Agency Problems and Dividend Policies Around the World Essay Example

is that dividend policies address agency problems between corporate insiders and outside shareholders. According to these theories, unless profits are paid out to shareholders, they may be diverted by the insiders for personal use or committed to unprofitable projects that provide private benefits for the insiders. As a consequence, outside shareholders have a preference for dividends over retained earnings.

Theories differ on how outside shareholders actually get firms to disgorge cash. The key point, however, is that failure to disgorge cash leads to its diversion or waste, which is detrimental to outside shareholders' interest. The agency approach moves away from the assumptions of the ModiglianiMiller theorem by recognizing two points. First, the investment policy of the firm cannot be taken as independent of its dividend policy, and, in particular, paying out dividends may reduce the inefficiency of marginal investments.

Second, and more subtly, the allocation of all the profits of the firm to shareholders on a pro rata basis cannot be taken for granted, and in particular the insiders may get preferential treatment through asset holding the investment policy diversion, transfer prices, and theft-even constant. Insofar as dividends are paid on a pro rata basis, they benefit outside shareholders relative to the alternative of expropriation of retained earnings. In this paper, we attempt to identify some of the basic elements of the agency pproach to dividends, to understand its key implications, and to evaluate them on a cross section of more than 4,000 firms from 33 countries around the world. The reason for looking around the world is that the severity of agency problems to which minority shareholders are exposed differs greatly across countries, in

part because legal protection of these shareholders varies (La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998), henceforth referred to as LLSV). Empirically, we find that dividend policies vary across legal regimes in ways consistent with a particular version of the agency theory of dividends.

Specifically, firms in common law countries, where investor protection is typically better, make higher dividend payouts than firms in civil law countries do. Moreover, in common but not civil law countries, high growth firms make lower dividend payouts than low growth firms. These results support the version of the agency theory in which investors in good legal protection countries use their legal powers to extract dividends from firms, especially when reinvestment opportunities are poor. Agency Problems and Dividend Policies 3 Section I of the paper summarizes some of the theoretical arguments.

Section II describes the data. Section III presents our empirical findings. Section IV concludes. I. Theoretical Issues A. Agency Problems and Legal Regimes Conflicts of interest between corporate insiders, such as managers and controlling shareholders, on the one hand, and outside investors, such as minority shareholders, on the other hand, are central to the analysis of the modern corporation (Berle and Means (1932), Jensen and Meckling (1976)). The insiders who control corporate assets can use these assets for a range of purposes that are detrimental to the interests of the outside investors.

Most simply, they can divert corporate assets to themselves, through outright theft, dilution of outside investors through share issues to the insiders, excessive salaries, asset sales to themselves or other corporations they control at favorable prices, or transfer pricing with other entities they control (see Shleifer and Vishny

(1997) for a discussion). Alternatively, insiders can use corporate assets to pursue investment strategies that yield them personal benefits of control, such as growth or diversification, without benefiting outside investors (e. . , Baumol (1959), Jensen (1986)). What is meant by insiders varies from country to country. In the United States, the U. K. , Canada, and Australia, where ownership in large corporations is relatively dispersed, most large corporations are to a significant extent controlled by their managers. In most other countries, large firms typically have shareholders that own a significant fraction of equity, such as the founding families (La Porta, Lopez-de-Silanes, and Shleifer (1999)).

The controlling shareholders can effectively determine the decisions of the managers (indeed, managers typically come from the controlling family), and hence the problem of managerial control per se is not as severe as it is in the rich common law countries. On the other hand, the controlling shareholders can implement policies that benefit themselves at the expense of minority shareholders. Regardless of the identity of the insiders, the victims of insider control are minority shareholders.

It is these minority shareholders who would typically have a taste for dividends. One of the principal remedies to agency problems is the law. Corporate and other law gives outside investors, including shareholders, certain powers to protect their investment against expropriation by insiders. These powers in the case of shareholders range from the right to receive the same per share dividends as the insiders, to the right to vote on important corporate matters, including the election of directors, to the right to sue the company for damages.

The very fact that this legal protection exists

probably explains why becoming a minority shareholder is a viable investment strategy, as opposed to just being an outright giveaway of money to strangers who are under few if any obligations to give it back. 4 The Journal of Finance As pointed out by LLSV (1998), the extent of legal protection of outside investors differs enormously across countries. Legal protection consists of both the content of the laws and the quality of their enforcement. Some countries, including most notably the wealthy common law countries such as the United States and the U.

