Bad actors and nation states, such as China and Russia, are becoming more proficient in using our financial system to support illicit activity. As bad actors become more sophisticated, so to [sic] must our tools to deter and catch them. One such tool is identifying the beneficial owners of shell companies, which are used as fronts to launder money and finance terrorism or other illicit activity.
Congressman Patrick McHenry (D. NC) made that statement on the House floor on December 8, 2020 as he was speaking in support of the Corporate Transparency Act, which became Title LXIV of the Anti-Money Laundering Act of 2020.[2]
The Congressman’s statement that shell companies are used as front companies may be reasonably accurate in equating shell companies with front companies, but not all shell companies are used as front companies, and not all front companies are shell companies. But he is not alone in his blurring of those lines: many people confuse shell companies with front companies, and shell companies with shelf companies.
Even the 2020 National Strategy referred to “shell and front companies” as if they were interchangeable. They’re not.
And many of the headlines in the media after the Corporate Transparency Act was passed also got it wrong when they touted “the end of shell companies” in the United States. In fact the Washington Post proclaimed:
Congress bans anonymous shell companies after long campaign by anti-corruption groups
(Indeed, the AML Act actually didn’t ban anonymous companies, shell companies, or anonymous shell companies: it banned bearer share corporations and LLCs.)
One of the six purposes of the AML Act is to establish uniform beneficial ownership in formation reporting requirements in order to “discourage the use of shell corporations as a tool to disguise and move illicit funds” (subsection 6002(5)(B) of the AML Act).
Shell companies are featured in the AML Act but not defined. What is a “shell company”? And how is it different from a “shelf company” or a “front company”?
Shell Companies, Front Companies, and Shelf Companies[1]
Although these terms are often used interchangeably, they are not the same. A Joint Report published by the FATF and the Egmont Group in July 2018 provides a great description or definition of each:
Shell company – incorporated company with no independent operations, significant assets, ongoing business activities, or employees.
Front company – fully functioning company with the characteristics of a legitimate business, serving to disguise and obscure illicit financial activity.
Shelf company – incorporated company with inactive shareholders, directors, and secretary and is left dormant for a longer period even if a customer relationship has already been established.
Shell companies are legal entities that exist “on paper” – more likely electronically on a state or Tribal company registry database – but have no physical presence, no activity, and no purpose. There is nothing illegal about shell companies. In fact, the hottest corporate device on Wall Street in 2020-2021 is the “SPAC”, or Special Purpose Acquisition Company. A SPAC has all the attributes of, and in fact is, a shell company: it has no operations, no employees, nor does it have a physical presence. It is created solely to “merge” with a privately-held business, and can take up to two years to do so. Investopedia explains what a SPAC is without using the term “shell company” (https://www.investopedia.com/terms/s/spac.asp) while Wikipedia tells us that a SPAC “is a ‘blank check’ shell corporation designed to take companies public without going through the traditional IPO process” (I don’t usually refer to Wikipedia, but the citations it relies on for this definition are reasonably solid).
PS – SPACs are publicly-traded on recognized US exchanges so they don’t fit the definition of “reporting company”. So they don’t have to reveal their Applicant (the natural person who files the application to form the company) nor any Beneficial Owner(s).
A shell company that serves as a vehicle or legal entity for business transactions to pass through, without itself having any significant assets or operations, can be acting as a front company. A front company, on the other hand, may be more than a shell, and as FATF and Egmont note, be a fully functioning company with a physical presence which may be conducting some legitimate business, but its main purpose is to disguise illegal activity. So a shell company can be a front company, but a front company isn’t always a shell company (think of a pizza parlor as a front for drug trafficking, or Madoff Securities as a front company for Bernie Madoff’s Ponzi scheme).
Shell companies that have been incorporated but have been sitting inactive “on the shelf” for months or years are known as “shelf companies”. Like new shell companies, aged shelf companies are perfectly legal. Having a shell company that was created three, four, or more years before provides the appearance of a business history and thus legitimacy. As FATF/Egmont note in their paper, “as shelf companies can also be considered a type of shell company, particularly following their sale or transfer of ownership, it is possible that jurisdictions referred to former shelf companies as shell companies when providing case studies.”
Wyoming is known for its shelf corporations: where a new “shell” company might cost $250 – $500 to set up, an aged “shelf” company can cost thousands of dollars. See Dusting off the Congressional Version of an “Aged Shelf Company” – RegTech Consulting, LLC.
Speaking of Shelf Companies – The Corporate Transparency Act Seems to Have Addressed Them
The Corporate Transparency Act (CTA) creates a new section in title 31 – 31 USC section 5336 – that requires a “reporting company” to submit its beneficial ownership information to the to-be-constructed FinCEN central registry or database of beneficial ownership information. A reporting company is defined in section 5336(a)(11)(A) as “a corporation, limited liability company, or other similar entity that is (i) created by the filing of a document with a secretary of state or a similar office under the law of a State or Indian Tribe; or (ii) formed under the law of a foreign country and registered to do business in the United States by the filing of a document with a secretary of state or a similar office under the laws of a State or Indian Tribe.”
