A bonus and incentive plan used by Royal Dutch/Shell Group apparently is being examined by the Securities and Exchange Commission (SEC) to determine whether it encouraged upper level management to overstate oil and gas reserves.

Citing people familiar with the matter, the Wall Street Journal said the SEC is reviewing how Shell tied executive bonuses to reserves booking. The SEC also wants to know how executives received their bonuses and how high into the management chain the bonus awards extended. The SEC announced a formal inquiry in February into Shell’s recategorization of 20% of its reserves (see NGI, Feb. 23).

However, the Journal noted that Shell’s audit committee, which also is reviewing the recategorization, was told that while reserve bookings played a role in Shell’s bonus scheme, the bookings did not materially affect any person’s compensation.

“Shell executives in the exploration-and-production business, including the company’s top reserve auditor responsible for vetting reserve bookings from Shell’s many global units, received bonuses based in part on the amount of energy reserves the company replaced each year,” the Journal said. “But the reserve-related weighting — the part of the bonus affected by reserve bookings — was small, ranging from nothing through the late 1990s to 15% last year, according to the person familiar with the Shell audit committee’s probe.”

The reserve-related weighting is part of a scorecard, according to sources, that is used to rate a business unit’s annual performance, and the rating would affect annual bonus calculations. However, the reserve weighting did not result in “material” payouts to executives in the company’s E&P units, according to sources. Sources told the newspaper that bonus plans for senior executives and top managers did not have any weighting related to reserves until last year.

Last week, the oil major dropped its position that it acted in “good faith” with the SEC following news that the former chairman may have known about the overbooking of oil and gas reserves as long as two years ago. A Shell spokesman said the company now says that “judgments were made in the past that would not be made today.”

The statement followed the resignation earlier this month of Sir Philip Watts, chairman of the joint Shell Group’s managing directors, who was ousted along with the exploration and production (E&P) chief amid the ongoing SEC investigation and investor pressure (see NGI, March 8).

According to reports, Watts and other top executives were warned of possible overstatements to Shell’s reserves up to two years ago. Apparently a memo, circulated to Watts and other senior executives in 2002 by an undisclosed employee, warned that Shell’s method of booking reserves appeared to be inconsistent with SEC guidelines. Sources said that the memo indicated then that Shell might have to revise downward its reserves by about 1 billion boe. In January, Shell cut its reserve total by 20%, or about 3.9 billion boe.

According to the Journal , Shell’s audit committee briefed directors recently about preliminary findings concerning the reserve revisions. The committee found a “trail of communications” that indicate Watts may have known about “longstanding internal questions over the validity of its reserves bookings.”

The committee apparently also found fault with Walter van de Vijver, who had headed Shell’s E&P unit who resigned at the same time as Watts. According to the committee, internal communications in early 2002 and “throughout last year” indicated van de Vijver brought the reserve problem to the attention of Watts to figure out how to correct it. “He didn’t bring it to the attention of the right people,” sources told the Journal.

If the sources are correct, the audit findings would contradict Shell’s assertions that it acted quickly to disclose problems and that the company acted in “good faith,” as Watts maintained in correspondence with the SEC and employees.

In a letter to Shell employees in mid-January, Watts said, “The scope and timing of our announcement were determined by compliance with regulatory requirements on disclosure. We released the information at the earliest possible time after the recategorized reserves had been quantified with some certainty.”

He wrote that during the fourth quarter of 2003, “in-depth reserves studies were completed that triggered a broad review of our previously booked proved reserves. These studies and reviews indicated that the proved reserves disclosed did not in all cases properly reflect the maturity of the development projects concerned, accounting for a significant proportion of the recategorization. Hence the need for immediate action.”

Last year, Shell centralized its global E&P operations, consolidating about 35 upstream businesses into five geographic centers. Each of the units has a senior technical manager who is responsible for booking reserve additions, which then are reviewed by directors of the E&P unit. Annual reserve statements are reviewed and approved by Shell’s audit committee, followed by the group’s committee of managing directors. Its outside financial auditors, KPMG and PricewaterhouseCoopers, are not required to sign off on the reserve statements.

The SEC provides specific guidance on booking reserves, and the rules only require “reasonable certainty,” which allows companies to use some assumptions. The SEC also does not require third-party verification, and most of the majors use internal staff to audit reserves.

Shell has hired New York-based Debevoise & Plimpton, a securities law firm, to represent it before the SEC. Shell representatives also have met with SEC investigators in Fort Worth to discuss the probe, but the SEC would not comment on the investigation.

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