When Genius Continues to Fail: What We Didn’t Learn from Penn Square Bank, Enron, and Chesapeake Energy

By J. C. Whorton, Jr. & Richard S. Shuster OCCASIONAL PAPER 48

2013

International Research Center for Energy and Economic Development Occasional Papers: Number Forty-Eight

WHEN GENIUS CONTINUES TO FAIL: WHAT WE DIDN'T LEARN FROM PENN SQUARE BANK, ENRON, AND CHESAPEAKE ENERGY by

J. C. Whorton, Jr. and Richard S. Shuster

ISBN 0-918714-74-5

Copyright © 2013 by the International Research Center for Energy and Economic Development No part of this publication may be reproduced or transmitted, except for brief excerpts in reviews, without written permission from the publisher.

Cost of publication: U.S. $10.00

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When Genius Continues to Fail: What We Didn’t Learn from Penn Square Bank, Enron, and Chesapeake Energy
J. C. Whorton, Jr. and Richard S. Shuster* “Any fool can make a million dollars. Just not every fool can hang on to it.” Tom Slick, known as the “King of the Wildcatters” In the dawn of the hydrocarbon world, the principal risk that one could encounter was the exploratory risk of a dry hole condemning a prospect both technically and financially. From those nascent days of an industry’s evolution, risk profiles have evolved considerably. The energy risk matrix has expanded such that the very term risk now has a totally different array of definitions for each department throughout the corporation and for its board as well. The management of risk has become a new and daunting task for each firm and the industry in general. Today, managing risk, in part, is attempting to predict and manage change. In the world of business, change is neither bad nor good, just inevitable in its due course. What is bad or good is how institutions and the people who run them choose to manage change. If corporate conscience allows change to occur without adequate analysis and appropriate thought-out controls and governance, change can do irreparable harm not only to stakeholders but the industry at large.1 The domino effect of a failed company on its peer group can be astounding. Within any organization, the primary job description for each and every employee is to deliver value to the stakeholders. If the enterprise is a sole proprietor, the goal must be to make the sole proprietor money. If the company is public, all employees must endeavor to create value for the shareholders. Exactly how this is accomplished is a function of the role the individual plays in the entity.

As the following three scenarios are reviewed, a common theme appears: a lapse in corporate governance between senior management and the best interests of the major stakeholders. Penn Square Bank was a privately held bank federally regulated by the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC). Enron Corporation was a high-profile publicly traded corporation with very visible controls, policies, and procedures in place while key employees committed fraud and criminal acts to circumvent public transparency in reporting. Both Penn Square Bank and Enron are insolvent entities no longer in business. Chesapeake Energy Corporation, on the other hand, is a going concern based in Oklahoma City, Oklahoma, but it has serious corporate governance and financial issues that must be addressed immediately to ensure its future viability. Chesapeake faces a number of the same challenges as many other similar public companies that are run by the original founders and managed and governed as though they are still a privatelyheld enterprise with little or no accountability to others. These three examples over the last 30 years most readily come to the forefront for re-examination. Two of these examples are history; one is in the midst of a crisis in 2013. Each is irrefutable proof that the more things change, the more they stay the same. Why does it always seem that every lesson must be relearned by a new generation? Penn Square Bank, NA—1982 “His education cost fifty million dollars and all he learned was how to subtract.” Robert Gregory, Oil in Oklahoma2 1982: It was the best of times, it was the worst of times. Penn Square Bank, NA was a very small commercial bank located in the rear of Penn Square Shopping Mall in Oklahoma City, Oklahoma, with very grandiose plans. The bank’s owner and founder, 2

William P. “Beep” Jennings, wanted the bank to become the premier energy merchant bank in the world. Having been there at the time, there was little question in the minds of those involved that the bank had the vision and the desire to achieve its lofty goals. What it sorely lacked was the experience, expertise, riskmanagement tools, and corporate governance aptitude to properly chart the course. It always has seemed that energy prices and the industry are never quite in sync with the rest of the country—or the world for that matter. The boom years of the late 1970s and early 1980s were no exception. The lumber industry in the Pacific Northwest, the automotive industry in the Midwest, real estate in the Northeast, foreign loans to South America—all were experiencing significant downturns. Major regional banks all desperately needed new downstream-origination sources for their loan portfolios. Penn Square soon became the quick financial fix. In 1979, when the Shah of Iran was exiled from his country, fears of oil shortages created widespread panic buying and a surge in oil and gasoline prices. During the Oklahoma and Texas oil boom of the late 1970s and early 1980s, the bank quickly made its name by originating highrisk energy loans based largely on flawed and failed petroleum reserve studies and forecasts. Engineering reserve studies began with flat prices for six months then quickly escalated to $100 per barrel and higher for the life of the reserves. Unfortunately, at that time there were no futures or derivative markets to lay off the financial risk of failed forward curves or price volatility. Fortunately, Penn Square had billions of new energy loans available for immediate participation with the “right” (i.e., “good old boy”) upstream counterparts, not to mention that it had millions of dollars in lending agreements that got scrawled on cocktail napkins and bank money spent on private jets, hookers, and alcohol, according to Phillip Zweig’s 1985 book, Belly Up: The Collapse of the Penn Square Bank.3 Bill Patterson, Penn Square’s flamboyant, fun-loving energylending chief, loved to entertain the larger international banks’ 3

