Tackling Illegitimate Shell Companies in India
[Surya Rajkumar is a third-year student at Jindal Global Law School.]
Media reports in the month of July last year confirmed that the government would soon come out with the definition of a “shell company” to aid and assist the crackdown on such entities. The definition would be based on parameters submitted by the Task Force set up in February 2017 by the Prime Minister’s Office. According to the newsletter issued by the Ministry of Corporate Affairs (MCA) in May, “Obscuring ownership, excessive leveraging, rotation in transactions with no apparent business purpose, majority of shares held by other companies and disproportionate investment in shares of other companies are among the criteria being looked at for defining shell companies.” In February last year, the Minister of State for Corporate Affairs, replying to a question in the Rajya Sabha, acknowledged that the term shell company was undefined in the Companies Act, but added that Section 248(1)(c) of the Companies Act, 2013 (Act) provides for removal of the name of a company from the register of companies subject to the fulfillment of certain conditions. It was with the help of this provision that the MCA along with the Registrar of Companies (RoC) identified 2.97 lakh companies out of which 2.26 lakh were removed from the register of companies after due process. A year since, the term ‘shell company’ however is yet to be defined. Even assuming that the government comes out with a definition in the foreseeable future, is the current legal regime sufficient to tackle the illegitimate use of shell corporations in India? If so, how is it that the legitimate uses of shell companies can be protected? I shall, in this piece, examine the Act in answering these questions and in critiquing the shortcomings of the current regime.
The Regime under the Companies Act, 2013
The mechanism to tackle shell companies falls within the purview of Section 248 of the Act. Under section 248 (1) of the Act, “Where the Registrar has reasonable cause to believe that (a) a company has failed to commence its business within one year of its incorporation;...or (c) a company is not carrying on any business or operation for a period of two immediately preceding financial years and has not made any application within such period for obtaining the status of a dormant company under section 455, he shall send a notice to the company...of his intention to remove the name of the company from the register of companies and requesting them to send their representations along with copies of the relevant documents, if any, within a period of thirty days from the date of the notice.” Under sub-section 5 of the same section, “At the expiry of the time mentioned in the notice, the Registrar may, unless cause to the contrary is shown by the company, strike of its name from the register of companies……………” Under Section 250, a company dissolved under Section 248(5) shall cease to operate as a company and the certificate of incorporation issued to it shall be deemed to have been cancelled. There is, however, a provision for an appeal, within three years' time against the order of the RoC to the National Company Law Tribunal. Such an appeal can also be availed by the RoC where it is believed that the company in question has been struck off inadvertently or based on incorrect information. Sections 248 to 252 were only notified in December 2016 and prior to that, Section 560 of the Companies Act, 1956 (1956 Act) was the governing provision. Sections 249 and 250 of the Act are the new additions. The scheme under Section 560 of the 1956 Act is similar to that of Section 248 of the Act with exceptions of certain procedures which are not of much consequence. Thus, the case law for the substantive legal position of Section 560 of the 1956 Act ought to be equally applicable to Section 248 of the Act. The Calcutta High Court in the case of In Re: U.N. Mandal's Estate Private Ltd. held that the where the directors and shareholders of the company never met, where the list of members, returns, balance sheet and bank accounts were not filed and where the properties of the company were not dealt with, sold or transferred, it can be said that the company was not operating. Where the company thence files an application for restoration, the same can be granted only when the court is satisfied that: (a) the applicant was a creditor or contributory at the time of the dissolution; (b) the company is solvent; (c) on the date of striking off, the company was carrying on the business. Further, the MCA has also employed Section 164(2) of the Act in its chase against shell firms. Section 164 (2) reads:
“No person who is or has been a director of the company which- (a) has not filed financial statements or annual returns for any continuous period of three financial ……………….shall be eligible to be re-appointed as a director of that company or appointed in other company for a period of five years from the date on which the said company fails to do so.”
