The Weekly Wrap — May 11, 2012 (Part I)

Apart from the entertainment value, what is the big deal about the saga of Aubrey McClendon, the CEO of Chesapeake Energy, and his use of the company as a piggy bank? The big deal is that, more than any single individual apart from the innovator George Mitchell, McClendon is responsible for the shale gas boom that is shaking up geopolitics. Of course, McClendon’s hijinx do not change the geopolitical shakeup, but they are a window into the type of personalities who make up the wildcat boom (pictured above, McClendon, left, owns the Oklahoma City Thunder professional basketball team along with Clayton Bennett, right). As with most such revelations, the kernels and sometimes the whole kit-and-kaboodle are detailed in the fine print of a company’s annual 10-K filing with the Securities and Exchange Commission. The thing is, few people bother to read such material — apart that is from the folks over at footnoted.org, whose whole business is to do so. The footnoted folks have been talking about McClendon for awhile now (such as here, here and — from today’s Website — here). I asked footnoted’s Theo Francis for some insight into Chesapeake. His reply follows.

O&G: What could and should a Chesapeake investor, given an ordinary read of the company’s 10-K annual reports, have known about Aubrey McClendon’s compensation package, perks and financial dealings in recent years? As a followup, if that same investor elected to dig deeper and follow the trail of citations, what would he or she have been able to know?

Theo Francis: Piecing it together can take some work and patience, but it’s there, mostly in the annual proxy filing, with updates scattered across other filings over the course of a year.

A snapshot of McClendon’s compensation in 2011 (primarily from an April 30 amendment to the company’s 10-K filing) illustrates what’s available: Salary of $975,000; a $1.95 million discretionary bonus — meaning it isn’t based on any kind of performance measures, but just on the board’s general sense of how well he’s done; $13.6 million in stock awards; and $1.3 million in perks and retirement-plan contributions. Those perks are telling too: $500,000 in free personal trips on company aircraft (on top of another $650,000 in jet rides for which he reimbursed the company), $250,000 in personal accounting services provided by company employees (about which more in a moment), and $121,570 in personal security benefits. Total for 2011: $17.9 million. Over the last three years, McClendon’s compensation has added up to more than $57 million. Plus, Chesapeake doesn’t even count some perks, because there’s ostensibly no incremental cost to the company, including for an unknown number of tickets to sporting events. McClendon has also built up $7.5 million in a deferred-compensation plan, a kind of IOU from the company.

Which brings us to the related-party transactions, the ones that the company did disclose: Buying McClendon’s map collection for $12.1 million in 2008 (a transaction that was ultimately unwound after a lawsuit); paying the Oklahoma City Thunder basketball team, in which McClendon personally owns a 19.2% stake; $2.9 million to $4.1 million a year for more than a decade for stadium naming rights, plus another $36 million over 12 years for sponsorship and advertising costs; and $4.6 million on tickets and games in 2011-12. There’s also the board’s decision in 2009 to ease the stock-ownership requirement and front McClendon $75 million toward his investments in the company’s drilling operations, after he had to sell pretty much all his Chesapeake shares in a margin call the year before.

And then, of course, there’s the long-standing "Founder Well Participation Program," which allowed McClendon to invest alongside Chesapeake in its drilling operations, and which is what’s at the heart of the current series of embarrassments for the company. The disclosure about the program in last year’s proxy was 1,500 words, which sounds like a lot, and there is a fair amount of detail: How the program works (very generally), why the board does it (with extra business clichés) and so on, as well as an estimate of the present value of McClendon’s interests in the wells ($308 million at the time) and a table showing annual revenues, capital and operating expenditures, along with cash-flow from the program for McClendon. But there was an awful lot that wasn’t disclosed. Since the original Reuters report, the news of an informal SEC inquiry, the company’s decision to wind down the well participation program, and so on, the company has produced a lot more information about the program, McClendon’s borrowing and other details, in a series of filings and statements.

The bottom line, I think, for any reasonable outside observer — and I’m talking about before the Reuters bombshell  — is that Chesapeake feels like a company run by McClendon, for McClendon and his buddies. As long as the company delivered for shareholders, there was a good chance that things could proceed with only minimal reforms for quite a while. But there’s very little sense here that these people ever stopped and thought, ‘You know what, we’re playing with other people’s money; maybe we should rein it in a little.’

And as we’ve seen time and again over the years, that certainly sets the stage for a revelation like the one we got from Reuters.

Same framework — what went undisclosed that we’ve learned about in recent weeks?

Quite a bit, and that’s why you’ve seen shareholders react so badly.

For me, Chesapeake had the feel of an insouciant bad boy: It seemed like it was being pretty brash and up-front about its extremes, and that shareholders were for the most part shrugging it off. We always worry about what’s not disclosed, and on one level, when a company flouts conventions to the degree that Chesapeake has, you have more to worry about (with Enron being perhaps the ultimate modern-day example). But after a while, it’s easy to think, ‘OK, look, they almost got away with the map thing, and although they had to unwind the sale, there wasn’t too much of a fall-out; if I were they, I’d just lay it all out and shrug when the good-governance types whine.’ Maybe that’s what they’re doing — you don’t want to count on it, but heck, I don’t own the stock, so I can let it lie.

Instead, the new revelations suggest there was, and is, a lot more lurking below the surface. There’s a single line in last year’s proxy that suggests McClendon might be borrowing under the Founder Well Participation Program, saying the program "does not restrict sales, other dispositions or financing transactions" involving his interests in it. What’s missing is any indication that he might have more than $1 billion in borrowing backing the program, that his lenders might also do business with Chesapeake (putting him in a potentially awkward situation, to say the least), or that — as the original Reuters article suggests — his personal loans might require him to take certain actions that put him in conflict with Chesapeake’s shareholders. That’s a lot.

