3. Definitions of beneficial ownership
As discussed in the introduction to this topic, there are various ways in which an entity, or a person, can exercise effective control over a company.
The most intuitive is that of equity ownership – owning shares in the company. This is the way non-experts instinctively understand ownership to work. In fact, several other channels of control complement it. Debt, the use of nominees and trusts, control of a company’s supply chain, and nested shell companies are all ways in which control over a company’s assets and activities can be exercised.
Beneficial Ownership through shareholding
In its simplest form, beneficial ownership could be exercised in simple proportion to the number of shares in a company. Most jurisdictions in which beneficial ownership is enforced effectively have materiality thresholds, meaning that ownership of shares above a certain percentage triggers certain disclosure requirements.
For example, companies which are listed on the New York stock exchange must publish a list of shareholders holding more than 1% of the company’s shares each year. In the UK, reporting obligations apply if any one shareholder is reaching, exceeding or falling below 3% of the value of the company.
The graph below illustrates the type of information typically made available online through company registries.
Figure 1: Disclosure of company information through registries
Source - 'The Puppet Masters: How the Corrupt Use Legal Structures to Hide Stolen Assets and What to Do About it', The World Bank, 2011.
Challenges in determining ownership through shareholding
Ownership as shown through shareholding is not always transparent.
Firstly, some countries have allowed “bearer shares”, in which ownership of the underlying stock is determined by ownership of a certificate which can be held anonymously. This system is still practiced in the Netherlands, for example, which has become a popular destination for the incorporation of affiliates in business networks that are largely concentrated on financing, and maintains a form of incorporation called the “Naamloze Vennootshap” (“NV), which allows bearer bonds.
In the global move towards transparency that has taken place during the last 20 years, these kinds of instruments have now been banned in some countries but are still allowed in many others. A company with a significant number of bearer shares may therefore have beneficial ownership structures which can never be determined.
Secondly, ownership is not necessarily the same as control. As companies get bigger, they tend to “dilute” or issue more shares to new shareholders as they seek to raise more capital. Often different tranches of shares carry different rights and liabilities, in relation to shares of dividends, or voting rights, for example.
Many companies issue “preferential shares”. These usually have privileged rights in terms of access to the profits, or dividends of the company. They could, for example, be debt that was converted into shares. Many preference shares do not carry any voting rights. So, in one context of beneficial ownership, that of share of profits, ownership of 10% of the equity of company through preferential shares would have superior status to 10% shares. But in another sense, that of control, it would be inferior.
But who exactly are the shareholders?
In addition to the cases noted above, there are several widely used mechanisms enabling ownership and influence to be hidden.
Firstly, shares may be held through a trust. The use of trusts has expanded considerably in the last two decades and in many jurisdictions, trusts are subject to less disclosure than other business entities, especially if they are held in a country where disclosure requirements are low, such as the Cayman Islands or Guernsey.
Secondly, it may be the case that the people who legally own the shares might not be the person who is really making the decisions. For example, powerful politicians may designate friends or relatives to hold shares and avoid exposing any conflict of interest with their public roles.
The concept of the Politically Exposed Person (PEP), an individual “entrusted with a prominent function”, has evolved in the last 15 years as a way of unearthing undue connections between political power and business. But the reality is that despite the recommendations of regulatory bodies and the attention to best practice, political power and big business intersect in ways that are frequently hidden.
Finally, there are other ways in which control can be exercised over a company’s activities – and the allocation of its profits – most notably, through the supply chain.
Large companies themselves award large contracts, and it is possible for relationships of control to be hidden within supply contracts either in or out of a company in a way which has a real impact on management of the company but which is not immediately apparent to an external party.
As well as shielding ownership and influence, mechanisms such as those noted above can be used to reduce transparency in combination with another phenomenon of business structures in the modern world: the incorporation of complex, multi-layered, and global networks of affiliate companies, each a separate “legal entity”.
This concept, often referred to as “Nested Chains of Corporation” is explained in the sections which follow.
Nested chains of incorporation
A 2014 study of the British energy giant BP tracked a total of 1,180 affiliates in 84 countries. Nearly every upstream operation passed back through chains that were three or four stages deep, and there were some chains of 14 separate incorporations, before they passed back to BP Plc, the holding company listed on the London stock exchange.
Other multinationals show similar complexity. It is likely that ExxonMobil and Shell each have over 1,000 affiliate structures, and the French company Total recently disclosed a network of 908. Mining companies tend to have smaller networks but they may still number over a hundred affiliate companies.
Moreover, these chains frequently pass through many countries. For instance, a BP subsidiary chain for upstream operations in Indonesia passes via the Bahamas and the United States in six stages before ending up back in the UK. The wave of mergers and acquisitions which have taken place in the extractive industries in the past couple of decades has introduced further complications.
