Law and Tunneling
Atanasov, Vladimir, Black, Bernard, Ciccotello, Conrad S., Journal of Corporation Law
I. 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
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. …