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Chesapeake's CEO Inconvenienced By Having To Find New Creative Ways To Exploit Shareholders

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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.