CEO of Chesapeake Energy Ran a Private Hedge Fund From His Office

This story is a good example of the loose regulations in the commodities markets that allow executive behavior that should never be tolerated.

Special Report: Inside Chesapeake, CEO ran $200 million hedge fund

By Joshua Schneyer, Jeanine Prezioso and David Sheppard

NEW YORK | Wed May 2, 2012 9:48am EDT

(Reuters) - As chairman and CEO of Chesapeake Energy Corp, Aubrey McClendon has been a powerhouse in the vast U.S. natural gas market, directing the company's multibillion dollar energy-trading operation and setting output targets for America's second-largest producer.

Behind the scenes, a Reuters investigation has found, McClendon also ran a lucrative business on the side: a $200 million hedge fund that traded in the same commodities Chesapeake produces.

On Tuesday, two weeks after Reuters reported that McClendon has taken up to $1.1 billion in loans against his stakes in Chesapeake oil and gas wells, the company stripped McClendon of the chairmanship and reiterated that it's reviewing details of the loans. A statement quoted McClendon, who will stay on as CEO, saying that the move will enable him to focus his "full time and attention on execution of the company's strategy."

But for at least four years, from 2004 to 2008, McClendon's attention extended well beyond his job at Chesapeake.

During that time, said a veteran trader who helped run McClendon's private hedge fund, the Chesapeake executive engaged in "near daily" communications and "exhaustive" calls to help direct the fund's trading.

The fund, Heritage Management Company LLC, was started by McClendon and Chesapeake co-founder Tom Ward. The hedge fund listed Chesapeake's headquarters in Oklahoma City as its mailing address, documents show. Heritage's staff included an accountant who was simultaneously employed by Chesapeake. The fund also earned McClendon and Ward management fees and a cut of profits from outside investors.

There is no evidence that McClendon or Ward used inside knowledge gleaned from Chesapeake in their hedge fund trading. Neither the company nor McClendon would comment, and Ward said he saw nothing wrong with the arrangement.

But experts on energy trading, corporate governance and commodity-market regulation said they were stunned by the latest revelation.

"An executive's first responsibility is to shareholders and the betterment of their investment," said Carl Holland, who ran the trading-compliance department at former U.S. oil major Texaco. "Personal trading in the commodity around which the CEO's business is based would be a clear no. We would never have tolerated that, ever."

Thomas Mulholland, a risk-management consultant to oil and gas producers for Golden Energy Services in St Louis, said such matters are "taken very seriously by energy companies, and there are strict codes against it. Even if there is just a whiff of impropriety," he said, "it can be enough to lead to a termination."

The commodities markets are less regulated than equity markets, where corporate executives are prohibited from trading stock in their own companies based on undisclosed financial information. In commodities markets, insider trading isn't illegal unless price manipulation can be proven.

Nonetheless, personal dealing in energy markets is typically forbidden by oil and gas companies for a variety of reasons.

In Chesapeake's case, McClendon would have been aware of major decisions that could affect natural gas prices before that information became public. Accounting for 5 percent of U.S. natural gas production, Chesapeake holds tremendous sway over markets. On January 23, the company announced sharp output curbs in response to low prices. In response, U.S. natural gas futuressurged by 8 percent the same day.

"If the company needs to make an operating decision which might move the market against the CEO's positions, there's a risk that will influence the decision-making at the top of the company," said Jeff Harris, former chief economist at the market's U.S. regulator, the Commodity Futures Trading Commission, and now professor of finance at Syracuse University.

Another potential problem is known as "front-running." That's when a trader buys or sells a commodity in advance of a client's or his company's orders. In theory, McClendon's first-hand knowledge of Chesapeake's own plans to trade would enable him to profit by trading ahead of Chesapeake - a move that could raise costs for the company.

"Advance knowledge of Chesapeake's activities could be perceived as having insight into the movement of commodities prices, which certainly raises conflict-of-interest issues as well as ethical issues about the ability to enrich himself on non-public information," said Tim Rezvan, oil and gas industry analyst at Sterne Agee in New York.

"If correct," Rezvan said, "these disclosures would be even more alarming than the personal loans."

A securities law professor said the very existence of the hedge fund could prompt a securities investigation.

"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," said Elizabeth Nowicki, a professor at Tulane University. She said a failure by McClendon and Ward to disclose their fund to Chesapeake's shareholders may constitute a "material omission" that could draw SEC scrutiny.

"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," Nowicki said. "That, it seems to me, is a slam dunk."

An SEC spokesman declined to comment.

UNANSWERED QUESTIONS

It remains unclear whether McClendon received permission from Chesapeake's board to run a hedge fund and actively trade in the commodities markets for himself, or whether his trading continues. Chesapeake and McClendon's personal spokesman declined to comment.

Chesapeake also declined to say whether employees would be prohibited from operating such a hedge fund or trading their own cash in oil and gas markets. The issue isn't clearly addressed in a code of ethics published on Chesapeake's website.

Two Chesapeake board members contacted by Reuters declined comment. "Given litigation, we are constrained in what we can say," said Chesapeake spokesman Michael Kehs, who was referring to shareholder lawsuits filed in the wake of the Reuters report on McClendon's personal loans.

Oil and gas markets are secretive, and trading positions are almost never made public. McClendon's hedge fund partner Ward said the two were always careful not to let Chesapeake's decisions influence the hedge fund's endeavors.

Ward, who continues to trade his own personal cash in commodity markets and is now CEO of oil and natural gas driller SandRidge Energy, said he doesn't know whether Chesapeake's board knew of the hedge fund he ran with McClendon. But he said he sees "no conflict of interest."

"We did not use any proprietary knowledge of (Chesapeake) trades to make our own individual decisions," Ward said.

Peter Cirino, who helped trade natural gas for the hedge fund, also said he knew of no discussions about what Chesapeake was doing in energy markets: "They were much too smart as individuals," Cirino said of McClendon and Ward. "They would be able to manage that conflict there, if there was one."

Today, McClendon leads the three-man team that oversees Chesapeake's trading in oil and gas for the purposes of hedging, or offsetting the risk of unfavorable price swings. When Reuters asked McClendon last year whether he traded for himself in energy markets, McClendon said: "No, no, no. I'm part of Chesapeake's hedging committee."