loan officers while drinking amaretto out of his Gucci loafers or French champagne from his custom-made cowboy boots. Mr. Patterson was eventually charged with violations of U.S. banking laws and was sentenced to two years in federal prison in 1988. Between 1974 and 1982, the bank’s assets increased more than 15 times to $525 million and its deposits swelled from $29 million to more than $450 million. Very soon the Penn Square energy customer base had grown quickly and included some very substantial regional and international borrowers (53 in all) with more than $2.5 billion in loan participations. To maintain overall bank liquidity, the bank was paying very high Certificate of Deposit (CD) rates to attract very large individual depositors. Unlike most previous bank failures that occurred since the FDIC was formed in 1933, Penn Square still ranks as one of the most publicized, most difficult, and most colorful bank resolutions in U.S. history. As most of the deposits came from other financial institutions and represented high interest-rate jumbo (greater than $100,000) CDs that were third-party brokered and largely uninsured, this represented an unprecedented major loss for the depositors. No other banks were willing to assume the deposits at the time of Penn Square’s failure. Subsequent investigations by the FDIC after the failure uncovered more than 450 possible criminal violations including fraud and insider transactions.4 An article in the Chicago Tribune Business Section on February 19, 1987, stated that “former senior officers of Continental Illinois National Bank and Trust Co. of Chicago in late 1981 purposely hid from the bank’s outside auditors a conflict of interest in Continental’s involvement with the now-defunct Penn Square Bank of Oklahoma City, a lawyer for the auditors said Wednesday.”5 In opening arguments to a Federal District Court jury, Daniel F. Kolb, attorney for the accounting firm Ernst & Whinney, said Continental management violated its responsibility to the accounting firm by failing to disclose that John R. Lytle, the bank’s senior loan officer in Oklahoma, had received more than $500,000 in personal loans from Penn Square Bank. 4

During this time of overreaching, the major bank that was most aggressive in its energy lending was Continental Illinois National Bank and Trust Company, then the largest moneycenter bank in the Midwest and seventh largest in the nation. When it came to energy lending, the Wall Street Journal called Continental Illinois “the bank to beat.” But when energy prices began to weaken and Penn Square subsequently was closed, it became clear that Continental Illinois, with its huge portfolio of energy loans from Penn Square and other energy banks, large and small, was in serious trouble. In 1984, two years after Penn Square’s collapse, there was a global run on the bank as other banks and companies pulled their money out. All questionable energy loans—which were the majority—were called, leaving all energy lenders scrambling to refinance with most simply filing for bankruptcy protection. The bank’s collapse coincided with the 1980s oil glut and Penn Square was the first of approximately 139 bank failures in Oklahoma alone during this period. Altogether, Penn Square’s demise caused an estimated 486 banks to close; none of them were of the magnitude of Continental Illinois. The integrity of the entire interconnected banking system was placed in serious jeopardy. After reviewing the possible consequences and determining there was no other choice, the federal government intervened with a huge bailout that included $8 billion in emergency loans, $5.5 billion in new capital, and new management. Continental Illinois, deemed “too big to fail” (sound vaguely familiar?) in fact, had been nationalized. In April 1981, oil prices peaked at $36.95 per barrel (and not the $100-plus a barrel as predicted by the pundits) and then began to fall. Economic recessions in oil-consuming nations, conservation efforts, and the sale of oil by some members of the Organization of the Petroleum Exporting Countries (OPEC) in excess of their quotas all combined to reduce oil prices rapidly in world markets. The demand for oil rigs began to reach its peak. As oil prices continued to decline during 1982, profits for the oil industry slowed markedly, especially in the southwestern United 5

States. Needless to say, energy lending was no longer in vogue. Upstream exploration and production capital dried up and vanished. The boom was over and the bust had begun. As a result of this bust, by the mid-1980s the energy industry had lost more than half a million career employees. Most of these individuals were professionally educated and trained. With their departure, the industry did not lose its wildcatter, cowboyentrepreneurial image, it simply lost most of the talent across the board to deliver the hydrocarbons that the world’s industrial machine soon would need again to fuel its growth. The young— those for whom the oil patch was both a legacy and a future— suffered the greatest casualties. As a result, the industry has suffered a catastrophic generational skip which, 30 years later, is still being felt today as companies sometimes spend as much time looking for talent as they do the precious hydrocarbons to grow their companies.6 Enron—2001 “After all, they were the smartest guys in the room.” Bethany McLean and Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron7 Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, which at that point was the largest in U.S. history, Enron had been a high-profile powerhouse. It employed approximately 20,000 and was one of the world’s leading electricity, natural gas, communications, and pulp and paper companies, with claimed revenues of nearly $101 billion in 2000.8 Fortune magazine named Enron “America’s Most Innovative Company” for six consecutive years (1996–2001). But at the end of 2001, it was revealed that Enron’s reported financial condition was sustained substantially by institutionalized, systematic, and creatively planned accounting fraud, known as the 6

