Amendments to Existing Rules

IV. Discussion

A. Demutualization Issues

1. Conflicts of Interests

2. Funding of SRO Obligations

a. SRO Responsibilities

b. Representations of Existing and New CME

3. Outsourcing of SRO Responsibilities

4. Exchange Governance

V. Conclusion and Recommendation

Note: Copies of the appendices listed below are available from the Office of the Secretariat upon request  at (202) 418-5100. 

Appendix A: Proposed Approval Letter to be Issued by the Commission

Appendix B: Proposed Order

Appendix C: Submissions of Existing and New CME

Appendix D: Proposed Certificate of Incorporation of New CME

Appendix E: Proposed By-laws of New CME

Appendix F: Current Articles of Incorporation of Existing CME
                        Current Certificate of Incorporation of New CME

Appendix G: Proposed Amendments to Existing Exchange Rules

Appendix H: New CME Proxy and Prospectus

I. Introduction

By letters dated May 16 through June 13, 2000, the Chicago Mercantile Exchange (“Existing CME”) submitted certain rules and rule amendments to the Commodity Futures Trading Commission (“Commission”), pursuant to Section 5a(a)(12)(A) of the Commodity Exchange Act (“Act”) and Commission Regulation 1.41(c), to implement its proposed demutualization plan.1 Under this plan, Existing CME would convert from an Illinois not-for-profit membership corporation into a Delaware for-profit stock corporation.

The demutualization plan involves a two-step merger and an associated recapitalization, with all steps occurring essentially simultaneously. In the first step, Existing CME, an Illinois not-for-profit membership corporation, would be merged into a transitory Delaware nonstock corporation. In the second step, the Delaware nonstock corporation would be merged into a for-profit Delaware stock corporation known as the Chicago Mercantile Exchange Inc. (“New CME”).2 In the associated recapitalization, the stock issued by the Delaware stock corporation in the second step would be converted into shares of Class A and Class B common stock.3 Upon the completion of this two-step merger and associated recapitalization, members of Existing CME would receive shares of the common stock of New CME. The demutualization plan was approved by an affirmative weighted vote of 98.3% of the members casting votes at a special membership meeting held on June 6, 2000.4

As part of the proposed demutualization plan, Existing CME and New CME are requesting that all of Existing CME’s contract market designations be transferred to New CME and have notified the Commission that Existing CME will transfer all contracts listed for trading by exchange certification to New CME.5 In addition, the following materials are submitted to the Commission for its review and approval: (1) the Certificate of Incorporation of New CME;6 (2) the By-laws of New CME;7 (3) the deletion of Existing CME’s current Articles of Incorporation;8 and (4) conforming amendments to certain existing rules found in the current CME Rulebook (“CME Rulebook”).9

II. Existing CME’s Proposed Demutualization Plan

Existing CME is seeking to fundamentally change its organizational structure by converting from an Illinois not-for-profit membership corporation into a Delaware for-profit stock corporation. To accomplish this change in structure, Existing CME would undergo a two-step merger and an associated recapitalization with all steps occurring essentially simultaneously. In the first step, Existing CME (an Illinois not-for-profit membership corporation) would merge with and into a recently formed Delaware nonstock corporation known as the CME Transitory Co.10 Under this merger agreement, each membership interest in Existing CME would be converted into an equivalent membership in the CME Transitory Co.

In the second step, the CME Transitory Co. would merge with and into New CME (a newly formed for-profit Delaware stock corporation).11 Under this merger agreement, the membership interests in the CME Transitory Co. would be converted into shares of the common stock of New CME. In the recapitalization step, the common stock issued by the transitory Delaware stock corporation in the second step will be converted into shares of Class A and Class B common stock. Each of these steps is conditioned upon the completion of the previous steps.

According to Existing CME, through the adoption of the demutualization plan, it is seeking to:

(1) Improve the current governance and managerial structure to facilitate accelerated decision-making;

(2) Change the current financial decision-making model to emphasize stockholder value;

(3) Create a catalyst for pursuing new business strategies;

(4) Unlock members’ equity holdings by allowing them to sell a portion of their interest in Existing CME; and

(5) Provide an indication of interest of and an instrument for working with strategic partners.

However, before the demutualization plan may be completed, certain other contingencies must be fulfilled.12 First, Existing CME is seeking to obtain a favorable ruling from the Internal Revenue Service (“IRS”) concerning the federal tax implications of the demutualization plan.13 Such a ruling would enable the exchange of membership interests in Existing CME for shares of the common stock of New CME to be accomplished on a tax-free basis. Consequently, existing members would not recognize any gain or loss strictly as a result of receiving New CME common stock in exchange for their membership interests. Second, Existing CME must obtain Commission approval of the various new rules and rule amendments described herein and of the request to transfer all existing contract market designations to New CME.14

A. Conversion of Existing Membership Interests into Shares of the Common Stock of New CME

As a result of the two-step merger described above, existing membership interests in Existing CME would be converted into shares of the common stock of New CME. As a result of the recapitalization step, there would be two classes of common stock at New CME – Class A Common Stock, which confers equity rights, and Class B Common Stock, which confers both equity rights and trading rights. 15 Existing owners of full Chicago Mercantile Exchange (“CME”) memberships, International Monetary Market (“IMM”) Division memberships and Index and Option Market (“IOM”) Division memberships would receive shares of both Class A and Class B Common Stock. Existing owners of Growth and Emerging Markets (“GEM”) Division memberships (both full interests and fractional interests) would receive shares of Class B Common Stock. Class A and Class B Common Stock would be distributed as follows:

