The Vicious Circles of Control

Abstract

How can one account for the puzzling behavior of insider-managers who, in stripping assets from the very firms they own, appear to be stealing from one pocket to fill the other? The authors suggest that such asset-stripping and failure to restructure are the consequences of interactions between insiders (manager-owners) and regional governments in a particular property rights regime. In this regime, the ability to realize value is limited by uncertainty and illiquidity, so managers have little incentive to increase value. As the central institutions that rule Russia have ceded their powers to the regions, regional governments have imposed various distortions on enterprises to protect local employment. Prospective outsider-investors doubt they can acquire the control rights they need for restructuring firms and doubt they can avoid the distortions regional governments impose on the firms in which they might invest. The result: little restructuring and little new investment. And regional governments, knowing the firms' taxable cash flows will have been reduced through cash flow diversion, have responded by collecting revenues in kind. To disentangle these vicious circles of control, the authors propose a pilot for transforming ownership in insider-dominated firms through a system of simultaneous tax-debt-for-equity conversion and resale through competitive auctions. The objective: to show regional governments, for example, that a more sustainable way to protect employment is to give managers incentives to increase enterprises' value by transferring effective control to investors. The proposed mechanism would provide cash benefits to insiders who agree to sell control to outside investors. The increased cash revenue (rather than in-kind or money surrogates) would enable regional governments to finance safety nets for the unemployed and to promote other regional initiatives.