Subsection 5336(a)(11)(B) provides that a reporting company “does not include” twenty-four types of entities. Included in that list is what appears to be a classic shelf company: a company created by a corporate formation agent that does no business, has no employees, etc., and simply sits “on the shelf” of the corporate formation agent, waiting for someone to buy it and use it. Subsection (xxiii) provides that a reporting company does not include:
(xxiii) any corporation, limited liability company, or other similar entity
(I) in existence for over 1 year;
(II) that is not engaged in active business;
(III) that is not owned, directly or indirectly, by a foreign person;
(IV) that has not, in the preceding 12-month period, experienced a change in ownership or sent or received funds in an amount greater than $1,000 (including all funds sent to or received from any source through a financial account or accounts in which the entity, or an affiliate of the entity, maintains an interest); and
(V) that does not otherwise hold any kind or type of assets, including an ownership interest in any corporation, limited liability company, or other similar entity
Although the intent of Congress was likely to exempt companies that had been in business at one point but had been dormant for at least a year, what they came up with is literally the definition of a US shelf company. But what happens when that shelf company is taken off the shelf and purchased by someone? It appears from the definition in (xxiii)(IV) that it is no longer a shelf company: it has “experienced a change in ownership” and no longer qualifies as a dormant company that is exempt from providing beneficial ownership information.
The Act contemplates that a change in beneficial ownership will trigger a reporting requirement. Subsection 5336(b), “Beneficial Ownership Information Reporting”, provides in part:
(D) UPDATED REPORTING FOR CHANGES IN BENEFICIAL OWNERSHIP.—In accordance with regulations prescribed by the Secretary of the Treasury, a reporting company shall, in a timely manner, and not later than 1 year after the date on which there is a change with respect to any information described in paragraph (2), submit to FinCEN a report that updates the information relating to the change.
Based on the explicit wording of section 5336(b)(D), only reporting companies need to submit a report to FinCEN when there is a change in beneficial ownership. A shelf company (a subsection xxiii dormant company) is not a reporting company, but a shelf company that is taken off the shelf and purchased becomes a reporting company because of a change in ownership. And once taken off the shelf, it could act as a front company to disguise nefarious activity. It is no longer excluded from the definition of “reporting company” and would have to register its beneficial owners. But updated reporting for changes in beneficial ownership only applies to reporting companies that have a change in ownership, not to non-reporting companies that become reporting companies because of a change in ownership.
Phew. It’s complicated. Can shelf companies that become front companies avoid the beneficial ownership information disclosure laws? Probably not. Subsection 5336(b)(2)(E) provides:
(E) REPORTING REQUIREMENT FOR EXEMPT GRANDFATHERED
ENTITIES.—In accordance with the regulations promulgated by the Secretary, any corporation, limited liability company, or other similar entity that is an exempt entity described in subsection (a)(11)(B)(xxiii), shall, at the time such entity no longer meets the criteria described in subsection (a)(11)(B)(xxiii), submit to FinCEN a report containing the information required under subparagraph (A).
That seems to cover off situations where shelf companies could become shell companies or front companies. But …
Oddly Enough, Shell Companies That Become Front Companies May Be Exempt From Registering Their Beneficial Owners
Finally, there’s another oddity in the Corporate Transparency Act. An existing shell company must register its Applicant (the natural person who who files the application with the state or Tribal government to create or register the corporation or LLC) and Beneficial Owner(s) with FinCEN within two years. Suppose, though, that this shell company is indirectly owned and controlled by two drug traffickers who are using it as a pass-through entity to “layer” transactions and launder drug proceeds. Those drug traffickers would be well-advised to convert their shell company to a front company by leasing a warehouse space and some trucks, finding twenty “mules” to act as paid employees, and ensuring that they generate more than $5 million in revenues. If they can accomplish that – converting their shell company to a front company within two years – they can avoid registering their Applicant and their two names as Beneficial Owners.
This loophole, and others, and the AML Act of 2020 and the Corporate Transparency Act generally, are discussed in greater detail in Richards on the AML Act – The Good, The Bad, and The Ugly.
[1] This is a play on a heading “Shell, Front, and Shelf” in an article “Follow the Proliferation Money” by Professor Moyara Ruehsen and Leonard Spector, published in the Bulletin of the Atomic Scientists 2015, Vol. 71(5) 51–58 (September 2, 2015). The article provides an excellent description of the differences between shell companies, shelf companies, and front companies. As referenced in the body, the joint FATF/Egmont paper, “Concealment of Beneficial Ownership”, offers perhaps the best descriptions and examples of shell, shelf, and front companies and how they are used to conceal true beneficial ownership and to disguise illicit activity. I highly recommend it.
[2] House Congressional Record from December 8, 2020 CREC-2020-12-08-pt1-PgH6919-3.pdf (congress.gov) at pages H6932-6933. See Appendix A for the full transcript.