Forensic Accounting; the ‘Knight in Shining Armour’ for Regulators against Fraudulent Shells

An Overview of Fraud through Shell Companies

The pandemic triggered an increased perception of fraud worldwide in various sectors as businesses saw a slowdown in activities. A report titled, ‘Rethinking Fraud and Economic Crime,’ predicted that some companies might resort to round-tripping, fund diversion, and evergreening of loans in a desperate attempt to stay afloat to overcome the economic consequences of Covid-19 due to a lack of liquidity. The report further stated that volatile cash flows, insufficient reserves, and a limited capacity to get supplementary debt or equity funding might put enormous pressure on enterprises to transfer funds between corporations for illegal or covert purposes.

Fast forward to 2022, the instances of fund diversion are rampant in the country, with industry giants resorting to shell companies to route money to raise loans fraudulently. Accordingly, the Enforcement Directorate (ED) probed a notable real estate developer for round-tripping of funds through businesses acting as fronts to record bogus costs, write-off project expenses, advance interest-free loans to sister concerns, and fabrication of assets within and outside the country. Following an inquiry into one of the country’s largest scams, the CBI claimed that the accused incorporated over 98 businesses to siphon cash to generate personal possessions and for the sole intention of evergreening loans. The fraud was mostly due to the company making huge transactions to related parties and then creating adjustment entries. It was also claimed that huge sums of money were invested in its foreign company by diverting bank loans, which were declared fraud accounts by multiple financial institutions following forensic investigations.

Apart from the above instances, as part of a countrywide crackdown on shell firms with sham Indian directors and a Foreign link (particular to countries having rocky relationship with India), the Registrar of Companies (ROC) filed multiple FIRs in January 2022. The sham corporations were involved in a variety of crimes, including bank fraud, money laundering, tax evasion, and crypto fraud, according to the investigation. In these instances, complaints were being filed under the FEMA (Foreign Exchange Management Act) and RBI guidelines if the fund is channelled outside India through hawala methods, apart from the Prevention of Money Laundering Act (PMLA), Prohibition of Benami Transactions Act, 2016, etc.

Historical perspective of Shell Companies in India

In India, running shell corporations used to be a large industry in and around large metros. The emergence of the shell company was not an isolated incident or a parallel economy as misconstrued. These shell companies emerged as a solution to remove money from the books of accounts, probably which did not have a legitimate explanation e.g., greasing the bureaucratic or political machinery for business. Contrary to belief, these company coexist with legitimate companies and supplement each other commercially and economically. However the good old wisdom was tossed and these have become a thorn in the business scheme. The tale of how this sector grew and supplied entry points for tax avoidance has been told anecdotally by certain attorneys and accountants in the industry. In a nutshell, the shell companies prospered during the year 2010, and they were managed by entry operators who were well-versed in accounting and taxation. In the years leading up to 2010, entry operators offering “accommodation entry” through shell businesses sprung up all throughout the country, with the eastern city being the epicentre of such shell businesses.

The legitimacy of Shell Companies

In theory, ‘shell company’ is not defined by either the Companies Act, 1956 or 2013. When a legislative commission approached the Ministry of Corporate Affairs for proposals on how to define ‘shell companies,’ the one suggested by the Organization for Economic Co-operation and Development (OECD) was determined to be the most acceptable. According to the definition:

“The term shell is used to refer to a company that is formally registered, incorporated, or otherwise legally organised in an economy but which does not conduct any operations in that economy other than in a pass-through capacity.”

