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We examine how dividends are related to the strength of shareholder rights.

The evidence reveals an inverse association between dividend payouts and shareholder rights, i.

e.

firms pay higher dividends when shareholder rights are more suppressed.

This evidence is consistent with the substitution hypothesis (La Porta, Lopez-De Salinas, Shleifter, Vishney 2000), which contends that firms with weak shareholder rights need to establish a reputation for not exploiting shareholders. As a result, these firms pay dividends more generously than do firms with strong shareholder rights. In other words, dividends substitute for shareholder rights. Further, there is some evidence that regulation influences the association between dividends and shareholder right.

[G30, G32, G34].

•Dividend payouts have been argued to mitigate agency conflicts by reducing the amount of free cash flow avail- able to managers, who may not necessarily act in the best interests of the shareholders (Grossman and Hart, 1980; Easterbrook, 1984; Jensen, 1986). In addition, Easterbrook (1984) argues that dividends help alleviate agency conflicts by exposing firms to more frequent monitoring by the primary capital markets because pay- ing dividends makes it likely that new common stock has to be issued more often.

Grounded in agency theory, this article contends that dividend payouts are influenced by the severity of agency costs and agency costs are related, in tum, to the strength of shareholder rights (Gompers, Ishii, and Metrick, 2003).

There should thus be a relation between dividend payouts and the strength of shareholder rights. We advance two competing hypotheses. The first hypothesis is primarily predicated upon the free cash flow hypothe- sis (Jensen, 1986). The managerial opportunism hypoth- esis argues that opportunistic managers are likely to retain cash within the firm, allowing them to consume more perquisites, engage in empire building, and invest in projects and acquisitions that may enhance their per- Pomsit Jiraporn is an Assistant Professor of Finance at the Great Valley School of Graduate Professional Studies, Pennsylvania State Uni- versity, in Malvern. PA 19355.

Yixi Ning is an Assistant Professor of Fi- nance at the University of Houston-Victoria in Sugarland.

TX 77901.

Most of the empirical work was conducted while the first author was affiliated with Texas A & M International University (TAMIU) in Laredo, Texas. The first author thanks TAMIU for a summer research grant, which made this project possible. We thank an anonymous referee for helpful comments and suggestions. Naturally, all remain- ing errors are ours.

sonal prestige but not necessarily benefit shareholders.

Firms with weaker shareholder rights are subject to more managerial opportunism because their managers operate at their own discretion with little monitoring from share- holders. Managers of firms with weak shareholder rights may opportunistically attempt to retain cash within the firm rather than pay it out to shareholders. The empirical prediction of this hypothesis is a positive association between dividend payouts and the strength of share- holder rights - the weaker the shareholder rights, the less paid out in dividends.

On the contrary, the substitution hypothesis is based on an argument made by La Porta et al. (2000).' This view argues that dividends substitute for shareholder rights.

This argument relies on the assumption that firms need to raise money in the external capital markets, at least occasionally. To be able to raise external funds on attractive terms, a firm must establish a reputation for moderation in expropriating shareholder rights.

One way to establish such a reputation is by paying dividends, which reduces what is left for expropriation (La Porta et al., 2000), A reputation for good treatment of shareholders is worth the most for firms with weak shareholder rights.

As a result, the need for dividends to establish a reputa- tion is the greatest for such firms. By contrast, for firms with strong shareholder rights, the need for a reputation mechanism is weaker, and, thus, so is the need to pay dividends. This view, therefore, posits that, all else equal.

'La Porta et al. (2000) examine dividend policies of firms in 33 coun- tries and provide strong empirical support for agency theory as an ex- planation of dividend payouts.

24 JIRAPORN & NING — DIVIDEND POLICY, SHAREHOLDER RIGHTS, AND CORPORATE GOVERNANCE 25 dividend payouts should be higher in firms with weaker shareholder rights. In other words, there is expected to be an inverse relation.

Following Gompers, Ishii, and Metrick (2003), we employ the Govemance Index to gauge the strength of shareholder rights. The Govemance Index measures the strength of shareholder rights in terms of how many cor- porate governance provisions exist that restrict share- holder rights. The empirical results in our study indicate that the strength of shareholder rights does affect divi- dend payouts. Specifically, the relation is negative, i.e.

firms where shareholder rights are more restricted pay higher dividends. This evidence is in favor ofthe substi- tution hypothesis.

It is worth noting that our evidence is different from that in La Porta et al. (2000), who do not find support for the substitution hypothesis. The difference may be attrib- uted to the fact that La Porta et al. (2000) examine divi- dend policies across disparate legal systems whereas our study investigates variation in dividend payouts within the US legal system. Our studies are similar in spirit, though, for we both concentrate on the link between div- idend policy and shareholder protection.

Finally, we investigate how regulation may influence the relationship between dividend policy and shareholder rights.

Regulation is likely to affect agency costs.

Because regulators already provide a certain degree of monitor- ing, managers of regulated firms should be less able to reap private benefits at the expense of shareholders (Booth, Comett, and Tehranian, 2002; Kole and Lehn, 1997).