MEMBERSHIP DIVISION CLASS A SHARES CLASS B SHARES
1 CME membership 16,200 shares 1 share; Series B-1
1 IMM membership 10,800 shares 1 share; Series B-2
1 IOM membership 5,400 shares 1 share; Series B-3
1 GEM membership ____ 1 share; Series B-4
1 GEM Fraction membership ____ 1 share; Series B-5

The demutualization transaction is not an initial public offering (“IPO”). As discussed in more detail below, ownership of New CME would initially be limited to members of Existing CME following the completion of the demutualization transaction.16 Class B Common Stock would generally be transferred in the same manner in which membership interests in Existing CME are currently bought and sold.17 The decision of whether to pursue an IPO would rest with the management and the Board of Directors of New CME.

B. Trading Rights Associated with Class B Common Stock

As noted above, Class B Common Stock would carry traditional equity rights as well as the trading rights of its associated membership division, including floor access rights and privileges. Accordingly, holders of Series B-1 Common Stock would have trading rights in the CME Division; holders of Series B-2 Common Stock would have trading rights in the IMM Division; holders of Series B-3 Common Stock would have trading rights in the IOM Division; and holders of Series B-4 and B-5 Common Stock would have trading rights in the GEM Division.18

1. Floor and GLOBEX2 Trading Rights

An individual or entity that owned Class B Common Stock, and that also satisfied New CME’s ownership and eligibility criteria,19 would have the right to trade on the floor of New CME and electronically through the GLOBEX2 system as long as the individual or entity owned such shares.20 The holder of a series of shares of Class B Common Stock would be entitled to appear upon the floor of New CME and to act as a floor broker and/or trader in the particular contracts that had been assigned to the relevant Class B series. Similarly, when accessing GLOBEX2 terminals from the trading floor, such holder would be authorized to trade only those contracts that had been assigned to the relevant series. In all other circumstances, the holder of Class B Common Stock would be able to trade any product listed on the GLOBEX2 system as is currently true.

2.b Leasing of Trading Rights

The trading privileges associated with Class B Common Stock may be leased out to another individual or entity provided that such individual or entity also satisfies the ownership and eligibility criteria imposed by New CME.21

3. Clearing Fees

Existing CME’s clearinghouse is owned by Existing CME and, upon the completion of the demutualization plan, will be owned by New CME. Accordingly, the relationship between New CME and its clearinghouse will not differ from the current relationship. Fees on cleared trades would continue to be differentiated based on the trader for whom the trades were cleared. Traders who held or leased Class B shares would continue to be charged a lower clearing fee for trades for their own accounts.

C. Voting Rights

1. Election of the Board of Directors of New CME

Initially, New CME’s Board of Directors would be composed of the same members that are currently serving on Existing CME’s Board of Directors. The size of New CME’s Board would ultimately be reduced from thirty-nine directors to nineteen directors during a transition period as certain directors’ terms expire.22

At each succeeding annual meeting of the stockholders of New CME after December of 2001, approximately one-half of the Board would be up for election. Each director would serve a two-year term, expiring at the annual meeting of the stockholders held in the second year following his or her year of election and until his or her successor was duly elected, qualified, and has accepted office.23 Any director could be removed from office at any time, but only for cause and only by the affirmative vote of the holders of at least two-thirds of the voting power of the shares entitled to elect such person as a director.24

a. Equity Directors

Following the phased reduction of the size of New CME’s Board of Directors, the holders of Class A and Class B Common Stock voting together as a single class on a Class A share equivalent basis25 would have the right to elect thirteen of the nineteen directors. These directors are referred to as the “Equity Directors” in New CME’s Certificate of Incorporation.

b. Class B Directors

In addition, the holders of certain series of Class B Common Stock would have the right to elect six of the nineteen directors as follows: Series B-1 Common Stock would have the right to elect three directors; Series B-2 Common Stock would have the right to elect two directors; and Series B-3 Common Stock would have the right to elect one director. The Class B shareholders would, therefore, be able to directly elect six of the nineteen directors even though the Class B shareholders would represent only approximately ten percent of the overall equity interest. Such voting rights, along with certain Class B special approval rights,26 offer certain ability to Class B shareholders to block changes.

2. Core Rights

Members would no longer have referendum rights that currently allow members to overturn Board approved rule changes. Instead, holders of Class B shares would have the right to approve changes to certain “core rights.” Holders of Class A shares would not have the right to vote on changes to the core rights. These Class B core approval rights would include changes to:

(1) products which a holder of a series of Class B shares is authorized to trade;

(2) trading floor access rights and privileges, including the commitment to maintain floor trading as long as an open outcry market was deemed to be liquid;27

(3) the number of authorized and issued shares of any series of Class B shares;28 and

(4) eligibility requirements for an individual or entity to hold any shares or any series of Class B shares or to employ the affiliated trading rights or privileges.

