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Business and Society Review 110:2 171 180

Blackwell Oxford, Business BASR 0045-3609 ??? O 2 102 BUSINESS BELDEN, riginal 2005 2005 Center UK Article and Publishing, FISTER, and Society for SOCIETY Business and Ltd. Review KNAPP REVIEW Ethics at Bentley College

Dividends and Directors: Do Outsiders Reduce Agency Costs?


SUSAN BELDEN, TODD FISTER, AND BOB KNAPP

INTRODUCTION
he world is littered with agency problems. Agents in government, society, and business make decisions for others, their principals. Elected leaders tax and spend their constituents earnings. But if the elected ofcials, the agents, do not share the same priorities as their principals, the voters, the agents decisions may not be in the best interest of the governed. Voters have redress; they can vote out the elected ofcials in the next election. In society, parents act as agents for their children, making decisions, for example, about their education. Even though the intentions are almost always good, it is not clear that the decisions always line up with the interests of the children even in the long run. As a business professor I have counseled students forced into majoring in business who are getting little out of their education. Children, perhaps have redress once they can fund their own graduate education. These examples illustrate the pervasiveness of agency problems beyond the business world. In this paper we investigate the agency problems faced by owners of public companies. For shareholders in public companies, agency problems and costs arise from the separation of ownership and control. Managers make decisions every day about what to do with the companys earnings. But these earnings belong to the shareholders, not the company.
Susan Belden is an associate professor of management and business at Skidmore College, 815 North Broadway, Saratoga Springs, NY 12866; Todd Fister is in business optimization solutions; and Bob Knapp is a professor of business at the University of Colorado at Colorado Springs.

2005 Center for Business Ethics at Bentley College. Published by Blackwell Publishing, 350 Main Street, Malden, MA 02148, USA, and 9600 Garsington Road, Oxford OX4 2DQ, UK.

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If managers have priorities that differ from the shareholders, these decisions are costly to the rms owners. For example, a CEO who is keenly interested in maximizing his own compensation may rob shareholders of their earnings. It is the responsibility of the board of directors to monitor managers, the agents, to ensure that shareholders interests remain the priority in decision making. One action that boards control, and that also reduces agency costs and limits management discretion to make decisions for owners, is to vote to pay out earnings to the shareholders as dividends. Then the agency problem is short-circuitedthe shareholders decide for themselves how their earnings should be used or invested. However, one problem with board oversight is that some members of boards are insiders, company managersthe exact people who need monitoring. As a result, when we think about dividend policy, we expect boards with greater monitoring power, greater outsider representation, to make higher dividend payments. This paper investigates whether that is the case. We hypothesize that rms with a larger share of outside directors on their boards pay higher dividendsan action that reduces agency costs. We test this hypothesis by looking at the statistical relationship between dividend policy (our dependent variable) and board composition (one of many independent variables that also affect dividends).

BACKGROUND AND TIMELINESS


The idea that outside directors are better monitors has recently gained traction. In the wake of scandals, the rules of corporate governance have been restructured to require more outside directors and more meaningful participation by them. Requirements by regulators and the stock exchanges reect the belief that outside directors reduce agency costs by being effective representatives for shareholdersor at least more effective than inside directors. Companies listed on the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation (NASDAQ) must have boards of at least 50 percent outsiders. Writing in BusinessWeek,1 Mike McNamee asserts, the exchanges clearly believe that independent directors are key to making boards the rst line of defense against short-term thinking and self-dealing schemes by management.

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The Sarbanes-Oxley Act, passed in 2002, is another example of the perceived value of outsiders in the boardroom. Not only must companies now have more outside directors, but these outsiders must also meet separately so they can have candid discussions about the insiders they are supposed to be monitoring. Finally, the unanimous approval by the Securities and Exchange Commission (SEC) to begin requiring outside directors to serve on audit committees again reects the belief that outsiders are better able to represent and consider shareholder interests than are insiders.

