Historically, off-the-shelf structures were used to streamline a startup, but selling them as a way to get around credit guidelines is new
With revenues down and debt financing tougher to get than ever, it's not a stretch to imagine entrepreneurs being tempted toward desperate measures. One of those avenues could involve a vehicle called a "shelf corporation"—a corporation formed in a low-tax, low-regulation state expressly to be sold off for its pristine credit rating. Historically shelf corporations were considered a legitimate way to streamline a startup, but this attempt to sell them as vehicles to get around credit guidelines is fairly new, according to Nick Harycki, CEO of Swift Financial, a Wilmington (Del.) financial services company dedicated to small business banking. Doug Broten, president of the BBB of Central California, recently investigated a purveyor of shelf corporations and concluded that they are clearly unethical, and possibly illegal. He spoke with Smart Answers columnist Karen E. Klein about why small business owners should steer clear. Edited excerpts of their conversation follow.
I've heard of a "shell corporation" but what's a "shelf corporation"?
We explain on our Web site that a shell corporation is a business entity with no significant assets or ongoing business activities. A shelf corporation is a shell corporation that is formed and then held on to—put on a shelf—for a few years while some credit history is established for it. The idea is that it will eventually be sold to someone who wants to start a company without going through the steps to create a new one, or someone who wants to get a bank loan but can't qualify because his or her own company doesn't have the necessary credit scores or business history.
How is a credit history established for an empty company?
All that D&B [Dun & Bradstreet (DNB), a business credit agency] requires is six transactions a month from 10 or 15 creditors over a period of a year before they will qualify a company as creditworthy. So someone sets up a whole bunch of corporations in another state—the ones we looked into were incorporated in Wyoming—and starts billing in between all of them. So over time they show income and expenses, and they are paying their bills on time. They're not real businesses, but eventually they look like they're established, credit-worthy companies.
And then what happens?
Picture me as a landscaping company owner who needs some money but is having a tough time and can't get a loan from the bank. Instead, I go online, or I run into a guy who says I can purchase one of these shelf corporations that has a multiyear history and a great credit rating and I can use that corporation to get a loan from a bank.
How much do they sell for? And wouldn't bankers have the resources to discover that these were sham corporations?
In our situation, the shelf corporations were being sold for $5,000 up front or 20% of the loan total on the bank end. It's never advisable to pay up front for anything, but if you do the math on the back end it's pretty bad also because the business owner is paying interest on the entire loan amount but only getting 80% of the total cash.
Some bankers might look closely at the shelf corporations, but in our case the small business owners were being told which banks to go to and advised to request loans of $150,000 or less. That's about the threshold where banks check credit scores but don't always investigate further. If large banks did investigations on every $150,000 business loan they make they'd have to add whole new departments. Frankly, that's not worth it because they don't make or lose that much money on these smaller loans anyway.
But what happens if the business owner defaults on the loan?
Well, they can just walk away and let the bank go after a corporation which has no assets, no income and no accounts receivable.
What's particularly bad right now is that when banks lose money, it's our money. It's the government's money that belongs to all of us. So the public in general is getting scammed.
How did you come across these shelf corporations?
They kind of dropped into our laps when somebody local who was doing this applied for BBB accreditation. He was charging an advance fee, which is against our policy, so we denied accreditation. He appealed the denial and came in to explain what he was doing in front of an appeals committee that we gathered, including a banker.
And what was their conclusion?
We denied him again and contacted the FBI. The banker on our committee contacted her fraud department.
Is this practice illegal?
Our conclusion was that it is clearly unethical and possibly illegal. I understand that small business owners are strapped for cash and unable to get loans, but they should stay away from these things.
If you can't get a loan from a bank, you need to look at other options and maybe even close your doors. It's a bad time, but if you can't secure capital with what your company has in assets, liabilities, and cash flow, you shouldn't try to fool a financial institution.
How widespread is this?
We had never heard of it before at the BBB, but the guy we investigated told us that there were 60 other salesmen around the country doing the same thing he was. And if you look up "shelf corporation" online you'll find quite a bit of information, including Web sites selling them.
It looks as if some of the information online includes complaints from individuals who got scammed when they sent money up front to buy shelf corporations that supposedly had already established lines of credit. Of course, after the money was paid the sellers disappeared.
Exactly why we always warn people never, ever send money up front. Those kinds of transactions are almost always scams.