Managerial value diversion and shareholder wealth

The agents to whom shareholders delegate the management of corporate affair s may transfer value from shareholders to themselves through a variety of m echanisms, such as self-dealing, insider trading, and taking of corporate o pportunities. A common view in the law and economics literature is that suc h value diversion does not ultimately produce a reduction in shareholder we alth, since value diversion simply substitutes for alternative forms of com pensation that would otherwise be paid to managers. We question this view w ithin its own analytical framework by studying, in a principal-agent model, the effects of allowing value diversion on managerial compensation and eff ort. We suggest that the standard law and economics view of diversion overl ooks a significant cost of such behavior. Many common modes of compensation can provide managers with incentives to enhance shareholder value; replaci ng such compensation would reduce these incentives. As a result, even ii th e consequences of a rule permitting Value diversion can be fully taken into account in setting managerial compensation, such a rule might still produc e a reduction in shareholder wealth-and would not do so only if value diver sion would have some countervailing positive effects (a possibility which o ur model considers) that are sufficiently significant in size.