This potential reduction in agency costs may have implications for the association between dividend pay- outs and shareholder rights. Accordingly, when we explicitly distinguish between regulated and unregulated firms, we find that regulation does have an impact.^ I. Sample Selection and Data A. Sample Selection The original sample in this study is compiled from the Investor Responsibility Research Center (IRRC) corpo- rate govemance database. The IRRC collects data on corporate govemance provisions, which we use to mea- sure the strength of shareholder rights, for about 1500 firms from various sources, such as annual reports, proxy statement, and SEC 10-Q and 10-K documents. The sample of IRRC firms, mainly drawn from the S&P 500 and other large corporations, represents over 90% of total market capitalization on NYSE, AMEX, and NASDAQ. However, the IRRC expanded the sample by ^In this article, we employ utility firms to represent regulated companies.

adding several hundreds of smaller firms with high insti- tutional ownership in 1998.^ The IRRC collects data only periodically and so our sample is restricted to the years for which the IRRC has data on corporate governance. We use data from 1993, 1995, 1998, 2000, and 2002. We then eliminate firms whose accounting data are not available in COMPUSTAT. Financial firms with SIC codes between 6000 and 6999 are excluded because they have different accounting and financial characteristics. Exhibit 1 dis- plays the distribution of the final sample by year. The final sample consists of 3,732 firm-year observations.

B.The Governance Index (GINDEX) To measure the strength of shareholder rights, we employ the Govemance Index (GINDEX) developed by Gompers, Ishii and Metrick (2003), henceforth GIM.

They use data from the IRRC, which publishes detailed listings of corporate govemance provisions for individ- ual firms in Corporate Takeover Defenses (Rosenbaum 1993, 1995, 1998, 2000, and 2002)." The data on gover- nance provisions are derived from various sources, such as corporate bylaws, charters, proxy statements, annual reports, as well as 10-K and 10-Q documents filed with the Securities and Exchange Commission (SEC). Exhibit 2 lists the individual governance provisions included in the construction ofthe Govemance Index. GIM classify provisions into 5 categories: tactics for delaying hostile bidders (Delay); voting rights (Voting); director/oificer protection (Protection); other takeover defenses (Other); and state laws (State).

The Govemance Index is constructed as follows; for every firm, GIM add one point for every provision that restricts shareholder rights (increases managerial power).

While this index may not accurately refiect the relative impacts of the various provisions, it has the advantage of being transparent and easily reproducible. The index does not require any judgments about the efficacy or wealth effects of any of these provisions; GIM only con- siders the impact on the balance of power.

'Since the IRRC database only included large corporations before 1998, and added several hundred firms in 1998, the empirical results using the full sample may be biased towards large corporations. As a robustness check , we employ only the data from 1998 and later years and repeat our analysis. The findings remain similar.

•"This index has been widely employed in a large number of recent studies. For instance, the Govemance Index has been related to capital structure (Jirapom and Gleason, 2006), to the cost of debt financing (Klock, Mansi, and Maxwell, 2005), to the cost of bank loans (Chava, Dierker, and Livdan, 2005), to the cost of equity (Huang, 2005), to corporate diversification (Jirapom, Kim, Davidson, and Singh, 2006), to CEO compensation (Jirapom, Kim, and Davidson, 2005), and to auditor selection (Jirapom, 2006).

26 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006 Exhibit 1. Sample Distribution by Year The sample is derived from the Investor Responsibility Research Center (IRRC). Firms are excluded whose financial data are not available on COMPUSTAT. IRRC collects data on corporate governance provisions only periodically. Hence, our sample is limited to the years 1993, 1995, 1998, 2000, and 2002.

Year N Percent 1993 1995 1998 2000 2002 Total 598 650 843 804 837 3,732 16.02% 17.42% 22.59% 21.54% 22.43% 100.00% To clarify the logic behind the construction of the Govemance Index, GIM use the following example in their paper:

For example, consider classified boards, a provision that staggers the terms and elections of directors and, thus, can be employed to slow down a hostile takeover.

If management uses this power judiciously, it could possibly lead to an increase in overall shareholder wealth; if management, however, uses this power to maintain private benefits of control, then this provision would diminish shareholder wealth.

In either case, it is apparent that classified boards enhance the power of managers and weaken the control rights of large shareholders, which is all that matters for constructing the index.

(Gompers, Ishii and Metrick 2003, p. 114) Most provisions other than classified boards can be viewed by the same logic. Almost every provision enables management to resist different types of shareholder activism, such as calling special meetings, changing the firm's charter or bylaws, suing directors, or replacing them all at once. GIM note, however, that there are two exceptions, secret ballots (confidential voting) and cumulative voting. A secret ballot or confidential voting designates a third party to count proxy votes and, there- fore, prevents management from observing how spe- cific shareholders vote. Cumulative voting enables shareholders to concentrate their directors' votes so that a large minority shareholder can ensure some board representation. These two provisions are usually pro- posed by shareholders and opposed by management because they enhance shareholder rights and diminish the power of management. GIM add one point to the Governance Index when firms do not have each of these provisions. For all other provisions, GIM add one point when firms do have each of them. The Govemance Index is the sum of one point for the presence (or absence) of each provision.

II.

Empirical Results A. Descriptive Statistics Exhibit 3 shows the descriptive statistics for the Govemance Index. A high value for the index indicates that a firm has weak shareholder rights, and a low value indicates that the firm has strong shareholder rights. The Govemance Index averages 9.36 (9.00 median) for our sample, suggesting that on average the sample firms impose 9 govemance provisions that restrict shareholder rights.