“Enron Scandal.” Enron since has become a popular symbol of willful corporate fraud and corruption. The scandal also brought into question the accounting practices and activities of many companies throughout the United States and was a factor in the creation of the Sarbanes–Oxley Act of 2002, which required much greater financial disclosure. The scandal also affected the wider business world by causing the dissolution of the Arthur Andersen accounting firm—which had given Enron a clean bill of health through its audits—and an immediate meltdown of energy merchant trading activities by others for almost a decade. Just like Penn Square Bank two decades earlier, Enron was one of the biggest and most complex failures to date causing severe rippling effects felt for years after. Enron’s origins dated back to 1985 when it began life as an interstate pipeline company through the merger of Houston Natural Gas and Omaha-based InterNorth. Kenneth Lay, the former chief executive officer of Houston Natural Gas, became CEO, and the next year won the post of chairman. From the pipeline sector, Enron began moving into new fields. In 1999, the company launched its broadband services unit and Enron Online, the company’s website for trading commodities, which soon became the largest business site in the world. About 90 percent of its income eventually came from trades over Enron Online. Growth for Enron was rapid. In 2000, the company’s annual revenue reached $100 billion. It ranked as the seventh-largest company on the Fortune 500 list and the sixth-largest energy firm in the world. The company’s stock price peaked at $90 per share. However, cracks began to appear in 2001. In August of that year, Jeffrey Skilling, a driving force in Enron’s revamp and the company’s CEO of six months, announced his departure, and Lay resumed the post of CEO. In October 2001, Enron reported a loss of $618 million—its first quarterly loss in four years and the media began to seriously question the company’s finances. Chief financial officer Andrew Fastow was replaced, and the U.S. Securities and Exchange commission launched an investiga7

tion into investment partnerships led by Fastow. That investigation would later show that a complex web of partnerships was designed to hide Enron’s debt. By late November, the company’s stock was down to less than $1 a share. Investors had lost billions of dollars. On December 2, 2001, Enron filed for bankruptcy protection in the biggest case of bankruptcy in the United States up to that point. (Lehman Brothers collapse would later steal that dubious honor.) Roughly 5,600 Enron employees subsequently lost their jobs.9 First and foremost, Penn Square and Enron are monumental examples of the failure of corporate governance, auditor manipulation, and the hazards of rubber-stamp boards. At Penn Square, Mr. Patterson and other executives ran circles around a board consisting of a retired Air Force general, a local car dealer, a physician, and various assorted businessmen—none of whom bothered to ask questions until the bank began its descent into insolvency. Some of the directors, in fact, received sweetheart loans from Penn Square, an illegal practice.10 Likewise, outside auditors at both Enron and Penn Square were mired in conflicts of interest. After firing Arthur Young & Company (now Ernst & Young), which had tarnished it with a qualified opinion, Penn Square hired Peat, Marwick, Mitchell & Company (now KPMG). Peat Marwick saw fit to give the bank a clean bill of health about three months before it failed. As it turned out, Penn Square had made loans to Peat Marwick partners for investments in real estate and drilling funds. They also invested heavily in at least one partnership sponsored by a major Penn Square borrower. Like Enron, Penn Square amassed huge liabilities off the balance sheet, which contributed to its demise. Penn Square issued millions of dollars in letters of credit, which can be legally counted off the balance sheet, to enable doctors and dentists to buy into an array of limited partnerships sponsored by its oil and gas customers. When the partnerships failed, these investors defaulted on their loans. Moreover, both Enron and Penn Square played prominent political roles. Whether Enron’s millions in contributions to politicians 8

and political parties bought regulatory forbearance that enabled it to delay its day of reckoning remains unclear. But in both instances, the contributions certainly bought access that helped convey an aura of invincibility. Chesapeake Energy Corporation—2012 “May he not be knave, fool and genius altogether?” Herman Melville, The Confidence-Man11 Today, many of the younger energy professionals have never heard of Penn Square Bank and the few that know have very little of the saga other than overhearing older colleagues mention it in passing over lunches or cocktails. Some might have heard enough to recognize that it remains the vile culprit for a generational gap in energy talent in North America. Enron, on the other hand, is an iconic example of corporate greed, hubris, and abuse of power that still lingers. The analogies among Penn Square Bank, Enron, and more recently Chesapeake, are many and quite disturbing: failed forecasts, unbridled growth, off-balance sheet transactions, questionable accounting practices, excessive political lobbying and donations, selfdealing by senior management, poor corporate governance practices, and cronyism in board nominations, just to name a few. Although Penn Square and Enron are long gone, Chesapeake is still very much alive and a force to be reckoned with in the U.S. oil patch. It has faced much turbulence in the past years and is still far from having righted the course. The next several years may be the most challenging of its 24-year history. Beep Jennings, Bill Patterson, Ken Lay, Jeff Skilling, and Chesapeake founder Aubrey McClendon are all examples extraordinaire of classic promoters and empire builders. At Enron—and now at Chesapeake—you don’t just work there, you become part of a corporate culture. Enron had its Enron Towers connected by a Sky Ring with its own restaurants and uniquely aggressive and innovative corporate culture. 9

