In a company with a controlling shareholder, wealth transfers from the corporation to the controlling shareholder (ie, tunneling) is the main agency problem. In corporate groups—which are important economic players in many emerging markets—tunneling often occurs in the form of internal transactions among affiliated companies. Against this background, this article examines ‘three components of a controller’s internal-transaction tunneling’: (1) the difference of a controlling shareholder’s ownership in two affiliated companies engaging in an internal transaction (ie, ‘ownership gap’); (2) a discrepancy between a fair market price and a transaction price (ie, ‘price gap’); and (3) the quantity of goods or services in the internal transaction. This article shows that a controlling shareholder’s pecuniary benefits from internal-transaction tunneling increase (and thus, non-controlling shareholders are damaged): (1) as a controlling shareholder’s ownership gap becomes larger; (2) as a price gap becomes greater; or (3) as the size of internal transactions becomes larger.
In addition, this article reinterprets Sinclair Oil Corp v Levien and Weinberger v UOP Inc, in the context of jurisdictions with corporate groups. Based on these two leading US cases on conflicted transactions, I provide an analytical tool which applies an adjusted fairness standard to internal-transaction tunneling in corporate groups. Specifically, I rigorously explore ‘three conditions of the Sinclair standard’: (1) a controller’s domination on both sides of a transaction; (2) exclusion of non-controlling shareholders from benefits available to a controller; and (3) detriment of non-controlling shareholders. It is noteworthy, however, that I do not propose that jurisdictions where corporate groups are main business players accept the US fairness standard as it is. Although US corporate law jurisprudence can provide implications for many countries, Sinclair and Weinberger may not be precisely applicable to these jurisdictions. Rather, in my article, I provide such jurisdictions with guidance on how the US fairness standard can be reinterpreted and modified in the specific context of corporate groups.
Due to the difficulty of defining a pinpointed fair market price, this article supports the concept of a fair range of price gap. Put differently, as long as the price gap falls within a fair range that regulatory agencies or courts set in reviewing the fairness of internal transactions, this article recommends that regulatory agencies or courts regard internal transactions as fair. This is not because law enforcement should protect controlling shareholders’ illegitimate internal transactions and tunneling. Rather, it is inevitable to keep the flexible concept of fair price range, since a theoretically-assumed, pinpointed fair market price has a margin of error. In addition, when a market price of goods or services fluctuates widely and constantly (like the wild movement of recent petroleum prices), a corporate group can find it difficult to immediately correct pricing for day-to-day internal transactions. In this respect, in determining the fairness of internal transactions, courts or regulatory agencies should consider the characteristics of goods or services of internal transactions, timing, geographical regions, market structure (eg, monopoly, oligopoly, or competition market), creditworthiness and the hold-up risks of alternative transaction parties in an external market, and other inevitable reasons for internal transactions, if any.
This article also provides courts or regulatory agencies with an analytical framework for examining a special issue of substantially large internal transactions in which a controlling shareholder might earn significant, but not abnormal, profits. Furthermore, I explain in my article that in jurisdictions with corporate groups, market-based mechanisms can mitigate adverse effects of tunneling to some extent. For instance, when non-controlling shareholders purchase stocks, they discount the value of stocks due to the high chance of a controlling shareholder’s tunneling in the future. Also, through their diversified portfolios, non-controlling shareholders can reduce the risk of tunneling (although there are limits).
In sum, this article puts forward a new, more sophisticated law and economics-based analysis of tunneling, particularly in corporate group settings. In doing so, it sheds light on a new field of corporate governance scholarship.
Sang Yop Kang is an Associate Professor of Law at the Peking University School of Transnational Law.