The median firm in GIM has 9 govemance provi- sions as well. Thus, it seems that our sample is reason- ably representative of the slightly larger sample used by GIM.5 We employ three altemative measures of dividends.

We use the dividend/eamings ratio, the dividend/sales ratio, and the dividend yields Exhibit 3 Panel B shows the descriptive statistics for the dividend payout ratios.

The dividend/eamings ratio averages 0.2966 (0.1263 median) and the dividend/sales ratio averages 0.0179 (0.0086 median). The average dividend yield is 1.7% (1.0% median). The percentage of firms paying divi- dends in our sample is 69.02%.

Exhibit 3 Panel C shows the summary statistics for the sample firms. The average firm has $4,168 million in sales ($1,292 median) and $4,520 million ($1,330 median) in total assets, suggesting that our sample firms are large. The long-term debt to total assets ratio aver- ages 23.65% (22.66% median). On average, the sample firms are profitable as evidenced by the average EBIT 'The Govemance Index ranges from 2 to 18. Gompers et al (2003) classify a firm whose Govemance Index is less than 5 as a democracy whereas one whose Index is greater than 14 is regarded as a dictator- ship.

Hence, it appears that our sample encompasses some "demo- cratic" and "dictatorial" firms.

'The dividend yield is the cash dividend divided by the stock price (end-of-year price).

JIRAPORN & NING — DIVIDEND POLICY, SHAREHOLDER RIGHTS, AND CORPORATE GOVERNANCE 27 Exhibit 2. Individual Governance Provisions Employed in the Construction of the Governance index The detailed explanation for each govemance provision is available in the Appendix of Gompers, Ishii, and Metrick (2003) Delav Blank Check Classified Board Special Meeting Written Consent Compensation Plans Contracts Golden Parachutes Indemnification Liability Severance Voting Bylaws Charter Cumulative Voting Secret Ballot (Confidential Voting) Supermajority Unequal Voting Other Anti-greenmail Directors' duties Fair Price Pension Parachutes Poison Pill Silver Parachutes State Anti-greenmail Law Business Combination Law Cash-out Law Directors' duties Law Fair Price Law Control Share Acquisition Law Note: Cumulative voting and secret ballot (confidential voting) are usually proposed by shareholders and opposed by management because they enhance shareholder rights and diminish management powers. GIM add one point to the Govemance Index when firms do not have each of these provisions. For all other provisions, GIM add one point when firms do have each of them.

The Govemance Index is the sum of one point for the presence (or absence) of each provision.

ratio of 12.48% (13.60% median). Tobin's Q', which proxies for growth opportunities, averages 1.43 (1.06 median). Finally, Exhibit 3 Panel D shows the descrip- tive statistics for the board of directors, the average (median) percentage of independent directors is 64.22% (66.67% median) while the average board size is 9.33 (9.00 median). The board size in our sample is similar to that in Denis and Sarin (1999), who employ a sample of randomly selected CRSP-Hsted firms, but the proportion of independent directors is higher than their randomly- chosen sample.

B. Univaritate analysis The univariate results are displayed in Table 4.

To deter- mine the association between dividends and shareholder rights, we create two extreme portfolios based on the Govemance Index as in GIM.

Firms where the Govemance Index is equal to or higher than 14 are included in the "dictatorship" portfolio because shareholder rights are severely restricted in these firms. On the contrary, firms 'Tobin's Q is calculated based on Chung and Pmitt (1994). Tobin's Q is the sum ofthe market value of equity and the book value of debt di- vided by the book value of assets.

The book value of debt is the differ- ence between the book value of assets and the book value of equity.

where the Govemance Index is lower than or equal to 5 are placed in the "democracy" portfolio as shareholders enjoy strong shareholder rights in these firms.

Then, we compare dividend payouts between the dic- tatorship portfolio with 232 firms and the democracy portfolio with 330 firms. The results in Exhibit 4 indi- cate that the dividend/eamings ratio averages 0.8295 (0.2693 median) for the dictatorship portfolio and 0.0428 (0.0000 median) for the democracy portfolio. The differ- ence is statistically significant at the 5% level. The results also reveal that the average dividend/sales ratio is 0.0176 (0.0152 median) for the dictatorship portfolio and 0.0136 (0.0017 median) for the democracy portfo- lio.

The difference is statistically significant at the 10% level. Finally, the dividend yield averages 0.0209 (0.0197 median) for the dictatorship portfolio and 0.0116 (0.00 median) for the democracy portfolio. The differ- ence is significant at the 0.1 % level. We also find that the percentage of dividend-paying firms in the dictatorship portfolio (83.19%) is much higher than that in the democracy portfolio (53.64%).

Thus, it appears that firms with more restrictive gover- nance are more likely to pay dividends, and dividend- paying firms pay more dividends than do those with more liberal govemance. This is evidence in favor ofthe substi- tution hypothesis. Firms with suppressive govemance 28 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006 Exhibit 3. Descriptive Statistics Leverage is defined as long-term debt divided by total assets. The EBIT ratio is earnings before interest and taxes divided by total assets.

Tobin's Q proxies for growth opportunities and is calculated based on Chung and Pruitt (1994). Cash dividends are defined as total cash dividends paid to common and preferred stockholders.

Governance Index N Mean Panel A.

Governance 9.36 3,732 Panel B. Dividends Median 9.00 3,732 S.D.

