MIDLANDS STATE UNIVERSITY

FACULTY OF COMMERCE

MASTER OF COMMERCE IN STRATEGIC MANAGEMENT & CORPORATE

GOVERNANCE

CORPORATE GOVERNANCE: SHELL CASE STUDY

Introduction
Corporate governance is referred to by Cadbury (1992) as how organizations are directed and
controlled, while Talaulicar (232) refers to it as the wide range of policies used by boards of
directors, executive managers, and stockholders in running an organisation. This essay seeks to
explore the corporate governance at Royal Dutch/ Shell, a Company that suffered a drawback
due to Corporate Governance issues.

Background
The history of Shell dates back to 1833 when Marcus Samuel opened a shop in London, selling
sea-shells. This business quickly developed into a thriving trading company which was later
managed by his son, Marcus Samuel Jr. His business visits to the Far East made him realize the
potential for supplying kerosene to be used for lighting and cooking, from the developing
Russian oilfields, to the large markets in China and the Far East. The Royal Dutch/Shell Group
was formed in 1907 through the merger of the assets and operations of the Netherlands-based
Royal Dutch Petroleum Company and the British-based Shell Transport and Trading Company.
In the new firm, the former had a stake of 40%, while the latter had a majority share of 60%. The
Organisation has operations in more than 70 countries around the world (Crowley 36).

In January 2004, the Company, which was then the third largest oil exploration and production
company in the world, announced that its financial statements had shown inflated oil reserves in
the earlier years, and that it would downgrade nearly four billion barrels of its 'proven' oil and
gas reserves. This announcement caused panic amongst the investors and industry analysts who
blamed the complex and opaque twin-board governance structure for the company's problems.
Experts believed that this structure lacked accountability and facilitated financial manipulations..
Some were of the opinion that apart from lack of standard policies with regard to reporting and
categorization of oil reserves; and absence of third party audits of oil reserves to ensure
transparency, one major reason for the crisis was Shell's organizational structure. They found
that the bi-national Dutch/English ownership structure of Shell with two boards and a Committee
of Managing Directors had resulted in lower accountability. Absence of clearly defined roles and
responsibilities of the top management made misrepresentation easier.
The internal review report released by Shell on April 19, 2004, stated that the top managers at
Shell knew about the inflated reserves for years and had been arguing about whether and how to
lie about it to the company's shareholders. The controversy led to the exit of top managerial
personnel and a fall in the company's credit ratings. Apart from shattering investor confidence,
the reputation of the company was also badly hit. Analysts were of the opinion that apart from
lack of standard policies with regard to reporting and categorization of oil reserves; and absence
of third party audits of oil reserves to ensure transparency, one major reason for the crisis was
Shell's organizational structure.

In response to the potential collapse of the entity, Shell announced a merger of the Royal
Dutch/shell Group of companies under a single parent company in October 2004. This case study
seeks to examine, in detail, the twin board governance structure of Shell and the loopholes in
such structure.

Corporate Governance Issues at Shell

Royal Dutch was negatively affected by shortcomings in its governance structures and it was
claimed by Berger and Montague that it recklessly violated accounting rules and guidelines,
which resulted in an enormous and shocking overstatement of oil and gas reserves. The Law
firm also instituted legal proceedings against Shell on the grounds that the “enormous” deception
harmed shareholders and “severely overstated” the firm's market value. The violations led to an
overstatement of the company’s oil and gas reserves (The Economist, 2004). In spite of the
disclosures, the company’s chairman, Sir Philip Watt, denied any incompetence or wrongdoing
on the part of the management in relation to the overstatement. However, the board sacked him
following the incident. Prior to his dismissal, it was established that the chairman was aware of
the misrepresentation since 2002 (The Economist, 2004). The facts were established through an
internal investigation launched by the company.

Shareholders were concerned that the executives who were responsible for exaggerating the
estimates of proved reserves were given large grants ofsalaries and pensions (Dakar, 2004).
Newspaper reports suggested that both Walter van de Vijver and Judith Boynton also received
pay-offsof around one million each (Griffiths, 2004). Some Shareholders also suggested that the
executive bonus system might have encourages manager s to overbook the reserves. However,
the Company’s spokesperson replied that this measure of operational performance accounted for
only 6% of annual bonus payments (Harrison, 2004).

