Paper Companies

In India, the term "paper company" or "shell company" is often used to describe entities that exist primarily on paper, with little or no actual business activity. But if we step back, it’s clear that all companies, by their nature, are paper entities—legal constructs rather than physical beings. A company is an artificial entity, created through documentation and compliance procedures, defined by the paperwork that establishes and governs it. It is the legal paper that makes a company a company; they are not people, and they don’t exist outside the constructs of law and compliance.

The distinction, therefore, is not between real companies and paper companies but between those that serve a lawful, intended purpose and those that might be structured to obscure dubious activities. Many paper-based entities operate legitimately, while others may misuse the legal framework.

Legitimate Roles of Low-Activity or Dormant Companies

Several business structures operate with minimal visible activity but serve valid and strategic purposes:

• Holding Companies: Holding companies are legitimate entities set up to manage and control shares in other companies. They typically exist to organize assets, streamline operations, and facilitate business strategy but may not engage in daily business transactions.

• Asset-Specific Companies: Some companies are established specifically to hold a single asset, such as intellectual property or real estate, and have no operational need for employees or frequent transactions.

• Dormant Companies: Businesses may register and maintain companies with future prospects in mind. Dormant companies, or early-stage startups, might be inactive yet compliant, waiting to launch or re-purpose based on business needs.

These companies exist to fulfill legal and strategic purposes, even if their day-to-day activities are minimal or absent. Simply put, they are "paper companies" in the sense that they are entities governed by documentation and legal requirements, but they are not illegitimate.

Regulatory Oversight and the Broad Approach

Despite the inherent legitimacy of paper entities, regulatory bodies like the Ministry of Corporate Affairs (MCA), the Securities and Exchange Board of India (SEBI), and the Income Tax Department have intensified scrutiny on companies with minimal operations, concerned that they may be conduits for tax evasion, money laundering, or other illicit activities. However, their approach often categorizes all inactive or minimally active companies together, leading to a broad sweep that includes legitimate entities within its scope.

When Overreach Affects Compliance

A key example of such overreach was seen in 2017, when the MCA deregistered over 200,000 companies due to inactivity. While the intent was to target suspicious entities, many compliant holding companies, dormant businesses, and investment vehicles were also affected. This broad-brush approach does not account for the varied, legitimate reasons a company might remain inactive or minimal in operations, even while fully compliant with tax filings, MCA requirements, and other obligations.

The Distinction Between Inactive and Illegitimate

In India’s regulatory environment, the lack of a legal definition for "shell company" or "paper company" has led to misinterpretations. Inactive does not mean illegitimate, and minimal operations do not equate to suspicious intent. Key reasons why inactive or paper-based companies are legitimate include:

1. Strategic Legal Structuring: Many entities, such as holding companies or asset-specific entities, play crucial roles in corporate strategy without the need for day-to-day transactions.

2. Compliance-Driven Purpose: Companies that file taxes, submit MCA documentation, and meet regulatory requirements operate within the law, regardless of their operational size.

3. Future-Ready Ventures: Companies may maintain dormant status for future purposes, such as expansions, investments, or future reactivation, without engaging in substantial activities immediately.

The Need for a Targeted Approach

Regulatory efforts would benefit from focusing on specific patterns of non-compliance or suspicious transactions instead of generalizing based on minimal activity. Distinguishing between companies with complex business structures and companies involved in illicit transactions would allow authorities to better target actual misuse.

By refining their approach, regulatory bodies could more effectively identify companies involved in suspicious activities, without unduly penalizing those that serve lawful, strategic purposes. This would protect the interests of law-abiding businesses, support economic strategy, and help prevent the unnecessary burdens that blanket measures create.

Conclusion

In essence, every company is a paper entity—formed and governed by legal documentation. Yet, the function and purpose of these entities vary widely, from active trading companies to passive holding structures. While regulatory oversight is essential to curb misuse, a more discerning, criteria-based approach is needed to differentiate between companies with minimal activity for legitimate reasons and those structured for dubious purposes. This would foster a balanced, fair regulatory environment that supports lawful business operations while focusing resources on genuine cases of misuse.

