Law, Ownership, Corporate Governance, and Dividend Payout Policy

Miller and Modigiliani (1961) prove that dividend policy is irrelevant to share value in perfect and efficient capital markets. In this setup, no rational investor has a preference between dividends and capital gains. However, dividend payout policy is still discussed extensively until now. In this proposal, I use a sample of companies from 33 countries around the world to shed light on the relationship among legal origin, insider holdings, corporate governance, and dividend payout policy.

This idea mainly comes from Professor Shiu in corporate finance class at NCU. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998, henceforth referred to as LLSV) examine laws differ around the world give investors limited bundle of rights. Countries of the common-law traditions tend to protect investors more than the civil-law. LLSV (1998) remind us the importance of law to investor protection around different countries. After LLSV (1998), LLSV (2000a) find that a common element explaining these differences is how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms.

Moreover, they show that common law counties assign higher valuations to publicly-traded stock. LLSV (2000b) state that the agency approach is highly relevant to an understanding of corporate dividend policies around the world. Firms operating in countries with better protection of minority shareholders would pay higher dividends. Their 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. However, LLSV (2000b) just test the dividend payout ratio of many firms in different law.

Therefore, I deeply study dividend payout policy across different countries. In my proposal, I use legal origin, inside ownership, and corporate governance, totally three surfaces, to clarify the relationship between the agency problem and dividend payout policy. I examine a larger sample of countries around the world. I adopt the same sample following LLSV (200b). I divide 33 countries into two groups, named common-law group and civil-law group. The common-law group implies shareholders would have better shareholder protections. On the contrary, the civil-law group means shareholders have poor shareholder protections. In this proposal, I concern some questions listed as follows. First, would firms in stronger investor protection countries increase the dividend payout ratio when insider ownership increases the stockholding ratio? Moreover, is dividend payout policy monotonic increasing with corporate governance index?

Second, in worse investor protection countries, would firms have the reverse direction to decrease the dividend payout ratio when insider ownership increases the stockholding ratio? I also investigate whether there is a monotonic decreasing function between the dividend payout policy and insider ownership in the civil-law group. I hope to find out some empirical evidences to support my hypothesis. Better corporate governance and stronger legal investor protection environment will reduce the agency problems. Following the interest of convergence theory (Morck et al., 1988), the insider shareholders have higher shareholding ratio would lead to higher market valuation.

Therefore, the main hypothesis in my proposal is that firms would have higher dividend payout ratio when the insider shareholders have higher shareholding ratio based on better corporate governance and stronger legal investor protection. The remainder of this proposal is organized as follows. Section 2 reviews relative literatures about the agency problem, law, corporate governance, and some dividend payouts. Section 3 introduces data and methodology used in this study. Section 4 presents the predict results and conclusions.

2. Literature Review

I study the dividend policy based on several reasons. First, dividends can reflect the primary determinant of equity value. Second, a firm can do two things with its earnings: pay them out to equity holders or reinvest in positive NPV projects. Third, as a firm matures, growth opportunities want to reduce the free cash flow, and then dividend will be the better choice. Finally, the price of a stock is strong signal of expected future dividend payments. Dividend policy is that firms’ managers decide to pay out earnings versus retaining and reinvesting them. I summarize three theories of dividend policy as follows. First, in the Modigliani-Miller (1961) world has shown, investors may be indifferent about the amount of dividend as it has no influence on the value of a firm. The MM theorem implies any payout is OK, but it bases on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Similarly, managers may be indifferent as funds would be available or could be raised with out any flotation costs for all positive net present value projects.

Second, Bird-in-the-hand theory (Gordon and Lintner) says that investors prefer a high payout. Dividends (a bird in hand) are better than retained earnings (a bird in the bush) because the latter might never materialize as future dividends (can fly away). Third, tax preference theory states investors prefer a low payout. Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends. Hence, firms should set a low payout dividend policy based on the tax preference. Truth is one. However, three theories all derive different dividend payout policy. This is why dividend payout policy is still discussed extensively until now. Jensen and Meckling (1976) first addressed the agency problem. They examined the relationship between principal and agent within the theory of the firm. Agency theory has identified the existence of two agency relationships. First, in the manager-shareholder relationship, the manager acts as an agent for the shareholders who are considered to be the owners. Shareholders are not in control of the company, since the managers make all pertinent decisions.

