As readers will appreciate, the article that actually appeared, although in my name, is placed in its final form by an editorial process over which I have no control – indeed I saw the published text for the first time after publication on Sunday. Because of news items, the article was heavily cut. This is not a complaint, it's just how newspapers work. Inevitably, therefore, much of the story was left out and some of the phrasing was not mine at all. The article originally submitted*, which is directly based on the 12,000 word chapter in the book, runs essentially like this:
For nearly 100 years Shell was a 60:40 joint venture between Royal Netherlands Petroleum and Shell Transport and Trading, in which the Dutch company had a controlling interest. Shell continued to prosper, and was consistently voted one of the world's most admired companies. It was run by a Committee of Managing Directors whose Chairman since 2001 was Phil Watts, later Sir Philip. The non-executive directors, distinguished is such fields as academica, diplomacy, environmentalism and law, met with all the other directors in a body called the Conference which Sir Philip also chaired, as had his predecessors. It was all very agreeable, but at least one of the outside directors was thinking of resigning because of a lack of real engagement with the business. Then in 2004 everything changed. The non-execs found themselves driving the biggest restructuring of any business to date, under considerable pressure from investors and the press. In Constructive Engagement, for the first time, we tell the inside story.
“I am becoming sick and tired about lying about the extent of our reserves issues ” said Walter van de Vijver to Phil Watts in an astonishing email sent on November 9th 2003. This was an escalation of the serious dispute that had been going on between them for over two years, ever since van der Vijver succeed Watts as head of Exploration and Production (EP). As described by van de Vijver: “Soon after coming to office as head of EP in June 2001, I observed that ... EP was in a far worse state in mid 2001 than was ever portrayed by my predecessor to senior management or the Conference.”
The value of an oil company depends to a large extent on the state of its oil reserves. Reserves are divided into Proved and merely Probable, and reserves are not Proved if there are potential environmental, political or commercial showstoppers or if there is a risk that the oil will not be extracted before the end of the licence period. The SEC lays down guidelines for when companies can claim Proved reserves: as with many other disclosure methodologies these are somewhat arbitrary with a number of manifest absurdities but US filings must abide by SEC rules.
In February 2002, van de Vijver had warned that proved reserve exposures could be as high as 2.3 bn Barrels of Oil Equivalent because of non-compliance with SEC guidelines. But Sir Philip directed him to leave no stone unturned to achieve more than 100% replacement of (proved) reserves for 2002. So the plan became to 'manage' the totality of the reserve position over time, in hopes that problematic reserve bookings could be rendered immaterial by project maturation, license extensions, exploration successes and/or strategic activity. But it became increasingly clear that the plan to 'manage' the exposure would not work. Shell's Group Audit Committee had raised the issue of whether Shell's figures were in accordance with the SEC guidelines in 2003 and had been told that much if not all, of the potential exposure was offset by Shell's practice of not disclosing reserves in relation to gas production that is consumed on site as fuel or (incidental) flaring and venting. Following external legal advice, a project began to review the reserves. In December 2003 EP staff produced a 'draft script for Walter' stating that “If and from the time onwards that it is accepted or acknowledged ... that, when applying the SEC rules, the 2002 proved reserves as reported in the Form 20-F are materially wrong, [we] are under a legal obligation to disclose that information to all investors at the same time and without delay.” Astonishingly, on the same day this script was provided to Walter van de Vijver, he immediately e-mailed one of its authors: This is absolute dynamite, not at all what I expected and needs to be destroyed. Because of prompt interdiction by internal counsel, the document was retained.
Both Sir Philip Watts and Walter van der Vijver are very able but apparently rather complex characters, who come across at least to some observers as rather arrogant and as not having great communications skills. One of them was described as giving the impression that “he considered the rest of the human race in general and his fellow-MDs in particular as intellectual pygmies.” A senior NED of Shell, when we were discussing this later, pointed out that Sir Philip had never been an NED of another company and suggested that such service might have helped give a more rounded outlook.
