Introduction II. Unbundling Tunneling A. Cash Flow Tunneling B. Asset Tunneling C. Equity Tunneling III. Principal Laws and Rules that Affect Tunneling A. Cash Flow Tunneling B. Asset Tunneling C. Equity Tunneling 1. Equity Offerings 2. Freezeouts 3. Sales of Control 4. Insider Trading and Market Manipulation D. An Overview of Gaps in Anti-Tunneling Rules E. Case Studies of Tunneling in the United States 1. Cash Flow Tunneling Examples a. Williams Sonoma and CEO Howard Lester b. Excessive Perquisites at Buca, Inc. c. Enron and Enron Global Power and Pipelines 2. Asset Tunneling Examples a. Asset Tunneling In: Coca Cola and Coca Cola Enterprises b. Investments in Affiliates: Ronald Perelman and M&F-Panavision 3. Equity Tunneling Examples a. Executive Compensation at Fairchild Corporation b. Dilutive Equity Offerings: Enron's Rhythms Transaction IV. Informal Mechanisms that Limit Tunneling A. Equity Ownership of the Tunneler B. The Controller's Reputational Concerns C. Actions by Other Shareholders D. Organizational Transparency E. Liquid Stock Markets F. Remaining Gaps V. Implications Design and Enforcement of Law A. Reduce Legal and Accounting Arbitrage Opportunities B. Shareholder Power to Approve or Challenge Self-Dealing C. Disclosure of Self-Dealing Transactions D. Gatekeeper Review for Fairness VI. Summary I. INTRODUCTION
Managers and controlling shareholders (insiders) can extract (tunnel) wealth from firms using a variety of methods. Tunneling occurs across both developed (1) and developing (2) markets, and impacts both trading prices and premia paid for corporate control. (3) 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. (4)
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, (5) another discusses executive compensation, (6) and a third discusses the weak protections for minority shareholders in private companies. (7) Ronald Gilson and Jeffrey Gordon discuss generally how to limit the power of controlling shareholders, but focus on freezeouts and sales of control. (8) Most studies also consider only corporate and securities law. (9)
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.
We limit the scope of this project to public companies and U.S. rules. We do not study special rules for particular industries. We do not consider tunneling by equity holders from debt holders, or vice-versa. (10) However, our taxonomy of tunneling is not limited to the united States. our analysis is whether a broad set of rules, taken together, can control particular forms of tunneling and whether the rules are adaptable to other countries.
The Article proceeds as follows: Part II provides a summary of tunneling types. Part III examines how accounting rules and tax, corporate, and securities law impact various types of tunneling. Part IV uses case studies to illustrate the current gaps in the web of anti-tunneling protections. Part V discusses informal mechanisms that complement the law and limit tunneling. Part VI suggests how legal changes could address those gaps. Part VII concludes.
Simon Johnson, Rafael LaPorta, Florencio Lopez-De-Silanes, and Andrei Shleifer define "tunneling" as the "transfer of resources out of a company to its controlling shareholder (who is typically also a top manager)." (11) This definition is appropriate for emerging markets, where most firms have a controlling shareholder. Here we use a broader definition that includes transfers to managers who are not controllers. For transfers to managers, tunneling includes executive compensation that exceeds a market rate. We follow the taxonomy of tunneling developed by the authors, and divide tunneling into three basic types: cash flow tunneling, asset tunneling, and equity tunneling. (12) We summarize these here, without pretending to capture all of the creative ways in which insiders can extract value from firms.
"Cash flow tunneling removes a portion of the current year's cash flow, but does not affect the remaining stock of long-term productive assets, and thus does not directly impair the firm's value to all investors, including the controller." (13) "Cash flow tunneling can repeat year after year, but the fraction of cash flow which is tunneled can change over time." (14) Often, cash flow tunneling transactions are not directly with insiders, but instead with firms that the insiders control (or simply have a larger percentage economic ownership than in the subject firm). (15)
"Asset tunneling involves the transfer of major long-term (tangible or intangible) assets from" (to) the firm for less (more) than market value. (16) It includes overpriced asset or equity purchases in affiliated firms and underpriced asset sales to affiliated firms. (17) Asset tunneling differs from cash-flow tunneling because the transfer has a permanent effect on the firm's future cash-generating capacity. (18) Transfers out of (into) the firm may also affect the profitability of the firm's other assets if the transferred assets have positive (negative) synergy with the firm's other assets. (19)
"Equity tunneling increases the controller's share of the firm's value, at the expense of minority shareholders, but does not directly change the firm's productive assets" or cash flows. (20) Examples of equity tunneling include dilutive equity issuances and freeze-outs of minority shareholders.
If one describes a firm as a grove of apple trees, which grow better together than apart, these tunneling techniques can be described as follows: cash flow tunneling can be seen as stealing some of this year's crop of apples; asset tunneling out of the firm involves stealing some of the trees which could potentially make the remaining trees less valuable; and equity tunneling would involve stealing claims to ownership of the grove.
Cash flow tunneling primarily affects the income statement and statement of cash flows and captures the flow of firm value. (21) In contrast, asset and equity tunneling "principally affect items on the balance sheet, and involve the transfer of the stock of firm value." (22) Equity tunneling often does not affect the firm's financial statements at all. (23) "In terms of operational impact, asset tunneling directly affects the company's future operations and profitability, while equity and cash flow tunneling do not." (24)
This Part dissects tunneling into our three main types: cash flow, asset, and equity. We begin by summarizing which types of transactions and activities fall within each type, and then discuss transactions that do not fit cleanly within our typology. Transactions between a firm and related parties can sometimes be intended to benefit the firm--sometimes called propping. (25) One firm investing in a troubled affiliate is a common example. The transaction both props the affiliate and is a form of asset tunneling for the investing firm. We do not discuss here the argument that tunneling and propping transactions within business groups can sometimes reflect efficient risk-sharing in an inefficient capital market. (26)
Cash Flow Tunneling
Cash flow tunneling can be defined as "transactions...
Law and tunneling.
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