Financial Times: Flaws in controls take shine off Shell

Published: April 21 2004 21:59 | Last Updated: April 21 2004 21:59  

The fact that three ratings agencies have downgraded Royal Dutch/Shell was a big blow for a company that saw its superior rating as one of its most prized accomplishments.

But the reason Moody's Investor Services gave for stripping the group of its triple A credit rating is arguably even more devastating.

It pointed to this week's audit report, saying that it indicates "a range of reporting and oversight flaws inconsistent with a highly rated entity, and raises major questions about Royal Dutch/Shell's controls, reporting standards and corporate governance."

The report revealed the extent to which senior Shell management failed to disclose the true level of reserves at one of the world's biggest oil companies. How, despite an internal control system which should have picked up discrepancies, they kept the true picture out of the public arena for two years.

The root of the problem lies in the 1990s when Shell radically overhauled management and operations. These changes left controls confused and lines of reporting inadequate.

In the mid-1990s, Shell was organised on geographical lines with semi-autonomous regions deciding on issues such as exploration expenditure. The changes meant that such decisions were now made by the global division rather than the region. But ridding Shell of its powerful fiefdoms - including Australia and Nigeria, where some of the biggest reserves misjudgments were made - was harder than expected.

More importantly, at the time, those responsible for preparing Shell's accounts were not reporting to the chief financial officer.

Amid the turmoil, Shell's guidelines on SEC regulations were vague and the issue was not taken seriously enough, insiders said.

Moreover, the company did not set up strong enough systems to review fields that had been booked as proved to ensure they remained in compliance with US Securities and Exchange Commission, the report revealed. Shell had one part-time auditor who reviewed its large fields once every four years and who "had neither the power nor the facilities to ensure such compliance," the auditors' report said.

Even when problems were recognised, Shell did not immediately de-book fields. Instead, they were earmarked to be taken off the books when Shell had other fields to add so the blow would be softened, he said.

But one of the most fundamental differences between Shell and many of its competitors appeared to be its interpretation of the SEC's rules prior to 2001. That was when the SEC issued guidance that companies had to have investment commitments and other supporting evidence to show they still believed that the fields would be developed under prevailing financial, political and technical factors.

Shell is expected to argue that until that new guidance, it was in compliance with the SEC's rules as it understood them. This is significant because most of the fields removed from Shell's books on January 9, 2004 were booked as proved between 1996 and 2002.

Meanwhile, the industry was going through huge changes: Shell's competitors were growing by merging and the market was calling for capital discipline.

At the time, Sir Mark Moody-Stuart, who is a non-executive director of Shell Transport and Trading, Shell's UK arm, was chairman (1997-2001) and instituted a policy of cost-cutting.

It was in part Shell's capital discipline at a time when rivals had more generous exploration and production budgets that prompted it to slip in replacing reserves organically, adding pressure on executives to book more aggressively, analysts said.

Shell has begun to improve its lines of reporting, its financial controls and auditing functions. But the admission by former Shell employees and the auditors' report that Shell's internal controls were deficient is doubly important in the post-Enron era.

The Sarbanes-Oxley Act, introduced after corporate scandals, imposes a new financial and regulatory burden on companies to thoroughly document and check that their internal controls are working properly.

Internal controls are broadly defined as processes designed to provide assurance on the reliability of financial reporting, the effectiveness and efficiency of operations and compliance with laws and regulations.

A company quoted in the US, as Shell is, always had a duty to ensure the controls were adequate but they must now be specifically certified as working correctly by management.