You may remember that Chesapeake Energy got some bad press last week for giving its CEO interests in all of its wells, and that CEO taking hundreds of millions of dollars in loans against those interests, and Chesapeake maybe not telling shareholders about that in the most forthright conceivable way. At the time, Chesapeake’s general counsel Henry J. Hood let everyone know that everything was fine and Chesapeake’s board was on top of the situation. Today, though, we learn that Henry J. Hood’s bosses are not as supportive as, I dunno, Dan Walfish’s*:

Chesapeake also wishes to clarify a statement appearing in its April 18, 2012 press release captioned “Chesapeake Energy Corporation General Counsel Henry J. Hood Issues Statement.” The statement 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 Mr. McClendon used interests acquired through his participation in the FWPP as security in personal financing transactions. 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.

That statement doesn’t need clarification! That statement is perfectly clear! “The Board is fully aware of the existence of the financing transactions” means “everyone on the board is aware that financing transactions exist.” If Henry J. Hood had meant “The Board is fully aware of the details and amounts of the financing transactions,” he’d have said that. Being aware of the existence of a thing is the lowest level of knowledge that you can have about that thing. I am fully aware of the existence of Pinterest. The full extent of my knowledge about Pinterest is that it exists. See? Shut up everyone who’s all “‘fully aware’ means ‘generally aware’ now HUH LAWYERS?”

THAT’S RIGHT, say lawyers. I’m going to go out on a limb here and guess that the skills that allowed Henry J. Hood to say “the board has heard of this thing you call ‘financing’” but get a bunch of people to hear “the board knows all the details of what Aubrey’s up to, and it’s fine so don’t trouble your pretty little heads about it” served him well (1) in law school (you know this) and (2) in parsing the SEC rules governing related-party transactions, which restrict pledges of stock as collateral:

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.

The SEC is taking an informal peek, but my money’s on Hood. I like the cut of his jib.

Because of this publicity, though, the “Founder Well Participation Program” in question is all over now, by which I intend to convey that maybe it will all be over in the future:

Chesapeake Energy Corporation (NYSE:CHK) today announced that its Board of Directors has determined that it does not intend to extend the company’s Founder Well Participation Program (FWPP) with its chief executive officer, Aubrey K. McClendon, beyond its present 10-year term ending December 31, 2015. The Board of Directors and Mr. McClendon have committed to negotiate the early termination of the FWPP and the amendment to Mr. McClendon’s employment agreement necessary to effectuate the early termination.

That will no doubt be fun. Part of the puzzle in this whole freakout is that it consisted entirely of hypotheticals: Reuters, which broke the story, basically found a bunch of people not otherwise involved with Chesapeake to say things like “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” or “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?”

And of course of course of course you can imagine those things. My rough guess is that the FWPP really does more or less align his interests – levered and all – with CHK’s, but also that there’s probably some shadiness at the margins. There’s shadiness at lots of margins, and if you have an active imagination you will frequently be shocked.

But let’s apply our active imaginations to the next steps here. How will these negotiations go?

(1) McClendon keeps the existing FWPP wells but doesn’t get to participate in any future wells. Then all of the conflicts that exist currently will still exist with respect to the legacy wells. Plus more! Does CHK devote a marginal dollar to drilling a new well or producing at an existing (FWPP) well? As of today, that decision is made based on which choice has a higher NPV – for Chesapeake and Aubrey both. After the FWPP dries up, it will be influenced by whether Aubrey needs production at the FWPP well to pay off his debt, pushing Chesapeake away from good new exploration and toward cashing in on old wells. Or so I just imagined. See?

(2) He gets rid of the existing FWPP by selling them back to Chesapeake. At what price? Aubrey’s personal statement** about the loans basically shows that he’s ~100% levered based on a PV9 valuation (present value at 9% discount rate of proved reserves assuming NYMEX strip pricing): $846mm of loans vs. $852 of PV9 value. ON THE OTHER HAND, Chesapeake carries those wells on their books at “SEC PV10″ valuations, which use a 10% discount rate and backward-looking spot prices and, well, here:

So the bid/ask starts at, what, $852mm vs. $410mm? Next month’s headline is “Chesapeake bought interests in its own wells from its CEO at a price 2x where it was carrying those same wells on its books.” Who could possibly complain about that?

(3) He gets rid of the existing FWPP by selling it on the open market? Sure, why not. Note “CEO’s sales of well stakes raise questions at Chesapeake”, and that a portfolio of 2.5% interests in a bunch of Chesapeake wells shrouded in controversy may not be the very easiest thing to sell.