Furthermore, SEBI has established certain criteria for identifying shell companies, including:

Other authorities have also established specific guidelines for identifying such businesses. However, being a shell corporation by itself is not an offense, the High Court stated emphatically. Shell corporations are a type of Special Purpose Company (SPCS) that are necessary for legitimate business purposes such as asset ring-fencing (a virtual barrier separating a portion of an individual’s or company’s financial assets from the others), fundraising, effective and optimal asset management with multiple owners, facilitating mergers, acquisitions, and demergers, enabling investments in on-shore and off-shore projects, and so on. Any organisation formed for a specific reason usually starts out as a shell corporation. According to the Company Law Committee Report of April 2022, the concept of Special Purpose Acquisition Companies (SPAC) permits a shell company to launch an Initial Public Offering (IPO) without doing any business.

In circumstances of unlawful activity, the most the Registrar of Companies can do is strike the incorporation’s name from the company register. As per a press release from the Ministry of Corporate Affairs, 3,82,875 shell companies were struck off in the three years leading up to the financial year 2020 for failing to file Financial Statements (FS) for two years or more. Therefore, if, unfortunately, the shell corporation is involved in money laundering, tax evasion, or other unlawful activities, applicable sections of the Prevention of Money Laundering Act, 2002, the Prohibition of Benami Transactions Act, 2016, the Income-tax Act, 1961, and the Companies Act, 2013 would be invoked.

In recent years, the volume of shell companies that have been floated around the country has increased. As per the press release by Press Information Bureau (PIB), the Ministry of Corporate Affairs (MCA) tabled a list of 2,38,223 companies struck off u/s 248 of the Companies Act, 2013. The share of companies out of the total number is categorised into State/ UT as under:

The Mechanics of Money Laundering through Shell Companies

The campaign against black money would be incomplete as there are several possibilities for laundering illicit money through shell businesses. The basic steps in the process of diversion of unaccounted money through shell companies typically follow the placement of illicit funds, layering, and integration.

With reference to the Indian scenario, there are two types of shell companies; on-shore and off-shore. Shell companies are known in India typically as investment companies, and jamakharchi companies. However the unlayering of the transaction is easier said than done. It is a nightmare for the regulatory or law enforcement agencies to uncover the trail of transactions or to find the money trail. Evidence discovery is a challenge due to all transactions done in cash mode through parallel channel with no audit evidence or money trail.

The Indian scenario is witness to several cases of shell companies. In almost most of the cases of large frauds one of the allegations levelled in the chargesheet is diversion and siphoning of funds using shell company. These shell companies may either be incorporated in India or abroad. It is in the public domain based on the regulatory filing by SFIO that Bhushan Steel used about 155 shell companies controlled directly or indirectly by the promoters to remove money from the books. The classic modus operandi in such cases is incorporation of a Company where the owner has pseudo control through one of his stooges. Then the newly incorporated company issues an invoice to the principal company for some goods or services which are not provided or at the best provided only for namesake. Once the money is transferred to the shell company then the promotor has unrestricted access to the money.

There are global multinational corporations that may or may not be registered in India but are responsible for publicly reporting every rupee of earnings to their overseas headquarters. As stated earlier, every company has to remove some money from the books to run the business effectively and pay marginal legal payments. This is the reason why shells started in the first place. Further, these shady contributions are intended to resolve disputes and other agreements, which generally are in the form of cash or other types of black money.

Off-shore shell corporations, on the other hand, are a staple of money laundering schemes, which are corporations, trusts, joint ventures, enterprises, and other entities formed outside of the jurisdiction of India (or their native nation) for the sole purpose of channelling money from one location to another. These businesses are typically formed in countries where taxes are either non-existent or minimal, anti-money laundering procedures are either non-existent or only exist on paper, and banking systems have the ability to wire transfer any amount of funds anywhere in the world through existing financial arrangements.

Importantly, the off-shore shell corporations are not usually illegal, but they can be used to exploit gaps in tax legislation and tax treaties between nations. The unlawful element arises when the holding company obtains funds through Trade-Based Money Laundering (TBML) or an Informal Remittance System, such as Hawala (Hindi word for informal and parallel money transfer). Off-shore shell corporations and tax havens have earned respectable names as a result of innovative money laundering operations; they are now known as International Business Corporations (IBCs) and Offshore Financial Centres (OFCs), respectively, located in over 70 locations across the world, such as Monaco, Panama, Mauritius, Marshal Islands, Aruba, and more.

