If there is no objection, the minutes of the last meeting are approved as written. Also, if there is no objection, the acts of the Board of Directors and officers since the 2001 Annual Meeting stand as approved.
I want to thank all of you who have taken the time to attend today's annual meeting, either in person or via Membernet.
I have been honored to be your Chairman over the last few years and I want to report to you on the progress we have made. Let me review some of these accomplishments and in doing so I want to emphasize one important point: these successes would not have happened without the efforts of many people, management and members both:
- Developing a strategic vision and business model designed to give our customers and members the best open auction and electronic platforms, considering both member profits and exchange profits as part of an overall plan.
- Putting in place an excellent management group headed by Bernie Dan, Carol Burke and Bill Farrow, and setting standards of communication and decision-making so that Board, management, and members work together to improve the overall CBOT® enterprise.
- Working to give our customers what we believe to be the best technology in both open auction and electronic platforms:
- Greatly improving the efficiency of open auction so that now close to half of our customer orders are electronically routed, saving paper handling and paperwork, and planning for further efficiency with the institution of real time trade matching and processing.
- Adopting LIFFE CONNECTTM as our new electronic platform, a decision enthusiastically endorsed by the trading community.
- Finalizing our plan to change the CBOT to a for-profit corporation with a member vote to be scheduled soon after SEC review is completed.
- Keeping our finances sound with good business practices, while reducing member fees, eliminating dues and making important technology investments.
- Working to resolve the four major lawsuits we faced at the end of 2000 (all four are now either settled or we have court decisions in our favor), while going through the last two years with no new major litigation.
- Refining our member fee preference rules so that ownership is encouraged.
- Taking strong stands and speaking out about market integrity, so that our customers and the public generally know how important this is at the CBOT.
- Working with customers to market and develop our products, with resulting volume records and new product introductions like the mini-sized DowSM, Swaps, and Fed Funds options.
- Most importantly, communicating regularly with our members, customers and the public generally.
Bernie and Glen Johnson will tell you about our financial results in detail, but let me touch on the highlights. The year 2002 was a record year for both volume and finances for the CBOT, with net income over $33 million, far above the $4.4 million of 2001 and the $10.1 million loss of 2000. Our ending cash balance was close to $86 million at year-end 2002, versus $53 million for 2001 and the long-term debt on the building was down to $53.5 million at year-end 2002.
II. Restructuring Proposal.
Once the SEC declares our registration statement effective, the proxy statement and prospectus included in the registration statement will be mailed to members, and we will follow up with member meetings.
First, I want to make it clear that a corporate restructuring, whether at the CBOT or other enterprises, is often effected for the purpose of organizing the capital structure, corporate governance structure and or operations in a manner that more closely fulfills the objectives of the enterprise. In our case, the objectives of our proposed restructuring are to improve our competitiveness and structural flexibility while preserving our ability to provide member benefits and opportunity. Over the past several years we have implemented a number of important initiatives designed to complement the proposed restructuring in achieving these objectives.
I say this because some people not familiar with us think that the significant amount of time we have spent developing a restructuring proposal means we have not otherwise been making the progress towards our objectives we should have. Obviously, that is not so, as my description of our accomplishments shows, as well as the evidence of our record volumes and revenues.
We have encountered some delays in our effort to bring a restructuring proposal to a membership vote, e.g., delays associated with resolving our disputes with the CBOE and the litigation brought by certain Associate Members, GIMS, IDEMS and COMS, and the SEC review process, but we have used this time to create what we believe to be an excellent proposal that will help achieve the objectives of our enterprise.
Let me tell you why I believe that the restructuring proposal should be passed. First, the restructuring proposal contemplates the creation of a holding company, which will be a for-profit, stock corporation that will have the ability to declare and pay dividends. Although it is not currently anticipated that the holding company will pay dividends in the near future, it is possible that with a successful transition to LIFFE CONNECTTM and with continued increases in trading volumes, the holding company will have available to it the resources necessary to declare and pay dividends, although there can be no assurances in this regard.
Second, we have invested a significant amount of time and effort in developing a proposed allocation of equity in the CBOT, which we believe is the product of an independent and fair process, and litigated challenges to the restructuring as I mentioned earlier. I believe that if we were not to proceed with the restructuring proposal at this time, we would only be deferring the resolution of these issues to some point in the future with much of the investment made to date in resolving these issues being largely wasted. In other words, we should go forward now while we have made the progress we have.
I am not for this restructuring proposal because it will substantially change our corporate governance structure or the way we do things; in fact, I believe the proposed changes are relatively modest. Further, approving this restructuring proposal will not mean that we must conduct an IPO or sale or issuance of shares to individuals who are not members. A decision on a sale of shares in the future will NOT be made or preordained by passage of this restructuring proposal. Such a decision will require an amendment of the charter of the proposed holding company, which will need to be approved separately by the board of directors and the stockholders of the holding company.
