362 Part Four Financing Decisions and Market Efficiency
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few dominant stockholders holding large blocks of shares. In the U.S., the law protects minor-
ity stockholders from exploitation, but minority stockholders in other countries do not always
fare so well.^12
Financial economists sometimes refer to the exploitation of minority shareholders as tun-
neling; the majority shareholder tunnels into the firm and acquires control of the assets for
himself. Let us look at tunneling Russian-style.To grasp how the scam works, you first need to understand reverse stock splits. These are
often used by companies with a large number of low-priced shares. The company making the
reverse split simply combines its existing shares into a smaller, more convenient number of
new shares. For example, the shareholders might be given two new shares in place of the three
shares that they currently own. As long as all shareholdings are reduced by the same propor-
tion, nobody gains or loses by such a move.
However, the majority shareholder of one Russian company realized that the reverse stock
split could be used to loot the company’s assets. He therefore proposed that existing share-
holders receive 1 new share in place of every 136,000 shares they currently held.^13
Why did the majority shareholder pick the number “136,000”? Answer: Because the two
minority shareholders owned less than 136,000 shares and therefore did not have the right to
any shares. Instead they were simply paid off with the par value of their shares and the major-
ity shareholder was left owning the entire company. The majority shareholders of several
other companies were so impressed with this device that they also proposed similar reverse
stock splits to squeeze out their minority shareholders.
Such blatant exploitation would not be permitted in the U.S. or many other countries.EXAMPLE 14.1^ ●^ Raiding the Minority Shareholders
● ● ● ● ●Equity in Disguise
Common stocks are issued by corporations, but a few equity securities are issued not by cor-
porations but by partnerships or trusts. We will give some brief examples.Partnerships Plains All American Pipeline LP is a master limited partnership that owns
crude oil pipelines in the United States and Canada. You can buy “units” in this partnership
on the New York Stock Exchange, thus becoming a limited partner in Plains All American.
The most the limited partners can lose is their investment in the company.^14 In this and most
other respects, the partnership units are just like the shares in an ordinary corporation. They
share in the profits of the business and receive cash distributions (like dividends) from time
to time.
Partnerships avoid corporate income tax; any profits or losses are passed straight through
to the partners’ tax returns. But various limitations offset this tax advantage. For example, the
law regards a partnership merely as a voluntary association of individuals; like its partners,
it is expected to have a limited life. A corporation, on the other hand, is an independent legal
“person” that can, and often does, outlive all its original shareholders.(^12) International differences in the opportunities for dominant shareholders to exploit their position are discussed in S. Johnson et al.,
“Tunnelling,” American Economic Review 90 (May 2000), pp. 22–27.
(^13) Since a reverse stock split required only the approval of a simple majority of the shareholders, the proposal was voted through.
(^14) A partnership can offer limited liability only to its limited partners. The partnership must also have one or more general partners,
who have unlimited liability. However, general partners can be corporations. This puts the corporation’s shield of limited liability
between the partnership and the human beings who ultimately own the general partner.