A new compensation controversy in the making... at Chesapeake Energy

A lot of the controvery over compensation schemes have mostly centered on financial companies. The most famous so far is the Merrill Lynch bonus payments just before it was purchased by Bank of America—I'm sure to the shock of many involved, this has opened up a can of worms, with potential illegal actions by various government officials and the CEO of Bank of America. Another big one was the bonus payments to AIG Fincial Products employees. The controvery this time had to do with the fact that the employees that bankrupted the company and ended up requiring $100+ billion bailout by the US government was being paid bonuses. Admittedly, some of the key employees who brought down the house don't work there anymore, although many others, mostly lower level, likely still do. I mean, even my Ambac has paid more than $10 million to the executive who was on the board (at that time) overseeing the expansion in structured finance. Ambac hasn't caused any controvery yet though--mostly because taxpayers haven't paid anything.

Now, we have a different sort of controversy brewing. This time it's Chesapeake Energy, whose share price has completely collapsed, although I'm not sure if the change in fundamentals justifies all of the price change. It seems that the CEO of Chesapeake was paid more than $100 million, which will probably make him the highest paid CEO last year:

On Apr. 21, the Oklahoma City-based company disclosed what may turn out to be the largest CEO pay package of 2008. In a year when Chesapeake shareholders saw their stock fall nearly 60% and the company's profits drop by 50%, McClendon's pay soared fivefold to $100 million. And as they say in late-night TV commercials, that's not all. The company also agreed to purchase McClendon's personal art collection—vintage maps that had been hanging in Chesapeake's corporate office—for $12.1 million. In addition, the company's proxy filing notes that Chesapeake paid $4.6 million to sponsor the Oklahoma City Thunder, a National Basketball Assn. team in which McClendon owns a 19% stake. The filing says the company received TV air time and other sponsorships in return.

McClendon, 49, ran into financial trouble last October with the market's steep slide. He had borrowed money to buy Chesapeake's once high-flying stock and had become the company's largest individual shareholder. With Chesapeake's shares tumbling along with commodity prices, McClendon received margin calls and was forced to sell nearly all of his shares over three days. A stake that was worth $1.9 billion just a few months earlier vanished almost overnight, and McClendon said in an Oct. 10 press release that he was "very disappointed" by having to sell. But McClendon's board supported him and in December offered him a new pay package. According to public filings, the company designed his new plan to keep McClendon from leaving and to reward him for four large deals he negotiated last year. Chesapeake sold interests in four of its fields to BP (BP), StatoilHydro ASA (STO), and Plains Exploration and Production (PXP) in transactions that raised $10.3 billion.


McClendon and former partner Tom L. Ward founded Chesapeake in 1989. Through canny acquisitions and a big bet that new reserves could be found under thick shale deposits, the pair turned Chesapeake into the nation's largest producer of natural gas. Ward has since left the company, but McClendon continues to be part of an unusual arrangement Chesapeake calls the Founder Well Participation Program. McClendon is allowed to invest his personal money for an up-to-2.5% interest in any wells the company drills. That program was a big part of McClendon's compensation package last year. Rather than have him pay out of his own pocket, Chesapeake paid $75 million to cover McClendon's share of the well investments.

This is basically what I call the 'founder problem'. Many entrepreneurs and founders who take their companies public treat them as if they were the sole owners. A lot of questionable behaviour related to compensation, such as getting the company to pay for their art collection, or making the company pay for their private transporation, don't pose a problem when the companies are private and the founder generally owns 100% of the company. Unfortunately, many still maintain their behaviour even after taking a company public and ending up with way less than 50% of the ownership (generally the case.) There are supposed to be independent boards but when you stack their with your allies, which is almost always the case with these situations, it's questionable whether anyone is independent.

To make matters worse, the founders tend to be very valuable to the company and hence it is not in shareholder's interest to lose him/her. So how do you compensate properly in such a situation? An oil & gas driller like Chesapeake probably doesn't want to lose its founder so what is the proper compensation?

To complicate matters further, should compensation be tied to share price performance or not? Some argue it should be based on fundamental performance. Investors such as Warren Buffett argue that compensation should be based on fundamentals. But even that doesn't solve the problem. If it is so, as long as the executive performs well on fundamental metrics, high compensation is proper regardless of share performance. This is clearly the stance of the Chesapeake board in this case. The board argues that the CEO cut some deals, possibly to avoid a bankruptcy--of course it's questionable why the CEO put the company in a bankruptcy-prone situation but no one really asks these questions. Similarly, basing pay on fundamentals would have led to cases like Home Depot in the early 2000's when its CEO was paid $245 million over 5 years even though the stock price declined 12% (versus its arch-rival which was up +173% and its CEO was paid less than $35m.)

The main reason Buffett, who advocates pay for fundamental performance, doesn't run into this problem is because he is very cheap and sets very low compensation. Furthermore, Buffett tends to purchase businesses owned outright by their owners which is quite different from the case of an executive who owns less than 5% of a company. However, I have a suspicion that Berkshire Hathaway will run into all sorts of compensation problems (i.e. will end up paying out hundreads of millions for dubious performance) after Buffett passes away because new management and board will behave more like contemporary corporate America.

Anyway, going back to Chesapeake, there is no easy answer to all this. If they didn't pay the $100 million, I'm sure the CEO would have walked away and the company would have faced some difficulties.


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