The incident highlighted major governance shortcomings within Royal Dutch Shell. The
chairman, one of the highly ranked managers of Shell, had violated rules and regulations that
might have led to the collapse of the company. The company manifested a governance structure
that lacked accountability. Figure one below shows the changes that resulted from the
restatement of the company’s oil and natural gas reserves:
Figure 1: Changes after restatement of reserves

Source: “Royal Dutch/Shell: Another Enron?: Assessing the Seriousness of Shell’s Crisis” (13).

Analysis of the Issues

From an economic and legal perspective, the focus of governance in any corporation illustrates
the process of defending the interests of stockholders. The main issue arising from the stated
scenario at Shell involved misleading the shareholders. However, it is also important to note that
the misrepresentations made in the books may have been meant to benefit other stakeholders.
Alternatively, they may have been aimed at benefiting the company alone.

Corporate governance also entails ensuring that these structures are functioning to uphold the
reputation of the company. It is also addresses the integrity of the entity and its responsibilities to
the various stakeholders (Sussland 50). The case of Royal Dutch Shell indicates a failure in this
aspect. Management hid information about the ‘proven’ and ‘probable’ oil and gas reserves from
the stakeholders. Ultimately, the deception harmed the integrity and reputation of Shell as a
global corporation.

In addition, the uniqueness of Shell's organisational structure was that, from 1907, the company
remained a joint venture, run by a twin board of directors, rather than a single corporation. The
60:40 joint venture partnership and separate identity of the partners remained intact for nearly a
century. When the 'oil reserves' controversy broke out, analysts wondered whether the company
had become a victim of its own illustrious and unparalleled history as the most complex
organization in the corporate world with authority divided between The Hague, London and
Houston.

The revelations made by Sir Philips, together with his sacking by the board of directors, revealed
deep seated disagreements between the two governing bodies. This was a fundamental issue that
the Company may have neglected to address because conflicts were bound to arise between the
twin Boards over the control of the Company. Many analysts have since confirmed that the
functioning of the twin-board structure was very complex to understand .
Such a structure was bound to be obscure, lacking clarity and transparency. Far-flung and
decentralized operations managed by a complex reporting system made financial disclosures a
tough task and led to manipulations (Datar, 2004). It is important to note that the
misrepresentation may have been disclosed in an amicable manner if the two sides were in
agreement. The resulting negative publicity might also have been averted.

Further to the foregoing, Tukuta, Nkhosa and Rozaiwo (2012:12) argue that coporate governance
is a system which balance personal and community targets, economic and societal goals. In the
case of shell this was not applied because there was no balance in what the CEO and senior
management did in publishing false information to match their personal target

Though the merger proposal was lauded by the investors and many corporate governance
experts, a few analysts did express doubts about the success of the merger. Analysts felt that the
single board was not going to be a panacea for all the cultural clashes between the Dutch and the
English managers, because the single board was again going to comprise the bi-national
directors. How the differences in their operational styles were going to be resolved was not made
clear. Analysts commented that good governance meant competence and a management team
that would abide by corporate ethics; whether it was a uni-structure or twin structure
organization was immaterial. The merger proposal was just a public relations gesture of the
management to appease disgruntled investors and in reality, the introduction of a unified board
might not achieve any major benefits.

Based on the arguments made by Talaulicar (233), it is apparent that Royal Dutch Shell suffered
from agency problems. The separation of control and ownership in corporations is bound to
generate problems.

Theories of Corporate Governance in Relation to Royal Dutch Shell

Agency Theory
The theory describes a contractual relationship between two parties. According to this theoretical
framework, such an engagement is established when one party (the principal) engages another
(the agent) to perform given task or services (Talaulicar,233). The relationship entails delegating
the authority to make decisions to the agent. The principal-agent problem occurs when the
interests of a principal and agent conflict. Companies should seek to minimize these situations
through solid corporate policy. These conflicts present normally ethical individuals with
opportunities for moral hazard. Incentives may be used to redirect the behavior of the agent to
realign these interests with the principal's concerns.

