Law And Tunneling by SSRN

Vladimir A. Atanasov

College of William and Mary – Mason School of Business

Bernard S. Black

Northwestern University – School of Law; Northwestern University – Kellogg School of Management; European Corporate Governance Institute (ECGI)

Conrad S. Ciccotello

Georgia State University – Department of Finance

December 8, 2011

Journal of Corporation Law, Vol. 37, pp. 1-49, 2011

ECGI – Law Working Paper No. 178/2011

Northwestern Law & Econ Research Paper 09-35

U of Texas Law, Law and Econ Research Paper 158


Insiders (managers and controlling shareholders) can extract (tunnel) wealth from firms using a variety of methods. This article examines the different ways in which U.S. law limits, or fails to limit, three types of tunneling – cash flow tunneling, asset tunneling, and equity tunneling. We examine how U.S. corporate, securities, bankruptcy, and tax law, accounting rules, and stock exchange rules impact each form of tunneling, and identify important weaknesses in these rules. Using case studies, we show how tunnelers exploit these gaps. Decisions to tunnel reflect both legal and informal constraints. We conclude that even though the overall level of tunneling in the U.S. is limited, complex asset and equity transactions and excessive equity compensation can escape both legal and informal constraints.

For a shorter version of this article, see Atanasov, Black, and Ciccotello, Self-Dealing by Corporate Insiders: Legal Constraints and Loopholes, in Brett McDonnell and Claire Hill, editors, Research Handbook on the Economics of Corporate Law ch. 22 (forthcoming 2011), available at

How The U.S. Law Fails To Or Limits Three Types Of Tunneling – Introduction

Managers and controlling shareholders (insiders) can extract (tunnel) wealth from firms using a variety of methods. Tunneling occurs across both developed and developing markets, and impacts both trading prices and premia paid for corporate control. This Article studies how effectively United States’ rules limit tunneling by insiders of public companies. We consider three broad types of tunneling: cash flow tunneling, in which insiders extract some of the firm’s current cash flows; asset tunneling, in which insiders buy (sell) assets from (to) the firm at below (above) market prices; and equity tunneling, in which insiders acquire equity at below market price, either from the firm through an equity issuance or from other shareholders, often in a freezeout.

We also examine how a broad set of rules, including corporate, securities, accounting, tax, and creditor protection rules, impact each type of tunneling. Prior law and finance literature discuss the potential anti-tunneling role of these sources, but not how they affect particular types of tunneling. Also, creditor protection rules have been seen as important only to protect creditors. However, as we develop below, they also have an important role in indirectly protecting minority shareholders.

Prior research on the strengths of anti-tunneling protections in the United States is usually limited to a single type of tunneling. For example, one literature discusses freezeouts, another discusses executive compensation, and a third discusses the weak protections for minority shareholders in private companies. Ronald Gilson and Jeffrey Gordon discuss generally how to limit the power of controlling shareholders, but focus on freezeouts and sales of control. Most studies also consider only corporate and securities law.
In contrast, this Article studies how a broad set of rules affects a broad range of tunneling transactions. This breadth comes at a cost as we delve less into the details of specific regulations or types of transactions. But this breadth lets us develop a theme that has not been expressly recognized: U.S. rules do not effectively limit the full range of tunneling transactions. We use case studies to illustrate where current rules permit tunneling.

In cash flow tunneling, for example, entire fairness review under corporate law has some bite. Corporate tax law limits pyramid structures, and thus incentives and opportunities for cash-flow tunneling within business groups, but is less effective in limiting cross-border transfers through creative transfer pricing. Securities law and accounting rules ensure some disclosure of related party transactions, but the disclosure can often be generic and leave investors in the dark about transaction fairness. For asset tunneling, disclosure is often limited, and corporate law leaves substantial room for transactions at off-market prices. The principal protection against mispriced transactions is review by independent directors, but if shareholders can do little, the insiders can fool or co-opt them. Bankruptcy law provides some protection against asset tunneling for failing firms. Equity tunneling through freezeouts is relatively well-controlled, but creative insiders can extract value through recapitalizations, and can extract a surprising amount of value over time through equity-based executive compensation. Written broadly, current U.S. rules block some brute-force schemes that might succeed in less developed markets, but often permit more complex schemes to succeed. We propose rule changes to address the principal gaps that emerge from our analysis.


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