Dividend Policy

Dividend Policy refers to the framework that companies use to decide when and how much to pay stockholders in the form of dividends. The choice to distribute profits as dividends or reinvest them back into the company can significantly impact corporate growth strategies, market presence, and stockholder satisfaction. Companies might opt to pay dividends to signal financial health or to satisfy stockholder expectations, particularly in cases where institutional investors hold significant shares. However, conflicts of interest can arise, particularly when high-level executives prioritize personal gains over stockholder returns.

The landscape of dividend policy has been shaped by financial scandals, particularly in the early 2000s, leading to increased regulatory measures like the Sarbanes-Oxley Act. This legislation aims to enhance financial transparency and accountability in corporate governance. Shareholder rights play a critical role in this context, as they empower investors to demand fair treatment and influence dividend decisions. Additionally, there are alternative methods for companies to increase shareholder wealth, such as stock buybacks and issuing additional shares, which can also affect overall investment strategies. Understanding these dynamics is essential for investors seeking to navigate the complexities of corporate finance and governance effectively.

Published in: 2021

By: Erbschloe, Michael

Subject Terms

Dividend Policy

This article examines the payment of stockholder dividends and how policies are set or how practices evolve that govern the payment of dividends. The scope of stockholder rights is explained along with methods that stockholders utilize to assure that their rights are properly manifested when investing in a company. Conflicts of interest between stockholders and corporate executives that may result in stockholders not receiving dividends are explained. Financial scandals of the early 21st century are reviewed as well as laws, regulations, and management practices that have been implemented to help prevent companies from releasing false or misleading financial reports.

Keywords: Dividends Policy; Financial Statements; Public Accounting Oversight Board (PCAOB); Sarbanes-Oxley Act; Stock Dividends; Stockholder rights

Dividend Policy

Overview

A company's dividend policy provides guidance on when to pay stockholders dividends or when not to pay the dividends and use profits for other purposes. When profits are held and not paid out as dividends, funds can be used for new product development, market expansion, or acquisition of other companies (Sheppard, 2008). Other factors that impact dividend policy in some companies include corporate tax situations as well as the impact on the tax conditions of the shareholders receiving dividends (Cohen & Yagil, 2008). The type of stockholder that has invested in the company may also impact dividend policy. When a company is publicly traded and there is institutional ownership stock by investment funds or retirement funds, there may be more pressure to pay dividends (Guo & Ni, 2008) (Aivazian, Booth, & Cleary, 2006).

Why Pay Dividends?

Dividends can be paid for several reasons. In some cases, dividends are paid to satisfy existing stockholders (Azhagaiah & Priya, 2008) (Ben Naceur, Goaied & Belanes, 2006). When high-level executives hold large quantities of stock, paying dividends can be viewed as a form of a bonus for the executives.

In other cases, dividends may be paid as a signal that the company is successful. This may influence the opinions of stock analysts or future investors in the company (Li & Zhao, 2008) (Dickens, Casey & Newman, 2002). Companies have attempted to use dividend payouts as a way to favorably influence their stock price. Many have found that announcing a large dividend pay out, or making a larger than normal pay out of dividends, may result in improved stock prices for a short time — there is little supporting evidence that the strategy is always effective (Wann, Long, Pearson, & Wann, 2008).

Alternative Investor Incentives

Although dividends are the primary mechanism by which an investor increases their wealth through company investment, there are other means by which companies can reward their investors. Stockholder wealth can also be increased through stock buy-back programs where, instead of paying a direct dividend, a company buys stock back from investors at a preferred and attractive price (Wiemer & Diel, 2008). Another approach aside from dividend payments or payouts to shareholders is the distribution of additional shares of stock in proportion to the number of shares already owned. This can result in concentrating power in the hands of very few shareholders (Denis, 1990).

Company Value & Dividend Payout

The value that a company achieves by paying dividends varies with economic conditions. As the mood of investors shifts, so do their investments. At times, they prefer dividend-paying stocks; at others, they prefer growth stocks such as many of those in the high-tech sectors. Under the Bush administration there was a short-lived effort to promote dividend payout as a practice to lower taxes on dividends for recipients. This had very little impact on the number of companies paying dividends (Bank, 2006)(Henry, 2003). However, the managers of NASDAQ firms generally concur that a consistent history of dividend payouts helps to sustain company value, at least in the perception of investors (Baker, Powell & Veit, 2002).

