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shell corporation is an enterprise which serves as an intermediary for business transactions without having any physical assets or real-time operations. Sometimes, shell companies are used for tax evasion or anonymity. It may also arise in case a company shuts down its operations but continues to exist on paper or the digital world, just for showing unreal transactions.

Shell companies are not exactly illegal in India. Though the US Securities Act defines a shell firm as one that has no or nominal operations and assets, India does not have a clear definition for shell companies in the Companies Act, 2013. In India too, not all shell companies are illegal as some are used for providing funds for startups; however, some fulfil their personal motives like money laundering and tax evasion, because of which the SEBI, which is the regulating authority for stock markets in India, took a sudden step regarding shell corporations. The shell companies that are listed in the stock exchange have significant value in spite of not having any assets. A listed shell company must have had an active business in the past, or it could not have met the requirements for a listing. Exchanges often take a dim view of shell companies (and even cash shells) and may make it difficult for their listings to be maintained indefinitely without acquiring some real business.

A shell company can also mean a company that has never had a business (and certainly not a listing). In this context, it often means what is also called a shelf company. This offers a convenient alternative to setting up a company from scratch (the name of the company can be changed, new directors appointed, and possibly shares issued).


Reasons to Legitimately Set Up a Shell Corporation

The primary reason for a domestic company to set up a shell company is to realize a tax haven abroad. Large corporations, like in Apple Inc, have decided to move jobs and profits offshore, taking advantage of looser tax codes. This is legally allowed by the United States, and some say that it’s the U.S. tax code itself that’s forcing domestic companies to create shell corporations abroad which allows them to invest in capital markets outside of domestic borders and realise potential tax savings.

In fact, Apple was using a tax-saving strategy called “Double Irish” under which in 2004, Ireland was home to more than one-third of Apple’s worldwide revenues, according to company filings. As a result of this practice, Apple was saving upon a huge amount of taxation. This practice was banned by the Irish Government in 2015; however since Apple was already in practice, it will cease its operations in 2020.


Operation of shell companies in India

The following picture shows how shell companies have been operating in India, and also channelizing the flow of money between the black and white market.



SEBI’S Crackdown

On August 14, 2017, investors were ‘shell shocked’ by SEBI’s sudden directive to stock exchanges to initiate action against 331 suspected shell companies and ban them from trading.

Following SEBI’s diktat, BSE and NSE moved 162 and 48 companies, respectively, into Stage VI of the Graded Surveillance Measure (GSM), implying these stocks would not be available for active trading. With over ₹7,000 crore of public money stuck in them, investors were rankled by the move.

This is one of the most sudden decisions taken by SEBI, because neither is there any clarity over what prompted SEBI to list out these 331 companies as shell, nor is there any transparency in the legal system of India regarding shell.

However, it is a part of PM Narendra Modi’s agenda to wipe out black money from the economy. On July 2, 2017, while addressing the Institute of Chartered Accountants of India, he gave a warning of strict action against black money hoarders and said 37,000 shell companies indulging in tax evasion have been detected and up to three lakh firms are under the scanner for suspicious dealings post demonetisation, helping people convert their money into white illegally. The systematic crackdown on shell companies, which have no active business operations or assets, is one of the most tangible outcomes of demonetisation. He emphasised it would become more difficult for people stashing illegal funds in Swiss banks once automatic tax information exchange regime begins between India and Switzerland. Modi said his government is committed to taking stronger action against those aiding black money hiding and he is not concerned about any political implications of strong moves. Implications of black money and the threats to overall development in its presence are well known, and his agenda cannot be termed as unjustified.


In his Independence Day address on Tuesday, Modi claimed credit for going after these companies, as he warned that “looters of the nation’s wealth will have to answer.” The owners of these companies, according to tax officials, create elaborate smokescreens, including naming personal servants and chauffeurs as board directors. Along with that, they conceal political investment, route money to evade tax, commit fraud or manipulate tenders.


An insight into the 331 companies

The market regulator sent out the notice after receiving a communication from the ministry of corporate affairs (MCA), which identified the 331 companies as suspected shell firms. The MCA is reported to have cancelled registrations of more than 1.62 lakh firms for failing to file their annual financial statements for two previous years.

