Tunneling

What Is "Tunneling" and When Does It Become a Crime?

In the world of corporate finance and governance, "tunneling" refers to the illegal or unethical diversion of a company's assets or profits by its executives or controlling shareholders for their personal enrichment.

Tunneling is fraud where controlling shareholders or management divert assets and profits for personal use.

In a financial and legal context, tunneling refers to a form of financial fraud in which controlling shareholders or management divert the company's assets and profits for their own benefit, harming minority shareholders.

This becomes criminal when these actions include clear fraud, theft, or deliberate deception, violating criminal laws.

This practice undermines the integrity of the corporation and harms minority shareholders, who see the value of their investment diminished.

While the term may sound abstract, the actions it describes are concrete and can lead to severe criminal penalties if charged.

Key Takeaways

• Tunneling is often seen as a subtle scheme because those involved typically adhere to formal legal procedures for transactions, making it seem legitimate at first glance.
• Whether tunneling is classified as a civil matter (resolved through damages lawsuits) or a criminal offense largely depends on the jurisdiction and the specific actions taken.
• In many jurisdictions, including some parts of the U.S. and other common law countries, courts evaluate the fairness of transactions with conflicts of interest by applying principles such as the duty of loyalty and the duty of care.
• The fraud is in the transaction terms, which are deliberately designed to favor the controlling parties unfairly.
• A common form of tunneling involves compelling the company to sell assets to a second company owned by the controlling shareholders at unreasonably low prices.
• Tunneling also involves manipulating transactions between related companies to move profits to entities where the controlling shareholders hold a larger financial stake.

Defining Corporate Tunneling

At its core, tunneling involves insiders exploiting their position of power to transfer resources out of a company for their own benefit.

This can be accomplished through various schemes, many of which are designed to appear as legitimate business transactions. Common methods of tunneling include:

• Excessive Executive Compensation: Granting unauthorized or grossly inflated bonuses, salaries, and stock options that are not tied to performance.
• Asset Sales to Related Parties: Selling valuable corporate assets to other companies owned by the insiders at below-market prices.
• Unfair Loans: Providing personal loans to executives from corporate funds with favorable terms, low interest rates, or no expectation of repayment.
• Fraudulent Expense Reimbursements: Using company funds to pay for personal luxuries, such as lavish parties, vacations, or expensive personal items, by disguising them as business expenses.
• Sham Contracts: Creating fake contracts or non-compete agreements that funnel payments directly to insiders rather than to the corporation.

The key feature of tunneling is that these actions are taken at the expense of the company and its other shareholders.

While insiders are entitled to fair compensation, tunneling crosses a line when their actions prioritize personal gain over their fiduciary duty to the corporation.

When Tunneling Becomes a Federal Crime

Tunneling transitions from an internal governance issue to a federal crime when it involves fraud, deception, or the violation of specific federal laws.

The act of diverting assets is often accompanied by efforts to conceal the scheme, such as falsifying business records or making misleading statements to shareholders and regulators.

Tunneling usually shifts from an unethical business activity to a criminal act when it includes certain elements:

• Fraudulent Intent: The main difference lies in intent. If the act involves intentionally falsifying records, misrepresenting information, or deliberately deceiving other shareholders for personal financial gain, it qualifies as criminal fraud.
• Violation of Federal Statutes: Actions like embezzlement, theft, or violations of specific securities fraud laws are considered criminal offenses under existing criminal statutes.
• Lack of Disclosure: Some "legal" tunneling might happen in jurisdictions with weak investor protections. However, actions turn criminal if they break mandatory disclosure rules or clearly breach fiduciary duty, especially when the intent is solely expropriation without a valid business reason.
• Collusion and Deception: These involve intricate schemes like insider collusion, false bankruptcy filings, and manipulation of legal or auditing processes, such as paying officials to issue false charges against the original owners, all of which are evident forms of criminal activity.

Federal Criminal Statutes Related to Tunnelling

Prosecutors have several federal statutes at their disposal to charge individuals involved in tunneling schemes. These include:

• Securities Fraud (15 U.S.C. § 78j(b) and 17 C.F.R. § 240.10b-5): If the tunneling scheme involves making false or misleading statements in public filings, financial reports, or other communications to investors, it can be prosecuted as securities fraud. This occurs when the deception artificially manipulates the company's stock price or defrauds shareholders.
• Mail and Wire Fraud (18 U.S.C. §§ 1341 and 1343): These statutes make it illegal to use mail services (mail fraud) or interstate electronic communications (wire fraud) to execute a fraudulent scheme. Since most corporate transactions involve mail, email, or wire transfers, these are powerful and commonly used tools for prosecuting tunneling.
• Conspiracy (18 U.S.C. § 371): Prosecutors often charge individuals with conspiracy when two or more people agree to commit a crime, such as a fraudulent tunneling scheme. This allows the government to prosecute all participants involved in planning and executing the illegal activity.
• Falsifying Business Records (18 U.S.C. § 1519): Manipulating a company's books and records to hide the diversion of assets is a crime in itself and serves as evidence of a broader fraudulent intent.

Real-World Cases of Criminal Tunneling

Two high-profile cases illustrate how federal prosecutors pursue tunneling.

• Dennis Kozlowski of Tyco International (United States v. Dennis Kozlowski): As CEO of Tyco, Dennis Kozlowski engaged in a massive scheme to loot the company of hundreds of millions of dollars. He and other executives used corporate funds to finance their extravagant lifestyles, including paying for a multimillion-dollar birthday party and luxury apartments, disguising these personal expenses as business costs. They also took tens of millions in unauthorized bonuses and orchestrated loan-forgiveness programs that funneled company funds directly to themselves. In 2005, Kozlowski was convicted of grand larceny, securities fraud, and falsifying business records.
• Conrad Black of Hollinger International (United States v. Conrad M. Black): Conrad Black, the former head of Hollinger International, was prosecuted for a scheme involving fraudulent "non-compete" payments. When Hollinger sold newspaper assets, Black and his associates arranged for millions of dollars in payments to be made directly to them, claiming they were for non-competition agreements. Prosecutors argued that these fees rightfully belonged to the corporation and that the arrangements constituted self-dealing designed to siphon corporate funds. Black was ultimately convicted of mail fraud and obstruction of justice in 2007.

Penalties for Criminal Tunneling

The consequences for being convicted of criminal tunneling are severe. Individuals face significant penalties that are intended to punish the offender and deter similar conduct. Possible penalties include:

• Imprisonment: Convictions for charges like mail fraud, wire fraud, and securities fraud can carry lengthy prison sentences, often up to 20 years per count.
• Fines: Courts can impose substantial fines on individuals and, in some cases, the corporations involved. These fines can amount to millions of dollars.
• Restitution: Defendants are often ordered to pay restitution to the victims, which means compensating the company and its shareholders for the financial losses they suffered as a result of the tunneling scheme.
• Disgorgement: This requires offenders to surrender any illegally obtained profits.

If you are under investigation or have already been indicted for a tunneling-related crime, contact our federal criminal defense lawyers at Eisner Gorin LLP for a case review.

Our attorneys can evaluate your case and develop a defense plan. Contact us by phone or request an online assessment, and we will explain your options.