A vote on any proposal to alter such “core rights” would be weighted by series.29

3. Other Matters

Under Delaware stock corporate law, the voting rights of members of Existing CME will change. Currently, approval by two-thirds of those voting is necessary to authorize charter amendments or major corporate transactions such as a merger, a sale of all the corporate assets or a dissolution for Existing CME under Illinois law. In contrast, Delaware law allows approval by a simple majority of the outstanding voting shares. As a lower number of votes would be needed to authorize such activities it may be easier for New CME to undertake such activities.

Members of Existing CME also will gain voting rights under Delaware law. Holders of a class, or series, of stock would be allowed to vote as a separate class or series on any proposed charter amendment that would adversely affect their rights under Delaware corporate law. No such statutory right is provided under Illinois law. Furthermore, Delaware law gives stockholders the right to dissent from a transaction involving a merger or sale of all the corporate assets. If there is no public market for the shares, Delaware law gives stockholders the right to receive payment equal to the appraised value of the shares. Under Illinois law, no such dissent right exists.

D. Other Differences in Ownership Rights

Currently, liquidation rights in Existing CME are based on what the respective membership divisions originally paid-in for their membership interests. Liquidation rights under New CME would be determined on a Class A share equivalent basis.30

E. Restrictions on the Transfer, Sale, or Lease of the Common Stock of New CME

Although Class A Common Stock could eventually be bought and sold by the general public, it would initially be subject to transfer restrictions that gradually expire over a period of fifteen months after the completion of the demutualization plan.31 Class B shares would be bought and sold through Existing CME’s membership office, with New CME acting as transfer agent, the same transfer process that currently applies to the transfer of membership interests in Existing CME.32 The management of New CME and its Board of Directors would have the authority and ability to pursue an IPO in the future.

F. Governance

1. Board of Directors

The initial members of the Board of Directors of New CME will consist of all the members of the Board of Existing CME at the time of the completion of the demutualization plan. For future elections, nominees for election as Equity Directors would be selected by the Nominating Committee, a committee of the Board of Directors. The Nominating Committee, which would be composed of five directors, would be responsible for reviewing the qualifications of potential candidates and for providing for compliance with regulatory Board composition requirements.33 Nominees for election as Class B Directors would, consistent with current practice, be selected by members of a nominating committee of their respective series.34

According to both Existing CME and New CME, the nomination process under the By-laws is intended to ensure that the Commission’s required composition requirements for exchange governing boards would continue to be met.35

2. Executive Officers

The initial executive officers of New CME will consist of all the executive officers of Existing CME at the time of the completion of the demutualization plan.

3. Exchange Employees

The initial employees of New CME will consist of the employees of Existing CME at the time of the completion of the demutualization plan, and no changes to staffing levels are currently planned. However, Existing CME expects that its new chief executive may reorganize the governance and management structures and may desire or need to utilize both new and existing management and staff. Any such reorganization would likely necessitate rule changes that would be submitted to the Commission for prior review pursuant to Section 5a(a)(12) of the Act and Commission Regulation 1.41.

4. Board Committees

The Board of Directors of New CME will have four committees. The four committees will be an Executive Committee, an Audit Committee, a Compensation Committee and a Nominating Committee.36 Members of these committees are expected to be elected by New CME’s Board following the implementation of the demutualization plan.37 The Audit and Compensation committees would be composed of Board members that were not employees of Existing CME.

III. Proposed Rules and Rule Amendments

Under the demutualization plan, as described above, there would be a separation of equity ownership rights from membership trading rights.38 A natural person or legal entity could acquire Class A shares and/or Class B shares as an investment, without becoming a member of New CME. However, in order to exercise floor trading privileges at New CME, under the demutualization plan, a person must (1) hold the trading rights associated with a Class B share, and (2) be elected as a member under the current membership approval process. Many rules would be amended to reflect this distinction.39

A. Certificate of Incorporation and By-laws of New CME

The Certificate of Incorporation describes the size and selection of the Board of Directors for New CME, including the staged reduction in the size of the Board in December 2000 and December 2001. The By-laws of New CME cover a number of topics relating to corporate governance. The submission states that, under the demutualization plan, New CME would continue to comply with Commission regulations regarding how contract market governing boards are selected. For example, Regulation 1.63 prohibits a person from serving on a governing board if, within the last three years, he or she was found to have committed a “disciplinary offense.” Under the current Board selection process, staff screens the candidates being considered as nominees for election to the Board so that persons with a disqualifying offense are not nominated. A similar process would be used to screen the nominees for the Board of New CME, although the screening would be carried out by the Nominating Committee.

Similarly, Regulation 1.64 sets forth certain composition requirements for self-regulatory organization (“SRO”) governing boards. The submission states that the nomination process under Section 3.5 of the By-laws was intended to ensure that such composition requirements would continue to be met according to both Existing CME and New CME.40

B. Conforming Amendments to Existing Rights

Under the proposed rule changes, most of the substantive rules would not be changed.41 The proposed amendments to the CME Rulebook chiefly involve governance issues. As noted above, one of the primary stated goals of the demutualization plan is to streamline Existing CME’s governance and managerial structure in order to accelerate and improve the decision-making process. Many of the rules in Chapter 2 of the CME Rulebook would, therefore, be deleted because they would be inconsistent with the provisions of New CME’s Certificate of Incorporation or By-laws.42 However, as discussed above, Existing CME and New CME represent that New CME would continue to comply with Commission regulations restricting how contract market governing boards are selected.43 Furthermore, Existing CME’s conflicts of interest rule, Rule 300.C, would not be amended and would continue to apply to possible conflict situations affecting New CME.

