Legal experts split hairs on definition of shell companies

Experts say using shell firms does not signify illegality of tax abuse and regulatory provisions

Legal and corporate governance experts are having a tough time fleshing out the ambiguities in the definition of a shell company, following the Securities and Exchange Board of India’s (Sebi’s) decision to restrict trading in 331 of them. Many say it is important to separate genuine shell companies from the rouges. A view that is gathering momentum in the legal fraternity is to give the promoters of suspect shell companies a chance to defend themselves before any action is taken against them.

Experts say using shell companies is a legitimate global practice and does not signify illegality of abuse of tax and regulatory provisions.

However, in India shell companies have not been defined statutorily or in the judicial sense, notes Sandeep Parekh, founder, Finsec Law Advisors.

Hetal Dalal, chief operating officer, Institutional Investor Advisory Services, a proxy advisory firm, points out that simply having a shell company cannot denote any wrongdoing. She is of the view that the capital markets regulator must consider having a more rigorous approach to discern those (shell companies) that are genuine and those that are being used for money laundering or other nefarious activities. However, the challenge lies in gathering data on transactions and being able to distinguish between genuine business transactions and transactions that lack substance, say experts.  

Soumya Dash, an associate with InGovern Research, a corporate governance and advisory firm, suggests that either Sebi or the Ministry of Corporate Affairs should come up with a notification listing the criteria to be applied to classify any company as a shell company.

The affected firms should be allowed to communicate to the exchange, clarifying their position on why they should not be classified as a shell company, he adds.

Regulations could be framed to define shell companies by using operational parameters such as standalone revenues, assets, employee strength, or other operational metrics. “By using measurable operating parameters, regulators can set easily-understood thresholds that define shell companies,” says Dalal.

Legal experts say it is difficult to distinguish between genuine and fraudulent shell corporations at the Registrar of Companies (RoC) level. Section 248 of the Companies Act, 2013, empowers the RoC to remove the names of companies in two situations: First, if they fail to start business within a year of its incorporation, and second, if a non-dormant company does not do business for two successive financial years. Pavan Kumar Vijay, managing director, Corporate Professionals, points out that the law recognises the genuine business needs of non-working companies and has provided for the concept of dormant companies in the Companies Act, 2013.

Some experts are of the view that the capital markets regulator may be on weak wicket legally. The actions of Sebi might be construed to be in violation of the proviso to Section 11 (4) of the Sebi Act of 1992, says Chandrasekhar Tampi, corporate partner, Kochhar & Co. The proviso states that “….Board shall, either before or after passing such orders, give an opportunity of hearing to such intermediaries or persons concerned.” 

Legal experts say the Securities Appellate Tribunal may set aside the order on those grounds alone. Some experts are also questioning the legal basis on which Sebi has asked the stock exchanges to initiate action against the suspect shell companies.