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CFO Report: Chesapeake Energy Corporation Essay (Critical Writing)

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Updated: May 9th, 2022

Introduction

Chesapeake Energy Corporation is among the largest producers of natural gas, oil, natural gas liquid, and a driller of new wells in the US (Chesapeake Energy Corporation, 2012). It has large stakes in many companies across the US. It also has subsidiaries, which conduct most of its business and marketing activities.

This report looks at corporate governance, analysis of financial statement in annual reports using forensic financial analysis approaches and provides policy recommendations for the company.

The company has a long-term problem of corporate governance, which has affected its performance in the stock exchange as traders react to questionable acts of the CEO (Chief Executive Officer). This implies that Chesapeake’s Board of Directors has “not been effective in formulating policies and controlling the company” (Chesapeake Energy Corporation, 2012).

CEO’s questionable activities

The company has experienced some serious corporate governance issues in the past involving the CEO. According to Reuters, the CEO had “borrowed $1.1 billion against his investments in the company’s wells over the past three years” (Putnam, 2012). The CEO then proceeded to make a personal investment of “up to 2.5 percent and used these investments as collateral to take out loans from the same company that issued loans Chesapeake” (Putnam, 2012).

This was a clear case of conflict of interest in the company. It is also worth noting that the company failed to disclose these transactions to its shareholders. Consequently, such transactions affected the company share prices because of failure to disclose them. The company also has troubles with its $10.5 billion net debt. Currently, Chesapeake has cash shortfall that has forced it to “trade-off some of its assets and turn to issue additional $2 billion from the stock” (Putnam, 2012). Such actions have raised the curiosity of SEC (Securities and Exchange Commission) and possible lawsuits from shareholders.

Chesapeake has records of questionable financial transactions, which have negative consequences on shareholders’ returns. For instance, the company allowed a special bonus to bail out the CEO in 2008 and bought the CEO’s collection of maps to ease his fiscal crisis.

Assessment of Corporate Governance

Corporate governance refers to “the relationship among the Board of Directors, top management, and shareholders in determining the direction and performance of the corporation” (Wheelen and Hunger, 2012). Investors do not have any role in operation of the company. However, they have claims on the company’s profits. It is the role of the management team to run the company. Shareholders have limited liability and limited involvement in corporate activities. However, they have the right to choose directors who have legal rights to protect interests of shareholders and represent them. Thus, directors are legal representatives of investors. This gives them power and the responsibility to set up corporate policies and ensure that top management follow such policies.

The authority of the Board of Directors allows it to approve all decisions that may have long-term impacts on activities and operation of the company. This implies that the board of directors has “control over company as it oversees the top management with agreements of investors” (Wheelen and Hunger, 2012).

The Role of the Board of Directors

The company’s Board of Directors has failed in corporate governance leading to questionable acts of the CEO and undisclosed financial transactions. Therefore, the Board of Directors must clearly redefine its roles and formulate new policies for effective corporate governance.

It must oversee activities of the senior management. In this area, the Board works, consults, advises, and monitors activities of the top management team. The Board must act with complete honesty and integrity and ensure that the top management team also adheres to the same standards.

The Board must formulate policies that ensure honesty, accountability, and openness between its members and top management team. This must promote a culture of integrity among all stakeholders of the company. The Board must review all policies as new challenges emerge. It must also not grant any waiver of the code to any senior management of the company.

Composition of the Board

The Board must have many directors as the company’s rule states. The company must conduct an annual election of directors. All directors must meet conditions and rules of the company, SEC, New York Stock Exchange, Federal, and State requirements. The Board must represent interests of investors, uphold unquestionable standards of integrity, and demonstrate independent thoughts and judgment.

Directors must allocate adequate time to oversee the operation and performance of the company. The best composition of the Board must have directors with various skills, knowledge, talents, and experiences. These skills include business leadership, government or public policy, corporate governance, international, energy consumption, legal, energy production or distribution, risk management, financial expertise, and technology.

