# **Why Insiders Do Not Maximize Value**

Every system of corporate governance is a structure of control rights such that suppliers of finance assure themselves that their investment will not be squandered by those to whom it is entrusted. In the classic agency perspective, agency costs arise from (i) monitoring expenditures by the principals; (ii) resources spent by insiders to guarantee to outside shareholders that shirking shall be limited, or "bonding" expenditures by the agents; and (iii) the "residual loss," or the reduction in the value of the firm that obtains when the owner dilutes his ownership stake.'<sup>5</sup> Firms that are owned by managers and salaried employees, from this perspective, should face smaller agency costs of corporate control than those hold by outsiders. There should be no need for a governance system in enterprises wholly owned by those who initiate and implement decisions, provide the financing, and bear the residual risks (and returns) associated with those decisions. Thus we are faced with having to account for the puzzling behavior of insider-managers in Russia-as well as other post-socialist environments in which privatized firms are insider dominated-who, in stripping assets from the very firms they own, appear to be stealing from one pocket to fill the other.

The central problem of corporate governance in Russia, however, does not involve the protection of minority shareholders or other financiers. Here, managerowners do not face sufficient incentives to restructure the firm and maximize its value over the long run for three possible reasons. First, due to the problems of property rights delineation, manager-owners perceive title as uncertain and temporary, potentially subject to expropriation. With short time horizons, then, their expected gain from increasing value and share appreciation or dividends is typically less than the value of stripped assets. Second, maximizing value is a reasonable long term objective only if value can be realized. The confidence of managers-owners that if they increase value it can be realized by selling their shares is limited: as will be described below, insider control is so entrenched that an outside investor has little confidence that he will be able to take control of the fimn even if he buys a significant share. Given this illiquidity of secondary markets, managers have little incentive to increase value and might instead sell the _actual assets themselves_ as a way of alienating their control rights. Third, since in many cases the managers do not have formal claim to shares of _employees_ (although they control their voting rights), distribution of dividends and realization of capital gains creates the potential for severe conflicts between employees and managers. Barter allows an opaque income accounting to hide income from employees (as well as from the authorities), as we discuss below.

# **Asset Stripping and Diversion of Cash Flows**

While the original rationale for quick privatization was to prevent asset stripping by managers in SOEs, manager-owners have significantly degraded enterprise assets ever since. Instead of increasing a firm value through reinvestment, enterprise managersowners have typically extracted income streams from these firms at the expense of

**'5** As ownership is diluted greater managerial discretion implies a loss to profits that is responsible for the residual loss. See Michael Jensen and William Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure," _Journal of Financial Economics_ 3 (1976): 305-60; for an alternative perspective, see Oliver Williamson, "Corporate Finance and Corporate Governance," _Journal of Finance_ 43 (1988): 567-591.

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