Payout Policy, Agency Conflicts, and Corporate Governance

Abstract

This paper examines the role of corporate governance for payout policy design from the perspective of pre-commitment. We test the effect of external and internal corporate governance on the design of payout policy and use of pre-commitment, level and structure of cash distributions, and firm dividend and repurchase behavior.

We argue that firms use pre-commitment to dividend payments to mitigate the agency conflict due to poor governance. We argue that there is an important distinction between dividends and repurchases from the perspective of pre-commitment. Managers that deviate from the chosen dividend policy incur a cost due to a strong negative market response, which reinforces the pre-commitment role of dividends. On the other hand, the market treats share repurchases as more flexible, irregular payouts made at the manager's discretion, which makes repurchases less effective at mitigating the agency conflict. Therefore, a standalone repurchase policy is not sufficient to mitigate the governance failure, introducing the need for dividend pre-commitment as part of payout policy. Empirically, we find that weak governance is associated with a greater emphasis on dividend pre-commitment in total payout composition. Firms with weak governance are also significantly less likely to use standalone repurchase policies as opposed to a dividends - only or a mixed dividends - repurchases payout policy. Costly dividend pre-commitment presents few benefits to well-governed managers. Instead, they either store excess cash in the firm or distribute it through repurchases. We find that the type of monitoring mechanism is relevant for predicting discretionary payouts.

Given the generally strong investor protection level in the US, poorly monitored managers are not immune from firing and they will follow a costly dividend policy. Consistent with the proposed explanation, we find that firms with weak corporate governance on average pay higher dividends. The relation between dividends and governance is stronger for firms with high free cash flow.

Managers faced with a high takeover threat (external monitoring) are more likely to repurchase and tend to repurchase more on average. On the other hand, strong internal governance (board, institutional blockholder) allows more accurate following of managerial actions and is associated with fewer cash distributions of any kind, including repurchases.

Keywords: payout policy design, dividends, repurchases, pre-commitment, corporate governance, agency conflicts

JEL Classification: G30, G34, G35