Paul Hodgson: Governance rowing upstream at Chesapeake Energy

Running the rule over the controversial natural gas company

“Did you know he had a team of 10 Olympic hopeful rowers on staff?”
“No, I didn’t.”
“Does that surprise you?”
“Nothing surprises me about Aubrey McClendon anymore.”
Thus went one of many such exchanges between myself and Anna Driver, the Reuters journalist largely responsible for the exposé of the extraordinary goings on at Chesapeake Energy.
Why rowers?
The answer was simple, but shocking: Aubrey McClendon is a rowing fan. With company money, he turned a “dry and weed-choked riverbed” in its hometown of Oklahoma City into an Olympic-class rowing venue.
This kind of arrangement was rampant at the company, a signifier of a relationship between founder McClendon and his company that, not only from a governance standpoint but many others, was deeply troubling. McClendon will retire from Chesapeake on April 1 due to “philosophical differences” with the board. Those differences might be that the board no longer wants to run the company as McClendon’s personal empire.
In that Reuters exposé, it was revealed that McClendon had broken virtually every single governance rule in the book, and that didn’t even count the classified, entrenched board, the plurality voting, the excessive CEO pay, and the controversial Founder Well Participation Program. Fundamentally, Chesapeake had gone public, but had not grown up. As a result, McClendon continued to treat the firm as a private fiefdom. He had Chesapeake employees working on private projects, from mending his house after a hailstorm, sponsoring the basketball team he part owns, and providing corporate jets for his wife and her friends.The most troubling issue, however, came in early 2012 with the revelation that McClendon had borrowed as much as $1.1 billion in unreported loans over the previous three years. He had pledged his stake in the company’s wells as collateral and made the loans via three companies he controlled that were apparently headquartered at Chesapeake’s headquarters. The money from the loans was being used to help finance the opportunity to buy into those same stakes McClendon was using as collateral.
My suspicions surrounding the Founder Well Participation Program (FWPP) predated this by seven years. Chesapeake was the perfect example of a CEO floating the company he founded but still treating it as his own.

This is how the FWPP worked. McClendon was entitled to participate in rights to wells the company developed under the program “approved” by shareholders in 2005. These rights meant that he could take up to a 2.5% working interest in all of the company’s wells. He was required to pay the drilling, completing, operating and leasehold costs attributable to his interest in each well before receiving the profits from the wells. Those were profits that would otherwise accrue to Chesapeake shareholders, of course, but that was clearly not a fact considered by the board – the shareholders representatives – when it approved the programme. In 2008, Chesapeake entered into a new five-year employment agreement with McClendon that included a one-time $75M incentive award structured as a net credit against future billings from the company for ‘Well Costs’ owed by Mr. McClendon under the FWPP. In other words, the company was now bearing the costs of McClendon’s interests while he continued to receive the profits.

The situation was reminiscent of behaviour that I had flagged in a number of other industries. For example, during the nineties and early noughties most of the big investment banks – Bear Stearns, Citigroup, Lehman Brothers – allowed executives to invest in partnerships, with a leveraged matching company investment, that invested in special funds. Once those funds made money, the executives kept all the profits and paid back only the original company investment. I asked the question then: shouldn’t the banks be concentrating on investing the funds of their clients and investors rather than those of their executives?

Another industry where the interests of public shareholders are in marked contrast to those of the founders is the internet.
Company after company – Google, Facebook, Zynga, Groupon – went public with a dual class share structure so that the founder retained every ounce of voting power and control.
Indeed, Chesapeake was not the only company in the energy sector to structure themselves so that it appeared executives’ or founders’ interests were placed ahead of the shareholders. One only has to look at Sandridge Energy, whose CEO Tom Ward has a raft of odd relationships with the company that are unrelated to his management of it. Ward owns an ownership interest in the same basketball team as McClendon and Sandridge pays the team for sponsorship and leases a suite at its arena. The company is drilling on land in which Ward has interests, or which have been set up as trusts for his children. The company also buys tickets for sporting and other events from Ward for use by other company employees.
It may be that the existence of many private, entrepreneurial companies in this industry encourages those running public companies to continue behaving like their former colleagues even after they have gone public.Not everything that McClendon has done has been problematic. Oklahoma City, where Chesapeake has its headquarters, has undergone a huge revival due in large part to McClendon’s personal and corporate philanthropy and property development. Furthermore, there was a governance revolution at the company last year caused by Southeastern Asset Management and Carl Icahn. This took the chairman role away from McClendon and forced through proxy access and majority voting, as well as declassifying the board and putting four new shareholder-nominated directors on it. Finally, major changes to the executive remuneration programmes were initiated.
Sometimes when governance conditions are so bad, they can only improve.
But in dealing with this governance disaster that is now resolving itself, I have neglected to talk of the environmental damage that is also represented by the company’s official business. And in this industry, governance problems often go hand in hand with environmental and/or social issues. The lawsuits and prosecutions at Chevron and BP, for example, are indicative. Not all, but many energy companies score poorly across the ESG spectrum.
As one of the biggest frackers in the business, Chesapeake has had its share of environmental violations to deal with, not to mention antitrust lawsuits. With the flood of cheap natural gas on the market, due in part to Chesapeake’s and other companies’ over-rapid exploitation of wells, the company’s business model has come under fire and the share price has fallen from a high of almost $66 to hover around $20 for months. In addition, McClendon has been accused of not moving quickly enough from gas into oil. The firm’s acquisition of huge tracts of property for potential exploitation that it now cannot realise has resulted in it having to sell much of the land off.

Yet more industry risk is likely to result from the Environmental Protection Agency’s current review of fracking operations and their safety for the environment. These reviews are largely in flux but even at their weakest are likely to result in significant regulatory demands that may be costly and expensive to implement in the short term though they will contribute to the long-term efficiency and profitability of the companies involved. If properly implemented and enforced, regulatory changes will at least slow down, if not halt, the numerous local, state and national lawsuits against the company. Every oil and gas company engaged in fracking faces the same risks.
But since, for many, fracking is a small part of theiroperations it is unlikely to cause the kind of value damage that it has at Chesapeake.
And while the dash for energy independence in the US is likely to prevent outright bans against fracking as in France and Bulgaria, there are still moratoria such as in New York State and the Delaware River Basin, and the Province of Quebec in Canada. If these spread, the profits will drop right out of the industry and the environment will be a lot happier. The latest idea: to transport dirty, toxic water away from fracking sites on barges and float them on… water…shows how out of touch with environmental safety the industry is.

Paul Hodgson is an independent governance analyst