For example, BP has three separate chains of incorporation in Indonesia – which correspond to an original one the company developed itself, and then two others which it inherited from acquisitions undertaken respectively with Amoco and Atlantic Richfield in the late 1990s. In these structures, Indonesian companies are linked through several layers in the US, which was the headquarters of those two companies. However, these chains were never integrated into one consolidated reporting line of companies after the acquisition by BP.
Such networks can represent a barrier to understanding how different patterns of cross-ownership relate to liabilities and benefits in the upstream extractives sector.
Operational and Indirect Control
Definitions of beneficial ownership go beyond the question of who owns what percentage of a company, recognising that there are many more ways to control a company than through share ownership.
Most of these other forms of control and benefits are harder to track than the equity (share ownership) channel. Companies are typically incorporated as a certain kind of entity, for example a limited liability corporation, a limited or unlimited partnership). In each case the law will specify some general frameworks to be used, in terms of issues such as the allocation of capital, benefits, or dividends.
Most companies will also have specific articles of association, which can create company-specific sets of rules and mechanisms for management, and could be considered “the Constitution”, or founding document, of that company. The number of jurisdictions in the world and the flexibility at the level of the company itself means there are literally thousands of variations on who could be classified as beneficial owners, and under what circumstances. Broadly speaking, however, they fall under several categories, described in the following sections.
Management and the board
Management is empowered to run the company day to day, and are typically overseen by a board of directors. The basic theory of modern capitalism is that the role of the board is to represent shareholder interests. A board therefore can and sometimes does remove management if performance is not deemed to be satisfactory.
However, due to the large number of possible arrangements (referenced above) it is possible that someone who is not a significant shareholder can exercise considerable control over the management or the board of a company. Therefore, most definitions of beneficial ownership also include those who are able to nominate, or remove, a majority of members of the board, or make significant changes to personnel in key roles in the company (company officers). These roles include the Chief Executive and Company Secretary.
Another complication that sometimes arises is that board members and company officers can also be nominees. So, as with the ownership question, it is may not be immediately clear who is making decisions about the people who should fill key roles in the company.
In so-called tax havens, this is particularly common. There are tens of thousands of companies in the Cayman Islands, for example, where the Company Secretary and Treasury are themselves nominee service companies – businesses whose sole purpose is to offer this kind of supporting role to other companies, and who will never really get involved in the running of the company themselves.
However, this practice is not restricted to tax havens. BP, for example, transferred the Company Secretary role of most of its UK affiliates to a company named Sunbury Secretaries Limited in 2010, during the Deepwater Horizon disaster in the Gulf of Mexico. This company carries fiduciary responsibility in the UK for turnover totalling over $100 billion, but has no employees, one director and only a nominal capital float.
Debt and supply chain
Much business in the modern world relies on credit and financing. Normally, a company’s debts and liabilities must be paid before it can declare profits to be distributed to shareholders. Since creditors have a superior call on funding than shareholders, there may be many contexts in which creditors can effectively exercise control over a company, for example by appointing or firing management, converting debts owed to them into equity, and in some cases dictating the nature of business activity. In this situation, a company’s creditors can also become beneficial owners.
This kind of control relationship could intensify if the creditor is also within the same overall business group as the debtor. Many multinationals channel project finance raised from capital markets in the form of bonds, loans, and other instruments through a specialised form of company called the “group treasury”. In extractives, the group treasury then lends on capital to affiliates in the operating countries. In these cases, the operating entity, which is often the only one the host government interacts with regularly, then runs chains of ownership and debt out of the country, each to different affiliates within the same overall business group.
Project finance, or capital, can be considered just one form of supply. More broadly, the supply chain represents another route to exercise beneficial ownership. If companies reach the stage where they rely on actors in their supply chain, then those customers or suppliers can in some cases be considered beneficial owners of the company.
The traceability of these kinds of relationships gets harder if it passes through transactions which are apparently unconnected with the core business of the company.
Raymond Baker, founder of the Global Financial Integrity, in his book ‘Capitalism’s Achilles Heel’, relates some of the ways this can happen. For example, he references “facilitation fees”, paid by a multinational to a low profile local company, or consultancy or research contracts are agreed. He also describes how there might be an entirely separate deal, for example, acquisition of property at below or above market rates and taking place at one or more steps removed from the activities of the company.
Ultimate Beneficial Ownership
The impact of all these mechanisms, such as company service businesses, trusts, and above all multiple chains of incorporation, have led to an increasing emphasis in recent years on “ultimate beneficial ownership”.
To understand the full range of actors involved in making decisions and receiving benefits from a company’s activity, it is important to be able to trace back ownership and control through any intervening mechanisms to real people at the end of the chain.
An example was highlighted in research carried out by the group ‘Frontier Research’ in Sierra Leone. The company which holds a mining concession might be owned by two other companies. But since each of these companies is owned in its turn by other companies, in different percentages, it is difficult to work out who the ultimate beneficiaries are, unless these companies also have public definitions of their ownership and control.