That committee has helped Chesapeake "lock in" high prices for the gas it sells. This year, the company has not hedged. It told investors in a presentation that it doesn't expect natural gas prices - near 10-year lows - to continue falling.

The company's own trading has been a big success. "The bottom line is that Chesapeake has delivered $8.4 billion in realized hedging gains to shareholders since 2006," said Kehs, the company spokesman. "That's extraordinary shareholder value added through innovation and by far the best record in the oil and gas industry."

After Reuters disclosed McClendon's $1.1 billion in loans, Standard & Poor's cut Chesapeake's debt rating, citing "shortcomings" in corporate governance. The SEC and the Internal Revenue Service have begun probes in the wake of the loans report.

Chesapeake shares rose more than 7 percent on Tuesday on the news that McClendon is being replaced as chairman. After the stock market closed, the company reported a first-quarter net loss of $71 million. Its shares fell 5 percent in after-hours trading and are down almost 20 percent this year.

BIRTH OF HERITAGE

A search of Chesapeake's public filings turned up no disclosure of McClendon's hedge fund, Heritage.

Reuters traced its roots to Delaware, where it was registered in 2004 by Corporation Trust Company, a firm that helps companies incorporate. Another filing in New York, where Heritage employees executed many of the fund's trades, lists its mailing address as Chesapeake headquarters in Oklahoma.

A Heritage telephone number listed in several business directories was answered "Chesapeake Energy" by a person who said she hadn't heard of the fund. The fund is also listed in a database compiled by the National Futures Association, which doesn't disclose its owners.

Heritage also shared at least one employee with Chesapeake: John D. Garrison. Garrison, an accountant listed as executive business manager for Chesapeake Energy in federal election campaign donation filings and as a Chesapeake employee since 2004, handled the hedge fund's bookkeeping, Cirino said. The arrangement is not illegal.

Business directories including Dun & Bradstreet also list Garrison as Heritage's chief financial officer. Garrison declined to comment when a reporter visited his home near Oklahoma City.

Heritage was born when commodity trader Cirino and four other traders went searching for capital to start a hedge fund, Cirino said. Through industry contacts, they landed a coveted audience with McClendon and Ward, already famed Oklahoma drillers before becoming pioneers of the shale-gas boom.

The Chesapeake founders, Cirino recalled, agreed to seed the fund with a total of $40 million of their own cash. But McClendon and Ward insisted on full ownership and involvement in the fund's trading strategy, Cirino said.

"They took a leap of faith to invest money in us, so we knew we were on the line," said Cirino, Heritage's former head trader and risk officer. "That they were in charge was made very clear."

The fund's trading wasn't limited to energy markets. It bet on a variety of goods, from natural gas to cocoa and coffee. It even had a cattle trader in Oklahoma.

As Heritage racked up stellar returns of between 15 to 25 percent a year, McClendon and Ward decided to open the hedge fund to outside investors, including friends and associates, Cirino said. When Ward left Chesapeake in 2006, he retained his stake in the fund.

By 2007, Heritage was managing around $200 million, Cirino said. That enabled Ward and McClendon to profit in another way: by charging outside investors a management fee equal to 2 percent of assets and pocketing 20 percent of the fund's profits. It's a typical structure in the hedge fund industry, known as "2 and 20."

Cirino and Ward's recollections differ on at least one point. Ward said he didn't interact with the fund's outside investors. Cirino recalled that "every investor I was involved with either met with McClendon and Ward or at least spoke with them by phone before investing." The hedge fund's healthy gains were a lure, but "the cachet of those two individuals certainly also helped," Cirino said.

In addition to weekly Monday conference calls and regular emails, the two owners met frequently with traders in New York and occasionally in Oklahoma, Cirino said.

In 2007, as the price of natural resources surged on booming demand from China and other fast-developing countries, commodity traders with a successful track record were popular on Wall Street. After three years of double-digit returns, the fund's traders told McClendon and Ward they wanted an equity stake, Cirino said.

But the executives weren't ready to cede control, Cirino said, and the traders left to open their own shop, Perennial Capital LLC, a $200 million fund that has no financial ties to McClendon or Ward. Cirino said the departure was amicable.

At Heritage, all of the money from external investors was returned by 2008, Cirino said. McClendon and Ward continued to operate the fund during that year, Ward said, but by 2009, Heritage traded no more.

What happened next to McClendon's commodity-trading ventures is unclear.

By June 2008 - as natural gas and oil prices were peaking, and just before the financial crisis - McClendon and Ward both held huge positions in natural-gas derivatives, according to confidential trading data disclosed last year by U.S. Senator Bernie Sanders, an independent from Vermont.

The trading information was assembled as part of a CFTC inquiry into derivatives markets and their impact on real-world energy prices. McClendon and Ward were among only a handful of individual investors identified by the CFTC. Most of the other players were big corporations.

The data indicated McClendon and Ward were betting that the rally of 2008 would continue. By purchasing derivatives, they controlled nearly identical positions in natural gas worth around $2.3 billion apiece, according to Reuters calculations based on closing futures prices as of June 30, 2008. McClendon held oil contracts worth another $240 million, the CFTC data showed.

Of 300 banks, hedge funds, energy companies and other traders identified in the CFTC survey, only four held larger bullish bets in natural gas.

Oil fell by more than 75 percent between July and December. Natural gas futures dropped almost 60 percent.

It isn't clear how McClendon and Ward's investments fared. McClendon would not discuss his trading. Ward said he could not recall the outcome of his own trades in 2008.

McClendon suffered a well-documented personal cash crunch later that year, however.

In early 2008 McClendon held a big position in Chesapeake stock purchased with borrowed money. Later that year, margin calls from his brokers forced McClendon to unload more than 90 percent of his Chesapeake shares and suffer a $2 billion paper loss. His selling contributed to an 88 percent fall in Chesapeake's share price from its all-time high of $74 that year. Chesapeake has since restricted "leveraged" trading in the company's shares by its executives.

Months later, McClendon became one of the highest paid CEOs in America for the year, receiving a total compensation package worth $112 million. The payout included a one-time cash bonus of $75 million to help him meet requirements for paying the costs of his personal stakes in Chesapeake-owned wells.

