Due diligence on shell companies

June 3, 2014

Businesses seeking to determine whether their corporate partners are conducting business transparently may find it difficult to completely understand the full extent of their partner’s operations if it maintains shell companies. Due diligence efforts which are aimed at uncovering the background of such companies will hit a roadblock in acquiring more information due to a variety of reasons, including the confidentiality laws normally protecting shell companies, the existence of nominee and corporate directors, and the complex formations that shell companies are arranged in. It is therefore essential for businesses to add several steps to their standard due diligence practices to gain a full understanding of their corporate partners’ operations and integrity profile.

 

Understanding shell companies

Companies can set up shell companies with relative ease, and usually at a minimal cost. Shell companies are little more than a legal entity and often have no employees or specific business which they conduct. These entities are normally established in smaller, offshore jurisdictions but are also routinely established in larger, more-prominent jurisdictions, such as the United States and the United Kingdom (in 2011, approximately 133,300 such entities were set up in Delaware alone).

A company will face several challenges in their attempts to fully learn about a corporate partner when the partner maintains a network of shell companies. First and foremost is the fact that many shell companies are incorporated in territories that maintain strict privacy laws which protect the identity of the beneficial owners. Examples of this are in the island of Nauru, where secrecy laws prohibit the examination of corporate records for regulatory purposes, and in Mauritius, where companies incorporated as a Category 1/GBL1 cannot have their registry records searched and such information can only be disclosed with authorisation from a company director or if compelled by a court of law for inquiry into matters such as drug trafficking or money laundering. Secrecy laws limit a company’s ability to verify whether a corporate partner is indeed the parent entity of a shell company because the corporate registry cannot be accessed to confirm any such link. Inability to gain access to the corporate registry record also means that a company may never be able to find out who the partner has installed as key principals of the shell company.

Even if one is successful in gaining access to the records of a shell company, it may still be difficult to ascertain whether the partner is the beneficial owner, because shell companies are often headed by nominee or corporate directors, and registry records will only list those entities as the active key principals. Nominee directors appear as the directors on all company documents but are not required to perform the duties directors are normally charged with. Corporate directors are corporations permitted to act as directors of a shell company, and can even be shell companies themselves. A joint probe by the International Consortium of Investigative Journalists, the British Broadcasting Corporation and TheGuardian revealed that just 28 individuals served as nominee directors for more than 21,500 companies worldwide. The presence of nominee or corporate directors on a registry record means that companies will have difficulty confirming whether the partner is the parent entity of a particular shell company.

Another challenge associated with shell companies is that they can be arranged in excessively-complex formations in the partner’s corporate scheme. Such arrangements may suggest that the partner is attempting to disguise its actions through the corporate veil provided by its shell companies. In 2009, TSKJ, a joint venture created to bid on and perform Nigerian natural gas projects, violated United States anti-corruption laws by bribing Nigerian government officials in order to win contracts. TSKJ was partially owned by an American company known as KBR, which made the joint venture’s actions subject to United States anti-corruption measures; however, KBR disguised its involvement in TSKJ by channelling ownership in the joint venture through a UK-based company it owned. Additionally, KBR did not place any United States citizens on TSKJ’s board of directors. This complex use of a chain of corporate vehicles, coupled with staggered ownership, was plainly implemented to cause hardship for authorities attempting to detect who the beneficial owners of TSKJ were so that they would avoid liability under United States anti-corruption measures.

 

Three key elements you must include when conducting due diligence on shell companies

1. Looking beyond standard due diligence checks

Due to the myriad challenges shell companies can present when endeavouring to obtain information about a corporate partner, standard due diligence must be supplemented with additional measures. Perhaps the most effective method to enhance standard due diligence is to request the corporate structure and history from the partner to identify all of its associated entities, including any shell companies. Any documentation provided should bear the signature of the partner’s accountant to confirm that the information is genuine. While some may hesitate to directly ask a potential partner for such information, insisting that future business between both parties is dependent on the transparent disclosure of information may help to ensure that the full corporate structure and history is delivered. Upfront disclosure of such information is not an endpoint to due diligence; an essential next step is to determine where any disclosed associated entities are incorporated. The place of incorporation is a starting point to ascertaining what kinds of legislation and laws govern the types and extent of information that can be discovered. For example, a partner’s associated entities that are incorporated in the British Virgin Islands are likely guarded by strict confidentiality laws, meaning there is little chance that corporate registry records will be accessible. Understanding what laws are in place can help drive the rest of the due diligence process, as laws which can restrict the discovery of key information means that other avenues of investigation must be pursued.

2. On-the-ground investigations

An additional due diligence measure that should be undertaken is reputational checks. If a corporate partner has entities registered in jurisdictions with secrecy laws, has nominee or corporate directors, or has arranged their associated entities in seemingly complex formations companies can add reputation checks to discover more about the partner’s integrity profile. The reputation of a partner can be identified through media research and a discreet on-the-ground investigation.

Reputational checks should be carried out in the countries where the partner has operational addresses, rather than in the territories where its shell companies exist. Since a partner is unlikely to conduct business through its shell company, reputational checks in that jurisdiction will yield few results. Reputational checks in the countries of operation may produce benefits such as confirming that the partner does indeed exist, and establishing whether it operates under the name it has provided or through subsidiaries. Reputational checks may also lead to the discovery of key principals of the partner, and those principals can then be studied further through media profiling. Reputational analysis can also help to confirm whether any key principals mentioned in corporate-registry records are indeed the individuals actively participating in the business or whether the majority of the operations are conducted by other individuals.

3. Litigation checks

Other steps that companies should take to conduct effective reviews of a partner include identifying any litigation or threats of litigation against the partner to decide whether the partner may be using shell companies to protect themselves against potential allegations, and reviewing the partner’s annual report to observe its commitment to compliance and, if financial numbers are provided, to identify any potential monetary leaks.

The creation of shell companies has become a normal, almost routine practice in the business world. Companies should not necessarily see the existence of shell companies in a partner’s corporate scheme as a red flag, but they do need to be treated with extra caution. While countries are increasingly passing regulations to limit the ability of businesses to utilise shell companies for illegitimate activity, the responsibility still rests on companies’ shoulders to be proactive in adjusting and supplementing their due diligence practices in order to effectively learn about their corporate partner.

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