The big question about whether to pay or not to pay stock dividends concerns who benefits from firm wealth. Stockholders are obviously seeking a return or they would not have invested in the company. Managers, on the other hand, may be both stockholders as well as employees that receive bonuses such as revenue growth or increased market share. Thus stockholders seek ways of assuring their rights.

Applications

Methods of Assuring Stockholder Rights

Some form of shareholder rights is a part of corporate law in most countries throughout Europe and North America. These rights may include the right to hold periodic shareholders' meetings and be provided annual or other reports from management. In addition, in most situations stockholders will usually have the right to receive dividends paid out of corporate profits. In the event that new stock is issued, existing stockholders may have the right to purchase shares prior to public sale ("Shareholder rights," 2008). The more established the shareholder group in age, organization, and tradition, the more likely it is that there will be dividends paid. This rewards the shareholder for investing their money and supporting the company over a long term. It is also seen as a method of keeping control of wealth and preventing managers from using the funds solely for their desired purposes (Jiraporn & Ning, 2006).

Corporate Governance

Boards of directors control a corporation through a governance process. Laws relating to corporate governance have been evolving around the world. The Organization of Economic Cooperation and Development (OECD) has provided a framework for countries to structure their laws and to help guide boards of directors to develop their own governance approaches. The OECD framework promotes both stockholder rights and board responsibilities. The scope of shareholder rights ranges from timely access to accurate information, accurate financial statements, voting power, and redress when their rights are violated. The framework also charges the board of directors with a range of responsibilities including monitoring the management of the company, reviewing and approving corporate strategy, assuring the accuracy of financial statements, and deciding the compensation and tenure of high-level executives ("OECD principles," 2004)

Shareholder Activism

Shareholders have become more organized and more active over the last two decades. This activism has taken many shapes and forms. In some cases, shareholder activism can be motivated by desires for social change or protection of the environment achieved through changing corporate policy or managerial practices. Most often, such activism surfaces in the form of a resolution to be considered at an annual meeting. Few such resolutions pass and when they do they are generally considered to be only advisory in nature. These resolutions do help raise concerns and may actually be acted upon, but in informal manners (Hendry, Sanderson, Barker & Roberts, 2007). There are, however, many criticisms of shareholder activism including the fact that it is expensive, time consuming and, many argue, not very effective (Thomas, 2008).

The intensity level of activism and the direction of the activism of stockholder groups are changing considerably. Some of the more high-intensity groups now practicing shareholder activism include religious organizations and institutional investors holding large amounts of stock (Van Buren, 2007). Among the most active institutional investors are public pension funds, union pension funds, mutual funds and hedge funds that hold large blocks of stock (Minow & Hodgson, 2007). Religious organizations have well-tuned capabilities when it comes to putting pressure on corporations and at this time, they do seem to focus on socially oriented agendas. Institutional investors tend to focus on the financial stability of the held company and for the last several years have spent considerable time and effort on reducing high managerial salaries.

The activism of the institutional investors, especially those that have considerably high levels of funding from retirement funds of labor unions or public employees, has been fueled by relatively recent events. When Enron and WorldCom collapsed, several investment funds and retirement funds belonging to thousands of individuals lost value. Individual members of retirement funds were outraged and angry with the people managing their retirement funds. The fund managers in turn had little choice but to pass this anger on and to do so in a manner that better helped to protect the value of the retirement funds for which they are responsible (Minow & Hodgson, 2007).

Sarbanes-Oxley Act

As a result of numerous corporate failures, the Sarbanes-Oxley Act was passed in 2002 by the United States Congress. This act was a very significant step in the regulation of publicly traded companies and was intended to help protect investors by requiring more stringent controls on corporate financial reporting and disclosures. As one of many control mechanisms, the act established the Public Company Accounting Oversight Board (PCAOB). "The PCAOB is a private-sector non-profit organization that is charged with overseeing the audits of public traded companies" (Walther, 2009). These companies are regulated by numerous securities laws and must submit regular reports to the Securities and Exchange Commission (SEC).

