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48

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

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

INTERNATIONAL RESEARCH CENTER FOR ENERGY

AND ECONOMIC DEVELOPMENT (ICEED) 850 Willowbrook Road

Boulder, Colorado 80302 U.S.A.

Telephone: (303) 442-4014

Fax: (303) 442-5042

Email: iceed@colorado.edu

Website: http://www.iceed.org

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 con-

demning 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 institu-

tions 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 enter-

prise is a sole proprietor, the goal must be to make the sole proprie-

tor money. If the company is public, all employees must endeavor

to create value for the shareholders. Exactly how this is accom-

plished is a function of the role the individual plays in the entity.

2

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 Insur-

ance 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 seri-

ous corporate governance and financial issues that must be ad-

dressed 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 found-

ers and managed and governed as though they are still a privately-

held 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, Okla-

homa, with very grandiose plans. The bank’s owner and founder,

3

William P. “Beep” Jennings, wanted the bank to become the prem-

ier 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, risk-

management 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 North-

east, foreign loans to South America—all were experiencing sig-

nificant 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 high-

risk 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 fi-

nancial 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 mil-

lions of dollars in lending agreements that got scrawled on cock-

tail 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 energy-

lending chief, loved to entertain the larger international banks’

4

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 De-

posit (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 resolu-

tions 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 inves-

tigations by the FDIC after the failure uncovered more than 450

possible criminal violations including fraud and insider transac-

tions.4 An article in the Chicago Tribune Business Section on

February 19, 1987, stated that “former senior officers of Conti-

nental 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 ac-

counting 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.

5

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 money-

center 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 ma-

jority—were called, leaving all energy lenders scrambling to re-

finance 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 Okla-

homa 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 in-

terconnected 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 be-

gan to fall. Economic recessions in oil-consuming nations, con-

servation 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

6

States. Needless to say, energy lending was no longer in vogue.

Upstream exploration and production capital dried up and van-

ished. 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, cowboy-

entrepreneurial image, it simply lost most of the talent across the

board to deliver the hydrocarbons that the world’s industrial ma-

chine 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 suf-

fered 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 bank-

ruptcy 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 In-

novative 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, sys-

tematic, and creatively planned accounting fraud, known as the

7

“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 dis-

solution of the Arthur Andersen accounting firm—which had giv-

en Enron a clean bill of health through its audits—and an

immediate meltdown of energy merchant trading activities by oth-

ers 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 in-

terstate 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 me-

dia 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 investiga-

8

tion into investment partnerships led by Fastow. That investiga-

tion would later show that a complex web of partnerships was de-

signed 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 pro-

tection in the biggest case of bankruptcy in the United States up to

that point. (Lehman Brothers collapse would later steal that dubi-

ous 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 manipu-

lation, and the hazards of rubber-stamp boards. At Penn Square,

Mr. Patterson and other executives ran circles around a board con-

sisting of a retired Air Force general, a local car dealer, a physi-

cian, 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 & Compa-

ny (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 bal-

ance sheet, which contributed to its demise. Penn Square issued

millions of dollars in letters of credit, which can be legally count-

ed off the balance sheet, to enable doctors and dentists to buy into

an array of limited partnerships sponsored by its oil and gas cus-

tomers. When the partnerships failed, these investors defaulted on

their loans.

Moreover, both Enron and Penn Square played prominent polit-

ical roles. Whether Enron’s millions in contributions to politicians

9

and political parties bought regulatory forbearance that enabled it

to delay its day of reckoning remains unclear. But in both instanc-

es, 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 lit-

tle 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 genera-

tional 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 analo-

gies among Penn Square Bank, Enron, and more recently Chesa-

peake, are many and quite disturbing: failed forecasts, unbridled

growth, off-balance sheet transactions, questionable accounting

practices, excessive political lobbying and donations, self-

dealing by senior management, poor corporate governance prac-

tices, 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 extraor-

dinaire 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.

