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E-MailYongqiang Chu is Associate Professor of Finance at University of South Carolina Darla Moore School of Business. This post is based on his recent article, forthcoming in the Review of Financial Studies.
In my article, Shareholder-Creditor Conflict and Payout Policy: Evidence from Mergers between Lenders and Shareholders, which is available on SSRN and is also forthcoming at the Review of Financial Studies, I show that the conflict of interests between shareholders and creditors induces corporations to pay excessive dividends at the expense of debt holders.
The classical agency theory (e.g. Jensen and Meckling, 1976, and Smith and Warner, 1979) posits that the conflict of interest between shareholders and creditors can induce agency costs in the form of excessive dividend payments, claim dilution, asset substitution, and underinvestment. Excessive dividend payments, in particular, may lead to significant wealth transfers from creditors to shareholders. Black (1976) points out that “there is no easier way for a company to escape the burden of a debt than to pay out all of its assets in the form of a dividend, and leave the creditors holding an empty shell.” In this sense, dividend policy can reflect the extreme effect of shareholder-creditor conflict.
On the other hand, the existing literature on payout policy has paid little attention to the effect of shareholder-creditor conflict on payout policy. In a recent survey on payout policy, Farre-Mensa, Michaely, and Schmalz (2014) reviewed no papers related to the shareholder-creditor conflict. In an earlier review article, Allen and Michaely (2003) reviewed only a handful of papers on the relationship between the shareholder-creditor conflict and payout policy, most of which show, at best, indirect evidence for the relevance of the shareholder-creditor conflict. In this article, I provide direct evidence that the shareholder-creditor conflict affects payout policy.
The lack of direct evidence is partly due to the difficulty of empirically measuring the shareholder-creditor conflict. Most existing literature relies on stock and bond price reactions to specific corporate events to infer the shareholder-creditor conflict. Others explore variation in leverage as a proxy for changes in the shareholder-creditor conflict. However, capital structure decisions are often simultaneously determined as investment and payout decisions, and, hence, relying on variation in leverage alone is unlikely to uncover the causal relationship between shareholder-creditor conflict and corporate policy.
In this paper, I build on the idea by Jiang, Li, and Shao (2010) that dual holders, who simultaneously hold both equity and debt claims of the same firm, can alleviate the shareholder-credit conflict. To this end, I also measure the shareholder-creditor conflict with dual holders. Furthermore, I also try to isolate potentially exogenous variation of the conflict by exploiting mergers between shareholders and creditors of the same firm.
Under the agency theory, shareholders may pay excessive dividends at the expense of creditors to maximize shareholder value when the debt contract is in place. In equilibrium, firms pay out more than the first best in the presence of the shareholder-creditor conflict. When a shareholder merges with a creditor of the same firm, the merged entity becomes a dual holder of the firm. Consequently, the conflict of interest between the shareholder and the creditor decreases, and, hence, the merger pushes the payout toward the first-best level.
Using the mergers as the natural experiments, I find that treated firms, that is, firms whose shareholder and lender merged, experience a decrease in payout, both cash dividends and share repurchases, relative to a group of control firms not affected by these mergers. In particular, the treated firms become less likely to increase payout, but do not become more likely to cut dividends. This result is consistent with the agency theory that shareholder-creditor conflict can induce firms (on behalf of shareholders) to pay out more than what is best for the firm. The mergers, which create dual holders of these treated firms, reduce the conflict of interest between the merging shareholder and the merging lender, and hence lead to a lower corporate payout.
In addition, I also find that the effect of the mergers on payout depends on the relative stakes the merging shareholder has against other institutional shareholders. The merging shareholder’s incentive to cut payout will necessarily be in conflict with other shareholders, and the merging shareholder’s stake will thus increase her ability to push management to cut payout. On the other hand, the effect also increases with the stake the merging lender has in the treated firm. The merging lender’s stake increases the merged entity’s incentive to maximize the combined value of equity and debt claims, and hence to cut payout. The effect of the mergers is also stronger for firms in financial distress. Firms in financial distress often have intensified shareholder-creditor conflict, and the mergers appear to be very effective in alleviating this intensified conflict.
Overall, the results in the paper suggest that firms do pay out more in the presence of shareholder-creditor conflict and mitigating that conflict leads to lower payout.
The complete paper is available for download here.