(Additional reporting by Sarah N. Lynch, Brian Grow, Anna Driver and Roberta Rampton. Editing by Blake Morrison and Jonathan Leff.)

What follows are the prior stories from Reuters in lead up to the story above. 

Exclusive: Chesapeake board member lent money to CEO McClendon

By Brian Grow and Anna Driver
(Reuters) - As Chesapeake Energy Corp.'s board of directors moves to distance itself from loans taken by CEO Aubrey McClendon, documents reviewed by Reuters show that at least one former board member had undisclosed personal financial ties to him in the past.
Now-retired board member Frederick Whittemore lent money to McClendon in the late 1990s, the documents show, even as Whittemore helped determine how much the CEO should be paid to run Chesapeake.
This week, the energy giant reversed an earlier statement that its board was "fully aware" of up to $1.1 billion in personal loans that McClendon has taken in the last three years. "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," the company said.
In June 1998, documents filed in Oklahoma County court show, McClendon had a financial relationship with Whittemore, a veteran Wall Street executive who served on Chesapeake's board from 1993 until 2011. For all eighteen years on Chesapeake's board and at the time of the loan, Whittemore served on Chesapeake's compensation committee. In that capacity, he helped determine how - and how much - McClendon would be paid. He also served as a member of the corporate governance and audit committees.
Whittemore, now 81, did not respond to messages left at his office and home.
Ron Hutcheson, McClendon's personal spokesman, acknowledged the existence of the loan but said the deal between Whittemore and McClendon ended in March 1999. He did not say whether the debt was repaid.
Provided with a copy of the financing documents and asked for comment, former Oklahoma governor and current Chesapeake director Frank Keating said in an email that he would "refer this to our legal team for review and response as appropriate."
Although nearly 14 years old, the McClendon-Whittemore deal raises a number of concerns, some analysts said. Among them: whether a board member who helps determine McClendon's salary should have a separate, private financial relationship with the CEO he oversees.
"For an independent board member on the compensation and corporate governance committees to be doing a deal with the CEO, that's something that would be inappropriate governance and that should be disclosed," said David Larcker, a corporate governance specialist and professor of accounting at the Stanford University Graduate School of Business.
Whittemore, who worked for more than 20 years at Wall Street giant Morgan Stanley and its predecessors, was chairman of the American Stock Exchange from 1982 to 1984, according to a biography compiled by Forbes.
Because the underlying loan agreement is private, the total value and precise terms of the financing agreement between McClendon and Whittemore remain unclear. The documents reviewed by Reuters refer to a "Security Agreement dated effective May 20, 1998 between the Debtor, and the Secured Party." The debtor is identified as McClendon, and the secured party as Whittemore.
A summary of the collateral pledged by McClendon shows he granted Whittemore all "right, title and interest" in a company called Chesapeake Investments LP. That firm was established and run by McClendon. It was regularly used to hold stakes McClendon acquired in each new oil or gas well drilled by Chesapeake, both before and after the financing deal with Whittemore, according to mortgage documents filed in Oklahoma, Texas and Louisiana reviewed by Reuters.
The well investment program is a unique perk that Chesapeake gives McClendon - an incentive that Whittemore helped oversee during his years on the board in his role as a member of the compensation committee. McClendon used Chesapeake Investments to borrow against the well interests he obtained through the program. Chesapeake Investments is now known as Arcadia Resources.
Given the dearth of details on the loan, some analysts weren't certain what to make of the arrangement.
"On this specific issue, it's difficult to say whether there is a conflict - unethical or even questionable - from my viewpoint, unless you knew what assets were underlying the debt obligation," said Raymond Deacon, a managing director at investment bank Brean, Murray, Carret & Co in Boston. "If (McClendon) was using company assets as collateral or interests in his ownership of wells, I think there is a clear conflict and it should have been disclosed."
On Thursday, Chesapeake's board announced it was negotiating an early termination of the well perk program, which was set to expire in 2015. The board also has launched a review of McClendon's related-party loans, and the Securities and Exchange Commission opened an informal inquiry into the well perk program.
The moves come in the wake of a Reuters investigation last week that showed McClendon has borrowed as much as $1.1 billion in the last three years to fund the costs of well stakes granted to him by Chesapeake. Most of the loans were made by EIG Global Energy Partners, an investment management firm that has invested $2.5 billion in Chesapeake along with other investors.
Investors and analysts have criticized Chesapeake's board for failing to monitor McClendon's borrowing against his share of company wells. They contend his personal borrowing may create conflicts of interest that could put McClendon at odds with Chesapeake shareholders.
(Editing by Blake Morrison and Michael Williams)

