Introduction: The term "shell company" generally refers to limited liability companies and other business entities with no significant assets or ongoing business activities. Shell companies are formed for both legitimate and illicit purposes, and typically have no physical presence other than a mailing address, employ no one, and produce little to no independent economic1 value.
Shell companies can be publicly traded or privately held. Although publicly traded shell companies can be used for illicit purposes, the vulnerability of the shell company is greatly compounded when it is privately held and beneficial ownership can more easily be obscured or hidden. Lack of transparency of beneficial ownership can be a desirable characteristic for some legitimate uses of shell companies, but it is also a serious vulnerability that can make some shell companies ideal vehicles for money laundering and other illicit financial activity.2
Common uses One of the common uses for a shell company is in the reverse acquisition.3 The procedure will often involve a simple acquisition of a shell company, with shares of a private company used as consideration. The shell company, which at one point may have been an active company publicly traded on a stock exchange, issues shares to the shareholders of a private company sufficient to give those shareholders a majority interest in the shell company, thereby effectively taking the private company public without the usual costs associated with an initial public offering, and giving shareholders of the private company control over the shell company. It should be noted that the shell company in the reverse acquisition is often a formerly active company, not one created solely to be a shell.
The reverse acquisition process has in the past been subject to abuse. For example, if the expected value of the private company is fraudulently exaggerated, investors buying into the company may lose a considerable percentage of their investments when the company turns out to be worth much less. Those who fraudulently promoted the company have at that point already sold their stock and made a handsome profit. These "pump and dump" schemes often involve shell companies with low market capitalisation whose stock trades at pennies per share on the "pink sheets."4 One indicator of this scheme is concentrated trading in normally thinly traded stocks.5
Some steps have been taken to prevent this type of abuse. The SEC in order to protect investors in the securities markets from fraud and abuse involving the use of shell companies adopted procedure to check such fraud, while allowing the use of shell companies for legitimate corporate structuring purposes.6
Role in common financial crimes
Shell companies may play a role in common financial crime schemes such as the credit card bust-out, whereby credit is built up on cards using false identities, then phony transactions with co-operating businesses or shell companies are made and the phony charges are received as payments from the unsuspecting credit card companies.7
A technique commonly seen by corporate accountants involves an employee over-invoicing or creating false invoices and pocketing the difference. The director of a nutritional supplement company was convicted of money laundering in 2004. He had set up a shell company and was paying false invoices for the purchase of nutritional supplements. In addition, he received kickback payments from another nutritional supplement company in exchange for purchasing their products. His company was established by a service provider that also provided mail and phone forwarding for the shell company.8
The individuals or companies that create shell companies may play a significant role even after the shell is created and sold.9 In fact; a convenient and popular service combines formation with ongoing support.
One Delaware-based service provider provides formation services as well as mail forwarding services, telephone lines, e-mail accounts, and accounting services to file tax returns.10
Forming and supporting small companies is neither difficult nor expensive, and requires no special skill other than understanding the laws in the various states. The majority of shell companies sold to foreign interests appears to differ significantly from those used in reverse acquisitions, for example, in that they appear to have been set up solely for purchase and were not "aged" or put on the shelf after some period of actual operation (though they, too, may not be used immediately).11
By virtue of the ease of formation and the absence of ownership disclosure requirements, shell companies - generally defined as business entities without active business or significant assets - are an attractive vehicle for those seeking to launder money or conduct illicit activity. While business entities generally, and shell companies specifically, have legitimate commercial uses, this lack of transparency in the formation process poses vulnerabilities both domestically and internationally.
The advantages of using these business entities for legitimate business purposes are in some senses outweighed by the potential for abuse presented by some entities, and by the risks to and potential deleterious effects on the financial system that result from lack of transparency regarding beneficial ownership.
Domestic shell companies (LLCs and other varieties) have some legitimate and legal uses, but the ability to abuse such vehicles for illicit activity must be continually monitored.
The use of domestic shell companies as parties in international wire transfers allows for the movement of billions of dollars internationally by unknown beneficial owners. This could facilitate money laundering or terrorist financing.
Company formation agents and similar service providers play a central role in the creation and ongoing maintenance and support of domestic shell companies, some of which appear to be used for illicit purposes domestically and abroad.