Audit Requirements under IBC

• U/r 7(2)(ca) and 13(2)(ca) of the IP Regulations, both an IP and IPE are required to pay 1% of their annual turnover to the Board within 30 days of the end of each financial year
  
  
• U/r 7(2)(cb) of the IP Regulations r/w 31A(2) of the CIRP Regulations, a fee of 1% of the cost incurred in a CIRP must be paid to the Board within 30 days of the end of each quarter
  
  
• U/r 15(1)(b) and 15(5) of Liquidation Regulations, the progress report of a Corporate Debtor will contain audited accounts of the liquidator’s receipts and payments for the financial year. This report needs to be filed with the Adjudicating Authority within 15 days of the end of the fiscal year
  
  
• Tabulating all costs and revenues of the IP, IPE, and the Corporate Debtors at the end of every year / quarter is often a huge task that requires at least an internal audit and ideally a statutory audit
  
  
• Due to the incomplete audit, IPs and IPEs are compelled to submit fees to the Board based on provisional financials to comply with the Board's regulations
  
  
• However, these provisional figures are subject to change, resulting in fees being paid to the Board based on inaccurate revenue and cost estimates
  
  
• It is reasonable to expect that any fee levied by any statutory authority, including the Board, should be calculated based on audited financial statements. That is why most taxes and levies are also based on audited financial statements
  
  
• Surprisingly, the Board only requires IPs to complete audits of themselves, IPEs, and Corporate Debtors within tight timelines of 15 or 30 days
  
  
• This expectation is unrealistic and places undue burden on IPs, leaving room for potential misrepresentation to the Board and potential penalties in the future
  
  
• Therefore, the Board may reconsider its timelines for fee levies until audits of IPs, IPEs, and Corporate Debtors can be appropriately completed

Early Warning Signals of Stress in a Corporate

Stress in the world of banking and finance is associated with sign of  incipient sickness in the conduct of business of borrower. To know the concept of  stressed asset in corporate  we need to look back to couple of decades after  bank nationalization. 

In the early ninety’s of last century prudential norms of asset classification and capital adequacy  were introduced in the country under Banking and Financial sector reforms which together with the industrial sector reforms made a paradigm shift from age old banking practice in India. Prior to that in two tranches nationalization of banks took effect leading to fast expansion of banking throughout the length and breadth of the country. The resultant surge of industrial activities in India due to relatively easy access to fund, deregulation in industrial sector and liberal industrial policies and encouragement by way of incentives & subsidy from both the central and  state governments altogether changed the sloth, slow moving underdeveloped  economy to a rapidly growing developing economy.

The resultant economic activities brought sea changes in social sector gradually shifting large chunk of population from agriculture towards micro, medium and large industries. As a natural consequence service sector started growing by leaps and bounds and India freed itself from  dependence of first world country  in matters of food grains, machineries etc.

In the above back drop, banks, more particularly Public Sector Banks which were the only players gradually shifted their preference in urban and metros from trade and small priority sector lending to industrial advances, advances to service sectors and retail lending. 

To regulate the fast growing  banking activity Reserve Bank of India  was focussed towards honest implementation of  income recognition and asset classification, tight provisioning norms and capital adequacy in banks besides the traditional credit management approach. With the formation of separate Tribunal under the prescription of Narasimham Committee for recovery of Non Performing Assets,  the credit discipline from the point of view of lenders and borrowers were satisfactory. The system started wilting with time as there were stiff competition within the banks for sharing chunk of the pie.

In the midst of unhealthy competition among banks inadequate credit appraisals of new industrial and infrastructure advances became a new norm leading to acceptance of small, medium and large advances proposals from dubious entities having little exposure, knowledge and inadequate investible funds with them. The generous approach of banks by way of relaxations in various norms and securities encouraged fly by night operators to encash the opportunity. The unfortunate result of dilution of norms was quick mortality ( means slippage of an advance facility within one year of disbursement). As a result there were unmanageable pile of suits in   Debt  Recovery Tribunal and locking up of bank funds necessitated new enactment SARFAESI Act 2002 to enable bankers to encash their enforceable securities. 

Post Global Financial Crisis in 2008 saw another new development with the introduction of regulatory forbearance by RBI. The asset classification norms were tweaked in restructured accounts to give relief for temporary mismatch in cash flow in the existing economic slow down throughout the world. The bankers, particularly the PSBs allowed all and sundry including insolvents within the facility thus deferring identification of potential NPAs. At withdrawal of the regulatory forbearance there were flood of slippage and the NPA level of all banks and particularly PSBs went to new height not experienced in previous two decades.

