Corporate Board Member Magazine (March/April 2005 issue): Shell Rebuilds Itself: “Investors are still divided about the culpability of Shell’s directors in the reserves debacle.”: “The stock price plummeted—losing some $22 billion in value at its nadir—and the bond-rating agencies stripped Shell of its triple-A rating. Class-action suits were springing up in the U.S. like poisonous toadstools.”: “…Lord Oxburgh conceded that Shell executives had been “economic with what they passed on to the board. Evidence of just how “economic” Watts & Co. had been soon began to mount…”: “The Shell board recognized that its top priority was restoring the company’s reputation…”: “William S. Lerach—the California corporate scourge whose law firm brought a consolidated U.S. class-action suit on behalf of shareholders against Shell, its executives, and its directors for mismanagement and fraud—judges the reforms timid and inadequate” (ShellNews.net) 21 March 05

By Chris Redman

How a crisis over oil reserves led the board to do what it should have done long ago—create an entirely new company.

It was as if the Tower of London’s famous Beefeaters woke up one morning to find that one in five of the crown jewels had vanished. On January 9, 2004, Royal Dutch/Shell announced that it would slash its proved energy reserves, a key measure of an oil company’s worth, by a heart-stopping 20%—the equivalent of 3.9 billion barrels of oil, valued at $130 billion at that day’s price. The reserves crisis—or rather crises, since there were several re-estimates further thof exactly how much oil Shell had in its holdings—prompted one of the most far-reaching corporate restructurings ever. Along the way, board members from both sides of the Anglo-Dutch company ousted its top management, turned its culture inside out, and ultimately voted for reforms that removed many of them from their directors’ jobs. How they went about it is a drama in itself.

Investors are still divided about the culpability of Shell’s directors in the reserves debacle. Were they somnolent while the problem was brewing? Were they blindsided by a corporate culture that kept them in the dark? Maybe. “The care and feeding of the board members had become something of an art,” recalls one former senior executive. “We really didn’t care too much about them, and we fed them very little.” Vincent Cable, Shell’s former chief economist and now a member of the British Parliament, recalls briefing the so-called Conference—a regular gathering of board members from both sides of the company. “I didn’t get the impression they were there to do much probing,” he says. “They seemed to have a largely decorative function.”

If so, Shell had adorned itself with some pretty impressive ornaments—and plenty of them too, thanks to the company’s bifurcated structure, which for historical reasons required both British and Dutch boards. The Dutch side, Royal Dutch Petroleum, numbered among the seven members of its supervisory board Wim Kok, a former prime minister of the Netherlands; Lawrence Ricciardi, former president of RJR Nabisco and general counsel of IBM; and Maarten van den Bergh, who had been Royal Dutch/Shell’s most senior executive for much of the ’90s and who now sat on the boards of BT Group, British Airways, and the British bank Lloyds TSB. Shell Transport & Trading, the British side of the business, boasted enough knights and nobles to form a Round Table. These included Lord (Ronald) Oxburgh, a former scientific adviser to the British government, and Sir John Kerr—soon to be Lord Kerr—former permanent undersecretary of the British diplomatic service and a recent ambassador to Washington. Also on the board: Sir Peter Burt, non-executive chairman of the ITV television network, who had been governor of the Bank of Scotland until 2003, and Sir Mark Moody-Stuart, who had headed Shell Transport & Trading during the ’90s.

The blue-chip company with the blue-blood board would not have had such problems had Shell been doing what oil companies are supposed to do—find enough oil and gas to replace the hydrocarbons they extract from the ground. By the late 1990s, Shell’s so-called reserves-replacement ratio had slipped to worrisome levels—90% from 1996 to 2001, compared with 100% for Exxon Mobil and 138% for BP. Shell’s top managers, led by CEO Sir Philip Watts, convinced themselves that their rivals’ superior performance had more to do with aggressive accounting than with greater success in finding oil. They also knew their annual bonuses depended in part on increases in the company’s reserves. The end result: a management consistently claiming more reserves than U.S. Securities and Exchange Commission rules allowed.

As a former senior executive for a rival oil giant observes, “When everyone starts leaning on the same side of the canoe, sooner or later it’s going to capsize.” When that happened, Watts insisted that the shortfall had only recently come to light after the company’s own probes in Nigeria and Oman. Investigators, however, would soon discover that Watts and his successor as chief of exploration and production, Walter van de Vijver, had been sitting on the bad news for years.

Now that it was public knowledge, investors were on the warpath. The stock price plummeted—losing some $22 billion in value at its nadir—and the bond-rating agencies stripped Shell of its triple-A rating. Class-action suits were springing up in the U.S. like poisonous toadstools. Some of Shell’s senior independent directors were coming to the conclusion that Watts and others would have to go. While denying there had been a cover-up, Shell Transport board member Lord Oxburgh conceded that Shell executives had been “economic with what they passed on to the board.”

