Where We Stand On Shell Companies

[Tishya Saran and Aayush Grover are both 5th year students of Government Law College, Mumbai]

Background

Continuing its crackdown on shell companies, the Government has promulgated the Companies (Amendment) Ordinance, 2018 (the “Ordinance”), with effect from 2 November 2018. The Ordinance, amongst other things, seeks to enhance accountability for non-filing of charges, maintenance of documents and non-commencement of business by a newly incorporated company. The Ordinance has also sought to reintroduce the commencement of business certificate under section 10A of the Companies Act, 2013 (the “Act”), which was removed from the Act to facilitate ease of doing business. The section has been reintroduced to enable the Government’s efforts to remove dormant companies from the system. In this post, we seek to analyse the actions of the Government, their consequences and determine whether such actions are like to have their intended effect.  

Efforts of the Central Government to Tackle Shell Companies

In the war against black money, the Government has sought to draw a causal link between striking off dormant companies and the prevention of fraud through shell companies in the economy. Demonetisation of high denomination currency marked the beginning of the Government’s ‘crackdown’ on shell companies. This was followed by the Ministry of Corporate Affairs (“MCA”) notifying sections 248 to 252 of the Act in December 2016.  Section 248 of the Act provides for dormant companies that have not obtained dormant status under section 455 of the Act to be struck off from the records of the Registrar of Companies (“RoC”).  The process to strike off companies differed in the newly notified sections as compared to that under the Companies Act, 1956 (the “erstwhile Act”). The Act provided defunct companies with an opportunity to voluntarily apply for striking off their names from the records of the RoC.  In the same breath, the MCA also issued the Companies (Removal of Names of Companies from the Register of Companies) Rules, 2016 to provide for the procedural aspect to the strike off.

Thereafter, the MCA exercised its powers under sections 164 and 167 of the Act to disqualify directors of defaulting companies that had failed to file annual returns for the past three years. The enforcement of the sections was viewed with much disdain. Section 164 of the Act corresponds to section 271 of the erstwhile Act, which was much narrower in ambit. While section 271 of the erstwhile Act did not apply to private companies, section 164 is inclusive of both private and public companies. The MCA notified section 164 in April 2014 but there has been much conflict over whether or not the disqualifications have retrospective effect. Naturally, the move has been subject to voluminous litigation as a result of aggrieved directors filing writ petitions throughout the country. Different High Courts have adopted divergent views over whether or not the disqualifications should be stayed. For instance, the Bombay High Court ruled against the disqualifications but the Madras High Court ruled in favour of the disqualifications. The Supreme Court has intervened and stayed all High Court orders that set aside the disqualifications. However, this measure is merely interim in nature.

Further, there have been legislative efforts to curb the illicit flow of money using shell companies, such as the Benami Transaction Amendment Act, 2016 and the Companies (Significant Beneficial Ownership) Rules, 2018, but many key areas still remain unaddressed.

Defining Shell Companies

The Government’s initial efforts had largely revolved around eliminating dormant companies that may be used as a vehicle for illicit activities. In February 2017, the MCA realised the need for a more integrated effort and set up the Task Force on shell companies (“Task Force”). The mandate of the Task Force was “to check in a systematic way, through a coordinated multi-agency approach, the menace of companies indulging in illegal activities including facilitation of tax evasion and commonly referred to as ‘Shell Companies’”. The Task Force consisted of multifarious government agencies (Department of Financial Services, SEBI, RBI, CBDT, SFIO and CBI, to name a few) as its members, to ensure a ‘whole of government approach’. The most significant contributions of the Task Force have been the narrowing down of 18 parameters to identify shell companies, compilation of a database of shell companies and segregation of the same into three categories, namely, confirmed, derived and suspected. This was a welcome move, as it ensured a more holistic approach in flagging shell companies, instead of focusing solely on dormant companies potentially being conduits.

Resolving the definitional issues surrounding shell companies could lead to much required clarity and uniformity. A Parliamentary Standing Committee on Finance (“Committee”) examined this issue and revealed, in its report submitted in March 2018, that they had questioned the MCA on how they were going about identifying shell companies in the absence of any statutory definition of the term. The MCA, in its written response, made a reference to the definition laid down by the OECD and opined that there was no need to lay down a definition in the Act, especially considering the fact that the Task Force had, at that point of time, decided to attempt a commonly accepted definition and attributes by taking inputs from all of its members. The Committee opposed this view and urged the MCA to frame a ‘clear-cut’ definition of shell companies, which included an element of fraudulent intent, and introduce the same to the Act, in order to make a clear distinction between cases of irregular filings and fraudulent conduct. Following this, the Government has reportedly been mulling over incorporating a definition into the Act. In July 2018, Union Minister P.P. Chaudhary also stated that the Government will soon define shell companies. However, based on publicly available information, no significant step has been taken in that direction.

