Tunneling: What it is, How it Works, Example

What Is Tunneling?

Tunneling is an illegal business practice in which a majority shareholder or high-level company insider directs company assets or future business to themselves for personal gain. Actions such as excessive executive compensation, dilutive share measures, asset sales, and personal loan guarantees can all be considered tunneling. The common threat is the loss to the minority shareholders, whose ownership is lessened or otherwise devalued through inappropriate actions that harm the overall value of the business and therefore the value of the shares owned by the minority shareholders.

How Tunneling Works

This risk is especially prevalent for investors in emerging markets, where government and regulatory controls may not be sufficient to stop the practice from occurring. This may often happen under legal guises. The practice is not reserved for moderately advanced economies; many instances can be found in advanced economies, especially those under systems of "civil law." 

The U.S. legal system is rooted in "common law," which provides broad enforceable laws with simple maxims like "fairness" and "for the common good." Under civil law, the letter of the law is the most respected measure, so would-be tunnelers can pass an act of tunneling off under certain technicalities, which often hold up in court.

Special Consideraitons

Tunneling initially came to rise in Central Europe following the post-privatization era. During this time, funds were transferred from corporations to privately-owned companies with the same management. These transfers were done via large loans made without the expectation for repayment. 

Tunneling can include a variety of activities, such as asset sales at lower valuations or dilutive share measures. Other activities can include personal loan guarantees and excessive compensation.  

Tunneling vs. Theft 

Tunneling is different from outright theft, where there are different legal procedures. Theft generally relates to the outright stealing of goods or services. Tunneling is unethical, but it’s a gray area when it comes to legality, as the penalties will vary. Some states charge criminal sanctions for tunneling, while others impose civil suits or no sanctions at all. 

Example of Tunneling

For example, XYZ company has a majority shareholder and executive named Bert. Bert is planning to leave the company in a couple of years because the company isn't doing as well as he'd thought it would. In the meantime, Bert wants to take in as much money as possible. 

He uses his influential position to vote for significant executive compensation packages and pays himself inappropriately large bonuses, draining financial resources from the company. This hurts the company because it negatively affects its valuation due to the significant loss of cash.