How Does Law Affect Finance? An Examination of Equity Tunneling in Bulgaria

We model and test the mechanisms through which securities law affects tunneling and tunneling affects firm valuation. In 2002, Bulgaria adopted securities law changes which limit two forms of equity tunneling – dilutive equity offerings and freezeouts. Following the changes, minority shareholders participate equally in secondary equity offers, where before they suffered severe dilution; freezeout offer price/sales ratios quadruple; and Tobin’s q rises sharply for firms at high risk of tunneling, relative to lower risk firms. . At the same time, return on assets declines for high-equity-tunneling-risk firms, suggesting that controlling shareholders partly substitute for reduced equity tunneling by engaging in more cash- flow tunneling. We thus present evidence on (i) the importance of legal rules in limiting equity tunneling, (ii) the role of equity tunneling risk as an important factor in determining equity prices; and (iii) substitution by controlling shareholders between different forms of tunneling.