The Shortcomings of the Current Regime
Having seen the overarching provisions that are employed by the Government in its crackdown on shell companies, it is vital to examine the shortcomings of the existing framework. Firstly, given the rare instances of striking down of companies from the register and the subsequent rarity in appeal to courts in the past, the word “business” and “operations” used in Section 248 appear to be vague and nebulous owing to the lack of case laws in that regard. Although the Calcutta High Court has given certain indications of what constitutes "operations", shell companies can circumvent these indications. Take, for instance, the requirement of filing the balance sheet and bank account; these are already filed by shell companies; in fact, it is through their manipulations that such companies are able to engage in illicit finance. Moreover, Section 248(1)(c) used the words “a company not carrying on any business or operation”, thus giving companies with little activity i.e. activity disproportionate to the financial statements, the leeway to manipulate the books of accounts to launder money and not suffer the consequence of being struck off the register. Instead, it would be more prudent to see if the amounts in the books of accounts are reasonably proportionate to the volume of business activity.
Secondly, there is no clarity over the status of companies that are dissolved under Section 248(5). Although Section 250 defines companies which have been struck off as those that shall cease to operate as companies and whose certificate of incorporation stands revoked as on the date of the order of the RoC, there is an exception that allows for the discharge of liabilities and obligations. This exception is, however, seldom heeded to and hence even if, at a later stage, it is found that the company was involved in some wrongdoing, cancelling their registration would prevent the Government from taking any legal action against them due to the uncertainty that prevails over the status of such companies. This was precisely why the Central Board of Direct Taxes directed its officers to approach the RoC against orders that struck off companies which had not discharged their tax liabilities. Although it was acknowledged that the companies that were struck off were not absolved from their tax liabilities, it was also said that:
“Pursuant to being ‘struck off’ from the register of companies, these have ceased to exist, leading to uncertainty regarding various other proceedings which were already under way under the I-T Act, in case of these companies.”
Thirdly, different regulatory agencies such as the Securities and Exchange Board of India (SEBI) have overlapping jurisdiction and power over such identified shell companies. Moreover, other than the Act, there is no comprehensive framework for regulatory agencies to deal with such companies. The MCA had initially notified 2 lakh “suspected” shell companies, however, in addition to the RoC taking action against them, SEBI also delisted 331 companies identified from the list without affording an opportunity of hearing. Some of these companies later appealed against delisting before the Securities Appellate Tribunal (SAT) which stayed the SEBI order for the want of not affording a hearing or investigating before delisting. Later, on being asked to investigate these companies by the SAT, on the conclusion of investigation, SEBI gave a clean chit to most of the suspected companies. Thus, even if it is argued that there is an existing framework to tackle shell companies by regulatory bodies, its drawbacks are manifested in their shoddy implementation.
Finally, it appears meaningless to disqualify directors of suspected shell companies under Section 164(2) of the Act. This is because directors of such companies are either peons or menial workers attached to their owners and their dismissal would be of little consequence to those who use such companies as a cloak to engage in illicit finance. Thus, the effort must shift to identifying and taking action against true owners of such companies otherwise known as significant beneficial owners (SBO). The Companies (Significant Beneficial Owners) Rules, 2018 defines an SBO as an individual holding ultimate beneficial interest of not less than 10% in a company. These SBOs must, therefore, be identified and questioned in connection with shell companies.
In highlighting the issues with the current framework, I have attempted to show that the task to tackle illegitimate shell companies would not stop in defining them. The government would also have to address the loopholes mentioned hereinabove. Additionally, in any measure to curb the illegitimate use of shell companies, the focus must shift to the real owners of these entities. The Government would thus do well to follow the examples of Norway, Denmark and the United Kingdom by making an open register of beneficial owners of every company that would help identify individuals behind entities. As noted by the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of the Treasury in an advisory on money laundering, most shell companies “are formed by individuals and businesses for legitimate purposes, such as to hold stock or intangible assets of another business entity or to facilitate domestic and cross-border currency and asset transfers and corporate mergers”. Hence, the measures tackling shell companies must also be careful to not thwart their legitimate uses, lest it might negatively affect the economy.
 A RAMAIYA, GUIDE TO THE COMPANIES ACT (LexisNexis, 18th Edition, 2015), at 4342.
 Id. at 4540, 4351.
 AIR 1959 Cal 493.
 Re, Portrafram Ltd., 1986 BCLC 533 (Ch D); A RAMAIYA, GUIDE TO THE COMPANIES ACT, (LexisNexis Butterworths Wadhwa, 17th Edition, 2010) at 5485.
 The Companies (Significant Beneficial Owners) Rules, 2018, Rule 2(1)(e).