In a new paper, we use agency theory to explore the effect of board independence on dividend policy. Over the past few decades, many studies have incorporated several market imperfections into their model of capital markets, such as transaction costs, taxes, and shareholder heterogeneity. We focus on agency costs, which can be mitigated by effective governance mechanisms, such as a more independent board of directors.
In our study, we exploit as a quasi-natural experiment enactment of the Sarbanes-Oxley Act of 2002 (SOX) and the associated exchange listing requirement that public companies have a majority of independent directors.
Dividends serve as a governance mechanism to mitigate agency conflicts, reducing free cash flows, which managers may exploit for personal gain rather than using them to maximize shareholder wealth. In addition, dividends subject corporations to more regular monitoring by the capital markets, as the payment of dividends raises the likelihood that equity must be issued more frequently.
In what way should board independence influence dividend policy? Under one view, greater board independence enhances board effectiveness and reduces agency costs by compelling management to distribute more cash to shareholders. When a company has less cash on hand, opportunistic managers are less capable of expropriating from shareholders, and so a more independent board results in more dividend payouts. This is called the outcome hypothesis.
A contrasting view is that a more independent board causes corporations to pay smaller dividends. As is widely documented in the literature, dividends serve a governance function by preventing opportunistic management from exploiting free cash flows. This argument holds that greater board independence reduces the need for dividends as a governance mechanism. In other words, board independence substitutes for dividends in mitigating agency problems. This viewpoint is termed the substitution hypothesis. In the presence of strong board independence, opportunistic managers are less able to exploit free cash flows, allowing firms with strong board independence to keep larger free cash flows inside the firm. As a result, stronger board independence results in lower dividends.
Based on over 20,000 observations spanning nearly two decades (1996-2014), our difference-in-difference analysis indicates that corporations compelled to improve board independence increase dividends significantly compared with those that are not required to change board independence. The evidence is therefore in favor of the outcome hypothesis. Stronger board independence forces managers to disgorge more cash to shareholders in the form of larger dividends. We perform a variety of robustness checks on our findings. For instance, we look at a shorter period to minimize any confounding events and account for a wide range of other governance mechanisms in addition to the behavior of the board of directors. All the robustness checks confirm that stronger board independence leads to larger dividend payouts.
We also explore the impact of board independence on share repurchases as repurchases are another way to disburse cash. However, there is no evidence that repurchases are related to board independence. One possible explanation is that share repurchases are subject to managerial discretion and therefore do not function as dividends do. While dividends are in theory also subject to managerial discretion, most companies attempt to keep dividends steady. Therefore, managers generally do not have discretion over dividends.
Our research results have several practical implications. For instance, for shareholders, our results highlight the influence of independent directors on important corporate policies, such as dividend policy. For regulators, our study highlights the effectiveness of corporate governance and, in particular, independent directors and the need to account for that in determining how to regulate companies. Investors who rely on dividends as an important factor in their investments analysis should find helpful our conclusion that board independence is an important determinant of dividend policy.
This post comes to us from professors Pandej Chintrakarn at Mahidol University International College, Sirimon Treepongkaruna at the University of Western Australia, and Pornsit Jiraporn and Sang Mook Lee at Pennsylvania State University. It is absed on their recent paper, “The effect of board independence on dividend payouts: A quasi-natural experiment,” available here.