The Chesapeake Campus has its own doctors, dentists, chaplains, company historian, 10 Olympic rowing hopefuls on staff, a world-class Olympic rowing facility, a 72,000 square-feet fitness center, fitness trainers, Olympic-sized swimming pool, free teeth whiting and Botox injections, three-employee restaurants, and a high-end grocery store. What more could anyone possibly ask for? No wonder it has been named one of America’s best places to work for six consecutive years. But along with this success, there have been many looming problems that have now come to light. Founded in Oklahoma City in 1989, just seven years after Penn Square’s demise and only a few blocks down the street, by the charismatic and embattled Aubrey McClendon and former President and COO Tom L. Ward (now Chairman and CEO of Sandridge Energy, Inc. NYSE:SD), the company began with 10 employees and a $50,000 initial investment. McClendon named the company due to his love of the Chesapeake Bay region, which is evident when touring the sprawling 111-acre campus developed using a modern interpretation of Georgian-style architecture reminiscent of the 1700s and 1800s in the Chesapeake Bay region. Focusing on a strategy of drilling horizontal natural gas wells in unconventional reservoirs, the company built a sizable position in the Golden Trend and Sholem Alechem fields of south-central Oklahoma and in the Giddings field of southeast Texas.12 Forbes magazine recognized Chesapeake as the “Best Managed Oil-and-Gas Company” in 2007 and it was named to Fortune magazine’s “100 Best Companies to Work for List” from 2008 through 2013. In 2013, it ranked #26, the highest ranked company in Oklahoma. Chesapeake is ranked #6 in the large company category, which compares companies with more than 10,000 employees. The company was named the 2009 Energy Producer of the Year by Platts’ Global Energy Awards and received the Industry Leadership Award for its role in championing natural gas as the fuel of the future. The company was also a finalist in the Deal of the Year, CEO of the Year, and Community 10

Development Program of the Year categories and is only one of two firms to receive multiple awards. It was the second time in three years that Chesapeake had been named Platts’ Energy Producer of the Year. In 1993, the company completed its initial public offering at a split-adjusted price of $1.33 per share. In 1995, Chesapeake moved from the NASDAQ to the NYSE and changed its stock symbol to CHK. After struggling with attempts to extend the Texas Austin Chalk play into western and central Louisiana and the coinciding price collapse of oil and natural gas in the late 1990s, the company modified its strategy to focus almost exclusively on natural gas production. This focus utilized the newest technologies to target a more diversified, longer reserve life and lower risk asset base as it began to incorporate aggressive land and corporate acquisitions into the company’s business plan. During the years 2003–2007, the company experienced rapid growth thanks to upward shifts in U.S. natural gas prices. During this time, the company expanded its land positions into unconventional reservoirs such as fractured carbonates, tight sandstone, and shales, for example, the Barnett, Fayetteville, and Marcellus shales. In 2006, Chesapeake was added to the S&P 500, replacing Dana Corporation. In 2008, Chesapeake announced its discovery of the Haynesville Shale in east Texas and northwestern Louisiana. The Haynesville is projected to become the nation’s largest natural gas producer by 2015 and, along with the Marcellus Shale, perhaps one of the five largest natural gas fields in the world over time. Chesapeake now owns leading positions in the Eagle Ford, Utica, Granite Wash, Cleveland, Tonkawa, Mississippi Lime, and Niobrara unconventional liquids plays and in the Marcellus, Haynesville/Bossier, and Barnett unconventional natural gas shale plays. On July 22, 2011, Chesapeake Energy agreed to a 12-year naming rights partnership with the Oklahoma City-based NBA 11

team—the Thunder—to rename their arena Chesapeake Energy Arena. The agreement between Chesapeake and the Thunder has an initial annual cost of $3 million with a 3-percent annual escalation. Included in the agreement Chesapeake will have its branding throughout the building, prominent premium placement on the high-definition scoreboard, and on the new state-of-the-art interior and exterior digital signs. This expensive corporate branding strategy sounds very familiar to the former Enron Field, now Minute Maid Park, home of the MLB team, the Houston Astros. For Chesapeake, that was then and this is now. The stock price of the energy company is down more than 30 percent. The board has stripped McClendon of his chairmanship amid scandal and self-dealings. Today, his estimated billion-dollar personal fortune has shrunk by more than half. In June 2012, the company appointed Archie W. Dunham as Chairman, replacing Aubrey McClendon, who retained his position as CEO. Dunham, who retired as chairman of ConocoPhillips in 2004, was appointed in response to shareholder concerns about corporate governance issues under McClendon’s watch. The week before the Chesapeake Annual Meeting, television cameras showed Dunham and McClendon sitting next to each other at a Thunder basketball game and creating speculation that the company was exchanging one set of cronies for another. On April 18, 2012, a Reuters report revealed that Chief Executive Aubrey McClendon borrowed as much as $1.1 billion against his stake in thousands of company wells.13 The loans, which had been undisclosed to shareholders, were used to fund McClendon’s operating costs for the Founders Well Participation Program, which offers him a chance to invest in a 2.5-percent interest in every well the company drills. McClendon, in turn, used the 2.5-percent stakes as collateral on those same loans. Analysts, academics, and attorneys who reviewed the loan documents stated the structure raised the potential for conflicts of interest and also raised questions on the corporate governance and business ethics of Chesapeake Energy’s senior management. 12