Now there’s a suggestion, in an article by The Wall Street Journal’s excellent Russell Gold, that Chesapeake may not have fully disclosed some $1.4 billion in off-balance-sheet arrangements of its own. That would seriously ratchet up the disclosure failures, in my view.

Go to the Jump for more of Theo Francis and the rest of the Wrap.

What is unusual, and what is de rigeur, about the disclosures? Is there a tradeoff — if you throw in your lot with a wheeling-and- dealing risk-taker such as McClendon, in which the upside is there for the very reason of that part of his character, are these downsides just part of the calculus? Or is what we have learned even outside that pale? Do McClendon or Chesapeake differ materially from other big shale gas wildcatters?

I’d say he stands out not just from other big energy tycoons but also from among the other flashy, perk-laden, royal CEOs. McClendon and Chesapeake are a beautiful example — from the compensation, conflicts and corporate-governance perspective, anyway — of the perils of the imperial CEO. Accounting and auditing experts have called imperial CEOs a red flag for years — the my-way-or-the-highway, brash, domineering CEO of Hollywood. We don’t look so much at how executives run their companies except through the narrow lenses of their pay and governance practices. But from that angle, McClendon is a prime specimen. And the Founder Well Participation Program isn’t the kind of thing we see very often.

So on the one hand, a lot of what we saw at Chesapeake was unusual. On the other hand, it was mostly unusual by degree. A lot of companies pile on the perks; Chesapeake just did so to an extreme. Too many companies have one or two or three questionable related-party transactions; Chesapeake seemed to make them a specialty.

Not surprisingly, these kinds of extremes can seem a little more common where you find flashy risk-takers — casino companies, energy exploration and production companies — but I’m not sure that’s necessarily accurate. Barry Diller collects pay and perks from multiple companies, and title insurer Fidelity National Financial (FNF) paid more than $450,000 in membership and other costs to a ranch owned by its executive chairman, on top of more than $40,000 to wineries and restaurants he owns. So it can crop up in a lot of places.

Is it a tradeoff? I suppose it can be, but it isn’t a necessary one. Plenty of larger-than-life and extremely successful CEOs manage to avoid this kind of thing. Warren Buffet is perhaps the obvious example. Steve Jobs was another (though the company did once give him a free airplane.) They might be extremes in the other direction — high-performance executives who pare their pay and potential conflicts back to the basics. But there’s a lot of room between them and McClendon.

Is there anything super-interesting in the SEC documents on which you guys have reported that has not yet hit the mainstream news?

One of the things that struck me about Chesapeake early on, and which I think hasn’t gotten enough attention, is who’s been minding the store. The board of directors is ultimately responsible for overseeing management. McClendon may have been chairman, but the board, and each director, has an obligation directly to shareholders, and is supposed to watch the company on their behalf. Even if a board at some point argues that its CEO was misleading them, it was their job to ask the tough questions and to be comfortable that their CEO isn’t misleading them; did they go far enough?

At Chesapeake, these guys made big bucks: Every director who served the full year, save one, made more than $550,000 in 2011, and the exception (Charles T. Maxwell, who’s retiring this year) made more than $386,000. That’s high, for any size company. Most of it is stock — $230,000 or more in most cases — which makes some corporate-governance experts happier. But most of them also took home more than $150,000 in cash, and another $150,000-plus in personal flights on Chesapeake’s NetJets account. Each director gets up to 40 hours of flights a year, on top of flights to board meetings (spouses included, plus a tax gross-up for spousal travel). That’s not a very common perk for independent directors, much less an entire board.

Nor are they paid so handsomely for a particularly onerous job: This board met four times in 2011, and held eight conference calls; none of the committees met more than four times in person, or more than 10 times counting phone calls. There are higher-paid directors around. A number of companies have individual directors who make more than $1 million; a very few companies have boards that average $600,000 or more apiece. But Chesapeake’s directors are very well compensated for what is very much a part-time job.

Even in less clubby circumstances, with a less dominant executive, you can imagine it being pretty difficult to make too many waves when you’re being taken care of so well. That’s not to say highly paid directors are being paid off to turn a blind eye, but I think the threat of complacency rises with pay beyond a certain point.

Your call: do McClendon and/or Chesapeake survive?

Probably the most eye-opening development for me in all of this — other than the sheer magnitude of the $1 billion in loans, which seems to have swollen even as the market showed its disapproval in recent weeks — are the revelations about the board and what it knew. First, we were told the board was "fully aware" of McClendon’s loans. Then it turns out the board was only "generally aware" but didn’t know specifics.

It’s not very reassuring for investors, and it can’t be fun for the directors (however much they might have brought it upon themselves). Even congenial boards can turn on a CEO when they feel they’ve been burned — left in the dark, misled — or when they feel their own necks are on the line. Look at what happened to Hank Greenberg at AIG when Eliot Spitzer and the SEC came sniffing around in the middle part of the last decade. But a key word here is "can" — they don’t necessarily turn on the CEO that has fed them for all these years. And it isn’t clear yet how much pressure this board is going to face — real pressure, in the sense of shareholder backlash or regulatory scrutiny.

If they really want to clean things up and regain investors’ trust, McClendon may well have to go. Much of the board may have to go, even if gradually, if they really want to be convincing about it. Chesapeake’s annual meeting is usually held on the second Friday in June. Shareholders are sometimes willing to forgive a lot as long as the share price broadly heads in the right direction. We’ll see.

Go to Part II of the Weekly Wrap