What do people mean by "tunneling" or "expropriation"?
Essentially, tunneling is an agency problem between a controlling shareholder and minority shareholders that manifests in the extraction of private benefits of control by the controlling shareholder at the minority shareholders’ expense. Tunneling is driven by the controlling shareholder’s desire to increase his/her cash flow rights. This can be achieved by either (a) transferring assets in such a way that their cash flow rights to the tunneled assets increases, or (b) increasing their cash flow rights within the firm at below market rates. Note that both scenarios represent a shift in wealth from the minority shareholders to the controlling shareholder. Expropriation is a more general term defined by Claessens, Djankov, Fan, and Lang (2000) as the process of using one’s control powers to maximize own welfare and redistribute wealth from others.
Johnson, LaPorta, Lopez-de-Silanes, and Shleifer (2000) define “tunneling” as the “transfer of resources out of a company to its controlling shareholder (who is typically also a top manager).”
They divide tunneling into two categories:
“Self-dealing” transactions, which include transfer pricing, excessive compensation, taking of corporate opportunities, and asset sales.
Financial transactions that “discriminate against minorities,” such as dilutive equity offerings and minority freeze-outs.
Atanasov, Black and Ciccotello (2007) rely on the Johnson et al. definition, but divide tunneling into three types:
Equity tunneling increases the controller's share of the firm's value but does not directly change the firm’s productive assets. Examples of equity tunneling are dilutive offerings, freeze-outs of minority shareholders, and insider trading.
Asset tunneling involves the transfer of productive, long-term (tangible or intangible) assets from the firm for less than market value, such that the transfer has a permanent effect on firm operations.
Cash flow tunneling removes a portion of current year's cash flow, but does not affect the remaining stock of productive assets. Examples include transfer pricing (sale of outputs to an intermediary controlled by insiders for below-market prices; or purchase of inputs at above-market prices) and excessive executive salaries or perquisite consumption.
Ehrhardt and Nowak (2003) state that in the finance literature, “tunneling” typically refers only to pecuniary private benefits of control, but they differentiate non-pecuniary benefits such as:
Amenities are benefits seemingly unrelated to the pecuniary wealth of the controlling owner, but which can easily be transferred to another owner, e.g., there are plenty of people who would derive high utility (“joy”) from owning the NY Times or the Yankees (even if they would never receive any positive cash flows).
Reputation benefits are those that are hardest to transfer to another owner, because they take time to build, are owner-specific, and in many cases require family or at least geographical membership.
Wikipedia defines “tunneling” as a colloquial for financial fraud committed by company's own management or major shareholders, consisting of legally pumping out valuable property into their own, private firms. It should be distinguished from theft which is illegal.
The question of legality is a tricky one. Court assessment of tunneling uses two broad principles:
Duty of care: Director is responsible to act as a reasonable, prudent or rational person would act in his position.
Duty of loyalty (fiduciary duty): Addresses conflict of interest: insiders must not profit at the expense of outsider shareholders or the corporation.