SHELL GAMES: A Reuters Investigation
Articles in this series explore the extent and impact of corporate secrecy in the United States.
By Joshua Schneyer and Brian Grow
TRAVERSE CITY, Michigan (Reuters) - Late in the summer of 2010, hundreds of farmers in northern Michigan were fuming.
All had signed leases with local brokers permitting drillers to tap natural gas and oil beneath their land. All were demanding thousands of dollars in bonuses they had been promised in exchange. But none knew for certain whom to go after.
That's because the company rejecting their leases hadn't signed them to begin with. In fact, the company issuing the rejections wasn't much of a business at all. It was a shell company - a paper-only firm with no real operations - called Northern Michigan Exploration LLC.
One jilted land owner, Eric Boyer-Lashuay, called to complain to the broker who had handled his lease. Northern, he recalls saying, is "a shell company ... a blank door with no one behind it."
Today, he puts it this way: "It was all a fake, all a scam."
Northern has voided hundreds of land deals, and was indeed a facade - a shell company created so that one of America's largest energy companies could conceal its role in the leasing spree, a Reuters investigation has found. Oklahoma-based Chesapeake Energy Corp., the nation's second-largest gas driller, was behind the entire operation.
Chesapeake had created one shell company that set up another, Northern Michigan Exploration. Next, Northern hired brokers who signed leases with residents such as Boyer-Lashuay. And those brokers were under strict orders not to divulge Chesapeake's role, records reviewed by Reuters show.
In fact, the effort in Michigan was directed from the very top - by Chesapeake's CEO, Aubrey McClendon. In corporate filings that Chesapeake made public earlier this year - nine months after McClendon's agents began signing Michigan land leases - McClendon is named as the chief executive officer of Northern, the shell company that voided hundreds of those leases.
Chesapeake's effort to hide its involvement isn't illegal. To the contrary, the company's maneuvering exemplifies how U.S. corporations routinely can conceal financial and corporate transactions through the use of shell companies.
President Barack Obama has called on other nations to improve corporate transparency, but under state laws governing corporate formation in America, privately held businesses aren't required to disclose the individuals or companies who really own them.
Chesapeake's own website advises land owners that their "main consideration" before leasing should be "to discover who will ultimately be producing your minerals." But Chesapeake's strategy made that extremely difficult for the Michigan land owners.
Legal scholars say the operation serves as an intriguing test case of the use of shell companies.
The tactics "raise moral and ethical questions about how entities can be used," says Joshua Fershee, a contract law professor at the University of North Dakota.
Others, including Chesapeake, defend the need to use shell companies and front companies - contractors with local ties who do business on behalf of a larger corporation. John Lowe, a professor of energy law at Southern Methodist University, calls it "business as usual."
"Shells aren't just a device to pull the wool over land owners' eyes," Lowe says. "You have to weigh some of the unfortunate cases against the fact that these companies can facilitate doing business, making it easier and probably cheaper to obtain leases. If I were a regulator, I'm not sure I'd change anything or try to limit the use of shells."
At least one lawmaker, Rep. Raul Grijalva, a Democrat from Arizona, says he will be "arguing for some intervention" to control the use of shell companies in such deals.
"Private property owners who enter into these transactions with good faith shouldn't be getting duped by a front company," says Grijalva, a member of the House Committee for Natural Resources. "It's deception and you can't call it anything else. It's a good example where the intervention of government to require disclosure and binding contracts is needed."
The effort to secure leasing rights in Michigan was part of Chesapeake's national "land grab," a term the company has used in its filings with the U.S. Securities and Exchange Commission.
But Chesapeake's Michigan land rush quickly ended. In court this month, lawyers for land owners alleged that lease agreements were voided after Chesapeake learned a well it drilled in the state had come up dry.
Bonuses promised to land owners went unpaid, according to court documents submitted by lawyers for the land owners. Northern Michigan Exploration, the Chesapeake-affiliated shell company, rejected more than 97 percent of the leases its Michigan agents had signed with farmers and other land owners, the documents allege.
More than 800 Michigan land owners - many of them elderly farmers - had their leases terminated by Northern, Reuters found.
As a consequence, owners missed opportunities to lease their land to other oil firms. At least 115 have sued, alleging that Chesapeake breached their contracts and defrauded them. On average, they each had been expecting $95,000 in bonuses, those lawsuits show.
The near-blanket cancellation of the contracts raises the question of whether Chesapeake ever intended to pay if it failed to find oil or gas immediately, says Mark Gergen, a contract law professor at the University of California-Berkeley law school.