The Board will also have the Emeritus Director from its former members to act as an advisor to directors of the company. The full Board must decide on important policies, actions, and recommendations. The Board must act within its mandate based on SEC Act of 1934 and meet all requirements of SEC.

The company’s Board election shall take place by majority voting. All directors have equal opportunities to participate in the election. The company’s bylaws support uncontested election of directors by shareholders. Therefore, candidates who receive majority votes become the Board of Directors.

Responsibilities of the Board

The Board must meet at “appropriate times every year in order to discharge it duties” (Chesapeake Energy Corporation, 2012). The quorum of the meeting depends on the number of directors in attendance. These members have the mandate to pass a resolution on any matter before them. All directors have the responsibility to attend all the meetings unless there are specific reasons for absenteeism. These duties require directors to have adequate time in order to conduct them effectively.

Directors must practically depend on “honesty and integrity of fellow directors, the company’s top management, advisors, and auditors when discharging their duties to the company” (Chesapeake Energy Corporation, 2012). Thus, directors have benefits of indemnification as the law permits, and company’s liability insurance. The crucial responsibilities of the directors include:

  • Setting corporate strategy, agenda, general direction, mission, or vision
  • Hiring and dismissing the CEO and senior management
  • Controlling, monitoring, or overseeing senior management’s activities
  • Reviewing and approving the use of resources
  • Considering investors’ interests

The Board’s Committee

The Board must have various committees such as “Standing Audit, Compensation, and Nominating and Corporate Governance Committees” (Wheelen and Hunger, 2012) to conduct various functions in their areas. The committee members must meet all requirements as the Board demands.

The committee must keep a charter with all its purposes, structures, and functions. This charter enables the Board to evaluate performance of the committee annually. The committees can also get advice and help from various sources from both internal and external bodies like accounting, legal, auditors, and other advisors based on their needs. The chair of the committee sets the meeting and determines their frequencies based on the charter.

Resources of the Board

The Board must have “free resources and gain access to various resources in the company” (Chesapeake Energy Corporation, 2012). Therefore, the Board and its committees may ask for “legal, financial, accounting or other expert advice from sources independent of management to the level deemed essential or suitable” (Chesapeake Energy Corporation, 2012).

Compensation of the Board

Compensation team shall establish, recognise, and review the directors’ compensation regularly. This compensation shall act as the sole fees for the Board and its committees based on services provided.

Directors’ compensation may consist of cash, options to purchase the company’s common stock, awards of the company’s common stock, the right to take part in the company’s deferred compensation opportunities or a combination of these compensation options as the Compensation Committee decides. The Board feels that most of the directors’ yearly retainer should be in a form of equity of the company.

Setting the management of the company and its succession plan

The Board’s compensation team has the responsibility of reviewing the company’s senior management together with the CEO in order to ensure succession by qualified executives of the company and its subsidiaries. This process must also account for various strategies for reviewing and nominating possible successors.

It should be the responsibility of the nominating and corporate governance team to seek for, nominate, review, and rate potential successors of the CEO and other senior executives. The CEO must also recommend his candidates.

Directors Orientation

The company must engage all directors in continuous orientation and education processes to make them familiar with their roles and responsibilities to the organisation and its shareholders. The Board must supply all directors with necessary documents with all the required policies, bylaws, code of conducts, business ethics, insider trading policies, confidentiality requirements and other important aspects of the Board’s functions.

All directors must meet with top executives of the company to review strategic business plan, financial position and its strategies, operational approaches, and objectives of the company.

The Board must encourage all directors to take part in programmes and training. This provides opportunities to allow board members comprehend and carry out their duties as directors. The company may create such programmes internally or may use externally created training materials. The company shall compensate all directors for “reasonable costs incurred because of attending such programmes” (Chesapeake Energy Corporation, 2012).