One of many issues surrounding the massive financial collapses of Enron and WorldCom was the accuracy and reliability of internal audits. These audits are provided to the board of directors and the stockholders as accurate depictions of the financial health and condition of a publicly traded company. Reports are also filed with the SEC as a matter of public record. The Sarbanes-Oxley Act addressed the reliability and independence of audits and requires that any and all documentation regarding financial statements be persevered. (The urban legend surrounding the Enron collapse is that managers in the company and those in the independent auditor's office were shredding documents that showed the fabricated annual financial statement. This is like Richard Nixon erasing tapes.) The act also holds executive officers and boards of directors more accountable for the accuracy of financial reports and prescribes rather severe criminal penalties for false or misleading reports ("Sarbanes-Oxley Act," 2006).

Issue

Conflict of Interest in Dividend Policy

Corporate Scandal

In the first decade of the twenty-first century there occurred numerous business scandals that make television soap operas look dull in comparison. Some very large or long-standing companies in the United States went bankrupt or got into very complex a deep financial problems. A partial list includes Enron, WorldCom, Xerox, Global Crossing and Halliburton Oil Services. It was one thing to be in the news as a poorly managed company. Citizens for the most part would find that laughable. But these scandals not only rocked financial markets with losses, they also resulted in job loss and drew the attention of the public as well as the United States Congress. Eventually, some chief executives were even convicted of fraud (Bhamornsiri, Guinn & Schroeder, 2009).

The big question on the minds of many ordinary citizens and thus eventually the minds of regulators as well as lawmakers was about the competence of the highly paid executives of these failing companies. The news of the large salaries and bonuses being paid to executives as workers lost their jobs led to considerable public outrage about how private corporations are managed, and especially about executive compensation (Thomas, 2008). Shareholder activism on executive compensation accelerated and has resulted in the ouster of several CEOs or the reduction and restructuring of compensation packages (Nicholas, 2007) (Melican & Westcott, 2008).

Manager Conduct & Dividend Policy

As investigation after investigation unfolded, questions about executive competence evolved into questions about honesty. Among the key questions about executive honesty was to what extent can executives manipulate financial results of a company in order to influence their own personal salaries? Such dishonesty can directly relate to dividend in its development and execution. Thus executive actions can be potentially riddled with conflicts of interest (Ghosh & Sirmans, 2006). If executives manipulate financial statements or redirect corporate assets in a self-serving manner, stockholders not only loose their dividends, but the value of their stock can radically decline.

Many investors prefer long term but steady dividends as part of their personal wealth building strategies. Conservative investors often fear over spending by managers. An organization's performance goals have an effect on how trustworthy a manager is. When revenue growth, for example, is a performance goal, then managers may be overzealous when it comes to expanding manufacturing or distribution channels. In other cases, managers may push to acquire competitors or smaller companies in the hope that this will improve their performance and result in greater compensation (Belden, Fister & Knapp, 2005).

Lenders & Dividends

Lenders (such as an investment bank) can also hold significant equity in a company and may attempt to exert control over dividends or to even liquidate a failing company as a means to recover part of their investment in a short period of time (Kanatas & Qi, 2004). Institutional investors such as retirement funds can also hold considerable equity positions in private corporations which put the funds at risk, but also provides opportunities for involvement and oversight (Xu, 2007). These positions may very well help a company as well as all of the shareholders but can also lead to conflicts.

Oversight

There are several ways that shareholders, through the board of directors of a corporation, can attempt to control how the company is managed. These include performance-based salary systems, long-term compensation plans tied to long-term performance, or compensation plans tied to specific performance goals such as revenue increases or size of dividend payments (Thomas, 2008). "Since the adoption of the Sarbanes-Oxley Act in 2002, most public companies have established a compensation committee to aid in setting and evaluating executive compensation. Compensation committees are an important corporate governance tool to ensure that executives are fairly compensated" (Wilson, 2009). This also provides the shareholders with oversight opportunities to potentially control executive corruption.

Auditing

The relationship between executives and financial audit firms also came into question during the course of the scandals of the last decade. In the Enron case for example, Arthur Andersen LLP was the independent auditor. Upon the collapse of Enron, conflict of interest questions were raised about the relationship between the auditors and the corporate executives. Although there are still unanswered questions about what happened, Arthur Andersen LLP pretty much closed up shop in the United States.

