Abuse of Incorporation of Companies to Commit Fraud

Priyanka Parag Taktawala

Introduction:

Limited Liability Companies are usually a preferable choice of vehicle for most people who wish to
conduct business internationally and domestically. They are beneficial to the economy of the country
1
because it stimulates growth, creates employment and motivates local community .

We know that there is an increasing ratio of fraud registered, but still our understanding is limited to the
companies which help fraud because there is not much statistics available. Committing fraud by way of
sham companies like phoenix companies, fraudulent trading or long firm fraud can have a negative
2
impact on the economy by ripping off creditors, public, suppliers and customers

The opportunity to curb this type of crime can be by viewing the shortcomings of the legal system of
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incorporation and strengthening the KYC ‗Know Your Customer ‘ requirements who operate such
companies.

Benefits associated with incorporation:

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(1) Separate Legal Entity : the incorporated company is a separate and distinct entity, which is
separate from the directors, management, shareholders and company secretary. Meaning
whereby the company can enter into contracts and sue without being referred to the members or
the officers of the company.
5
(2) Limited Liability : incorporation of a company restricts the liability of the officers to the amount of
the shares unpaid and there is no risk of personal assets. Private companies usually issue ‗fully
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paid ‘ shares which means that a member will be liable only for the value of the shares and any
loans advanced to the company. The directors and management rely heavily on the ‗veil of
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incorporation‘ which means that the directors of the company are protected have limited liability
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although ‗lifting of corporate veil‘ is done in certain circumstances.
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(3) Ease of incorporation : setting up a company is a very easy process with ‗red tape‘
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(4) No disclosure requirement of beneficial ownership of company : the real identity of directors,
shareholders, promoters etc. can be hidden behind nominee directors.
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(5) No minimum capital requirement : most companies can be formed without any capital restriction
depending on the country of incorporation.


LL.M Gujarat National Law University
1
The World Bank (2012) Doing business 2012: doing business in a more transparent world. Available from doingbusiness.org/.
2
Department for Business, Innovation and Skills (2012) About BIS [online]. Available from bis.gov.uk/about.
World Bank (2012) Doing business 2012: doing business in a more transparent world. Available from doingbusiness.org/.
3
Companies House (2012) About us [online]. Available from companieshouse.gov.uk/about/functionsHistory.shtml.
4
Tutor2U (2012) Advantages of forming a limited company [online]. Available from tutor2u.net/business/finance/
legal_company_advantages.htm.
5
Lindsay v O‘Loughnane [2010] EWHC 529 (QB). Available from bailii.org/ew/cases/EWHC/QB/2010/529.html.
6
Companies House (2012) Strike off, dissolution and restoration (GP4). Available from companieshouse.gov.uk/about/
7
The Insolvency Service (2012) Insolvent companies and disqualified directors [online]. Available from
bis.gov.uk/insolvency/Companies/insolvent-companies/what-action-can-be-taken-against-a-director.
8
Money Laundering Regulations 2007, 3(10). Available from legislation.gov.uk/uksi/2007/2157/contents/made.
from hmrc.gov.uk/mlr/getstarted/register/tcsp.htm
9
Association of Company Registration Agents (2012) Homepage [online]. Available from acra-uk.org/.
10
Serious Fraud Office (2012) Fraud [online]. Available from sfo.gov.uk/fraud/what-is-fraud/corporate-fraud/fraudulenttrading..
11
Action Fraud (2012) Types of fraud [online]. Available from actionfraud.police.uk/fraud_protection/
long_term_and_short_term_fraud.
Issue 4. Available from fraudadvisorypanel.org/publications.php?c_id=19.
Applications for incorporation are scrutinized by the Registrar of Companies or Companies House,
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depending on the country of incorporation . They check if the director is disqualified and if the same
name is already been registered by some other company or has any offensive or sensitive word.

