Abstract: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.Keywords: equity tunneling, preemptive rights, dilution, freezeout, corporate governance, securities law, emerging markets JEL codes: G32, G34, K22 We would like to thank an anonymous referee for greatly improving the paper. We are also grateful to

This paper documents that law affects finance in emerging markets through the methods used by controlling shareholders to "tunnel" wealth out of the firm. We find that Bulgarian securities law enabled financial tunneling via dilution and freeze-out tender offers. During the period 1999-2001, about two-thirds of the 1,040 firms on the Bulgarian Stock Exchange were delisted. Freeze-out tender offers for minority shares averaged about 25% of the shares' intrinsic value. Bulgarian securities law changes in 2002 made financial tunneling more costly for controlling shareholders. Subsequent increases in stock market valuations and liquidity suggest that controlling shareholders have shifted from financial tunneling to less value-destroying methods, such as transfer pricing, to extract wealth from firms.

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