Meanwhile, during the last decade RBI felt urgent necessity of implementing stringent credit monitoring mechanism to curb the disproportionate growth of impaired assets and introduced stressed assets concept within the standard asset category based  on period of default in payment of either the principal or interest or for continuous excess of balance outstanding over limit or drawing power or for non renewal of accounts within a definite time frame. Depending upon time period of overdue the stressed assets other than NPA are SMA 0( 1 to 30days default), SMA 1 (31to 60 days default) and SMA 2 (61 to 90 days default). If the default persist on 91^st day accounts turned to NPA. The periodical AQR(Asset Quality Review) of RBI for big advances of Banks to recognise incipient sickness in accounts and prescribe immediate corrective measures is a step towards this direction.

Finally, the Insolvency and Bankruptcy Code 2016 is based on default concept of corporate and has given free hand to bankers to quickly move to the NCLT to save upon time and   value of the impaired assets.   

What is a CRR?

Cash Reserve Ratio (CRR) is a percentage of deposits that banks must hold as cash reserves either with themselves or with the central bank.

For example if the CRR is 6% and a customers have deposited $100 with a bank, the bank should in turn hold cash reserves of $6. While most banks are allowed to keep this money as cash reserves, it is usually deposited with the central bank.

How is CRR used by central banks?
CRR is used as a monetary tool to contain inflation. When the central bank sees a situation of rampant inflation it raises the CRR to contain it. In effect raising the CRR means reducing the amount of money that a bank will have to lend out and thus decreasing money supply in the market.

This works out more potently than most of us imagine.

Imagine a situation where you deposit $100 in a bank, if the CRR is 10% then the bank can lend $90 to me and then I deposit $90, out of which 81 can be lent again, in the next round this will be 90% of 81 viz. 72.90 and so on and so forth. The total sum of all this is $900. So with $100 initial deposit and 10% CRR, the money supply created in the economy is $900.

Now if in the same situation the CRR is 20%, out of the initial $100 only $80 can be lent now and $64 in the next round and so on and so forth till the total lending is $400.

So a doubling of CRR leads to more than halving the money supply creation in the economy. That is why central banks raise the CRR whenever they face rising inflation.

When does raising CRR not work?

While CRR is a potent tool, it is not free from criticism. World over economists tend to think that open market operations which means that the central bank just goes out in the open market and buys up currency there is equally effective, if not more.

Raising CRR means that the banks raise the rate of interest at which they lend out funds to investors, so basically that translates into slowing down lending and economic activity and overall can translate into lower GDP growths.

Loan Appraisal Process

A bit lengthy message, but a must read for all

Do's and Don'ts of Loans

1) KYC - yes KYC is must. You must first identify the customer. It is better to approach the customer rather customer approaches you. Sometimes borrower is not selected properly he is either new customer or introduced by another stranger or middlemen. Never involve middlemen, talk to customers directly. Avoid giving multiple loans to single party/ family or a group, to minors, lunatics or insolvents. It is compulsory to complete all the KYC norms before even thinking of giving loan. For KYC the following things are to be taken care of-

a) Proof of Identity

b) Proof of residence

c) Proof of business address

d) PAN number

e) Photocopies of all these must be verified with original and also get them signed by the borrower and kept on record.

2) Understanding Credit Cycle - the credit cycle consist of credit opportunity -> Credit Creation -> Credit management -> Credit Completion -> Credit creation. Which ever branch you land at you will find loans in one stage or the other.

3) RBI’s Defaulter List - it must be confirmed from RBI’s Defaulter’s list, available on RBI’s website. Confirm that borrower/guarantors name do not appear in the defaulters list and confirmation of same must be put on record.

4) CIBIL reports – next step is to search the CIBIL reports of the borrower and guarantors in all loan cases and commercial CIBIL report in case of firms/ companies. CIBIL reports should be analyzed thoroughly viz. whether borrower/ guarantors availed loans from other banks or financial institutions is there any overdue amount. There should be documentary proof to satisfy these irregularities.