(4) He quits? That has some support:

Phil Weiss, an analyst at Argus Research, argued that Chesapeake would be stronger without Mr McClendon. “If he separated from the company, there would be some fall-out, but it would be better for Chesapeake. It has become so complex and convoluted that it really needs somebody else to stand back and take a good look at it.”***

I guess. I suspect that there will always be some irreducible conflict of interest between CEOs and their companies. This may be worse than most – but I’m not sure it is. It’s not an encouraging precedent if no one can find a way to resolve this one without getting rid of the CEO.

SEC starts probe of Chesapeake CEO’s well stakes [Reuters]
Chesapeake Energy Corporation’s Board and CEO Aubrey K. McClendon Agree to Negotiate Early Termination of Founder Well Participation Program [CHK]
Supplemental Disclosure Regarding Aubrey K. McClendon’s Interests in Chesapeake Energy Corporation’s Founder Well Participation Program [BusinessWire]

* So, awkies, I know and like Dan, he’s a smart guy, and I’m sure his boss is right and the Journal is wrong re: who told whom about who was blowing whose whistle.

** This is not on Chesapeake’s website; it comes from Aubrey all on his own. I assume that lawyers had something to do with that but it’s hard to fathom why.

*** You may remember Phil from footnote ** here. It’s safe to say that complexity bothers him.

Comments (34)

  1. Posted by guest | April 26, 2012 at 5:09 PM

    Three asterisks? Weak.

  2. Posted by guest | April 26, 2012 at 5:16 PM

    I don't get where the conflict of interest is.

  3. Posted by Texashedge | April 26, 2012 at 5:23 PM

    I just don't understand how people are suddenly surprised that this program–which has been publicly advertised for years–exists or that sometimes E&P companies compensate their employees through overrides or working interests (and usually for the explicit purpose of aligning interests)

    Given that this program basically replicates, in miniature, all of CHK's working interest, there's a hell of a lot more alignment of interests here than for, say, a stock option program (which encourages risky management behavior) or basically any banking compensation structure that doesn't include clawbacks.

    People raise debt and collateralize it with assets all the time. In this case, it's with wellbore interests. And of course he's using the same bank to do this as CHK does: because they have already signed off on all the engineering reports on these wells. I don't get it. I don't get why this is a controversy, and I'm starting to feel dumb because I don't get it.

  4. Posted by 2_Small_2_Bail | April 26, 2012 at 5:30 PM

    Not only are those discount rates different, the reserve categories aren't even the same. CHK is carrying them at PDP (Proved Developed Producing) whereas Aubrey is carrying at Total Proved…so his book is more risky on 2 basis'.
    I bet that they just let the deal expire in 2015 and he doesn't sell his interests back. I just can't see a situation where this deal gets done. CHK has to respond to the market which is punishing a nat gas weighted company with a mediocre balance sheet and would hate levering itself even more to pay a favorable price. Aubrey, on the other hand, has been doubling down for years and apparently has the credit lines to keep going infinitely until gas turns so no chance he wants to sell at the bottom(ish) of the cycle for a shitty price. When gas turns (anyone's guess between 2-5 years), he will be worth 11 figures.

  5. Posted by Bobby | April 26, 2012 at 5:30 PM

    Texas, have you absolutely any experience in this space? Your comment sounds like something a generalist would say.

    He doesn't pay 2.5% of all the CapEx CHK pays, only for the drilling of ways. This completely explains why CHK is a consistent overpayer for land and why their ROICs are the lowest in the industry. (E.G. buy vast amounts of land at too-high prices hoping to find some great drillable acreage, and then pay to drill that well.)

    He is actively destroying shareholder value for his own interests.

  6. Posted by Addendum | April 26, 2012 at 5:34 PM

    Sincerely,

    Goldman Sachs MD

  7. Posted by PermaGuestII | April 26, 2012 at 5:43 PM

    The bulk of journalists in New York, including those breaking this story, likely know as much about the details of oil and gas industry financing mechanisms as I know about the best places to go drinking in Lubbock, TX. I would take that into consideration.

  8. Posted by Avid Reader | April 26, 2012 at 5:44 PM

    Good stuff, Matt!

  9. Posted by Texashedge | April 26, 2012 at 5:53 PM

    The answer to your question is: wherever the Texas Tech Pi Phis are that night.

  10. Posted by Andrew Ross Sorkin | April 26, 2012 at 5:55 PM

    Hey !

  11. Posted by E. Texas Gas Trader | April 26, 2012 at 6:40 PM

    I think the best take on this would come from the JPM analyst Aubrey sort of cuts off each time there are questions during an earnings conference call. (See Seeking Alpha transcripts of same.) I can't wait to hear what JPM has to say about all this.

