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Chesapeake CEO's Personal Loans Draw Investor Ire

A top energy analyst and some shareholders on Friday called for Chesapeake Energy Corp. CEO Aubrey McClendon and members of the board of directors to step aside following disclosures of questionable personal financial transactions by McClendon.

Reuters first reported that McClendon over the past three years has taken out more than $1 billion in personal loans secured by the 2.5% interest he holds in company wells to cover the operating expenses related to investing in the wells. The Founders Well Participation Plan (FWPP) has existed at Chesapeake since 1993 and was approved in 2005 by shareholders. It allows McClendon the right to take a stake in every well that Chesapeake drills.

However, what stirred the emotions of shareholders was that more than half of McClendon's personal loans were provided by a significant investor in the corporation. The news, which unfolded last Wednesday, initially sent the stock price tumbling more than 5% to end the day at $18.07 from $19.12 -- a year earlier the company was trading at $35.75. On Friday Chesapeake investors remained wary; the stock closed at $17.44 for the week.

Reuters, which with financial experts, said it reviewed thousands of company documents. The loans to McClendon were done with board of director approval and disclosed in company reports, according to the company. McClendon has frequently borrowed money over the past 20 years. However, in the past three years, "the terms and size of the loans have changed substantially," and he has borrowed as much as $1.1 billion, which it noted is "an amount that coincidentally matches Forbes magazine's estimate" of his net worth, Reuters noted.

The loans were broken down as: $225 million in June 2009 from Union Bank in California, with a pledge for a share of wells as collateral; $375 million in December 2010 from TCW Asset Management, a private equity firm; and $500 million in January from a unit of EIG Global Energy Partners, a private equity firm founded by former TCW executives -- and a Chesapeake Energy Corp. investor. EIG, formerly Energy & Infrastructure Group of Trust Company of the West, was spun off from TCW in January 2011. Reuters uncovered the loans through a review of the minutes of a February 2011 meeting between EIG and the New Mexico State Investment Council, the state's public investment fund.

"In fall 2008, Mr. McClendon didn't have liquidity to participate in the (well) program in 2009, at which point EIG entered into discussions with him" and formed a special purpose entity (SPE) called Larchmont Resources, EIG COO Randall Wade reportedly said. Through the SPE, EIG apparently acquired the rights to all of McClendon's well stakes for 2009 and 2010 and set up another SPE -- Jamestown Resources -- to control McClendon's well shares in 2011, with rights to 2012. "EIG sweeps 100% of the cash flow generated by those projects until EIG has gotten all of its money back plus a 13% realized return," Wade reportedly said. EIG also receives a 42% cut of McClendon's share of the well profits "in perpetuity."

Earlier this month Chesapeake sold the preferred shares of newly formed subsidiary CHK Cleveland Tonkawa LLC (CHK C-T), and a 3.75% overriding royalty interest in the first 1,000 new net wells to be drilled, to an investment group led by GSO Capital Partners LP, an affiliate of the Blackstone Group, which included EIG (see NGI, April 16). CHK C-T owns about 245,000 net leasehold acres in the Cleveland and Tonkawa liquids-rich tight sands plays in Oklahoma's Roger Mills and Ellis counties. Chesapeake retained all of the common equity interests in the subsidiary.

Last November Chesapeake sold EIG $500 million of perpetual preferred shares of CHK Utica LLC, and followed that sale a month later with another $750 million sale to EIG (see NGI, Dec. 12, 2011; Nov. 7, 2011). CHK Utica owns about 700,000 net leasehold acres within the EIG area of mutual interest in the Utica Shale, which covers 13 counties in eastern Ohio.

"Through the financial transaction led by EIG, our drilling program in CHK Utica is almost entirely funded for the foreseeable future (including cash flow from anticipated production)," said McClendon at the time. "We have achieved very strong initial drilling results in the wet natural gas and dry natural gas areas of our Utica Shale play and are beginning to accelerate our evaluation of the oil area of the play, which the EIG transaction will help enable." Chesapeake holds all the common interests in CHK Utica. As part of the EIG transaction, Chesapeake committed to drill a minimum of 50 net wells a year through 2016, up to a minimum cumulative total of 250 net wells.

Chesapeake spokesman Jim Gipson last Wednesday provided NGI the company's responses to the Reuters story, answered by Land & Legal General Counsel Henry J. Hood. The full responses are posted on Chesapeake's website.

