SHELL COMPANIES: CRACK DOWN, DEFINITION; IS THE GOVERNMENT MAYBE JUMPING THE GUN?

Right after the demonetization drive in the year 2016, and partially in an attempt to showcase the success of the anti-black money offensive by the Government, there was a spurt in the coming to light of cases of existing shell companies in India and the subsequent need to categorize the same. But has the Government really thought this through or is this offensive proving to be way too harsh for all other such companies, simply stuck in the crosshairs? We shall only see in due time.

During Financial Year 2017-18, the Registrar of Companies has identified and removed from the register of companies, the names of 2,26,166 companies as part of the Government’s crackdown on shell companies. Further, 3,09,619 directors have also been disqualified u/s.164(2)(a) read with Section 167(1) of the Companies Act, 2013, for failing to file Financial Statements or Annual Returns for a continuous period of immediately preceding 3 financial years (2013-14, 2014-15 & 2015-16). A lack of tentative definition for shell companies has been a major part of the problem, considering that there are shell companies that can successfully prove viable operations and are solely guilty of non-compliance to statutory norms and are yet being treated on the same scale as the companies actually guilty of financial frauds against the Country.

To tackle this issue, a Special Task Force (“STF”) was set up by the Prime Minister’s Office in February 2017, under the joint Chairmanship of the Revenue Secretary and Secretary, MCA (Ministry Of Corporate Affairs). The STF is taking a multi-agency approach to tackle the menace of Shell Companies, indulging in tax evasion, money siphoning etc. and includes Enforcement Directorate (ED), Financial Intelligence Unit (FIU), Directorate of Revenue Intelligence (DRI), Securities and Exchange Board of India (SEBI) and the Income Tax Department, among others.

As stated earlier, there is no set definition of Shell Companies in the Companies Act, 2013 or in any other Act for that matter. A standard definition of the same would mean to include a multi-layered Company, with financial assets but no substantive business activity and a company that is not involved in hiring human resources or creating products or even generating revenue. The above definition applies only to companies that have been set up for legitimate agendas such as promoting start-ups by storing funds at early stages or companies that have segregated their HR department into a separate company altogether, etc. Such a shell company, as defined above, becomes an illegal entity, if it is set up with the intention to make financial transactions to divert or launder money.

AN INITIATIVE TO DEFINE SHELL COMPANIES

The Government, with the help of the STF, is looking to define and categorize shell companies. Hopefully, the same can help segregate legit shell companies from the ones constituted solely for as a vehicle to carry out unlawful activities.

The definitions under consideration by the STF also include those from the Organisation for Economic Co-operation and Development (OECD), which is an inter-governmental organization responsible for suggesting policies and regulations for countries around the globe.

OECD has defined shell company as – “a firm that is formally registered, incorporated or otherwise legally organized in an economy but which does not conduct any operations in that economy other than in a pass-through capacity.” 

The U.S. Securities and Exchange Commission defines a “shell” company as follows – The term shell company means a registrant, other than an asset-backed issuer as defined in Item 1101(b) of Regulation AB ( § 229.1101(b) of this chapter), that has:

(1) No or nominal operations; and

(2) Either:

(i) No or nominal assets;

(ii) Assets consisting solely of cash and cash equivalents; or

(iii) Assets consisting of any amount of cash and cash equivalents and nominal other assets.

The suggestions under consideration by the STF include, inter alia:

• Obscure ownership;
• Excessive leveraging;
• Disproportionate investment in shares of other companies;
• Any entity having no significant operational assets or business activity of its own but acting in a pass-through capacity as a conduit (suggested by SEBI);
• Entities with insignificant business or assets;
• Entities set up mainly to facilitate cross-border asset/currency transfer;
• Firms with no economic rationale in their respective financial transactions;
• Multiple Companies with the same address;
• No physical existence at the given address;
• High ticket transactions inconsistent with the business of the firm;
• Rotational transactions with no apparent purpose or with a legitimate business group.

IS THE GOVERNMENT JUMPING THE GUN?

The Government’s orchestrated crackdown on shell companies took a controversial turn when it started the process of disqualifying and ‘naming shaming’ the directors associated with these firms. With the disqualification of more than one lakh directors and with 55,000 others been made public defaulters, this issue is seemingly giving rise to a series of controversies, that could have been avoided, had the government not acted so hastily on initiating penal action without first making a solid case against the suspected firms. The government’s unpreparedness is evident by the fact that a group of high-profile industrialists, who went to the Court against the same, were granted a stay order against the directive. Further, another group of 500 companies, finding their group of directors in the crosshairs are fighting the same, vehemently.

One need not lose sight of the fact that a fair number of shell companies exist for legitimate reasons – holding treasury shares, intellectual properties or simply for the various projects under implementation. The companies under the radar have failed to comply with the requisite statutory compliance, with only 6 lakhs of the 15 lakhs registered companies found to be regular with their financial filings. But, the key problem with the so-called crackdown is that the MCA has failed to make out a penal case of money laundering or the likes of, against the identified companies and it is only the breach of law that has led to the initiation of penal actions. A few of the listed companies under the radar have even been successful at providing viable operations in front of the SAT which is why this policy of ‘naming and shaming’ is very much opposed to the principles of natural justice.

Most of the shell/zombie companies exist due the tedious process of corporate liquidation and if statutory compliance is somewhat a factor leading to the said crackdown, simplifying the exit policy for corporations will be a major step in the right direction and would even make this entire shakedown, redundant to a large extent.  Insolvency and bankruptcy code can be seen as a step in the right direction but the impact of it in easing exit process for companies, dying to wind up is still to be seen.

It is, of course, imperative to define, regulate and penalise shell companies set up for unlawful purposes but a demarcation still needs to be drawn between the ones that are exclusively set up for tax evasion and money laundering form the ones that are set up to promote business and start-ups etc., and are working well within all legal bounds and with no financial irregularities whatsoever.