Shell Companies: A Report Worth Reading

CRITICS of Jersey's finance industry who say that the Island is a tax haven with strict secrecy and lax regulation are wrong, according to an independent report out this week. The study by the Centre for Governance and Public Policy at Australia's Griffith University tested firms in 182 countries by posing as fake customers, including would-be money launderers, corrupt officials and terrorist financiers, trying to set up anonymous companies. And the results surprised those carrying out the research with so-called 'tax havens' - including Jersey - ranking top in the world and countries such as the UK, Australia, Canada and the US, near the bottom of the list. As a result they concluded that it was 'more than three times harder' to obtain an untraceable shell company - basic legal companies that can act as a shield for the people behind them - in tax havens with places such as Jersey complying with international rules in 100 per cent of their approaches. (1)

The full report - and it is not that long to read, is at the Centre for Governance and Public Policy at Australia's Griffith University

http://www.griffith.edu.au/business-government/centre-governance-public-policy/research-publications/?a=454625  

It's a good example of applying experimental method to financial studies, and the results are counter-intuitive:

Evidence is drawn from more than 7,400 email solicitations to more than 3,700 Corporate Service Providers that make and sell shell companies in 182 countries. The experiment allows us to test whether international rules are actually effective when they mandate that those selling shell companies must collect identity documents from their customers. Shell companies that cannot be traced back to their real owners are one of the most common means for laundering money, giving and receiving bribes, busting sanctions, evading taxes, and financing terrorism.

1. Overall, international rules that those forming shell companies must collect proof of customers' identity are ineffective. Nearly half (48 percent) of all replies received did not ask for proper identification, and 22 percent did not ask for any identity documents at all to form a shell company.
2. Against the conventional policy wisdom, those selling shell companies from tax havens were significantly more likely to comply with the rules than providers in OECD countries like the United States and Britain. Another surprise was that providers in poorer, developing countries were also more compliant with global standards than those in rich, developed nations.

Running directly counter to conventional policy wisdom on the subject, providers based in tax haven countries were significantly more likely to follow the rules, to apply the "Know Your Customer" principle, than those in non-tax haven countries. Another surprise was that providers in poorer, developing countries were at least as compliant as those in rich, developed countries.

As the authors note, rules can be in place, but simply flouted. The most robust rules in the world are no use if they cannot be enforced. They simply look good on paper.

These results present a far more accurate and robust picture of the true state of affairs on shell companies and the effectiveness of the international rules that supposedly govern them than any previous study. The cases of shell-company enabled crimes that come to the attention of law enforcement or the media are by definition unrepresentative, simply because they have become public. International organizations and government agencies often try to assess policy effectiveness by either just reading the rules on the books, which may have limited correspondence to what actually happens in practice, or by counting successful prosecutions or totals of dirty money seized, which again gives little idea as to how many violations occur without official notice.

But let's not also forget that Tax Information Exchange Agreements (TIEAs) also look good on paper, but need to be tested in practice. A case in point is the tussle between Jersey and Norway in 2011, reported in the Telegraph and Private Eye, but unfortunately without any follow up, suggesting it was resolved in the end in a satisfactory manner to both parties:

Jersey is refusing to hand over information to Norway relating to a tax investigation, despite having signed a tax information exchange agreement (TIEA) with the country.(2)

The same article notes the weaknesses of some paper provisions, especially the "white list" TIEAs.:

TIEAs have come in for criticism since their creation in 2002 because no information is automatically offered up and any country requesting information must state, among other things, the identity of the person under examination or investigation and the grounds for believing that the information requested is held within the jurisdiction of which the request is made. In other words, to ask a question you have to know the answer - a situation made even more difficult by the fact that tax evaders regularly use trusts and companies as a way of shielding their identity and avoiding public record. (2)

TIEAs are a necessary but not sufficient step towards preventing tax dodging, and they are a start. But shell companies are also worth scrutiny.  Why are shell companies a threat? The study explains, and gives examples. It's is interesting that the examples are mostly from larger, supposedly well-regulated jurisdictions: New Zealand, Germany, USA:

Shell companies are a threat when they cannot be traced back to the real person or people in control. Anonymous shell companies are so useful to criminals because they screen or veil illicit conduct.

In December 2009 a plane searched in Bangkok was found to be carrying North Korean arms bound for Iran, in violation of international sanctions. The plane had been leased by a New Zealand shell company, but there was no information on the individual who controlled the company

The Iranian government used shell companies from Germany, Malta, and Cyprus to evade international sanctions by concealing the ownership of its oil tankers

Teodorin Obiang, son and heir-apparent of the president of the oil-rich West African nation of Equatorial Guinea, laundered corruption proceeds in the United States by using a series of Californian shell companies to hold bank accounts and title to his $35 million Malibu mansion.

Russian arms dealer Viktor Bout was convicted in November 2011 of conspiracy to provide aid to a terrorist organization. Bout's illicit activities were crucially dependent on a network of shell companies in Texas, Delaware, Florida, and elsewhere around the globe.
The Mexican Sinaloa Drug Cartel employed New Zealand and other shell companies to launder tens of millions of dollars of cocaine profits through Latvian banks

They then lay out how misuse of shell companies can be tackled. This is worth looking at:

The first potential option is for law enforcement agencies to have strong investigative powers to track down shell company owners. The difficulty here, however, is that police powers are limited by national jurisdictions, whereas the misuse of shell companies is all too often an international problem.

The second option might seem the most promising: having government company registries collect and file information on the real owners. If companies are creatures of law, they cannot exist without some documentation lodged with some form of company registry. From here it might seem an easy step to simply require these registries to demand and hold owners' proof of identity. Company registries, however, largely have a passive, archival function of collecting a very limited range of information. Though some registries hold more information on companies than others, currently to our knowledge only one, that in Jersey, holds the information on the beneficial owner

By elimination, this leaves the third option, requiring CSPs to collect and hold identity documentation on customers forming shell companies according to the "Know Your Customer" principle. In practice, this is the only way to reliably establish the real owner of shell companies. This solution depends on licensing and regulating providers (something which many countries, including the United States, do not do), imposing a legal duty on them to collect proof of identification from customers, and auditing providers to make sure they do in fact collect this information, with penalties for non-compliance.

The experiment is a random one, which is good. One of the weaknesses of the study by Mark Hampton in his book "The Offshore Interface" was that it did not use random sampling, but a "snowball sampling", which basically was more or less following up leads from one company to another. This was not scientific, whereas this approach is clearly following statistical principles. While it does not rule out the use of tax havens for money laundering, or other weaknesses in the system, it is highlighting one very basic area where more diligence is needed.

Central to our project is the random allocation of different emails among the pool of providers. The reason behind this approach is to find out what causes CSPs to be more or less compliant with the rules on shell companies by mimicking the logic of randomized drug trials. In order to find out whether a particular new drug is effective in fighting some disease, and if the drug causes harmful side effects, it must be subject to a randomized clinical trial.

The ability to shop for a shell company for dubious purposes they call the "doggy shopping count":

The Dodgy Shopping Count for tax havens is 25.2, which is in fact much higher than the score for rich, developed countries at 7.8 - meaning it is more than three times harder to obtain an untraceable shell company in tax havens than in developed countries. Some of the top-ranked countries in the world are tax havens such as Jersey, the Cayman Islands and the Bahamas, while some developed countries like the United Kingdom, Australia, Canada and the United States rank near the bottom of the list. It is easier to obtain an untraceable shell company from incorporation services (though not law firms) in the United States than in any other country save Kenya.

The report also looks at the ethics of deception, and notes that the cost to providers was minimal, and the good of the study outweighed that element:

We estimate that providers took 3-5 minutes to respond to our emails, so costs were minimal. Since our approaches closely mirror the day-to-day business of subject firms, there was no harm inflicted. We destroyed all identifying information on individuals and individual firms to ensure that none can be penalized for the responses they gave. We could not have found out the availability of untraceable shell companies without deception. Directly asking people or firms if they follow rules is not a reliable way of finding out whether they really do follow such rules in practice, especially if they routinely behave inappropriately. Shell companies are a major factor behind criminal successes and all the associated human suffering. Better knowledge on the effectiveness of existing policies on shell companies should help improve these policies and reduce the harm caused by crime. The potential benefits of the research are therefore significant.

It's also worth noting, as a 2006 report by the Financial Crimes Enforcement Network on "The Role of Domestic Shell Companies in Financial Crime and Money Laundering" that shell companies are just one way in which money laundering has a conduit:

Although the focus of this paper is on limited liability companies, other business entities, including trusts, business trusts, and corporations, are also vulnerable to abuse...It is anticipated that attention will be given in the future to studying other business entities which are subject to abuse and illicit use as shell companies or to otherwise mask ownership for illicit purposes.(3)

But this is a good start, because it puts tests on a solid scientific basis.

Of course, it is entirely possible for schemes to be in place, like Jimmy Carr's one, that are entirely legal but effectively seek to find a loophole in the tax legislation, or for other kinds of tests, like the Panorama undercover journalist who exposed a major weakness with a Jersey bank. But while these incidents show up the vulnerability of the systems, what they cannot do is to statistically address the scale of the weaknesses, and how much money may be funneled through them in illegitimate ways. That's what this report does with shell companies - and note with shell companies alone - it doesn't try other forms of testing.

Yet that does bring to light major weaknesses in systems, as seen in a recent news report:

According to a new report from non-profit Global Witness, a U.K.-registered company saw about $700 million flow through its account at a Kyrgyzstan bank despite the fact that its identified owner, a Russian from a remote area, had died three years before the company was registered. Moreover, records cited by Global Witness said he attended a company meeting in London after his death. "It is so easy to set up a secretive 'shell' company in the U.K. and elsewhere that criminals, terrorists and corrupt politicians can easily move money around the world with impunity," said Tom Mayne, a Global Witness campaigner, in a statement attached to the report. "Not only that, but you can do this perfectly legally." (4)

But what it does do, it does scientifically, with the rigor of a proper experiment. Hidden trillions there may be in offshore (or even onshore shell companies!), but unless it comes to light in legal action, or is exposed by newspapers (as in the Carr story), the sums involved are speculative, and any figures could be conjured out of thin air.

What is needed is not just case studies, important though they are, but also more scientific testing. A case study is a falsifier to the notion that a jurisdiction - such as the UK - is "well regulated", but it is unlikely that any legislation can totally rule out falsifiers like that, so a more detailed study giving a test of the scale of weakness is a necessary complement to it.

And it is clearly about time the USA, with all its talk of tax evasion, put its house in order. Global Witness has an "Idiots Guide to Money Laundering" which highlights major weaknesses in the USA and UK.

If you're concerned that it won't look too good having a company registered in some sunny Caribbean island secrecy jurisdiction, don't worry! There are two easy ways round this:

.Start a company in the US state of Delaware: an American company sounds like it ought to be squeaky clean, but in fact Delaware doesn't publish any information on who's behind its companies, nor does it collect any in the first place. This means that even the police find it difficult to find out who owns Delaware companies.

.Or, you could go to another less dodgy-sounding place, like the UK. The UK tells everyone who owns British companies, but that's OK because it's very easy to get round this. Just make the owner of your UK company another company registered somewhere else, where they're not so open with this information.

It also mentions other weaknesses within the EU. So much for tax harmonisation!

Your ownership of a Dutch company will be kept secret as long as you own less than 100% of the company: do this by getting another company to own 1%.

Banks in places such as Latvia ask very few questions. And once you've got your money into a Latvian bank, you can move it anywhere you like within the EU without any checks being carried out at all.

Links
(1) http://www.thisisjersey.com/business/2012/09/27/secrecy-slurs-are-wrong-says-report/
(2) http://www.telegraph.co.uk/finance/personalfinance/offshorefinance/8577451/Jersey-and-Norway-locked-in-tax-disclosure-battle.html
(3) http://www.fincen.gov/news_room/rp/files/LLCAssessment_FINAL.pdf
(4) http://blogs.wsj.com/corruption-currents/2012/06/19/global-witness-shows-how-u-k-shell-companies-aided-money-laundering-at-kyrgyz-bank/
(5) http://www.globalwitness.org/sites/default/files/Global%20Witness%27s%20Idiot%27s%20guide%20to%20money%20laundering_2.pdf