Tunnelling and the Skoda

case
International Securities Regulation
School of Law University of Navarra

Julia Polvorosa Cceres

117346-4

Julia Polvorosa Cceres

Tunnelling and the Skoda case

Introduction

When Communism ended, a whole economic system had to be changed. In the old
continent, we had rich countries with a developed industry that was emerging in a
globalized world. However, the privatization of Czech Republic failed, and many
corporations went bankruptcy after being managed by politicians who did not realize
that managing a public and a private company were two different paths.

1. What is tunnelling?

The term was originally created for the expropriation of minority shareholders in the
Czech Republic as in removing assets though an underground tunnel. It describes the
transfer of assets and profits out of firms for the benefit of those who control them.1

Tunnelling usually takes place in when the controlling shareholder is typically the top
manager. In the public companies of Europe, Asia and Latin America, this subjective
position is usually common, but it does not involve other problems related to the
sometimes wrongful management of those entities.

We can distinguish two kinds of tunnelling depending on the right transferred. In one
hand, the controlling shareholder can transfer to its own profit non-financial products
such as contracts or assets sales. Those performances sometimes include theft or fraud,
which are illegal worldwide, but it is not always easy to detect or punish because of the
subjective position of the shareholder, who is the companys top manager. On the other
hand the controlling shareholder can transfer or trade with financial products for
increasing his share of the firm.

The financial transactions are done usually

discriminating against the minority shareholders.

2. How courts allow tunnelling?

1

Johnson, La Porta, Lopez-de-Silanes & Shleifer. Tunnelling. National Bureau of Economic Research
(Cambridge, MA), 2000, Working Paper 7523. Page 2.

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Tunnelling and the Skoda case

Internationally, the law is permeated with two broad principles. The duty of care is
derived of the roman concept of mandatum with in this context refers to the
responsibilities of corporate directors and it is applied to controlling shareholders in so
far as they also serve as directors.2 It requires a director to act with the care enough to
inform himself before making a decision. The second general principle is the fiduciary
duty which is required to act solely in another partys interest, in this case in the
corporation interest, which may not be profitable for the shareholders.
In common law countries, the duties of loyalty and care need very different standards of
proof3 . In the case of duty of care, there must be a requirement for exercising a certain
amount of care and when a director fails to exercise such care, he is considered guilty of
negligence, whereas in the case of fiduciary duty, the very fact that the interests of a
director are in conflict with those of the company itself constitutes the basis for liability,
and if the interests of the company are prejudiced as a result of such conflict, liability
for breach of fiduciary duty arises4 . However, the civil law system emphasizes the
legal certainty and it diminishes the amount of judicial discretion and as a consequence,
developed countries stop theft and fraud, but it is more difficult to stop self-dealing
transactions with a plausible business purpose.

In sum, civil law countries should have in their national Securities Law some provisions
regarding those two principles indispensable for a fair management of a corporation.

3. Financial tunnelling

The most common practice in financial tunnelling is avoiding the observance in the
national mandatory bid

rules (MBRs).

MBRs require

making offers to the

shareholders for getting the shares enough to keep his power within the corporation. If
the controlling shareholder does not offer the shares to the minority shareholders and
2

Johnson, La Porta, Lopez-de-Silanes & Shleifer. Tunnelling. National Bureau of Economic Research
(Cambridge, MA), 2000, Working Paper 7523. Page 3.
3
Johnson, La Porta, Lopez-de-Silanes & Shleifer. Tunnelling. National Bureau of Economic Research
(Cambridge, MA) Working Paper 7523, 2000. Page 4.
4
Shibuja. Fidaciary duty of directors-fairness in Regulation of Corporate Dealing with Directors , Law in
Japan: An Annual, 1972, 5 (97), page 127.

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Tunnelling and the Skoda case

purchase those, they will lose power in benefit of the top manager, whose power would
be increased5 .

Arrived to this point, it is important to point out the difference between dispersed and
concentrated ownership. Dispersed ownership structures are more susceptible to various
forms of earnings management while concentrated ownership is more prone to
appropriation of private benefits con control6 .

4. Financial tunnelling in an emerging market

The Coase classic finance theory expounds that financial markets can function well
regardless of the legal environment. But scholars as La Porta, Lopez-de-Sillanes,
Shleifer and Vishny provide that the legal environment is a significant factor in
explaining capital market growth and development7 .

The paperwork made by Atanasov, Black, Ciccotello and Gyoshev proves by a complex
economic study that the law change has a significant effect on share values, increasing
the price/earnings and the price/sales ratios. It also proves that controlling financial
tunnelling through legal protection of shareholders rights affects financial markets
outcomes. It is also remarkable that the importance of financial tunnelling risk as a
factor in equity pricing in the emerging markets.