I am FOR this restructuring proposal because I believe it will help achieve our objectives of improving our competitiveness and structural flexibility while preserving our ability to provide member benefits and opportunity. In addition, I am FOR this proposal because it contemplates that we will be restructured into a for-profit, stock corporation that could distribute the money made at the corporate level. Further, I am FOR this proposal because we have invested time and effort in developing a proposed allocation of equity in the CBOT, which we believe is the product of an independent and fair process, and litigated challenges to the restructuring. Last, I am FOR this proposal because it preserves member involvement in our corporate governance structure, and it reserves for subsequent approval whether or not we choose to issue shares to persons other than the membership.
Let me emphasize one very important point. Before completion of the transactions contemplated by the restructuring proposal, you will have a membership in a not-for-profit, nonstick corporation. After completion of such transactions, you will have one or more memberships in an exchange subsidiary, which will be organized as a for-profit, nonstock corporation, plus shares of common stock in a holding company, which will be organized as a for-profit, stock corporation. Immediately following completion of these transactions, you will own common stock and membership interests that together provide you substantially the same bundle of rights and obligations that you own today as a member of the CBOT.
The restructuring proposal does not contemplate that there will be additional shares of common stock in the proposed holding company available for issuance without a vote of the stockholders; all shares of common stock authorized are to be issued to CBOT members. The restructuring proposal further contemplates that shares of common stock in the holding company and Class B memberships in the exchange subsidiary will be stapled together until the stockholders of the holding company and Series B-1 and Series B-2, Class B members, (effectively the Full and Associate members of the CBOT), of the exchange subsidiary, vote otherwise. The Class C membership in the exchange subsidiary, which essentially represents the "exercise right", will not be subject to the same restriction on transfer.
The restructuring proposal does not contemplate the issuance of extra shares of common stock in the holding company, including by way of an IPO, and such a plan would require the approval of the board of directors and stockholders of the holding company. A stock option plan for employees and, again, the issuance of common stock in the holding company under such a plan would require the approval of the board of directors and stockholders of the holding company.
I congratulate the CME on its successful IPO and its market acceptance shows the value of exchanges. However, the members I talk to understand that such a stock sale is not free money. An IPO requires careful consideration as to if, how and on what terms public stock would be sold and it is certainly premature to make such decisions today.
Although the proxy statement and prospectus that will be mailed to you is lengthy and complicated, I believe that a series of member meetings will assist the membership in understanding the proposal and the, armed with such understanding, the membership will overwhelmingly approve the restructuring proposal.
III. Market Integrity.
I believe that one of the most critical issues for our markets is investor confidence and avoiding or eliminating conflicts of interest. These conflicts generally involve improperly combining the roles of principal and agent and can be summed up in the phrase "A man cannot serve two masters."
I have talked about market integrity many times over the last two years. It includes everything from analysts hawking investment banking services to accountants influenced by consulting fees. Along the way we have seen stories of executives cooking the books and lying about results to pump stock prices. Investors and regulators have focused on those practices, hopefully to stop them and jail wrongdoers.
But there are more subtle threats attacking the fairness of our markets. These are the problems that result when firms want to go beyond acting as an agent or broker for a customer attempting to get the best possible price, but instead the firm looks to profit from the customer order in a way that the customer does not see.
These concerns about market integrity came through loud and clear in former SEC Chairman Harvey Pitt's recent letter to each of the five security option-exchange chairmen, including the CBOE:
"I am seriously concerned that economic inducements to order flow providers and internalization by member firms create serious conflicts of interest that can compromise a broker's fiduciary obligation to achieve best execution of its customers' orders."
Mr. Pitt went on to state that payment for order flow and internalization of order flow by firms "can discourage competition for orders among market makers" and "have the potential to encourage firms to consider their own economic interests over those of their customers." Consequently, he recommended that these practices be ENDED.
I am proud that CBOE Vice Chairman Mark Duffy has fought against payment for order flow for years and that CBOE Chairman Bill Brodsky responded to the SEC by strongly agreeing with their views, stating:
"At a time when investor confidence in the securities markets is at a nadir, bold action is needed to eliminate practices that work to the detriment of investors. Just as the Commission has taken a firm stand against the conflicts of interest affecting securities analysts, accountants and corporate executives for the protection of investors, it should also move quickly to eliminate the conflicts of interest inherent in internalization and PFOF."
As you know, "internalization" is a benign sounding term that means that the customer's broker trades buys or sells the customer's order for himself, while "payment for order flow (PFOF)" means that the first broker can sell the customer order to another broker who trades against it.
