Independent directors and the propensity to pay dividends

Journal of Corporate Finance 17 (2011) 1001–1015

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Journal of Corporate Finance j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j c o r p f i n

Independent directors and the propensity to pay dividends☆ Vineeta Sharma ⁎ School of Accountancy, Coles College of Business, Kennesaw State University, 1000 Chastain Rd, MD 0402, Kennesaw, GA 30144-5591, United States

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Article history: Received 5 May 2008 Received in revised form 11 May 2011 Accepted 14 May 2011 Available online 20 May 2011 JEL classification: G35 G34 K22

Keywords: Payout policy Independent director Corporate governance Equity incentive Busy director Director tenure

a b s t r a c t Using data from 944 public companies in 2006, I examine how a firm's propensity to pay dividends is related to (i) board independence and (ii) independent directors' tenure, number of board seats (busy) and equity incentive compensation. After controlling for the effects of traditional economic, CEO entrenchment and ownership determinants of the propensity to pay dividends, I find evidence of a positive association between the propensity to pay and (i) board independence and (ii) director tenure, and a negative association between the propensity to pay and (i) busy directors and (ii) greater equity incentive compensation in the director pay structure. I find consistent results when the decision is to pay cash dividends or repurchase shares. In further tests, I find that equity incentive compensation in the independent director pay structure is the most pervasive determinant across other dividend measures such as dividend payout, total payout and repurchases. Overall, the findings suggest that the characteristics of independent directors are important determinants of the payout policy. The results also suggest that future corporate governance research could benefit from incorporating characteristics of independent directors rather than limiting governance measures to board independence especially when recent empirical evidence (Linck et al., 2008, 2009) shows convergence, and therefore, narrowing variation in the proportion of outsiders and insiders on a board. © 2011 Elsevier B.V. All rights reserved.

1. Introduction Despite more than 50 years of empirical research, the propensity to pay dividends remains a ‘puzzle’. The literature offers several explanations for ex-ante corporate dividend policy such as agency conflicts, catering, clientele, investment opportunities, and signaling. Recently, Denis and Osobov (2007) conclude, based on a comprehensive study, that signaling, clientele, and catering theories are weak explanations for the propensity to pay dividends. They find support for the agency explanation of dividend policy. In this study, I adopt the agency view and investigate the association between characteristics of independent directors on the board and the propensity to pay dividends. 1 Specifically, I examine how board independence, independent directors' tenure on the board, their multiple-directorships, and their compensation structure are associated with a firm's propensity to pay dividends. 2 While prior research investigates how board independence mitigates agency problems associated with the propensity

☆ I would like to thank Jeffry Netter (Managing Editor) and the anonymous reviewer for their comments and suggestions. ⁎ Tel.: + 1 770 794 7626; fax: + 1 770 499 3420. E-mail address: [email protected]. 1 I define a director as independent following the new corporate governance rules approved by the Securities and Exchange Commission (SEC). A director is considered independent if the outside director has no business, employment, consulting or family based affiliation with the firm or any of its subsidiaries other than as his/her role as a director on the firm's board. An independent director is also one who does not receive any consulting, advisory or compensatory fee other than fees normally paid for the directorate role. For details refer to the SEC Rule Release No. 34–48745 (SEC, 2003b). This definition of independent directors excludes gray directors. 2 I acknowledge there are other potential independent director characteristics that I do not investigate. Some of these include board interlock, director is a current CEO, educational and professional qualifications, industry experience, other board sub-committee memberships, gender, and age. 0929-1199/$ – see front matter © 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jcorpfin.2011.05.003

