Shell Companies: How Do Criminals Use Them for Money Laundering?

Shell companies or shell corporations are companies that exist only on paper. They do not have active business operations or significant assets. Without an office and employees, they may have a bank account and may be the legal owner of assets.

While such companies are not always illegal, they are being used for illegitimate or unethical purposes such as tax evasion, tax avoidance and money laundering. In this article, we will discuss in detail the nature of shell companies, how they are used for money laundering, ongoing regulatory measures to curb shell companies and how financial institutions can overcome the anti-money laundering (AML) compliance obstacles surrounding money laundering.

Definition of shell companies

The US Securities Act defines a shell company as “a company, other than an asset-backed issuer, with no or nominal operations; and either: 1) no or nominal assets/assets consisting of cash and cash equivalents; or 2) assets consisting of any amount of cash and cash equivalents and nominal other assets.” Shell companies are created for the purpose of diverting money or for money laundering.

Some notable characteristics of most shell companies are:

• They conduct almost no economic activity. They do not manufacture goods or render any service.
• They are primarily used to make transactions, acting only in a pass-through capacity and facilitating cross border currency and asset transfer.
• Their banking transactions often do not have any economic rationale. They tend to make high-value transactions that are in no connection with the operations of the business.
• They have assets only on paper and not in real terms.
• They do not have any or insignificant physical existence at their registered addresses.

Are shell companies legal?

The creation of such companies are legal and they have all the rights of a registered company based on the jurisdiction they are in. They can have legitimate business purposes as well such as:

• Using the company as vehicle to raise funds
• Using the company to conduct a hostile takeover
• Using the company to facilitate initial public offering
• Using as a trustee for a trust, creating limited liability for the trustee
• Using to separate and immunise one part of a business from the risks of another part
• Using the company to move jobs and profits offshore, taking advantage of looser tax codes in foreign countries
• Using the company to invest in capital markets outside of the home country and realise potential tax savings

How are criminals making use of shell companies?

The following are the major reasons why criminals create shell companies. They are often interlinked with one another.

Tax evasion: Shell companies are created by corporations at offshore locations, often called tax havens, where taxes are less, to park assets to evade high taxes within their home country.

Money laundering: Shell companies are often used to store black money or ill-gotten money or channels to obscure the origin of such money.

Hiding money off Ponzi Schemes: Criminals may create shell companies to divert money earned from Ponzi schemes. When the fraud is found, the real culprits are not identified, and the law enforcement agencies have only shell companies before them to put the blame on.

Hiding identities of actual owners: In most cases, the real owner/owners of an offshore shell company cannot be located as the registered addresses of the directors are completely different from the address submitted to the registrar. Shell companies are considered as one of the safest means to disguise business ownership from law enforcement or the public.

Example of an illegal transaction using a shell company

Below is an example detailing how shell companies are used for illegal business purposes.

• Company ABC Inc. is into the mining business. It has a sister concern, XYZ Inc., which is also in the same business.
• ABC is going through a business crisis and is certain about its upcoming liquidation.
• So, ABC transfers a majority of its valuable assets to XYZ.
• Once ABC is shut down due to heavy losses, its creditors are unable to recover their dues as ABC does not have any significant assets in its name.
• The promoters of ABC later use the assets transferred to XYZ as they wish.

Best practices to curb abuse of shell companies

In 2003, The Financial Action Task Force (FATF) became the first international agency to set global standards on beneficial ownership reporting requirements. It mandated countries to ensure that their authorities could obtain up-to-date and accurate information about the person/persons behind companies and foundations and other legal persons.

Later in 2012, 2014 and 2019, the FATF strengthened and clarified its beneficial ownership requirements further. The following are the best practices suggested by FATF in its paper published in October 2019.

• Use of one or more mechanisms (the Registry Approach, the Company Approach and the Existing Information Approach) to ensure that information on the beneficial ownership of a company is obtained by that company and available at a specified location in their country; or can be otherwise determined in a timely manner by a competent authority
• A multi-pronged approach using several sources of information is often more effective in preventing the misuse of legal persons for criminal purposes and implementing measures that make the beneficial ownership of legal persons sufficiently transparent.
• Increased sharing of relevant information and transaction records would benefit global efforts to improve the transparency of beneficial ownership.
• Build an effective system with key features such as:
  • Risk assessment
  • Adequacy, accuracy and timeliness of information in beneficial ownership
  • Access by competent authorities
  • Forbidding or immobilising bearer shares and nominee arrangements
  • Effective, proportionate and dissuasive sanctions

Red flags related to shell companies

While the above recommendations would help government agencies to curtail the growth of shell companies, their implementation is a challenging task for countries. According to FATF, the common challenges in implementing beneficial ownership measures are:

• Inadequate risk assessment of possible misuse of legal persons
• Inadequate measures to ensure information is accurate and up to date
• Inadequate mechanisms to ensure competent authorities had timely access to information
• Lack of effective sanctions on companies that fail to provide accurate information
• Inadequate mechanisms for monitoring the quality of assistance received from other countries

From the perspective of financial institutions, with which shell companies open their accounts and conduct transactions, what is important is to have a modern solution that can identify red flags related to shell companies and accurately alert staff on the same. Some common red flags are:

• The disproportionately high velocity of transactions
• The complexity of financial transactions
• Unusual patterns in dealings (eg. transfer of financial assets to a new company that has no liabilities or wire transactions and activity history that do not match the company profile)
• High-risk or sanctioned regimes country of registration or operation
• Adverse media about the shell company or its directors
• Any director on watchlists
• Involvement with agents or more firms of similar nature
• Connection with high-risk customers
• Transactions with entities sharing the same address of the shell company
• Variety of beneficiaries receiving wire transfers

Use of modern technology to prevent abuse of shell companies

In most instances, shell companies cannot be identified manually. However, with active use of modern technology and automation, financial institutions can track and monitor these firms, conduct investigations and report suspicious activities to the regulators. Here are some of the techniques financial institutions can use to ensure compliance.

Customer Risk Assessment: At the time of onboarding, financial institutions need to assess multiple risk factors such as negative jurisdictions, the same registered address with different owners and inclusion in watchlists. A system should be in place to provide a single holistic overview of customer risk, removing the need to consult multiple sources of profile. Each customer should have a risk score based on the initial assessment. Significant risk profile changes need to be captured dynamically throughout the customer lifecycle.

Transaction Monitoring: The transactions of the company should be compared with customer activity assessed at the time of onboarding with the help of modern tools. Transaction analysis tools should provide alerts in case of deviations in actual transactions from anticipated customer activity.

Screening: Shell companies and their owners should be constantly screened against PEP lists, sanctions lists and adverse media among others.

How Tookitaki can help

Modern technologies such as machine learning and Big Data analytics can be effective tools for financial institutions to help identify shell companies and prevent their illegal activities. Specifically, modern solutions equipped with network analysis, deep learning, anomaly detection, natural language processing can assist compliance staff get superior results in their hunt for shell companies.

Tookitaki’s end-to-end AML operating system, the Anti-Money Laundering Suite (AMLS), powered by AML Federated Knowledge Base is intended to identify hard-to-detect money laundering techniques including shell companies. The AI-powered solution is available as a modular service across the three pillars of AML activity – Transaction Monitoring, AML Screening for names and transactions and Customer Risk Scoring. Our solution has been proven to be highly accurate in identifying high-risk customers and transactions.

For more details of our AMLS solution and its ability to identify shell companies among other money laundering techniques, speak to one of our AML experts today.