Investors Overreact To Chesapeake CEO Loan Scandal

| About: Chesapeake Energy (CHK)

Chesapeake Energy (CHK) is trading down 10% today as news broke of $1.1B in unreported loans were made to CEO Aubrey McClendon by Chesapeake-affiliated companies to finance his 2.5% stake in CHK wells.

I have always considered The Founder Well Participation Program, the perk that allows McClendon to buy 2.5% of every well discovered by Chesapeake, a ludicrously generous benefit (imagine if Steve Jobs or Bill Gates were given 2.5% of profits at Apple or Microsoft). While these loans once again demonstrate the shameless corporate cronyism present at Chesapeake, management's self-serving attitude is not new information -- I wrote an article detailing management as CHK's biggest risk from an investor standpoint. In fact, these loans may not be the worst example of the board's clear deference to McClendon: in the past, the company agreed to pay $12.1M for the CEO's antique maps (!) and when McClendon's own CHK stake was wiped out in a margin call in 2008, the board bailed him out with over $100M in "incentive" compensation, including a straight $75M bonus.

These loans merely reinforce what many investors already know: Chesapeake Energy is run for the benefit of its corporate managers, not shareholders. From an operational and asset standpoint, nothing has changed to warrant 10% less value. Furthermore, it is unclear whether these loans posed an actual conflict of interest or whether they merely present the possibility or appearance of such. No details on terms, such as interest rates, etc. have been made public of yet. On the surface, the terms looks similar to a house mortgage loan -- the bank lends money to the homebuyer to buy an asset (the home) and takes that same asset as collateral. From the scant details reported so far, it sounds like McClendon is doing something similar, borrowing money to finance his 2.5% well stakes and using those same stakes as collateral. Unless he somehow benefits from having these stakes lose value or the company is paying his interest costs, it seems like McClendon is still incentivized to help the company realize full value for these wells and thus raise his own stakes' value.

But if I am wrong and there is something more insidious going on, what is the worst that can happen? Aubrey McClendon and probably much of the board would be forced to leave under the onus of a corporate scandal, an outcome I believe the market would welcome and drive shares up as a result.

Despite the drop, I am content to hold my position. I am long CHK preferred D shares, which have lost only 3% compared to the 10% drop in ordinary stock. Trading around $87, my cost basis is around $55 so today's drop is not enough to get me to buy more shares. I think it unlikely that this story will be enough to drive out McClendon so a move into CHK ordinary stock remains unappealing in my eyes.

Disclosure: Long CHK preferred D shares.

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