Evidence of just how “economic” Watts & Co. had been soon began to mount. Heading up the initial stages of Shell’s internal investigation was general counsel Beat Hess, a recent recruit from the Swiss-Swedish electrical-engineering behemoth ABB. Hess quickly uncovered enough to know that Shell could be in deep trouble. In early February, he recommended that the company seize the initiative by going to the regulators. Only through full, proactive disclosure to the likes of the SEC and Britain’s Financial Services Authority could Shell hope to limit the damage. Hess also urged the twin boards to authorize an independent probe of the reserves problem.

The chairman of Royal Dutch’s supervisory board and the company’s general audit committee, Aad Jacobs, didn’t take much persuading, even though the notion of outside investigators went against Shell’s corporate instincts. Reclusive and proud—some would say secretive and arrogant—it had its own unique way of doing things, including a byzantine corporate structure headed by the committee of managing directors (CMD), which comprised the heads of Shell’s major operating divisions. The CMD effectively ran the company—the shared power within the committee theoretically providing all the checks and balances Shell would ever need.

Yet somehow things had been neither checked nor balanced. With unanimous board consent, the general audit committee called in the U.S. law firm Davis Polk & Wardwell to review the reserves issue. There was a risk that Davis Polk might uncover more than anyone had bargained for and provide a blueprint for regulatory investigators—and even criminal prosecutors. But doing nothing was even riskier. One insider subsequently put it this way: “We could either trample over ourselves or wait for others to do it to us.”

The Davis Polk report was damning. Even an early, interim version sent to the general audit committee on March 1, 2004, provided an indictment of Watts and van de Vijver. Two days later, both were fired. Oxburgh replaced Watts on an interim basis as chairman of Shell Transport, while Jeroen van der Veer, president of Royal Dutch/Shell’s board of management, took over as chairman of the powerful committee of managing directors. The final report confirmed the concealment of the reserves problem, portraying a company badly in need of reform. It called upon Shell to “enforce a culture of compliance” with regulatory and fiduciary obligations.

The Shell board recognized that its top priority was restoring the company’s reputation. The reserves debacle provided both the incentive and the opportunity for root-and-branch structural reform. As Lord Kerr explains, the crisis had a “catalytic effect.” The company’s transformation, he says, “would have happened at some point, but the reserves issue precipitated it.” Adds former chief economist Vincent Cable: “Shell made a virtue of necessity.”

On March 5 Shell’s boards asked Kerr, a director since 2002, to set up a committee of independent board members from both sides of the company—plus van der Veer and advisers from Citigroup and N M Rothschild & Sons—to review Shell’s structure and governance, and propose reforms by November. The idea was not to delve into the “entrails of the reserves crisis,” as Kerr puts it, but to look to “what would be best for the future of the company.” A smooth backroom operator with years of high-level European Union experience in Brussels, where national sensitivities cannot be ignored, Kerr was the perfect choice to tackle a company with a foot in each of two countries. Whatever plan he came up with, it was imperative that neither side should end up believing the other side had won.

Those who know him describe Kerr as a good listener, and that’s what he and his so-called structure group did for the first few months—consult within Shell, but above all listen to what outsiders had to say. “We talked to shareholders controlling over 50% of the company,” Kerr recalls. The first to admit that he is neither a business nor a governance expert, he was not afraid to follow up with specialists if there was something he didn’t understand. “In the end they got a pretty clear view of the expectations of the investor community,” says Peter Montagnon, director of investment affairs at the Association of British Insurers, many of whose members are major Shell shareholders.

Kerr knew from his years as a diplomat that any negotiation depends on pacing. He began slowly, allowing time for his structure group to bond and for the more cautious elements within Shell to get used to the idea of change. “‘If it ain’t broke, don’t fix it’ is a seductive argument,” he explains. “Radical reform has to be advocated cautiously.” By early summer, the group was ready to move from the listening phase to the governance and structure phases—ensuring that the problems of the past would not return, and choosing the framework that would work best in the future. Would it be some variation of the traditional “double-header” structure, or might Shell go for a more radical single-company solution, as a few big investors were urging?

After what Kerr describes as “fundamental debates,” the structure group—which met 21 times and considered 30 possible outcomes, he says—began to coalesce around some preferred reforms. It concluded that the committee of managing directors, which had reported to the Conference of the Dutch and British boards, should be replaced by a chief executive accountable to a single, more powerful board with a majority of outside directors. At the head of the board: a non-executive chairman. “In the past, the agenda for the boards was set by the chairman of the CMD,” Kerr says. “That wasn’t right. What is much better is for the board agenda to be set by a powerful, independent chairman.”