"It suggests they might have had a strategy going in of not honoring their agreements," he says. "The shells would have facilitated that" because Chesapeake could blame the shells for the cancellations, suffering no damage to its reputation.
Chesapeake says it acted properly. It says some land owners were paid bonuses. It also disputes "canceling" any Michigan contracts; rather, some contracts were "rejected" because property titles didn't pass muster, its corporate counsel says.
In written responses, Chesapeake says it sometimes uses shell companies to "keep a low profile" and avoid tipping off competitors and "speculators" about its land-leasing and drilling efforts. Such tactics are common in real estate, scholars say.
But now, Chesapeake also is using shells as a legal defense to shield itself against land-owner lawsuits. The energy giant has said in court that it was Northern Michigan Exploration, not Chesapeake, that canceled the leases.
If land owners prove that they should have been paid, at issue is who will be held accountable: Chesapeake, a corporation with $37 billion in assets, or Northern, a shell company with no publicly documented assets.
"If Chesapeake knew from the start there was a good chance it would renege on leases and used (Northern) to avoid liability, that is improper," says North Dakota law professor Fershee.
The burden now rests with lawyers for the land owners to prove that - to not only demonstrate that Chesapeake was directing the shell companies but also to show that Chesapeake used the shells to commit fraud.
To understand the role shell companies play in Chesapeake's business, Reuters reviewed hundreds of pages of lease agreements, rejection letters and contracts, and more than a thousand pages of court records.
Reporters also interviewed more than three dozen land owners, lawyers and "landmen," those who scout for areas rich with oil and gas and strike deals with land owners.
The northern part of Michigan has a long history of smalltime drilling. But the three-month land-leasing frenzy here last year was driven by speculation that the state's Collingwood Shale area might hold large amounts of oil and natural gas.
In recent years, shale drilling has created the biggest grab for resources in the U.S. since the California Gold Rush. Thousands of so-called "shaleonaires" have grown rich by leasing their land and collecting royalties from gushers.
Chesapeake is the single biggest player in that rush, employing about 4,500 landmen. Its CEO, McClendon, started his career as an oil landman, as did former President George W. Bush.
Chesapeake says it has paid more than $9 billion for land leases. Its holdings include about 15 million acres in at least 23 states - a drilling area nearly the size of Ireland. Since 2008, Chesapeake has raised $13 billion by selling off a portion of those leases to energy firms as far away as China and Australia.
The business is risky. Chesapeake often slips into a shale play early, committing hundreds of millions of dollars before it knows whether wells in the area will be gushers or dry holes.
The company's filings show it spent $6.95 billion acquiring "unproved" properties last year, more than double what it spent the previous year.
Such huge spending, coupled with U.S. natural-gas prices at 27-month lows, underscores Chesapeake's aggressive financial risk profile, according to Standard & Poor's. It rates Chesapeake's corporate debt BB+, a category considered junk status.
Some analysts balk at the difficulty of following the company's land transactions, including deals made through shell companies. The use of shells can make the moves hard to trace in financial statements.
In October, Reuters asked Chesapeake about its land-leasing in Michigan. In a written response, Chesapeake said then that it had spent about $400 million to acquire leases there, a figure it has neither disclosed nor is required to disclose in SEC filings. Company spokesman Michael Kehs declined to answer other questions submitted this month.
Left unanswered: Whether shell companies affiliated with Chesapeake have any assets.
"There are red flags when it comes to Chesapeake's transparency, convoluted ownership of shell entities and transactions shareholders can't see," says Phil Weiss, an equities analyst with Argus in New York, who downgraded the firm's shares to 'sell' on November 16. "I'd never know what happened in Michigan by looking at Chesapeake's filings."
Chesapeake's land strategy was pieced together in part from documents that emerged in the Michigan lawsuits. Since early in the legal fight, Chesapeake has denied it conducted business in Michigan. It also denied that Northern, the shell company that voided leases en masse, was its "wholly owned subsidiary."
For months, plaintiffs' lawyers couldn't figure out how Chesapeake could seemingly deny direct control of Northern. The answer lies behind the corporate veil of shell companies.
Chesapeake doesn't directly own Northern; rather, Northern was incorporated by another shell company - one that Chesapeake owns and had created a year earlier. That firm, LA Land Acquisition, is the beginning of a complicated chain of shells and front companies - local contractors - operating on Chesapeake's behalf:
* In April 2009, Chesapeake begat LA Land Acquisition Corp., a Delaware entity with no discernible assets.
