Aurora Borealis
1 December 2015 CFA Institute Journal Review

Governance and Payout Precommitment (Digest Summary)

  1. Jakub M. Szudejko, CFA

Investigating the role of cash distribution precommitment as a substitute for corporate governance and a mitigator of managerial agency conflicts, the authors explain how debt and dividend payout policies may be beneficial for firms with weak traditional corporate governance mechanisms.

What’s Inside?

The authors investigate the role of payout and debt policies in the context of corporate governance and managerial agency problems. They focus on the link between the level of traditional corporate governance and the use of regular dividend and debt commitments to ensure that shareholders receive adequate returns.

How Is This Research Useful to Practitioners?

Such traditional corporate governance mechanisms as boards and monitoring committees that deal with agency issues can be time consuming and costly. As an alternative, firms with weak governance can precommit to cash distributions to shareholders or debtholders to impose restrictions on cash and expose the manager to additional oversight from the external financing markets.

The authors investigate various financial policy structures and find that regular cash dividends have more credibility and significance than special dividends or share repurchases because cash payouts leave little room for managerial discretion. In addition, strong adverse shareholder reaction to and steep penalties for regular dividend cuts are effective in managing agency conflicts, particularly when the monitoring mechanism is viewed as weak.

The extent of managerial agency conflicts implies that the choice of oversight level and optimal financial policies is a dividend–debt trade-off. The authors believe that the agency benefits of stricter precommitments are greatest for firms with weak management monitoring. They note that those firms more often use a combination of debt and dividends than debt alone, which is believed to be insufficient to solve agency issues.

The authors conclude that the benefits of a cash distribution commitment as a monitoring mechanism should be weighed against its costs: Debt may cause financial distress, whereas dividends incur incremental external financing costs and personal taxation.

How Did the Authors Conduct This Research?

The authors’ research is based on payout, debt, and other firm-level data for US-based entities from 1980 to 2013, depending on the availability of each characteristic. Data are from Compustat, the CRSP, and IRRC/RiskMetrics.

To measure the strength of corporate governance, the authors use antitakeover provisions as a proxy for increased managerial power and the potential for inefficient behavior because the manager is shielded from oversight. In addition, the size of the board and the presence of large institutional investors that are more likely to monitor manager performance are taken into account.

By calculating the share of dividend and interest payments in total distributions, the authors evaluate the structure of outflows committed to external claimholders, and they run sensitivity tests using Tobit and logit models to measure the relationship between antitakeover provisions and the distribution structure (i.e., the debt–dividend trade-off).

The authors use robustness checks to ensure the validity of their results and measure the significance of key assumptions.

Abstractor’s Viewpoint

The authors propose financial policy as a credible alternative to governance mechanisms, but a precommitment to distribute cash may not guarantee the alignment of manager and shareholder interests.

A cash shortfall may actually encourage a self-interested manager to erode shareholder value by cutting investment spending, increasing debt, or manipulating earnings in order to meet the commitment. The role of an independent board seems to be justified, whereas having a bank as an additional stakeholder surely helps to ensure management’s compliance.

The study is comprehensive and may be useful for investors and scholars who investigate corporate governance in US-based firms.

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