By Matt Orsagh, CFA, CIPM
We have been watching the Chesapeake Energy Corp. (CHK) situation with interest ever since it was widely publicized that the company's CEO, Aubrey McClendon, (he also was chairman until earlier this week), had borrowed as much as $1.1 billion in the last three years against his ownership stakes in Chesapeake oil and gas wells, according to a Reuters report. Under the terms of this "Founder Well Participation Program," McClendon was allowed to own up to 2.5 percent of wells the company drilled, as long as he paid development costs proportionate to his stake.
Now, you may say, "No big deal, such extra participation in the wells aligns his interests with those of shareholders." That's really beside the point - as we learned in every financial crisis in recorded history, it's the inability to service debt that gets you when the market turns.
In 2008, the market began to turn and Mr. McClendon had to sell most of his shares in Chesapeake to repay debts. Conveniently, in 2009, the board granted the CEO a $75 million bonus to invest in the well program, and scrapped a requirement that he own shares in the firm worth five times his annual salary. Not exactly shareowner friendly behavior by the board.
Deals Ripe with Potential Conflicts of Interest
A dispute has been bubbling between the company and some its investors as to whether important details about the well participation program were adequately disclosed. According to a front page Wall Street Journal story yesterday, the Chesapeake board of directors claimed not to be aware of the details of Mr. McClendon's borrowings. Whatever the merits of the investors' case may be, the well participation program was highly susceptible to conflicts of interests and a diversion to the CEO's attention - not to mention the added kicker of a highly leveraged asset based on a historically volatile commodity. This was a powder keg of poor governance and poor risk management waiting to ignite. Shareowners and the Chesapeake board (if they were, in fact, informed of these risks) should have better managed the risks they were taking.
Fast forward to this week, and after some pressure from investors, including Southeastern Asset Management in Memphis, which owns over a13 percent stake in the company, Mr. McClendon was stripped of his board chairmanship, as well as the right to participate in the Founder Well Participation Program.
Oh, by the way, the SEC and IRS are now investigating the Founder Well Participation Program. Good luck with that Mr. McClendon.
Secret Hedge Fund Raises Other Investor Questions
It gets better (or worse, if you are a shareowner or Aubrey McClendon). It was revealed yesterday in another Reuters report (kudos to Reuters on this ongoing story) that Mr. McClendon secretly ran a $200 million hedge fund from 2004 - 2008 that specialized in the commodities Chesapeake produces. That this created a huge conflict of interest for Mr. McClendon would have enraged me as a shareholder, but I never would have known - none of this was ever disclosed to shareowners.
In the Reuters report, Tulane University law professor Elizabeth Nowicki states, "I would argue, and I think the SEC would argue, that the failure to disclose that you are engaging in this kind of conduct can constitute a securities fraud problem. A reasonable investor would want to know that the CEO could be in a situation where he's betting against the interests of the company personally."
For anyone who doubts the role corporate governance can play in company valuations, Chesapeake shares rose 7 percent when the company released details stating that Mr. McClendon was stepping down as chairman. Shares declined nearly 15 percent the next day, when details of McClendon's hedge-fund moonlighting came to light.
All of this, of course, calls into question the judgment of the Chesapeake Energy board of directors. This is the board that, in 2009, decided to pay Mr. McClendon $12.1 million for his map collection (Mr. McClendon subsequently bought the maps back in response to public scrutiny), judging that such a purchase was in the best interest of shareholders.
Expect fireworks at the company's annual meeting, which in years past has usually been held in the second week of June in Oklahoma City. I wonder if the directors plan to show up.