Expert Perspective by Grahall’s Garry Rogers
As a firm that specializes in both executive compensation and CEO contract negotiations, at Grahall we were more than a bit intrigued at the report that Mr. Aubrey McClendon, long time CEO and co-founder of Chesapeake Energy, had received a “bonus” of $75 million in association with a contract extension entered into in 2008, the conclusion of a year in which the company’s share price declined by 59%. Mr. McClendon and Chesapeake’s Board of Directors are currently in litigation over this award, characterized as an advance on Mr. McClendon’s potential payouts under the company’s Founder Well Participation Program, a shareholder approved program that allows Mr. McClendon to participate directly in profits from new natural gas and oil well projects.
Chesapeake’s decision to award this enormous bonus of $75 million has implications beyond executive compensation bonuses and equity ownership. Clearly it raises corporate governance issues. The bonus payment and resulting litigation bring to light an emerging trend: the media’s failure to report objectively and with full context in stories about compensation paid to the nation’s highest profile executives.
Background and Timing.
That Mr. McClendon was regarded as something of a boy wonder is beyond dispute. He co-founded Chesapeake in 1989, took it public in 1993, and helped build the company’s market capitalization to $40 billion as a major player in the natural gas industry. However, in October 2008, the bottom fell out of the natural gas market, and Mr. McClendon, who then owned approximately 5.5% of Chesapeake’s total outstanding equity, was forced to start selling shares to meet margin calls as Chesapeake’s stock cratered. His selling exacerbated the free fall, as the company’s shares headed south from roughly $70 a share to just over $16. Mr. McClendon’s sales eventually exceeded 95% of his holdings, essentially wiping out his once $2 billion stake in Chesapeake.
In December 2008, the Compensation Committee – unassisted by any outside independent compensation consultant – decided to make Mr. McClendon a $75 million annual incentive payment, despite the fact that the company’s stock price performance during 2008 was absolutely dismal. In addition, Chesapeake’s Board announced the purchase of certain “wall maps” owned by Mr. McClendon that adorned the walls of the company’s corporate offices, because it was “not appropriate to continue to rely on cost-free loans of artwork from Mr. McClendon”. The price? In excess of $12 million, which the company claims is approximately 40% below the maps’ collective replacement value.
There can be little question that a bonus of this magnitude appropriately exposes Mr. McClendon and the Board to criticism and potentially to legal liability. The Board attempts to convince us that this payment was necessary and desirable to “retain” Mr. McClendon.
Retention bonuses for CEOs upon signing a renewal contract are not unusual and can be appropriate under certain circumstances. However, the size and timing of Mr. McClendon’s bonus may illustrate a potential breakdown in the governance process at Chesapeake and a serious imbalance in the relationship between the CEO and the Board. Boards who have failed to adequately address succession planning, can be faced with tough decisions regarding CEOs for whom there is no viable replacement. Predictably and regularly, these unprepared Boards appease CEOs with “more” of everything, rather than risk a potentially damaging CEO departure. In the case of Chesapeake, the lack of succession planning was exacerbated by the fact that McClendon is a company founder, and had essentially built Chesapeake from the ground up. Perhaps Chesapeake felt it was simply safer and easier to “pony up” than to risk losing the company’s primary human asset, and maybe they were correct. However, we believe one of the best ways for companies to maintain balance in the relationship between the CEO and the Board is to have a viable succession plan in place at all times.
Multiple Employment Agreements
It is also worth noting that Chesapeake had negotiated an employment agreement with Mr. McClendon in October 2007, and revised that agreement in January 2008. So this December 2008 agreement was the third bite at the apple in 15 months. Moreover, Mr. McClendon’s existing agreement contained an “evergreen” provision, which guaranteed that the agreement would refresh itself and maintain the remaining term for no less than 4 years unless notice was given by the company. Thus, the new agreement was not replacing an expiring one.
Too many shares?
Should Mr. McClendon have held such a large amount of Company stock on margin? Given the burgeoning concern with the role compensation structure plays in promoting excessive risk taking, it’s a question whose time has come. Traditional thinking suggests that the more shares an executive holds, the better. Toward this end, more and more companies have adopted “share ownership guidelines,” which are essentially requirements that executives hold a specified amount of shares of company stock, most often determined as a multiple of the executive’s base salary.
But in this case, and in a market that is now clearly concerned with excessive risk taking by senior executives, perhaps we should ask a new question – should some type of maximum be placed on the amount of ownership a CEO holds in a company? Or should the SEC consider banning the practice of sitting executives purchasing shares on margin or somehow limit the amount of leverage?
Misalignment of Incentives
Though we want to emphasize that Mr. McClendon’s participation in the company’s new oil well program was shareholder approved, it’s hard to imagine when it was first implemented what it really added to his incentive scheme. The company claims the program was implemented to create better “alignment” between the shareholders and Mr. McClendon (originally, the program also included the company’s other co-founder). Yet it appears to us as a “mechanism of more” that was completely unnecessary for an individual who owned upwards of $2 billion in company stock.
Related party transactions
By the end of 2008, Mr. McClendon was in dire need of cash and magically at that time the company announced his $75 million bonus and the aforementioned $12 million for the historical maps. The proxy statement claims this amount was equal to Mr. McClendon’s cost basis in these maps, though it appears that this amount might instead represents a market value for such maps. (Mr. McClendon had a penchant for extravagant purchases, and later sold a portion of his wine collection for in excess of $2 million.)
Traditionally, the SEC’s approach to related party transactions has been disclosure, based on the principle that “sunlight is the best disinfectant.” Yet in the case of Chesapeake, the content of the disclosure seems wholly inadequate. The best illustration of this may be a snippet from Business Week, which reported that in a letter to the Compensation Committee regarding the company’s proxy disclosure and the incentive arrangements for Mr. McClendon, one of Chesapeake’s largest investors stated: “I sat in silence for 10 minutes contemplating my 25-year career in the investment management business… I have never seen a more shameful document.”
A final but important and not-so-obvious point regarding Chesapeake involves the media coverage. Like many stories about CEO pay, the stories regarding Chesapeake provided facts but lacked context and simply fostered the populist view that all CEOs are grossly overpaid executives who survive on company largess.
An inspection of Chesapeake’s 2008 proxy reveals the fact that Mr. McClendon purchased over 35% of his total equity ownership with $300 million of his own funds over a period of several years. While this fact in no way justifies an excessive bonus payment, or the potentially inappropriate incentive structure where an executive holding billions in company stock directly benefits from the profits of new revenue sources, it certainly differentiates Mr. McClendon from the typical characterization of CEOs who invest little or nothing in their respective companies and receive large severance payments when they fail. Yet we were unable to find a single reference to Mr. McClendon’s enormous personal investment in Chesapeake in any of the major media’s coverage of Chesapeake, a fact we find both stunning and disappointing.
Email Garry Rogers at firstname.lastname@example.org