The rules dealing with members’ reserved powers to amend or repeal rules through a petition and referendum process would also be deleted, as those rights would no longer be available.44 Except for a change to the “Core Rights” as defined in the Certificate of Incorporation, which must be submitted to a vote of the holders of the Class B common stock, neither members nor stockholders would have the power to prevent an action lawfully approved by the Board of Directors from going into effect.

IV. Discussion

A. Demutualization Issues

Four regulatory issues concerning exchange demutualization have been raised to differing degrees by various parties.45

1. Conflicts of Interest

For-profit exchanges must consider shareholder interests, perhaps at the expense of the interests of market users. Decisions and actions should be designed to maximize profits and stockholder value. Furthermore, shareholder interests may be protected by shareholder derivative litigation or shareholder class actions, at the expense of market participants. If an attempt to fulfill self-regulatory obligations negatively affects the profitability of a for-profit exchange, a conflict of interest might arise.46 Conversely, a conflict of interest might be thought to arise in the disciplinary proceedings of a participant of a for-profit exchange if the participant was the owner, or a significant shareholder, of a competing exchange.47

In its submission, Existing CME has pointed out that it has a strong business incentive to preserve its reputation as a well-regulated exchange and views its reputation for market integrity to be significant for New CME as well, rather than adverse to its interests. In addition, unlike a new exchange, Existing CME has already invested in the development of its compliance program. Consequently, the conflict between maximizing profits and stockholder value as opposed to the fulfillment of self-regulatory obligations would be lessened.

The Division also notes that the potential for conflicts of interest also is present under the current exchange organization. Traditional not-for-profit exchanges, operated by members, are interested in enhancing seat value and reducing costs. Furthermore, disciplinary procedures used in the current exchange structure traditionally allow members to sanction other members. Finally, Exchange decisions may be made for political reasons not connected to the concerns of every exchange member.

In all these situations, the Commission has oversight authority. For instance, Section 5a(a)(12) requires that rule proposals be submitted for prior Commission review and thus serves as a safeguard that exchange rule changes are not inconsistent with the Act and the Commission’s regulations. Similarly, the Commission’s oversight of the exchange’s rule enforcement responsibilities serves to determine whether exchanges are maintaining a program to secure compliance with the Act, the Commission’s regulations and the exchanges’ rules.

2. Funding of Self-Regulatory Obligations

a. SRO Responsibilities

The Act and Commission regulations impose self-regulatory responsibilities on designated contract markets. Section 5a(a)(8) of the Act requires a contract market to enforce all of its rules, including those adopted pursuant to Commission regulation or order. Commission Regulation 1.51 requires each contract market to maintain “a continuing affirmative action program” to secure compliance with the Act, Commission regulations and the contract market’s rules. Such program must include:

· Surveillance of market activity;

· Surveillance of trading practices;

· Examination of the books and records kept by members/participants;

· Investigation of customer complaints;

· Investigation of other alleged or apparent rule violations;

· Such other surveillance, record examination and investigation as is necessary to enforce such rules; and

· Procedures resulting in prompt, effective disciplinary action for any violation that is found to have been committed.

Commission Regulation 8.05 specifies that each exchange shall establish an adequate enforcement staff which shall be authorized by the exchange to initiate and conduct investigations, to prepare reports and to prosecute possible rule violations. The enforcement staff may not include members or persons whose interests conflict with enforcement duties, and the enforcement staff may not operate under the direction or control of any persons with trading privileges.

It is possible that a for-profit exchange, interested in reducing expenses to enhance stockholder value, might consider reducing self-regulatory programs or dedicate insufficient resources to its existing programs. However, this risk is also inherent for a mutual exchange whose members may also be interested in cutting costs to themselves. Furthermore, the Commission’s oversight authority of the adequacy of exchange programs for carrying out compliance and disciplinary regulatory responsibilities includes consideration of a lack of funding that contributes to an inadequate program. The Division recommends that the Commission remind New CME that it remains subject to self-regulatory responsibilities under the Act and the Commission’s regulations and that the Commission will continue to do Rule Enforcement Reviews evaluating exchange compliance.

b. CME Representations

In their submissions, Existing CME and New CME represent that New CME would, upon the merger, be the legal successor-in-interest to Existing CME, would meet all the requirements for contract market designation, would assume all the assets and liabilities of Existing CME and would comply with all self-regulatory requirements applicable to designated contract markets under the Act and the Commission’s regulations including, but not limited to, the surveillance and enforcement requirements, the governing board and disciplinary committee composition requirements, and the prohibition against conflicts of interest and insider trading.48 The rules and practices for complying with self-regulatory responsibilities would remain the same. Both Existing CME and New CME state that Existing CME has had a strong business incentive to preserve its reputation as a well-regulated exchange, and that a reputation for market integrity would be equally important for New CME.