The company disagreed that this was a conflict of interest or a violation of business ethics and issued a detailed statement. The day the Reuters article was published, Chesapeake Energy’s common stock fell over 5 percent at close and fell more than 10 percent intraday to its lowest level since July 2009. On April 26, 2012, Chesapeake Energy stated that its directors had never reviewed or approved McClendon’s mortgages on stakes in the wells and that it would be ending the Founders Well Participation Program. Additionally, the U.S. Securities and Exchange Commission (SEC) announced that it would be opening an informal inquiry of McClendon’s borrowing practices. On March 1, 2013, Chesapeake disclosed in a regulatory filing that the SEC was turning the informal inquiry into the Founders Well Participation Program into a formal investigation and had issued subpoenas for information and testimony. Aubrey McClendon, 53, endured a trying year running the second-largest natural gas producer in the United States in 2012. But as corporate, state, and federal probes into McClendon and the company continue, 2013 is not looking much easier. Facing a cash crunch, the natural-gas giant that McClendon founded had been counting on profits from land that was leased in Colorado, North Dakota, and Wyoming. The deals, however, have soured—at a cost to Chesapeake of more than a billion dollars— the company told investors in November 2012. On February 25, 2013, it was announced that Chesapeake had agreed to sell a stake in an oil and gas field straddling the Oklahoma and Kansas border to China’s Sinopec for $1.02 billion, approximately one-third of the deal’s estimated value. Sinopec, a Beijing based energy company, will take a 50-percent interest in 850,000 acres Chesapeake controls in the Mississippi Chat formation. The price equates to $2,400/acre, less than the $7,000 to $8,000/acre at which Chesapeake valued the asset in a July 2012 presentation. Chesapeake agreed to sell more than $12 billion in oilfields and pipelines since the beginning of 2012 to plug a cashflow deficit aggravated by low prices for natural gas, which accounts for about 80 percent of the company’s output. Chesapeake 13

failed to meet its asset-sales target in 2012 and the prices received so far this year have not matched the company’s projections.14 Like property owners in Michigan and Texas, landowners in North Dakota have sued Chesapeake over allegations that the company reneged on leasing agreements. And now, one of its leading regional contractors is suing Chesapeake for allegedly failing to pay a $15 million bill, court documents show. In building Chesapeake to the size and stature it holds today, McClendon oversaw $43 billion in spending over 15 years to snap up drilling rights across the country, holdings equal in area to West Virginia. But that empire, and the personal fortune he intertwined with it, is now under severe financial and legal strain across much of the United States. In April and May of 2012, Reuters reported that McClendon had arranged more than $1.5 billion in undisclosed personal loans and that his largest personal lender was also a major investor in Chesapeake. 15 The company removed McClendon as chairman and cut short a perk that enables him to invest in all of Chesapeake’s wells. The SEC and Chesapeake’s board of directors continue to examine the financial relationship between McClendon and the company. The Board’s stopping McClendon’s participation in wells should allow for a better use of corporate resources where in 2010 and 2011, $3.0 and $3.2 million of company personnel time, respectively, were used by McClendon for his well participation perk. Although there were terms for partial reimbursement, it deepens the intertwining of the personal needs and corporate assets of McClendon and Chesapeake. The latest revelations add to the struggles of a company that already was beleaguered by slumping natural-gas prices and a $16-billion pile of debt—more debt than Exxon Mobil, the largest oil and gas company in the world. McClendon declined an interview request and the company declined to discuss its ongoing internal investigation of McClendon’s business deals or the investigations by the SEC, the Justice Department, and Michigan’s Attorney General. But interviews 14

and a review of public records show that McClendon’s deals with individuals who also did business with Chesapeake continue today. One lender with prominent ties to Chesapeake has required that McClendon put up even more of his property to secure a three-year-old personal loan. McClendon’s personal finances also remain strained. In October 2011, McClendon signed over at least part of his wine collection as collateral on a personal loan from George Kaiser, an Oklahoma financier, according to a document filed in Oklahoma County. The loan originally was backed only by McClendon’s interest in two of his own companies—McClendon Ventures and Chesapeake Investments. In June, McClendon added to the collateral by pledging his collection of oil and gas memorabilia, according to a document filed in Oklahoma County. The October filing calls the latest collateral pledge the “Wine Security Agreement.” The amount financed was not disclosed. The call for additional collateral raises questions about how his financial situation is perceived by an important creditor of both McClendon and Chesapeake. Kaiser is chairman of BOK Financial Corporation, parent company of the Bank of Oklahoma. The bank is among a number of financial institutions that have extended credit to Chesapeake, according to the company’s filings with the SEC. In addition, Goldman Sachs and the private equity unit of the George Kaiser Family Foundation invested $421 million in Chesapeake through a complex deal known as a volumetric production payment (VPP), according to court records and SEC filings. The deal, signed in December 2008, provided cash to Chesapeake in exchange for future oil and gas production from the company’s wells in Oklahoma and Arkansas. “Because of the potential conflicts of interest that have existed prior and still exist at Chesapeake, any dealings that the company has with firms that are also dealing with Aubrey, I think investors have the right to know that,” said JPMorgan oil and gas analyst Joseph Allman.16 15