10

The Chesapeake Campus has its own doctors, dentists, chap-

lains, 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 archi-

tecture 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 siza-

ble 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 Man-

aged Oil-and-Gas Company” in 2007 and it was named to For-

tune 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 re-

ceived 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

11

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 Pro-

ducer 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 com-

pany 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. Dur-

ing this time, the company expanded its land positions into un-

conventional 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 Haynes-

ville 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, per-

haps 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

12

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 esca-

lation. 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 posi-

tion as CEO. Dunham, who retired as chairman of ConocoPhil-

lips 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 Ex-

ecutive 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 doc-

uments 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.

13

The company disagreed that this was a conflict of interest or a vio-

lation 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. Ad-

ditionally, 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 sec-

ond-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 Okla-

homa and Kansas border to China’s Sinopec for $1.02 billion, ap-

proximately 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 for-

mation. 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 cash-

flow deficit aggravated by low prices for natural gas, which ac-

counts for about 80 percent of the company’s output. Chesapeake

14

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 fail-

ing 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 Chesa-

peake’s wells. The SEC and Chesapeake’s board of directors con-

tinue 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, re-

spectively, 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 as-

sets 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 McClen-

don’s business deals or the investigations by the SEC, the Justice

Department, and Michigan’s Attorney General. But interviews

15

and a review of public records show that McClendon’s deals with

individuals who also did business with Chesapeake continue to-

day. 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 Octo-

ber 2011, McClendon signed over at least part of his wine collec-

tion 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 Chesa-

peake 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 com-

pany of the Bank of Oklahoma. The bank is among a number of

financial institutions that have extended credit to Chesapeake, ac-

cording 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 Ches-

apeake 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

16

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 presi-

dent of Otis Eastern, a New York-based contractor that laid pipe-

line 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 pay-

ing 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 de-

mands, 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 compa-

nies to drilling firms. Amid complex sales of many of the com-

pany’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 contrac-

tors to affiliated entities, but the company is still listed as the

debtor in the non-payment suits. And the liens filed for non-

payment 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 De-

partment 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

17

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 Depart-

ment of Justice and the Michigan Attorney General are investi-

gating 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 pre-

viously reported. The June 2012 Reuters’ exclusive report quot-

ed from internal Chesapeake emails that show top executives of

the two companies traded proposals to divide bidding responsi-

bilities 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 compa-

nies say no agreement was ever reached. In September, Encana’s

board of directors said an internal investigation found no evi-

dence of wrongdoing by the company. It did not say how it

came to that conclusion.

The ongoing Justice Department and Michigan Attorney Gen-

eral’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 ex-

perts say. They involve the review of thousands of documents

18

and emails and are likely to include interviews with key execu-

tives including McClendon. The investigations could necessitate

analyses by economists to determine whether the state of Michi-

gan and private landowners incurred losses.

McClendon most certainly has.

In 2011, Forbes estimated McClendon’s net worth at $1.1 bil-

lion. 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 sto-

ry. 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 Repre-

sentatives)—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 fi-

nancial information. In addition, penalties for fraudulent finan-

cial 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 corpo-

rate 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

19

members. By comparison, Exxon Mobil, the world’s third most-

profitable company in 2011, paid 13 non-executive board mem-

bers $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 unlim-

ited complimentary secretarial services for his personal ventures

and Chesapeake accountants and engineers handled about $3 mil-

lion 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 Chesapeake-

leased 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 cy-

cles. It is very interesting how weak natural-gas and softening

crude oil prices change attitudes in quick order. Oil and gas explo-

ration quickly falls out of favor to be replaced by mergers, acquisi-

tions, 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 man-

aged past cyclical tsunamis is beginning to fade away.

20

Sadly, Penn Square and Enron both received abundant acco-

lades from industry peers and investors during their glory years,

only to be replaced by rejection and punishment during their de-

mise.

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 manage-

ment 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 im-

proved” Chesapeake to emerge from its current seemingly end-

less 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 corpo-

rate governance faults, Chesapeake the corporation has been an

excellent corporate citizen and neighbor.