    In the gas bidness, as that old oil trading bastard here says can happen, there are a lot of people who are so dangerously competitive they fuck themselves and their fellow employees from time to time under the guise of doing good and "having skin in the game". My daddy lost all our money in a bad investment when I was a kid and I remember him saying he wasn't gambling; he did what he did for the family.

  12. Posted by General Observer | April 26, 2012 at 6:46 PM

    I guess the US military generals and admirals should all be working private mercenary contracts at the same time as they are leading our troops so they can have some skin in the game.

  13. Posted by Here You Go | April 26, 2012 at 6:53 PM

    "EIG Energy Partners or its predecessor company loaned upwards of $900 million to McClendon at the same time EIG was investing another $1 billion in Chesapeake’s new drilling ventures. Chesapeake claims there are no “cross collateral” issues with McClendon and no conflicts of interest. Well, hey, if there’s no conflict, then why not just disclose?"
    http://www.forbes.com/sites/energysource/2012/04/

  14. Posted by Energetic Guest | April 26, 2012 at 6:59 PM

    I agree. I hope Dealbreaker gets more into the foibles of the personnel in the oil, gas, refined products, power and chemical business. In the past decades there have been hundreds of good stories that the readership/commentariat would enjoy. Investment bankers and hedge fund folk are attached to the oil and gas business so it would make sense.

  15. Posted by Mac | April 26, 2012 at 7:02 PM

    private transaction, I'll be sure to bounce it off you next time

  16. Posted by Geez oil man | April 26, 2012 at 7:03 PM

    Hey !

  17. Posted by truth | April 26, 2012 at 8:19 PM

    yes it's been disclosed and everyone should have known, but it is also a corrupt as hell system that has nothing to do with alignment. how much do you think chk spends for land and exploration costs prior to each drill decision? ceo gets full participation after that point… each well is stacked in his favor to a crazy degree.

    now if the industry wants to get ceo's going along for 2.5% of EVERY capex dollar and land buy, fine.

  18. Posted by truth | April 26, 2012 at 8:28 PM

    just because you beat me to this point doesnt mean you need to hate on generalists.

  19. Posted by Alternate truth | April 26, 2012 at 9:05 PM

    And privately-traded REITS are shitty investments too because something like 15-18% of capital raise proceeds are skimmed right off the top. Everyone knows it. Just because it's a bad investment doesn't make it "corrupt."

  20. Posted by Energetic Guest | April 26, 2012 at 9:32 PM

    It's only private in a public company if you don't let it get disclosed, Mac. If you had bounced it off me I would have had the balls to say not to do it. Your subordinates count on your largesse to stay employed. I don't.

  21. Posted by Midstream Guy | April 26, 2012 at 9:39 PM

    My boss had a well participation deal but he couldn't borrow against it and he didn't get to decide on the specific wells. And, it was a private company.

  22. Posted by Tooth Fairy Believer | April 26, 2012 at 9:42 PM

    So do you suppose that EIG got any preferential participation deals based on the loans to Aubrey? I know such things would never happen in the energy business but they keep bringing it up in the press. One good thing about all this is that the board backs Aubrey completely and would never investigate any of the deals.

  23. Posted by Former Enron Hater | April 26, 2012 at 9:45 PM

    Oh…the old "everyone's doing it " defense! Clever!

  24. Posted by Alternative truth | April 27, 2012 at 1:06 AM

    Not quite. More like everyone knows what the investment entails. If you don't like It, don't do it.

  25. Posted by Tulsa Trading Expert | April 27, 2012 at 9:27 AM

    Let's get this CHK stuff going again today Matt! The internet is buzzing in Oklahoma City! Even the traders at certain firms in Tulsa have decided to discover what the "intertubenetwebs" is and how it can be used.

  26. Posted by PermaGuestII | April 27, 2012 at 9:47 AM

    Will make a note of that.

  27. Posted by Texashedge | April 27, 2012 at 10:27 AM

    truth, you could certainly make a case that as CEO he would be incentivized to have CHK buy into expensive leases since he doesn't have to share in the lease bonus payments but gets to participate in the in-the-money drilling programs. But it's still been the rule of the game since IPO and they've never hidden it.

  28. Posted by Irwin M. Fletcher | April 27, 2012 at 11:15 AM

    Simple- he turned around and accepted expensive financing terms from the same lender on the shareholders' behalf. He gets cheap $$ from EIG, shareholders get expensive $$.

  29. Posted by weeeeelygoat | April 28, 2012 at 12:05 PM

    fuck you.

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    CEO taking hundreds of millions of dollars in loans against those interests, and Chesapeake maybe not telling shareholders about that in the most forthright conceivable way. At the time, Chesapeake’s general counsel Henry J. Hood let everyone know that everything was fine and Chesapeake’s board was on top of the situation.

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