In everyday terms, imagine you hired a real estate agent to sell your house and he told you it would be better if he, the agent, bought it from you instead of and before showing it to other buyers. He collects a commission, plus buys the house - that's internalization. If he sells the opportunity to buy the house to another broker, that's payment for order flow. And, by the way, after either broker has bought your house, you can bet he doesn't short circuit his profit by just showing it to one person. He shows it to the entire market for the best price he can get which is what he should have done in the first place if he was truly acting as your agent.
The customer should know that he gets the best possible fill only if his order is handled by an agent solely dedicated to the customer's best interest, and not if his firm is acting both as principal and agent. It is true that a firm may get quotes from a marketplace before filling the order internally but there is no opportunity for price improvement by a crowd of competing market makers as when an order is presented for immediate fill. Further, if the firm is planning to buy or sell from its customer, it has reduced its incentive as the customer's agent to get the best possible price because the firm, as principal, wants to pay a low price.
Most importantly, by turning the exchange into a quote service, you destroy the vibrancy of the competitive market, by begging the question, "why quote if you don't get to trade?" and you disadvantage other customers and market participants. The entire market, including customers from other firms, is entitled to compete for the order and if the orders are withheld from the overall market, it means fewer and fewer participants will be there in the future. In other words, why bother to show up?
I mention these current problems of the securities options industry because we have some commodity firms that, despite the deleterious effect on investor confidence and the conflicts of interest, want to bring these practices to commodities.
I am talking about the FIA's effort to have the CFTC force by regulatory fiat "fungibility" of futures products. It has begun its campaign using innocent sounding phrases like "clearing choice" or "clearing competitiveness". But like "payment for order flow," no customer is asking for this; it is being pushed by a few firms for their own benefit, not for the benefit of customers.
The proponents of this have not really spelled out in detail how "clearing choice" would work or even shown how it could be practical to have a number of different clearing entities all clearing the same contract. However, I believe their goal is this: A customer order could be filled and cleared at an exchange and clearing entity with one set of rules, while being offset at another exchange with another set of rules. For example, while the CBOT has rules that require competitive exposure of orders, Brokertec lists identical products but has block trading rules that allow off market trades in private deals, rules that are unacceptable to the CBOT.
After executing a customer order via block trading at Brokertec, a firm could trade in the CBOT's open outcry or electronic markets to offset the block trading position and avoid any market risk it would have on the block trade. But only the firm would know the size and price of the block trade it was offsetting. The result: the CBOT goal and reputation of providing maximum price transparency and fairness would be severely undermined if not destroyed. Clearing choice, in effect, would allow Brokertec to override the CBOT's "trading choice." As this example shows, clearing choice would mean that no exchange would have sovereignty over how its markets would operate.
By making the contracts "fungible", the firm could use the liquidity and integrity of an exchange's contracts but ignoring that exchange's customer protection rules.
Most of you will be surprised to know that the FIA's justification of its proposal is that exchanges are "monopolies'. If that were true, FIA members would not have been able to start their own exchange, trading exact replicas of CBOT contracts. The fact of competition is obvious, not only from the Cantor Exchange and Brokertec, but from the announced entrance of Eurex. To me the motive of the "clearing choice" people is internalization, which is the opposite of competition, and, as Harvey Pitt said regarding payment for order flow, any supposed "competitive" benefits do not flow through to customers.
There is another extremely important consideration in addition to our rules mandating competitive exposure of orders: In these post-Enron days, I had one question asked of me many times: What financial protections do customers have at the Chicago Board of Trade?
My answer is simple: we have the Board of Trade Clearing Corporation with a AAA guarantee of their trades and surveillance programs that continuously monitor the financial condition of member firms and their ability to comply with obligations to customers. I don't think any customer would want to give up these protections.
In summary, I do not believe that the idea of "clearing choice" exercised by firms is any more acceptable than payment for order flow or internalization generally. These practices are not done in the customer's interest or of the market overall, but what some firms perceive to be in their interest and that is not a proper consideration.
Customer orders get the best price when brought to a competitive crowd for execution. Orders matched upstairs or traded against by a firm as principal do not get the same benefit of competitive execution. "Fungibility", "clearing choice", etc. are simply ways to keep customer orders away from competitive execution at open, transparent exchanges. I doubt if any informed customer wants that to happen, nor do I think the CFTC should make this possible by mandating fungibility. I am glad that SEC Chairman Harvey Pitt highlighted these issues.
As I conclude my Chairmanship, let me say it has always been challenging, sometimes intensely so. Nonetheless, even with the serious responsibilities involved, I have enjoyed it. I have had the privilege of contributing to a great institution and working with many, many people committed to its success. Charlie Carey has been an excellent Vice Chairman, he knows all the issues and is running unopposed for Chairman. Charlie, best wishes; I know you will do a great job.
Now let's hear from Bernie Dan, our CEO, and then from Glen Johnson, our Chief Financial Officer, following which we will discuss the CBOT in response to your questions.