5) Search CERSAI or CIBIL Mortgage site - if mortgage of property is involved in the loan then before proceeding further search should be made on CERSAI or CIBIL Mortgage site to ascertain that there is no mortgage outstanding against the property in any other bank/ FI.

6) Loan safety - safety of your loan is directly related on the basis on which decision to was taken, type and quantum of credit to be given and terms and conditions of the loan. But practically no loan is safe as we can’t see what is going on in the borrowers mind. Loans with all proper documentation and all due diligence paid also goes NPA. But still you can wisely apply points mentioned in article and save a going to be NPA loan.

7) Pre sanction Visit - next step is to visit the residence place of borrower, place of unit and property to be mortgaged. Pre sanction visit is basically to determine the “bank-ability” and access related riskiness of the proposal. Identification of borrower and site must be ascertained beyond doubt by inquiring from neighbors and other surrounding people. The whole observations must be noted down and to be placed on the record.

8) Assets and liabilities Reports - assets and liabilities statements of all borrowers/ guarantors must be prepared on prescribed format mentioning full detail of assets & liabilities duly signed by borrower/ guarantor and accountant/ manager. You should also take necessary proof of asset and liabilities be taken.

9) Balance Sheets – in case of working capital limits 3 years balance sheets of the unit along with income tax/ Sale tax returns etc.( for higher amount get audited balance sheets) projected balance sheets of next 2 years in cases of working capital limits and for the period of loan in case of term loan is mandatory. The balance sheets must be thoroughly analyzed and sanction-able limits be assessed. You should analyze the following points in balance sheet-

a) How capital or fund is raised?

b) How capital or fund is utilized?

c) Financial stability of firm.

d) Profitability?

e) Repayment capacity.

f) Expenditure analysis.

g) Sales achieved.

h) Existing loans and liabilities.

10) Project report - project report ( for the proposed project if term lending is required) containing details of the machinery to be acquired, price, name of suppliers, capacity utilization assumed, production , sales, projected profit and loss and balance sheets for the next 7-8 years till the proposed loan is to be paid. Project report should be analyzed and feasibility be ascertained.

11) Credit Rating - credit rating must be done in all the loan cases as per bank’s guidelines. Retail loans like Housing Loan, auto loan, and education loan should be done as per bank norms. Rate of interest should be fixed as per credit rating. In agriculture loans there is no need of credit rating. Credit rating should be done judiciously based on analyzing balance sheets. Always avoid sanctioning loan credit rating below 3.

12) Legal opinion - verification of title deed of property to be mortgaged is utmost necessary. It must be ascertained that it is original not fake, scanned copy or duplicate one. In Legal opinion revenue authority should personally verify that title deed to be mortgaged tally with the one kept with revenue records. Must get certified copy of the title deed and tally it with original Title deed. Also take certificate from advocate that certified copy tallies with the original one. Thoroughly read the legal opinion given by the advocate and observe that there is no objectionable which goes against the bank’s interest. Also obtain all the documents mentioned in the legal opinion. Here it is also important to personally verify that submitted title deed belongs to the property you visited earlier. Also make sure that SARFAESI act 2002 is applicable on the property. Certificate of change of land must be took in case unit to be financed is to be built on agriculture land.

13) Any additional limit sanctioned against same securities already charged to the bank ensure-

a) To extend charge to such limits too.

b) All concerned should be kept informed.

c) Acknowledge debt / balance conformation with the borrower.

14) Valuation - valuation of property to be mortgaged is to be done from valuer on banks panel. Considered value is earlier circle rate or realizable value which ever is lower. After that realizable value can be considered. For agriculture land circle rate fixed by the collector revenue for the area/ Circle. Land revenue Authority/ Tehsildar/ DM/ or any other authority for determining the valuation of land should be considered. Valuation report of the valuer must be thoroughly analyzed that it should not contain any comment which may harm the bank’s interest on later stage. The title deed, revenue numbers, area of the land must tally with deed/ legal opinion and valuation report.

