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Dividend Policy and Corporate Governance$

Luis Correia da Silva, Marc Goergen, and Luc Renneboog

Print publication date: 2004

Print ISBN-13: 9780199259304

Published to Oxford Scholarship Online: April 2004

DOI: 10.1093/0199259305.001.0001

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(p.156) 9 Conclusion
Dividend Policy and Corporate Governance

Luis Correia Da Silva

Marc Goergen (Contributor Webpage)

Luc Renneboog (Contributor Webpage)

Oxford University Press

Abstract and Keywords

The study provides new interesting results that are important for the ongoing debate about the best possible corporate governance system. Although, recently, the Continental European system of corporate governance has somehow fallen into disrepute, the system has some clear advantages as compared to the main competing system, the Anglo‐American system. One of these advantages is that the average firm in Continental European does not have to rely on costly dividend signalling.

Keywords:   convergence of corporate governance systems, corporate control, corporate governance, corporate ownership, dividend policy, Germany, UK, US

As little empirical research has been undertaken on the dividend policy of firms outside the Anglo-American corporate governance system, this book attempts to close this gap. In the first part of this book, we provide the reader with a description of the various corporate governance regimes that may shape dividend policy. This is followed by a survey of the—mostly Anglo-American—literature on dividend policy. In the second part of the book, the empirical part, we ask the question whether the dividend policy in a blockholder-based corporate governance regime has a different role from in a market-based system. In particular, we want to determine whether there is a negative relation between the level of dividends and the level of concentration of control. If this is the case, then dividends and control may be substitute monitoring mechanisms. Another interesting question is whether large shareholders are able to impose a dividend policy which is optimal for their tax status. For Germany in particular, often labelled as a bank-based economy, it is worthwhile to study whether bank control—based on equity ownership and proxy votes—is associated with lower dividends and less reluctance to cut and omit the dividend.


We broadly define a corporate governance regime as the amalgam of mechanisms which ensure that the agent (the management of a corporation) runs the firm for the benefit of one or multiple principals (shareholders, creditors, suppliers, clients, employees, and other parties with whom the firm conducts its business). Roughly speaking, there are two generic corporate governance regimes: the market-based and the blockholder-based regime. The former is characterized by a high number of companies listed on the stock exchange, diffuse ownership, the one-share-one-vote rule, an active market for corporate control, and strong shareholder and creditor rights. The UK and the USA are the prototypes of this system. The blockholder system can be described by a small number of listed companies, the presence of large blockholders, complex ownership structures (shareholder pyramids and cross-ownership), frequent violations of the one-share-one-vote rule and weak shareholder protection. The Continental European countries are part of this regime. Our description of corporate governance regimes also highlights that not only does the control concentration differ across regimes, but so does its nature. In the UK and the USA, financial institutions hold most of the shares, although the size of their holdings is modest. A second important category of shareholder in these countries is directors. Their significant ownership has been (p.157) documented to be potentially harmful in situations of poor performance as it may lead to entrenchment. In Continental Europe, the main shareholder categories are families or individuals, and corporations. Moreover, in Germany, the banks are an important source of finance. First, they frequently act as house banks by being the main provider of debt capital to companies. Second, they frequently hold substantial voting stakes and their control tends to be strengthened by proxy votes.

If the one-share-one-vote principle applies, having control over a firm requires a large investment. Still, in most European countries, mechanisms exist to deviate from the one-share-one-vote principle. As a consequence, it is possible to combine a high degree of control with a limited percentage of cash flow rights. These mechanisms are ownership pyramids or cascades, multiple voting rights, non-voting shares, and proxy votes. The combination of strong control with limited investment may lead to the expropriation of the minority shareholders by the large shareholder. In contrast, in the Anglo-American system where the principle of one-share-one-vote is normally upheld and ownership tends to be diffuse, the major agency problem is between managers and shareholders.

We focus on those corporate governance devices which may have a direct or indirect impact on dividend policy and distinguish between internal and external governance mechanisms. The internal mechanisms consist of the board of directors and the blockholders whereas the main external ones comprise the market for corporate control, the market for block trades, and creditor monitoring. We also show the importance of the regulatory framework (legislation, self-regulation, and stock exchange rules), such as investor and creditor protection, mandatory bid rules, and legal origin.