Evaluation of performances

The Board, with support from the nominating and corporate governance team, must carry out an evaluation of the Board’s performance every year. The Board also has the mandate to review performance indicators periodically as it deems fit. Performance evaluation is necessary to identify progress of the company on corporate governance and areas that need changes.

The relationship with stakeholders

The Board must allow senior management to represent the company. The CEO is in charge of establishing effective communication links with the company’s stakeholder such as “shareholders and other investors, customers, employees, local communities, suppliers, creditors, federal, state and local governments and non-governmental organisations, legislators and regulators, research analysts, the media, and other corporate partners” (Wheelen and Hunger, 2012). This process creates accountability and transparency in the organisation.

However, the company must establish effective communication channels with all stakeholders. Therefore, all forms of communications must follow established procedures such as “clearing the subject matter with responsible committee and reporting the outcome of such communication to the management” (Wheelen and Hunger, 2012).

Protecting Documents

The Board must ensure that all its governing documents conform to provisions in the law, company’s certificate of incorporation, and other bylaws. Therefore, it must avert any case of conflict using the State applicable laws, bylaws, provisions in the certificate of incorporation, corporate governance requirements, and the committee charter.

The principles of corporate governance must assist the Board governing the corporation by providing a flexible framework in which the Board and its committee may work. However, such principles depend on other guiding laws of the company and the State.

The Board must disclosure its corporate governance principle to all stakeholders through permanently and readily available sources. The company may use its Web site to display such information to interested partners.

Improving Corporate Governance by complying with the Sarbanes-Oxley Act of 2002 and Dodd-Frank Act of 2010

Given the rising cases of financial scandals in major corporations and consequences of the financial crisis of 2008, it is appropriate for the company to align its corporate governance principles with the Sarbanes-Oxley Act of 2002 and Dodd-Frank Act of 2010. These Acts shall protect the current and uncontrolled excesses of the CEO. They will also make the Board independent from external interference.

One major challenge Chesapeake faces today is the loan granted to the CEO. This implies that the company’s Board failed to align its corporate principles with the Sarbanes-Oxley Act. The Act prohibits granting of loans to senior executives by the Board. The Act also gives the whistleblower procedures and channels of reporting questionable auditing and financial transaction. In addition, it also protects a whistleblower from any form of retaliation from the company.

The CEO and CFO (Chief Finance Officer) must certify all documents with financial data of the company. At the same time, the same auditor cannot provide both internal and external auditing services to the company. Chesapeake must also have independent financial experts in the audit team.

Chesapeake must comply with the new disclosure requirements on financial activities. The company will not postdate any CEO’s or any other executives’ stock options.

The company must disclose its code of ethics as the Act requires under the provision of SEC. the company must ensure that its Board of Directors in the Committee of Nominating and governance have independent outside directors as the New York Stock Exchange requires under the Sarbanes-Oxley Act. The company must also satisfy NASDAQ requirements under “nomination of new directors by the majority of the independent outside directors” (Dodd-Frank Act, 2010).

Chesapeake must align its corporate governance principles with the Dodd-Frank Act of 2010. This Act aims to create sound economic foundation to protect “shareholders, consumers, rein in activities of the Wall Street and huge bonuses of executives” (Dodd-Frank Act, 2010).

The company must restore accountability, responsibility, and transparency in its financial systems so that stakeholders can develop confidence in the company.

The company must create a warning system as a part of its corporate governance principles. In this context, Chesapeake must create a committee to identify and review potential risks from complex and large financial activities. The company did not have such a system before to detect action of the CEO and his loans.

Chesapeake must establish transparent and accountable process in its relationship with the lenders. For instance, the same company that awarded the company the loan also approved the CEO’s loan without proper procedures. Such practices are abusive, risky, and usually unnoticed.

The Act recommends that shareholders should have inputs on corporate governance and executive compensation packages. Thus, shareholders must vote to approve some of their packages and corporate affairs. At the same time, it also requires corporate governance practices to protect shareholders through transparent and accountable processes.