15) Filling of Appraisal note - after verifying all the documents the appraisal note should be filled. Care should be taken that full detail should be filled and it should be complete in all respects. Appraisal should reveal whether proposal is fair banking risk. documentation forms the basis for legal relationship between bank and borrower. Following points should be taken care off:

a) Information of the borrower: name, full address, phone numbers, PAN no., date of birth and net worth and constitution should be given.

b) While processing credit processing figure out both positive and negative points on a piece of paper.

c) Now compare the proposal with circular of the bank. All circulars have checklist. Tick point by point and figure out gaps if any. *Also jot the measures that you or the party needs to take to fill those gaps.

d) Get confidential reports from other bank and FI.

e) Amount of loan and purpose of loan should be given in full.

f) Constitution of account- whether account is individual/ joint/ co- borrower/ proprietorship/ partnership/ pvt ltd. Co/ ltd co.

g) Full details of his accounts with other banks, branches should be given in full detail.

h) Information of guarantors should be given in detail viz. name. address, PAN number, Date Of Birth, Phone no. , net worth etc.

i) Detail of Primary security should be given in full as related to the case e.g. if it is mortgage of property full address as mentioned in the legal opinion should be given along with date of legal opinion and valuation report and values viz. market value , realizable value and accountant/ manager with date. If hypothecation of vehicle – its RC no, date, engines no. value, date of insurance etc.

j) Similarly for additional security full detail should be given as the case may be.

k) Balance sheet figures should be given in full, preferable consisting of last 2 years audited figures, current year’s provisional figures and projected figures of next 2 years. Ratios like current ratio, debt-equity ratio etc. must be calculated and filled. Observation about balance sheet must be mentioned in the note.

l) Credit rating must be mentioned in the note and based on it rate of interest should be mentioned by quoting circular no on which it is based.

16) Repayment - detail of repayment mentioning amount of EMI, duration in months must be mentioned. If moratorium period allowed then it must be mentioned and also mention date of first installment.

17) Disbursement - in case of term loan, disbursement should be as per schedule approved by the bank. In case of housing loans disbursement should be related to actual progress in implementation of project. For that you should visit the site periodically. For any delay in project you should seek the borrower’s arguments. Also monitor costs being incurred and scrutinize receipts being produce by the borrower.

18) Role of periodic inspections - periodical inspections enables bank to keep check on the stocks hypothecated to bank. Now what you should do in periodical inspections? 

a) Obtain basic info on the functioning of unit.

b) Do physical verification of the stock.

c) Match the stock with the stock statement given.

d) Do rough valuation of stock on MRP or market price.

e) Quality of stock hypothecated to bank. It should not be of inferior quality what is charged to bank or obsolete or rejected stock which is of no market value.

f) The bank’s name should be prominently displayed onsite the unit where goods are hypothecated to bank. E.g. *“OUR BANK , SBI bank* Board like this should be displayed outside.

g) In case of pledge- ensure that storage area is properly maintained, earthquake and flood resistant, goods are stored in a proper manner, stock audit is regularly conducted and a proper register is maintained.

h) Also note that the stocks or securities that are offered should be adequately insureand that too on continuous basis.

i) Branch should maintain a inspection register where all the findings at the site should be noted. It is a good idea to take 2-3 snapshots and paste them on register with signature of visiting officials.

j) Inspection should be done vigorously and not pre-informing the borrower and telling him to prepare tea/snack(on a lighter note). Inspection should be done without even making borrower know that you are going to visit and which date or time. Just caught the borrower red handed only then you will come to know how he behaves and looks in real life.

k) In case if housing loans, visit office of sub registrar or revenue office to verify charge of bank on the mortgaged property.

19) CERSAI - after disbursing the mortgage related cases the mortgage must be registered with the CERSAI within one month of mortgage. It is mandatory and registered number must be mentioned in the loan file.

20) Post sanction appraisal - post sanction appraisal generally deals with documentation of the facility and after care follow up. One must carefully view the transactions on the loan/ CC facility given. Non payment of interest on due date should be immediately followed up with the borrower. In case of CC frequent overdrafts should not be allowed. Also transactions with sister concerns should be monitored. Scrutinize the stock statements which are periodically submitted. Physically verify the securities and books of accounts of the borrower.

21) ROC - in case of pvt and public ltd. Companies, the banks charge on assets of the company must be registered with ROC within 30 days of creation of charge. The search report of this charge must be on the record.

22) Review of borrower’s account - periodical review of borrower’s account is necessary for-

a) NPA control- if you can identify some odds during initial stages of account the you can easily minimize your future NPA.

b) Taking preventive measures for improvement in cash flow slippage into substandard/ doubtful category.

c) Necessary to ascertain if business is doing good or bad. If bad then take preventive measures.