At the end of December an emergency meeting of the Group Audit Committee was called for early January, which was so sensitive that no agenda papers were sent out. On the 9th Jan 2004 Shell shocked the market by announcing: “following internal reviews, some proved hydrocarbon reserves will be recategorised. The total non recurring recategorisation, relative to the proved reserves as stated at December 31st 2002, represents 3.9 billion barrels of oil equivalent (‘boe’) of proved reserves, or 20% of proved reserves at that date.” The market sensed trouble and the shares fell 7.5% that day. The Group Audit Committee engaged an outside law firm who and submitted an interim report on the 1st March. Two days later, Sir Philip Watts and Walter van de Vijver were asked to resign. Jeroen van der Veer was appointed President and Chairman of the Committee of Managing Directors. But, in view of the unprecedented situation, Conference decided to appoint an NED as Chairman: Ron Oxburgh, an academic geologist by background who had joined the board in 1996.
When the Reserves issue broke it was clear that serious Investor engagement was needed. Two Investor bodies took action. The Association of British Insurers (ABI) formed a special committee to address the questions, and the National Association of Pension Funds (NAPF) formed a Case Committee. On 2nd February 04 about a dozen institutional investors met a Shell delegation led by Lord Oxburgh. The issues raised included: Reserves replacement, Communications generally, the structure of the company, credibility of the Senior Management Team, and SEC methods. In particular the Shell team was able to explain some of the anomalies and complexities of the SEC's definition of 'Proven Reserves' and the fact that there is a considerable element of judgement in making such estimates. The point was also reinforced that the amount of oil in the ground had not changed. It was made clear that Royal Dutch had a veto on structure, and that UK Investors had to be very diplomatic and tactful.
When Sir Philip was having Investor meetings he was questioned about lack of independent and objective leadership, the role of NEDs, Internal controls and reporting lines and Investors wanted to know more clearly how decisions were made. There was some discomfort about the fact that the existence of discussions was being reported in the press, but this needs to be seen against a background of strong pressure on the Institutional Investors to be seen to be acting as responsible owners.
Meanwhile a voluble activist investor called Eric Knight burst on the scene. After the dramatic departure of Sir Philip the pace of engagement accelerated further. By this time the Investor view in the UK was that “we wanted to see a streamlined structure – how they did it was up to them but we wanted at least a unified Board if not a unified company.” However UK Investors received the impression that “the Dutch will think that the departure of Phil Watts will suffice”. Investors wrote to Lord Oxburgh and there was a further meeting at the ABI on the 22nd March. This went well, with Investors seeing “a no-nonsense approach” and the NEDs being “pretty open about the problems.”
That day the London Evening Standard published a article headlined Shell Braced as Investors Get Chance to Vent Anger and the following day the FT had an article Shell UK arm hails 'helpful' talks with angry investors. The NAPF Case Committee met with Shell the following day 24th March. Understandably they requested that this meeting should not be publicised: indeed it is a basic rule of NAPF case committees that they should be wholly confidential while they are in existence, and any statement should only be made at the end of the engagement – the NAPF has kindly given permission for us to use the material to deepen understanding of the real process of constructive engagement.
At this meeting the Investors got a very frank and accurate picture of many of the governance issues. An important complication was that Shell T&T was very much the junior partner in the JV with Royal Dutch, a situation that was magnified by the existence of Priority Shares in Royal Dutch. Amazingly, the holders of these 1,500 Priority Shares had effective control of the entire group: they had the right to draw up a binding nomination consisting of two persons for filling vacancies on the Supervisory Board and the Board of Management of Royal Dutch, as well as the right to block any changes to the Articles of Royal Dutch or to the number of members of the Management or Supervisory Boards. The Priority Shares were controlled by a Foundation whose members were all the members of the Royal Dutch Management and Supervisory Boards. Therefore any changes had to be with their consent – it was legally impossible for Shareholders to force a change. Diplomacy and persuasion were necessary. If it appeared that ST&T were ganging up with shareholders to cause structural change, this would be counter-productive. There were also tax advantages of the dual structure which needed to be considered. Generally Investors were impressed with the openness and willingness to listen of the NEDs, but they were also concerned that the company was controlled by the bureaucracy and not by the Boards, and that the culture was deeply entrenched. “The body language was fascinating and the behaviour was also remarkable.” one of the attendees dryly remarked.