K. , provide effective protection of minority shareholders so that the outright expropriation of corporate assets by the insiders is rare. Agency problems manifest themselves primarily through non-valuemaximizing investment choices. In many other countries, the condition of outside investors is a good deal more precarious, but even there some protection does exist. LLSV (1998) show in particular that common law countries appear to have the best legal protection of minority shareholders, whereas civil law countries, and most conspicuously the French civil law countries, have the weakest protection.

The quality of investor protection, viewed as a proxy for lower agency costs, has been shown to matter for a number of important issues in corporate finance. For example, corporate ownership is more concentrated in countries with inferior shareholder protection (LLSV (1998), La Porta, Lopez-deSilanes, and Shleifer (1999)). The valuation and breadth of capital markets is greater in countries with better investor protection (LLSV (1997), DemirgucKunt and Maksimovic (1998)).

Finally, there is some evidence that good investor protection contributes to the efficiency of resource allocation and to economic growth more generally (Levine and Zervos (1998), Rajan

and Zingales (1995)). This paper continues this research by examining the dividend puzzle using shareholder protection as a proxy for agency problems. B. Agency and Dividends: Two Views B. 1. The Role of Dividends in an Agency Context In a world of significant agency problems between corporate insiders and outsiders, dividends can play a useful role.

By paying dividends, insiders return corporate earnings to investors and hence are no longer capable of using these earnings to benefit themselves. Dividends (a bird in the hand) are better than retained earnings (a bird in the bush) because the latter might never materialize as future dividends (can fly away). Additionally, the payment of dividends exposes companies to the possible need to come to the capital markets in the future to raise external funds, and hence gives outside investors an opportunity to exercise some control over the insiders at that time (Easterbrook (1984)).

Unfortunately, there are no fully satisfactory theoretical agency models of dividends that derive dividend policies as part of some broad optimal contract between investors and corporate insiders, which allows for a range of feasible financing instruments. Instead, different models, such as Fluck (1998, 1999), Myers (1998), and Gomes (2000), capture different aspects of the problem. Moreover, the existing agency models do not fully deal with the issues of choice between debt and equity in addressing agency problems, the

Agency Problems and Dividend Policies 5 choice between dividends and share repurchases, and the relationship between dividends and new share issues. We attempt to distill from the available literature the basic mechanisms of how dividends could be used to deal with agency problems. In particular, we distinguish between

two very different agency "models" of dividends. The predictions of these models that we test are necessarily limited by the fact that we do not look at all the financing and payout choices simultaneously.

Perhaps most importantly in this regard, we do not examine share repurchases, which have been commonly taken as an alternative to paying dividends. We note, however, that share repurchases are most common precisely in the countries where firms pay high dividends, such as the United States and the U. K. For example, between June 1997 and June 1998 there were 1,537 share repurchases in the world recorded by the Securities Data Corporation, of which 1,100 occurred in the United States. By market value, the United States accounted for 72 percent of world share repurchases during this period, and the United States, the U.

K. , Canada, and Australia combined accounted for 83 percent. In some civil law countries, share repurchases are even illegal or heavily taxed (The Economist, August 15, 1998). 1 If share repurchases are complementary to dividends, rather than a substitute for them, our evidence only underestimates the difference in total cash payouts to shareholders between civil and common law countries. B. 2. Dividends as an Outcome of Legal Protection of Shareholders Under the first view, dividends are an outcome of an effective system of legal protection of shareholders. Under an effective ystem, minority shareholders use their legal powers to force companies to disgorge cash, thus precluding insiders from using too high a fraction of company earnings to benefit themselves. 2 Shareholders might do so by voting for directors who offer better dividend policies, by selling shares to potential

hostile raiders who then gain control over non-dividend paying companies, or by suing companies that spend too lavishly on activities that benefit only the insiders. Moreover, good investor protection makes asset diversion legally riskier and more expensive for the insiders, thereby raising the relative attraction of dividends for them.

The greater the rights of the minority shareholders, the more cash they extract from the company, other things equal. It is important to recognize that this argument does not rely on minority shareholders having specific rights to dividends per se, but rather on their having the more general rights of voting for directors and protesting wealth 1 It could be argued that the discouragement of share repurchases is a form of shareholder protection since, unlike dividends, share repurchases can be discriminatory.

This argument is less plausible in light of the fact that most share repurchases in the United States and the U. K. are open market, and, moreover, appear to supplement rather than substitute for dividends. 2 Even under an effective system, residual agency problems must remain, for if they are totally resolved, we are back to the world of Modigliani and Miller with no reason for dividends. 6 The Journal of Finance expropriation. A good example from the United States is Kirk Kerkorian forcing Chrysler Corporation to disgorge its cash by paying dividends in 1995 to 1996.

