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

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

Th
is 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)




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