Musings: Chaos In Chesapeake's Energy Board Room Raises Questions

Chaos In Chesapeake's Energy Board Room Raises Questions

For the past few weeks, energy investors have been treated to a spectacle involving corporate governance of the second largest natural gas producer in the nation and a controversial and once a high-flying stock. The drama unfolding at the Chesapeake Energy Corp. campus in Oklahoma City has raised shareholder ire (lawsuits), forced the company's founder to yield both his role as board chairman and his participation in a special drilling arrangement with the company, and attracted investigations by the Securities and Exchange Commission and the Internal Revenue Service. As a director of three publicly-traded companies and the chairman of the governance committee of two and a member of a third, we have been troubled by the corporate governance revelations and the circus underway at Chesapeake.

We do not enjoy criticizing companies and their managements, but there are situations where the criticism is warranted due to the fallout from the events underway on the image of all other energy companies. Such a situation now exists in our view. The industry is being attacked for many fundamental issues – the risk of deepwater drilling, the pollution from horizontal drilling and hydraulic fracturing, making record profits while not paying a fair share of corporate taxes, and manipulation of commodity markets. Energy corporate scandals hurt the image of the energy industry much like the downfall of Enron tarred the industry for a number of years.

Having to rely solely on public regulatory filings and media reports, we admit to having limited information regarding the dealings that led to the scandal. This means we take to heart Chesapeake CEO Aubrey McClendon's admonish on last week's earnings report conference call that "Your mother told you not to believe everything you read or hear for good reason, and that's certainly been the case for the past two weeks." That said, however, the events and disclosures over the past several weeks and the history of Mr. McClendon and his board of directors raise serious questions about corporate governance at Chesapeake.

The current furor stems from recent disclosure that Mr. McClendon, who has a nice executive perk of being able to personally invest in all the wells his company drills, had extensive personal loans based on the value of his interests in these Chesapeake wells. He has pledged those interests to the financial institutions extending the loans. Additionally, the company had dealings with several of those financial entities that were providing the personal loans to Mr. McClendon. While this situation may not be illegal, the propriety of the dealings is in serious question when it was revealed that Mr. McClendon's loans totaled over $1 billion. The Founder Well Participation Program (FWPP), the special arrangement allowing Mr. McClendon to invest in the drilling of these wells, was begun in 1993. The program was approved by the shareholders in 2005 and was scheduled to run for 10 years, but clearly not all the details surrounding Mr. McClendon's personal finances related to the program had been disclosed either to shareholders, or, it appears, fully to the board of directors. We don't know whether any of his financial arrangements were disclosed to the members of the board's compensation committee that is responsible for supervising the FWPP program, but we doubt it based on the series of press releases claiming the board knew about the details and then backtracking on that statement.

The FWPP in which Mr. McClendon was able to invest in 2.5% of all the wells drilled by Chesapeake was in the limelight at the end of 2008 when the board of directors awarded him a $75 million bonus to enable him to fund his share of the drilling program after his shareholdings were wiped out by a margin call during the stock market collapse during the financial crisis. The board determined that this bonus was an incentive to both keep Mr. McClendon and align his interests with the shareholders. A key question left unanswered is whether taking shareholders' money to pay Mr. McClendon, which then enabled the chairman and CEO of the company to earn this interest in the company's wells, was in the best interest of the shareholders? Had Mr. McClendon not been able to fund his drilling participation, presumably that 2.5% interest would have accrued to the shareholders. Would the present value of the reserves developed by that 2.5% interest been worth more to the shareholders than the $75 million payment? Remember, this sequence occurred in the early phase of the great gas shale revolution, something Chesapeake was leading and that led to the company's premium value in those years. On the other hand, one could ask whether it was likely that had Mr. McClendon not received his bonus he would have left the company. These are all questions we would have hoped the board members were asking themselves when they deliberated on granting the bonus, but based on the latest developments and revelations, we wonder whether those questions were ever raised.

Because Mr. McClendon's shareholdings were wiped out by the margin call, the company has instituted a policy prohibiting the use of derivative and speculative transactions involving company stock. This is a policy that virtually all publicly-traded companies have had for quite a while, so Chesapeake was behind the curve, but we are glad they have caught up. Importantly, as we understand, the board did not know about the hedged stock until the margin call triggered the sale of the shares. Did the board ask about other financial dealings Mr. McClendon may have been engaged in that might raise issues of conflicts of interest? It appears they didn't or they might have learned about the borrowings related to the FWPP. Or they also might have learned about Mr. McClendon's ongoing personal involvement in a hedge fund trading oil and gas commodities, the company's primary business, while using the corporate address as its office address. Again, this is probably not illegal, but certainly questionable for the chairman and CEO of an important oil and gas company to be participating in, especially when his fiduciary duty is to devote full time and attention to the affairs of Chesapeake for the benefit of its shareholders.

The history of Chesapeake and Mr. McClendon is one of bold moves and brash attitudes. The company has been nearly bankrupted by this approach to running the business, but it has also been wildly successful at times. In other words, Chesapeake is not your typical "widows and orphans" stock. The company's past successes cannot be ignored, but on the other hand, how they were achieved has raised many eyebrows. If one looks at the compensation of the members of the board of directors, the cash and stock component provided approximately $385,000 ($153,000 in cash and $232,000 in restricted shares; these are approximate since each director earned slightly different amounts) of compensation last year. Directors also are provided the use of an executive jet, which resulted in about $200,000 being credited to each director's total compensation last year. That means many Chesapeake directors are reported in the company's proxy statement to have received approximately $585,000 in total compensation in 2011. We find this pay level eye-catching as Exxon Mobil Corp., one of this nation's largest corporations, directors received $100,000 in cash plus 2,500 restricted shares, worth $185,000, for a total of $285,000 in total compensation last year. Each ExxonMobil director was also credited with $420 of compensation representing his pro rata share of a travel accident insurance policy.

There are other issues involving the corporate governance structure and policies at Chesapeake that have evolved from these various issues. Separating the roles of chairman and CEO is consistent with best practices for corporate governance, but there are strong arguments for not splitting the roles. The company has proposed for shareholder approval at the June annual meeting a resolution mandating majority voting for each director candidate, although the company retains its staggered board structure. We're happy to see Chesapeake improving its corporate governance, but the furor has given the energy industry a black eye at a time when it doesn't need one. There are enough critical issues about energy policy that need to be decided without such a distraction.

A column in the Financial Times discussing the Chesapeake governance issues tied it to the performance of the stock. The column pointed out that two Harvard Law School academics found last year that during the last decade the previous link between corporate governance and share price performance broke down. Their view was that this was due to the fact people understood the importance of good corporate governance so it was already priced into share prices. Other studies still point to the fact that there is a difference: better run companies have less volatile shares, which fit with the view that good governance reduces corporate risk.

At the beginning of the Chesapeake preliminary proxy filed with the SEC on April 20, 2012, there is the following statement: "I am honored to represent Chesapeake's shareholders. Your Board is committed to advancing shareholder interests and maintaining strong corporate governance." - Kathleen Eisbrenner - Director since 2010. We wonder how Ms. Eisbrenner feels about this statement now after the events of the last two weeks.


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