The Division believes that the change in status from a membership organization to a for-profit corporation does not inherently create an organization that would not have the ability or the motivation to comply with its regulatory responsibilities. The Division further believes that the Commission has the oversight ability and authority under the Act and the Commission’s regulations to hold an exchange accountable for failures to uphold its regulatory responsibilities.

3. Outsourcing of Exchange SRO Obligations

As mentioned in Section IV.A.2.c above, under the demutualization plan New CME does not plan at this time to change its rules or practices concerning SRO responsibilities. Therefore, any possible issue concerning the outsourcing of exchange SRO obligations is not applicable to the consideration of Existing CME’s demutualization plan. Any such outsourcing would be submitted to the Commission under Section 5a(a)(12) of the Act, and would be considered by the Commission at that time.

4. Exchange Governance

While members and market users extensively overlap in a member-owned exchange, under a demutualization plan, over time the percentage of shareholders that are also market users may, and probably will, decrease. Notwithstanding the composition of exchange ownership, Section 5a(a)(14) of the Act and Commission Regulation 1.64 require that exchange governing boards include meaningful representation of a variety of market users as well as other interests. On the other hand, the board of directors of a for-profit entity has the responsibility to represent the interests of its shareholders rather than the interests of market users, and corporate governance laws contain their own conditions for governing board composition. However, Delaware, the state in which New CME will be incorporated, specifically allows a corporation to dictate other qualifications for directors. Furthermore, while the issue of governance is important for the Commission to consider when reviewing any demutualization plan, as mentioned above qualifying factors have been included in the proposed By-laws that would require that the Nominating Committee for New CME’s Board of Directors consider the necessity of meeting the composition requirements found in Commission Regulations 1.63 and 1.64.49 These factors are the same factors now used by Existing CME.

Commission Regulation 1.63 limits service on SRO governing boards and committees for persons with disciplinary responsibilities. As mentioned above, Existing CME Rule 300.C, providing for the application of Regulation 1.63, would not be changed.50 Certain anti-takeover provisions would be contained in the charter and By-laws of New CME. These anti-takeover provisions are meant to encourage persons considering making unsolicited tender offers to negotiate with New CME’s Board of Directors.51 The Division believes that the provisions are not inconsistent with the Act and the Commission’s regulations.

V. Conclusion and Recommendation

Based on the foregoing, the Division believes Existing CME’s demutualization plan, including its associated amendments, is not inconsistent with the Act or the Commission’s regulations. Accordingly, the Division recommends that the Commission approve the proposed Certificate of Incorporation and By-laws of New CME., the proposed deletion of Existing CME’s current Articles of Incorporation and the proposed amendments to: (1) the definitions section of the CME Rulebook; (2) Rules 100, 101, 103, 104, 105, 106, 107, 108, 109, 110, 120, 121, 122, 127, 130, 131, 133, 135, 193, 194, 200, 201, 202, 203, 210, 211, 212, 213, 214, 215, 216, 217, 218, 219, 220, 221, 240, 241, 242, 243, 244, 245, 246, 247, 250, 251, 252, 253, 255, 256, 260, 261, 262, 263, 265, 266, 267, 268, 403, 435, 507, 574, 582, 600, 802, 902 and 913; and (3) Interpretation of Rules 135.D and 135.F and of Chapter 8 of the CME Rulebook, pursuant to Section 5a(a)(12)(A) of the Act and Commission Regulation 1.41(c). The Division also recommends that the Commission confirm to New CME that the status of each rule in the CME Rulebook, under the Act and the Commission’s regulations, is not affected by the consummation of the demutualization plan except as each rule is amended herein.

Furthermore, since the effect of Existing CME’s plan is to change the ownership structure of Existing CME without altering its self-regulatory rules or practices and without altering the terms and conditions of the contracts that have been designated by the Commission for trading on Existing CME, the Division, pursuant to consultation with the Division of Economic Analysis, recommends that the Commission issue the attached order transferring all Existing CME’s current contract market designations to New CME, including the transfer of all existing open interest in all such contracts.52 The transfer of these designations, and all related open interest, should take effect at precisely the same time as the merger itself. The Division also recommends the approval of the transfer to New CME of all contracts listed for trading by certification at Existing CME.53

The Division further recommends that the Commission remind Existing CME and New CME that any subsequent rule changes associated with the demutualization plan must be submitted for Commission review. In addition, the Division recommends that the Commission remind New CME that, as it agreed to in its representations, it will remain subject to all provisions of the Act and the Commission’s regulations applicable to designated contract markets, including self-regulatory responsibilities under the Act and the Commission’s regulations.


1  Existing CME is the first contract market to submit a demutualization proposal to the Commission. The Chicago Board of Trade (“CBT”) and the New York Mercantile Exchange (“NYMEX”) also are pursuing their own demutualization plans. The Commission has received several submissions from NYMEX, which expects that its demutualization membership vote will take place on June 20, 2000.

2  The demutualization plan involves several steps because Illinois law does not allow the direct merger of an Illinois not-for-profit membership corporation into a Delaware stock corporation.

3  The Division understands that the recapitalization step was added by Existing CME to its original plan, on the advice of its tax counsel, to emphasize the independent purpose of the merger of a not-for-profit corporation into a stock corporation from the separation of memberships into equity ownership and trading rights.