* A year later, in April 2010, LA Land formed Northern Michigan Exploration, another shell company with no known assets.
* Northern subsequently hired a local land-lease company, O.I.L. Niagaran.
* O.I.L. then hired another local company, Western Land. Both O.I.L. and Western negotiated with land owners here.
The firms agreed not to disclose the energy giant's role to land owners, according to a May 2010 contract between Chesapeake and O.I.L. and other records reviewed by Reuters.
In incorporation papers filed in Michigan, Northern's address is listed as the office of a law firm in Lansing. John Pirich, a Lansing lawyer listed in state records as the representative of Northern, declined comment.
The connection between Chesapeake, LA Land and Northern appears in a February 8 SEC filing, made public five months after Michigan land owners first filed suit. It shows that LA Land, which lists McClendon as a director, is the "sole member" or owner of Northern, which lists McClendon as its CEO.
Chesapeake didn't say why it used multiple intermediaries in Michigan. Lawyers say layers of shell and front companies can be used to cap liability when the companies behind the shells face lawsuits.
"The shells can complicate and delay things," says Gergen, the Berkeley law professor. "Chesapeake is probably betting that plaintiffs won't have sufficient resources or staying power to collect."
Last year, Chesapeake was competing for land in Michigan with the Canadian driller EnCana. In May 2010, EnCana announced that it had already leased 250,000 acres in the state.
Sue Brown, who owns 370 acres near Cheboygan, Mich., was bombarded with offers. "Landmen swooped in on this area like hornets out of hell," Brown says. "They'd be waiting in my driveway, completely paranoid that I was going to sign with somebody else."
That month, she and her husband were among the earliest farmers to sign a lease with a local broker working on behalf of Chesapeake. They received a $500-per-acre bonus.
Brown's contract featured a non-disclosure clause, forbidding her from revealing her offer to neighbors. She had no idea Chesapeake was behind it. The lease has been honored, she says.
As the frenzy intensified in June 2010, some Michigan bonuses rose to $3,000 an acre, up 200-fold from before the boom. Chesapeake's decision to remain hidden may have been a legitimate attempt to keep prices from going even higher, some experts say.
"It's common to take leases through a shell corporation or through a landman company," says Lowe, the professor of energy law at SMU's Dedman Law School in Dallas. "If you're a farmer or a rancher and you see a big, deep-pocketed oil company pull up in your driveway, then your price goes up."
After prices surged in Michigan, EnCana decided in July 2010 to pare back its leasing effort, a company spokesman says. According to allegations in several lawsuits against Chesapeake, CEO McClendon looked to take advantage of the opening.
He began to aggressively renegotiate or delay the completion of his own Michigan deals, the lawsuits allege.
The lawsuits by Michigan land owners also suggest a specific reason why Chesapeake's interest cooled: Through an affiliate, Chesapeake drilled an exploratory well in Michigan last July that came up dry. Chesapeake has not publicly disclosed the drilling results and declined to comment on the matter. But in the weeks after the exploratory well was drilled, Chesapeake's shell-within-a-shell - Northern - began rejecting leases en masse, letters sent to land owners show.
In some cases, Northern claimed that land owners missed a signing deadline, even though landmen had told them when to sign. Leslie and Sarah Schrier, a farming couple in their 80s who live near Brutus, Mich., had their lease voided weeks after a landman and a notary public drove to their farm to watch them sign ahead of the deadline, they say.
Also affected was John O'Hair, a former judge and chief county prosecutor in Detroit. He leased his 140-acre family farm in Antrim County, Mich., to O.I.L. in a contract that offered an $84,000 signing bonus. If successful wells were drilled, the O'Hairs would receive 12.5 percent royalties.
O'Hair had leased the same land to O.I.L. a few years earlier without a hitch. This time, months passed and no bonus check arrived.
O'Hair complained to O.I.L.'s president, Dwain Provins. The response: O.I.L. was working for another firm, whose name and role were secret, O'Hair recalls. That firm had voided the lease, he was told, because one of O'Hair's in-laws appeared to own a stake in his property. Provins declined comment.
"It was a completely bogus claim," says O'Hair, 82. "I'd leased the land previously to O.I.L. with no issues."
More months passed before O'Hair learned the truth from lawyers he had hired: O.I.L. was doing the bidding of Northern and Chesapeake.
By August 10, 2010, transcripts from court hearings show, at least one of Chesapeake's middlemen in Michigan seemed regretful that he had entered into business with the company.