LITERATURE REVIEW
Outside Directors Are outside directors really more effective monitors than inside directors? A special report on corporate governance in the Wall Street Journal in October 20032 answers the question, What makes a good director? by saying that it is . . . being more informed, more skeptical and more independent. Skepticism and independence are obviously linked to outsider status. A recent study by Shivdasani and Yermack3 supports the outsiders are better monitors theory. They nd that when CEOs participate in nominating directors, fewer outsiders are nominated. This indicates that CEOs perceive that outsiders are effective monitors, whom they, as insiders, would rather not have. Finally, the results of a recent survey by McKinsey and Co. reported in the Wall Street Journal on October 27, 2003,4 reveal that directors and institutional investors believe that CEOs are resistant to changes in corporate governance that require more outside inuence on decisions. Again it appears CEOs would rather not be monitored. There is also a body of academic literature that supports the hypothesis that outside directors are more accountable to shareholders than managers and inside directors. (Mishra and Nielsen5 provide a review of this literature.) If we can show that more outsiders on boards leads to higher dividend payments, we can also conclude that agency costs are lower, and monitoring is better. Dividends allow shareholders to make their own decisions about their own money. In effect, by paying out the earnings, the board has bypassed having to monitor how the insiders would have used those earnings had they been retained by the rm.

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Dividends Paying dividends clearly reduces agency costs by eliminating the possibility that managers will invest in projects that have insufcient returns. This is not an unwarranted concern. Jensen6 provides evidence that managers are reluctant to pay dividendsreluctant to give up control over earnings. He writes of rms that have abundant cash ow: The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organizational inefciencies. In a later paper, Jensen7 also documents the managers tendency to accept negative [net present] value projects, and gives examples of companies that have squandered cash on wasteful projects. If these companies had paid these earnings out, the temptation to make poor investment decisions would have been removed. Brush, Bromiley, and Hendrickx8 also provide data to bolster the contention that it may be wise to remove discretion from managers by paying out earnings. Their research shows that rms with greater free cash ow (money that belongs to shareholders by virtue of being left over after all other claims on the rm have been paid) also have less protable sales growth. Increased sales at these rich rms do not yield as much prot for shareholders as sales growth in rms that do not have free cash ow. This supports the notion that excessive free cash ow, deployed to boost sales growth, does not yield results that are in the owners interest. Paying dividends reduces overinvestment and subjects rms to the discipline of the capital markets. Without retained earnings, funding new investment ideas requires rms to explicitly sell their ideas and their securities to investors. So if outside directors help rms disgorge earnings, they are serving shareholders interests. Outside Directors and Dividends The literature is mixed on whether or not outside directors have an effect on dividend policy. Schellenger, Wood, and Tashakori9 nd that there is a positive correlation between the ratio of outside directors and dividend payout ratios. They conclude, . . . the ndings provide evidence that the composition of the board of directors affects dividend policy. This study supports the assumption that outside directors may be in a better position to protect shareholders

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interests than inside directors. Kaplan and Reishus10 nd compatible results. Their data suggest that outside directors are less likely to cut dividends. But in later research, Bathala and Rao11 nd the reverse: rms with more external directors have lower dividend payouts. Because there is conicting evidence about whether or not more outside directors results in higher dividend payments, we again tackle the problem. Our paper adds to the mixed literature on the relation between dividends and board composition by using more recent data and richer methodologies. Data We use data from 524 companies listed in the Forbes 500 list of the largest American companies by market value, revenue, prots, and assets in the years 1998 and 2000.12 The archival data on boards of directors comes from annual reports and proxy statements published in 1999 and 2001 for the 1998 and 2000 scal years. These data are then matched with data from Compustat and ExecuComp for performance and control variables. Data on the companies board composition, dividends, revenue, assets, number of employees, debt, market value, stock price volatility, two-digit SIC code, and executive compensation are taken from CompuStat, ExecuComp, and the Center for Research in Security Prices (CRSP). Our information on board composition includes the number of directors and the number of outside directors. In the end, our nal pooled regressions use a sample of 1,048 observations. The most common reason for excluding rms was the inability to identify the primary employer or occupation of the directorsinformation that companies are not required to publish in annual reports and proxy statements, and which is essential to determining insider/outsider status. Ordinary Least Squares Analysis We use ordinary least squares regression to test our hypothesis. This expands on the simple correlation analysis used in Schellenger, Wood, and Tashakori by controlling for a multitude of variables that might impact dividend policy rather than just looking at a simple correlation between dividend policy and board composition. We estimate two equations of the following general form:

