Dividend policy and corporate monitoring: evidence from the regulated electric utility industry

Financial Management (Financial Management Association), Spring, 1994 by Robert S. Hansen, Raman Kumar, Dilip K. Shome

Miller |13^ has argued that providing a rational explanation for the widely practiced policy of paying dividends is among the central tasks of modern corporate finance theory. Corporate finance textbooks often rationalize dividends as a signal, a payment to clienteles, or an irrelevant residual payout of earnings. However, in this paper we focus on the role that dividends play in the process of facilitating primary capital market monitoring that reduces the corporation's equity agency costs. Easterbrook |5^ points out that, by raising the dividend payout, the board of directors can increase the likelihood that the finn will have to sell common stock. As a consequence, there will be an investigation of management by investment banks, the securities exchanges, and capital suppliers (see Hansen and Torregrosa |8^). Or in Donaldson's |4, p. 54^ phraseology, the external equity financing will be accompanied by the "glare of publicity and shareholder attention which accompanies the decisions and actions of management, ..., attention which can be particularly disconcerting if the ultimate terms of financing are not as favorable as expected." As a result of this capital market monitoring, there will be reduced agency costs, and therefore, an appreciation in the market value of the firm's common stock.

We test the relevance of the monitoring theory for explaining the dividend policies of regulated electric utilities. For convenience, hereafter we refer to regulated electric utilities as utilities. We focus on this industry partly because its dividend policies are not easily reconciled by current textbook explanations. Moreover, relative to industrial firms, utilities are arguably somewhat more insulated from the discipline of other monitoring mechanisms for controlling agency costs. Furthermore, utility stockholders have the added need to obtain monitoring of the regulators. This suggests that if an important potential role for dividends is to promote primary market monitoring, evidence of this is most likely to be found in the case of utilities. Such evidence will suggest to practitioners and academics that monitoring can provide a rational basis for dividends.

It seems unlikely that the extraordinary dividend policies of utilities can be reconciled with either a clientele story or a signaling story or that their dividends are merely a residual distribution of earnings. Over the years, utilities' payout ratios have greatly exceeded those of industrials, with historical average payout ratios exceeding 60% of net income. Yet utilities are occasionally among the largest sellers of common stock. To explain this behavior with a clientele theory, whereby "corporations provide payout ratios that correspond to investors' preferences for payouts" (Miller and Modigliani |14^), would require that clientele members' tax penalties plus the firms' flotation costs be sufficiently below the net transaction cost of receiving the income as capital gains. Existing evidence is ambiguous concerning whether the necessary low personal tax rates are present (see Chaplinsky and Seyhun |2^).(1) The signaling story (see Bhattacharya |1^, John and Williams |12^, Miller and Rock |15^, and Ross |19^) seems unlikely because it is just too implausible that utilities, whose investment opportunities are rather well-known, have more valuable hidden information to signal than do industrial firms.

However, utilities' extraordinary dividends also do not appear to be reconciled as a residual, since they have often paid out increasing dividends during periods of heavy equity financing. Given the magnitude of utility dividends, it is thus not surprising that Miller |13^ has called for more evidence supporting a rational basis for dividends.

The idea that the high dividends paid by utilities are, at least in part, a mechanism to produce monitoring of regulators has been expressed by Miller |13^, Myers |16^ and Smith |22^. For example,

Public utility managements have found a policy of high dividends combined with frequent external equity financing to be a useful strategy for forcing their regulators to keep utility rates high enough to continue attracting new funds from investors. (Miller |13^, n. 17a.)

and

By paying high dividends, the regulated firm subjects both its regulatory body as well as itself to capital market discipline more frequently. Stockholders are less likely to receive lower-than-normal levels of compensation due to lower allowed product prices when the regulatory authority is more frequently and effectively monitored by capital markets. (Smith |22^, p. 10.)

From an agency perspective, we interpret this idea as emphasizing that dividends promote monitoring of what we call the stockholder-regulator conflict. Thus, in effect, in the case of utilities there is this additional monitoring role for dividends that complements Easterbrook's |5^ notion that dividends promote monitoring of the stockholder-manager conflict. We add that this monitoring rationale has the additional implication that paying particularly high dividends to disgorge discretionary cash flow can bring the primary market monitoring to bear on the expenditure of funds for new investments. Paying out large amounts of earnings, in spite of known forthcoming capital expenditure requirements for valuable investments, creates insufficient funds, thereby strengthening the link between the timing of capital investment and the receipt of the primary market monitoring. Thus, this additional monitoring benefit is somewhat akin to the benefit from reducing managers' possible misuse of funds by disgorging "free cash flow" (see Jensen |9^ and Stulz |23^).