The role of dividends in terms of corporate control can be twofold. First, the dividend payout may be a bonding mechanism precommitting managers to pursue value maximization. A high dividend payout ensures that managers focus on generating sufficiently high levels of cash flows and that these are not invested into projects with returns below the cost of capital. As such, a tight dividend policy allows corporate monitors to reduce their monitoring efforts. Dividend policy may, thus, be a substitute corporate governance device to several internal monitoring mechanisms such as the board of directors or the blockholders. Second, dividend policy may also constitute an important signal, as dividend cuts are interpreted by the market as powerful signals of bad news both about the firm's current situation and its prospects. Consequently, the failure to meet the anticipated dividend level or payout may activate alternative corporate governance mechanisms which are better suited to deal with poor performance or financial distress. Given that (industry-corrected) underperformance may not only be caused by the management, but may also be due to the failure of the internal monitors (such as the board or the blockholders), external corporate governance mechanisms (such as the market for corporate control) may be activated to start board and/or asset restructuring of the firm.

It is important to note that a pre-condition for dividends is a signal of failing performance and corporate control is dividend ‘stickiness’. In Anglo-American companies, there is ample evidence that managers are reluctant to reduce dividends, but it is questionable whether the same reluctance applies to Continental European companies, frequently controlled by one single dominant investor group. For example, as dividends of German firms are more volatile, they may be more in line with current earnings rather than with the (p.158) long-term prospects of the firm. Dividends are then no longer a strong signal of poor management and governance.


This book provides important, new insights into the dividend policy of companies from a corporate governance system—the German system—which is not characterized by the separation of ownership and control à la Berle–Means (1932). We show that German firms pay out a lower proportion of their cash flows than UK or US firms. However, on a published profits basis, the conventional wisdom that German firms have significantly lower dividend payout ratios than UK or US firms is no longer true, as we find the exact inverse. The company law provisions on profit reporting and on profit transfers between a company and its parent, as well as accounting rules largely account for these two conflicting patterns. The most important legal provisions which influence the payout ratio are the following ones. First, some corporations have control agreements with their parent companies, whereby they transfer the profit and/or loss to their parent companies. These transfers are not dividends per se, but can be an opportunity for the parent company to benefit from tax losses at the subsidiary level. In our analysis, we exclude firms with control agreements from our dataset in order to avoid double counting of dividends. Second, German corporations are usually required to pay out at least 50 per cent of their published profits as dividends, although there may be stipulations in a firm's articles of association that mitigate the impact of this provision. Finally, German firms are usually not allowed to buy back their own shares over the time period of our empirical studies such that if they want to return funds to the shareholders, they have to resort to increasing the dividend payout. This is in marked contrast to the USA where share buybacks are a frequent occurrence.

Another reason why German firms pay out higher dividends (on a profit basis) than their Anglo-American counterparts can be found in the accounting rules. German accounting rules are often considered to be deficient in the information disclosed to investors relative to the Anglo-American financial reporting. Under the German system, managers have incentives to report modest profits, especially in the light of the requirement to pay out at least 50 per cent of the published profits. In addition, pension and other provisions may also account for a certain downward bias in the published profit figure.

We also document that not only are the payout levels different between German and UK or US firms, but so are the dividend policies. Dividends-per-shares of UK and US firms are relatively smooth over time and are characterized by frequent small adjustments. Conversely, dividends-per-share of German firms show less frequent but larger discrete jumps. Therefore, it seems that German dividend policy is more flexible compared to that of the UK or the USA, because German dividend changes follow earnings and cash flow changes more closely.

We also find that the dividend payout is related to the degree of control in German firms. In general, widely held firms have lower payout ratios than closely held firms. However, within the closely held firms, we report that the nature of control (the type of blockholder) has an important impact on dividend policy. First, firms controlled by other corporations (p.159) have the highest payout ratios. Second, firms controlled by banks have dividend payout ratios which are significantly lower than the sample average. Finally, firms controlled by foreign companies, families, the state and holding companies are somewhat in the middle, all with virtually identical payout ratios.


The seminal work by Lintner (1956) and Fama and Babiak (1968) on US dividend policy suggests that managers change dividends primarily in response to unanticipated and non-transitory changes in their firm's earnings. Moreover, firms have well-defined dividend policies: They usually have a long-run target payout ratio and also set the speed with which they adjust dividends towards this target. We estimate whether the empirical relations between dividends and earnings documented for Anglo-American firms also hold for Germany by applying Lintner's partial adjustment model. The study in this book improves on earlier research by using a more appropriate estimation methodology (an approach with instrumental variables based on the Generalized Method of Moments), a larger and more representative sample (our sample represents about 80 per cent of the market capitalization of the commercial and industrial firms listed on the German stock exchanges), a longer time window (10 years) and two different proxies for profitability (published earnings versus cash flow). Our time period from 1984 to 1993 is chosen to encompass a five-year economic boom followed by a recession. We find an implicit target dividend payout ratio of 25 per cent (of published earnings), which is substantially lower than the observed payout of 86 per cent. This implies that German firms do not base their dividend decisions on long-term target payout ratios expressed in terms of public earnings. As the published earnings figure may not correctly reflect corporate performance given that German firms tend to retain a significant part of their earnings to build up legal reserves, and given that the published earnings figures are conservative, we perform some robustness tests defining the payout ratio in terms of cash flows. Our estimations are closer to the observed dividend policy. This implies that the payout ratios of German firms are based on cash flows rather than published earnings.


