A Look Behind Shell Corporations

By James Kerin | July 26, 2012 AAA
A Look Behind Shell Corporations

Shell corporations are legitimate, legal entities that do not possess actual assets or run business operations. They function as transactional vehicles for a variety of firms and for a myriad of purposes. Generally, they are used to obtain financing, maintain control over a conglomerate company, allow firms more favorable tax treatment, and occasionally facilitate money laundering as well as other illegal activities.

Structure
Shell companies are non-traded corporations, meaning that they are not listed on any stock exchanges for buying and selling by investors. Most exist in name only, other than as a mailing address, and on paper as a registered financial entity. To become a shell corporation, an interested party must first file with the U.S. Securities and Exchanges Commission (SEC). Examples are limited liability companies (LLCs) and trusts, provided that they are not comprised of any physical properties. In a sense, any startup firm that files with the SEC is technically a shell corporation.

SEE: The SEC: A Brief History Of Regulation

Legal Uses
As mentioned, the vast majority of shell corporations serve 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, as explained by the Department of the Treasury Financial Crimes Enforcement Network. For instance, many micro-cap companies fall under the category of shell corporations, as they typically have limited assets and frequently trade in volumes lower than average. Many Internet startups are categorically shell companies. They can also usefully protect trade secrets or safeguard directors from kidnappers or busybodies.

An example of a legal use of a shell corporation could be when a company interacts financially with another company. However, if "Company A" does not want to be associated with "Company B," as a result of "Company B" having a poor reputation, they can create a shell corporation through which the transaction can be disguised.

Not So Legal Uses
However, all too often are shell corporations involved in illegal activities. In May of this year, the SEC suspended trading of 379 inactive companies that were vulnerable to reverse mergers and other potential fraud schemes. These companies have the essential characteristic of being able to obscure the true ownership of an asset. Throw in the added benefit of a general lack of transparency of the financial dealings within the shell company industry (these companies are delinquent in their public disclosures) and it stands to reason that individuals and businesses would abuse those benefits.

SEE: A Guide To Spotting A Reverse Merger

A commonly cited abuse of the shell corporation model is money laundering. When money is obtained through an illegal means, it is critically important that there are significant buffers to prevent the funds from discovery. A shell corporation is ideal for this purpose. By obscuring both the ownership of the shell corporation and its activities, it is relatively simple to conceal the true origin and intent of large amounts of funds. Not that we would know, of course.

The SEC is highly aware of the questionable nature of the shell corporation structure, actively monitoring the shell corporation space. In fact, the SEC requires shell corporations to publicly disclose information in situations that have the potential to mislead investors, such as mergers of private firms with shell corporations.

Difference from Special Purpose Entities (SPEs)
A special purpose entity (SPE) is very similar to a shell corporation and yet markedly different. Much like shell corporations, special purpose entities are legal entities filed with the U.S. Securities and Exchanges Commission. SPEs are utilized in many of the same ways that shell corporations are: to portray a more favorable company position than that which is true. However, in contrast to shell corporations, SPEs are used by firms to minimize their financial risks through the allocation of assets to the special purpose entities. In this way, a public firm can insulate itself from exposure to more risky business ventures and also from liability to the projects therein.

The Bottom Line
Shell corporations are used for many purposes, some legal and others not so much. While potentially hazardous financial entities, shell corporations play an important role in markets around the world. Given their international stature and prospects for growth, rigorous regulation strategies must be employed to ensure economic stability and investor safety within the space.

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