McClendon's potential conflicts of interest are "a nebulous unspecified issue that is proposed to be solved by unspecified disclosure," Hood noted. "The FWPP is clearly a related-party transaction and every year the company makes extensive disclosure in the proxy, including amounts expended and the detail on how the FWPP works. We do not believe any conflicts of interest exist, but if any arise there are numerous mechanisms to counteract any such conflict..." The FWPP "clearly aligns Mr. McClendon's interest with the company's, while the business processes and the foregoing guard against any conflicts of interest arising," Hood said. The mechanisms put in place by the board avoid conflicts of interest and "we do not believe Mr. McClendon's financing arrangements have created or increased any risk to the company over the life of the FWPP."

In September 2006, following the Enron Corp. debacle involving related-party transactions, the Securities and Exchange Commission (SEC) revised related-party transaction rules to require companies to disclose when executives pledged corporate stock as collateral for loans. The SEC noted at the time that the "circumstances have the potential to influence management's performance and decisions." McClendon's loan collateral is backed by interest he has in the company wells, not in company stock, so the loans aren't covered by the SEC rules.

Chesapeake's board members' alignment with the CEO also is being called into question. Oklahoma's former Gov. Frank Keating and former U.S. Sen. Don Nickles serve on the board, as well as Oklahoma State University (OSU) President Burns Hargis, who in 2008 received a $1 million endowment from Chesapeake for a geosciences chair. The company also supports OSU athletics and other university programs, according to the 2011 proxy statement. Other members are National Oilwell Varco CEO Merrill Miller, Union Pacific Corp. CEO Richard Davidson, Kathleen Eisbrenner, now CEO of liquefied natural gas company Next Decade; energy analyst Charles Maxwell and former Geico CEO Louis Simpson.

Argus Research analyst Phil Weiss, who questioned Chesapeake's spending and business strategy in December 2010 (see NGI, Dec. 6, 2010), on Friday said the latest disclosures required changes at the top. At least one shareholder group also filed a lawsuit. "When we consider the full financial picture at Chesapeake, including its high debt levels, its use of financial engineering, the relatively low quality of its financial data, the questionable nature of some of the CEO's transactions with the company, and the apparent unwillingness of the board to put a stop to at least some of these practices, we believe the best thing for investors would be to replace the board and/or the CEO," Weiss wrote in a note.

The latest controversy isn't the first in which McClendon is the central figure. As the global financial crisis was taking hold, McClendon in late 2008 was forced by margin calls to involuntarily sell 31.5 million shares in Chesapeake, "substantially all" of his shares (see NGI, Oct. 13, 2008). Last year McClendon agreed to reimburse Chesapeake for selling his antique map collection to the company in 2008 for $12.1 million and apparently reaping $4 million in profit (see NGI, Nov. 7, 2011).

Chesapeake last week also laid plans to launch its onshore oilfield services unit through an initial public offering (IPO), but the separate company would continue to be closely tied to the producer. The oilfield operations were reorganized last year into Chesapeake Oilfield Services (COS), which McClendon said at the time might be worth as much as $10 billion this year (see NGI, Sept. 26, 2011). According to Chesapeake's year-end filings, COS booked $1.3 billion in sales last year; the Form S-1 filing with the SEC indicated that the IPO could secure funds of up to $862.5 million.

"We have placed substantial orders for additional new hydraulic fracturing units and expect to have eight fleets with approximately 315,000 hp in the aggregate operating by the end of 2012 and 12 fleets with approximately 450,000 hp in the aggregate operating by the end of 2013," the SEC filing stated.

Chesapeake, the second-largest U.S. gas producer, last year spent close to $13.3 billion to drill and complete 1,662 wells using more than 130 drilling rigs, the SEC filing said. By comparison, ExxonMobil Corp., the largest U.S. gas producer, in 2011 had less than half that number of rigs in operation in the United States, according to its year-end filings. Smith Bits reported that on April 13 Chesapeake was running 161 rigs in the United States, versus 58 rigs for ExxonMobil.

According to data compiled by NGI, Chesapeake also is holding more total net debt than integrated producer ExxonMobil. At the end of 2011, Chesapeake's total debt was $13.3 billion net, excluding minority interests, and $14.5 billion net, including minority interests. By comparison, ExxonMobil at the end of 2011 carried $4.37 billion net debt, excluding minority interests, and had $10.7 billion net debt, including minority interest. The figures excluded off-balance sheet debt items, including pipeline take-or-pay contracts, as well as volumetric production payments. In addition, ExxonMobil's market capitalization currently is 32 times that of Chesapeake's.

Once the IPO is completed, COS would become a holding company and would control all of its businesses. However, COS would be tied to Chesapeake long after it's a standalone company. It has, among other things, a master services agreement in place with the oil and gas drilling powerhouse, under which it provides services, supply materials and equipment to Chesapeake, while Chesapeake operates a minimum number of the COS drilling rigs and uses its fracking equipment for a minimum number of frack stages per month. The companies also have an administrative services agreement and a facilities lease agreement in place.

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