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Chesapeake, McClendon to End Well Incentive Program

Chesapeake Energy Corp.'s board of directors Thursday said it was working with CEO Aubrey McClendon to end the Founder Well Participation Program (FWPP) in which the CEO has the contractual right to participate and invest up to a 2.5% working interest in every new well the company drills.

The news preceded an unconfirmed report by Reuters that the Securities and Exchange Commission's Fort Worth, TX, office had launched an informal inquiry into the company's FWPP and the CEO's participation. Standard & Poor's Ratings Services (S&P) late in the day also cut the corporate credit ratings on the company and two related entities because of the "recent revelations."

Chesapeake shares ended regular trading Thursday at $17.56/share, down 57 cents from Wednesday. More than 47 million company shares traded hands, versus an average volume of 18.2 million.

Earlier this month McClendon was reported to have taken out more than $1 billion in personal loans over the past three years secured by stakes that he holds in company wells to cover the operating expenses related to investing in the wells (see Daily GPI, April 19). Close to half of the personal loans apparently were provided by EIG Global Energy Partners and a predecessor firm, which also have funded various Chesapeake transactions. The company's 2011 proxy statement, issued last week, indicated that McClendon's cumulative spending under the FWPP had "significantly exceeded cumulative production revenues to date" because capital spending had risen year to year (see Daily GPI, April 24).

The FWPP, which was renewed for 10 years with shareholder approval in 2005, is scheduled to terminate in 2015. However, the board and 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."

McClendon also has agreed to "separately disclose supplemental information regarding the interests he has acquired" through the FWPP as of Dec. 31, 2011. In addition the board is "reviewing the financing arrangements between Mr. McClendon (and the entities through which he participates in the FWPP) and any third party that has had or may have a relationship with the company in any capacity."

Chesapeake said it also wanted to "clarify a statement" from its original press release issued on April 18 by General Counsel Henry Hood that indicated the board had been "fully aware" of McClendon's financing transactions.

The press release, said the company, "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."

Following the announcement, S&P lowered its corporate credit ratings to "BB" from "BB+" on the corporation and two related entities, Chesapeake Oilfield Operating LLC, which is set to publicly launch at some point this year, and Chesapeake Midstream Partners LP. The ratings were placed on "CreditWatch with negative implications," said S&P.

The ratings revisions "reflect our view that recent revelations about personal transactions undertaken by Chesapeake's CEO relating to the company's unusual Founder Well Participation Program underscore shortcomings in Chesapeake Energy Corp.'s corporate governance practices," said S&P credit analyst Scott Sprinzen. "We believe these transactions heighten the potential for unmanaged and unmonitored conflicts of interest, or the perception thereof."

The FWPP's terms offer "no effective mechanism to protect against conflicts of interest, in our view. Indeed, Chesapeake has previously said the company does not review or approve financings of Mr. McClendon's personal assets, including his FWPP interests. It is our understanding that Mr. McClendon has also been under no obligation to disclose his dealings with third parties which also have lending, investment, or advisory relationships with the company," said the S&P analyst.

The decision by the board to negotiate an early termination to the FWPP and to review the CEO's loans with any third parties that have a relationship with the company "represents a significant governance deficiency," said Sprinzen.

"Turmoil resulting from these developments -- and from potential revelations resulting from the board investigation -- could hamper Chesapeake's ability to meet the massive external funding requirements stemming from its currently weak operating cash flow and aggressive capital spending."

The company has an "excellent drilling record and large acreage positions in the most promising North American liquids-rich basins" that "afford confidence about its ability" to transition from natural gas production to more liquids and oil output, the S&P analyst said.

"However, Chesapeake faces very large external funding requirements to sustain the aggressive planned investment needed to effect its strategic shift. In its investor presentation dated April 17, 2012, Chesapeake gave guidance of total investment of $10.9-12.4 billion in 2012, and $10.5-12.3 billion in 2013. This guidance encompasses well costs on proved and unproved properties, acquisition of unproved properties, and investment in oilfield services and midstream assets.

"Based on our estimates and price deck assumptions (including natural gas price of $2.00/MMBtu in 2012, $2.75 in 2013 and $3.50 thereafter), we expect Chesapeake's funds from operations to total only $3.4 billion to $3.8 billion in 2012 and $5.4 billion to $5.8 billion in 2013, implying massive internal funding shortfalls," said Sprinzen.

Chesapeake is set to deliver its first quarter 2011 earnings report on Tuesday, followed by a conference call on Wednesday.

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