Corporate Governance

The Need for Broader Federal Preemption of Executive Compensation Decisions

By J. Robert Brown

We have long noted on this Blog that the Delaware model of corporate governance does not provide any meaningful limitations on executive compensation.  We have likewise noted that while a number of federal reforms have been adopted, they have a limited horizon.  They only apply to TARP companies and they expire once the TARP funds are repaid.  We have, as a result, called for broader reform that would apply to all companies, not just those receive funds under TARP.

With that in mind, we turn to an example that helps illustrate the point:  Chesapeake Energy Corporation.   The Company has seen a precipitous decline in share prices, with prices plummeting from over $60 in the summer of 2008 to about $20 currently (the price closing at $20.29 on April 27).  Despite the drop, the CEO was paid an eye popping $100 million.  According to the Preliminary Proxy Statement:

How did the board arrive at the compensation package?  Most of it was the $75 million bonus labeled a  "cost incentive award".  The amount also included $648,096 for personal use of the aircraft, $438,750 in retirement contributions and $131,226 for "engineering" support.  What does that mean?  Apparently personal use of Chesapeake's engineering staff.  According to the Preliminary Proxy Statement:  

• This column represents Mr. McClendon's utilization of certain of the Company's reservoir engineering staff to provide reserve data and analysis related to personal financing transactions entered into by Mr.McClendon with respect to certain of his interests in the Company's wells acquired under the Founder Well Participation Program

The $100 million plus compensation package does not even include the amounts made from the related party transactions.  McClendon has been allowed to participate in the wells drilled by Chesapeake.  While the transactions have so far showed a loss (capital expenses have exceeded drilling revenues), the Preliminary Proxy Statement disclosed that McClendon valued the interests at $191 million.  Moreover, the Company:  

• Purchased an extensive collection of historical maps of the American Southwest, together with certain books, watercolors and photographs, from Mr. McClendon for $12.1 million, which represented his cost.

• Sponsored a basketball team in which McClendon was a 19.2% owner,  paying $3,495,525 in 2008 and $1,165,175 in 2009 in return for certain rights to advertising and promotional activities.  In addition, however, the Company "believes the sponsorship provides valuable support to the local community and contributes to employee morale."

• Paid $177,150 for food and beverage catering services to Deep Fork Catering, an affiliate of the Deep Fork Grill, an Oklahoma City restaurant, that is 49.7% owned by McClendon.

In other words, McClendon benefits nicely from his relationship with Chesapeake.  What kind of watch dog role are the directors playing?

First, there is a staggered board, something that provides greater insulation from shareholders and that federal law may eventually outlaw (the Schumer Bill apparently calls for an end to staggered board).  A shareholder proposal in the preliminary proxy statement that calls for the elimination of the staggered board is opposed by management.

Second, the Company does not have a majority vote provision in place.  A shareholder proposal that requests that the board implement a majority vote provision has been opposed by management. 

Third, the board is not particularly diverse.  The Board contains no women and, apparently, no people of color.  Six of the eight directors are 60 or older (the only exceptions are McClendon at 49 and Merrill A. 'Pete' Miller, Jr., at 58).

Fourth, the board doesn't hold physical meetings very often.  According to the Preliminary Proxy Statement:  "During 2008, the Board of Directors held four meetings in person and thirteen meetings by telephone conference."  And, for all of this work, how much were they paid?  Somewhere around $700,000 a year.  The table is below.  It includes personal use of the aircraft for family members of the board who accompany the directors when they travel on behalf of the Company.

Is it just a coincidence that a board paid somewhere around $700,000 for four physical meetings (more if you count conference calls) would have a highly supportive view towards the CEO? 

We on this Blog support the idea that boards should set CEO compensation and, that in general, caps on salaries are not the ideal approach for remedying problems of executive compensation.  On the other hand, the approach that accords almost unlimited discretion to "independent" directors to set compensation (and approve related party transactions) while ignoring directors fees and other disqualifying relationships or income streams makes a mockery out of the approval process. 

We have no idea how the directors and the CEO at Chesapeake interrelate or whether McClendon is in fact overpaid.  We know, however, that as a practical matter, the only realistic way for directors to lose their lucrative sinecure is to not be renominated by the board.  This is likely to occur where the director has an unsatisfactory relationship with the CEO.  This reality encourages directors to do what management rather than shareholders desires.

The only way to ensure that this does not occur is to preempt the state law standard for setting compensation.

Full post as published by The Race to the Bottom on May 01, 2009 (boomark / email).