In this case, Sir Philips, as an agent of the Company denied any wrongdoing following the
incident in Shell. The chairman felt that he was doing what was right for the company. This was
despite evidence that from internal correspondences that he was aware of the fact that the oil
reserves were overstated (Taylor, 2006). However, the decision by the board of directors
indicated otherwise. The directors felt that their decision to fire the chairman was the best for
Shell (Crowley 39).
The major problem behind the scandal at Royal Dutch Shell involves the agency’s concept of
corporate governance. The failure of the board of directors and the shareholders to determine the
actions of the management team led to the scandal. The problem might have been averted if the
managers were under the control of external and internal oversight systems.

Shareholder and stakeholder Theories

The shareholder theory was originally proposed by Milton Friedman and it states that the sole
responsibility of business is to increase profits. It is based on the premise that management are
hired as the agent of the shareholders to run the company for their benefit, and therefore they are
legally and morally obligated to serve their interests. The only qualification on the rule to make
as much money as possible is the conformity to the basic rules of the society, both those
embodied in law and those embodied in ethical custom.

Stakeholder theory, on the other hand, states that a company owes a responsibility to a wider
group of stakeholders, other than just shareholders. A stakeholder is defined as any person/group
which can affect/be affected by the actions of a business. It includes employees, customers,
suppliers, creditors and even the wider community and competitors.

The theory was applied in this case through the exaggeration of the oil and gas reserves figures
which initially favoured the shareholders, especially in the stock market. Shell management
seemed more inclined towards the shareholder theory because the scandal revealed that their
primary concern was to please the shareholders by ensuring that their shares maintained a high
value (though it was false). It is also evident when the Board Chairman pressurised the executive
to engage in the unethical activities such as concealing the true status of the reserves.

A conflict between the shareholder theory and the stakeholder theory is made apparent in this
case. The scandal at Shell reflects the imbalance between shareholders’ value and stakeholders’
interests. The governing regimes fail to realise that focusing on shareholders disregards the fact
that stakeholders are interdependent. Effective functioning of the corporation relies on the
effective cooperation between the parties in optimising their interests.
The book value of Shell should have acknowledged the real situation. Simply put, book value
provides an inventory of the financial assets and the market value of a corporation (Talaulicar
35). The figures neglected other aspects relating to the worth of the business. Royal Dutch
Shell’s management could have succumbed to stiff competition. Stiff competition, coupled with
short time cycle, may force managers to focus on results and how to get them fast (Sussland 50).
Shell’s management focused on evaluation of the company performance through financial
indicators only.

Transaction Cost Economics Theory

The other framework that can explain governance issues at Royal Dutch Shell is the transaction
cost economics (TCE) theory (Donaldson 265). The theory holds that firms are established with
the intent of avoiding some transaction costs in price mechanisms. Under TCE, corporations are
created by the market forces. They also originate from the attempts made by market actors to
avoid the transaction costs (Donaldson 266).

One of the major differences between TCE and agency theory is the former’s assumption of the
opportunistic nature of humans (Donaldson 265). On its part, the latter emphasises on the agency
costs and associated moral hazards. TCE takes into consideration the economics of governance
driven by workable arrangements and “good order” (Donaldson 269).
Good order in TCE entails spontaneous market arrangements.

The managers lacked motivation to manipulate the booking of oil and gas reserves. In light of
this, TCE theory might be used to effectively explain the scandal. The external and internal
market economic factors might have facilitated the deception. Based on the data presented in
figure 1, it is likely that the management may have been compelled to keep up with the
competitors, mainly Exxon Mobil and BP. The executive at Shell sought to govern by creating
workable arrangements and good order in the company.

TCE has a number of weaknesses. For example, it is inadequate in the determination of the
appropriate and workable arrangements. Establishing good order raises the issues of the probable
beneficiary. In addition, the issue of workability of arrangements becomes a problem in
corporate governance.

