Shareholder dividend options.

• Author: Goshen, Zohar

CONTENTS

1. THE USE OF DIVIDEND POLICY TO REDUCE AGENCY COSTS 885 A. The Dividend Puzzle 885 B. Agency-Cost Theory and Stable Dividends 887 C. Alternatives to Stable Dividends for Reducing Agency Costs 893 1. The Takeover Mechanism 893 2. Debt Financing 896 3. Shareholder Dividend Voting 899 4. Shareholder Dividend Options 903 II. IMPEDIMENTS TO THE ADOPTION OF AN OPTION MECHANISM 906 A. Tax Distortion 906 1. The Problem 906 2. Dividend Reinvestment Plans 908 B. Removing the Tax Distortion 910 1. Taxing an Option Based on Its Actual Exercise 910 2. Total Integration of Corporate Tax 915 3. Taxation Without Realization 916 III. DIRECT REGULATION OF DIVIDEND POLICY

   A. The Feasibility of Dividend Options 918

   1. Defining Earnings and Working Capital 918 2. Creditors' Constraints on Dividends 926

   B. The Role of the Courts 928

4. CONCLUSION

   A firm's dividend policy reflects management's decision as to what portion of accumulated earnings will be distributed to shareholders and what portion will be retained for reinvestment.(1) A firm's retained earnings represent the amount of financing that the firm can utilize without having to compete against other firms in the capital markets. Because dividend policy wholly determines the amount of earnings that a firm retains, dividend policy also determines the extent to which a firm can escape the scrutiny of participants in the capital markets.

   Retained earnings are the greatest source of capital for firms. The typical U.S. industrial corporation finances almost seventy-five percent of its capital expenditures from retained earnings, whereas new equity issues provide a negligible fraction of corporate funding.(2) Scholars have long recognized firms' significant dependence on retained earnings and negligible dependence on equity financing.(3) This phenomenon led Professor Baumol to the inescapable conclusion that a substantial proportion of firms "manage to avoid the direct disciplining influences of the securities market, or at least to evade the type of discipline which can be imposed by the provision of funds to inefficient firms only on extremely unfavorable terms."(4) Unfortunately for the sake of allocative efficiency, in recent years, most firms have also managed to aviod even the indirect disciplining influences of the market for corporate control.(5)

   Inefficient managers might try to escape a market inspection of their performance by adopting a low-payout dividend policy and avoiding the competitive external market for financing.(6) Seemingly oblivious to this threat of managerial opportunism, state courts have established that directors possess sole discretion over whether or not to declare dividends, and that, absent abuse of discretion, the law will not second-guess the business judgment of corporate officers.(7) The general rule is that only fraud, bad faith, or gross mismanagement can justify compelling distribution.(8) This rule removes any effective limit on managerial decisions concerning the timing and quantity of dividend distributions.

   In granting management the protection of the business judgment rule, courts have placed a heavy burden on shareholders who wish to challenge management's dividend policy. A shareholder suit to compel dividend distribution, based on the claim that management is investing in bad (negative net present value) projects, has virtually no chance of succeeding. In fact, in the last one hundred years, there has not been a single case in which U.S. courts have ordered a management-controlled, publicly traded corporation to increase the dividend on its common stock.(9)

   Although a few scholars have recognized the need to restrain managerial discretion over dividend policy,(10) a thorough analysis of the dividend policy issue has not appeared in either the law review or finance literature.(11) Moreover, to date, proposals to reform dividend law have been ineffective.(12) In general, the body of legal literature on dividend policy is sparse; this Article provides a much-needed analysis of how the law ought to regulate managerial decisions regarding dividend policy.

   This Article proposes a legal norm that shifts discretion over dividend policy from managers to the capital markets (i.e., shareholders).(13) State corporate law could effect such a shift by adopting a rule that mandates shareholder control over the dividend decision. The rule would require every firm to adopt an option mechanism that, at predetermined dates, provided each of the firm's shareholders with the right to select either cash or stock dividends in an amount equal to the shareholder's pro rata share of the firm's earnings. For instance, the law might require that, once a year, the firm offer to each shareholder the right to decide what percentage of her share of earnings she will take out of the firm--through a cash dividend--and what percentage she will leave in the firm--through a stock dividend. The option mechanism would be a cost-effective vehicle for assigning control over a firm's accumulated earnings to the capital markets.