UPDATE 9-US SEC starts probe of Chesapeake CEO's well stakes

Thu, Apr 26 2012

* SEC's Fort Worth office leading probe
* Company says board never reviewed McClendon loans
* Program to give CEO well stakes to end in 2015
* S&P lowers its credit rating
* Shares close Thursday down 3.1 pct
By Ernest Scheyder and Brian Grow
NEW YORK, April 26 (Reuters) - The U.S. Securities and Exchange Commission has opened an informal inquiry into Chesapeake Energy Corp's controversial program that granted Chief Executive Aubrey McClendon a share in each of the natural gas producer's wells, a source familiar with the matter said on Thursday.
That inquiry, being led by the SEC's office in Fort Worth, Texas, comes after Reuters reported about loans McClendon had obtained on those wells that raised concerns about a potential conflict of interest by the company's CEO.
Chesapeake said it would end the program that gives McClendon a 2.5 percent stake in every one of the company's thousands of wells in 2015, when the shareholder approval of the program that started in 2005 expires.
The company said in a statement earlier on Thursday that its directors had never reviewed or approved McClendon's mortgages on stakes in those wells, reversing its prior assertions that its board of directors was "fully aware" of McClendon's financing transactions around the well ownership stakes.
"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," the company said.
Ratings agency Standard & Poor's said on Thursday the turmoil surrounding the well ownership program and McClendon's personal transactions could hamper the company's ability to meet "massive external funding requirements stemming from its currently weak operating cash flow."
S&P lowered its credit rating for Chesapeake - which has been junk grade for some time - one notch to "BB" from "BB-plus" and said another cut could occur within a few months.
Chesapeake shares ended Thursday down 3.1 percent at $17.56 on the New York Stock Exchange, bringing the decline so far this year to about 20 percent.
The company's recently issued 6.775 percent note due March 15, 2019, the most active issue on Thursday, was down 0.5 to 0.75 point following the S&P downgrade, according to traders.
Reuters reported on April 18 that McClendon, who founded the company, had borrowed as much as $1.1 billion i n the last three years a gainst his ownership stakes in wells that he received under the company's "Founder Well Participation Program."
The majority of the borrowing came from an investment management firm that is also a major financier of Chesapeake itself.
On Thursday, McClendon disclosed that as of the end of 2011, he owed $846 million on loans taken out against his well stakes. But the company did not disclose the total amount McClendon has borrowed, or whether his outstanding debt has risen since the end of last year.
The loans had been previously undisclosed to shareholders, analysts and academics said, raising concerns that McClendon's personal financial deals could compromise his fiduciary duty to Chesapeake.
An informal inquiry is the first step taken by the SEC before it launches any full investigation into potential wrongdoing by a company.
One major shareholder questioned whether the company's new statements had been prompted by the SEC probe.
"It seems somewhat coincidental that the board has acted this way today, and the SEC announces its inquiry. You wonder if they didn't have the news," said David Dreman, chairman of Dreman Value Management LLP, which owns about 1 million Chesapeake shares.
'FULLY' VS 'GENERALLY'
Critics of the company have long complained the company's board acted a little more than a rubber stamp for McClendon, one of the energy industry's most visible leaders.
McClendon founded Chesapeake in 1989 and quickly built the company into one of the nation's fastest-growing producers of natural gas. It is now the second-largest U.S. natural gas producer behind Exxon Mobil Corp.
Chesapeake said "the statement last week that 'the Board of Directors is fully aware of the existence of Mr. McClendon's financing transactions' was intended to convey the fact that the Board of Directors is generally aware" that McClendon had used the well ownership stakes as security for the loans.
One analyst said Chesapeake's new statement did not provide any reassurance that it was addressing the issues.
"How can this make me more comfortable?" said Phil Weiss, an analyst with Argus Research. "Either you're fully aware, or you're not. 'Fully' and 'generally' are two entirely different words."
Chesapeake board members declined to comment in specific terms on why they reversed course on McClendon's stakes in the wells and how the company's general counsel could describe the board as fully aware of the CEO's related loans if they had "no knowledge" of them as the board said in a statement.
"All of this is a work in progress," Frank Keating, a Chesapeake board member and former governor of Oklahoma, said in an email.
But an investor said the move was a step in the right direction, and that it showed the company was listening to shareholders' complaints.
"It's basic due diligence that sadly wasn't being done before," said Jake Dollarhide, chief executive of Longbow Asset Management in Tulsa, Oklahoma, which owns Chesapeake shares. "It shows the free rein that McClendon had."
McClendon disclosed additional information about his ownership stakes in the wells, and the board is reviewing the CEO's financing arrangements.
The CEO listed his share of Chesapeake's proved natural gas reserves at 810 billion cubic feet equivalent, or slightly more than 5 percent of the company's total. That equates to about 12 days' supply for the United States based on 2011 consumption.
The Oklahoma City, Oklahoma-based company has been at the leading edge of the shale gas industry and holds vast acreage in the fields discovered in recent years that are expected to yield decades of fuel for the United States.
But the steep jump in natural gas output has sent prices for the fuel plummeting to their lowest level in decade, squeezing profits and pressuring share prices for Chesapeake and many of its peers.
Debt rating firm Fitch Ratings said on Thursday it had revised its outlook to "stable" from "positive" for Chesapeake, which has $13 billion in rated securities, largely because of the low natural gas prices.