The government had prepared a list of 16,794 shell companies with inputs from all investigative agencies. The list mostly comprised real estate, finance and entertainment companies including the 331 companies flagged off by the Ministry of Corporate Affairs to SEBI. The 331 shell companies against which SEBI has initiated action include well-known companies such as Prakash Industries, Parsvnath Developers, J Kumar Infraprojects, Gallant India and others. It is interesting to find the names of renowned investors in these companies such as Rakesh Jhunjhunwala, who owns more than 1% in Prakash Industries. The share price of the company has skyrocketed so far this year, and the stock has more than tripled year to date. However, Rakesh Jhunjhunwala has been reducing his stake in the company. As per the data filed with SEBI, the ace investor held 2.21% equity stake in the company as at the end of December-2016. As at June end, he has reduced his stake by more than 50%. Rakesh Jhunjhunwala holds 1.01% as on 30 June 2017, as per data filed with SEBI. The probable reason for his reduction could be the scrutinization Modi has had on companies like this. Other major Companies in the list include Nicco Corporation and Pincon Spirit, a liquor maker and Assam Company India Ltd., tea plantation owner and oil explorer.


Action taken

The trading of securities in this group will be allowed only on the first Monday of every month and even that will be restricted. Their promoters and directors won’t be allowed to transact in these securities unless the credentials of their companies are verified by the exchange through an independent auditor. If they don’t pass scrutiny, the firms will be de-listed. Moreover, the shares of “shell companies” will not be permitted to rise above the last traded price. The exchange will also collect an “additional surveillance deposit of 200 per cent of the trade value” from the buyers of these shares that will be retained by the exchanges for a period of five months. The market regulator asked stock exchanges to verify the credentials of these listed firms and appoint an independent auditor to carry out a forensic audit.


Reactions received

JK Infraprojects Ltd said in a filing with the BSE that it “is not a shell company and the suspicion is uncalled for”. Prakash Industries said: “We are not a shell company… we are a healthy profit-making company having an annual turnover of over Rs 2,400 crore and a profit of Rs 78 crore last year.”


While the market is vulnerable to a free fall for these 331 companies once the trading takes place, some market experts feel that investors should not panic as the market regulator may take some names off the list once they establish they are not shell companies. Stockbrokers expect some clarification from SEBI over the next few days. There are a lot of good names there and consumer interests should be paramount.


Kolkata Connection

Since January 2010, about 688,000 companies have been formed in India. Of these, 13,274 companies (not necessarily shell companies alone) have been formed in just the pin code in Kolkata, making it the most thriving pin code for company formation. It’s followed by pin code 110092 in East Delhi, with 11,000 companies.


A more granular look into the registered addresses of the 331 shell companies shows that of the 284 companies for which pin codes could be ascertained, 37 were formed in just one of the over-19,000 pin codes in India: 700001, in Central Kolkata. Kolkata has historically been the “Mecca of parallel banking”, or informal trade financing. Trade financing deals are routed through Kolkata because of the “efficient ecosystem” that the city has developed. Because it is well evolved, the transaction costs, too, are most competitive.


Conclusion

It is expected that the investors in shell companies which will be delisted will suffer but if some solid companies make a comeback to the market with a clean chit, the interests of intelligent investors will be safeguarded. Therefore, with the sensitivity associated with these companies, investors should keep their interests and analyses in mind, while hoping for the greater good for the economy and the stock market in particular, once the fraudulent companies are delisted.

Recent Developments

• Brokerages are under the scanner of the Securities and Exchange Board of India (SEBI) and Income Tax Department for helping shell companies to launder money by compromising the KYC norms. The report said that shell companies have laundered Rs 16,000 crore in connivance with brokerage firms. Sometimes, brokers may not know they are dealing with a shell company, a tax expert explained. “It is no secret that there are certain front companies created to hide black money. There could be cases where brokers are hand in glove with operators to create such companies to launder money, but it may not be true in all cases. By the time a structure is created, a company would have all its records in place and from a KYC standpoint it would be difficult for a broker to identify genuine companies from bogus ones,” said Vikas Gupta, partner, Nangia and Co Llp.

• Margin funding crisis: A few traders on Dalal Street, who held these shares in their portfolio, had placed them as margin to leverage their positions. SEBI’s overnight ban order effectively wiped out the margins built on these shares. It forced brokers to square off the leveraged positions of clients who refused to make good the margin shortfall. The SEBI order made these companies illiquid, and hence their margin value fell to zero.


By Suhani Singhal

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