Chesapeake’s cash crunch, like McClendon’s, is rippling through the company’s operations. Charles Joyce vows that he will never do business with Chesapeake again. Joyce is president of Otis Eastern, a New York-based contractor that laid pipeline for Chesapeake in northern Pennsylvania’s Marcellus shale formation from August 2008 until the fall of 2012. In the summer of 2011, Chesapeake began to fall behind paying its bills, according to documents in a lawsuit filed by Otis on October 9, 2012. By October, the outstanding balance had reached more than $15 million. After months of fruitless demands, Otis sued. It is now in the process of filing liens on Pennsylvania land that was leased by Chesapeake. Chesapeake, the most active driller of new wells in the United States, uses tens of thousands of vendors, from catering companies to drilling firms. Amid complex sales of many of the company’s assets, delays in paying some bills might not be unusual. But Chesapeake also faces a pronounced cash shortage—one that could cause it to conserve cash by delaying payments to vendors. Chesapeake had just $142 million in cash in September 2012, down from $1 billion in June, according to SEC filings. Chesapeake may have transferred the debts owed to contractors to affiliated entities, but the company is still listed as the debtor in the non-payment suits. And the liens filed for nonpayment show up as claims against landowners with whom Chesapeake cut deals. Such liens could interfere with an owner’s ability to sell the property, said Stanley B. Edelstein, a Philadelphia construction law attorney. “Depending on the language in a mortgage, it could be an act of default,” he said.17 In addition to slow payment to vendors, Chesapeake has been accused of other problems. Among the legal hurdles facing the company, one of the most serious is a federal inquiry by the Department of Justice’s Antitrust Division. The probe came after Reuters reported that Chesapeake and Canadian rival Encana Corporation worked to suppress land prices in Michigan in 2010.18 16

Reuters reported that Chesapeake and its competitor Encana had discussed taking measures to avoid bidding against each other for land they hoped to acquire in Michigan.19 The Department of Justice and the Michigan Attorney General are investigating whether Chesapeake, at McClendon’s behest, violated anti-trust laws. Emails reviewed by Reuters suggest the talks between the companies may have been more extensive and detailed than previously reported. The June 2012 Reuters’ exclusive report quoted from internal Chesapeake emails that show top executives of the two companies traded proposals to divide bidding responsibilities for nine private landowners and counties in Michigan. Neither Encana nor Chesapeake would comment on the emails.20 Darren Bush, a former Justice Department anti-trust attorney, said the emails and proposal comments were likely to be “deeply troubling” to Justice Department investigators already examining Chesapeake and Encana communications. 21 The emails and comments show “the purpose is to make sure that they are not bidding each other up,” said Bush, now a professor of anti-trust law at the University of Houston.22 “At some point, they think they can stabilize the prices. And then over time, they can have it decrease.”23 Both Chesapeake and Encana have acknowledged holding talks about forming a joint-venture in Michigan. But the companies say no agreement was ever reached. In September, Encana’s board of directors said an internal investigation found no evidence of wrongdoing by the company. It did not say how it came to that conclusion. The ongoing Justice Department and Michigan Attorney General’s probes have stymied Chesapeake’s plan to sell its Michigan acreage. In June of 2012, the company put up for sale 450,000 acres, for which it says it paid $400 million. A sale was expected by August 31, 2012; however, as of the time of this publication (early March 2013), no prospective buyers have been disclosed. The investigations could take years to resolve, antitrust experts say. They involve the review of thousands of documents 17

and emails and are likely to include interviews with key executives including McClendon. The investigations could necessitate analyses by economists to determine whether the state of Michigan and private landowners incurred losses. McClendon most certainly has. In 2011, Forbes estimated McClendon’s net worth at $1.1 billion. After being reported that McClendon had taken out more than $1 billion in personal loans, he fell off the magazine’s roster of the wealthiest 400 Americans. Forbes now estimates his net worth to be $500 million, less than half of its estimate a year ago.24 Penn Square Bank and Enron were only 20 years apart and both prompted outrage, litigation, and Congressional hearings. Both were variations on the classic oil-patch boom-and-bust story. As a result of Enron and other similarly failed companies of that era, Congress passed the Sarbanes-Oxley Act of 2002 (Pub.L. 107–204, 116 Stat. 745, enacted July 30, 2002), also known as the “Public Company Accounting Reform and Investor Protection Act” (in the Senate) and the “Corporate and Auditing Accountability and Responsibility Act” (in the House of Representatives)—more commonly called Sarbanes-Oxley, Sarbox, or SOX. It is a United States federal law that sets new or enhanced standards for all U.S. public company boards, management, and public accounting firms. As a result of Sarbanes-Oxley, top management must now individually certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Moreover, Sarbanes-Oxley increased the independence of the outside auditors who review the accuracy of corporate financial statements and increased the oversight role of boards of directors. So if Sarbanes-Oxley was the magic antidote to end all corporate governance malfeasance, what lessons did Chesapeake learn? For example, Mr. McClendon consistently has placed longtime friends on the Chesapeake board and showered them with compensation. From 2009 through 2011, Chesapeake paid $13.3 million in total compensation to 10 non-executive board 18