Exclusive: CEO's sales of well stakes raise questions at Chesapeake

Mon, Apr 23 2012

By Brian Grow and Anna Driver
(Reuters) - Chesapeake Energy Corp's chief executive came under fire last week after Reuters reported that he used his stakes in company wells to take out as much as $1.1 billion in personal loans.
Now, Reuters has found, CEO Aubrey K. McClendon has employed another way to cash in on a perk unique to the company he runs: He sold his share of two large energy plays at the same time the company divested its interest.
Analysts say the deals, which generated $6.5 billion in proceeds, pose a potential conflict because of the possibility that they could have been timed and structured to suit McClendon's personal interests, rather than those of the company he runs.
"I can imagine a scenario where Aubrey is suffering some financial distress and might want to get a deal done - and it's not the best price for the company," said Joseph D. Allman, oil and gas industry analyst at JPMorgan in New York. Because of the potential conflict, Allman said, Chesapeake should scrap the CEO perk that makes them possible.
McClendon's deals stem from his involvement in an incentive, unique to Chesapeake among large energy companies, called the Founder Well Participation Program. The well plan gives McClendon the right to purchase an interest of up to 2.5 percent in all the wells the company drills in a given year. In exchange, he pays an equal percentage of the costs.
Reuters reported last week that McClendon had used his stakes in thousands of Chesapeake wells as collateral for up to $1.1 billion in personal loans - the majority of which were extended to him by an investment management company, EIG Global Energy Partners, that is also a major investor in Chesapeake itself. The money was used to finance his participation in the well plan, Chesapeake said.
Chesapeake's shares fell sharply after the report. Some investors called for a management shake-up and full disclosure of McClendon's loans and other financial interests that may clash with those of the company. They say the loans are troubling because McClendon's big lender is simultaneously a major investor in Chesapeake, raising the possibility it received favorable terms. The size and terms of the loans also create the risk that McClendon could seek to influence corporate decisions on behalf of his lenders, instead of shareholders, analysts said.
On Friday, Chesapeake responded by disclosing the existence of McClendon's loans in a preliminary proxy statement, but it didn't report any amounts or terms.
In the two asset sale deals, one in 2011 in Arkansas worth $4.75 billion and one in 2008 in Oklahoma worth $1.75 billion, McClendon sold his interests in Chesapeake-controlled wells and acreage when the company divested its interests in the same properties.
The precise amounts earned by McClendon on those deals remain unclear. That's because Chesapeake has never disclosed his returns on sales of his interests in the company's wells in Securities and Exchange Commission filings.
Chesapeake declined to comment on the transactions, citing pending shareholder lawsuits filed since last week in response to the loan article. The company had previously said it did not disclose McClendon's return on sales of his personal well stakes to the SEC because it views them as private transactions that are not required to be reported.
After Reuters asked Chesapeake last week about McClendon's benefit from selling his share of wells alongside the company, Chesapeake amended its preliminary 2012 proxy to mention the fact that McClendon has sold well interests. It left the amounts earned blank, and the proxy indicated that it would divulge data only from 2011, not prior years.
"From time to time, Mr. McClendon has sold (well plan) interests separately and concurrent with sales by the Company of its interests in the same properties," the company wrote. "(During 2011, Mr. McClendon advises that he realized $ million from such sales, net of his $ million share of deal costs. According to Mr. McClendon, his net investment in these properties was $ , including lease costs and well costs paid to the Company, less revenues paid by the Company.)"
The company's proxies have also mentioned a third way in which McClendon has monetized his well interests: He has sold future oil and gas production from his share of Chesapeake wells to investors in exchange for cash. But the proxy statements do not divulge the amounts or the timing. On April 19, Forbes reported McClendon raised $130 million from two such deals, known as volumetric production payments, or VPPs.
Chesapeake declined to comment on those transactions, saying they were private and citing the pending shareholder suit.
The sales of future energy production by McClendon prompted one analyst to say he believed such deals were a new risk for conflict of interest.
"If the CEO entered into a (volumetric production payment) for well interests, Chesapeake would not be able to shut in the well due to poor economics (i.e., $1.90 natural gas) without compromising the CEO's VPP transaction," said Tim Rezvan, an oil and gas industry analyst with Sterne Agee, who had downgraded Chesapeake shares last week on news of McClendon's loans. "It could present a conflict of interest between CEO Aubrey McClendon and VPP participant Aubrey McClendon."
Chesapeake spokesman Michael Kehs called that interpretation "inaccurate," saying: "The company can and has on multiple occasions shut in production from wells where the production is subject to a VPP transaction with a third party, including Mr. McClendon's."
In August, Reuters was first to report on another opaque personal transaction: how McClendon cashes in on the well plan by selling his share of the oil and gas alongside the company.
The one deal previously disclosed by Chesapeake came in March 2011, when the company sold acreage and producing oil-and-gas wells in Arkansas to mining giant BHP Billiton for $4.75 billion. In a filing with the SEC, Chesapeake said McClendon and entities he controls - Larchmont Resources LLC, Jamestown Resources LLC and Chesapeake Investments - were "parties to the purchase agreement."
The filing said McClendon and his affiliates received the same deal terms as Chesapeake. The documents didn't say how much McClendon received from BHP for his interest in the wells. The deal is mentioned again in the company's 2011 proxy statement, which notes that McClendon reimbursed the company for transaction costs related to the deal.
The other deal - in which Chesapeake did not disclose McClendon's personal participation in securities filings - came in July 2008, when the company sold land and producing gas wells in Oklahoma to BP Plc for $1.75 billion.
In response to questions from Reuters in August, a company spokesman said that "similar to the BHP transaction, Mr. McClendon and Chesapeake sold their separate assets to BP as requested by BP." The company said the deal was too small relative to Chesapeake's enterprise value at the time to warrant a filing that disclosed McClendon's personal participation.
McClendon has elected to take a 2.5 percent interest in Chesapeake wells in every quarter since the second quarter of 2003, according to data provided by Chesapeake. In 1999, McClendon did not participate in the well program. But in the other years from 1995 to early 2003, he took stakes ranging from 1 percent to 2 percent. He has elected to participate again this year, at 2.5 percent.
In its proxy statements, Chesapeake does report that McClendon is allowed to conduct a range of financial transactions with his well interests. And it says that McClendon has sometimes sold well interests at the same time as the company.
McClendon and Chesapeake have said there is no conflict of interest. The company says the well plan aligns McClendon's interests and Chesapeake's by requiring that he fund his share of the cost of production and participate in every well drilled in a given year.
More pay days from well sales may be in the pipeline for McClendon.
A prospectus seen by Reuters shows that Chesapeake is seeking to sell 37,800 net acres in West Texas. Selling alongside the company are two of McClendon's personal companies - Larchmont Resources and Chesapeake Investments. The prospectus was prepared by Albrecht and Associates, an oil and gas divestment specialist in Houston.
A projected price for the sale could not be determined. The deal, which was expected to close in December 2011, has not been completed. Harrison Williams, an Albrecht executive named in the prospectus, did not return a call seeking comment.
Also, Chesapeake has told investors it plans to sell its 1.5 million acres in the Permian Basin in West Texas and New Mexico, as part of its plan to raise as much as $12 billion through asset sales. Permian fields, which contain vast amounts of oil and natural gas, are red-hot properties among bidders.
Since 2008, Chesapeake has drilled at least 367 wells in regions that include the Permian Basin, according to the company's financial disclosures. The precise number of wells - and the value of McClendon's potential share - remains unclear.
Because McClendon is selling his personal well interests controlled by his own companies, he effectively becomes an additional - and potentially competing - participant in Chesapeake's deals, said analysts.
"If your CEO is no longer a partner, but a third party, it can introduce all sorts of problems," said Charles Elson, a corporate governance expert and professor of law at the University of Delaware. "The CEO and the company's interests may no longer be aligned."
(Reporting by Brian Grow and Anna Driver; editing by Michael Williams and Blake Morrison)