2.73 3,732 Cash Dividends Cash Dividends/Earnings Cash Dividends/Sales Dividend Yield % of Dividend-Paying Firms 90.67 0.2966 0.0179 0.0170 69.02% 9.20 0.1263 0.0086 0.0100 305.92 2.8973 0.0293 0.0577 Panel C. Firm Characteristics Sales Total Assets Leverage EBIT Ratio Tobin's Q 4,168 4,520 23.65% 12.48% 1.43 1,292 1,330 22.66% 13.60% 1.06 9,842 10,033 15.65% 86.97% 1.23 Panel D.

Board Characteristics % of Independent Directors Board Size 64.22% 9.33 66.67% 9.00 18.42% 2.62 (and hence weak shareholder rights) need to establish a reputation for not exploiting shareholders. One way to do so is to distribute cash through dividend payouts. Hence, dividends serve as a substitute for shareholder rights.

Because the univariate results might merely reflect differ- ences in firm-specific attributes, we further test the hypoth- esis using a regression analysis in the next section.

C. Regression Analysis Exhibit 5 shows the results of the regression analy- sis.

A number of control variables are included. We employ the natural logarithm of total assets to proxy for firm size.

Profitability has been found to affect dividend policy (DeAngelo and DeAngelo, 1990; DeAngelo, DeAngelo, and Skinner, 1992). Thus, we control for profitability by using the EBIT/sales ratio. Growth has been reported to impact dividend policy as well (Rozeff, 1982).

We control for firm growth by using Tobin's Q. Leverage also influences dividend policy both because of its role in mitigating agency costs and because of debt covenants on dividends imposed by debtholders. Our proxy for leverage is the ratio of long-term debt to total assets.

Finally, with the growing importance and popu- larity of share repurchases, we include several share repurchase ratios to control for this alternative means of cash distribution.* Share repurchases could affect divi- dend payouts because cash spent on repurchases could otherwise be distributed as dividends (Grullon and Michaely, 2002).' In Model 1, the dividend/earnings ratio is the depen- dent variable; the Governance Index produces a positive and significant coefficient (t = 3.33, significant at the 0.1% confidence level). In Model 2 where the dependent variable is the dividend/sales ratio, the coefficient of the Governance Index is positive and significant (t = 3.97, significant at 0.1% level). Similarly, the Governance Index shows a positive and significant coefficient (t = 1.83, significant at 10% level) in Model 3 when we employ the dividend yield as the dependent variable. The results indicate a positive association between dividends "Repurchase activity is measured as in Dittmar (2000) using COMPUSTAT item 115 adjusted for change in preferred stock.

'Since cross-sectional dividend payout models are sensitive to the se- lection of control variables, we conduct a sensitivity analysis by using alternative control variables. For example, we use sales instead of total assets to measure firm size, total debt ratio in lieu of financial lever- age, market-to-book ratio for growth opportunities, and return on as- sets (ROA) rather than EBIT ratio to proxy for firm profitability. The alternative specifications yield similar results.

JIRAPORN & NING — DIVIDEND POLICY, SHAREHOLDER RIGHTS, AND CORPORATE GOVERNANCE Exhibit 4. Univariate Analysis of Dictatorship and Democracy Portfolios 29 The dictatorship portfolio represents firms where the Govemance Index is equal to or greater than 14 while the democracy portfolio includes firms whose Governance Index is equal to or less than 5.Leverage is defined as long-term debt divided by total assets.

The EBIT ratio is earnings before interest and taxes divided by total assets. Tobin's Q proxies for growth opportunities and is calculated based on Chung and Pruitt (1994). Cash dividends are defined as total cash dividends paid to common and preferred stockholders. Means are the first figures in each pair, and medians are in parentheses.

Dictatorship Democracy Difference (t-statistics) Cash Dividends/Earnings Cash Dividends/Sales Dividend Yield % of Dividend-paying Firms Total Assets Leverage EBIT Ratio Tobin's Q % of Independent Directors Board Size N 0.8295 (0.2693) 0.0176 (0.0152) 0.0209 (0.0197) 0.8319 3,382 (2,033) 26.17% (24.97%) 12.40% (12.78%) 1.26 (1.06) 69.74% (72.73%) 10.28 (10.00) 232 0.0428 (0.0000) 0.0136 (0.0017) 0.0116 (0.0000) 0.5364 3,964 (756) 23.70% (21.73%) 12.79% (14.48%) 1.55 (1.11) 52.62% (50.00%) 8.16 (8.00) 330 -2.01** -1.87* -3.83*** - 0.89 -1.74* 0.14 3.16*** 6.77*** -8.40*** *statistically significant at the . 10 level.

**statistically significant at the .05 level.

***statistically significant at the .10 level.

and the Govemance Index, i.e. firms where shareholder rights are weak (high Govemance Index), pay higher divi- dends.

This is again consistent with the substitution hypothesis. Firms with weak shareholder rights pay out higher dividends to alleviate the perception that share- holders may be exploited. In other words, high dividends compensate for weak shareholder rights in these firms.