The corporate governance should also guard against cases of fraud, conflicts of interests as witnessed in the company in the past years. Therefore, Chesapeake must comply and enforce all laws and bylaws governing its operation (Dodd-Frank Act, 2010).

Forensic Financial Analysis

Schilit and Perler refer to “financial shenanigans as actions or omissions designed to hide or distort the actual financial performance or financial condition of a company” (Schilit and Perler, 2010). These omissions and actions are not easy to detect with the normal auditing practices. As a result, Chesapeake must rely on a forensic financial analyst. Core skills of forensic financial analyst must include skills to carry out computer forensic analysis, fraud detection, prevention and response, forensic analysis, valuation, damage claims calculation, and financial statement analysis, appraisal and valuation among others.

Schilit and Perler identified core areas of shenanigans every forensic financial analyst must concentrate on when performing an analysis of a company’s annual reports. These include, “recording revenue too soon, bogus revenue, boosting income with one-time gains, shifting current expenses to a later or earlier period, failing to disclose all liabilities, shifting current income to a later period, and shifting future expenses into the current period” (Schilit and Perler, 2010). Apart from these actions, there are also other actions and practices worth investigating. They include losses from business interruption, lost profits, personal claims to injuries, loss of use, business appraisal and valuation processes.

Failing to disclose all liabilities

One of the prominent financial issues involving Chesapeake is the failure to “disclose the CEO’s $1.1 billion loan for the last three years” (Putnam, 2012). The CEO used his shares in the company’s wells to back the loan. Neither the company nor the CEO disclosed the loan to investors. This is a conflict of interest between the CEO and the company. Reuters discovered that the CEO borrowed the funds to “aid his acquisitions of shares at the wells” (Putnam, 2012).

According to Chesapeake, the disclosure does not apply in this case. First, Chesapeake argues that the loan transactions are in a private equity company. Consequently, SEC’s law on related party deals does not apply. Second, the company maintains that investments at the wells are business interests. Consequently, they are not under the investment law. However, SEC requires companies to report such pledges executives make using the company’s stock as collateral. SEC has not confirmed these claims.

Chesapeake also has liabilities amounting to $1.4 billion. The company did not disclose these liabilities to shareholders. These liabilities originated from some financial transactions that never formed a part of Chesapeake’s balance sheet. In addition, the company has been losing revenues due to low prices of natural gas. The company also recorded a decrease in earnings per share from 75 cents of the previous year to 18 cents in 2012.

The Wall Street Journal noted that Chesapeake “owes $300 million this year and $270 million next year” (Putnam, 2012). Analysts have predicted that, between 2014 and 2012, the company shall owe another $800 million. They believed the company would incur liabilities. However, they only provided an estimate and pegged it at $600 million. This figure turned to be half of the real amount.

The company also made several long-term commitments regarding delivery of some natural gas to Wall Street banks. These have also created liabilities for Chesapeake. This year, Chesapeake reported a debt increment of $2.46 billion. At the same time, the company announced $71 million of losses in the last quarter.

These extra liabilities and questions regarding accounting principles of the company have made the company’s stocks to fall as investors reacted to such information.

There are also cases of failure to disclose or partial disclosure of fractured wells. According to FracFocus.org, the company did not inform shareholders about the conditions of the fractured wells. The table below shows fractured wells and rates of disclosure.

FracFocus Reporting Rates

Bogus revenues and accounting practices

Analysts believe that the company presents its financial statements on a positive note. According to GMI Ratings, the company has a score of six. This reflects high percentage of corporate and accounting risks in the company as compared to its competitors. In June 2011, GMI Ratings showed that the company used aggressive accounting procedures to prepare its statements. The CEO can exploit this system to gain extra incentives from the company.

