Aubrey McClendon Pigs Out: Chesapeake Energy’s Hidden Loans

I got a call about two months ago from Brian Grow at Reuters asking for my help on a story he was working on.

We are looking forward to your thoughts. My timeline for feedback is asap, but we have a bit of time as we are still searching for more mortgages.

As we discussed, we are researching some $1.1 billion in mortgages identified to date, which were taken out by the CEO of Chesapeake Energy Corp, Mr. Aubrey McClendon. He pledges his share of the company’s oil and gas wells and related equipment, intellectual property and hedging contracts as collateral.

The transactions are done through three separate firms he controls called Jamestown Resources LLC, Larchmont Resources LLC and Chesapeake Investments LP.

The result of Brian’s work, with co-author Anna Driver, is a special investigative report, that came out this past week. The publication of the report last Wednesday moved the Chesapeake stock price to its 52-week low. There have also been calls for CEO McClendon’s ouster and lawsuits filed.

Chesapeake Energy has now agreed to provide additional disclosures to investors.

Talk about impact journalism!

I posted a column on to highlight the report and my quote in it.

You have to wonder whether Chesapeake Energy‘s Board of Directors and General Counsel Henry Hood have been overcome by fumes. The company’s response to inquiries from Thomson Reuters’ special investigation by Brian Grow and Anna Driver is not only disingenuous it’s borderline delusional.

McClendon has borrowed as much as $1.1 billion in the last three years by pledging his stake in the company’s oil and natural gas wells as collateral, documents reviewed by Reuters show.

The loans were made through three companies controlled by McClendon that list Chesapeake’s headquarters as their address. The money is being used to help finance what could be a lucrative perk of his job – the opportunity to buy into the very same well stakes that he is using as collateral for the borrowings.

The size and nature of the loans raise concerns about whether McClendon’s personal financial deals could compromise his fiduciary duty to Chesapeake investors, according to more than a dozen academics, analysts and attorneys who reviewed the loan agreements for Reuters…

Chesapeake said McClendon’s loans are “well disclosed” to company shareholders. General Counsel Hood cited two references in the company’s 2011 proxy. In them, the firm refers to McClendon’s personal “financing transactions,” including one in a section entitled “Engineering Support” that discusses McClendon’s use of Chesapeake engineers to assess well reserves.

Nowhere in Chesapeake proxy statements or SEC filings does the company disclose the number, amounts, or terms of McClendon’s loans. Veteran analysts of the company said they were never aware of the loans until contacted for this article.

“We believe the disclosures made by the company have been appropriate under the circumstances, particularly since the disclosure of the loans is not required in any event,” Hood said in a statement.

You may wonder where the SEC is in all this. Don’t the rules require disclosure of related party transactions regardless of “materiality”?

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.

As a result, no SEC regulation precludes McClendon from using his well plan stake as loan collateral. The SEC declined to comment on the McClendon loans.

The SEC may not be specifically requiring disclosure of the complicated relationship between McClendon and EIG, between EIG and Chesapeake, and between Chesapeake and all the investors in EIG hedge funds that count on McClendon staying alive and in charge of Chesapeake. However, the audit industry regulator, the PCAOB, has proposed a new auditing standard that will require auditors to take a closer look:

The importance to investors of auditing disclosures regarding related parties is recognized by Section 10A of the Securities Exchange Act of 1934 (“Exchange Act”), which requires each audit of an issuer to include “procedures designed to identify related party transactions that are material to the financial statements or otherwise require disclosure therein.”1/

Likewise, significant transactions that are outside the normal course of business or that otherwise appear to be unusual due to their timing, size, or nature (“significant unusual transactions”) can create complex accounting and financial statement disclosure issues and, in some instances, have been used to engage in fraudulent financial reporting. For example, significant unusual transactions, especially those close to period end that pose difficult “substance-over-form” questions, might have been entered into to engage in fraudulent financial reporting or to obscure financial position or operating results. In such instances, management might place more emphasis on the need for a particular accounting treatment than on the underlying economic substance of the transaction.

In addition, incentives and pressures for executive officers to meet financial targets can result in risks of material misstatement to a company’s financial statements. Such incentives and pressures can be created by a company’s financial relationships and transactions with its executive officers (e.g., executive compensation, including perquisites, and any other arrangements).

Several news reports confused the source of the loans, the source of the collateral, and how the  loans were used. The loans were made by a banks and private equity firms not Chesapeake. They were made using McClendon’s interests in the wells as collateral. The most recent ones were used by McClendon to purchase the participations in the wells via a special purpose vehicle  – a legal entity set up in partnership with the private equity firm EIG so that the well participations could be converted to an asset held an EIG hedge fund.

Since he co-founded Chesapeake in 1989, McClendon has frequently borrowed money on a smaller scale by pledging his share of company wells as collateral. Records filed in Oklahoma in 1992 show a $2.9 million loan taken out by Chesapeake Investments, a company that McClendon runs. And in a statement, Chesapeake said McClendon’s securing of such loans has been “commonplace” during the past 20 years.

But in the last three years, the terms and size of the loans have changed substantially. During that period, he has borrowed as much as $1.1 billion – an amount that coincidentally matches Forbes magazine’s estimate of McClendon’s net worth.

The $1.1 billion in loans during the past three years breaks down this way:

In June 2009, McClendon agreed to borrow up to $225 million from Union Bank, a California lender, pledging his share of wells as collateral.

In December 2010, he borrowed $375 million from TCW Asset Management, a private equity firm.

