Wednesday, June 17, 2009

Perverse Incentives

Much has been made of the $100 million salary of Chesapeake Energy (CHK) CEO Aubrey McClendon in 2008. This salary would be high even for a company providing phenomenal returns for its shareholders, but is particularly shocking considering that the company endured a 56% loss in market value during the year. Even more infuriating for shareholders is the fact that the company recently purchased McClendon's historical map collection for over $12 million. The most disturbing aspect of this situation, however, is how these transactions came to be and the resulting dangerous incentive system at Chesapeake which will likely cause the company material harm for years into the future.

As Charlie Munger has told us, "The most important rule in management is to get the incentives right." But Chesapeake's board appears to be transferring wealth from shareholders to McClendon in order to help offset losses which were the result of McClendon's own risk-taking: during 2008, McClendon purchased Chesapeake shares on margin, and was forced to sell these shares at a loss on October 10th. McClendon's $75 million bonus and the map collection purchase took place at the end of the year. While McClendon would likely have been the sole beneficiary of his margin position had Chesapeake stock soared, his downside risk appears to be subsidized by Chesapeake's shareholders!

A perverse incentive situation such as this encourages reckless and risky behaviour on the part of managers. Managers are more likely to take undue risks, due to the rewards that come with positive outcomes and the muted financial punishments that come with negative outcomes. It is also not surprising that the company had positive earnings of over $700 million for 2008 (showing strong results while it released the details of McClendon's compensation), but declared almost $10 billion in unusual expenses in the first quarter of 2009. You have to aggregate the company's earnings for the last 5 years in order for Chesapeake's earnings to top its CEO's 2008 compensation!

This is not the kind of company you want to own. But if you own the S&P 500 index, you do own this company.

Disclosure: None

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