There was a sense by early April that the Shell T&T NEDs had got the message but it was less clear whether the Dutch and the executives were on side. The general feeling was the Dutch Investors also wanted greater accountability but were much more cautious about an 'Anglo-Saxon' business model. They were also very unwilling to make public representations. At least one leading Dutch Investor expressed the view that the reserves story was about technical issues and not about governance, and basically sent a message that no change was needed. Eventually some ABI people were able to meet the Chairman of Royal Dutch, Aad Jacobs, in the Hague, on the 17th May, accompanied by one of the Netherlands' most influential Investors. The Royal Dutch side emphasised that significant changes had been made to the Board, that Dutch Government and Queen were significant stakeholders/ shareholders in this and that the responsibilities of the five MDs had already been redefined. They also made the point that Conference was now chaired by an Independent Director. There was a school of thought that these changes would be sufficient – how influential this view was remained to be seen.
It was clear to everybody that the governance issue would not go away. On 28th April Conference set up a Steering Group consisting of Sir John Kerr, Maarten van den Bergh, Sir Peter Job, Jonkheer Aarnout Loudon and Jeroen van der Veer. Their terms of reference were to review: the possible simplification of Board/Group management structures; improving decision making processes and accountability, and enhancing effective leadership for the Group as a whole. This team was carefully selected by Conference as a whole. There was a 60:40 balance. Sir John Kerr (now Lord Kerr) a consummate diplomat was elected by the Steering Group to be its Chairman – this was not a case of picking the Chairman and then his packing the committee. The Steering Group was also supported by a Working Group of some bright Shell people, three firms of lawyers (UK, Dutch and US) and, by bankers from Citigroup and Rothschilds.
Shell announced the existence of the Steering Group but initially would not disclose the members or the terms of reference. This met a barrage of criticism. When Shell NEDs met the ABI on the 14th June they were pressed on this, and meeting the NAPF on the same day, the Shell NEDs remarked that “initially it had not been appreciated how much interest there would be in the group. It had always been intended to name them at the AGM but perhaps this might be done sooner.” They explained that the working party had begun with 21 different corporate models and had whittled them down to 6 by that stage. There was useful discussion of the most intelligent way for Investors to vote, and the natural inclination of some Investors to register their disapproval of (for example) the Auditors was curbed by a greater desire to achieve beneficial change.
On the 28th June both Shell T&T and Royal Dutch held their AGMs, in London and The Hague respectively. Publication of the Accounts and the AGMs had been delayed because the proven reserves had needed thorough checking. At the Shell T&T AGM Lord Oxburgh began by “offering a sincere apology for the failures that led to the significant restatement of the Group's proved reserves earlier this year.” In an interesting slight contrast Aad Jacobs told the Royal Dutch AGM that “The Supervisory Board deeply regrets the issue of the reserves re-categorisation that has affected the reputation of the company in recent months” and that “We have decided to re-visit the governance structure of the Group, as well as Royal Dutch itself, and to see whether we can make it more effective, with better accountability and not least more intelligible to the outside world. Although, as the report of the independent working group and external auditors have also confirmed, we do not believe that there is a correlation between the reserves re-categorisation and the governance of Royal Dutch and the Group, it is in any event a good enough reason to review the structure of the Group and governance of both particularly when shareholders have expressed their keen interest and concerns in that respect.”
Jeroen van der Verr and his fellow Managing Director Malcolm Brinded delivered a remarkable speech where they each said “I would like to add a personal note. These recent months have felt simply dreadful. People everywhere ask What is going on at Shell? And I agree that such a crisis should never have happened. But it has. And I sincerely regret this.” and disclosed that “in May, we met with the top 400 leaders in Shell and asked some searching questions. Do we understand the word humility? Do we always put the enterprise first?” This won hearts and minds.
The Shell AGM went on for four hours. But the Royal Dutch AGM went on for six hours. A shareholder demanded an apology. There was criticism of having separate Boards and separate AGMs. A representative of the major Dutch state pension fund publicly complained about the governance, as did other shareholders. The resolutions to discharge the directors for 2003, usually a formality, was nearly defeated with a 39% vote against. The CIO of one of Holland's largest Investors publicly called for changes, and by the end it was clear that the idea of leaving the governance more or less unchanged was unsustainable.
Jeroen van der Veer was winning many friends amongst the Investors. They found him “business-like, friendly and relaxed.” He said he was aware of the concerns – very quickly, and that “we are doing something about it.” When told that Investors wanted an Efficient, Effective, Transparent and accountable decision-making process his response was “No problem.”