Having a clear-cut definition should be one of MCA’s top priorities. The lack of any statutory definition of shell companies may provide a good defence to the companies being investigated and may impede the Government’s investigative efforts. Thus, it is important for the parameters developed by the Task Force to be translated into statute.

Action against Listed Companies

In June 2017, the MCA had informed the Securities and Exchange Board of India (“SEBI”) of 331 listed companies that it categorised as “suspected shell companies”. Two months after the receipt of the notice, SEBI directed the exchanges to place these “suspected shell companies” under Graded Surveillance Measure (GSM) stage VI, wherein trading in the company’s securities is restricted to once a month under the trade to trade category along with stoppage of any upward price movement and high trade deposits collected from buyers.

SEBI’s move finds precedence in the United States of America where the Securities and Exchange Commission (“SEC”) had taken similar action against 379 listed companies. The intent was to scrutinise micro-cap stocks in the markets and identify shell companies that were dormant but could be used for potential fraud. Unlike SEBI, the SEC attempted to contact the companies, most of whom did not respond. The SEC staff also attempted to independently ascertain whether any of the companies were, in fact, operational. Despite following due process, which SEBI has conveniently overlooked, the SEC was ardently criticised by market participants and advocates that suggested the futility of the regulator’s action in curbing any actual fraud. The SEC argued that its actions were purely preventive and not punitive. Nevertheless, the SEC faced extensive litigation and failed to prove charges against the said companies. Clearly, SEBI’s actions did not meet with a very different fate.

At the outset, the restrictions imposed by SEBI were met with criticism and scorn. Two out of the 331 suspected shell companies appealed against the severe measures taken by SEBI, before the Securities Appellate Tribunal (“SAT”). Since the measures had been implemented without SEBI having conducted any inquiries with regard to the financials of the companies, the SAT stayed SEBI’s direction to all stock exchanges and directed SEBI to conduct the requisite inquiries. SEBI’s foremost defense was that it was implementing the directions issued to it by the MCA and that the appellant’s grievance towards the measures implemented ought to have challenged the MCA’s directions to SEBI. The SAT retorted by observing that MCA’s letter to SEBI merely required SEBI to investigate as to whether the companies mentioned in the letter were carrying on illegitimate businesses. The letter could not be construed to mean that the MCA directed SEBI to impose Stage VI GSM. The SAT also noted that SEBI’s failure to act on MCA’s communication upon its immediate receipt was demonstrative of the lack of urgency in the present situation.

In juxtaposition, the order of the Gauhati High Court in Assam Company and Anr. v Union of India and Ors[1]. (“the Order”) makes for an interesting read. The Court observed that the letter sent by the MCA to SEBI in June 2017 wrongly “branded” the identified companies as shell companies and that the MCA ought to have given a notice to the identified companies of its decision to do so. The Gauhati High Court has also gone a step further and stayed the letter of the MCA.

The contents of the letter sent by the MCA to SEBI are not in public domain, apart from what is discussed in the aforementioned adjudicated decisions of the SAT and the Gauhati High Court. However, should one consider SAT’s interpretation of the said letter, it would appear that the letter did not automatically invite SEBI to impose stringent measures upon the identified companies. The Order also begs the question as to why a letter by the MCA to SEBI was “stayed” by the High Court and the precedential implications that could follow such an action.

Additionally, the National Company Law Appellate Tribunal (“NCLAT”) has, on a petition filed by SEBI, imposed an interim stay on the takeover of Assam Company by BRS Ventures. The Gauhati High Court judgement becomes relevant when the NCLAT considers arguments for and against the said takeover. SEBI is likely to contend that the company is a suspected shell company. However, Assam Company may hold its ground by indicating that the Gauhati High Court finds credence in the repute and financials of Assam Company, as has been reflected in the Order.

Conclusion

The Government’s intent has been clear and laudable but the efforts on the part of all regulators must be coordinated and expedited. The lack of statutory definitions to identify shell companies could provide a solid defence for the accused companies, which would render the efforts of the Government futile. The new Ordinance shifts the focus back to dormant companies and does not completely address the need of the hour. Perhaps regulators would have been better served had the Government focused on the other parameters identified by the Task Force.

More difficulties arise when orders such as that of the Gauhati High Court are enforced. Not only does the Order set a peculiar precedent, it also raises ancillary issues such as the extent of interference the High Court may engage in against official communication between two regulators. Can the courts “stay” a letter between two regulators, especially when the letter, according to the SAT’s interpretation, was not directory in nature? Would such a letter constitute “branding” the suspected companies with a bad reputation? Apparently so. There is also no way of knowing how much credibility the Order would hold before the NCLAT or to what extent Assam Company could use the Order to its defence. With all due respect, it is submitted that the Order is bad in law and must be set aside.

Tishya Saran & Aayush Grover

[1] WP(C) 2572/2018, Order dated July 12, 2018

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