Paul Hodgson: Is there a governance ‘alpha’ at Nabors, Chesapeake and Apache?

The recent governance revolutions at three US companies

Alpha: a risk-adjusted measure of the active return on an investment.

Does it exist? If so, how much good governance must be implemented to achieve it? How long does it take to influence share price? And do shareholders have to have companies over a barrel in order to implement enough of it?
I’m going to try to answer these questions by looking at three oil and gas companies that, over the past few years, have had governance revolutions: Nabors Industries, Chesapeake Energy and Apache Corporation.
In each of these – for different reasons, and not because they are oil and gas companies – the shareholders were handed the keys to the castle and managed to force through a whole gamut of governance best practices. This allows us to see not only if they are better governed as a result, but also better managed and returning a better premium to shareholders. It is early days yet – governance improvements are likely to take as long to brew as governance disasters – but the indications are positive.
It should be noted that these governance reforms contrast with the results of hedge fund activism and any reforms that might be implemented as part of a legal settlement. Typically hedge fund activism focuses its governance changes on remaking the board and often replacing management. And governance settlements are typically less ambitious. I don’t know of any, for example, which resulted in proxy access – the ability of shareholders to place independent director nominees on the company ballot – though I am quite willing to be told otherwise.
The revolt at Nabors began in 2007, though reform took the longest to implement, not until 2014.
For Nabors, 2007 saw the beginning of an annual flood of shareholder resolutions focusing largely on executive pay at first, but then expanding into separating the roles of CEO and chairman, declassifying the board, and majority voting. All of these received substantial minority support right from the start, but it was not until 2011 that shareholder proposals began regularly to receive majority support. Management continued to ignore them – even in a rare case of shareholder cooperation when state funds from New York, Illinois, California, Connecticut and North Carolina combined on a proxy access resolution.
In 2013 change began to be implemented, but let’s step back a little and review why shareholders were so angry with the company – it wasn’t the stock price, which was outperforming the S&P 500 up until 2008.The target for most shareholder protest, as evidenced by the number of shareholder resolutions mentioned earlier, was the pay for former CEO Eugene Isenberg, who was set to receive a cash severance of $100 million, even if he just relinquished the CEO post and stayed on as chairman. That, and other excesses, caused the company to lose its pay vote – Say on Pay – three times in a row.
But even when the reforms started to come, they were half-hearted and ineffective initially. In 2012, the company declassified its board… but not straight away. It announced a director resignation policy in the event a director was not elected by majority vote, it removed exemptions from its director age limit for retirement, but only for directors elected since 2002, which had the effect of grandfathering, or should that be greatgrandfathering, the two directors who violated the age limit. In addition, the change to majority voting didn’t work out as well for shareholders as it did for directors. In 2013, shareholders in the majority voted against two directors, both of whom were on the remuneration committee, and they tendered their resignations. But the company’s response was to determine that this was not in its best interests and rejected their resignations.
Also in 2013, shareholder resolutions for an independent chairman, for proxy access, and for a cap on severance were all approved by a majority of votes cast. However, one of Nabors’ bylaws stipulated that all possible votes must be included in the denominator, even though those votes weren’t cast, so the company’s calculations showed that these resolutions were “defeated”. Nabors’ resistance to any real governance change was focused on every single reform. For example, in response to the proposal to appoint an independent chairman it claimed to have already a lead independent director who already held the responsibilities of the independent chairman that shareholders were clamoring for. But in describing his duties in detail in the proxy statement , the company said:
“…including developing and approving Board meeting agendas with the Chairman, calling and chairing meetings of nonmanagement directors, chairing certain portions of Board meetings….”
My emphasis. In fact the lead director was not a chairman and did not hold the duties of a chairman. He was, in fact, a lead director. And he was one of the directors that shareholders voted off the board, except the board decided to keep him anyway. Also in 2013, Nabors eliminated a $50 million cash severance for new CEO Anthony Petrello by paying him $60 million in stock and cash thus exchanging a potential payment for a definite one.

That was hardly a bargain for shareholders either.
On the other hand, Petrello, who took over when Isenberg relinquished the title to remain as chairman (a new board eventually refused to pay the $100 million severance) had his pay completely revamped to tie it closer to actual performance. And then Nabors agreed last year to allow its largest shareholder, Pamplona Capital Management, to nominate two independent directors.
When Petrello took over in October 2011 the share price was at a low of $13, down from a high of around $120. It has since climbed relatively steadily over the next two and a half years, gaining fresh impetus with each new, actual governance reform and the new independent directors.
Then on 14 April this year, the company announced a whole raft of further governance reforms including proxy access for shareholders which have held a 5 per cent stake for three years and capping severance at 2.99 times salary and bonus (though I doubt that cap includes accelerated equity), and, on the resignation of Petrello, the positions of chairman and CEO will be separated.
As a result of this announcement, the stock price began to rise again from around $24 to over $26, though it has since fallen back slightly. CalSTRS, CalPERS and the Blue Harbour Group were all involved in forcing through many of these reforms.
2009 saw the first flood of stockholder resolutions at Chesapeake, though its governance problems stemmed from far earlier. Indeed, they stemmed from before the company went public, as we shall see later. In 2006, for example, Aubrey McClendon, the CEO at the time, earned $116.9 million. Then in 2008, he earned $114.3 million. This included some $75 million from the infamous the Founder Well Participation Program (FWPP). This plan, approved by shareholders in June 2005, permitted the company’s two founders, McClendon and Tom L. Ward, to continue to participate as working interest owners in new natural gas and oil wells drilled by the company. The FWPP might have been an appropriate investment vehicle before the company went public, but afterwards it had no place in the compensation policy of a mature energy company. In the same year, McClendon was plagued with margin calls because of high capital expenditures as a result of the FWPP. McClendon owed the company between $33 million and $91 million and was forced to sell 31.5 million shares, 94 per cent of his stake, to help cover his obligations.