Ongoing obligations and compliance:

After incorporation, all companies including dormant companies have to comply with ad hoc and annual
requirements like filing annual returns, notifying changes to the ROC etc. Failure to comply with these
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requirements can be a criminal offence and can attract civil penalties .

Such ongoing continuous filings with the Registrar of Companies are subject to adherence and basic
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checks . Checks are not made to check the truthfulness of the information which is submitted or to
disqualify the appointment of the directors already existing in the company because this is a matter of the
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company .

All companies are not successful to comply with all obligations and the companies which fail to company
have to be struck down by the Registrar of Companies and are dissolved. Companies which are no
longer functioning or carrying on the business or are not communicating with the Registrar of Companies
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will be dissolved as an on going enforcement strategy . The courts can disqualify the Directors from
acting as directors of the company for a maximum tenure of 15 years, for various reasons like
misconduct, fraudulent trading or carrying on business while insolvent, and the names of such directors
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will be entered into the Disqualified Directors Register .

Company Formation Agents:

Such company formation agents would act on behalf of the clients in order to incorporate the company
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and would also offer services like registered office addresses . Such agents are regulated by ―HM
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Revenue & Customs (HMRC) or a recognized supervisory body ‖ for regulating anti-money laundering.
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These formation agents join the Association of Company Registration Agents (ACRA) voluntarily
because it is the only trade association which is recognized in this sector. The members of this
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association have to comply with the Code of Professional Conduct and are accountable for more than
half of the companies incorporated.

12
Action Fraud (2012) Types of fraud [online].
13
Fraud Advisory Panel (2011) Corporate identity fraud. Fraud Facts Issue 1 (2nd edition). Available from
fraudadvisorypanel.org/publications.php?c_id=19.
14
Companies House (2012) PROOF (protected online filing) scheme [online]. Available companieshouse.gov.uk/
infoAndGuide/proofArticle.shtml.
15
House of Commons Business, Innovation and Skills Committee (2012) The insolvency service (written evidence) [online].
Available from parliament.uk/business/committees/committees-a-z/commons-select/business-innovation-and-skills/
inquiries/parliament-2010/insolvency-service/.
16
The Insolvency Service (26 January 2012). Written ministerial statement: Edward Davey, Minister for Employment Relations,
Consumers and Postal Affairs; Department for Business, Innovation and Skills: pre-packed sales in insolvency. Available from
bis.gov.uk/insolvency/Consultations/PrePack?cat=closedwithresponse
17
See House of Commons Business, Innovation and Skills Committee (2012) The insolvency service (written evidence).
18
The Insolvency Service (2011) Company investigations: what we do. Available from bis.gov.uk/insolvency/Publications.
Note: this excludes sole traders or partnerships (unless they have limited liability) and companies that do not have a
UK business address or have been dissolved. It does include overseas registered companies that are operating in the UK.
19
Companies House (2012) Annual report and accounts 2011/12. Available from companieshouse.gov.uk/about/
Corporate Documents/annualReport2011_12.shtml. See page 4. Also see Companies House (2012) About us [online].
Available from companieshouse.gov.uk/infoAndGuide/reportingFraud.shtml.
20
Tesco Supermarkets Ltd v Nattrass [1972] AC 153.
21
Fraud Advisory Panel (2010) Boiler room fraud. Fraud Facts Issue 6. Available from fraudadvisorypanel.org/
pdf_show_150.pdf.
 Incorporation as a Vehicle for Fraud:
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Such companies are set up for the main objective of committing crime or subsequently being used for
the same purpose because the present registration process is very limited in the ability to discriminate
between good and bad. In certain extreme circumstances, the company is incorporated with the only
objective to enable fraud.

The impact of such an incorporation abuse floats throughout the country‘s economy and everyone in that
country pays the price for such fraudulent activities by way of higher taxes, increase in purchasing cost of
goods and services. The businesses that have a legitimate objective also has to write off losses because
of bad debts
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Victims are :

(1) Revenue collector (Government) –The Exchequer.