John Kerr's experience of diplomacy helped him to structure the complex internal and external processes on the governance review. There were three parts to the operation: listening to people inside Shell, liaising with Investors and addressing the structural and governance issues. When meeting Investors he would take careful notes, and then be able to refer specifically to their words in follow-up meetings. Eventually he and colleagues had seen Investors representing over 50% of the equity of the group, and in some cases met them three or more times. He could go back and say “when we last met you said X, can you explain a bit more why?” He was also at an advantage in that he really was listening, and learning things from the Investors. This increased his leverage within the company – he was the only person on the Board who had really listened to so many Investors, ever. It also enhanced his credibility with the Investors.
The other crucial decision was to leave the most difficult issues till last. This meant that they started with Governance issues, developing detailed documents to define the roles of the Chairman, Board, CEO, Executive Committee and Company Secretary, and deferring the difficult questions about corporate structure. This is an excellent general principle, because it builds up trust and momentum towards an agreement and by the end the parties are keen to resolve the difficult questions since the alternative is to lose everything that they previously agreed. It also sometimes turns out the that difficult questions are not so difficult after all when agreement on other matters has been reached.
Members of the Steering Group met Investors in July and made it clear that they were open to radical constructive ideas but that both a unitary board and, if necessary, duplicated boards were being considered. They were also considering the possibility of moving from the 60:40 ownership split to 50:50. There had been some concern in the Dutch press that the governance issues were being raised by Anglo-Saxons as a means of changing the 60:40 settlement and those Investor representatives who spoke to journalists were clear that this was not an Anglo-Saxon agenda but a desire to make Shell more successful. The point was strongly made to the Steering Group that the priority must be to come up with a long lasting solution, even if it meant missing the November dateline. For long term shareholders “the worst result would be a hastily reached solution that required changing in five years time”. Shell received similar feedback from Dutch investors – take your time (if necessary) and help make the group more successful. It was also very helpful that the Royal Dutch Board announced that they would give up the Priority Shares.
In August Shell settled with the SEC and the FSA. The Steering Group, met in all 21 times: many of these were all-day meetings. In addition to the ABI and NAPF members the Investors consulted included the major Dutch Investors, Capital (who is one of the largest shareholders in both companies) and Fidelity: both of these firms maintained their own dialogue rather than going through the ABI or the NAPF. Thinking began to coalesce around some preferred reforms. It concluded that there should be a proper CEO accountable to a unified board with a majority of outside directors and a non-executive chairman. The governance documents defining the roles of the key parties were discussed in detail and accepted at a long meeting of Conference on September 7th 2004. Everyone was very keen to avoid a US-style Chairman and CEO and they were also concerned about having a 'heroic' CEO. However the detailed checks and balances in the documents, which had been developed after studying the BP arrangements amongst others, helped avoid this. Conference also received the recommendation that the Board should initially have 10 NEDs and 5 EDs.
Meanwhile the structural options, and their legal and tax implications, were being studied by the Steering Group and even more by the Working Group. The review focused down to two options:
A best in class dual company structure, drawn from experience with such companies as Carnival and Rio Tinto, which have a unified Board but are legally two companies.
Unification into a single company.
The two options were carefully kept open, so that the difficult and highly emotive issues of national control could be dealt with last. But this had other advantages. Once the roles of the Board, the Chairman and the CEO were defined, the question of structure become largely technical: what structure best supports the efficient performance of these roles – both in terms of decision making and in terms of any tax and financial implications? Thus the Steering Group could ask for technical studies from the Working Group and the advisors. Furthermore the definition of roles and the nature of the process placed the onus on those who wanted a dual company to justify the increased complexity. This was particularly important because several years earlier a unification proposal had been rejected by the Board and “ we looked at this years ago and rejected it” always sounds like a powerful argument.
Eventually these two options were put to the Conference on October 8th. The expectation was that Conference would go for (A). There was a view that this was a matter for which the EDs should retire, since they were interested parties. But, backed by the Chairman, they insisted in being in the room, and when it was their turn to speak they astonished many of those present by all coming down in favour of Unification. This view carried the day with the Conference and with both Boards, although some on the Royal Dutch Supervisory Board wanted another alternative considered.
