The making and breaking of shell companies

The ecosystem of shell companies not only jeopardises the interest of investors and shareholders, but also adds fuel to the black money menace.

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 that govern a shadow economy, such as carrying out business transactions for cash, evading taxes, and dodging regulations, flourish during times of financial uncertainty.
A study by the Association of Chartered Certified Accountants (ACCA) states that the 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 the GDP (Rs 26, 15,800 crore) in 2016. To cripple the parallel economy, the Government of India has taken steps like digitisation and demonetisation, along with sustained efforts to keep shell companies in check. 
Drive towards a cleaner economy
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 the Goods and Services Tax Act, Real Estate (Regulation and Development) Act and the Insolvency and Bankruptcy Code. Securities and Exchange Board of India’s (SEBI) recent directive to initiate action against 331suspected, 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 any clarity on how these companies were detected or considered to be shell companies. Unfortunately, the 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 the stocks of these companies would not be available for active trading. In his last Independence Day speech, PM Modi said that post demonetisation, 3, 00,000 shell companies were detected, of which, 1,75,000 have been shut.
Understanding shell companies
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. 
Modus operandi
 A shell company is created using fraudulent or forged documents and personal servants, chauffeurs are named on the 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.
 Fake transactions are carried out 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 a third-party ally to siphon cash/assets from the books. 
 Money is parked in the form of investments in equity shares. This is facilitated by buying shares of shell firms, inflating the prices and selling after a year to claim tax exemption on long-term capital gains.
 Direct and indirect taxes are evaded 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 of metals and alloys manufacturing, where facilitation payments are common, money is laundered to fulfill illicit payments.
How to spot a shell company?
A shell company is hard to trace, as it disguises ownership to escape regulatory monitoring. However, some of the red flags to watch out for include the following: 
Its product or service is completely out of line, as opposed to the corporation’s core business.
There are recurring defaults in timely filing of returns and furnishing information to the regulatory authorities.
There’s a 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. This is essentially a backdoor entry to go public    without having to disclose the risk portfolio. 
It has a sudden increase in the traded volume of shares, possibly due to the trading of shares within the promoter group shareholders.
Several payments/transfers of high-value are carried out without any legitimate business objective between shell companies (US Department of Treasury website, Financial Crimes).
Beginning of the end
The ecosystem of shell companies not only jeopardises the interest of investors and shareholders, but also adds fuel to the black money menace. With its recent actions, SEBI sends a strong message to companies that 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 on various databases. The focus is on protection of investors through better governance and regulations. SEBI has directed the exchanges to initiate measures, including verification of credentials of such companies.  To strengthen the process further, the exchanges shall appoint an independent auditor, and if required, conduct forensic audit.
Companies with legitimate 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 keep a check on potential surreptitious activities and build trust among entities in the economic ecosystem. In conclusion, while encouraging compliance is high on the 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. 
About the author:
Samir Paranjpe is Partner at Grant Thornton India LLP.

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