Recommendations
The corporate decisions need to serve the interests of the enterprise and facilitate sustainable
value creation. The bottom line is the creation of a principle that strikes a balance between the
interests of the various stakeholders. The weaknesses of agency theory in relation to Shell can be
addressed through a combination of approaches. It is important to note that the compensation
problem may not be the major cause of the scandal. However, the issue should be reviewed.
Effective compensation systems require the introduction and review of equity ownership. As
equity owners, the managers might embrace transparency in their activities.

The recommendation is based on the assumption that the interests of the stakeholders will be
catered for if these agents are involved in decision making. In addition, their representatives
might bring with them expertise, skills, and experience in the boardroom. The added advantage
would enhance corporate value in general.

Other elements of corporate governance in Shell should also be addressed in regards to Power
distribution which must also be based on a clearly defined scope of responsibilities and rights.
For instance, the roles of the chief executive officer and the board chairman should be separated.
Managers must be granted the autonomy necessary to drive the corporation forward. However,
their freedom must be exercised on a framework of accountability. Such an objective can be
achieved through efficient decision making processes by executives.

Shell’s corporate structure should clearly define the legal entitlements and legitimate roles of
stakeholders. Various external and internal control mechanisms should be designed and
implemented to avoid repetition of such incidents. The governance structure should uphold
transparency and integrity. Furthermore, responsibility, stewardship, and accountability should
feature in Shell’s governance framework. The main role of governance should be to foster
quality care through the creation of value for the stakeholders and the enterprise. The benefits of
an effective corporate governance framework are many. By supporting socially accountable
behaviour, Shell would gain the trust of investors. Well governed organisations are also likely to
generate high equity returns. Shell would increase its market value and improve its performance.

The future of corporate governance is characterised by numerous challenges. Most of these

issues are related to globalisation. Such challenges are significant considering the evolving
nature of global enterprises. A holistic model of corporate governance may help to overcome
such issues. Changes in economic relationships and market structures influence corporate
governance.

The process is also affected by the nature of interactions between the community, the
stakeholders, and the business forces. As such, administrative systems require regular reviews to
help corporations cope with the changing environmental needs. Good corporate governance is a
function of a number of factors. They include legal, social, economic, and personal elements.
Such corporations as Shell should invest in mechanisms meant to check the operations of
corporate governance.

Conclusion
The major issue affecting the company was lack of transparency. Transparency with regards to
honest disclosure of a company’s information is vital for effective corporate governance. Shell’s
management exhibited lack of transparency in restating oil and gas reserves. It is not possible to
point out to the beneficiaries of this practice. Some people may argue that the company did
nothing wrong as it could have been human error. However, it is obvious that the reputation of
the organisation was negatively affected.

The company was also characterised by lack of a balanced corporate structure. Such a structure
is needed for efficient corporate governance. The firm’s governance model fails to address the
varying interests of stakeholders. The management seems to focus more on the creation of value
for shareholders than on other aspects of the organisation. The skewed focus led to deceptions in
relation to the actual value of
the company.
Works Cited
“Royal Dutch/Shell: Another Enron?: Assessing the Seriousness of Shell’s Crisis.” The
Economist 11 Mar. 2004: 13. Print.
Chau, Soling. “An Anatomy of Corporate Governance.” The IUP Journal of Corporate
Governance 10.1 (2011): 7-21. Print.
Crowley, Michael. “Corporate Governance- Royal Dutch Shell, Terrorism and Reputational
Risk.” Legal Issues in Business 11 (2009): 35-47. Print.
Datar, R. (2004) Shell Shock, BBC2 programme, 15 July
Donaldson, Thomas. “The Epistemic Fault Line in Corporate Governance.” Academy of
Management Review 37.2 (2012): 256-271. Print.
Sussland, Willy. “Business Value and Corporate Governance: A New Approach.” Journal of
Business Strategy 25.1 (2004): 49-56. Print.
Talaulicar, Till. “The Concept of the Balanced Company and its Implications for Corporate
Governance.” Society and Business Review 5.3 (2010): 232-244. Print.
Griffiths, K. (2004) Shell Looks to Draw a Line under Reserves Fiasco with Shake-up of Board
Structure, The Independent, 25 April, 19
Harrison, M. (2004) The Independent, 16 July
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