As a robustness check, we run altemative regressions allowing individual firm fixed-effects. Fich and Shivdasani (2006) champion the use of fixed-effects regressions because the approach is robust to the pres- ence of omitted fimi-specific variables. The results remain qualitatively similar and, therefore, appear to be robust to the estimation method.'" Finally, in Model 4, we explore whether shareholder rights affect the decision to pay a dividend of any size or not to pay anything at all. The dependent variable is a dichotomous variable equal to 1 if the firm pays a divi- dend of any size and 0 if the firm does not pay a dividend "The fixed-effects results are not shown but available upon request.

at all. The results of the logistic regression reveal that the Govemance Index has a positive and significant coeflfi- cient. This implies that firms with more restrictive gov- emance (weaker shareholder rights) are more likely to pay dividends, which further confirms our findings in the univariate analysis. Again, this evidence is in agreement with the prediction of the substitution hypothesis.

Incidentally, it is worth noting that two of the three repurchase ratios in Exhibit 5 (repurchase/eamings and repurchase/sales) and the repurchase dummy show posi- tive and significant coefficients. This suggests that firms that pay higher dividends tend to spend more on repur- chases as well. Dividends and repurchases are not found to substitute for each other, at least in our sample.

The board of directors is a crucial govemance mecha- nism. Hence, the extent of agency conflicts may be affected by the structure of the board. For example, fimis with weak shareholder rights may not suffer severe agency costs if they have strong boards. Since our hypothesis on dividend policy is predicated on agency theory, it would be appropriate to control for board 30 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006 Exhibit 5. Regressions of Dividend Payouts on the Governance Index and Controls Leverage is defined as long-term debt divided by total assets. The EBIT ratio is earnings before interest and taxes divided by total assets. Tobin's Q proxies for growth opportunities and is calculated based on Chung and Pruitt (1994). Cash dividends are defined as total cash dividends paid to common and preferred stockholders. Repurchase activity is measured as in Dittmar (2000) using COMPUSTAT item 115 adjusted for change in preferred stock. The repurchase dummy is equal to one if the firm has repurchase activity of any amount, 0 otherwise.

Independent Variable Intercept Govemance Index Ln (Total Assets) Leverage Profitability Growth Opportunities Repurchase/Earnings Repurchase/Sales Repurchase/MV of Equity Repurchase Dummy N F-statistic Adjusted R^ Pseudo R^ *statistically significant at the .10 level.

''statistically significant at the .05 level.

'''statistically significant at the .10 level.

Model 1 (t-statistics) Div./Eamings -0.602" (-2.31) 0.053'** (3.33) 0.050* (1.67) -0.147 (-0.52) -0.001 (-0.02) -0.027 (-0.74) 0.362*** (27.32) - - - 3,732 126.96**' 16.8% - Model 2 (t-statistics) Div./Sales -0.027*** (-9.83) 0.001"* (3.97) 0.005"* (15.06) 0.001 (0.47) 0.002'" (3.26) 0.002'" (3.88) - 0.026'" (2.92) - - 3,732 55.13'" 8.0% - Model 3 (t-statistics) Dividend Yield -0.000 (-0.05) 0.001' (1.83) 0.002'" (3.65) -0.001 (-0.17) 0.002* (1.90) -0.004*** (-5.17) - - -0.025 (-1.23) - 3,731 8.39'" 1.2% - Model 4 (Wald-statistics) Div. Dummy -3.572**' (216.41) 0.155'" (114.09) 0.423*" (195.67) -0.727'" (8.83) 1.048"* (23.27) -0.166*** (27.34) - - - 0.377*" (23.37) 3,732 - - 19.2% Structure. Two features of the board that have gamered enormous attention in the literature are board composi- tion and board size." Therefore, we collect data on the percentage of independent directors and on board size from the IRRC director database.

The data on board struc- ture are available for 2,283 observations (out of 3,723).

In Exhibit 6, we replicate the regressions in Exhibit 5 but include board composition and board size as control variables. As shown in Exhibit 6, the coefficients of the Govemance Index in all models remain positive and sig- nificant. Thus, even when board structure is taken into account, the inverse relation between shareholder rights and dividend payouts still persists. Finally, we attempt to "On board composition, see Hermalin and Weisbach (1991), Cotter, Shivdasani, and Zenner (1997), Mayers, Shivdasani, and Smith (1997), Bhagat and Black (2001), among others.

On board size, see Lipton and Lorsch (1992), Jensen (1993), Yermack (1996), Denis and Sarin (1999), and Eisenberg, Sundgren, and Wells (1998), among others.

capture the temporal variation in dividend policy by includ- ing year dummies.

Fama and French (2001) document that dividend payouts decline over time. In additional regres- sions (results not shown), we include the year dummies and obtain qualitatively similar results. It thus does not appear that the declining dividend payouts documented in Fama and French (2001) materially affect our results.'^ D. Possible Endogeneity between Shareholder Rights and Dividend Policy We have found empirical evidence, supporting the substitution hypothesis that firms with weak shareholder '^Furthermore, Fama and French (2001) report that firms that pay lower dividends tend to be small firms with less profitability and strong growth opportunities.

We do control for these firm characteristics in this study.

JIRAPORN & NING — DIVIDEND POLICY, SHAREHOLDER RIGHTS, AND CORPORATE GOVERNANCE 31 Exhibit 6. Regressions of Dividend Payouts on the Governance Index and Controls with Board Variables Leverage is defined as long-term debt divided by total assets. The EBIT ratio is earnings before interest and taxes divided by total assets.