His 2008 bonus was structured to “partially offset his obligations to the company under his FWPP”, in other words to pay his debt for him.
Eventually, McClendon borrowed a total of $1.1 billion from the company using hundreds of different loans that were the subject of investigations by both the SEC and the Internal Revenue Service.And then there were the perks. Each year McClendon was paid for accounting support (sometimes upward of $600,000 worth of it), for personal use of company aircraft, for engineering support (don’t ask), for financial advisory services, supplemental life insurance premiums, country club dues, and tax reimbursements for spouse/family travel.
Not only that, but related party transactions between Mr. McClendon and the company covered pages and pages of the proxy statement. Here are just two of them:
The company purchased a collection of antique maps from Mr. McClendon in 2008 for $12.1M [these were subsequently repurchased by Mr. McClendon following a shareholder lawsuit]. In 2009 the company paid $3.8M to sponsor a basketball team Mr. McClendon partially owns.
Since 2007, shareholders withheld support from Chesapeake directors, until in 2012, the only two directors up for election on this classified board, both received support from less than a quarter of outstanding shares. Though not required to do so by the company’s bylaws, they tendered their resignations. At that same June 2012 annual meeting, 97 per cent of votes cast supported the introduction of majority voting at the company, Say on Pay received only 20 per cent support, shareholders refused to approve a new annual bonus plan, 86 per cent supported the elimination of supermajority voting (so a simple majority, i.e. 50 per cent not 65 per cent, could amend and pass bylaws), and proxy access passed. Subsequently, McClendon was stripped of his chairmanship and a coalition between Carl Icahn and Southern Asset Management, the company’s two largest shareholders, replaced four directors on the board with their own nominees.
The stock price started to climb immediately, from a low of around $14, though it didn’t really pick up steam until January when McClendon resigned as CEO. It is now trading at nearly $29. While this recovery could be attributed to the McClendon effect, since McClendon was the source of the poor governance, this doesn’t negate the argument that the governance improvements at the company were responsible for the rise in the company’s value. While selling off poorly performing assets could also be credited, this would not have happened had not McClendon resigned as a result of his power being wrested from him, so governance again is the culprit.

Finally, Apache Corporation, which recently boasted that it had not had a single environment-related shareholder proposal on its proxy since 2004. To be fair, Nabors has had no environmental shareholder resolutions in the last 10 years or so, and Chesapeake only two in 2010 (New York State’s pension fund and Green Century Capital Management filed a fracking resolution that got 25%, while CalSTRS called for a sustainability report). And this despite the fact that they are all serial frackers.

Since 2004, when there was a shareholder proposal from SRI firm Boston Common Asset Management which requested that a board committee assess how the company is “responding to rising regulatory, competitive, and public pressure to significantly reduce greenhouse gas emissions”, Apache’s CEO Steve Farris has worked closely with Steven Heims, managing director of Boston Common. This has apparently kept environmental resolutions off the ballot
But, as with Nabors and Chesapeake, the environment wasn’t the problem. Governance was. Since 2007, shareholders have been calling for proxy access and for the board to be declassified. Then, in 2013, the Say on Pay resolution received only 50 per cent support. The company had even lowered independent director compensation prior to the annual meeting to try and pacify shareholders, and eliminated tax gross-ups on perks, but it didn’t work.
Subsequently, Apache met with shareholders representing about four-fifths of its ownership, and, having listened to them, instituted a governance revolution on its own, with the board now seeking to declassify itself. It also eliminated its poison pill, gave shareholders the right to call a special meeting, introduced a mandatory retirement age for directors, at the same time as replacing directors to reduce average age and tenure, gave more powers to the lead director, adopted “Apache’s Human Rights Principles” and announced statements on political expenditures, board oversight, and indigenous peoples.At the same time, and again in response to shareholder consultation, the board eliminated the CEO’s bonus for that year, and redesigned the plan so it wouldn’t pay out when performance was poor, and added safety and fracking water cleanup targets to it. It also terminated its use of stock options and increased its use of performance shares, stopping short of eliminating payouts for below median performance (this illogical practice is very common in the US), but reduced maximum payouts and modified the peer group. Also, executives must retain 60 per cent of net shares received from equity plans until retirement. It also adopted an anti-hedging policy, so executives could not bet on falling stock prices and benefit from it. The remuneration committee got an additional member, and a new consultant. And, finally, severance packages were reduced and capped.

While fears surrounding the company’s operations in Egypt may have caused some of the decline in the company’s stock from a high of $133 in 2011, governance concerns clearly contributed. The stock began its decline in July 2011, but the latest round of political turmoil in Egypt began in January 2012, and the company has nevertheless had three years of uninterrupted production there. And since the disastrous 2013 annual meeting, the stock has risen from $70 prior to around $88 today, and continues to climb.
Measured by share price alone, at these three companies at least, it would seem that governance pays.

Paul Hodgson is an independent governance analyst.