As a large shareholder in Chrysler, Kerkorian had no specific rights to dividends, but used the voting mechanism to put his associates on the board and then force the board to sharply raise dividends. Another good example is Velcro Industries, the producer of the famous "touch fastener" incorporated

on the island of Curacao in the Netherlands Antilles, "where shareholders have no right of dissent" (Forbes, October 15, 1990). Two-thirds of the shares of Velcro Industries are ontrolled by the Cripps family that runs Velcro (Forbes, May 23, 1994). In 1988, despite having a large cash reserve, the company suspended dividends "for the foreseeable future" (Forbes, October 3, 1988), -delisted itself from the Montreal Stock Exchange, and aggressively wrote down assets to slash earnings, evidently to "buy out Velcro minority holders cheap" (Forbes, May 23, 1994). The share price dived and, in 1990, with dividends remaining at zero, the Crippses offered to repurchase minority shares at slightly above the market price.

Minority shareholders sued in New York and "when a New York judge ruled that the United States was the proper jurisdiction, secretive Sir Humphrey Cripps decided to call off his offer rather than go under the light of U. S. court of law" (Forbes, May 23, 1994). The company subsequently resumed its dividend payments. This case illustrates that, in a high protection country like the United States, in contrast to a low protection country like the Netherlands, shareholders are able to extract dividends from companies by virtue of their ability to resist oppression rather than having any specific dividend rights per se.

In a cross section of countries with different quality of shareholder protection, the implication that better protection is associated with higher dividend payouts is testable. There is one further implication of this theory. Consider a country with good shareholder protection, and compare two companies in that country: one with good investment opportunities and growth prospects, and another with poor opportunities.

Shareholders

who feel protected would accept low dividend payouts, and high reinvestment rates, from a company with good opportunities because they know that when this company's investments pay off, they could extract high dividends. In contrast, a mature company with poor investment opportunities would not be allowed to invest unprofitably. As a consequence, with good shareholder protection, high growth companies should have significantly lower dividend payouts than low growth companies.

In contrast, if shareholder protection is poor, we would not necessarily expect such a relationship between payouts and growth since shareholders may try to get what they can-which may not be muchimmediately. This also is a testable implication. 3 The implications of the outcome agency model of dividends are illustrated in Figure 1. 3 Ambarish et al. (1987) derive the negative relationship between growth and payouts in a dividend signaling model. They do not focus on how this relationship would vary depending on how well shareholders are protected. In principle, this extension is possible.

Agency Problems and Dividend Policies Div/Earn 7 H L ow P ro tection igh P rote ctio n Investment Figure 1. Outcome Opportunities model of dividends. B. 3. Dividends as a Substitute for Legal Protection of Shareholders In an alternative agency view, dividends are a substitute for legal protection. 4 This view relies crucially on the need for firms to come to the external capital markets for funds, at least occasionally. To be able to raise external funds on attractive terms, a firm must establish a reputation for moderation in expropriating shareholders.

One way to establish such a reputation is by paying dividends, which reduces what is left for expropriation. For this

mechanism to work, the firm must never want to "cash in" its reputation by stopping dividends and expropriating shareholders entirely. The firm would never want to cash in if, for example, there is enough uncertainty about its future cash flows that the option of going back to the capital market is always valuable (Bulow and Rogoff (1989)). A reputation for good treatment of shareholders is worth the most in countries with weak legal protection of minority shareholders, who have little else to rely on.

As a consequence, the need for dividends to establish a reputation is the greatest in such countries. In countries with stronger shareholder protection, in contrast, the need for a reputational mechanism is weaker, and hence so is the need to pay dividends. This view implies that, other things equal, dividend payout ratios should be higher in countries with weak legal protection of shareholders than in those with strong protection. 5 4 The closest informal discussion to the substitute model is Easterbrook (1984). Formally, the model that comes the closest to taking this point of view is Gomes (2000).

However, the recent drafts of his paper have moved away from focusing on dividends, and hence our discussion should not be interpreted as a description of Gomes's model. ' Dewenter and Warther (1998) argue that there is less need to signal future earnings with dividends in Japan than in the United States. This may be because Japanese firms have better ways of information transmission to the relevant investors than do U. S. firms, or because Japanese managers are more insulated from investor pressure (Kang and Stulz (1996)).