Investing expert Charlie Munger, Warren Buffett's right hand, warns us that we should always pay attention to the power of incentives. While well-crafted incentives can promote good management that leads to strong returns for investors, poorly crafted incentives can lead to mismanagement that can cause our investments to plummet.
So I'm concerned that SandRidge Energy (UNKNOWN:SD.DL) has given its board incentives to serve management's interests rather than shareholders' interests. Here's why.
What do shareholders get in this quid pro quo?
In its 2013 proxy, SandRidge disclosed that it signed a three-year contract to rent commercial space from an entity that is partially owned by board member Roy T. Oliver. Under the contract, SandRidge will pay $510,000 in annual rent, minus the cost of any renovations it makes to the property.
The disclosure indicates that the board believes the terms of the contract are fair market rates. While I don't see a particular reason to be concerned about the price the company is paying for the property (given the limited information that is provided), I am concerned about the possibility that this business relationship may create a "quid pro quo" relationship between SandRidge's management and Oliver, who may be grateful for SandRidge's patronage.
And Oliver's gratitude could be risky for investors. Note that Oliver is classified as an independent board member despite this business relationship. He was a member of SandRidge's compensation committee in 2012, and is currently a member of the nominating and governance committee. Oliver's presence on these committees puts him in a strong position to help CEO and Chairman Tom Ward secure attractive compensation packages and recruit board members that would be charitable to management.
Note that the presence of this business relationship doesn't mean Oliver will make decisions that favor management over investors. However, management's willingness to engage in these related-party transactions can give board directors incentives to curry favor with management in hopes of getting something in return down the road, even at the expense of shareholders.
Stealing our Thunder
SandRidge also disclosed certain business dealings with NBA team Oklahoma City Thunder, in which Tom Ward owns a 19.23% interest, and board director Everett Dobson owns a 3.85% interest. Interestingly, Dobson is also categorized as an independent board member despite this business relationship, and is the chair of SandRidge's audit committee.
In 2008 SandRidge signed a five-year sponsorship agreement with the Thunder, costing the company about $3,275,000 annually. When the team qualified for the playoffs last year, the same sponsorship agreement required the company to pay out an additional $612,000. In 2009, SandRidge entered a four-year agreement to license a suite at the Thunder's home arena.
This sponsorship decision could be good for the company in that it provides a valuable marketing opportunity. However, the fact that two board members have sizable personal financial interests in the Thunder makes me worry that this decision could be at least partially driven by the board's willingness to help Ward and Dobson line their own pockets at the expense of shareholders.
Given the abundance of marketing opportunities that are available, I prefer my companies to avoid even the appearance of such misconduct. The willingness to engage in questionable deals like these suggests to me that there may be a larger pattern of shady dealings.
Don't forget that Chesapeake Energy (NYSE:CHK) also sponsored the Thunder while then-CEO Aubrey McClendon also held a sizable stake, and that this shady dealing was part of a larger pattern in which McClendon mixed personal interests with business interests in ways that were arguably detrimental to shareholders. Also, like Chesapeake, SandRidge offered its CEO and chairman the opportunity to take a stake in company-owned wells. But Ward's perk was even more lucrative than McClendon's. Ward had the ability to take a 3% stake in each company well, while McClendon had to settle for a 2.5% stake.
Other questionable dealings
Besides the Thunder, SandRidge has financial relationships with two other businesses in which Tom Ward or his family have a sizable stake -- TLW Land & Cattle and WCT Resources. According to the disclosures, SandRidge paid these companies more than $2.5 million in 2012 in royalties, lease payments, and asset purchases. The proxy failed to provide any information about how these deals were priced and whether SandRidge was getting a good deal.
The Foolish takeaway
I believe an abundance of related-party transactions, and the board's repeated approval of management's decisions that can put their personal interests at odds with the larger business interests, should raise a red flag for investors. It can reflect a view among board members that the company belongs to company insiders rather than shareholders. At SandRidge, I'm concerned that this is exactly what is occurring.
Motley Fool contributor M. Joy Hayes, Ph.D. is the principal at ethics consulting firm Courageous Ethics. Joy has no position in any of the stocks mentioned. Follow @JoyofEthics on Twitter. The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.