4  The vote was 5,361 to 74 with 18 abstentions. Existing CME’s Board of Directors unanimously approved the demutualization plan in October of 1999 and on March 28, 2000. Subsequently, the Board unanimously recommended that the membership approve the plan at the special meeting held on June 6, 2000. Approval of the plan required a two-thirds majority vote of those members casting votes by proxy or in person at the meeting.

5  Existing CME and New CME have also represented that New CME will assume responsibility for maintaining the certification conditions for all contracts listed for trading by exchange certification.

6  The proposed Certificate of Incorporation of New CME is attached to this Memorandum as Appendix D.

7  The proposed By-laws of New CME are attached to this Memorandum as Appendix E.

8  Existing CME’s current Article of Incorporation is attached to this Memorandum as Appendix F.

9  These rule amendments are attached to this Memorandum as Appendix G. The CME Rulebook, as amended herein, would govern the trading activities on New CME. Most of the rules are not being amended and would apply to New CME in their current form. See infra note 41. According to Existing CME, rules are being amended to bring the rules in the CME Rulebook into conformity with the proposed Certificate of Incorporation and By-laws of New CME, and that most of the substantive rules are not changed. See Letter from Carl A. Royal, Senior Vice President and Special Counsel, Existing CME to Jean Webb, Secretary to the Commission 1, 4 (May 16, 2000). As Existing CME, under its demutualization plan, is carrying out a merger into a new entity, the Division has asked for, and received, the representations of Existing CME and New CME that New CME, upon completion of the mergers, will meet the requirements for contract market designation. However, unlike the contract market designation process for a new contract market, the Division reviewed the amendments of, and additions to, the CME Rulebook for inconsistency with the Act and the Commission’s regulations rather than reviewing a new set of rules in their entirety.

10  This merger would be effected under an agreement and plan of merger between Existing CME and the CME Transitory Co. Since the CME Transitory Co. was formed for the sole purpose of effecting the demutualization transaction, it has no present assets or business operations. Currently, Existing CME is the sole member of the CME Transitory Co. and this membership interest would be cancelled upon the effectiveness of the merger.

11  This merger would be effected under an agreement and plan of merger between the CME Transitory Co. and New CME. Since New CME was formed for the sole purpose of effecting the demutualization transaction, it has no present assets or business operations, although it has filed a preliminary Certificate of Incorporation with the state of Delaware. The CME Transitory Co. is the sole shareholder of New CME and this stock interest would be cancelled upon the effectiveness of the merger. The Securities and Exchange Commission (“SEC”) declared New CME’s registration statement effective on April 26, 2000.

12  One contingency was the requirement that PMT Limited Partnership, which operates Existing CME’s GLOBEX2 electronic trading system, approve the sale of its assets and operations to Existing CME. PMT Limited Partnership approved the sale of its assets and operations to Existing CME on June 6, 2000, by an affirmative weighted vote of 84% of the eligible votes cast.

13  This ruling request was filed with the IRS on December 30, 1999. The IRS has not yet issued a ruling on the request.

14  Existing CME represents that none of the rule changes under the demutualization plan will affect the rights and obligations of all participants with open positions transferred from Existing CME to New CME and that the rules changes do not relate to how such contracts are cleared. See Letter from Carl A. Royal, Senior Vice President and Special Counsel, Existing CME to Riva Spear Adriance, Attorney-Advisor of the Division 1 (June 7, 2000). The Division also notes that market participants have been notified of changes to the CME Rulebook, the concurrent transfer of the contract market designations from Existing CME to New CME and related transfer of all open interest upon consummation of the merger of Existing CME into New CME under the demutualization plan.

15  According to its Certificate of Incorporation, the Board of Directors of New CME also is authorized to issue shares of Preferred Stock in one or more series, to establish the number of shares to be included in each series, and to fix the rights, preferences and privileges of the shares of each series. The Board may authorize the issuance of Preferred Stock with voting or conversion rights that could adversely affect the voting power or other rights of the holders of Class A and/or Class B Common Stock. See Certificate of Incorporation of the New CME, Article Four, Division A (Preferred Stock). CME maintains that at the present time, there are no plans to issue any shares of Preferred Stock. See CME, Proxy Statement and Prospectus 37 (April 25, 2000).

16  See infra Section II.D. Class A Common Stock would be subject to transfer restrictions that would incrementally lapse over a period of fifteen months after the completion of the demutualization plan.

17  Class B shares would be bought and sold through New CME’s membership office, with New CME acting as transfer agent. Persons acquiring shares of Class B stock would be able to trade only if the person satisfied New CME’s trading eligibility requirements and agreed to be bound by the rules of New CME. However, under the demutualization plan, a person could acquire shares of Class B stock for investment purposes even if they never applied to trade those shares.

18  A current requirement, unconnected to the demutualization plan, obligates the holders of all GEM Division fractional membership interests to combine their interests into full GEM Division membership interests by November 3, 2000. Under the demutualization plan, the holders of such fractional interests would have the option to convert their Class B-5 shares into Class B-4 shares (representing full GEM membership interests) by that date. Any shares not so converted would be converted into Class A shares at the close of business on November 3, 2000.