Special Report: Chesapeake CEO took $1.1 billion in shrouded personal loans

Wed, Apr 18 2012

By Anna Driver and Brian Grow
(Reuters) - Aubrey K. McClendon is one of the most successful energy entrepreneurs of recent decades. But he hasn't always proved popular with shareholders of the company he co-founded, Chesapeake Energy Corp., the second-largest natural gas producer in the United States.
McClendon, 52, helped cause Chesapeake shares to plummet amid the financial crisis when he sold hundreds of millions of dollars in stock to raise cash for himself. Later, to settle a lawsuit by shareholders, he agreed to buy back a $12 million map collection that he'd sold to Chesapeake.
His approach to running his company also is renowned: Among other employee perks, on-site Botox treatments are available at its headquarters in Oklahoma City, Oklahoma.
Now, a series of previously undisclosed loans to McClendon could once again put Chesapeake's CEO and shareholders at odds.
McClendon has borrowed as much as $1.1 billion in the last three years by pledging his stake in the company's oil and natural gas wells as collateral, documents reviewed by Reuters show.
The loans were made through three companies controlled by McClendon that list Chesapeake's headquarters as their address. The money is being used to help finance what could be a lucrative perk of his job - the opportunity to buy into the very same well stakes that he is using as collateral for the borrowings.
The size and nature of the loans raise concerns about whether McClendon's personal financial deals could compromise his fiduciary duty to Chesapeake investors, according to more than a dozen academics, analysts and attorneys who reviewed the loan agreements for Reuters.
"If Mr. McClendon has $1 billion in debt through his own companies — companies operating in the same industry as Chesapeake — he has or could have a high degree of risk for conflicts of interest. As in, whose interest will he look out for, his own or Chesapeake's?" said Joshua Fershee, an associate professor of energy and corporate law at the University of North Dakota.
The revelation of McClendon's bout of borrowing comes as he is scrambling to help Chesapeake avert a multi-billion-dollar cash shortfall amid a plunge in natural gas prices.
It also exposes a potentially serious gap in how U.S. regulators scrutinize corporate executives, a decade after those rules were tightened in the wake of major accounting scandals.
The loans portend a number of possible problems, the analysts said. McClendon's biggest lender is simultaneously a major investor in two units of Chesapeake. That connection raises questions about whether Chesapeake's own financing terms could be influenced by its CEO's personal borrowing.
Another concern: A clause in the deals requires McClendon "to take all commercially reasonable action" to ensure that other owners and operators of the wells - including Chesapeake - "comply with…covenants and agreements" of the loans. Such clauses are common in energy-finance deals. But it is rare for the CEO of a major energy company to be personally subject to one involving the corporation that he runs. That means McClendon could have an incentive to influence Chesapeake to act in the interest of his lenders, rather than of his shareholders.
"Basically what you have here is a private transaction that could potentially impact a public company, depending on the manner in which the clause is interpreted and applied," says Thomas O. Gorman, a partner at law firm Dorsey & Whitney in Washington, D.C., and a former special trial counsel at the Securities and Exchange Commission (SEC). "That may create a conflict of interest."
As a result, the loans should have been fully disclosed to Chesapeake shareholders, the academics, attorneys and analysts said.
NO CONFLICT
Both McClendon and Chesapeake say the loans are purely private transactions that the company has no responsibility to disclose or even to vet. And they disputed the view that the deals could create a conflict of interest.
"I do not believe this is material to Chesapeake," McClendon said in an email response to questions. "There are no covenants or obligations in my loan documents or mortgages that bind Chesapeake in any way."
Chesapeake general counsel Henry Hood said in a statement that the clause in the loan agreements questioned by analysts - called "Compliance by Operator" - is "typical boilerplate language" used in oil and gas mortgages. It requires borrowers to exercise their rights with operators of wells, such as Chesapeake, on behalf of the lender.
Neither the existence of McClendon's loans nor their terms create the possibility of a conflict of interest, Hood said, in part because the company has a first lien on McClendon's share of company wells. That would mean Chesapeake gets paid before all other creditors in the event that McClendon defaults on his debt.
"Any loans are Mr. McClendon's personal business and not appropriate for review or monitoring by the company or public comment," Hood said.
The company has many checks to protect against conflicts, Hood said. Among them: Some of the world's largest energy companies own a share of Chesapeake wells and "monitor the actions of the Company" via well audits, government filings and participation in development plans, Hood said.
He added that Chesapeake now employs more than 13,000 people and drills more than 2,000 wells per year, "all of which minimizes the ability of any one person" - McClendon included - "to influence actions on any single well."
Less than four years ago, a personal transaction by McClendon did negatively influence the company.
To buy more Chesapeake stock, McClendon borrowed money from his brokers - what's called "buying on margin." In October 2008, just after the financial crisis erupted with the bankruptcy of Lehman Brothers, he was forced to sell more than 31 million Chesapeake shares for $569 million to cover margin calls from those brokers. The company's stock fell nearly 40 percent the week of McClendon's share sales. McClendon issued an apology but the company's credibility with many shareholders suffered significantly.
Chesapeake's board of directors is aware that McClendon has borrowed against his share of company wells, Hood said, but "the board did not review or approve the transactions." Nor did the company vet the loan terms for possible conflicts. "If there were any conflicts of interest," Hood said, "they would have surfaced by now."
Chesapeake board members contacted declined to comment. Marc Rome, Chesapeake's vice president for corporate governance, did not respond to requests for comment.
WELL INVESTMENT PLAN
The loans reveal how McClendon is using an unusual corporate incentive as collateral. The perk, known as the Founder Well Participation Plan, grants Chesapeake's billionaire co-founder a 2.5 percent stake in the profits - and makes him pay 2.5 percent of the costs - of every well drilled during each year he decides to participate.
Today, Chesapeake is the only large publicly traded energy company to grant its CEO the opportunity to take a direct stake in wells it drills. Chesapeake says the well plan is a uniquely powerful incentive because it aligns McClendon's personal interests with those of the company's.
The well plan does not allow McClendon to select the wells in which to invest; Chesapeake says the program is an all-or-nothing proposition so that McClendon can't cherry-pick only the most profitable wells.
"He has to eat his own cooking here," said company spokesman Michael Kehs.
