Reuters special report: Chesapeake CEO took $1.1 billion in shrouded personal loans

BY ANNA DRIVER AND BRIAN GROW -- Reuters Published: April 18, 2012

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. (Read Chesapeake Energy Corp.'s response to a set of questions from Reuters)

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.

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