(2) Customers, investors, suppliers and lenders –Legitimate Businesses
(3) Tax payers, customers and investors- Individuals.

Different ways of incorporation are used by fraudsters to commit crime, but some of the common ways
used for such fraudulent trading are:
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(1) Fraudulent Trading : the company‘s main objective is to carry on business purposefully for
defrauding creditors when it is being wound up or is declared insolvent.
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(2) Long and Short firm fraud : when fraudsters incorporate the company with the sole motive of
defrauding legitimate businesses. Such sham company trades legitimately for some period of
time so as to establish a creditable reputation before they place huge orders with suppliers and
then disappear with the supplied products. Short firm fraud is when the fraud occurs in a short
period of time after its incorporation.
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(3) Phoenix company fraud : it is when the assets of the dissolving company are transferred to a
phoenix company (newly established). The dissolving company is then wound up which leaves a
huge list of debts and creditors. The new company is able to conduct business with a clean sheet

Companies which is established only for the purpose to commit fraud, create an illusion that they are
secure financially and more reputable than what they actually are so they it is easy to dupe the investors,
customers and suppliers. The Registrar of Companies has introduced a Protected Online Filing (PROOF)
27 28
Scheme in 2005 . In order to reduce paper filings to prevent ―a company‘s vulnerability to fraud‘

22
Charity Commission (2011) Registering as a charity (CC21) [online]. Available from charity-commission.gov.uk/
Publications/cc21.aspx#45. Charity Commission (2008) The essential trustee: what you need to know. Available from
charity-commission.gov.uk/Charity_requirements_guidance/Charity_essentials/The_essential_trustee.aspx.
23
Fraud Advisory Panel (2010) Fraud reporting: a shared responsibility. Available from fraudadvisorypanel.org/
publications.php?c_id=24.
24
Financial Services Authority (2012) FSA handbook [online]. Available from fsahandbook.info/FSA/html/handbook/FIT/1.
See FIT 1.3.1 Release 131 November 2012.
25
See Fraud Advisory Panel (2011) Pre-employment screening. Fraud Facts Issue 3 (2nd edition). Available from
fraudadvisorypanel.org/pdf_show_153.pdf.
26
M., Nielson, D., and Sharman, J. (2012) Global shell games: testing money launderers‘ and terrorist financiers‘
access to shell companies. Available from griffith.edu.au/__data/assets/pdf_file/0008/454625/
Oct2012-Global-Shell-Games.Media-Summary.10Oct12.pdf
27
Palan, R, Murphy, R and Chavageneux, C 2010. Tax Havens: How Globalization Really Works. Ithaca, NY: Cornell University
Press.
28
‗Offshore secrets: How many companies do ―sham directors‖ control?‘, The Guardian, 26 November. Available at: theguardian.
com/uk/datablog/2012/nov/26/offshore-secrets-companies-sham-directors.
 Pre- Pack Administrations:

Liquidators and pre- pack administrators are controversial because they lack transparency and are highly
prone to be abuse and they are always seen as disadvantageous for the creditors. This issue was
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subjected to public consultation and reviews by the Insolvency Service though the government didn‘t
make any legislative changes and considered it in a larger portion of the Insolvency Code.

The Perpetrators:
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Those who are abusing the system can be categorized as professional criminals (organized) who
incorporate a company with the only objective of defrauding the creditors; and there are accidental
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fraudsters who are the directors who control the management of the company and which ‗floats‘ into
fraud through financial difficulty or incompetence.

The professional fraudsters use the professional advisers and the company to legalize their transactions
and create a veil between law detection and themselves. These perpetrators are highly educated and are
professional at running businesses and use multiple jurisdictions so that they cannot be tracked.

The accidental fraudsters like the incompetent director do not know their responsibilities towards the
company.

Enforcement:

The responsibility is of the Insolvency Service for the investigation of non-criminal allegations of corporate
abuse. Though such enforcement agencies would deal in regulatory issues and crimes which are
generated by the companies.

