Can Firms Build Capital-Market Reputation to Substitute for Poor Investor Protection?

The following post comes to us from Jie Gan, Professor of Finance at Cheung Kong Graduate School of Business, Beijing, China; Michael Lemmon, Professor of Finance at the University of Utah; and Martin Wang of Hang Seng Bank.

In the paper, Can Firms Build Capital-Market Reputation to Substitute for Poor Investor Protection? Evidence from Dividend Policies, which was recently made publicly available on SSRN, we provide empirical evidence of one particular commitment mechanism that firms use to establish a reputation for good treatment of shareholders. Specifically, we show that in countries where legal protection of shareholders is weak, firms with good growth prospects establish capital-market reputation through commitments to generous dividends so that they can gain better access to the equity market in the future. To qualify for a credible commitment, two conditions need to be satisfied. First, it has to be costly so that other (bad) firms do not want to mimic. Second, it has to be “credible” in the sense that there is significant gain from the (costly) commitment. Dividends are costly because they reduce the amount of earnings that can be retained to fund future growth and, because external financing is more costly than internally generated funds. Moreover, dividends are particularly costly to insiders in countries with weak legal protection of shareholders because in these countries it is easy for insiders to expropriate corporate profits and paying out profits as dividends reduces the opportunity for expropriation. Dividend payouts also bring potential benefits by exposing companies to the need of raising new money in the capital market in the future, thus precipitating monitoring from the outside investors, and reducing future financing costs (Easterbrook, 1984).

Based on a sample of 17,483 firms in 40 countries during the period 1985-2005, our empirical analysis shows that, in countries where investor protection is weak, growth firms tend to initiate dividends earlier and pay a higher level of dividends than their counterparts in countries with strong investor protection. This result is even stronger for those growth firms that are more dependent on equity financing. There is also evidence that, in weak protection countries, high-growth and equity dependent firms pay more dividends even as compared with mature firms; a result in sharp contrast to the findings from countries with strong legal protection for minority investors (La Porta et al. (2000)). Furthermore, consistent with the hypothesis that firms commit to high dividends to obtain better access to equity markets, in countries with weak investor protection (but not in strong-protection countries), growth firms and equity-dependent firms with a good dividend history raise significantly more equity financing. Similarly, firms that have recently raised dividends also obtain significantly more equity financing proceeds, in weak investor protection countries.

The empirical patterns we identify would be puzzling if it were not because dividends are used as a commitment device to build capital market reputation and gain better access to equity markets. A well-known result in the existing dividend literature is that firms pay dividends when they become mature and have stable income. In stark contrast to this conventional wisdom, we find that, in countries with weak legal protection of shareholders, growth and equity-dependent firms pay more dividends than matured firms. Further, after they establish a good dividend history, they raise more equity financing. This would not have made sense—as Miller and Rock (1982) put it, “it would be uneconomic as well as pointless” —for firms to pay dividends and then raise capital immediately.

The idea that dividend policies can address the agency problems between corporate insiders and outside shareholders is not new. It is not clear, however, what would prompt insiders to voluntarily commit to a dividend policy that prevents themselves from investing in their pet projects or from diverting corporate resources for their personal use. In fact, as argued by La Porta et al (2000) (LLSV (2000) hereafter), dividend payouts cannot be taken for granted—investors need to use their legal powers, if any, to extract dividends from firms. Our paper empirically demonstrates that it is the need to raise future financing that gives insiders the incentive to commit to moderation of expropriation and that such commitment is most valuable in countries where investor protection is weak and investors are generally not as ready to provide financing.

That growth firms pay more dividends to mitigate the impact of weak investor protection on their access to capital markets is not inconsistent with LLSV’s (2000) finding that dividends are the “outcome” of good investor protection. While dividends ratios are generally lower in countries with weak investor protection, this does not rule out that, in these countries, firms with good growth prospects intentionally pay more dividends to establish a capital-market reputation. In fact it is precisely when investors do not have the legal power to force firms to pay more dividends that the equity market financing is hindered and a reputation for commitment is necessary. In this paper, we move beyond the LLSV’s (2000) outcome-based explanation of dividends and explore implications of a substitution mechanism through commitments and reputation building.

We have several findings that are difficulty to explain with an outcome story. For example, in weak protection countries, growth firms initiate dividends earlier than mature firms, and, when they are equity dependent, they pay a greater amount of dividends. More importantly, we find that growth firms that pay more dividends actually raise more equity financing subsequently. These findings do not square with the outcome explanation—if shareholders use their legal power to extract dividends to overcome the agency problem, they should extract fewer dividends from firms with good growth prospects and thus less severe agency problems. They should extract even less dividends if the firms are expected to raise external financing in the near future because, to the extent that external financing are more costly than internally generated funds, dividends increase the overall cost of financing which is borne by all shareholders.

Finally, we must emphasize that our findings that firms establish capital-market reputation to mitigate the impact of country-level weak investor protection do not in any way refute the importance of investor protections in shaping firms’ external finance. Quite on the contrary, it is precisely the external financing environment as determined by legal protection of investors that prompts firms to establish reputation. Further, reputation building is costly. In the case of dividends, the firms have to substitute the relatively cheaper internal funds for more expensive external financing, which adds to the overall cost of financing and results in foregone investment opportunities compared to the first best. These costs are the consequence of weak protection of outside shareholders. While not inconsistent with the importance of investor protection, the fact that firms can actively build reputation to (partially) compensate for weak investor protection fills a gap in our understanding of the dynamics of how institutional factors and corporate finance are played in the real markets. It suggests a need to reassess the overall impact of country-level institutional factors on finance. It also suggests room for regulatory enforcement, such as mandatory dividends, as an (albeit imperfect) alternative to judiciary enforcement. Here, lies the main contribution of our paper.

The full paper is available for download here.

Both comments and trackbacks are currently closed.