21

NOTES

*J. C. Whorton, Jr., a senior-level energy professional with

over 35 years of industry experience, holds a B.A. from the Uni-

versity of Oklahoma and a M.A. from Oklahoma City Universi-

ty. 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 execu-

tive and board level. Mr. Whorton currently serves as CEO and

Director of Pangea Energy Corporation, an international explora-

tion and production company incorporated in British Columbia,

Canada. The author was a member of the National Energy Con-

sulting 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 Commodi-

ties Future Trading Commission (CFTC). He has managed insti-

tutional energy trading desks at Prudential Securities and Morgan

Stanley and has worked closely with global commodity ex-

changes as key energy futures and options contracts, such as nat-

ural gas and power, have evolved into price risk-management

benchmarks. The author has provided strategic insight and mar-

ket 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 fi-

nancial topics having made presentations to over 150 conference

forums in North America and Europe; he has been a guest lectur-

er at 10 major North American universities. As an award win-

ning author, Mr. Whorton co-authored the book, Power Play –

22

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 (Pe-

troleum) with more than 35 years of experience over a wide

spectrum of the oil and gas industry, including major and inde-

pendent producing companies as well as service and equipment

firms. His background includes management, engineering, oper-

ations, and business analysis. The author has practical

knowledge of emerging and growing companies and has devel-

oped specialized financing concepts for large projects. During

his career Mr. Shuster has built and/or effected change manage-

ment strategies for numerous companies such as Grace Petrole-

um, 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 PricewaterhouseCoop-

ers), 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 Cor-

poration, sits on the boards of TrueStar Petroleum Corporation

and Ceiba Petroleo S.A., and is part of the U.S./China Coopera-

tive Zone initiative.

1 J. C. Whorton, Jr. and Paulette Whitcomb, Power Play: Who’s in

Control of the Energy Revolution? (Tulsa, Oklahoma: Pennwell Pub-

lishing Corporation, 1998).

23

2 Robert Gregory, Oil in Oklahoma (Muskogee, Oklahoma: Leake

Industries, 1976).

3 Phillip L. Zweig, Belly Up: The Collapse of the Penn Square Bank

(New York: Ballantine Books, 1985).

4 Mark Singer, Funny Money (New York: Dell Publishing Co., Inc.,

1985), p. 188.

5 Bill Barnhardt, “Penn Square Bank,” Chicago Tribune, February

19, 1987.

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

7 Bethany McLean and Peter Elkind, The Smartest Guys in the

Room: The Amazing Rise and Scandalous Fall of Enron (New York:

Penguin Group, 2003).

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

10

Phillip L. Zweig, “Learning Old Lessons from a New Scandal,”

The New York Times, February 2, 2002.

11

Herman Melville, The Confidence-Man: His Masquerade (New

York: Penguin Classics, 1990, first published in 1857).

12

Chesapeake Energy Corporation website, available at http://www.

chk.com/.

13

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.

24

14 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/.

15

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.

16

Brian Grow, Anna Driver, and Joshua Schneyer, “Chesapeake,

McClendon Endure Rocky Year; More Uncertainty Ahead,” The Chi-

cago Tribune, December 27, 2012.

17

Ibid.

18

Brian Grow, Joshua Schneyer, and Janet Roberts, “Special Re-

port: 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

Ibid.

20

Brian Grow, Joshua Schneyer, and Janet Roberts, “Exclusive:

Chesapeake, Encana Plotted to Suppress Land Prices: Documents,”

Reuters, June 25, 2012.

21

Ibid.

22

Ibid.

23

Ibid.

24

“Forbes 400 List Dropoffs,” Forbes, and Brian Grow, Anna Driver,

and Joshua Schneyer, “Chesapeake, McClendon Endure Rocky Year;

More Uncertainty Ahead.”

25

25 John Shiffman, Anna Driver and Brian Grow, “The Lavished and

Leveraged Life of Aubrey McClendon,” Reuters, June 7, 2012, availa-

ble at www.reuters.com/article/2012/06/07/us-chesapeake-mcclendon-

profile-idUSBRE8560IB20120607.

26

Ibid.

27

Ibid.

28

Agustino Fontevecchia, “Ex-Billionaire McClendon out at Chesa-

peake over Differences with Board,” Forbes, January 29, 2013, availa-

ble at www.forbes.com/sites/afontevecchia/2013/01/29/billionaire-mccl

endon-out-at-chesapeake-over-differences-with-board/.