But because McClendon is using the loans to finance his participation in the well plan, he defrays his risks. Two of McClendon's lenders, both private equity firms, in turn spread the loan risks to other investors by raising money from state pension funds and other investors to fund them. Those insights emerge from a February 2011 document detailing a meeting between McClendon's largest personal lender and a prospective investor.
"If he hasn't had to put up any of his own money, how is that alignment" of McClendon and Chesapeake's interests, asked Mark Hanson, an analyst with Morningstar in Chicago.
Chesapeake said McClendon's loans are "well disclosed" to company shareholders. General Counsel Hood cited two references in the company's 2011 proxy. In them, the firm refers to McClendon's personal "financing transactions," including one in a section entitled "Engineering Support" that discusses McClendon's use of Chesapeake engineers to assess well reserves.
Nowhere in Chesapeake proxy statements or SEC filings does the company disclose the number, amounts, or terms of McClendon's loans. Veteran analysts of the company said they were never aware of the loans until contacted for this article.
"We believe the disclosures made by the company have been appropriate under the circumstances, particularly since the disclosure of the loans is not required in any event," Hood said in a statement.
THROUGH THE CRACKS
Legal experts say the size and terms of McClendon's borrowing are unusual - and highlight a gap in regulatory scrutiny of American corporate executives.
In the past, major Wall Street banks formed separate companies - or special purpose vehicles, just as McClendon has - to allow select employees to borrow from the employer and make investments. The WorldCom accounting scandal was, in part, fueled by more than $1 billion in loans taken out by former chief executive Bernard Ebbers that were secured by his shares of company stock. And energy giant Enron used off-balance-sheet entities to hide debt from investors. New accounting and corporate governance laws and regulations banned such transactions or required their disclosure.
In September 2006, the SEC revised its related-party transaction rules to require companies to disclose when executives pledged corporate stock as collateral for loans. "These circumstances have the potential to influence management's performance and decisions," the SEC wrote.
McClendon's loans - backed not by stock but by stakes in company wells - aren't covered by the SEC rule. "Because they have decided to compensate him with a business interest, it kind of falls through the cracks," says Francine McKenna, an accounting expert and author of the accounting-related blog re: The Auditors.
As a result, no SEC regulation precludes McClendon from using his well plan stake as loan collateral. The SEC declined to comment on the McClendon loans.
TEETH WHITENING
Tall and thin, McClendon is a tireless booster for the oil and gas industry - and of his company. At an energy conference in November in Houston, he sported a tie printed with tiny drilling rigs. His daring deals and stirring speeches to investors have attracted some adoring followers.
During one speech last September, McClendon said opponents of a controversial drilling technique called hydraulic fracturing were interested in "turning the clock back to the Dark Ages."
"What a great vision of the future!" he said sarcastically. "We're cold, it's dark, and we're hungry!"
McClendon's investor presentations are standing-room-only. But he often bristles when his business model is questioned by analysts, frequently arguing that Wall Street does not understand the company.
That tension has intensified as Chesapeake scrambles to shed more than $10 billion in debt through the rapid-fire sale of assets amid the lowest natural gas prices in a decade. This year, it has done a series of deals to try to close a cash shortage estimated by analysts to be as high as $6 billion.
McClendon continues to treat his employees well. In recent years, he built a 50-acre red-brick campus in Oklahoma City as Chesapeake headquarters. It boasts a 72,000 square-foot state-of-the art gym, visiting doctors who provide lunchtime Botox treatments for employees, and dentists to whiten teeth.
A part owner of the NBA's Oklahoma City Thunder and supporter of charitable causes in the state capital, McClendon holds considerable sway in Oklahoma. Former U.S. Senator Don Nickles and former Oklahoma Governor Frank Keating, both Republicans, are members of the Chesapeake board.
McClendon's close relationship with the board hasn't left him immune to tensions with stockholders.
After Chesapeake's board agreed to buy McClendon's map collection in 2008 for $12.1 million, shareholders sued. The lawsuit was settled in November 2011, when McClendon agreed to refund the $12.1 million, plus interest, and hold stock worth 500 percent of his annual salary and bonus. Chesapeake also agreed to hire Rome, the vice president of corporate governance, and an executive compensation consultant to evaluate corporate pay packages.
The well participation plan, which was approved by shareholders in 2005 and cannot be discontinued until 2015, has remained unaffected.
Disgruntled investors continue to launch challenges. On March 13, New York Comptroller John C. Liu and the $113 billion New York Pension Funds called on Chesapeake to let large long-term shareholders put up their own nominees for the board of directors.
UNTANGLED
Key aspects of McClendon's loans remain hidden from shareholders. Because promissory notes underpinning the loan agreements are private, the interest rate, the exact amount borrowed and other terms of the transactions are not publicly known.
But the loan agreements demonstrate the extent to which McClendon has leveraged his interests: He has pledged as collateral almost every asset associated with his share of Chesapeake wells. Oil, gas and land interests, platforms, wells and pipelines, hedging contracts, geological and business data, and intellectual property are among scores of well-related assets that can be seized should McClendon default.
Chesapeake said it would be "unaffected by any dispute" between McClendon and a lender in the event of a default because of its first lien on oil and gas production, equipment and land leases.
The company also said that McClendon's share of "related assets" pledged as collateral - such as business data and hedging contracts associated with wells - is completely separate from similar assets owned by Chesapeake. That means Chesapeake would not become entangled should McClendon default, the company said.
Chesapeake "does not have an interest in the (McClendon's) related assets … and Mr. McClendon does not have an interest in the company's related assets," general counsel Hood said in a statement.
In explaining why Chesapeake's board isn't obligated to monitor McClendon's personal loans, Hood cited a September 2003 decision by a Delaware Chancery Court. The ruling in Beam v. Stewart found the board of Martha Stewart Living Omnimedia did not breach its fiduciary duty to shareholders by failing to monitor her personal investments. (Stewart served five months in prison in 2004 following her conviction for obstruction of justice in an unrelated insider-trading case.)
Given the size, scope and complicated terms of the loans, their particulars constitute important stockholder information and therefore should be more fully disclosed, said David F. Larcker, a professor of accounting at Stanford University's Graduate School of Business.
