London, May 12th 2012
To: Richard K. Davidson - Board Member
To: Kathleen M. Eisbrenner - Board Member
To: V. Burns Hargis - Board Member
To: Frank Keating - Board Member
To: Charles T. Maxwell - Board Member
To: Merrill A. "Pete" Miller, Jr. - Board Member
To: Don L. Nickles - Board Member
To: Lou Simpson - Board Member
6100 North Western Avenue
Oklahoma City, Oklahoma
Dear Board Members of Chesapeake Energy Corporation ("Chesapeake Energy (NYSE:CHK)"),
Enough is enough!
Noster Capital can sympathize with the fact that some members of the Board may have been unaware of the amount of personal financing that Mr. McClendon had linked to his Founder Well Participation Program ("FWPP"), although good corporate governance should have mandated that the Chief Executive Officer of a company whom you oversee reports to you any and all material information that could conflict his personal interests with those of Chesapeake Energy's shareholders.
Once the news of Mr. McClendon's $1.1 billion debt was made public, the Board lost significant credibility with investors by claiming initially that you were fully aware of these financing arrangements, only to moderate your stance eight days later by retracting the Company Counsel's prior statement, claiming that "The Board of Directors did not review, approve or have knowledge of the specific transactions engaged in by Mr. McClendon or the terms of those transactions". In our opinion, the final insult came when the "punishment" for Mr. McClendon's substantial use of personal leverage (news that has led to a formal SEC inquiry) was simply to strip him of the company's Chairmanship and to terminate the FWPP earlier than originally anticipated. We are sorry to say but a truly independent Board would have terminated its Chief Executive Officer on the spot for a far lesser infraction, especially given Mr. McClendon's historical use of leverage.
The company has stated that it does not believe the personal use of such leverage linked to the FWPP (nor the fact that one of the funds that personally lent money to Mr. McClendon later participated in a company bond offering) created a conflict of interest, but yet the market seems to disagree, as the company's shares have fallen 23% since that news was made public, even though the price of NYMEX natural gas has actually risen by 29% during that same time frame. We believe that CEOs of public companies need to remain focused on their fiduciary duty at all times, and the use of such substantial personal indebtedness can pressure them to act in ways that are in conflict to the goal of creating substantial value for shareholders over the long-term, not to mention the emotional distress that having such personal liabilities must cause.
When we first analyzed Chesapeake Energy with the idea of potentially becoming shareholders, a significant red flag we discovered was the fact that Mr. McClendon had, in the past, invested in Chesapeake Energy shares using margin debt and that in 2008, after the stock market collapsed, was forced to liquidate more than 90% of his shares to meet margin calls. And what was the Board's response to this remarkable misuse of personal leverage? An approximate $110 million pay package for the 2008 fiscal year that included:
- $75 million to buy interests in Chesapeake Energy wells
- $20 million stock grant
- $12 million to buy Mr. McClendon's map collection (which he was later forced to repurchase back from the company after losing a lawsuit from Chesapeake Energy shareholders)
- $648,000 for the private use of corporate private jets
- $577,000 for accounting services
- $131,000 for personal engineering support (we are not quite sure what this relates to)
Mr. McClendon was the 2nd highest paid CEO in America over the past 5 years, with a total compensation package of $303.6 million, a period during which CHK shares lost 23% of their value (excluding dividends).
On top of the very generous pay package for 2008, during times when most of us (even those who have made the right investment decisions, without the use of leverage) were tightening our belts, the Board went one step further and also agreed to pay $4.7 million to sponsor the NBA's Oklahoma City Thunder during its 2008/2009 season, a team that Mr. McClendon owns a 19.2% stake in. We could go further and talk about the company's expenditure of $177,000 for food and beverage catering services, primarily for 2 large events sponsored by the company, using Deep Fork Catering's services, an affiliate of Deep Fork Grill, in which Mr McClendon is a 49.7% owner, but we think you got our point by now.
While on the topic of generous perks we do not believe that owning fractional shares in 22 different jets (a high-end Gulfstream G-550, eight other Gulfstream jets and 13 Cessna jets) are necessary in order to retain good quality managers or in order to conduct day-to-day business. According to a Wall Street Journal article, Chesapeake is by far the largest single owner of fractional corporate jets in the US. This is once again proof that despite the hardships of the economy, the weak market in natural gas prices and the extreme cash needs that Chesapeake Energy faces in the short-term to keep operating as a going concern, the Board does not seem to be acting in the best interests of its shareholders. Does a company the size of Chesapeake Energy really need a fleet of 22 private jets? This article from the Journal continues to stipulate that the company is currently being sued for understating perquisites granted to its executives by as much as $10 million a year (from an already generous $14 million over a 5 year period).