In September 2012, the company revised its estimates on values by more than two billion dollars within three months. The revision on losses were almost $2.1 billion against $879 of the same period in the previous year. The company has spent more money on operation than it revenues in the third quarter of 2012. This may indicate a serious financial problem with the company.

The company’s accounts receivable reflects an abnormal gain of more than 20 percent compared to the same prediction of the year 2011, March. This number is more than the average industry figure of 15.9 percent. This may indicate that the company has problems of revenue recognitions.

Using one-time gains to boost income

On November 1, 2012, Chesapeake published its operational and financial results for the third quarter of 2012. The company had a net loss in common stockholders of $3.19 per share or $2.1 billion of completely diluted share on income of three billion dollars. Chesapeake also adjusted net income of common stockholders to $0.10 per share equivalent to $33 million. It also had operating cash flow of $1.1 billion with adjusted Ebitda of one billion dollars. These adjustments resulted into sequential increment in cash flow of 25 percent and 27 percent for adjusted Ebitda.

However, Chesapeake results had items, which are usually not included in the published financial results. If these items were not part of the financial results, then the results would be different considering net income of common stockholders of $0.1 per share and Ebitda of one billion dollar. These would be the results:

  • There would be noncash after tax charges of two billion dollars concerning carrying value of oil and natural gas properties. This will result into ten percent decrease when we take the average gas price until the end of the third quarter (September 30, 2012). In addition, the company had not developed the DJ Basins and Williston to leasehold.
  • The company had $63 million as unrealised noncash after-tax mark-to-market loss. These came from interest rate hedging programmes, natural gas liquids, and natural gas.
  • There were also losses resulting from impairment of given fixed assets amounting to $28 million as an after-tax charge.
  • Finally, there was $19 million from the sale of investment as a net after-tax gain.

Reconciliations of the statement with reviews on “Ebitda, adjusted Ebitda, and cash flow using generally accepted accounting principles gives different results” (Chesapeake Energy Corporation, 2012).

However, in Form 10-K filed with SEC, the company gave a long list of factors, which may influence such results.

Tendencies to shift or manipulate dealings and transactions

Some shareholders like Gilberta S. Norris believe that the company has wasted several resources in top executives and board members usages of corporate jets for personal reasons. This has contributed to rising costs of operation. In this matter, the company reported that it had spent almost $14 million between 2007 and 2011 in executives’ flights using company planes. However, some attorneys claim that undisclosed sum in internal statements amount to $10 million or more every year.

An investor filed the lawsuit against the company on behalf of investors who “purchased Chesapeake Energy Corporation stock pursuant to the registration statement and prospectus (collectively, the “Registration Statement”) filed with the SEC in connection with Chesapeake’s July 2008 secondary offering” (Putnam, 2012). According to this lawsuit, the company disregarded federal securities laws. The lawsuit maintained that Registration Statement that Chesapeake issued was wrong and false because it did not disclose the following. First, the company did not adequately address its exposure to natural gas price declines based on its hedging activities before the offering. Second, the company initiated hedging contracts with Lehman Brothers. Lehman Brothers acted as an underwriter in the offering. However, Chesapeake knew that the company was experiencing rapid decline and would not be able to meet it financial commitment in the offering. Third, the lawsuit also claimed that before the company offered stocks, it had engaged in aggressive hedging strategies in order to increase its price of natural gas and stocks. Fourth, the company’s lease brokers engaged in aggressive bidding in order to increase prices the company was to pay in royalty agreement and leases. Finally, the company did not “write down impaired goodwill on the assets it was acquiring” (Putnam, 2012).

In September 2011, Robyn Coffey from Taxes filed a federal class action lawsuit against the company’s subsidiaries. She claimed that Chesapeake “manipulated royalty owners in transaction involving methane gas-rich Barnett Shale” (Putnam, 2012). According to Robyn Coffey, Chesapeake owes “more than $5 million to royalty owners because of the way the company had calculated payments to them” (Putnam, 2012). The lawsuit indicates that the company did not pay “royalty owners based on the full market value of the natural gas” (Putnam, 2012). Instead, the subsidiary transferred the gas under “a fictitious price” to Chesapeake. This price was lower than the usual price the company pays when dealing with other purchasers.