States do not appear to impose effective accountability safeguards on company formation agents and similar service providers to ensure that the business entities they create, buy, sell, and support are not violating state laws specifying that the companies be used only for lawful and allowable purposes.12
Prohibitions in USA
The use of shell companies for establishing a US correspondent account has been limited subject to the following requirements:
-- To identify its owners and the name of the persons in the US to accept service of process;13
-- The bank must have a physical presence in the country of establishment;14
-- Foreign bank is not being used by that foreign bank to indirectly provide banking services to another foreign bank that does not have a physical presence in any country;15
-- The foreign bank must employ one or more individuals on a full time basis;
-- Maintains operating records related to its banking activities;
-- And is subject to inspection by the banking authority which licensed the foreign bank to conduct banking activities;16
-- There is one exception to the shell bank prohibition: a US financial institution may provide a correspondent account to a foreign shell bank, if such a shell bank (1) is an affiliate of a domestic or foreign banking institution that maintains a physical presence in the United States or a foreign country, as applicable; and (2) is subject to supervision by the affiliate banking institution's regulator;17
-- Financial institutions internally establish concentration accounts to facilitate the processing and settlement of multiple or individual customer transactions by commingling funds. To commingle such funds, a financial institution may need to separate the customer-identifying information, such as name, transaction amount, and account number, from the underlying financial transaction;18
-- US law prohibits financial institutions from allowing clients to specifically direct transactions that move their funds into, out of, or through an internal financial institution's concentration account;19
-- Under the law the Treasury or the US Attorney General may, by written notice, order a financial institution to terminate its relationship with a foreign correspondent bank that has failed to comply with a subpoena or summons or has failed to initiate proceedings to contest a subpoena or summons;20
-- Must respond to a request for information from a Federal banking agency within 120 hours (five days) of receipt of such request. Financial institutions must thus provide documentation for any account opened, maintained, administered, or managed by the institution in the US that may relate to any money laundering activities.21
Conclusion
Certain domestic jurisdictions, especially when serviced by corrupt or unwitting service providers, are particularly appealing for the creation of shell companies to be used for illicit purposes.
The US enforcement agency FinCEN is undertaking a number of key initiatives to deal with the issues addressed here and to mitigate risks posed by shell companies:
1. FinCEN is issuing an advisory to financial institutions highlighting indicators of money laundering and other financial crime involving shell companies, and reminding financial institutions of the importance of identifying,
2. FinCEN is continuing to collect information and studying how best to address the role of certain businesses specialising in the formation of business entities in its effort to reduce money laundering and related vulnerabilities in the financial system through the promotion of greater transparency.
The efforts made in this regard will effectively kill the existing advantages of a shell bank and it will not be possible to engage a shell bank in financial crimes.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)
1. Shell companies are often formed by individuals and businesses to conduct legitimate transactions, such as domestic and cross-border currency and asset transfers, or to facilitate corporate mergers and reorganisations.
2. Such companies are prohibited to establish a US correspondent account, see 31 USC 5318 K(3) L(iii).
3. Also known as a reverse merger or take-over.
4. (www.pinksheets.com).
5. Ralph A. Lambiase, former president of the North American Securities Administrators Association (NASAA) and director of the Connecticut Division of Securities, noted in 2004 the existence of "a steady stream of fraud and misconduct in the distribution and manipulation of shares of shell companies and the companies that combine with shell companies." 2 "NASAA Wants All Merged Shell Companies to Provide Full Disclosure, Transparency," M2 Financial Wire, 06/28/2004.
6. SEC Release Nos. 33-8587; 34-52038; International Series Release No 1293; File No S7-19-04, "Use of Form S-8, Form 8-K, and Form 20-F By Shell Companies," 70 FR 42233 (July 15, 2005). The SEC's rules are disclosure-oriented and require the public reporting of information that would then be accessible through the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). The SEC acknowledged in its rulemaking that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes, such as certain change of domicile or business combination transactions.
7. Referring to a case involving a foreign national who is suspected of providing bust-out proceeds to terror groups, FBI Intelligence Analyst Joseph Enright said, "one of the co-conspirators in the bust-out case linked to the New York case had an American identity under one name, with which he incorporated shell businesses and obtained checking accounts, and a completely different 'new name' under which he obtained a passport from his native country." "Are bust-out schemes financing terror?," Vision, FBI New York, 04/07/2005.
8. "Information issued by US Attorney's Office for the Northern District of Texas on March 11: Former director of sports nutrition at Texas Tech University sentenced to 33 months in federal prison," US Fed News, 03/11/2005.
9. FATF its Proliferation Financing Report, 2008 recommended that shell banks be prohibited. See Para 150 of the report.
10. A number of suspected shell companies created by the firm appear in Suspicious Activity Reports.
11. This type of Shell Company appears to have few legitimate uses, and can fairly easily be employed to disguise ownership or movement of assets or to facilitate illicit activity.
12. A few states - most notably Delaware - impose "standards of conduct" on persons serving as "registered agents." For example, the Court of Chancery in Delaware can enjoin a person from serving as a "registered agent" if the person has engaged in criminal conduct or in conduct that is likely to deceive or defraud the public. Service as a "registered agent" forms only part of the services that company formation agents and similar service providers often offer their clients. Moreover, a business entity need not organise or conduct activities in Delaware or any other sate that imposes "standards of conduct."
13. USA Patriot Act § 319 (b).
14. Benjamin Mojuvc, What Banks Need to Know About the Patriot Act, The Banking Law Journal, (March 2007).
15. Id.
16. Id.
17. Id.
18. Id.
19. USA Patriot Act, § 325.
20. USA Patriot Act, § 319.
21. Id.