Dividend Policy, Dividend Initiations, and Governance Micah S. Officer* Marshall School of Business Department of Finance and Bu

Dividend policy, dividend initiations, and governance Micah S. Officer* Marshall School of Business Department of Finance and Business Economics University of Southern California Los Angeles, CA 90089 Phone: 213-740-6519 Email: [email protected] This draft: October 5, 2006 Abstract: Dividend policy can either be an outcome of strong governance or a substitute for weak governance. This paper provides evidence that dividend policy is a substitute for weak internal and external governance by focusing on a sample of firms that should pay dividends. Specifically, predicted dividend payers with weak governance are significantly more likely to pay dividends than are predicted dividend payers with strong governance. Firms with weak governance also have significantly higher dividend initiation announcement abnormal returns than other firms, consistent with the notion that dividend policy is a substitute for other governance attributes and that the market prices the decrease in agency costs resulting from the initiation of dividends. * I thank Harry DeAngelo, Linda DeAngelo, Ehud Kamar, Harold Mulherin, Mike Stegemoller, Ralph Walkling, and Mark Weinstein for comments, and Jim Linck for providing some of the data. Introduction While finance academics have long wondered why firms pay dividends when cash distributions in the form of dividends are tax disadvantaged relative to retention or stock repurchases (e.g. Black (1976)), recent theoretical and empirical work significantly expands our understanding of whether, when, and why firms pay dividends (Fama and French (2001), DeAngelo, DeAngelo, and Skinner (2004), DeAngelo and DeAngelo (2006), and DeAngelo, DeAngelo, and Stulz (2006)). The interaction of dividend policy and governance is central to the debate about the agency costs of free-cash-flow (Easterbrook (1984) and Jensen (1986)). In particular, Easterbrook (1984) argues that a policy of paying dividends reduces agency costs by improving the monitoring and risk-taking incentives of managers. While the initiation of a policy of paying dividends should reduce the agency costs of free-cash-flow ex post, the relation between ex ante agency problems and the decision to pay dividends is not as clear. La Porta et al (2000) discuss two models of the relation between ex ante agency problems and dividend policy: the “outcome model” and the “substitute model.”1 In the outcome model, the payment of dividends is the result of effective governance – well-governed firms pay dividends because strong governance makes expropriation from shareholders (the worst manifestation of the agency problems of free-cash-flow) more difficult and shareholders successfully pressure managers to distribute excess cash.2 In the substitute model, the payment of dividends replaces other governance characteristics in the portfolio of policies that firms employ to convince shareholders that they will not be expropriated.3 The substitute model predicts that poorly- 1 La Porta et al (2000) discuss dividend policy in the context of shareholder protection in various legal regimes around the world. In this paper I take that discussion and apply it to differences in governance characteristics between firms in the same legal regime (United States). 2 Tse (2004) questions the logic of the relation between agency costs and dividend policy in the outcome model – if well-governed firms are more likely to pay dividends, then shareholders shouldn’t need to rely on the payment of dividends to reduce the agency costs of free-cash-flow because such costs should already be low for well-governed firms. 3 Also see Rozeff (1982). 1 governed firms make dividend payments because such firms need an alternate means of establishing a reputation for acting in the interests of shareholders if they intend to raise capital from public markets in the future, and therefore a policy of paying dividends is the most valuable at the margin to firms with agency problems. I identify a sample of firms with fundamentals that suggest that the firms should be dividend payers, and test whether governance characteristics affect the decision to pay dividends in that sample. This sample-selection strategy offers several advantages over the empirical methods employed elsewhere in the literature. First, the outcome model predicts that well- governed firms are more likely to pay dividends only when firm fundamentals (size, growth, earned capital, etc.) support the adoption of a policy of paying dividends. In other words, the outcome model doesn’t stand a chance against the alternative (the substitute model) unless one conditions first on the appropriateness of adopting a policy of paying dividends. Second, a sample of firms that are predicted dividend payers is likely to contain firms that, all else equal, have higher-than-average agency costs of free cash flow. Therefore, this sample should provide a strong empirical test of whether characteristics associated with strong governance are positively (the outcome model) or negatively (the substitute model) correlated with a policy of paying dividends, because the higher-than-average agency costs of free cash flow give shareholders ample motivation to insist on payouts if the governance structure allows (the outcome model) and managers ample motivation to voluntarily offer payouts to compensate for otherwise weak governance structures (the substitute model). I identify firms that should pay dividends (predicted dividend payers) using the models in Fama and French (2001) and DeAngelo, DeAngelo, and Stulz (2006), and find that predicted dividend payers with characteristics associated with weak governance and managerial entrenchment are significantly more likely to pay dividends than are predicted dividend payers with strong governance. For example, firms with large boards, CEO/Chairman duality, and low ownership by insiders and institutional investors are significantly more likely to pay regular cash 2 dividends to shareholders. These results are consistent with the substitute model in La Porta et al (2000), which predicts that firms use dividend policy as a substitute for otherwise weak governance. I offer further support for the substitute model by demonstrating that firms with weak governance have significantly more positive dividend initiation announcement returns than do firms with characteristics consistent with strong governance. This suggests that the market prices the reduction in agency costs associated with the initiation of dividends by firms with weak governance, consistent with the hypothesis that dividend policy is one component of the firm’s governance and bonding policies and therefore substitutable with other governance policies. Endogeneity is certainly a concern in interpreting my results. However, the substitute model in La Porta et al (2000) suggests that dividend policy and other governance characteristics are endogenous choices that firms make as part of an equilibrium monitoring/bonding package to reduce agency costs. While my empirical models are structured as tests of whether governance proxies (implicitly exogenous in the regressions) affect dividend policy choices, the substitute model does not suggest that any of these policy choices are truly exogenous. Therefore, the most that can be concluded from my results (and the other results in this literature), is that dividend policy choice and other policy choices that affect governance quality are negatively correlated. Firms that choose governance policies that are associated with entrenchment (such as having many anti-takeover provision insulating managers from hostile takeovers) are empirically more likely to pay dividends, but it is impossible to conclude that one of these policy choices causes the other. As discussed in Rozeff (1982), the data is most consistent with the interpretation that dividend policy decisions are made as part of an endogenous package of governance choices that optimally reduce the agency costs generated by the separation of ownership and control. Recent empirical papers in this literature have offered consistent support for the substitute model in La Porta et al (2000) (although few papers use that language). For example, Fenn and Liang (2001) report that firms with low managerial stock-option holdings (and therefore lower- powered incentives) have significantly higher dividend and total (including repurchases) payout 3 ratios, although this result could be due to the lack of “dividend protection” afforded by most executive stock option contracts (Lambert, Lanen, and Larker (1989)). Hu and Kumar (2004) find that the likelihood and level of dividend payouts is increasing when factors such as managerial and outside blockholder ownership, CEO compensation policy, and board independence indicate a high likelihood of managerial entrenchment and high agency costs. John and Knyazeva (2006) report that dividend and total payouts (the sum of dividends and repurchases) are significantly more likely when internal and external governance measures indicate weak governance. Pan (2006) shows a similar association between the propensity to pay dividends and measures of managerial entrenchment based on indices of anti-takeover charter provisions. Several earlier studies report complementary evidence. Rozeff (1982) reports that dividend payout ratios are significantly negatively associated with insider ownership and positively associated with the dispersion of outside ownership. Essentially identical results are found in a simultaneous-equations framework by Jensen, Solberg,

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