Tobin's Q proxies for growth opportunities and is calculated based on Chung and Pruitt (1994). Cash dividends are defined as total cash dividends paid to common and preferred stockholders. Repurchase activity is measured as in Dittmar (2000) using COMPUSTAT item 115 adjusted for change in preferred stock. The repurchase dummy is equal to one if the firm has repurchase activity of any amount, 0 otherwise. Board data are not available until 1998.

Independent Variable Intercept Govemance Index Log of Board Size % of Independent Directors Ln (Total Assets) Leverage Profitability Growth Opportunities Repurchase/Eamings Repurchase/Sales Repurchase/MV of Equity Repurchase Dummy N F-statistic Adjusted R^ Pseudo R^ *statistically significant at the **statistically significant at the ***statistically significant at the Model 1 (t-statistics) Div./Eamings -L069** (-2.03) 0.072*** (2.81) 0.216 (0.81) -0.385 (-1.05) 0.046 (0.84) -0.067 (-0.16) -0.059 (-0.31) -0.010 (-0.21) 0.299*** (13.39) - - - 2,283 24.06*** 7.5% - .10 level.

.05 level.

.10 level.

Model 2 (t-statistics) Div./Sales -0.057*** (-16.61) 0.0003* (1.77) 0.015*** (8.57) 0.018*** (7.28) 0.002*** (6.88) 0.012*** (4.11) 0.008*** (6.56) 0.002*** (5.69) - 0.024*** (3.28) - - 2,283 71.51*** 19.8% - Model 3 (t-statistics) Dividend Yield -0.033*** (-2.98) 0.000* (1.83) 0,021*** (3.75) 0.019** (2.49) -0.001 (-0.85) 0.007 (0.75) 0.015*** (3.68) -0.004*** (-3.47) - -0.023 (-0.87) - 2,283 7.13*** 2.1% - Model 4 (Wald-statistics) Div. Dummy -7.670*** (278.63) 0.128*** (40.58) 2.173*** (104.32) 0.645** (5.40) 0.224*** (26.04) 0.774*** (5.40) 0.773*** (8.39) -0.107*** (7.61) _ - 0.385*** 2,283 _ _ 26.9% rights are more likely to pay dividends more generously.

We draw the conclusion that a firm's dividend policy is caused by the strength of shareholder rights. However, numerous prior studies have documented the potential effects of dividend payments on agency conflicts between shareholders and managers (Grossman and Hart, 1980; Easterbrook, 1984; Jensen, 1986). It is conceivable that a firm's dividend policy may affect its shareholder rights as measured by the Govemance Index. In light of this argument, we fiarther examine a possible endogenous relation between dividend policy and shareholder rights.

Shareholder rights and dividend policy may have a bi- directional causality. One way to test the endogenous relation between shareholder rights and dividend policy is to construct a simultaneous equation model that can be estimated by 2-stage or 3-stage least square regressions.

However, it is difficult to find truly exogenous instru- ments variables for the model (Himmelberg, Hubbard, and Palia, 1999; Gompers, Ishii, and Metrick, 2003).

As a consequence, we follow Chi (2005) in exploring the correlations between changes in Govemance Index and changes in dividend payments. If changes in the Govemance Index are correlated with fiiture changes in dividend payments, it is more likely that shareholder rights influence dividend policy. On the contrary, if changes in the Govemance Index are correlated with past 32 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006 changes in dividend payments, it is more likely that divi- dend policy influences the strength of shareholder rights.

Correlations between changes of GINDEX and the three dividend variables provide some evidence that changes in the Govemance Index are positively correlated with future changes in the dividend/sales ratio (p = 0.012) and the dividend yield (p = 0.020) from Year +1 to Year + 2.

The evidence thus shows that it is more likely that the strength of shareholder rights affects dividend policy." On the contrary, we do not find any significant evidence that dividend policy affects the Govemance Index.

We fiirther explore the causal relationship between dividend policy and shareholder rights using a Granger causality test (Granger, 1969)'^ The Granger causality analysis tests the condition that changes in the cause var- iables should precede changes in the effect variables. So we consider the following models:

(1) (2) Other control variables + /i, GI,= Other control variables + e, where ^, and e, are uncorrelated error terms.

ifS^i^O and 72 ^ 0, we infer an endogenous bi-directional relationship between shareholder rights and dividend policy. lfd,^O but y2 = 0, it is more likely that the Govemance Index affects dividend policy. If (5, = 0 but }'2 T^ 0, it is more likely that dividend policy affects shareholder rights.

If both ^1 = 0 and 72 = 0, dividend policy is not related to shareholder rights.

For the causal relation between the Govemance Index and the ratio of cash dividend to eamings, Exhibit 7 shows that S, = 0.055, which is significantly different from zero (t = 2.69, significant at the 1% level). But 72 is not different from zero statistically (t = -0.79, insignifi- cant).

Hence, we infer unidirectional and positive Granger causality from shareholder rights to the ratio of cash dividends to eamings. We also document similar uni-directional Granger causality from the Govemance Index to the cash dividend/sales ratio (3, 7^ 0, t = 2.67; 72 = 0, t = 0.24), and from the Govemance Index to the dividend yield (^, ?t 0, t = 5.84; 72 = 0, t = 0.93). The Govemance Index has a positive impact on both the dividend/sales ratio and the dividend yield.