If managers hold less than 100% of the shares, then they may invest less effort in managing firm resources and may transfer the resources to their own benefits. Second, in the shareholder-debtholder relationship, the manager is assumed to act on behalf of the shareholders. If an investment yields large returns, then equity holders capture most of the gain. If it fails, debt holders bear the consequence. In both of these relationships, the interests of the agent and principal are separated, imposing agency costs. According to Jensen and Meckling (1976), the optimal capital structure is to minimum the agency costs. Jensen (1986) argues that there are important divergences of interest between managers and shareholders that might induce managers to issue equity and waste funds by taking up negative NPV projects. On the other side, Jensen thinks that debts may reduce agency costs. The firms may have free cash flows under management’s discretion.

Therefore, raising the leverage ratio would reduce the free cash flows problem because the management has to pay out cash regularly. The benefits and drawbacks of debts constitute the trade-off theory of capital structure. Although debts can increase the value of the firm when the firms have less debt, debts also reduces the value of the firm when the debts are too many. Hence, the firm has to find an optimal capital structure to maximize the value of the debts. In addition, Jensen (1986) also suggests increasing dividend payout ratio in order to mitigate the free cash flow problem when firms have a lot of free cash flows. According to Jensen’s paper, I think the relationship between the agency problem and dividend payouts is very stronger. In this proposal, I study the relationship between the agency problem and dividend payouts. I use insider ownership and corporate governance index to proxy the agency problem. LLSV (1998) discuss a set of key legal rules protecting shareholders and creditors and document the prevalence of these rules in 49 countries around the world.

They also aggregate these rules into shareholder (anti-director) and creditor rights indices for each country, and consider several measures of enforcement quality, such as the efficiency of the judicial system and a measure of the quality of accounting standards. LLSV (1998) use these variables as proxies for the stance of the law toward investor protection to examine the variation of legal rules and enforcement quality across countries and across legal families. LLSV (2000a) further find that a common element explaining these differences is how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms.

They show that common law counties assign higher valuations to publicly-traded stock. In the other word, law would impact the valuation of firms. LLSV (2000b) show that minority shareholders press corporate insiders to pay dividends, since they cannot be sure to get a fair return particularly in countries where shareholder rights are not well developed. My proposal mainly wants to extend LLSV’s work and clarify what factors indeed influence the dividend payouts. In this section, I introduce the relationship between dividend payouts and insider holding. Schooley and Barney (1994) indicate that negative relationship between dividend payouts and ownership exists before a turning point; once managerial ownership exceeds the critical point, it switches to a positive one. However, as La Porta et al. (2000b) point out, legal protection causes that widely-held firms dominate in a protected environment and closely-held firms in an unprotected one. Some research addresses a negative relationship between dividend payouts and ownership. I think it is because their samples are usually composed of firms in a specific environment without including a lot of countries.

Therefore, I try to locate the relationship by considering totally four surfaces in my proposal. Jensen and Meckling (1976) and Morck et al. (1988) have provided important contributions to the research on ownership structures and corporate valuation. Jensen and Meckling concluded that concentrated ownership is beneficial for corporate valuation, because large investors are better at monitoring managers. Morck et al. distinguish between the negative control effects and the positive incentive effects of higher shares of ownership. They suggest that the absence of separation between ownership and control reduces conflicts of interest and thus increases shareholder value. Shleifer and Vishny (1997), La Porta et al. (1998,1999), Morck et al. (1988) and Claesens et al. (2000a, 2000b) studied the conflicts of interest between large and small shareholders.

Their policies may result in the expropriation of minority shareholders when large investors control a corporation. Such companies are unattractive to small shareholders and their shares have lower valuation. According to these literatures, the ownership structure is an important factor in studying the dividend payouts. Jensen et al (1992) and Chen and Steiner (1999) examine the relation between corporate governance issues and the dividend payout policy. Gompers and Metrick (2003) find that firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions.