Moral Hazard and Operations of Shell Companies

In 2012, Jason Sharman presented a paper on "Financial Secrecy, society and vested interest" in Norway. The paper discussed whether the FATF laws to counter the anonymity issue of the shell companies effective? 

As per the FATF recommendation 24, he pointed out, corporate service providers should maintain relevant information about the ownership of the shell corporations that they aid in setting up. This includes, for example, asking for notarized copies of individuals involved in the setting up of the shell company and other relevant authorisation documents. 

To test the hypothesis the researchers created around 21 fictitious identities. Each identity was assigned citizenship of a different country e.g Pakistani, Arab (Saudi), Mexican etc. The role of assigning different citizenships was to provide some signal to the corporate service providers about the potential areas that the shell firm might be involved in. For e.g. enquiry for setting up of a shell company in Pakistan or Saudi could potentially be involved in terror financing while that from Mexico could be related to drug laundering etc.

A control email draft was then created. It can be simply thought of as an email that is considered a baseline. E.g,

Next, other emails were drafted which were formed by simple tweaks of some wordings of the baseline email. These emails basically were to be sent to around 3700 Corporate Service Providers over the period of 2 years and act as an enquiry from these "individuals" for setting up shell companies. The changed wordings from the baseline were to act as a signal to the corporate service providers about the potential dealings of the shell company - e.g. terrorist financing, corruption laundering etc. Some emails also went forward to include the words like FATF and IRS in their body. E.g,

This was done to observe whether such wordings could induce a changed response from service providers i.e. if an act of reminding them about these rules or organizations induces compliance from service providers.

The objective of this research, basically, was to analyse the response of corporate service providers. The response was classified into 4 parts - (1) Service providers asking for no documentation at all and agreeing to be able to aid in forming a shell firm (2) Service providers asking for partially/some documentation but not up to the level that FATF has put forward (3) Service providers asking all the required documentations and (4) Simple denial from their end, maybe, because they feel its too risky or some other reason that is outside the scope of this study.

Since a large number of "individuals" were created and randomly attached to each of these created emails, this project acted as an RCT. Hence, any difference in the response attached to "treatment emails" could be causally attached to the variation of these changed wordings. 

Analyzing the responses provided interesting results. Amongst others, here I'd like to discuss the results of compliance distribution by country type (shown below)

What was observed is that the doggy shopping count (think of search-match kind of number i.e. number of firms you will have to search before, on average, one agrees to your request. So, the greater this number, difficult it is to find a service provider that could set up a shell company). Interestingly, tax havens have the greatest score i.e. it was most difficult to find a corporate service provider that could set up a shell firm in tax havens. Developing nations, on the other hand, performed worse than tax havens but it was OECD nations who performed worst of all. This is the moral hazard problem that I mentioned in the title. 

Governments and surveillance institutions around the world believe tax havens would perform worse in this context and would be a source of many illicit activities. Consequently, they are kept a keen eye upon. However, this, I believe has made the service providers in such nations be more cautious. On other hand, in the lax regulated countries like OECD, where nobody or only a few believe such activities to take place, the corporate service providers are most non-compliant. It is possibly because they believe they won't be caught as not many eyes are upon them. This is a sweet example of moral hazard and an interesting one as it brings forwards how OECD nations, at present, might be a source of several "illicit" activities.

Reference:

- Jasan Sharman, Untracable Shell Companies and financial secrecy: Experiment, Feb 2013, NHH Norwegian school conference, Norway, URL: https://youtu.be/zelMqK52NRE