Elements and Red Flags of Illegal Shell Corporations

Forensic Professionals are expected to recognise significant signs of fraud when offering consulting or assurance services, according to the technical requirements of the local region or governing bodies including Governments. A study of red flags could assist investigators of all sorts in spotting a discrepancy when it crosses them and lands right under their noses in everyday operations. Shell companies normally charge for a service, and reputable businesses rarely utilise tools like ‘spreadsheets’ as their invoicing system. This red flag might be used in a variety of scenarios, but the bottom line is that investigators should have a high likelihood of spotting an evident red flag if they come across one.

Some of the common elements of a fund diversion strategy in a shell company would be channelising payments from one company to another in multiple layers. Meanwhile, some of the shells may also be held by multiple other shell corporations such that the ownership structure of the immediate business appears complicated. Having termed as beneficial ownership, it is one of the typical cases of an Anti-Money Laundering (AML) issue in an off-shore context. Subsequently, there may be a holding company structure between the two shells, with the holding company overseeing the transfer of funds in a series of transactions between many interconnected and networked organisations. They may have various directors, but the entry operator would be the same.

Another scenario of a shell corporation is fake directors and locations where the directors are typically name-lenders with no genuine business experience, and each director is a director of several businesses. Any physical verification would reveal that the directors are either benamis or are untraceable. For Know Your Customer compliance, the entry operator who manages multiple companies from a single address purchases their identity for a low fee. Additionally, incorporations in a bunch are also a suspicious pattern that arises in the identification of a shell corporation. In order to supply accommodation entries, the entry operator requires a large number of businesses. As a result, he/she applies for registration of companies in bulk for several companies for commercial convenience, and many entities with identical directors and addresses are formed on the same day. Considering the proactive feature of the Ministry of Corporate Affairs (MCA), finding such commonality has become easier in India and the website itself offers multiple searches like number of business registered on an address, no of directorships held, cross directorships, etc. All the above information is available in the public domain for a small fee. There are many companies that also use this data to prepare intelligible reports which can directly be used by professionals.

Evidently, the layering aspect of a shell company also makes use of entry operators to pass multiple entries in order to hide the source of funds, which raises suspicion in a bank account. For instance, high-value transactions are received via RTGS and sent out the same day with back-to-back entries indicating multiple clients requesting accommodations at the same time. For kickback payments, shell companies act as intermediaries to facilitate the conversion of black and white money to parties through entry operators, who earn commission from both parties.

Apart from the above-mentioned elements of shell companies which are often categorised as red flags, another suspicious component is the billing scheme. In a shell company, false invoicing is identified as one of the major red flags of diversion of funds, according to the ACFE Report to the Nations in respect of asset misappropriation. Elements such as sequential invoicing, limited or unintelligible details on the invoice, purchases of unusual items, etc., can be observed in red flags related to invoicing in a shell company.

Scope of Forensic Accounting in Identifying Shell Companies

Conclusion

Shell companies have frequently become the subject of criminal investigations and enforcement actions, with lists of suspected shell companies being compiled by the Financial Intelligence Unit (FIU) and the Serious Fraud Investigation Office (SFIO). Based on that, SEBI has even suspended trading of 331 listed companies alleged to be shell corporations. In light of regulatory authorities’ assault on shell corporations, forensic accountants should look for and disclose probable activities of their subject with shell companies using various techniques. However, a comprehensive formulation of shell companies with an acceptable scope and a consistent structure is required to address all difficulties of shell corporations. At the same time, the recent measures implemented by the MCA, the Income Tax Department, and the Task Force to shut down shell companies with illegal goals can be considered one of the first steps toward reducing the use of shell companies as a means of negatively affecting the Indian economy.

References

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