Some Inside Baseball

Why Are Seats Rallying At Chicago Exchanges?

After the court set a court date for a lawsuit to proceed, seats at CME Group rallied. That seems like a bad purchase to me for a number of reasons. I don’t own a seat, and I own very little CME stock. If it goes to zero, I don’t care (Hint: It’s not going to zero)

The city of Chicago is a ghost town when it comes to finance. What’s the worst thing you could say to an investment banker who is working and living in NYC? “Hey, we are moving you to Chicago.” Sure, CME and CBOE are HQ’ed there, but as far as M+A and the other moneyed practices of finance, Chicago is not in the top 5 cities of the US and is an afterthought when it comes to world finance. It’s a connecting airport when it comes to finance.

Colin Cowherd has no idea what he’s getting himself into. He’s moved from Los Angeles to Chicago. Same taxes. Same Marxists. Worse weather. Worse Chinese and Korean food. Better hot dogs, pizza, and Italian beefs.

The editorial in the Tribune a few weeks ago was misleading and unrealistic. If you owned a seat at demutualization, it was impossible to hang on to all your stock unless you were already so wealthy it didn’t matter; if you weren’t trading for a living and had another line of work to support your family; or you just lived like a hermit and spent no money. Virtually 99% of people I knew had to sell stock and their membership in order to support themselves when the markets went electronic.

This isn’t being disintermediated by a competitor that no one saw coming, like Uber did to taxis. Which, by the way, the government protected via taxes and regulations. This was being disintermediated by competition you saw coming, and corporate decision-making that enabled the competition while disadvantaging you.

First, the class has already been certified. Correct me if I am wrong, but if I bought a seat tomorrow, I wouldn’t be a member of the class, as I read the lawsuit. Personally, I don’t think the way the class is defined is correct, since it was the people who owned seats back at the time of demutualization who were harmed the most. But don’t let the facts get in the way of a good donnybrook.

Second, I think there is a lower limit to any damages the class receives should the case be decided in their favor. But I also think there is an upper limit, too. It’s not infinity on the upside. If you think you are going to receive millions in damages, you might want to refigure your math. I find it hard to get past a $1M number. At a million per seat, it’s $2.8 billion for just CME B’s, and I don’t foresee that happening, but I am not a lawyer, so I reserve the right to be woefully incorrect in my analysis.

There is a chance that plaintiffs get a big fat zero.

Not being a lawyer, I don’t think like one. Not being a lawyer means I truly do not understand case law, class actions, and things like that in practice. But, I think I can grasp strategy and am empathetic to both sides of this lawsuit.

On the plaintiff side, they think they got jobbed. I see their point. Corporate suits made decisions that deliberately hurt their ability to make money. In some cases, that was making money by leasing a seat out. In other cases, that meant making a living trading. The trading floor transitioned to a trading screen, and there is no difference between the two, but as I recall, l the decisions made by the suits disadvantaged the guys on the floor.

Would they settle? I don’t know. The class action lawyers are going to take at least a third of any settlement. I don’t know how many CBOT seats there are, but at CME there are three different classes with 625, 824, 1350, respectively, for a total of 2799. The 625 will expect a larger payment than the 1350 receives despite the fact that both were harmed equally if the case is decided their way. That’s due to voting rights and the old PMT system.

That is the core of their case.

On the defendant's side, they don’t see what they did wrong. However, it might behoove them to find a settlement. Why would they pay anything and not extinguish every single core right the B share claimed it had? They’d have to do that in order to make sure there wasn’t a lawsuit like this again.

That would allow the CME to decrease the size of the board by getting rid of B board members, but more importantly, change their entire fee structure to be based on volume and not specific ownership. Traders who traded the most would get the lowest fees. The entire trading fee structure could be based on the elasticity of demand for any given contract. Redoing the fee structure could be a gigantic boon to CME profits long term.

For what it is worth, CME’s existing board is far too large. It’s 22 people. 6 are reps for B shares. By the way, vote your B shares if you own one. If you own a B and can’t find your control number, call CME investor relations for help. The number is 312 930 3484. Update your contact information.

I cannot imagine owning a B share and declining to vote, especially given what is going on.

The CME annual meeting is coming up soon. I suspect if questioned about it, they will say that since it’s an ongoing legal case, they cannot comment on the advice of their attorney, or something like that. Don’t expect any big revelations on the case at the CME annual meeting.

But, expect the Chicago Teachers’ Union to show up and demand that the CME give it more money. Expect the Chicago left-wing media to be there and fill the void with all kinds of speculation.

In my opinion, the CME board should be no larger than 13-15 max. They might be able to go as small as 9-11. Board size at CME is somewhat determined by CFTC regulations on representation. Exchanges where stock is listed will also have standards and recommendations on board size and representation. Board size is also determined by the best practices of public company boards.

Additionally, if CME buys back the B share in any transaction, the owner of that B share is going to be subject to long-term capital gains taxes, assuming they have owned it for more than a year. One key tenet during demutualization was that no one paid any taxes. Goodbye to that.

Suppose I just jumped into the market hoping for a big buyout. You might be a bagholder, not a speculation sweepstakes winner. B-1 shares jumped $300k since the trial date was set. It seems like there is a lot of speculation. I’d be tempted to sell and not take the risk of a lawsuit. If the plaintiffs lose, how much will B shares fall in price?

Court cases are risky. How risky? Here are two examples. They are patent cases, and not “rights” cases, so the precedents and facts of the cases are different. But they illustrate risk/reward.

A company I was invested in had a patent that a public company trampled all over. The startup company sued. They won, and won treble damages. The losing company appealed. They settled the case before appeal, and it was less than the treble damage amount. I don’t know if the pending case against CME is a treble damage case, but it raises the stakes of any outcome if it is. For every dollar awarded to the plaintiffs, CME is liable for 3x that dollar.

Another company I was invested in owned a patent. A big public company trampled on it. The startup sued. The big company won in court. The small company is still in business, but the patent portfolio it thought was valuable is less valuable.

There are no sure things in a court of law except that the lawyers will make money. Markets like certainty. So far, the market action on CME stock says this lawsuit is going to be decided in the company’s favor, or it doesn’t matter how it is decided. It’s not going to affect the price of the stock or the health of the business. CME has a healthy business. If I were Warren Buffett, I’d buy a big chunk of CME and put it away for a long time.

It is not clear who is going to win this lawsuit. If I were CME, I’d find a way to settle if they can. But any settlement is going to provide certainty that it can not ever happen again. That’s also assuming the plaintiff side is rational and would accept a settlement. Lawyers generally can make irrational people rational.

The lawyers on each side are going to make the lion’s share of the money. Hope they aren’t in Illinois, where they might have to pay a payroll tax.