It is for this reason that the Financial Action Task Force recommendations, when they were updated in 2012, defined beneficial ownership in terms of “natural persons”, in place of using the concept of “legal persons”. The latter are the intermediate holding companies, trusts and so on, which are in turned owned by other legal, or natural persons.
These recommendations have however not been universally adopted, even by OECD countries. For example, the USA Patriot Act passed in the immediate aftermath of the 11 September attacks in New York, only established requirements relating to natural persons who are the beneficial owners of a business if they are foreign individuals, or working through foreign entities. It did not impose corresponding requirements on US nationals.
Companies divide into two main categories when it comes to beneficial ownership. Publicly listed companies in most major financial markets routinely publish lists of all shareholders who hold more than one percent equity of the listed company’s stock. While in theory these companies could have controlling stakes held by a non-transparent entity, blocking access to an ultimate beneficial owner, in practice the sums of money involved are so large that there are few cases where there are such unknown players.
Companies which are privately held, however, tend to have a lower market value as well as lower disclosure requirements in most jurisdictions, meaning that such hidden ownership and control may be possible.
A far reaching new directive was passed in the European Union in mid- 2015, requiring ultimate beneficial ownership. The fourth Anti-Money Laundering Directive will be transposed over time into the law of its 28 member states, and the first full reporting cycle under the new laws may be complete in 2018.
In terms of the directive, member states will contribute data relating to ultimate beneficial owners to a centralised registry held across the European Union, that will be open to various authorities and actors, such as banks. This data will not however be held as open data available to the public. In addition, many jurisdictions in Europe which are home to incorporation networks, such as Switzerland, the Isle of Man, or Liechtenstein, will not fall under this directive.
Use of “tax havens”
Since businesses are incorporated globally, and there can be many layers to ownership and control chains of companies, it follows that to determine ultimate beneficial ownership externally could require accessing information in many different jurisdictions. But around the world there are many so-called “tax havens” where it may be difficult to trace this information.
“Offshore financial centres”, to use a more technical term, have been defined in several ways by actors such as the OECD, the International Monetary Fund, and an international pressure group called the Tax Justice Network, which in 2013 introduced its Financial Secrecy Index.
The first defining feature of tax havens is that they might typically have lower rates of taxation for various forms of revenues than other countries, encouraging companies to incorporate there. Second, they have lower reporting requirements for various forms of incorporation. “Numbered” bank accounts are the most famous example of this but it could extend across information needed to set up bank accounts, or a company, or a trust.
A table that can be found here shows the 2015 results of the Tax Justice Network's Financial Secrecy Index.
These two factors together may represent a significant blockage in the ability of countries either “upstream” or “downstream” to trace all stages of the chain and reach the natural persons who are the ultimate beneficial owners of an operating company.
One recent study of the petroleum sector in Kenya, published by Oxfam America, found that 17 out of 35 companies operating in the upstream had incorporation chains that ran directly through tax havens which included Barbados, the Cayman Islands, Mauritius, the British Virgin Islands, and the US state of Delaware. However, the impact of these jurisdictions could be higher than that, since these chains only concerned equity. As has already been discussed, a business group could establish a group treasury operation in a tax haven which services the entire group.
Resulting flows of capital and debt, which could determine business operations on the ground, may not necessarily pass through the direct “parent” ownership structures. The same study found that all but five of the 37 parent companies of those entities operating in the Kenyan upstream have some part of their incorporation networks in tax havens.
Beneficial ownership as part of due diligence
Although beneficial ownership has excited a lot of interest in resource governance circles, it is important to note that it is only one of several functions of what is more broadly known as “due diligence”. Other fields include background or integrity checks on key individuals at management or ownership levels in businesses, and verification of technical competence and access to capital.
These last two are particularly relevant in extractive industries. Often projects require a huge amount of capital to be developed at the production stage, yet exploration licenses require little outlay. Many smaller and “mid-cap” companies therefore aggressively go looking for licenses to prospect in. But if such a company holds a license which requires much higher investment for actual development, with extensive capital expenditures, it may or may not be able to lock in the capital and expertise needed.
If it is unable to, the resource could lie undeveloped for a long time, and the state’s ability to put it back in play could depend on a host of factors, not least of which are its rights to impose relinquishment on the company which holds a license. Larger players, such as the Middle Eastern oil industries, might afford to be selective in the companies they allow to bid in the first place, restricting them to known players with a long track record and ample access to capital, and imposing bonds and pre-qualification criteria. Other countries may not have the market position to impose this. In these contexts, financial and technical checks at entry could be critical.
Due diligence is itself a fast-growing business sector, with many commercial providers offering “know your customer” (KYC) services.
Although the other aspects of due diligence can be critical, none of them can be truly effective without identifying the beneficial owners first.
The figure below illustrates designated non-financial businesses and professions (DNFBPs) and provides a definitional overview. It is featured in Transparency International's technical guide to implementing beneficial ownership principles and is a useful illustration of the principles discussed in this section.
Figure 2: Designated Non-Financial Businesses and Professions (DNFBPs) - Definitional Overvie