And in January 2012, McClendon borrowed $500 million from a unit of EIG Global Energy Partners, a private equity firm formed by former TCW executives.

In one document provided to me by Reuters for my review, EIG Chief Operating Officer Randy Wade makes a pitch to the New Mexico State Investment Council for an investment in a new hedge fund his firm has created.

Mr. Wade responded that they have known Chesapeake Energy for 25+ years and provided pre-IPO financing for them in the late 1980s. He explained that Chesapeake’s chairman Aubrey McClendon has the personal right to invest, for a 2.5% interest, in every well that Chesapeake drills during a calendar year. In fall 2008, Mr. McClendon didn’t have liquidity to participate in the program in 2009, at which point EIG entered into discussions with him and ultimately came up with an SPV called Larchmont, which is in Fund XIV and is the analogy to Fund XV’s first investment. He said EIG set up a new entity and made a senior secured loan to the entity, and McClendon contributed his rights to participate in the 2009 drilling program at Chesapeake with an option on 2010, which EIG ultimately exercised.

He said 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; and in perpetuity EIG has a 42% net profit interest in all of the leases for which a well was drilled with EIG’s capital. To put it into context, 2,500 wells were drilled in this program, which ended in 2010, and this is the largest most diversified drilling program EIG has ever participated in. Fortunately, EIG had taken a fairly conservative underwriting approach on reserves and production; and while it is still early in the program, generally they are 25%-40% outperforming their base case.

Reuters reports that several state pension plans are counting on McClendon staying healthy, and on the job, at Chesapeake. That’s the only way these investments pan out for them.

An investment management firm that has loaned hundreds of millions of dollars to Chesapeake Energy Corp.(CHK.N) Chief Executive Aubrey McClendon raised money for its most recent investment fund from 19 institutional investors, including some of the largest U.S. public pension funds, according to a private equity research firm.

The list of state pensions that put money into the $4.1 billion EIG Global Energy Partners fund include ones from Alaska, Connecticut, Louisiana, Maryland, Minnesota, Missouri and Texas, according to research firm Preqin. Other large investors in the EIG Energy Fund XV were insurance giant MetLife and a Teamsters pension plan.

Chesapeake Energy’s auditor is PricewaterhouseCoopers. The auditor is paid less than $3 million to prepare an opinion on this challenging company. Sometimes you can be paid too little to be sufficiently skeptical…

Aubrey McClendon was also named an Ernst & Young Entepreneur of the Year last year.

6 replies
  1. shecky levine
    shecky levine says:

    It seems that these very smart reporters have found another slime deal.Beware as the snowball just started .It will be very scary even as it hits the low teens and gets halted

  2. Gautam Doshi
    Gautam Doshi says:

    But, what exactly is wrong in the Chairmanin his personal capacity owning a share in the wells which fact is disclosed. The
    The Chairman may sell or pledge his interest-that is his personal issue. His pledging his interest to third parties is not a rela
    ted party transaction. Yes it exposes the company to the risk that in the event of forfeiture by a lender to the Chairman it
    may have an unknown coowner but this should be guarded against by appropriate conditions in the terms of coownership.

  3. George Smithgolf
    George Smithgolf says:

    Some interesting observations here, but a cheap shot IMO at their auditors in the penultimate paragraph of the article. Those not in the audit business need to understand that one audit client which restricted the scope of the audit, including not paying enough to pay for the procedures they deem necessary, is a “former” client. On the Enron case, pundits argue that the auditors were paid too much and now the pendulum has swung to not paying enough. Both can be valid points, but let’s stick to the facts or at least support any conclusions.

  4. Francine
    Francine says:

    @George Smithgolf

    The Enron problem was also not paying enough – for the audit. The ability to make tons more on consulting sent the audit to the basement interns of priorities. The bigger challenge now is to do enough consulting at an audit client to outweigh the pressure on audit fees that has resulted for the Sarbanes-Oxley backlash. In some cases it can’t be done because Audit Committees push back. In others the audit committees look the other way while auditor still does almost everything, including things they shouldn’t, and they all hope no one catches on. Look at Ernst & Young and News Corp or GE and KPMG cases I’ve highlighted.

  5. George Smithgolf
    George Smithgolf says:

    I don’t believe the primary Enron problem was not paying enough — for the audit. This may have contributed to the audit failure, but it was, as you said, the audit partner taking accounting positions that the client was pushing for AND the audit partner’s perspective was unduly influenced by the fear of losing a large consulting and audit client if he rocked the boat — if the audit were lost, the major client would walk. AA probably could have gotten more audit fees, but that would not have fixed the problem. Proof of this is the mandates for separating certain types of services provided by the independent auditor in Sarbanes Oxley.

    Unfortunately, you still have not supported your conclusion that this was the case for PricewaterhouseCoopers as you stated. I would love to hear the audit firms Chairman rebuttal to your statement which is just your somewhat nonchalant opinion. No doubt their fees will increase in 2012 due to the recent allegations/litigation, if they are not replaced. If they are replaced, then the fees will go through the roof.

  6. Francine
    Francine says:

    @George Smithgolf

    The thing about a blog is that I get to express my “nonchalant” opinion. You can take it, leave it, or disagree. The support for my opinion is that, in my opinion, the fees for PwC’s audit given the complexity and problematic history of Chesapeake are very low, based on my experience. I would love to hear either Chesapeake’s Audit Committee Chairman or PwC’s Chairman tell me how hard PwC works to audit Chesapeake given the serious tone at the top issues.

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