   Theory and evidence suggest that an unfettered management retains an excessive amount of earnings.(14) Entrusting the capital markets with control over the earnings reinvestment decision would facilitate optimal earnings retention by firms(15) and lessen the need for the indirect and expensive discipline provided by the market for corporate control.(16) Moreover, by giving the capital markets some control over the allocation of approximately seventyfive percent of corporate expenditures, shareholder dividend options would enhance the importance of capital markets in achieving allocative efficiency.(17)

   Part I of this Article analyzes the role of dividend policy in reducing agency costs. It begins by presenting the "dividend puzzle" and questioning why distribution of dividends affects a firm's value, given the theoretical irrelevance of dividend policy. This Part then rehearses the agency-cost explanation for the existence of dividends. Next, it compares the current practice of firms--maintaining a stable dividend distribution--with alternative mechanisms for controlling agency costs. Finally, it argues for the superiority of shareholder dividend options.

   Part II explores why firms do not voluntarily adopt the option mechanism in spite of its superiority to current practice. The most likely explanation is the tax distortion in the Internal Revenue Code that would require current taxation of shareholders receiving a dividend option. Indeed, to the extent that firms are willing to sustain tax costs, they do adopt an option mechanism to enhance efficiency: dividend reinvestment plans. The remainder of the Part considers means of removing the tax distortion.

   Part III considers the justification for and workability of a corporate law rule mandating the option mechanism. It argues that a mandatory rule is justified by the need to improve the performance of inefficient firms by exposing them to the scrutiny of the capital markets. It also demonstrates the feasibility of mandating the option mechanism and discusses the role of the courts in implementing dividend options. Part IV summarizes the preceding arguments and concludes that shifting control over dividend policy to shareholders is desirable and should be implemented, albeit gradually.

1. THE USE OF DIVIDEND POLICY TO REDUCE AGENCY COSTS

   A. The Dividend Puzzle

   The logical starting point for any discussion about dividends is the "Irrelevance Theorem" of Modigliani and Miller.(18) According to this theorem, if a firm's investment policy is predetermined and immutable, dividend policy cannot affect the firm's value. If a firm does not distribute dividends, the price of its equity will rise proportionally with earnings, and investors can obtain a "homemade dividend" by selling a fraction of their shares on the market and liquidating their capital gains. On the other hand, if a firm does distribute dividends, and hence finances new investment by raising funds in the capital markets, the price of its equity will decline in proportion to the dividend payout. The capital markets, therefore, should be indifferent as to whether or not a firm distributes dividends, because in either case the investor possesses the same amount of wealth. Nevertheless, given the high costs of raising new funds in the capital markets and the inferior tax treatment of cash dividends compared to capital gains,(19) distributing dividends will generally reduce the value of the firm. Consequently, no prudent management should pay out dividends. In practice, however, managers do not behave as if they subscribe to the irrelevance theorem. Firms do distribute dividends, and management's promise to increase the dividend payout ratio usually leads to increases in the price of the firm's equity. Actual practice suggests that investors and managers do care about dividend policy. This conflict between theory and practice is known as the "dividend puzzle."(20)

   The literature on dividend policy revolves around this puzzle. Why do managers distribute dividends at all? Why do investors care about dividends? Scholars have offered various explanations. First, dividends might have information or signaling effects: Managers might change their firm's dividend payout ratio to signal their forecast of the firm's future performance.(21) Second, tax rates drive investors to hold stock in firms with particular payout ratios: Other things being equal, low tax bracket investors hold stock in firms that pay high dividends, and high tax bracket investors hold stock in firms that pay high dividends, and high tax bracket investors hold stock in firms pay low dividends.(22) Third, dividends can increase a firm's efficiency by reducing agency costs: Distribution of dividends diminishes the internal cash flow subject to management's discretion.(23) The agency-cost resolution of the dividend puzzle is the most compelling of the proferred...