By Paul Hodgson – CCO and Senior Research Associate
[This blog first appeared on Forbes.com]
The following is an excerpt from our forthcoming report, Ratings Foresights, which summarizes a few of the companies where GMI Ratings made predictions that governance, accounting, environmental and/or social failures would lead to significant value destruction.
Indeed, in November 2007, this is what we wrote:
We are downgrading our rating on the company to D from B due to concerns over executive compensation. Total actual compensation for Chief Executive Officer, Aubrey K. McClendon, was $116.9M in 2006 of which $975,000 was base salary, 1.6M was annual bonus, $1.8M was all other compensation, $102.5M was value realized from the exercise of options and $10M was value realized from the vesting of shares. Mr. McClendon’s total actual compensation ranks him as the second highest paid CEO in the petroleum & coal extraction sector and in the 99th percentile for S&P firms.
We wrote much the same in 2008. Then a poison pill expiration caused a brief upgrade to the company’s rating later in the year, until information released in its proxy statement a few months later caused an immediate downgrade.
Chesapeake Energy has filed its proxy statement and annual reports for the fiscal year ended in December of 2008. Based on information therein, The Corporate Library has downgraded the company’s rating from C to D. A major area of concern relates to CEO compensation for co-founder Aubrey K. McClendon. For fiscal 2008, total realized compensation for Mr. McClendon was $114,286,867, or about 2,500 times the nominal U.S. GDP per capita in 2007 ($45,725 according to IMF). Despite a 40% decline in stock price in 2008, Mr. McClendon received a bonus of nearly $77 million. In addition, the board awarded Mr. McClendon the very high sum of $1,800,817 in “all other compensation” in 2008. The total included an extraordinary $577,113 for accounting support (the need for accounting services at this level may itself be a sign of excessive compensation), as well as $648,096 for personal use of fractionally-owned company aircraft, $131,226 for engineering support, $438,750 for company matching contribution to retirement plans, and $5,632 for other benefits such as financial advisory services, supplemental life insurance premiums, country club dues, and tax reimbursements for spouse/family travel. Finally, the CEO’s new employment agreement reduced the ownership requirement for Mr. McClendon from 500% of annual salary to 200%. This adjustment was made after the CEO sold down his stockholdings to meet margin calls; the fact that this step was necessary raises serious concerns about the CEO’s commitment to an adequate level of continuing ownership in the company. Seen as a whole, all of these compensation practices and related party transactions raise concerns about the board’s ability to align executive interests with those of shareholders.
And as if that weren’t enough (engineering support?), part of the bonus that was paid out was attributed to the Founder Well Participation Program, as is detailed here:
$75 million was awarded under the Founder Well Participation Program (FWPP). This plan, approved by shareholders in June 2005, permits the company’s two founders, Mr. McClendon and Tom L. Ward, to continue to participate as working interest owners in new natural gas and oil wells drilled by the company. Through this program, Mr. McClendon continues to be a significant co-investor in the company, and as such, should not need an additional and extensive CEO compensation package to incentivize him.
As we have frequently expressed, the FWPP might have been an appropriate investment vehicle before the company went public, but afterwards had no place in the compensation policy of a supposedly mature energy company. In addition, concerns were expressed about the margin calls referred to earlier.
Due to high capital expenditures in recent years, as a result of the FWPP, Mr. McClendon has owed the company between $33M and $91M at the end of each fiscal year. Mr. McClendon was forced to sell 31.5M company shares, 94% of his stake, in October 2008 to help cover his obligations. His 2008 bonus was structured to partially offset his obligations to the company under his FWPP. It is not clear why Mr. McClendon could not relinquish part of his holdings under the FWPP or sell those to reduce his contribution requirements rather than the company providing an excessive bonus not related to performance to ameliorate those obligations.
Not only that, but related party transactions between Mr. McClendon and the company covered pages and pages of the proxy statement. Here are just two of them:
The company has also been involved in a high number of related-party transactions with Mr. McClendon in recent years and purchased a collection of antique maps from him in 2008 for $12.1M [these were subsequently repurchased by Mr. McClendon following a shareholder lawsuit]. In 2009 the company paid $3.8M to sponsor a basketball team he partially owns.
Since 2007, shareholders had also been withholding support from Chesapeake directors. GMI Ratings raised additional concerns about directors’ age and their long-tenure. In 2009, opposition to directors increased, and it increased again in 2010 to 32 percent and 41 percent.
In 2010, the proxy statement also revealed that the cost of providing accounting support for Mr. McClendon had increased yet again to $623,000. The speculation in the earlier analyst commentary that this level of accounting support might be a sign of excessive compensation is true, but such an excessive need for accounting support might also be closely related to revelations that Mr. McClendon had borrowed $1.1 billion in hundreds of different loans that are now being investigated by both the SEC and the IRS.
That compensation policy is a window into the soul of the board could hardly have received a more perfect justification. Even the fact that excessive perquisites – of their nature only a tiny portion of a pay package that exceeded $100 million on several occasions – have an importance in signaling governance concerns that far outweighs their relative cost could hardly have received a more perfect justification. The unlimited power wielded by Mr. McClendon over the strategic direction of the company which has resulted in the company losing half its value during 2011 is clearly signaled by the board’s complete inability to design a compensation package that could realistically and appropriately reward the CEO.
The news that four new, independent directors are to be elected to the board along with an independent chairman, may signal a shift in the balance of power, but until this board gets to work on Mr. McClendon’s compensation package, these moves will not of themselves, improve the governance rating. For a start, the board should ensure that additional accounting and, now, legal costs associated with related class action lawsuits and SEC and IRS investigations are not paid for by the company and, ultimately, shareholders but by Mr. McClendon himself.
Simply electing four new independent directors is a nominal change. Governance at the company must improve in practice as well as in theory, and such improvement can only be demonstrated by actions, not by elections. If actions signal an improvement, however, we will be the first to recognize this and upgrade the company.
However, if the governance rating improves, it may still not be enough to lift the overall ESG rating, since the environmental rating of F, based on the company’s use of the controversial drilling process called hydraulic fracturing and the numerous lawsuits surrounding the pollution of drinking water that follows on from this process, is unlikely to change.