UK: Letter from Sir Philiip Watts to the FSA

The Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS

Dear Sirs

We enclose by way of service a Reference Notice which has been filed with the Financial Services and Markets Tribunal (the "Tribunal") today in relation to the Final Notice issued to Shell on 24 August 2004.

In issuing the Final Notice, the FSA has breached its obligations under Section 393 of the Financial Services and Markets Act 2000 ("FSMA") by making findings which both identify and prejudice our client, Sir Philip Watts, and by unfairly denying him his right to make representations and review the evidence in respect of the FSA’s findings prior to their publication.

In doing so, the FSA has also unfairly pre-judged matters that remain in issue in its ongoing investigation in relation to Sir Philip.

Section 393 fsma deals with third party rights in respect of FSA notices. The purpose of section 393 is to ensure fairness where there is some wrong-doing alleged on the part of a third party who is not himself the subject of action by the FSA. Among other things, section 393:

• Requires that the FSA gives a third party the opportunity to make representations if any of the reasons for the FSA’s action relates to a matter which (i) identifies the third party and (ii) in the opinion of the FSA, is prejudicial to the third party; and

• Affords the third party access to the evidence on which the FSA relies.

We contacted the FSA on three separate occasions prior to publication of the Final Notice to seek assurances that the FSA would comply with its statutory duties. Nonetheless, in its haste to resolve its investigation into Shell, the FSA has flouted those obligations, leaving our client no option but to seek redress by way of Reference to the Tribunal.

While the FSA has recently publicly committed to increasing the speed with which it concludes enforcement actions, on this occasion, early publication has been achieved at the expense of proper investigation and fairness to our client.

The FSA’s failure to afford our client his statutory rights is particularly egregious given the limited investigation that was undertaken by the FSA prior to publication of the Final Notice in relation to matters on which they make findings in that Notice. Had the FSA completed its investigation and/or afforded our client his right to make representations before issuing its decision against Shell, the FSA’s findings would have been shown to be fundamentally flawed.

By way of example:

• On the contrary, each year, Shell’s resource base was the subject of extensive business assurance processes that included reviews by internal and external auditors and reports to our client, the Committee of Managing Directors ("CMD"), and the Group Audit Committee that Shell’s reserves were estimated in accordance with SEC requirements.

• Notes and memoranda to CMD cited by the FSA contained information relating to potential future issues relating to reserves which were the subject of ongoing work by Shell’s Exploration and Production ("EP") business and EP represented that no de-bookings were necessary.

• Furthermore, these notes and memoranda were met with requests by our client for formal and fully transparent follow up by EP to CMD, and, in 2003, to the Group Audit Committee.

• Our client believed that bookings were made in accordance with Shell guidelines in effect at the time and were reviewed by Shell’s internal and external auditors.

• The FSA dismisses KPMG’s review by stating that it "did not constitute an audit of Shell’s proved reserves" and "formed no view as to the reasonableness of any reliance placed on that review"

• However, Statement of Auditing Standards No. 52 ("SAS 52") requires auditors to determine that the methods for estimating proved oil and gas reserves comply with Generally Accepted Accounting Principles ("GAAP"). This included enquiring as to whether those responsible for estimating reserves had appropriate qualifications, whether the internal Shell guidelines complied with SEC rules and whether Shell’s methods and bases for estimating proved reserves were documented and current.

• SAS 52 requires that, if the external auditors believe that proved reserves do not comply with GAAP, they are to make further enquiries. If they are unable to evaluate the responses they receive or still doubt that the proved reserves comply with GAAP, they are to document their concerns in their report on the entity’s financial statements filed with the SEC.

• The FSA has singled out the Group Reserves Auditor as ineffective. This ignores the fact that KPMG, one of Shell’s external auditors, confirmed his competence and independence in a three-page opinion in December 2002.

• We note that the FSA has not addressed this letter in its Final Notice (just as Davis Polk did not address the issue, or the role of the external auditors generally, in the Executive Summary of their report to the Group Audit Committee).

• Assurance as to the thoroughness of the Group Reserves Auditor had earlier been provided to our client by the external auditors in their report to CMD and the Group Audit Committee in March 2002.

• The SEC rule that defines proved reserves in terms of volumes "reasonably certain" to be extracted was enacted in 1978

• The revisions of Shell’s 1998 guidelines criticised by the FSA ignored the fact that the changes were carefully implemented with the involvement and support of Group Audit and External Auditors.

• The SEC "guidance" of March 2001, relied upon by the FSA in describing Rule 4-10’s requirements, is non-binding staff guidance for which the SEC expressly " disclaims responsibility".

• Shell routinely modified its internal guidelines. The revised guidelines were reviewed by Shell’s external auditors as our client was aware when, in 2002 and 2003, they reported on the revisions to CMD and to the Group Audit Committee.

• Shell debooked approximately 4.5 billion barrels of oil equivalent ("boe") of reserves. A substantial part had been booked by 1996, before our client began his tenure at EP and other reserves were booked after his tenure ended.

• Reserves debooked had originally been booked as early as 1986 (Brunei) and as late as 2002 (Kashagan).

6. The FSA’s Final Notice fails to acknowledge that Sir Philip requested rigorous and immediate review of proved reserves after report of two unsatisfactory audits.

• Once CMD was alerted, on 18 November 2003, to unsatisfactory audits in respect of Nigeria SPDC and Oman, our client took steps to establish a thorough review of Shell’s reported reserves. It was this review which led to the announcement by Shell on 9 January 2004 of the recategorisation of significant volumes of reserves.

Sir Philip has, to date, refrained from making any substantive public comment during the currency of the FSA’s investigation. However, in the light of the FSA’s premature publication of its findings in breach of its statutory obligations, he feels compelled to begin to correct the record by making this Reference to the Tribunal. Accordingly, Sir Philip is referring to the Tribunal the FSA’s failure to afford him his third party rights as well as challenging the reasons on which the Final Notice is based.

Sir Philip remains confident that a full and fair examination of the evidence in these proceedings, or any other proceedings the FSA may bring against him, will find that he acted properly and in good faith.

Yours faithfully

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