Given that the dividends per share time series of German firms are characterized by a high discreteness, that is, frequent large changes, we opt for a discrete choice modelling approach. We analyse how past, current, and future profits affect the timing of dividend changes rather than the amount of the dividend change. We find that bottom line earnings are key determinants of dividend changes, a finding which is consistent with Lintner (1956). We also use cash flows to correct for accounting conservatism in the earnings figure and find that cash flows are also important determinants of the decision to change the dividend.

(p.160) We highlight two features of German dividend policy that are not captured by the Lintner model. First, we observe that the level of net earnings is not the main determinant of a dividend reduction or omission. In fact, the occurrence of an annual loss has higher explanatory power than the magnitude of the loss itself. We find that 80 per cent of the firms with at least five years of positive earnings and dividends omit the dividend in the loss year, irrespective of the magnitude of the earnings loss and of the past and future earnings. Second, German firms quickly revert to the dividend level prior to the dividend omission or reduction. We find that more than half of the German firms, which omitted the dividend, return to the dividend payout prior to the omission within merely two years. A similar pattern applies to dividend reductions. These findings contrast with the predictions of Lintner (1956) and Miller and Modigliani (1961) that dividends will only change if managers believe that the dividends will not have to be reversed in the short run. Therefore, these models do not capture the dividend behaviour of German firms with a temporary deterioration in profitability. The Lintner model describes the dividend policy of well performing firms, but not that of firms facing sudden and temporary falls in profitability. Our findings also contradict those of DeAngelo, DeAngelo, and Skinner (1992) who report that US firms are more likely to reduce dividends when the current loss is higher and when persistent future earnings problems are expected.

Our findings can be interpreted in the light of signalling theories of dividend policy. The fact that German firms frequently omit and cut dividends and quickly revert to the payout prior to the omission or cut suggests that dividends do not convey (much) information about the future value of the firm.


We also examine the impact of the cross-sectional and inter-temporal variation in control on dividends paid by German corporations. As control is usually concentrated in the hands of a large shareholder, we investigate whether dividend patterns reflect this. Different forms of control may indeed give rise to the setting of different dividend payouts and dividend policies. We also examine the impact of different control structures on the willingness of German firms to omit the dividend following a significant deterioration in earnings.

We report a U-shaped relation between the proportion of the voting equity held by the largest shareholder and dividend payouts. This result seems consistent with agency costs arguments for dividend policy. For low levels of control, an increase in control by the largest shareholder is negatively related to the dividend payout ratio. This is consistent with the argument that an increase in control tends to reduce agency costs between managers and shareholders. At high levels of control, the payout ratio then increases. This implies that there is a point beyond which control no longer acts as a substitute for dividends. High concentration of control may deal with the agency problem of controlling managers, but it may be at the expense of minority investors, who face a higher risk of expropriation in a system with weak investor rights. Our results suggest that, if there is expropriation of small investors by the controlling shareholder, this is not achieved via the payment of lower dividends.

(p.161) It is important to consider not only the degree of control but also the type of the controlling shareholder, as each type may give rise to different agency relations and costs. A central result that emerges from our analysis is that bank ownership of voting equity is associated with lower dividend payouts and a stronger propensity to omit the dividend. Our results are consistent with the argument that direct bank control mitigates asymmetries of information and agency costs. However, the exercise (of a sometimes large percentage) of proxy votes does not constitute an alternative to direct bank control.

Finally, we estimate the impact of the tax status of shareholders on the dividend policy of German firms. We examine whether taxation on dividends (relative to taxation on capital gains) creates tax clienteles. Our evidence does not support the proposition that controlling shareholders with different tax preferences for dividends impose their preferences on minority shareholders. We also find that a preference for a low dividend payout ratio in bank-controlled firms is somewhat offset by a preference for high dividends from a taxation standpoint.

The stylized facts and other empirical results uncovered by this book contribute to the ongoing discussion on corporate governance and the optimal system of corporate governance. Our results show that, although the Anglo-American system has a clear advantage in the form of higher investor protection, the German or Continental European system also has a major advantage as it provides firms with a higher flexibility in terms of their dividend policy.