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The Talk about Shell Companies

By Emily Lehmberg – June 16, 2016

Events in recent months have attracted attention to the use of corporate vehicles—among them, different forms of companies, trusts, and foundations—that are expressly organized to hold money, usually tremendous sums of money and often in foreign jurisdictions. Upon encountering such an entity, a business litigator can be either emboldened or discouraged, depending on his or her case and objectives. The prevailing perception is that the primary and intended purpose of these entity structures is to facilitate tax evasion or to serve as an instrument of money laundering.


The fact that this negative view is so generally held should be of concern to those who understand the practical applications of employing complex business structures, and foreign corporate entities, for facilitating international business transactions. The use of these structures, and the organization of foreign entities, is a mainstay of global business; entire banking and investment markets have developed in areas of lower regulation and lower taxes, to provide banking, investment, and legal services for these foreign capital holding companies. This isn’t a dirty, little secret. Yet, since the media first published the story of the Panama Papers data leak, this has become quite a big deal.


The Panama Papers leak, which is believed to be the largest global information data leak in history—roughly 2.6 terabytes of encrypted internal data from Mossack Fonseca, a Panamanian law firm—was made to a German newspaper by an anonymous source. This information is said to have revealed the existence of at least 214,000 offshore shell companies, mostly tied to individuals—high-net-worth individuals, heads of state, foreign politicians, and corporate executives. Without any direct evidence or admission of impropriety, the media have written story after story implying wrongdoing.


The International Consortium of Investigative Journalists delayed public release of the papers until after it had completed its own granular analysis of the information, and on May 9, 2016, it made available to the public only a fraction of the data. However, even prior to the release of this information, simply being identified as having associations with foreign shell companies has resulted in public scrutiny and criticism so severe that several global leaders—including the prime minister of Iceland and the acting minister of industry, energy, and tourism of Spain—have already resigned from their positions, while many others have been forced to publicly disavow involvement and the law firm and lawyers responsible for facilitating these structures have come under attack. With this scandal has come renewed attention to the practice of American companies using such corporate vehicles to hold profits offshore, primarily in an effort to decrease taxes. This practice has attracted harsh criticism for some time, but it is now also being critiqued by presidential nominees, journalists, and the public.


The use of shell companies is commonly referred to as a “loophole,” and the structuring of this entity form has been dubbed “quasi-legal manipulation.” Corporations that use these entity forms are blamed for growing income disparities and are targeted for not paying their “fair share” of taxes. However, in all the frenzied discussion, there has been little consideration given to the potential merits of these entity structures. And while many recognize these structures are legal, there has been little intelligent discussion of existing laws or practical means of change. Instead, we have seen a leveraging of vocabulary. Perception has become more important than purpose.


Perception blurs the lines between what is legal and what is popular, and places officers and directors of corporations, and the lawyers who represent them, in a difficult position as they struggle to reconcile the fiduciary duties they owe with the potential backlash of popular opinion.


The Structure of Shell and Shelf Companies
A shell company is generally defined as a nonoperational company: a legal entity with no current operations, ongoing business activities, or appreciable assets. This definition makes no mention of impropriety or wrongdoing; however, the classification as a “shell” has created a negative connotation that a company is a “front” or lacks a proper purpose.


Shell companies are commonly used to serve legitimate business and economic functions. This entity structure is often used to facilitate corporate mergers, whereby two merging companies structure the transaction so that they are consolidated under a third, neutral shell company. Similarly, this entity structure is used in joint ventures, whereby a shell company is incorporated in a neutral jurisdiction to ensure neither party to the transaction receives favoritism. Shell companies are also used to organize partnership payments and profit-sharing agreements involving parties from different jurisdictions, potentially to allow for the pre-tax division of revenues and income between shareholders.


