The making and breaking of Shell companies

Samir Paranjpe

Today, the ascent of a shadow economy is no surprise. In fact, this system has existed since the very inception of the term ‘economy’. What’s surprising is how shadow economies are mushrooming around the world. The clandestine activities which govern a shadow economy, like carrying out business transactions for cash, evading taxes, and dodging regulations flourish during times of financial uncertainty.  

Shadow economy in India is estimated to shrink to 13.6 per cent of the GDP by 2025 as against 17.22 per cent of GDP (INR 26, 15,800 crore) in 2016, says a study by Association of Chartered Certified Accountants (ACCA). In order to cripple parallel economy, recent initiatives by the Government of India like Digitisation and Demonetisation along with sustained efforts to keep shell companies in check have grabbed headlines.

Banning suspected shell, drive to a cleaner economy, a post-demonetisation recap

Shell companies perpetuate money laundering and black money. Post demonetisation last year, the government stepped up its fight against black money with key regulatory changes like Goods and Services Tax Act, Real Estate (Regulation and Development) Act, Monetary Policy Committee (setting up), and Insolvency and Bankruptcy Code.

Securities and Exchange Board of India’s (SEBI) recent directive to initiate action against 331 suspected, listed shell companies is the first step in this arduous journey. These companies most possibly posit serious risk to public investors. The response to the directive has been mixed. Experts believe that the move is good as it will not only reduce tax evasion, but also bring sensibility to the market. However, the sudden directive also drew a lukewarm response from the investor community, primarily owing to the absence of clarity on the basis behind selection of these companies.  Unfortunately, lack of a concrete legal definition of a ‘shell company’ in India makes matters slightly complicated.   

The BSE and NSE on further orders by SEBI moved 162 and 48 companies, respectively, into Stage-VI of the Graded Surveillance Measure (GSM), indicating that these stocks would not be available for active trading.In his last Independence Day speech, PM Modi said post-demonetisation 300,000 shell companies were detected, of which, 175,000 have been shut.

Understanding shell companies, their operations and what they do

In the US, Rule 405 of the Securities Act defines a shell company as a company that has no or nominal operations and no or nominal assets (or assets consisting solely of cash and cash equivalents.)

Generally, the utility of shadow companies ranges from carrying out unethical business practices to laundering money for terrorist organisations. Most shell companies are created to satiate the need of the perpetrators to indulge in these malpractices.

Typical motifs deployed are listed below:

Modus operandi

• Create a shell company using fraudulent or forged documents. The inception is done by naming personal servants, chauffeurs as board of directors to create obscurity. As creating these firms requires a trail of paperwork, enterprising auditors are appointed to form and expand such companies.
• Carry out fake transactions to window dress the financial statements of the company and create cash. For instance: Record sales and purchase over and above the actuals, inflate payrolls, under or over value stock and assets, etc. This usually requires an ally third party to syphon cash/assets from the books.
• Park money in the form of investments in equity shares. This is facilitated through buying shares of shell firms, inflating the prices and selling after a year to claim tax exemption on long-term capital gains.
• Evasion of both direct and indirect taxes to ensure the audit trails do not leave any footprint of the illegal transactions. To evade indirect taxes, companies misrepresent information during the return filing process, especially those associated with product categories, vendors, customers and quantum of transactions etc.Consequently, these companies survive as shadow firms and inject money to propel the growth of a parallel economy or black market in India. Shell companies launder money by operating below the radar and acting as fulcrums, converting black money to white and vice versa. Experts believe that in sectors such as real estate and manufacturers of metals and alloys, where facilitation payments are common, money is laundered to fulfill illicit payments.

How to spot a shell?

Shell companies are hard to trace as they disguise their ownership to escape regulatory monitoring.

However, some of the red flags to watch out for include:

• Its product or service is completely out of line as opposed to the corporation’s core business.
• Recurring defaults in timely filing of returns and furnishing information to the regulatory authorities.
• Reverse merger, involving a formerly private company gaining access to the stock market by allowing itself to be acquired by a firm whose shares already trade, essentially a backdoor entry to go public without having to disclose the risk portfolio.
• Sudden increase in the traded volume of shares possibly due to the trading of shares within the promoter group shareholders.
• Several payments of high-value or transfers between shell companies carried out without any legit business objective  (US Department of Treasury website, Financial Crimes).

Beginning of the end

The ecosystem of shell companies not only puts in jeopardy the interest of investors and shareholders, but also adds fuel to the black money menace. SEBI, with its recent actions sends a strong message to such companies which have falsified their accounts, or flouted the legal and regulatory system to launder money.

The government plans to increase vigilance by initiating big data analytics using data from various databases. The focus is on protection of the investors through better governance and regulations. SEBI has directed the exchanges to initiate measures including verification of credentials of such companies.  Further, in its endeavour to strengthen the process, the exchanges shall appoint an independent auditor and if required, conduct forensic audit.

Companies with legit operations and business activities can avoid being reprimanded for irregularities through increased focus on compliance of various statutes. Setting the right tone at the top, improving governance, conducting due diligence, and avoiding corrupt practices will lead to keeping a check on potential surreptitious activities and build trust among entities in the economic ecosystem.

In conclusion, while encouraging compliance is high on government’s agenda in its journey towards making the economy clean, it may definitely be worthwhile for offenders to come out of their “shell” before it is too late.

With contributions from Geetanjali Singh and Prashant Gupta, Forensic & Investigative Services

The blog appeared in CFOIndia.