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.

BREAKING DOWN 'Tunneling'

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 to 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.

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 rake in as much dough as he can. 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.

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