23) Vetting - the executed documents of loans of larger amounts must be got vetted from advocate on the banks panel and certificate should be put on the record. In case of larger loans the documents must be got vetted second time from another advocate on the banks panel and certificate be put on record.

24) Post sanction follow up  – for post sanction follow up ensure terms and conditions of sanction is intimated to borrower well in advance also ensure borrower advised the same. Ensure receipt of acceptance of terms and conditions and kept on record and are fulfilled before disbursement.

25) Post lending visit - this visit is very important to verify the end use of funds. Assets to be created by the loan sanctioned must be verified physically and facts noted in the visit report.

26) Renewal or revival - renewal or revival of accounts must be done on due date on basis of latest financial documents.

The checklist is only indicative and not exhaustive. The guidelines may vary. But It will help people dealing in advances portfolio to take judicious and prompt decisions dealing loan proposals. The mantra for good credit is simple –

“Good system of appraisal/ assessment of credit Needs and Effective supervision and follow up post sanction”

Fault Lines

“A working capital loan is a loan that is taken to finance a company’s everyday operations. These loans are not used to buy long-term assets or investments and are, instead, used to provide the working capital that covers a company’s short-term operational needs.” - Investopedia

The Indian financing sector is no stranger to Working Capital Loans. Any 1st year analyst is aware of the terms “inventory”, “book debts”, and “trade payables” while assessing the “working capital gap”, “DP”, and “margin requirement” for a manufacturing or trading company. In essence, lenders are willing to finance the amount secured against stock and book debts of a company. They reduce the trade payables to arrive at the working capital and reduce a “margin” requirement akin to “promoters’ contribution” and arrive at the “DP” or Drawing Power, i.e. the amount of funding the borrower is eligible for and can secure the bank against his working capital. This offers a dual benefit

1. Banks are secured against what are believed to be “liquid” securities, being inventories and book debts which are fast moving in usual business circumstances;
2. Businesses are able to draw funds at low rates with a tax shield thus enabling them to operate at higher capacities.

So it arrives from the discussion that a business having negative working capital is not eligible for working capital funding.

1. There is no security against the working capital debt;
2. If a business is able to hold off paying its creditors (0 interest) while being able to collect faster from its debtors, then there’s no need to draw any working capital;

So far so good. This is why we see most companies having negative working capital not having any working capital loans. While one may see substantial long-term loans on their books, the short-term working capital loans are almost non-existent. Such companies are also ones with good working capital management being able to collect-first and serve-later.

 That is why it is surprising when we find the adjacent financials in one of the largest companies in the country. It is clear that the massive amount of Trade Payables easily turns the working capital of the company negative. However, the company enjoys working capital facilities of ₹ 24 from banks and others.

As per the RBI’s Master Circular dt 2 Jul 2012 on “Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances”, it is stated that,

“Banks should ensure that drawings in the working capital accounts are covered by the adequacy of current assets, since current assets are first appropriated in times of distress… A working capital borrowal account will become NPA if such irregular drawings are permitted in the account for a continuous period of 90 days even though the unit may be working or the borrower's financial position is satisfactory.”

On the face of it, our company in question maintains a Current Asset base of ₹ 167. However, of these current assets, only ₹ 46 is a part of the working capital and ₹ 32 is liquid. The bulk of the current assets are unquoted investments which may or may not be marketable in times of distress. Further, the company also has a large Current Liability base of ₹ 310 eating into the security for working capital loans. It is also seen that this inadequate working capital is not a one-time delinquency in the company but more of a behavioural pattern.

So the question arises, if the working capital loans are neither deployed nor secured by current assets, then what has been their use? And which is this company that we are talking of?

The 1st question remains unanswered.

For the 2nd question, we’ll leave you with a few hints

1. All figures quoted have been in ‘000 Cr, i.e. the working capital loans are not ₹ 24, they are ₹ 24,000,00,00,000
2. This was the 1st Indian company to cross ₹ 10 lac Cr in market cap;
3. The company has been trying to bring down its debt levels since 2019, and has resulted in some of the largest FDI inflows in the country during the COVID-19 period