The primary mechanism of tax evasion that is orchestrated using shell companies relies on the use of a shell entity to obfuscate the identity of the real owner or owners of the underlying assets, substituting relatives, fictitious individuals, or strawmen in place as owners of record; the owners then fail to report their ownership of the shell entity and the underlying assets to the applicable tax jurisdictions where they have liabilities. They effectively evade their tax requirements by failing to report their ownership in the company that they effectively own and control.           


A shelf company is a company that is organized using a standard memorandum or articles and left dormant for the purpose of enabling its sale to another party at a later date. This can provide a buyer an opportunity to avoid delays associated with registering and forming a new business, or allow the buyer to obtain an existing business history, tax history, and credit history for its new business. This is typically viewed as a shortcut, as well as a way to mislead the general public, creditors, and investors about the true history of the business. The primary concern of governments and tax jurisdictions in policing these companies and this structure is the potential for nefarious buyers to purchase shelf companies and never officially transfer ownership to their names. This leads to the conclusion, real or not, that shelf companies provide a direct mechanism for obtaining shell companies for the purpose of obfuscating the owners’ identities.    


Ownership, Management, and Duties to Shareholders
In the United States, many jurisdictions permit companies to issue shares in certificate form, as a type of scrip; these shares are known as bearer shares and allow their holders to exercise rights of ownership in the underlying company—this includes applicable rights to payments or income distributions. The bearer share instrument form continues to attract negative attention related to the perception that it is a means of obfuscating business entity ownership, secreting assets, and laundering money. Much of this criticism relates to the ability of holders of bearer share to anonymously transfer ownership through physical delivery of the certificate, person to person, as this has been seen as an avenue for money laundering.


Most jurisdictions, including those in the United States, have implemented policies to require share registration, including immobilization and dematerialization. These measures are implemented to eliminate the bearer instrument quality of being “unregistered”; through immobilization, this is accomplished by requiring that a custodial agent maintain possession of the shares in order to prevent anonymous and unreported transfers of ownership; through dematerialization, this is accomplished by requiring registration of the shares on a company ledger.


These processes eliminate the means for shareholders to legally transfer shares anonymously, person to person, and to do so without recording the transactions; it also effectively passes responsibility for registering shares and maintaining ownership records to the issuing company. This might seem redundant, as most companies issuing shares in this form, or any other form, require the registration of shares by shareholders in order to basically comply with tax accounting and anti-money-laundering compliance requirements, and in order for shareholders to prove ownership as necessary for exercising ownership rights.


It would appear that a significant problem facing regulators is an entity structure that allows individuals or groups to have effective control of an entity and its interests while avoiding registering or reporting their ownership. For this reason, it might seem wise to target the structures that are most fraught with impropriety; however, to engage in this process is a fool’s errand because it is not possible to make a determination of wrongdoing, or the intent to do wrong, through a top-down appraisal of an entity vehicle or organization structure. A system that does not embrace a case-by-case approach to examination will likely prove tantamount to a witch hunt.


State codes allow corporations to be formed for any lawful business purpose, and the corporate charters of many large publicly traded corporations describe company purpose in similarly general terms. Corporate case law instills officers and directors with fiduciary duties premised on acting in the “best interest of the company.” These broadly worded mandates have encouraged ample debate on when acting in the corporation’s best interest includes maximizing profits for shareholders.


It may be true that no fiduciary duty mandates corporate officers and directors to act to maximize profits. In fact, corporate boards generally do not have a fiduciary duty to do anything; rather, their duties are centered on protecting entity and shareholder interests. In Burwell v. Hobby Lobby, 134 S. Ct. 2751, 2771 (2014), the U.S. Supreme Court that “[m]odern corporate law does not require for-profit corporations to pursue profit at the expense of everything else, and many do not do so.” This statement has encouraged advocates of corporate social responsibility to argue for corporations to adopt strategies aimed at achieving social good over maximizing immediate distributions to shareholders. Yet, to be protected by the business judgment rule, decisions of this nature are only justifiable when they are reasonably related to maximizing long-term profits of the corporation and, ultimately, long-term distributions to shareholders.