The details were approved unanimously at a final meeting on October 27th. They involved creation of a new company, Royal Dutch Shell plc, listed in the UK but headquartered in Holland, with ‘A’ and ‘B’ shares. Royal Dutch shareholders received ‘A’ shares and Dutch-sourced dividends while Shell T&T shareholders received ‘B’ shares and UK-sourced dividends. These ‘A’ and ‘B’ shares are otherwise be identical and will vote together as a single class on all matters and have dividends of the same amount declared, in Euros and Pounds respectively. The Board shrank to 10 NEDs and 5 EDs and new NEDs would be rotated in. When these arrangements were approved (at the AGM in June 2005) Aad Jacobs would become Chairman but would step down in 2006 in favour of a new Chairman from outside the Group, indeed they subsequently appointed the former CEO of Nokia. As John Kerr put it “we surprised ourselves by going much further than we thought we would.”
On 28th October 04 Shell announced their structure change. “It caught us all by surprise” a key Investor recalls “we switched on our PCs and there it was. 'What, Shell have done it!' And they sort-of over-delivered. The shares went up despite the fact that they also announced yet another downgrade of reserves. Also there were no leaks, which was most impressive.” The fact that it was attacked by 'nationalist' elements in both the English and the Dutch press was, in a strange way, mildly encouraging. But it clearly had the support of the Investors and of powerful establishment figures in both the UK and Holland, including the former Prime Minister Wim Kok.
The following day five Royal Dutch/Shell Directors met the NAPF Case Committee, whose chairman congratulated the Shell team on their achievements and for meeting all the Committee's aspirations. There were some interesting questions on governance. The Shell team explained that they were phasing in recruitment of new NEDs over three years, partly because Shell is a large and complex business and it is important to have a Board with people who know the company. They stated that they now see themselves as neither Dutch nor British but as a major global company and the nationality of key people will be a matter of chance deriving from ability rather than turn-and-turn-about. The new Articles of Royal Dutch Shell plc would be in complete compliance with the Combined Code. The new CFO made it clear that he would not have accepted the role if he did not have total functional control, and Jeroen van der Veer again impressed Investors with his honest assessment of the culture that had existed and the need to change.
All in all there was a consensus, both with the NAPF and with the other major Investors, that the engagement had worked very well. Simon Fraser of Fidelity summed it up as follows: “Shell seemed to go well. The discussions with Investors were good. They did seem to listen. They got on the front foot and they over-delivered: announcing the changes a bit sooner than they had promised and changing more than the Investors had expected.”
Another leading Investor put it like this: “It was a good engagement and outcome – so far. In a way it is not over – they have arrived at a new structure – now they have to make it work. There is always a difficulty of translating strategy into specifics. But so far so good.”
In 2004 Shell was hit by a scandal. From
being relative outsiders,
the non-executives had to drive through the largest corporate
restructuring in history, with intense investor engagement. From
interviews with key Directors and Investors and unpublished documents,
this story can be told for the first time.
“I am becoming sick and tired about
lying about the extent of our
reserves issues.” Walter van de Vijver pressed send, and
the email
went to Sir Philip Watts on November 9 2003. They were locked in
a
bitter struggle, ever since Watts had become Chairman of the Commitee
of Managing Directors of Shell and van de Vijver had succeeded him as
Managing Director, Exploration and Production. Shell was
regularly
voted one of the world's most admired companies. But it wasn't a
company: it was a joint venture between Royal Dutch Petroleum, which
had a controlling interest of 60%, and Shell Transport and Trading,
which had the remaining 40%. It was run by the Committee of Managing
Directors. Non-executives met with the other directors in a 21-strong
body called the Conference, which Sir Philip also chaired. It was
all
very cosy, but at least one of the outside directors was thinking of
resigning because of a lack of real engagement with the business.
They were unaware of the storm between these two men - complex
characters, one of whom was described as "giving the impression that he
considered the rest of the human race in general, and his fellow MDs in
particular, to be intellectual pygmies." This centred on
the
over-aggressive booking of oil reserves, the lifeblood of any oil
company and a key indicator of its future prospects. When
executives
realised that the bookings were in excess of those allowed by SEC
rules, the plan became to "manage" the position over time. But it
became clear that this would not work....