The next step was to introduce these ideas gradually to the two boards. At a September 7 meeting of both boards at Royal Dutch headquarters in The Hague, directors seemed ready to ditch the CMD in favor of a strong chief executive, although they agreed they didn’t want a U.S.-style “super CEO” who would also serve as chairman of the board. At another joint meeting on October 8, this one at London’s Shell Centre, something dramatic happened. As Kerr tells it, “The five executive [inside] directors insisted on being in the room, and all said they shared our belief that the single-company option would be the best.” They liked the clearer, simpler structure, and this preference, coming unanimously from Shell’s top executives, carried the day. “Even the conservative board members turned out to be less conservative than we thought,” says Kerr.

That outcome was completely contrary to the one he would have predicted when he began his work. It was a reform that went far beyond the demands of most major investors and further than the structure group had believed was possible. Even toward the end of the review process, Kerr had thought that the single-company outcome would be “too strong meat” for the boards to stomach and that they would settle for an updated version of the double-headed structure. But, he told Corporate Board Member, “we surprised ourselves by going much further than we thought we would.”

At a meeting at Shell’s HQ in London on October 27, the two boards unanimously accepted the new structure in a discussion and vote that lasted less than 30 minutes. It was a speedy end to what the Financial Times described as “a century-old structure that resembled a kind of Austro-Hungarian dual monarchy run by a Soviet-style central committee.”

The new-look Shell had something for almost everybody. The proposals called for the new company, named Royal Dutch Shell PLC, to be headquartered in The Hague and have tax residence in the Netherlands, but to be incorporated in the United Kingdom. Under the proposed new structure—to be voted on by shareholders this June—the board will comprise 10 outside directors, including the chairman, and five insiders. Six of the 10 outsiders will come from the Dutch side, four from the British part. (In the 2003 annual report, Shell listed 10 board members for its U.K. branch—one insider and nine outsiders—while the Dutch operation had two executives and seven non-executives.) Van der Veer, designated as the first chief executive of the unified company, will report to the board. Aad Jacobs of Royal Dutch Petroleum will be the chairman until his retirement next year. Kerr will be his deputy and has the task of finding the next chairman. “The headhunters are already lining up outside my office,” he says.

With the committee of managing directors now history, the chiefs of Shell’s various businesses will report to CEO Jeroen van der Veer, and their chief financial officers will report to Peter Voser, recently recruited from ABB to the newly created position of group CFO. “Saying farewell to the collegiate system will enable me to speed up strategic decision-making,” van der Veer said after the announcement. Whether the new structure can prevent a recurrence of reserves inflation remains to be seen. But it should result in speedier detection of any transgressions and faster remedial action. And reserves bookings will no longer be part of bonus calculations.

“In line with the Davis Polk recommendations, I think we are going to see compliance becoming part of the company’s DNA,” says an insider who followed the reserves problem closely. “Shell has come through a humbling experience. It has come to realize that it has to be more sensitive to local custom, law, and regulation around the globe.”

Not everybody is happy with the announced reforms. William S. Lerach—the California corporate scourge whose law firm brought a consolidated U.S. class-action suit on behalf of shareholders against Shell, its executives, and its directors for mismanagement and fraud—judges the reforms timid and inadequate. “They are proposing to go from a very bad, very dysfunctional corporate governance structure to a conventionally bad single-company corporate governance arrangement,” he claims, adding that independent board members will still lack vital powers.

But his is a minority opinion. “Shell met our expectations in every way,” says Eric Knight, managing director of Knight Vinke Institutional Partners, an investment firm partly owned by the Calpers pension fund. “We really did get what we were looking for.” If Knight has a quibble, it is that Shell—and all the

oil majors—should be using external auditors to sign off on reserves bookings. But he and others also see the reforms producing not just greater accountability and better governance but, most important of all, stronger financial results. Says the Association of British Insurers’ Peter Montagnon: “We had thought for some time that Shell’s unconventional governance structure resulted in underperformance. These reforms are about performing better.”

Which is what Shell’s future must be about—or it may not have one for long. The company still confronts the challenge that led to its recent difficulties: finding oil. The stated life of Shell’s reserves is just over 10 years, compared with 14 for BP and 13.5 for Exxon Mobil. To catch up, Shell will have to outperform the competition. It is earmarking billions for the task, and with huge projects like the Salym oil and Sakhalin II gas fields in eastern Russia, it may yet restore its fortunes. But for now Shell has gone from being a no-growth outfit with poor corporate governance to being simply a no- (or at best, low-) growth outfit. Having reinvented the company and reorganized itself, Shell’s board still has a lot more to do.

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