19  The membership approval process at New CME, including the ownership and eligibility criteria, would be substantially similar to the existing approval procedures.

20  See By-law Section 6.3(a) and (b). Thus, conversely, under the demutualization plan, equity ownership rights are separate from membership trading rights. A natural person or legal entity can acquire Class A shares and/or Class B shares as an investment without becoming a member of New CME (and thus without exercising the associated trading privileges). See also infra note 39.

21  See By-law Section 6.3(c).

22  At the annual meeting to be held in December of 2000, the terms of eighteen of the directors will expire. At that time, nine individuals would be elected to New CME’s Board for a term of two years. Six of those nine directors would be elected by the holders of Class A and Class B Common Stock voting together as a single class. The holders of Series B-1 Common Stock would elect one director, the holders of Series B-2 Common Stock would elect one director, and the holders of Series B-3 Common Stock would elect one director. See Certificate of Incorporation, Article 5(B). At the annual meeting to be held in December of 2001, the terms of the remaining twenty-one directors will expire. At that time, ten individuals would be elected to New CME’s Board for a term of two years. Seven of the ten directors would be elected by the holders of Class A and Class B Common Stock voting together as a single class. The holders of Series B-1 Common Stock would elect two directors and the holders of Series B-2 Common Stock would elect one director. See Certificate of Incorporation, Article 5(C).

23  See Certificate of Incorporation, Article 5(D).

24  See Certificate of Incorporation, Article 5(F).

25  For purposes of certain voting and participation in any dividend or liquidation distributions, shares of Class B stock would be treated as if they represented a specified number of Class A shares (Class A share equivalents). One share of series B-1, B-2, B-3, B-4 and B-5 represent 1,800; 1,200; 600; 100; and 10 equivalent shares of Class A stock respectively.

26  See infra Section II.C.2.

27  Under the Certificate of Incorporation, New CME would have the obligation to maintain floor trading as long as the open outcry market was “liquid.” An open outcry market would be deemed liquid if the market met any of four factors on a quarterly basis. While the decision whether to maintain floor trading for any liquid market would be a core right of holders of Class B shares, the Board of Directors would have the ability to determine whether or not to continue to maintain floor trading for any open outcry market that did not pass the liquidity test, as determined by the Board of Directors. See Certificate of Incorporation, Article 4, Division B - Common Stock, Definitions (“Commitment to Maintain Floor Trading”).

28  The core approval rights do not include the rights to approve the conversion of Series B-5 Shares into Series B-4 Shares as this conversion was previously decided.

29  Holders of Series B-1 (CME) shares would have six votes per share, holders of Series B-2 (IMM) shares would have two votes per share, holders of Series B-3 (IOM) shares would have one vote per share, holders of Series B-4 (GEM) shares would have one-sixth vote per share, and holders of Series B-5 (GEM Fractions) shares would have one-sixtieth vote per share. Series B-5 shares will be converted by November 3, 2000, and thereafter will no longer be in existence. See supra note 18.

30  See note 25.

31  Originally, after the demutualization transaction, Class A shares could only be transferred with the associated Class B shares. During this period, New CME would carry out extensive efforts to inform analysts and investors of the value of the Class A shares. After six months, shareholders could begin to sell up to 25% of their initially allocated Class A shares separately from the associated Class B shares. Up to 50% of a shareholder’s Class A shares could be sold separately nine months after the demutualization transaction, and up to 75% could be sold separately from one year after the demutualization transaction until the end of the restriction period.

32  However, persons would be able to trade on the floor of the exchange only if, as is true currently, the person satisfied trading eligibility requirements and agreed to be bound by the rules of New CME, thereby becoming a “member.” Membership would be defined as the trading rights associated with a series of Class B shares. See proposed amendments to the CME Rulebook, Definitions (amending the definition of “membership”). Existing CME’s eligibility requirements allow an adult of good moral character, reputation and business integrity, with adequate financial resources and credit to assume the responsibilities and privileges of membership, to be eligible for election to membership in Existing CME. The Membership Committee of Existing CME reviews applicants and conducts proceedings to determine whether candidates meet the membership criteria. Such procedures and requirements would continue under the demutualization proposal for persons trading on the floor.

33  The Nominating Committee would be required to take into consideration that the Board of Directors should be represented by (i) a diversity of interests, (ii) at least ten percent of Board Members should be persons representing farmers, producers, merchants, or exporters of principal commodities traded on the exchange, and (iii) at least 20 percent should be comprised of persons who do not possess trading privileges on the exchange, are not employees of the exchange, or are not officers, principals or employees of a person that possesses trading rights. See By-law Section 3.5.

34  The charter of New CME, in accordance with current practice, would require that director nominees for election by a particular series own, or be recognized under its rules as a permitted transferee (other than temporary lease-type transfers) of at least one share of that series. The members of the current CME, IMM and IOM nominating committees would act as the members of the series B-1, B-2 and B-3 nominating committees for the December 2000 Board elections. The nominating committee for each series would be responsible for assessing the qualifications of potential candidates for that series.