The company also relies on 1916 rule when paying taxes. The rule allows energy and gas producers to “postpone income taxes in recognition of the inherent risk because the wells may be dry” (Chesapeake Energy Corporation, 2012). For instance in 2012, the company made $5.5 billion in pretax profits. However, it only paid $53 million (one percent) in tax. Bloomberg claims that this is an outdated practice because of ‘fracking technologies’, which enable the company to detect risks of dry wells. This implies that Chesapeake may be using this rule to evade or postpone tax responsibilities.

Executives Compensation

The Board and Directors and the forensic financial analyst must review executive compensation at Chesapeake. For instance, in 2008, the Board of Directors on compensation awarded “the CEO a bonus of $77 million while the stock fell by 60 percent” (Chesapeake Energy Corporation, 2012). The company compensation and incentive programmes hurt shareholders’ returns. In 2012, the company added new elements to its extensive compensation plan.

The Compensation Committee claims that such structures are competitive with relative to the company peers. These compensations depend on the company’s performance. Since shareholders moved to express their grievances, the Compensation Committee has moved to rein in CEO’s pay scales by capping them at given scales.

In 2011, the company reduced the CEO’s award from restricted stock compared to the previous year. Since 2006, the Compensation Committee has restricted “the CEO’s salary at $975,000 and shall remain so until 2013” (Chesapeake Energy Corporation, 2012). In addition, the CEO’s bonus may not “exceed $1,951,000 until 2013” (Chesapeake Energy Corporation, 2012). However, the CEO sits on the Compensation Committee. This may explain the conflict of interests in the company, purchase of map collections, and ‘all other compensations’. ‘All other compensations’ are part of the contested flight costs with undisclosed costs. This Board has not been effective in controlling the CEO’s earnings despite the falling stock.

Source: Chesapeake Energy Corp - Form 10-K/A - April 30, 2012
Source: Chesapeake Energy Corp – Form 10-K/A – April 30, 2012

Policy recommendations

Investors face constant threats from poor corporate governance at Chesapeake. Investors can only withdraw from such risky investment at Chesapeake by analysing the prevailing stock prices of the company. Investors are not responsible for poor corporate governance at the company. However, they must insist that the Board of Director must create a stable company.

In order to build such corporate governance, shareholders must insist on the use of forensic accounting when analysing the company’s financial statements, communications, dealings, and transactions. The investors can rely on forensic accounting for revealing illegal accounting practices at the company.

For many years, the company has experienced challenges with corporate governance. The Board of Directors is unable to control the CEO’s questionable transactions. Therefore, the company needs reliable, independent, qualified, and experienced directors to oversee the company’s activities.

There is also a major problem with executives’ compensation and incentive plan. SEC, shareholders, and directors have not been effective in policing this kind of compensation and incentive at Chesapeake. In most cases, normal accounting techniques cannot detect such anomalies. Therefore, forensic auditors must be able “to collect and analyse data to detect deficient controls, duplicated effort, extravagance, fraud, or non-compliance with laws, regulations, and management policies” (Wheelen and Hunger, 2012).

References

Chesapeake Energy Corporation. (2012). Web.

Dodd-Frank Act. (2010). Dodd-Frank Wall Street Reform and Consumer Protection Act. Washington, DC: The US Government Printing Office.

Putnam, D. (2012). Chesapeake Energy clipped by corporate conflict. Web.

Schilit, H. and Perler, J. (2010). Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (3rd ed.). New York: McGraw-Hill.

Wheelen, T. and Hunger, D. (2012). Strategic management and business policy: toward global sustainability (13th ed.). New York: Pearson Education.

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