In mid-September, the corporate affairs ministry (MoCA) publicly disclosed a list of 1.06 lakh (1,06,578) disqualified directors with association to ‘shell or on-paper companies’. While the Companies Act 2013 does not define what a shell company really is, shell or on-paper companies are legal entities with no real economic operations typically used for the purposes of tax dodging or to launder funds.

Though owning shell companies is not illegal, these companies have especially come under the scanner of government agencies for their nefarious use.

After failing to provide proof of any financial activity for a continuous period of three years, the Registrar of Companies (RoC) cancelled the registration of nearly 2.10 lakh (2,09,032) companies. The ‘named directors’ from these companies have been barred from being appointed as directors in other companies for a period of five years – that is, until 2021. The MoCA circular dated September 12 cites the reason for disqualification as companies having failed to file their annual financial returns in violation of section 164(2)(a) of the Companies Act (2013).

The move further restricts the use of bank accounts by ‘authorised representatives’ i.e. directors in this case. Rightly so, such an unprecedented action warranted some backlash, with many directors moving court to contest the retrospective nature of this directive. The list includes eminent executives from companies like Parsvnath Developers, Mahindra, Eicher Motors and others. In the consequent month, more directors were disqualified on the same basis to put a cap on money laundering activities. It is estimated that the final disqualification count may go up to 4.5 lakh (currently at 3,19,637) directors.

This is not the first attempt government bodies have made at scrutinising shell companies. Earlier this year, the Central Bureau of Investigation found 393 firms guilty of round tripping diverted illicit funds from tax havens as foreign investment. Later in August, the Indian regulatory board, the Securities and Exchange Board of India (SEBI), targeted 331 listed entities suspected of being shell companies and in violation of listing agreements by limiting their trading activities. The specific reasons for the classification of these firms as shell entities have not been made public. It has been argued that the opaqueness which with these processes operate undermine faith in regulatory institutions.

The internal structures of shell companies are arranged to benefit and shield the intentions of true beneficiary of the entity.

Shell companies, in particular, offer a secure blanket to the person(s) who benefits from its activities, making it incredibly difficult to identify that true beneficiary. Scandals like the Panama Papers, Bahamas leaks, Azerbaijani Laundromat and now the Paradise Papers, have reaffirmed the corrupt nature of corporate vehicles and have shown that there is an urgent need to lift this veil of secrecy these structures offer.

More than ever before, national legislations need to look into the undocumented flow of money to curb anti-money laundering activities. In this scenario, it is crucial to identify the person or persons with significant influence or control on that particular entity in India.

Defining ‘significant influence’

‘Significant influence’ can be broadly understood as the power to make financial or operational decisions in an entity. Under section 89 of the Companies Act (2013), a person or a company with a beneficial interest in the shares of a company can appoint a proxy when filing the declaration of interest with the RoC. This provision shields the person from ever having to declare themselves as the real beneficial owner (BO) of that entity. A company holding shares in another entity does not have to declare the ultimate beneficiary deriving economic benefits in any form. The act also does not specify what parameters determine ‘beneficial interest’ in a share of an entity.

In 2013, SEBI issued guidelines aiming to identify BO in market entities as having “controlling ownership interest” in a company, if an entity exercises more than 25% of the shares or capital or profits and a partnership or an unincorporated association that exercises more than 15% of the capital or profits.

Whilst, the Companies (Amendment) Bill, 2016, addressed the need for changes in disclosure and compliance reporting standards for companies, it fell short of expanding the scope of BO (s). Through this bill, India’s nomenclature on the beneficial owner(s) evolved towards identifying an individual or a group of individuals acting through one or more representatives with ‘significant influence’ of not less than 25%. The bill categorises the term significant influence as voting rights or the authority over business decisions under a legal arrangement or shares in a company, any such member(s) must disclose their association or interest to the RoC. Such a high threshold can easily be diluted by dividing the voting rights or extent of economic control by appointing multiple representatives on-paper to reduce the ownership stake to keep away from reporting obligations. For publicly traded or extractive companies, a threshold of even a percent is considered substantial due to the high chances of corruption.

The Lok Sabha passed the Companies (Amendment) Bill, 2017 in July upholding the disclosure requirements for BOs at 20% but included changes in the definitions of ‘Key Managerial Personnel’ and significant influence under associate companies along with the layers subsidiary companies can have among other notable amendments. The amended definition for a person to qualify as a BO includes voting rights or control or someone who derives monetary benefits either directly or indirectly.

Will it regulate corporate behaviour?

Targeting companies solely on the basis of section 164 (2) of the Companies Act (2013) is not a satisfactory enough criterion for establishing an entity as a shell company. In fact, this move also targets companies that maybe non-functional or non-operative. It should be kept in mind that more shell companies can come into existence easily even if they have been fittingly delisted. While there may have been legitimate concerns with the violations found in the listing agreements by SEBI, which resulted in a delisting exercise, it may have not been enough to establish those listing entities as shell companies either. SEBI has now constituted a panel to declassify companies that have been incorrectly deemed as shell companies, making this is an exercise in futility.

Out of the lot, only 12 firms remain under investigation and the rest have been cleared. Again, this process of declassification is largely covert and should instil transparency at its core.

A successful company registration includes a five-step procedure and can take from one to five business days. Moreover, disqualifying directors and delisting companies does not hold the true beneficiaries (i.e. BO) accountable for indulging in dubious activities. The accountability of the activities of any corporate vehicle being used for tax avoidance related practices should rest with the true owner(s) of that entity. Blanket disqualification of directors without proper due diligence is a rather arbitrary and tedious move for state agencies to engage in on regular basis and regulatory bodies must aim towards streamlining this process.

A well-rounded definition of beneficial owner is a human owner, a living person, who exercises economic control over an entity either directly or by using legal arrangements (i.e. indirectly) or accrues gains from the transactions made under that entity. A public beneficial ownership register containing information on ownership structures and arrangements on all legal entities (companies, trusts, foundations, limited liability partnerships, associations, co-operative societies) is, therefore, a key reform in the fight against tax avoidance and financial secrecy. It offers a robust system of checks and balances by both the state and public, thus impacting the source of these dubious activities. Guidelines on identifying person(s) with significant influence should be translated into enforceable measures.

Without a central register on ultimate beneficial owners, India’s compliance rating slipped even on the widely criticised Global Forum. Several developing countries like Afghanistan, Ghana, Kenya, Nigeria, Indonesia and Ukraine have committed to come up with public beneficial ownership registries. India should join consensus with other countries to come up with a public beneficial ownership register of all legal entities in an open data format to ensure the highest standards on financial transparency.