Sarbanes-Oxley limits the scope of services that an auditing firm can provide a publicly traded company. Registered accounting firms cannot provide non-audit services if they serve as the auditor of the financial statements for the public company. Such services may include bookkeeping, appraisal services, internal audit services, or management functions (Sarbanes-Oxley Act, 2006). In addition, those firms that provide financial audit services are required to be rotated over time so that one audit firm cannot have control over the financial audit for long periods of time. It is difficult to predict the effect of the required rotation of auditing firms. But most analysts contend that there will additional costs incurred as new firms take over the financial audit function and spend time and resources becoming familiar with the company ("Public accounting firms," 2003).

Investment Banks

In addition to potential conflicts of interest when auditors and executives are allowed extensive freedom, there are also other conflicts that can arise when investment banks are involved. There were some investment banks that helped to facilitate and participated in several financial transactions with Enron which helped to obscure Enron's true financial condition. Since Enron, and other financial scandals occurred, research analysts at investment banks or brokerage houses have come under considerable public scrutiny for giving existing or potential investors deceptive investment advice so as to gain favor with the companies whose stock is being extolled.

Preventative Action

Such financial scandals led to several court cases, investigation, and prosecutions. In June 2001, the New York Attorney General started investigating the practices of one large brokerage firm. In 2002 the New York AG reached a settlement with the firm which resulted in $100 million worth of fines and regulatory reform which limits the ties between analysts and the investment banking industry.

To help control or reduce losses the stock exchanges also took several actions. In 2002, the NYSE and NASDQ attempted to prevent conflicts of interest by placing guidelines on analysts who may have investment banking interests in the firms they analyze. The rules necessitated a distinct division between the investment banking and research branches of large multi-service brokerage firms. One regulation requires that investment banking personnel be kept from viewing research reports before they are published. In addition, dialogue between research teams and the company being researched is controlled. The rules are very strict with regard to investment or brokerage companies receiving preferred pricing on stock issues as compensation for business services. Rules also extend to the family members of investment bankers and investment analysts.

United States Government regulators also took several actions. In 2003 the SEC adopted regulations that require research reports distributed by a broker, dealer, or certain associated persons to be certified by the research analyst as an accurate reflection of the analyst's personal views. The rules also required disclosure as to whether the analyst received compensation or other payments in connection with his or her specific recommendations or views ("Investment banks," 2003).

Conclusion

The financial scandals of the last have decade have raised many questions about the honesty of corporate managers and the adequacy of the laws that govern how publicly traded companies should be managed. Corporate failures cost the United States thousands of jobs and cost many citizens a considerable portion, if not all of their retirement savings that was invested in 401k plans or other retirement funds.

There were public hearings and criminal investigations. Many corporate executives were found to be out and out criminals. New laws were passed. Executives were convicted. Independent financial audit firms were found to be not so independent and their reputations have been severely tarnished; at least one of the largest auditing firms ceased to exist. New laws and regulations govern the behavior of financial audit firms along with the relationships they have with the companies they audit.

Stockbrokers were found to be misrepresenting the financial condition of companies. Some of these brokerages had a severe conflict interest as they released analyst reports with buy recommendations for companies that the brokerage had other financial relationships with. New requirements of the stock exchanges were implemented to reduce conflict of interest between brokers and publicly traded companies.

Terms & Concepts

Dividend Policy: The policy that guides a public company's payment of dividends to stockholders which can be influenced by tradition, profits, corporate goals, and stockholder desire.

Financial Audit Firms: Independent audit organizations that verify the financial statements of a company.

Investment Bank: A bank or lending organization that focuses on large funding plans or investments for publicly traded corporations.

Shareholder Rights: The rights that (through law or tradition) shareholders have when investing in a company. This could include the right to hold periodic shareholders' meetings, be provided annual or other reports from management, and be paid dividends from corporate profits.

Sarbanes-Oxley Act: A congressional act passed in 2002 to help protect investors from corporate failures and to hold companies and boards of directors more accountable for financial reporting.

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Dividend Policy

On this Page

Subject Terms

Dividend Policy

Dividend Policy

Overview

Why Pay Dividends?

Alternative Investor Incentives

Company Value & Dividend Payout

Applications

Methods of Assuring Stockholder Rights

Corporate Governance

Shareholder Activism

Sarbanes-Oxley Act

Issue

Conflict of Interest in Dividend Policy

Corporate Scandal

Manager Conduct & Dividend Policy

Lenders & Dividends

Oversight

Auditing

Investment Banks

Preventative Action

Conclusion

Terms & Concepts

Bibliography

Suggested Reading