Such complaints relating to companies have to be reported to the Insolvency Service and it is then
handled by the investigating team which derives it power from the Companies Act but is limited only to
investigate companies and on a non criminal basis for matters like scams, frauds, misconduct or in public
interest.

165 investigations took place in 2011-12 by the Insolvency Service when there were 3,523 complaints
registered because a its not necessary to always investigate every complaint under the Companies Act.
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And 355 winding orders were passed .
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―A company which has to be compulsorily wound up is investigated by the Official Receiver.‖ The
appointed inspector has to file a report of the conduct of the directors which would decide whether
investigation is necessary or not in the following circumstances- Financial failure, voluntary winding up,
administration and receivership.

29
Hampton, M 1996. The Offshore Interface: Tax Havens in the Global Economy. Houndmills, UK, & New York: Macmillan & St
Martin‘s Press. doi.org/10.1007/978-1-349-25131-5.
30
Maurer, B and Martin, SJ 2012. ‗Accidents of equity and the statistics of Chinese offshore incorporation‘, American Ethnologist
39(3): 527–44. doi.org/10.1111/j.1548-1425.2012.01379.x
31
Picciotto, S 1999. ‗Offshore: The state as legal fiction‘, in MP Hampton and JP Abbott (eds), Offshore Finance Centres and Tax
Havens: The Rise of Global Capital. Basingstoke, UK: Macmillan, pp. 43–79. doi.org/10.1007/978-1-349-14752-6_3.
32
Sharman, JC 2006. Havens in a Storm: The Struggle for Global Tax Regulation. Ithaca, NY: Cornell University Press.
33
Organisation for Economic Co-operation and Development (OECD) 2000. Towards Global Tax Co-operation: Report to the 2000
Ministerial Council Meeting and Recommendations by the Committee on Fiscal Affairs—Progress in Identifying and Eliminating
Harmful Tax Practices. Paris: OECD. Available at: oecd.org/tax/transparency/44430257.pdf.
Various routes of investigation lead to many outcomes which include: director warnings, disqualification of
directors, prosecution, no further action, winding up of company, reference to criminal investigation.

Barriers to investigation and enforcement:

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(1) Focus on criminal outcomes : fraud, if not proven is very difficult to prosecute. In such situations,
the insolvency proceedings and the civil system can have a quick solution for victims of such
frauds and such routes require less evidences.
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(2) Lack of cooperation and coordination : because of diverse agencies for enforcement and lack of
cooperation to share information between such enforcement agencies, there are many orphan
cases because no one can take it on
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(3) Insufficient resources : because of cost cutting measures by the government, the amount of
resources have reduced in both finance and man power in order to prosecute and investigate
financial crimes, corporate abuse and frauds
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(4) Cross- jurisdictional nature of cases : such fraudsters use various jurisdictions by moving
operations, assets and themselves from one jurisdiction to another. Some jurisdictions are more
accommodating than the other because of which investigations are hampered.
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(5) Lack of Enforcement teeth : such fraudsters exploit the weaker legal system of such
accommodating jurisdictions. Incorporation in such tax havens are cheap, simple and are lightly
policed. But also, lifting of the corporate veil is used to investigate some serious crimes like drug
dealing which shields their crimes.
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(6) Difficulty in successfully prosecuting corporate offences : proving that the company has
committed any offence, proving ‗guilty intent‘ and ‗acts and state of mind‘ of the representatives of
the company is very important. But this is next o impossible and thus resulted in failure of
prosecutions.