"The correlation analysis between changes in shareholder rights and dividend policies are not shown but are available upon request.

"A typical caveat is that Granger-causality can establish that one vari- able helps forecast or predict the other variable. While this may be a necessary condition for causality, it is certainly not a sufficient condi- tion since causality should be grounded a priori on theory and should not be inferred from empirical data. Hence, we do recognize that true causality may not be determined simply by using this methodology, we only make a modest claim that Granger-causality can increase the probability that the alleged causal relationship does in fact exist.

Given the correlation analysis and the Granger cau- sality test shown in Exhibit 7, we conclude that there is no endogenous relation between a firm's shareholder rights and its dividend policy.

While a firm's Govemance Index positively affect dividend policies, as predicted by the substitution hypothesis, the firm's dividend pol- icy has no observable effects on the strength of share- holder rights.

E. Regulated Firms We have noted that the association between dividends and shareholder rights may be impacted by regulation.

Regulation serves as an extemal mechanism that helps control agency costs. Hence, regulated firms may rely, to a lesser extent, on dividends to mitigate agency conflicts.

To test the impact of regulation, we segregate the full sample into industrial (unregulated) firms and regulated firms and re-estimate the regressions. The regulated sub- sample includes 367 utility firms (SIC codes between 4900 and 4999). The rest of the firms in the full sample are classified as industrial unregulated firms'^ The results for the industrial (unregulated) subsample are qualitatively similar to those for the full sample (results not shown). However, the results for the regu- lated utility subsample are different. Exhibit 8 displays the results of the regressions for the regulated subsam- ple.

In Model 1, the Govemance Index does not show a significant coefficient (t = 1.64).

In Model 2, the coeffi- cient of the Govemance Index is significant but negative (t = -1.76, significant at 10% confidence level). Finally, in Model 3, the Govemance Index produces an insignifi- cant coefficient (t = -0.56) when we use the dividend yield as the dependent variable. Hence, none of the results here suggest a positive relation. This is contrary to the results for the fiill sample and for the industrial sample. It seems that regulation does affect the associa- tion between dividends and shareholder rights. The rela- tion reported earlier does not appear to exist in regulated firms.

Finally, we estimate a logistic regression in Model 4 where the dependent variable is a dummy variable equal to 1 if the firm pays a dividend of any size and 0 if it does not pay anything at all.

The coefficient of the Govemance Index is positive and significant, implying that regulated firms with weaker shareholder rights are more likely to pay dividends (as opposed to not paying anything at all).

However, for firms that do pay dividends of any size, the amount of the dividend is not related to the strength of shareholder rights. Thus, there is partial but not com- plete support for the substitution hypothesis here.

"Financial firms (SIC codes 6000-6999) are not included due to their different accounting and financial characteristics.

JIRAPORN & NING — DIVIDEND POLICY, SHAREHOLDER RIGHTS, AND CORPORATE GOVERNANCE 33 Exhibit 7. Granger Causality Test of Shareholder Rights and Dividend Policies Leverage is defined as long-term debt divided by total assets. The EBIT ratio is earnings before interest and taxes divided by total assets.

Tobin's Q proxies for growth opportunities and is calculated based on Chung and Pruitt (1994). Cash dividends are defined as total cash dividends paid to common and preferred stockholders. Repurchase activity is measured as in Dittmar (2000) using COMPUSTAT item 115 adjusted for change in preferred stock. The repurchase dummy is equal to one if the firm has repurchase activity of any amount, 0 otherwise.

Div./ Earnings(t) GINDEX(t) Div./ Sales(t) GINDEX(t) Dividend Yield(t) GINDEX(t) Constant Governance Index (t-1) Div./Eamings(t-1) Div./Sales(t-1) Dividend Yield(t-l) Ln (Total Assets) Leverage Profitability Growth Opportunities Repurchase/Earnings Repurchase/Sales Repurchase/MV of Equity N Adjusted R^ F -0.703** (-2.01) 0.055*** (2.69) -0.004 (-0.21) - - 0.056 (1.40) 0.162 (0.42) 0.003 (0.06) -0.027 (-0.58) 0.311*** (15.60) - - 2375 9.4% 36.22 *** 1.38*** (11.0) 0.895*** (122.7) -0.006 (-0.79) - - -0.019 (-1.36) 0.156 (1.13) 0.010 (0.53) 0.001 (0.08) -0.002 (-0.29) — — 2375 86.5% 2178.5*** -0.012*** (-5.58) 0.0003*** (2.67) - 0.515*** (45.89) - 0.002*** (7.30) 0.002 (0.63) 0.001 (1.63) 0.002*** (5.76) — -0.001 (-0.09) - 2375 52.5% 376.5*** 1.382*** (10.93) 0.894*** (122.6) — 0.154 (0.24) - -0.020 (-1.37) 0.159 (1.15) 0.010 (0.53) 0.003 (0.17) __ -0.168 (-0.42) — 2375 86.5% 2178.0*** 0.009*** (-3.66) 0.001*** (5.84) __ __ 0.046*** (8.70) 0.003*** (9.32) 0.009*** (3.35) 0.001 (1.66)* 0.003*** (-9.43) __ -0.007 (-0.88) 2375 12.4% 48.8*** 1.393*** (11.07) 0.894*** (122.8) -0.260 (-0.93) -0.020 (-1.38) 0.163 (1.18) 0.010 (0.55) 0.000 (-0.1) -0.353 (-0.90) 2375 86.5% 2179.5 *statistically significant at the .10 level.