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Dividend policy = f (outside directors, revenue, assets, debt-tomarket value, stock price volatility, number of directors greater than the mean, the year of the observation, two-digit SIC code, executive compensation, and xed rm effects) We measure dividend policythe dependent variablein two ways, using the log of the dividend yield for the rst regression and the log of total dividends paid for a second.13 Estimating a second regression using the log of total dividends paid addresses the problem that high dividend yields might be positively correlated to the ratio of outside directors simply because outside directors have been hired as a reaction to poor stock price performance.14 Using this variable also requires that we introduce variables that measure rm size. Our work differs from the work of Kaplan and Reishus, who looked only at dividend cuts. It is also different from the approach of Bathala and Rao, who used the proportion of outside directors to total directors as their independent variable, not dividend policy as we do. For the key independent variable, outside directors, we use the log of the ratio of outside directors. We dene outsiders as board members who have no family or employment ties with company executives. Generally, this means that employees, executives of afliated companies or foundations, and their parents, siblings, and spouses are categorized as insiders. We include the other independent variables reported in Table 1 because research tells us that they may also inuence dividend policy. We will discuss the control variables rst and then focus on the critical variablethe outside director ratio. Table 1 reports the statistical results of our ordinary least squares (OLS) estimations. The log of revenue and of assets per employee are included because they are particularly important for the second equation where the dependent variable is the log of total dividends paid. Because this dependent variable is not scaled as is the dividend yield variable, we need to control for the size of the rm. Obviously larger rms, as measured by sales and assets, are expected to pay higher total dividends. The results, in Table 1, support this expectation. We include the ratio of debt to the market value of the rms stock because previous research15 shows that capital structure can also be used as a tool to lower agency costs. The discipline of debt is well known and can be a substitute for the discipline of paying higher dividends. This is not what we nd. In our sample, higher debt ratios

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TABLE 1 Results of Ordinary Least Squares Regression


Dependent variable method Log outside director ratio Log revenue Log assets per employee Debt to market value ratio Stock price volatility Number of directors greater than the mean Dummy variables Year Industry (two-digit SIC) Executive compensation Firm xed effects Number of OBs R2 Adj R 2 Log dividend yield pooled cross section coefcient (signicance level) 1.562 (0.000) 0.077 (0.135) 0.046 (0.499) 0.115 (0.000) 8.038 (0.000) 0.639 (0.000) Signicant Yes Yes No No 1,048 0.5995 0.5751 Log total dividends paid 2.297 (0.000) 0.848 (0.000) 0.202 (0.089) 0.099 (0.001) 13.570 (0.000) 1.145 (0.000) Yes Yes No No 1,048 0.6235 0.6006

complement higher dividend payouts: the rms that use dividends to limit agency problems also use debt. Our next variable, stock price volatility, is also expected to be related to dividend policy. We expect rms with higher dividend payouts and yields to exhibit less stock price volatility. We know that companies resist cutting dividends, except in dire circumstances. So the expected payout makes the stock a little more bond-like and provides some oor to returns as long as the companys performance does not deteriorate substantially. Our data conrm this expectation. The coefcients are negative and highly signicant. The variable number of directors greater than the mean is included to test whether board size has an impact on dividend policy. We expect that larger boards might provide better monitoring because there are more people to question decisions that reect the self-interest of the CEO. The results support this expectation, although we cannot be sure that this does not simply reect that

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older and more traditional companies, the ones that pay dividends, also have larger boards. But the inclusion of this variable avoids the problem that if we nd signicance on our outside director variable, it is not simply because the outside director variable is acting as a proxy for larger boards. The year and industry variables are both signicant as we expected. This indicates that dividends vary as market and economic conditions do, as would be expected. The results also conrm the welldocumented fact that dividend policy varies by industry. The results for executive compensation are interesting. Executive compensation, like capital structure, can provide another vehicle for monitoring. Linking pay to stock price is a classic way to attempt to align managers and shareholders interests. So boards that pay executives with more xed compensation may use dividends rather than performance-linked compensation to lower agency costs. But in our data set, there is no link between executive compensation and dividend policy. The variable rm xed effects is a dummy variable that controls for each rms specic characteristics, i.e., for any unobserved heterogeneity. It is not signicant in either of the pooled regression results. Finally we turn to the log of the outside director ratiothe variable of primary interest. After controlling for all these other factors, we nd that, yes, having a higher ratio of outside directors does result in more generous dividend payments whether measured by dividend yield or total dividends.16

SUMMARY
Using more sophisticated statistical analysis than previous studies and a database of over ve hundred rms, we nd that companies with more outside directors pay higher dividends. Knowing there is a link between outside directors and dividend policy is valuable information for individual shareholders and policy makers. Paying dividends reduces agency costs by returning the shareholders money to them. This removes the agency problem by allowing shareholders to decide for themselves what should be done with their money. If we can eliminate the agent, agency costs are lower. In some arenas this is not practical. We cannot each make a tax policy for ourselves. But returning shareholders money to them

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is easy. With this money in their pockets, shareholders do not have to worry that their agents will behave in the ways documented by Jensen (investing in subpar projects and squandering cash on low-returning strategies), and reported in the press (outright theft of shareholder money in some cases). Our results also justify changing regulation to require more outsiders on boards. Paying dividends is an easy, straightforward way to reduce agency costs. If outside directors are instrumental in that, having regulations to require more of them is good policy.