The broker, David W. McGuire of O.I.L. Niagaran, voiced concern about Chesapeake's directives, court records indicate. He told McClendon that Chesapeake was asking O.I.L. to default on contracts that Chesapeake never intended to pay, according to the court records.
McGuire told McClendon that he had "never been put in a position like this," court records show. His comments were recounted in court this month by lawyers representing land owners.
McGuire did not respond to requests for comment on the matter.
By mid-August, Northern began sending out rejection letters to land owners. Many were signed by the man listed as Northern's "senior landman," David W. Bolton. He also was a landman for Chesapeake itself. In an email exchange with local brokers, he used the address firstname.lastname@example.org - a Chesapeake address. He's also on a 2010 list of Chesapeake employees.
Bolton did not respond to email or phone messages requesting comment.
The lease-termination letters from Northern were a giant ruse, says Kevin Koonce, a landman who worked for a Chesapeake contractor in Michigan.
Koonce says he worked in Michigan from September to November 2010. He wasn't there to lease land. By the time he arrived, Koonce says, Chesapeake's strategy was to abandon leases it had already signed.
"Our instructions were to flunk the title if there was a word misspelled," Koonce says. He says he decided to speak publicly about the situation because he objected to the approach.
Emails reviewed by Reuters show Koonce's firm was fired in December 2010 for not signing any land owners to drilling leases in another state. He has filed an affidavit on behalf of Michigan land owners who are seeking to collect on their leases.
Koonce says his instructions to flunk leases came from a supervisor at another broker working for Chesapeake in Michigan. Koonce says he and eight other brokers participated in a conference call on October 27, 2010, with the supervisor. During the call, he says, they were ordered to speed up the rate of lease cancellations.
Neither the supervisor nor the other brokers on the call responded to emails requesting comment, and Chesapeake declined to comment on Koonce or his allegations.
One land owner whose lease was rejected was Mildred Lutz, a 93-year-old widow who lives near Alanson, Mich. She says she was told her $97,000 bonus wouldn't be paid because her late husband didn't sign the lease and the family trust, which owned the land, is in both her name and her husband's. Never mind that the landman drafted the lease in July 2010 - a month after her husband's death.
"He knew my husband had passed away and I would be the sole owner of my property," Lutz says. Chesapeake's lawyers have said the Lutz lease had clear formatting and title flaws.
In its letters to land owners, Northern offered several reasons for voiding leases: disputes over property ownership; improper formatting of leases; and claims that properties fall outside a geographic target area.
In some cases, Northern claimed that land owners had missed a signing deadline, even though they signed leases at a time and place specified by the company's leasing agents.
In scores of other letters, Northern says leases were void because of "unsubordinated" mortgages on property. That means a property - like the approximately 70 percent of U.S. real estate that is mortgaged - isn't owned free-and-clear.
In a written statement, Chesapeake general counsel Henry Hood says a mortgage is a valid title defect "if the mortgage pre-dates the lease and is not expressly subject to and subordinate to the lease." In previous filings with the SEC, Chesapeake said it generally scrutinized titles late in the process, before drilling, and not before paying out bonuses.
Chesapeake's main competitor in Michigan, EnCana, told Reuters that it honored the vast majority of leases it signed in the state and has faced no lawsuits that allege it reneged on any leases there.
EnCana "very rarely" voids any lease it has signed, spokesman Alan Boras says.
As Northern continued to reject leases, another company emerged in late October and went on a Michigan land-buying spree.
The hundreds of rejected leases had depressed land prices from the summertime high, and a company called Crystal Lake Resources became one of the top buyers of public land at a state auction on October 26, 2010.
The state land up for auction was also in the Collingwood Shale formation, not far from the land that Northern no longer wanted to lease from private land owners.
According to records from the Michigan Department of Natural Resources, Crystal Lake bought drilling rights on 30,000 acres for $20.97 an acre. That's a 99 percent discount on the price promised to some land owners whose leases were canceled by Northern.
Incorporation records show Crystal Lake was formed on October 25, 2010, a day before the public auction. Its Lansing address is the same as Northern's, the Chesapeake shell company that had been canceling private leases.
In a response to one Michigan lawsuit, Crystal Lake Resources is identified as a lease buyer for Northern.
In the months since its Michigan buys, Crystal Lake has also been busy signing land leases in at least one North Dakota county.
There, in Hettinger County, clerk Sylvia Gion says Crystal Lake's leases have been assigned to one company: Chesapeake.
Additional reporting by Jeff Jones in Calgary; editing by Blake Morrison and Michael Williams