Regulatory rulings on Shell’s reserves

Writedown may be letdown for investors

The exoneration of Shell’s most senior managers, coupled with the relatively light civil penalty imposed on Shell for market abuse, may lead investors to question whether the regulatory decisions delivered sufficient vindication for public interest.

When Royal Dutch Shell announced on January 9, 2004 that it was downgrading its end-2002 worldwide proved reserves booked with SEC by 20%, the event sent shock waves across the financial community and put the oil industry on the defensive. Four additional revisions brought the reduction to 29%. End-2003 reserves were also downsized by 10%.

These revisions had a negative impact on the company’s credit ratings, its net income, and the standardized measure of discounted cash flows reportable to SEC under accounting rules.

Government authorities have now closed their book on Shell’s actions. Their rulings may make the investors wonder whether the whole episode was a storm in a teacup.

Regulatory rulings

On Aug. 29, the US Securities Exchange Commission (SEC) provided notice that it had, after a two-year investigation, decided to drop charges against Shell’s ex-CEO, Sir Philip Watts, in connection with the reserves crisis. The agency also cleared two other former top executives, CFO Judy Boynton and Walter van de Vijver, deputy CEO and head of exploration and production. Watts was the predecessor of van de Vijver as the head of E&P.

A relieved Watts said through his lawyer that the SEC’s ruling vindicated his position that he had acted properly and in good faith at all times. SEC declined to comment on its ruling.

Watts and others remain defendants in civil litigation related to reserves overbooking.

The SEC’s ruling comes nine months after Britain’s Financial Services Authority (FSA) concluded not to take action against Watts, and the US Department of Justice’s earlier decision not to prosecute Shell.

The SEC decision also follows the agreement between Shell and the regulatory agencies reached in 2004. Without admitting or denying wrongdoing, Shell consented to pay $120 million to SEC and $31 million to FSA to settle market abuse charges. The company also paid a symbolic one-dollar disgorgement and agreed to spend $5 million on an internal reserves compliance program.

Judging the judgment

The exoneration of Shell’s most senior managers, coupled with the relatively light civil penalty imposed on Shell for market abuse, may lead investors to question whether the regulatory decisions delivered sufficient vindication for public interest. The disclosure of Shell’s reserve overbooking in January 2004 angered investors and resulted in a $15 billion drop in the company’s stock market value. Investors demanded transparency and accountability, and civil lawsuits, still pending, against the company followed.

There is no intention here to cast aspersions on any individual, but a few points relevant to the case are worth mentioning.

First, there comes to mind the report1 by US law firm Davis Polk & Wardwell, retained by Shell’s Group Audit Committee in early 2004 to carry out an independent internal inquiry of the events that led to the reserves scandal. The report, relying on a two-year tense communication between Watts and his deputy, paints a picture of van de Vijver warning Watts of SEC-compliance issues related to “legacy” (previously booked) reserves, and Watts resisting attempts to scale back reserves, with an exasperated van de Vijver protesting in an e-mail in November 2003: “I am becoming sick and tired about lying about the extent of our reserves issues and the downward revisions that need to be done....”

The report bears the hallmarks of a crisis-stricken senior management agonizing on reserves replacement ratios and brooding over regulatory compliance issues.

In the immediate aftermath of the scandal, Watts publicly asserted that the compliance issue had come to his attention only recently.

Watts’ other public assertion, that the reserves accounting process involved professionals in many countries who acted independently, should also be viewed in context. To the extent that Shell is a highly decentralized company, there is certainly merit in this argument.

On the flip side, however, it is also a fact that Shell’s operating companies do not act in a vacuum, and their performance targets are established in consultation with senior management at the headquarters. A centralized oversight of what transpires in operating companies is always in place.

As for the $120 million civil penalty imposed by SEC on Shell, it pales in comparison to the loss the investors suffered within weeks of the January 9, 2004 announcement. The fine is less than $150 million paid by the pharmaceutical company Bristol-Myers Squibb in 2004 for market abuse. The latter’s net income in 2004 was a little more than 10% of Shell’s.

The Justice Department said last year that Shell had fully cooperated with the government authorities, and this may explain SEC’s leniency toward the company.

Consolation for investors

Against the losses they suffered, the investors may find some solace in Shell’s reserves crisis in that some of the reserves de-booked by Shell were subsequently re-booked, e.g., the Kashagan field in Kazakhstan, Ormen Lange field in Norway,2 and that their share values since early 2004 have appreciated handsomely as a result of market forces.