5. Regulations in the emerging stock markets

During XX century, after the end of communism, Eastern Europe had the chance of
privatize a big amount of companies with the necessary infrastructure for introducing
5

Grant J., Kirchmainer T. & Kirshner J.A., Financial tunneling and the Mandatory Bid Rule. FMG
Discussion Paper No. 536. 2009. Page 2.
6
Coffee, A Theory of Corporate Scandals: Why the U.S. and Europe Differ. Oxford Review of Economic
Policy, 2005, page 200.
7
Atanasov, Vladimir A. and Black, Bernard S. and Ciccotello, Conrad S. and Gyoshev, Stanley B., How
Does Law Affect Finance? An Examination of Equity Tunneling in Bulgaria (May 1, 2009). nearly final
version, published in 96 Journal of Financial Economics 155-173 (2010); ECGI - Finance Working Paper
No. 123/2006. Page 3.

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Tunnelling and the Skoda case

itself in a capitalized economy system. Stringham, Boettke and Clark expose the case
posteriorly explained:
The Czech government, for example, created nearby two thousand joint stock
companies and enabled all citizens willing to pay a small fee to participate in a
voucher privatization. Although hopes for the development of markets were
high, within a few years the stock marked exhibited problems.
In contrast, Polish stock market is considered a model because the state played a
significant role promoting and creating order in stock markets.

Going back to the Czech Republic case, the scheme was successful: the government got
rid of industry, but many top managers, investment funds, and majority shareholders
expropriated resources of the companies. In addition, judges formed in communist
countries lack experience and they expertise was unreliable.

Initially, Czech market had not many Initial Public Offerings (IPOs) and the firms had
to go elsewhere for funds. Additionally, the government requirements for a company to
become public involved high fees and a non-friendly regulation for corporations. Even
now, the low number of IPOs in the Czech Republic showed that the market is not a
good source of equity finance, but the lack of IPOs cannot be attributed to a lack of
regulations.

The tunnelling phenomenon might be influenced by the fact that under communism,
secrecy and not transparency was the watchword. The corporations used to be opaque
since communism, and managers did not view their job as a responsibility but as a
privilege. After the whole privatization procedure, many politicians continued using
their position for their own gain. As Tomas Jezek stated, Some guys in government
now like to administer state properties, sit on corporate boards and run privatized
companies as if theyre still state-owned enterprises. They like their role. They want to
keep it permanently. (quoted in Calbreath. 1996b, p.5).

6. The Skoda case

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Tunnelling and the Skoda case

The Skoda case, tunneled by its top manager, was discovered when Lubomir Soudek
left the company.
Lubomir Soudek worked as a mining engineering and later become a member of the
Communist Party as a confident for StB. He started to rule Skoda in 1992, when the
whole business structure was in the process of privatization public companies. Through
its career, he was known in Czech Republic for his declarations to the press, elevating
himself and sometimes referring to the government and the Czech Prime Minister.
Skoda was purchased by Volkswagen, and Lubomir Soudek did his job. The company
had such a big loss, but nobody pointed him out for his management.
When Soudek got fired, it was discovered that Soudek had been accorded loans at a low
interest rate between Skoda and NERo, his engineering corporation, to purchase shares.
It is said in press that Soudek borrowed 315 million Kc. Finally NERo went bankruptcy.

In 2000 the state filed criminal charges in the regional court, and just one year later,
Skoda went bankruptcy. Finally, after appealing, the case went to Prague High Court.
Soudek was found innocent by the courts. Soudek refused to comment on the trial.

Conclusion

It is well known that financial markets, such as any other activity regulated, is faster
than the law, and when the communist society in Czech Republic changed immediately
the whole structure of the State was no prepared to face the issues involved.

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Tunnelling and the Skoda case

References

Articles:
Johnson, La Porta, Lopez-de-Silanes & Shleifer. Tunnelling. National Bureau
of Economic Research (Cambridge, MA), 2000, Working Paper 7523.
Shibuja. Fidaciary duty of directors-fairness in Regulation of Corporate
Dealing with Directors, Law in Japan: An Annual, 1972, 5 (97),
Grant J., Kirchmainer T. & Kirshner J.A., Financial tunneling and the
Mandatory Bid Rule. FMG Discussion Paper No. 536. 2009
Coffee, A Theory of Corporate Scandals: Why the U.S. and Europe Differ.
Oxford Review of Economic Policy, 2005
Atanasov, Vladimir A. and Black, Bernard S. and Ciccotello, Conrad S. and
Gyoshev, Stanley B., How Does Law Affect Finance? An Examination of
Equity Tunneling in Bulgaria (May 1, 2009). nearly final version, published in
96 Journal of Financial Economics 155-173 (2010); ECGI - Finance Working
Paper No. 123/2006

Press:
Siegfried Mortkowitz, Skoda Plzen mogul takes on all comer. The Prague
Post, January 20, 1999.
Peter Kononczuk, Getting away with it? The Prague Post, August 26, 2004.
Zuzana Kawaciukova, Ex-Skoda Plzen director cleared The Prague Post, April
24, 2003.