members. By comparison, Exxon Mobil, the world’s third mostprofitable company in 2011, paid 13 non-executive board members $9.9 million during the same period. Mr. McClendon operates a $200-million hedge fund from Chesapeake’s offices as well as AKM Operations and a restaurant owned by him. Chesapeake provides Mr. McClendon with unlimited complimentary secretarial services for his personal ventures and Chesapeake accountants and engineers handled about $3 million worth of personal work for McClendon in 2010.25 In 2011 the documents projected that Chesapeake employees would do about $3.2 million of free gratis work for McClendon. Chesapeake signed a $36 million, 12-year sponsorship deal with the Oklahoma City Thunder NBA team of which McClendon owns a 19-percent stake.26 In 2012, Chesapeake pledged to buy $3 million worth of tickets. McClendon and board members fly free on Chesapeake planes as do McClendon’s friends and family. In 2010, the McClendon’s took at least 75 personal flights on Chesapeakeleased aircraft at an estimated cost of $830,000 to $875,000. 27 Finally, McClendon and the Chesapeake board are notorious for using the shareholder’s funds to overpay for assets. No wonder Forbes magazine dubbed McClendon the “Reckless Billionaire.”28 Today, Chesapeake is not alone in its siege from hedge fund and shareholder activists as several other major companies are confronting the same scrutiny. As with Chesapeake, they face mounting criticism for perceived governance lapses, lack of focus, and irresponsible spending. Welcome to the world of energy boom and bust cycles! During the boom cycles, where rising tides seem to lift all ships, investors often choose to ignore the very same issues that they mount rebellions against during the bust cycles. It is very interesting how weak natural-gas and softening crude oil prices change attitudes in quick order. Oil and gas exploration quickly falls out of favor to be replaced by mergers, acquisitions, and divestures as the investment banker’s new “flavour du jour.” Unfortunately, as the hordes of Baby Boomers began to retire, the limited reserve of talent that has experienced and managed past cyclical tsunamis is beginning to fade away. 19

Sadly, Penn Square and Enron both received abundant accolades from industry peers and investors during their glory years, only to be replaced by rejection and punishment during their demise. Chesapeake’s reputation has been tarnished and its founder and decades-long leader is gone. A new management team will be selected to face the monumental challenges and very difficult and painful decisions that lie ahead. They will assume management of a company that lost 22 percent of its market value in the past year (2012) and recently announced its biggest annual loss since 2009. Hopefully, the seasoned and talented individuals that must be found will possess the appropriate vision and will implement and execute the proper business plan to right the ship and rebuild the former value-creation dynasty of the past. Maybe the lessons of earlier corporate ghosts will be recognized and relearned in 2013 by a new corporate generation—once again! Acknowledgements: Writing about companies such as Penn Square and Enron is easy when they are no longer in business and there are few around to challenge your assertions. However, much of these writers’ opinions and insight derived from being involved, at least peripherally, with all three companies critiqued. As for today, we are seriously hoping for a “new and improved” Chesapeake to emerge from its current seemingly endless entanglements. It has done far too much good for the Oklahoma City community and its absence would be devastating to a well-deserving city and its people. Despite the many corporate governance faults, Chesapeake the corporation has been an excellent corporate citizen and neighbor.

20

NOTES

*J. C. Whorton, Jr., a senior-level energy professional with over 35 years of industry experience, holds a B.A. from the University of Oklahoma and a M.A. from Oklahoma City University. His experience and leadership positions with six Fortune 500 companies has provided him with the opportunity of working with many of the world’s leading energy companies at the executive and board level. Mr. Whorton currently serves as CEO and Director of Pangea Energy Corporation, an international exploration and production company incorporated in British Columbia, Canada. The author was a member of the National Energy Consulting Practices at PA, PricewaterhouseCoopers, Andersen and SunGard, where he was recognized as an international Subject Matter Expert (SME) on strategy, operations, marketing, trading, and risk management. The scope and diversity of his experience allows him to offer multiple perspectives for value creation and companies’ strategic success in increasingly competitive and volatile environments. Mr. Whorton is a registered Commodity Trading Advisor (CTA) with the National Futures Association (NFA) and has held all major trading and principal licenses with the Securities and Exchange Commission (SEC) and Commodities Future Trading Commission (CFTC). He has managed institutional energy trading desks at Prudential Securities and Morgan Stanley and has worked closely with global commodity exchanges as key energy futures and options contracts, such as natural gas and power, have evolved into price risk-management benchmarks. The author has provided strategic insight and market commentary for many of the leading business and financial news and wire services such as Dow Jones, Wall Street Journal, New York Times, McGraw-Hill, and Bloomberg. Mr. Whorton is a well-known and frequently featured speaker on energy and financial topics having made presentations to over 150 conference forums in North America and Europe; he has been a guest lecturer at 10 major North American universities. As an award winning author, Mr. Whorton co-authored the book, Power Play –