Improving Due Diligence Checks on Company Directors:

There is a major requirement for improving safeguards for protecting legitimate businesses, public and
investors and for stopping rogue directors from establishing such sham companies. The Registrar of
Companies should perform regular checks against disqualified directors while allowing new applications
40
for appointment of directors and incorporation of companies . This is to ensure that such ‗bad‘ directors
cannot set up new companies

Inquiries regarding the beneficial owners should be made and check whether the nominees are the
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shareholders . Such information should be placed in public register for improving corporate
transparency. Nominee directors should be prohibited and there should be a record for residential

34
Maurer, B 1995. ‗Law writing, immigration, and globalization in the British Virgin Islands‘, Indiana Journal of Global Legal Studies
2(2): 413–28
35
Organisation for Economic Co-operation and Development (OECD) 2002. Agreement on Exchange of Information on Tax Matters.
Paris: OECD. Available at: oecd.org/ctp/harmful/2082215.pdf
36
Leigh, D, Frayman, H and Ball, J 2012. ‗Offshore secrets revealed: The shadowy side of a booming industry‘, The Guardian, 25
November. Available at: theguardian.com/uk/2012/nov/25/ offshore-secrets-revealed-shadowy-side
37
Palan, R, Murphy, R and Chavageneux, C 2010. Tax Havens: How Globalization Really Works. Ithaca, NY: Cornell University
Press.
38
Bowers, S 2014. ‗Luxembourg tax files: How tiny state rubber-stamped tax avoidance on an industrial scale‘, The Guardian, 5
November. Available at: theguardian.com/business/2014/nov/05/- sp-luxembourg-tax-files-tax-avoidance-industrial-scale.
39
Maurer, B and Martin, SJ 2012. ‗Accidents of equity and the statistics of Chinese offshore incorporation‘, American Ethnologist
39(3): 527–44. doi.org/10.1111/j.1548-1425.2012.01379.x
40 40
Palan, R, Murphy, R and Chavageneux, C 2010. Tax Havens: How Globalization Really Works. Ithaca, NY: Cornell University
Press
41
Maurer, B and Martin, SJ 2012. ‗Accidents of equity and the statistics of Chinese offshore incorporation‘, American Ethnologist
39(3): 527–44. doi.org/10.1111/j.1548-1425.2012.01379.x.
 42
addresses of such directors which should be verified . Habitual fraudsters would appoint middle men
who would act as beneficial owners.

Recommendations:
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In the short Term :

(1) Increase the list of Disqualified directors on the home page of the website
(2) Introduce due diligence checks for existing companies with new directors.
(3) Encourage companies to report fraudulent actions and victimization.
(4) Send guidance to all new companies and their directors on their liabilities and duties for the
registration process. Make new directors aware of such online information by notifying them
through email
(5) Have a cross sector and cross border group to have a due diligence guidance on ―Do you know
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who you are doing business with?‖ to help stakeholders have a self protection against such
fraudsters.

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In the medium term :

(1) Research the extent, nature and impact of such abuse on economy and victims
(2) Review the disqualification method and criteria and recommendations about its improval
(3) Require Registrar of Companies to monitor the companies to ensure due diligence and ensure
compliance and anti-money laundering laws

42
Organisation for Economic Co-operation and Development (OECD) 2000. Towards Global Tax Co-operation: Report to the 2000
Ministerial Council Meeting and Recommendations by the Committee on Fiscal Affairs—Progress in Identifying and Eliminating
Harmful Tax Practices. Paris: OECD. Available at: oecd.org/tax/transparency/44430257.pdf
43
Palan, R 1999. ‗Offshore and the structural enablement of sovereignty‘, in MP Hampton and JP Abbott (eds), Offshore Finance
Centres and Tax Havens: The Rise of Global Capital. Basingstoke, UK: Macmillan, pp. 18–42. doi.org/10.1007/978-1-349-14752-
6_2.
44
Ball, J 2012a. ‗Sham directors: The woman running 1,200 companies from a Caribbean rock‘, The Guardian, 25 November.
Available at: theguardian.com/uk
45
Rawlings, G 2005. ‗Mobile people, mobile capital and tax neutrality: Sustaining a market for offshore finance centres‘, Accounting
Forum 29(3): 289–310. doi.org/10.1016/j.accfor.2005.03.005.