**statistically significant at the .05 level.

***statistically significant at the . 10 level.

F. Robustness Checks A number of robustness checks are conducted to con- firm the results. First, out of concern that the results may be driven by industry effects, we industry-adjust all the variables and re-estimate the regressions.

The industry adjustment for each variable is accomplished by sub- tracting the industry median value from each given vari- able.

We use the first 2 digits of the SIC to identify the industry.

The results remain qualitatively the same even after the adjustment and, therefore, do not seem to be susceptible to an industry effect. Second, in case that outliers may have unduly affected the results, we exclude the extreme 5% of the observations and re-estimate the regressions. Again, the results remain similar, suggesting that outliers do not pose a problem in our dataset.

Further, since preferred stocks are hybrid securities and have some features of liabilities (e.g., fixed amount of preferred dividend payments), one argument is that we should exclude preferred dividends from the divi- dend measures.

To address this issue, we first conduct a Pearson correlation test between common dividends and total cash dividends. The Pearson correlations coefficient for the two dividend measures is as high as 99.9%.

In addition, we calculate the ratios of common dividends to earnings, common dividend to sales, and common 34 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006 Exhibit 8. Regressions of Dividend Payouts on the Governance Index and Controis for the Regulated Subsample Leverage is defined as long-term debt divided by total assets. The EBIT ratio is eamings before interest and taxes divided by total assets.

Tobin's Q proxies for growth opportunities and is calculated based on Chung and Pruitt (1994). Cash dividends are defined as total cash dividends paid to common and preferred stockholders. Repurchase activity is measured as in Dittmar (2000) using COMPUSTAT item 115 adjusted for change in preferred stock. The repurchase dummy is equal to one if the firm has repurchase activity of any amount, 0 otherwise.

Independent Variable Intercept Govemance Index Ln (Total Assets) Leverage Profitability Growth Opportunities Repurchase/Eamings Repurchase/Sales Repurchase/MV of Equity Repurchase Dummy N F-statistic Adjusted R^ Pseudo R^ •statistically significant at the •'statistically significant at the •••statistically significant at the Model 1 (t-statistics) Div./Eamings 1.024 (0.45) 0.151 (1.64) -0.133 (-0.78) -1.900 (-0.71) 0.948 (0.58) -0.766 (-0.66) 0.451 (2.57) - - - 367 2.03' 1.7% - .10 level.

.05 level.

.10 level.

Model 2 (t-statistics) Div./Sales 0.040^'' (2.70) -0.001^ (-1.76) 0.001 (0.75) -0.065'^^ (-3.77) 0.086**^ (8.10) 0.018'^ (2.41) - 0.040 (1.29) - - 367 18.63^'' 22.4% - Model 3 (t-statistics) Dividend Yield 0.009^*' (7.88) 0.000 (-0.56) -0.001 (-0.94) -0.008 (-0.63) -0.005 (-0.64) -0.034^^' (-5.75) - - -0.041 (-1.32) - 367 6.96'^^ 8.9% - Model 4 (Wald-statistics) Div. Dummy -2.867 (0.64) 0.544'^* (8.18) 0.697^^ (6.54) .14.064''^ (14.78) 2.632 (2.44) 0.368 (0.03) - - - 1.389 (2.51) 367 - - 44.3% dividend yield'* and, then, repeat the previous univariate analysis and multiple regressions. We obtain similar results as before. Finally, it can be argued that dividend payouts are a censored variable as it cannot be belov*' zero. We replicate all regressions using a Tobit analysis and obtain similar results. Since the results are subject to so many robustness checks and still do not change qualitatively, they seem to be robust.

III.

Concluding Remarks In this study, the empirical evidence demonstrates that dividend payouts are inversely related to the strength of "In other words, we exclude preferred dividends.

shareholder rights. Firms where shareholder rights are weak pay out higher dividends. This is in agreement with the substitution hypothesis, which posits that firms where shareholder rights are weaker try to establish a good rep- utation for not taking advantage of shareholders by pay- ing out more as dividends. Hence, dividends compensate for the weak shareholder rights. Further analysis also reveals that regulation does influence the association between dividends and shareholder rights.

This study is conducted in the same spirit as La Porta et al.

(2000) for both of our studies relate dividend payouts to agency problems. The empirical results, however, are dissimilar. La Porta et al. (2000) do not find support for the substitution hypothesis while we do in this study. We conjecture that the dissimilarity of our results, perhaps, lies in the fact that the extemal capital markets in the US JIRAPORN & NING — DIVIDEND POLICY, SHAREHOLDER RIGHTS, AND CORPORATE GOVERNANCE 35 are highly developed and, thus, provide better monitor- ing. Therefore, the need to establish a favorable reputa- tion in order to raise capital on attractive terms is stronger here than elsewhere in the world. As a result, the substitution hypothesis is supported when we look at the variation across firms but within the US legal system as opposed to La Porta et al. (2000) who examine divi- dend policies across disparate legal systems. In any case, both of our studies agree that the agency approach is highly relevant to our understanding of corporate div- idend policy.

This study contributes to the literature both in dividend policy and in agency theory.

As far as dividend policy, we show that shareholder rights are a significant determinant of dividend policy.

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