The Board of any public company is there to keep the executive team in check and to make sure that shareholders' and other stakeholders' interests are being well represented. Having failed to terminate Mr. McClendon after recently learning the full extent of the personal liabilities that he incurred in order to fund his participation in the FWPP, and after last Friday's news that there were a further $1.4 billion of previously undisclosed off balance sheet liabilities, we have lost trust in the Board. So have many of the company's previous shareholders as proved by the 883 million shares of Chesapeake Energy that have changed hands since the release of the Reuters story on April 18th 2012. (Chesapeake Energy has slightly over 663 million shares outstanding; this means that the shareholder base of the company has changed 1.3 times since the news of Mr. McClendon's personal finances broke, this is an increase in average daily volume in the order of 370% when compared with the average traded volume in the year preceding this event).
Investors are probably selling Chesapeake Energy's shares because of their lost confidence in Mr. McClendon, in his ability to lead the company given the scale and nature of his financial liabilities and because, in their view, the Board has failed to look after their own interests.
Our proposal is for the Board to immediately terminate Mr. McClendon and to retain him as an unpaid consultant for an indefinite period in order to help negotiate the asset sales that are currently being evaluated and to give the necessary guidance to a new professional management team that needs to be put in place. In this instance, and despite ceasing to be remunerated by Chesapeake Energy, Mr. McClendon's interests would remain very well aligned with those of shareholders, as he still needs the company to be successful in order to repay the $1.1 billion which he owes against the wells that he has acquired under the FWPP.
It is now time for the Board to act solely in the interest of shareholders. We urge that all acquisitions of proved and unproved properties are curtailed at once (unless they are being executed for the purposes of improving the value of resources which are earmarked for immediate sale) and that well completion capital expenditures are reduced to a bare minimum. The Board should also hold immediate discussions with interested parties regarding the outright sale of any of the company's assets that are not encumbered by a JV or VPP agreement, so that confidence in the company's financial posture can be restored. In addition, all use of corporate jets - for either corporate or personal purposes - as well as other perquisites must be stopped immediately.
As investors, we are interested in the net asset value of any company's assets. We believe that many investors, like us, are aware that Chesapeake's assets are of the highest class, and that on a gross basis they are worth an amount equal to many fold the current share price. However, as material terms regarding the company's liabilities have been withheld from the public domain, there is no way at the current time that any outside investor can value these assets on a net basis. And time is running out for the company if it is to avoid a material breach of covenants and/or expense a significant impairment to its stated book value.
Failure to take significant action quickly will bring Chesapeake Energy closer to being either a forced seller of assets or to be acquired by another corporate entity at a price which does not reflect the underlying economic value of the company's assets. Truth be told, we are certain Chesapeake Energy is becoming more compelling by the day to an oil & gas major which could easily digest an acquisition of this size in order to own a leader in hydraulic fracturing technology. The only parties to lose out would be minority investors like us who would be unable to benefit from a new management team's ability to crystallize the immense value that lies within Chesapeake Energy's balance sheet over the coming years (assuming there are no more off-balance sheet liabilities lurking).
We urge you, as members of the Board of Directors of Chesapeake Energy, to take immediate action. Not only to prove that you are truly independent, but to defend the interests of Chesapeake Energy's minority shareholders - which after all, is the fiduciary mandate you have.
Disclosure: Noster Capital is long Chesapeake Energy shares.
Pedro de Noronha
Noster Capital LLP
 Reuters - April 18th 2012
 Henry J. Hood, Senior Vice President and General Counsel of Chesapeake Energy- April 18th 2012
 Company release - April 26th 2012
 Company release - April 26th 2012
 Henry J. Hood, Senior Vice President and General Counsel of Chesapeake Energy - April 18th 2012
 Schedule 14A - April 30th 2009
 Fortune.com - America's Highest Paid Chief Executives
 Henry J. Hood, Senior Vice President and General Counsel of Chesapeake Energy - April 30th 2009
 WSJ Article - May 10th 2012
 WSJ Article - May 10th 2012
Disclosure: I am long CHK.