A bedrock principle of Delaware corporate law is that a corporate board work to promote the value of the corporation for the benefit of its shareholders. And Delaware case law has imposed a duty on a corporate board to maximize profits: “[T]he duty of loyalty [ ] mandates that directors maximize the value of the corporation over the long-term for the benefit of the providers of equity capital. . . . [S]tockholders’ best interests must always, within legal limits, be the end.” In re Trados Inc. S’holder Litig., No. 1512-VCL, slip op. at 33–34 (Del. Ch. 2013).


Tax Treatment and Resulting Hostility
The growing animosity toward the use of shell companies to hold profits in offshore accounts has seen a corresponding pressure on companies that do so, notably Apple, Google, and Nike, to pay taxes on those profits to the U.S. government. It is estimated that 72 percent of Fortune 500 companies hold profits in offshore shell companies, collectively amounting to roughly $2 trillion.


Current tax law requires corporations to pay taxes on all profits earned in the United States at a rate of roughly 40 percent, the highest corporate tax rate of any developed nation. The law also requires corporations to pay taxes at the same rate on all profits earned outside the United States, but only when those profits are brought back into the country. Corporations use offshore shell companies primarily to avoid paying taxes on profits earned outside the Unites States and, accordingly, hold profits in the same place: outside the United States. For corporations adopting this strategy, shell companies serve as a legitimate method of tax deferral just as an individual retirement account or pension plan.


This is tax avoidance, not tax evasion, and it is perfectly legal. Many individuals, however, are ignorant of the distinction between the two and look at all efforts by corporate boards and wealthy individuals to pay less in taxes as an effort by these parties to avoid paying their “fair share.” This, Tim Cook (the chief executive officer of Apple Inc.) has described as “total political crap.” Others are quite aware of the distinction but find the practice unethical, immoral, or ultimately injurious to society. Many simply find the secrecy surrounding the practice suspect and look down on the need to hide identities more than the need to hide profits. What has universally been considered fair for taxes, both corporate and personal, is the amount that is owed. As Justice Learned Hand famously said, “No one in the law is required to pay more tax than the law specifies.”


The choice by corporate directors to volunteer or willingly submit to pay a greater rate of tax than a business owes could be accurately viewed as a breach of a corporate board’s duty to its shareholders to maximize corporate profits, both immediate and long term. Is it fair to blame corporations for using the laws to their advantage? These entities themselves are completely legal; their owners are simply using them for illegal purposes.


The Role of Legal Counsel
The Panama Papers leak has also brought attention to the role of lawyers in structuring, sheltering, and moving money in offshore corporate vehicles. Like corporate directors, lawyers owe a fiduciary duty to act in the best interests of their clients, within the confines of the law. This includes using the law in creative and innovative ways to develop solutions to client problems. Lawyers, however, face an especially difficult challenge in achieving the lawful goals of their clients when those goals abut ethical considerations. Lawyers face an even greater challenge when the potential exists for their clients to use their services to achieve an unlawful purpose after they have achieved the purpose for which they were hired.


In response to questions from International Consortium of Investigative Journalists about its incorporation services, Mossack Fonseca stated that it “does not foster or promote unlawful acts,” adding that there are a number of legitimate purposes for incorporating entities in other jurisdictions. It further stated: “We regret any misuse of companies that we incorporate or the services we provide and take steps wherever possible to uncover and stop such use.”


As it applies to the use of corporate vehicles to provide anonymity to certain transactions or hold money offshore, lawyers must apply a rigorous examination of the law and tread lightly to stay within its confines. However, to what extent is a lawyer legally obligated to follow up with his or her clients to ensure that the clients have not used the lawyer’s services for an unlawful end?


Keywords: litigation, business torts, shell companies, shelf companies, Panama papers, Mossack Fonseca


Emily Lehmberg is an associate at Bell Nunnally & Martin LLP in Dallas, Texas.


 
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