NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Tunneling Directs Profits to Controlling Shareholders

"In countries that follow the civil law (as opposed to common law) tradition -- such as France, Belgium, Germany, and Italy -- 'tunneling' routinely occurs."

For people investing in emerging markets, incidents of corporate managers siphoning off profits and selling assets for personal gain may be considered part of the risk of doing business at the unbridled frontiers of modern capitalism. That individuals are not prosecuted for such brazen "expropriations" usually is attributed to the fact that the country in question lacks a mature legal system. But what if this sort of behavior, far from being confined to the developing world, routinely occurs in certain developed countries and, furthermore, is essentially sanctioned by a solid, legitimate legal system? Would different laws protect investors from the self-serving interests of a company's controlling shareholders?

In Tunneling (NBER Working Paper No. 7523), authors Simon Johnson, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer find that, even in developed countries, "the diversion of corporate resources from the corporation (or its minority shareholders) to the controlling shareholder can be substantial." The title of their study refers to imagery of transition economies in which corporate assets were spirited away as if through underground tunnels. The term is used by the authors "to describe the transfer of assets and profits out of firms for the benefit of those who control them."

The authors show that in developed countries that follow the civil law (as opposed to common law) tradition -- such as France, Belgium, Germany, and Italy -- "tunneling" routinely occurs, not in spite of an evolved legal code governing corporate behavior, but because of it. Courts sanction such deeds "not through neglect or incompetence, but using specific legal logic."

The authors note that in common law countries, such as the United States and the United Kingdom, laws protecting shareholder rights tend to focus on broad, basic principles, such as fairness, and to offer judges considerable discretion on whether some sort of disputed transaction illegally benefits majority shareholders. By contrast, the civil law countries are more rigid, emphasizing the "predictability" of their laws toward unscrupulous behaviors. This in turn "may invite (corporate) insiders to creatively structure unfair transactions so as to conform" simply to the "letter of the law."

The authors point to a case in which a family that was the majority shareholder in one French company established a second company, solely owned by the family members, which then turned around a leased warehouse space to the first company. When minority shareholders challenged the relationship, the French court dismissed their claim, showing "no interest" in whether the creation of the warehousing firm and the prices it charged for leasing space were intended to benefit the family at the expense of other investors. The court's only concern, the authors said, was that the warehouse seemed to have a "legitimate business purpose" and that it was not created solely to enrich the family.

Johnson et al point out that Germany's Neuer Markt and France's Nouveau Marché have succeeded because these civil law countries, through targeted legal reforms, attracted investment for new companies by offering greater protections to minority shareholders. "For less developed countries, including those that suffered from the Asian crisis, the failure of the legal system may be very costly precisely because it accommodates vast amounts of tunneling," the authors conclude.

-- Matthew Davis


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