Some shareholders agree. "While recognizing (McClendon's) right to privacy, the more information the company releases to shareholders the better - particularly when it's such a large amount of money and related to the oil and gas business," said Mike Breard, oil and gas research analyst at Hodges Capital Management in Dallas, which owns Chesapeake shares.
LOAN TRAIL
As with a mortgage on a residential home, state law requires that ownership rights to physical property be recorded with county clerks.
Reuters found McClendon's loan agreements by following the trail of well and land lease transfers from Chesapeake to three companies that list McClendon as their corporate representative, according to state deed records.
In county courts in Louisiana, Texas, Arkansas, Pennsylvania and Oklahoma, where Chesapeake operates thousands of wells, the company regularly files a form called a conveyance. In keeping with the corporation's well participation program, the conveyance grants McClendon a 2.5 percent share of each well and of the leased land on which it is drilled.
For years, Chesapeake has distributed 2.5 percent shares in wells and land to three McClendon-controlled companies - Chesapeake Investments LP, Larchmont Resources LLC and Jamestown Resources LLC.
Since he co-founded Chesapeake in 1989, McClendon has frequently borrowed money on a smaller scale by pledging his share of company wells as collateral. Records filed in Oklahoma in 1992 show a $2.9 million loan taken out by Chesapeake Investments, a company that McClendon runs. And in a statement, Chesapeake said McClendon's securing of such loans has been "commonplace" during the past 20 years.
But in the last three years, the terms and size of the loans have changed substantially. During that period, he has borrowed as much as $1.1 billion - an amount that coincidentally matches Forbes magazine's estimate of McClendon's net worth.
The $1.1 billion in loans during the past three years breaks down this way:
In June 2009, McClendon agreed to borrow up to $225 million from Union Bank, a California lender, pledging his share of wells as collateral.
In December 2010, he borrowed $375 million from TCW Asset Management, a private equity firm.
And in January 2012, McClendon borrowed $500 million from a unit of EIG Global Energy Partners, a private equity firm formed by former TCW executives.
It is unclear how much, if any, of those loans have been repaid.
Randall Osterberg, a senior vice president at Union Bank who signed the loan agreement, declined to comment. TCW and EIG also declined to respond to questions.
REAL LOSS?
At first blush, what the company tells shareholders suggests the well plan is a money-loser for McClendon.
In its proxy statements, Chesapeake says McClendon lost $116 million in 2009, and $141.9 million in 2010.
It's unclear whether McClendon has suffered any real losses, however. Asked about the calculations, Hood said McClendon's net loss is a byproduct of his drilling costs being "front end loaded," while his revenues accrue over many years.
"If they are showing that kind of negative cash flow, the wells don't have value," said Phil Weiss, oil analyst at Argus Research who has a sell rating on the company's shares. But given that McClendon has borrowed more than $1 billion based on the value of his well stakes, "I really don't think (the company's disclosures) tell me much," Weiss said.
Chesapeake has resisted attempts by regulators to get more information on McClendon's well-participation plan before. In 2008, the SEC requested more information about McClendon's benefits from the well plan as part of a review of the company's 2007 annual report.
From May to October that year, Chesapeake and SEC officials exchanged at least eight letters and held negotiations on the issue. After first refusing to provide more information, Chesapeake ultimately agreed to provide shareholders a chart detailing well plan revenues and costs, a review of the letters shows.
Chesapeake's Hood said in a statement that the company's disclosures are "fully compliant with all legal and regulatory requirements." The chart and other SEC filings contain "all material facts that Chesapeake was required to disclose," he said.
A spokesman for the SEC declined to comment.
BIG LENDER
McClendon's biggest personal lender, EIG, has been a big financer for Chesapeake, too.
In November, Chesapeake raised $1.25 billion from a group of investors including EIG through the sale of "perpetual preferred shares" in a newly formed entity, Chesapeake Utica LLC, which controls about 800,000 acres of oil and gas-rich land in Ohio. The sale offers lucrative terms to EIG investors, paying an annual dividend of 7 percent and royalty interests from oil and gas wells, according to analysts.
On April 9, the company announced a nearly identical deal to raise another $1.25 billion from EIG and other investors, in another new subsidiary called CHK Cleveland Tonkawa.
Dividends on preferred shares are controversial because they are paid before regular dividends owed to common shareholders. "Basically it's a form of more expensive debt," Morningstar's Hanson said. "It makes it appear that it's not debt, but it sits on top of obligations to the common shareholder."
The fact that McClendon's largest personal lender received favorable terms on its Chesapeake investments caused some Wall Street analysts to call for more information about McClendon's loans.
"I think the company should disclose this information. One reason is that the CEO is taking out loans from at least one entity, EIG, which recently provided financing to Chesapeake," said Joseph Allman, oil and gas industry analyst at JPMorgan in New York, who reviewed the loan agreements. "In the same way that investors want to know the counterparty to significant Chesapeake transactions, they would want to know if one of those firms has significant private dealings with the CEO."
Chesapeake's Hood acknowledged there could be "some theoretical possibility of a conflict of interest" with the company and its CEO borrowing from the same lender. But because Chesapeake does not believe there is "an actual conflict of interest," more disclosure is not required, Hood said.
CLOSING A GAP
McClendon's personal loans highlight a gap in current SEC rules governing disclosures of related-party transactions, say accounting experts. The SEC requires disclosure of any transaction over $120,000 involving a company and a related party, such as the CEO, directors and certain family members, "with direct or indirect material interest."
Chesapeake said the SEC's related-party rule doesn't apply to McClendon's loans - only to his participation in the well plan. That's because Chesapeake believes the loans "do not constitute a material transaction with Chesapeake or even involve Chesapeake," Hood said.
That disclosure gap may be closing. A proposed new standard, released for public comment by the Public Company Accounting Oversight Board on February 28, would require auditors to identify and evaluate "significant unusual transactions" with executives connected to publicly traded firms. The board defined such transactions as those "outside the normal course of business or that otherwise appear to be unusual due to their timing, size or nature."
Board chairman James R. Doty described the proposal as a way to scrutinize transactions that have played "a recurring role in financial failures." The oversight board declined to comment on McClendon's loans.
For now, said analyst Weiss, Chesapeake and McClendon are pushing the limits. "If Chesapeake were trying to make things muddy and unclear without breaking the law, this would be a good way to do it."
(Reporting by Anna Driver in Houston and Brian Grow in Atlanta; additional reporting by Joshua Schneyer in New York; editing by Blake Morrison and Michael Williams)