21

Who’s in Control of the Energy Revolution? and has contributed more than 40 magazine articles for industry publications Richard S. Shuster is a Registered Professional Engineer (Petroleum) with more than 35 years of experience over a wide spectrum of the oil and gas industry, including major and independent producing companies as well as service and equipment firms. His background includes management, engineering, operations, and business analysis. The author has practical knowledge of emerging and growing companies and has developed specialized financing concepts for large projects. During his career Mr. Shuster has built and/or effected change management strategies for numerous companies such as Grace Petroleum, Kenai Oil & Gas, and Ultra Petroleum Corporation. He also has extensive experience in the recognition of value in distressed properties. As an independent consultant, Mr. Shuster evaluated in excess of $1.2 billion in merger and acquisition transactions and provided negotiation support for his clients’ efforts. He also performed operational due diligence reviews for clients, such as EF Hutton and Coopers & Lybrand (now PricewaterhouseCoopers), and co-created the template for purchasing more than $2 billion in retail natural gas supply using tax-exempt financing. Operationally, in 1996 Mr. Shuster designed and executed the deepest “1 ½ coiled tubing cleanout in the industry at 20,424” as part of his responsibilities in managing a 350-well portfolio for a municipal group, and in 2005 he aggregated operators and co-managed the overall operations of 2,500 gas wells in the Powder River Basin of northeast Wyoming. Currently, Mr. Shuster is the Chief Operating Officer for Pangea Energy Corporation, sits on the boards of TrueStar Petroleum Corporation and Ceiba Petroleo S.A., and is part of the U.S./China Cooperative Zone initiative.
J. C. Whorton, Jr. and Paulette Whitcomb, Power Play: Who’s in Control of the Energy Revolution? (Tulsa, Oklahoma: Pennwell Publishing Corporation, 1998).
1

22

Robert Gregory, Oil in Oklahoma (Muskogee, Oklahoma: Leake Industries, 1976). Phillip L. Zweig, Belly Up: The Collapse of the Penn Square Bank (New York: Ballantine Books, 1985). Mark Singer, Funny Money (New York: Dell Publishing Co., Inc., 1985), p. 188. Bill Barnhardt, “Penn Square Bank,” Chicago Tribune, February 19, 1987.
6 5 4 3

2

J. C. Whorton, Jr. and Paulette Whitcomb, op. cit.

Bethany McLean and Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (New York: Penguin Group, 2003). United States Congress, Joint Committee on Taxation Report on Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1 (Washington D.C.: U.S. Congress, February 2003).
9 8

7

Cathy Booth, “The Enron Effect,” Time Magazine, May 28, 2006.

Phillip L. Zweig, “Learning Old Lessons from a New Scandal,” The New York Times, February 2, 2002. Herman Melville, The Confidence-Man: His Masquerade (New York: Penguin Classics, 1990, first published in 1857). Chesapeake Energy Corporation website, available at http://www. chk.com/. Anna Driver and Brian Grow, “Special Report; Chesapeake CEO Took $1.1 Billion in Shrouded Personal Loans,” Reuters, April 18, 2012, available at http://www.reuters.com/article/2012/04/18/us-chesap eake-mcclendon-loans-id USBRE83H0GA20120418.
13 12 11

10

23

Joe Carroll and Benjamin Haas, “Sinopec’s U.S. Shale Deal Struck at Two-Thirds’ Discount,” Bloomberg, February 25, 2013, available at http://www.bloomberg.com/news/print/2013/02/25/Sinopec -to-buy-chesapeake-oil-and-gas-assets-for-1-02-billion/. Ross Kerber, “Pushing Chesapeake on Governance, by Proxy and Fax,” Reuters, May 11, 2012, available at www.reuters.com/article/20 12/05/11/us-chesapeake-activist-idUSBRE84A12P20120511, and Sam Forgione, “Chesapeake Up Against Low-Key Activist Mason Hawkins,” Reuters, May 11, 2012, available at www.reuters.com/article/2012/ 05/11/us-chesapeake-hawkins-idUSBRE84A14P20120511. Brian Grow, Anna Driver, and Joshua Schneyer, “Chesapeake, McClendon Endure Rocky Year; More Uncertainty Ahead,” The Chicago Tribune, December 27, 2012.
17 16 15

14

Ibid.

Brian Grow, Joshua Schneyer, and Janet Roberts, “Special Report: Chesapeake and Rival Plotted to Suppress Land Prices,” Reuters, June 25, 2012, available at http://www.reuters.com/article/2012/06/25/ us-chesapeake-land-deals-idUSBRE85O0EI20120625.
19

18

Ibid.

Brian Grow, Joshua Schneyer, and Janet Roberts, “Exclusive: Chesapeake, Encana Plotted to Suppress Land Prices: Documents,” Reuters, June 25, 2012.
21

20

Ibid. Ibid. Ibid.

22

23

“Forbes 400 List Dropoffs,” Forbes, and Brian Grow, Anna Driver, and Joshua Schneyer, “Chesapeake, McClendon Endure Rocky Year; More Uncertainty Ahead.”

24

24

John Shiffman, Anna Driver and Brian Grow, “The Lavished and Leveraged Life of Aubrey McClendon,” Reuters, June 7, 2012, available at www.reuters.com/article/2012/06/07/us-chesapeake-mcclendonprofile-idUSBRE8560IB20120607.
26

25

Ibid. Ibid.

27

Agustino Fontevecchia, “Ex-Billionaire McClendon out at Chesapeake over Differences with Board,” Forbes, January 29, 2013, available at www.forbes.com/sites/afontevecchia/2013/01/29/billionaire-mccl endon-out-at-chesapeake-over-differences-with-board/.

28

25