35  See By-law Section 3.5. See also Letters from Carl A. Royal, supra note 9 at 3-4 (May 16, 2000); supra note 13 at attachment (June 7, 2000) (representations of New CME); and from Carl A. Royal, Senior Vice President and Special Counsel, Existing CME to Riva Spear Adriance, Attorney-Advisor of the Division at attachment (June 13, 2000). Representations cited herein from Existing CME were made by Carl A. Royal, counsel for Existing CME; representations cited herein for New CME were made by Craig S. Donohue, Managing Director, Business Development and Corporate/Legal Affairs for New CME. New CME currently exists as a Delaware stock corporation. See supra note 8.

36  See supra section II.F.1 for information on the Nominating Committee.

37  The Executive Committee would have the authority of the Board of Directors when the Board is not in session, except when action of the entire Board of Directors is required under the Certificate of Incorporation, the By-laws or by applicable law. As part of its demutalization process, Existing CME intends that New CME Board would be less involved in the day-to-day functioning of New CME. Existing CME states that currently some members may act in a decision-making capacity on the Board, but may also be in direct competition with Existing CME. As the demutualization plan would give management greater responsibility for the day-to-day operations, a common practice for public corporations, the impact of such conflicts would be reduced. Management with greater control over day-to-day operations can also react with greater promptness and agility, according to Existing CME. Examples of day-to-day decisions that would eventually be management decisions under New CME’s structure include: (1) the ability to make decisions regarding the listing of contracts electronically if the contract would be more successful; (2) changing clearing or transaction fees when appropriate; (3) expanding existing product and service offerings; and (4) judging investments and expenditures based on, among other reasons, prudent investment decisions to enhance stockholder value rather than political member influence.

38  See supra Section II.B. See also infra note 39.

39  For example, in the current rules, the term “membership” is used both to describe an asset that can be purchased and sold and the trading privileges associated with being a member. In the amended rules, “membership” would refer only to the trading rights of Class B shareholders, while the asset that could be purchased and sold would be called a “Class B share” or a “Class A share.” Therefore, a person could acquire a Class B share for investment purposes without becoming a member, instead leasing the associated trading rights to another person. The lessee could exercise such trading privilege only after satisfying New CME’s membership and eligibility requirements.

40  Letter from Carl Royal, supra note 35 at 3 (May 16, 2000). See also Letter from Carl A. Royal, supra note 13 at attachment (June 7, 2000).

41  For example, rules regarding contract specifications, trading on the floor via open outcry, trading electronically through the GLOBEX2 system, clearing and settlement, and enforcement of Exchange rules and Commission regulations would remain unchanged.

42  Rules 200—221 (dealing with board composition and governance), for example, would be deleted because those subjects are now being addressed in the Certificate of Incorporation and By-laws.

43  Rules 262—268. See supra Sections II.E and III.A.4. The Division would be able to monitor compliance with the composition requirements of Commission Regulation 1.64 through (1) the requirement under Commission Regulation 1.64(d) that each SRO submit a list of its governing board members within 30 days of a governing board election; and (2) its Rule Enforcement Reviews.

44  See supra Section II.C.2.

45  See e.g., Securities Industry Association, Reinventing Self-Regulation (Jan. 5, 2000) (“SIA White Paper”) (examining existing and alternative self-regulatory models); The Changing Face of Capital Markets and the Impact of ECN’s: hearing Before the Subcomm. on Securities of the Senate Banking Comm., 106th Cong., 1st Sess. (October, 27, 1999) (“Testimony of Chairman Levitt”) (testimony of Arthur Levitt, Chairman, SEC); Craig Pirrong, Electronic Exchanges Are Inevitable and Beneficial, Regulation, January 11, 2000, at 21.

46  Concern has been expressed that there may be conflicts of interest between operating a for-profit corporation and fulfilling self-regulatory obligations. See SIA White Paper, supra note 45 at 9-10 (examining existing and alternative self-regulatory models). See also Testimony of Chairman Levitt, supra note 45 (raising these concerns, Chairman Levitt suggested that strict corporate separation of the self-regulatory body from the market it regulated might be necessary).

47  SIA White Paper, supra note 45; Testimony of Chairman Levitt, supra note 45.

48  Letter from Carl Royal, supra note 38 at 3-4 (May 16, 2000) (including representations from Existing CME) and Letter from Carl Royal, supra note 35 (June 7, 2000) at attachment (containing representations of Craig S. Donohue, Managing Director, Business Development and Corporate/Legal Affairs, New CME).

49  See supra Sections II.F and III.A. See also By-law 3.5.

50  See supra Section III.A.

51  The anti-takeover provisions found in New CME’s charter and By-laws include: (1) a prohibition against stockholder action by non-unanimous written consent; (2) a restriction on who may call special meetings of stockholders; (3) an advance notice requirement for persons other then the members of the Board of Directors intending to present proposals for approval at stockholder meetings; (4) a restriction only allowing removal of Directors for cause by the holders of two-thirds of the voting power of outstanding shares; and (5) provisions that allow the Board of Directors to create rights to purchase securities or to take action designed to encourage potential acquirers of the company to negotiate with the Board of Directors.

52  See attachment to Appendix B (listing all contracts in which Existing CME is currently designated).

53  The Division bases its recommendation upon: (1) the representation by New CME that it would take over responsibility for maintaining the certification conditions; and (2) the absence of issues related to changes in the rights and obligations of participants with open interest in these contracts, as these contracts have not started trading.