The reality of the market forces over the past two years, in fact, may have a mollifying effect on the investors regarding the regulatory rulings.

Investors may also find some comfort in the fact that reserves reported to SEC are proved reserves, and are a conservative estimate of an oil company’s reserves pool. The more realistic estimate is the expectation value, typically used for internal decision-making.

In several respects, SEC’s reporting requirements inherently introduce conservatism.

What went wrong?

The regulatory decisions announced do not shed light on what really went wrong in Shell. What caused the world’s second-largest publicly-traded oil company to overstate its booked reserves on a massive scale?

The Davis Polk & Wardwell report and Shell’s own disclosures identify the problem: weaknesses in internal control and a corporate culture where insufficient attention was paid to SEC rules (Rule 4-10 of Regulation S-X and SEC staff’s guidance). The distinction between the SEC rules and the Group’s reserves guidelines (used for internal decision-making) was blurred, and non-compliant bookings were unnoticed or tolerated. There was little attempt to audit reserves internally.

At the management level, SEC’s rules and guidance for reserves booking requiring investment commitment, market assurance, and governmental approval were largely ignored, and at the technical level the staff in some cases identified reserves using less stringent criteria than called for under SEC’s “reasonable certainty” guidelines. In some instances staff boosted reserves at the encouragement of management.

Shell was reportedly warned by SEC prior to the fall of 2003 about some of the potentially aggressive reserves, but these warnings were ignored by the company.

On balance, it is safe to conclude that the failings of Shell in the reserves scandal were largely the failings of the management rather than the technical staff. It was the management’s responsibility to see to it that regulatory compliance issues attracted proper attention and to institute internal controls for assurance.

Concluding thoughts

Considering the impact the reserves write-down had on the investor community, and the turmoil it created in the oil industry, the decisions of the regulatory authorities on the Shell crisis may lead the investors and others to wonder what the fuss was all about.

Doubts will linger whether the exoneration of the senior managers and the relatively light penalty levied on the company served justice, and whether the regulatory decisions will act as a deterrent against misconduct by other oil companies.

Although reserves estimates are inherently subjective and imprecise, and booking guidelines imperfect (due to the interpretation of SEC’s “reasonable certainty” principle), there was little excuse for Shell to disregard some of SEC’s unambiguously worded guidance. Shell’s non-executive Supervisory Board admitted that much when, in the wake of the scandal, it referred to the scandal as a “major embarrassment” and asked shareholders for forgiveness. It is a major credit to the Board that that it owned up to the scandal.

It is reasonable to conclude that the scandal would have never surfaced if it were not for the perseverance of van de Vijver. While at times wavering in his stance, and worrying about “exposure” and the looming Sarbanes-Oxley Act (2002), he nevertheless acted as the driving force to come “clean” in public. In a sense, van de Vijver was a “reluctant hero.”

Most of the questionable reserves (“legacy” volumes), some dating back to early 1990s, were initially booked under the watch of Watts and his predecessor Sir Mark Moody-Stuart, an ex-CEO of E&P heritage. The problem had been festering for nearly a decade.

In June 2005 Shell issued new reserves booking guidelines to bring them in alignment with SEC’s, bolstered its staff training, and established a comprehensive reserves governance structure. The company has left the reserves scandal behind, but it will take years to repair the damage to its reputation.

Earlier this year the Group announced that it would no longer focus on reserves replacement ratio as a performance target, and concentrate on “value” instead.

Was Shell the only “dark horse” in reserves booking? After the company admitted its noncompliant booking in January 2004, a number of smaller oil companies, e.g., El Paso, followed suit and downsized their booked reserves. The majors took the higher ground and maintained that their bookings had been proper. That may have soothed the nervous investors, but the validity of that claim cannot be confirmed until these companies’ books are scrutinized in-depth by external auditors - a job clearly beyond the resources of SEC. The majors have traditionally vetted their reserves internally without third-party participation.

Also, there remains a question whether SEC conducted a probe of companies which, like Shell, had aggressively booked reserves in joint ventures shared with Shell.

References

1. Report of Davis Polk & Wardwell to the Shell Group Audit Committee - Executive Summary. Mar. 31, 2004. See www.shell.com

2. Demirmen, F. “Shell’s reserves revision: A critical look.” OGJ, Apr. 5, 2004.

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