NOTES
1. M. McNammee, N. Byrnes, and L. Lavelle, Turn Up the Heat on Board Cronyism, Mr. Grasso, BusinessWeek 3779, (2002): 3637. 2. Carol Hymowitz, How to Be a Good Director, Wall Street Journal, October 27, (2003): R1, R4. 3. D. Shivdasani and David Yermack, CEO Involvement in the Selection of New Board Members: An Empirical Analysis, The Journal of Finance 54 (5) (1999): 1829 1853. 4. Carol Hymowitz, How to Be a Good Director. 5. C. S. Mishra and J. F. Nielsen, Board Independence and Compensation Policies, Financial Management 29 (3) (2000): 5170. 6. M. Jensen, Agency Costs of Free Cash Flow, Corporate Finance and Takeovers, American Economic Review 76 (2) (1986): 323330. 7. M. Jensen, The Modern Industrial Revolution Exit, and the Failure of Internal Control Systems, Journal of Finance 48 (3) (1993): 831 880. 8. T. Brush, Philip Bromiley, and Margaretha Hendrickx, The Free Cash Flow Hypothesis for Sales Growth and Firm Performance, Strategic Management Journal 21 (4) (2000): 455 472. 9. M. Schellenger, David Wood, and Ahmad Tashakori, Board of Director Composition, Shareholder Wealth, and Dividend Policy, Journal of Management 15 (3) (1989): 457 467. 10. Steven N. Kaplan and David Reishus, Outside Directorships and Corporate Performance, Journal of Financial Economics 27 (2) (1990): 389 411. 11. Chenchuramaiah T. Bathala and Ramesh P. Rao, The Determinants of Board Composition: An Agency Theory Perspective, Managerial and Decision Economics 16 (1) (1995): 59 70. 12. Admittedly, these data are taken from a short period during the bull market and before the passing of Sarbanes-Oxley. However, we argue that if we nd that rms with more outside directors pay higher dividends in

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this period, we can be fairly condent that that behavior would be observed in post-bull and after-Sarbanes-Oxley data. Heres our rationale: During the bull market, rms were more likely to view investment as a protable option for earnings, and hence be less likely to pay dividends. The economy was healthy and the cost of capital was lowan environment when investment is favored. We argue that if boards with more outside directors paid more dividends before the focus on corporate governance and pressure for more effective outside monitoring, then those companies will also pay higher dividends after. We also note that the Spencer Stuart Board Index, 2002 says, There are three outside directors for each inside director, a ratio that has remained constant for the past decade. However, the same report for 2003 says the ratio of outside to inside directors had risen to 4:1. In conjunction with this increase in outside directors, we also note, using data from www.barra.com, that the dividend yield for the S&P 500 jumped from 1.63 percent in January 2002 to 2.11 percent in January 2003 a level higher than any year since 1996. The dividend payout ratio for the S&P 500 also rose from 28 percent in January 2002 to 33 percent in January 2003, the rst increase since 1994. These data are far from conclusive, but they are supportive of our claim that our results are not time specic. 13. There is no variable that perfectly isolates dividend policy decisions. Many studies use dividend payout ratios to measure dividend policy. We did not use the dividend payout ratio because we did not see its clear superiority in measuring policy decisions. Typically, boards are slow to change dividend payments. Falling dividends are a negative signal, so any increase in dividends has to be sustained. The result is that when earnings change, dividend payout ratios often automatically change. 14. When stock prices fall, dividend yields, dividend payment divided by price, automatically rise. When stock prices fall, it is also more likely that outside directors will be hired to get the rm back on track. We use total dividends to eliminate the inuence of stock price on the independent variable because that might give us misleading results as it may be correlated to the number of outside directors. 15. A. Agrawal and C. R. Knoeber, Firm Performance and Mechanisms to Control Agency Problems Between Managers and Shareholders, Journal of Financial and Quantitative Analysis 31 (3) (1996): 377291. 16. Our results were conrmed using more sophisticated instrumental variables analysis to control for the possibility that the outside director variable may not be independent of the error term. Those results are not reported as they simply conrm our hypothesis.

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