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to pay dividends, there is no research on how characteristics of independent directors influence the propensity to pay dividends. This study is situated in the propensity to pay stream of the literature. 3 I focus on the characteristics of independent directors for several reasons. First, boards of directors have the purview and influence over dividend policy and help mitigate agency conflicts between management and shareholders (e.g. Easterbrook, 1984; Farinha, 2003; Hu and Kumar, 2004; White, 1996). Dividend policy is one area where conflicts between management and shareholders may occur (Easterbrook, 1984; Jensen, 1986) and the board is the ultimate internal governance mechanism charged with protecting shareholders' interests. Second, prior research has yet to unequivocally demonstrate the empirical association between greater board independence and shareholder protection generally (Clark, 2005; Finkelstein and Hambrick, 1995; Zahra and Pearce, 1989), and more specifically, in the context of the propensity to pay dividends (Farinha, 2003; Hu and Kumar, 2004; White, 1996). Further research can help us understand the various contexts under which independent directors are more or less effective in addressing agency conflicts between management and shareholders. Third, while greater board independence is necessary from a regulatory perspective, I believe it is not sufficient to explain why some independent directors vigilantly protect the interests of shareholders and others do not. I believe that the characteristics of independent directors will become increasingly important in a regulatory environment where majority independent representation on the board is now mandatory. The Sarbanes-Oxley Act (SOX) (2002) driven corporate governance rule changes by the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ) require majority independent directors on the board. 4 Linck et al. (2008, 2009) demonstrate that the size and structure of the board has changed dramatically since the passing of SOX with boards comprising more independent directors. However, to comply with the stock exchange listing rules, firms may appoint seemingly ‘independent’ directors to their boards. Such appointments to the board may give the appearance of an independent and objective board but in substance the board may not be sufficiently independent of management and/or independent directors may not be willing to effectively monitor management policies. These so called independent directors may have incentives to foster their own self-interests. In addition, boards that lack substance but exhibit form (seemingly ‘independent’ boards) create a confounding effect for board independence research and handicap empirical research in dis-entangling determinants of variations in board effectiveness. For instance, while the substantial increase in the workload of directors following the corporate governance reforms has increased the demand for directors, the associated reputational and litigation risks are reducing the pool of available directors (Linck et al., 2009). To lure directors, Linck et al. (2009) find that companies are paying their directors an average of 50% more and with significantly greater equity incentive compensation in the post-SOX period. Such payments are attracting directors to accept more board appointments given that the supply of directors is declining. However, greater equity incentive compensation and more board seats are generally not conducive to effective governance (Linck et al., 2009). While boards are becoming more independent in the post-SOX period, boards with independent directors serving on multiple boards may be ineffective at monitoring agency conflicts between management and shareholders because these directors may be too busy. Similarly, paying directors with more equity may lead independent directors to not challenge management policies that potentially enhance stock values. Dividend payout is one policy that has been subject to conflict between shareholders and management as non-payment of dividends facilitates management's incentive to enhance the value of their shares and stock options (Lambert et al., 1989). Independent directors receiving greater equity compensation may also exhibit similar incentives. The U.S. Senate (2002) enquiry into the malfeasance at Enron identified director tenure as another significant governance defect. The findings suggested that directors with longer tenure developed close affiliations with management and thus were unwilling to challenge management. Some activists such as the National Association of Corporate Directors (NACD) and Council of Institutional Investors (CII) have long called for limits to director tenure but so far no tenure limit regulation has been introduced. Some argue that given the heightened scrutiny of boards, significant penalties for non-performance, risk of litigation and loss of reputation in a post-SOX world, directors may have incentives to more effectively perform their responsibilities. Longer board service creates a natural research tension as longer tenure could entrench the independent directors or provide opportunities for accumulating firm specific knowledge and garner support from other board members and shareholders to provide more effective monitoring of management over policies subject to conflict of interest between management and shareholders. I therefore examine how the tenure of the independent directors is related to dividend policy. My examination of the incentives underlying the three independent director characteristics in relation to dividend policy responds to the call for further research by Linck et al. (2009). They urge more research to extend our understanding of how the SOX-led board reforms affect the performance of the board. 5 In this study, I examine how a firm's propensity to pay dividends is related to board independence, independent directors' tenure, number of board seats (busy) and equity incentives in directors' compensation structure on a sample of 944 firms from fiscal year ended 2006. This study uses data extracted from Compustat and hand-collected from proxy statements filed with the Securities and Exchange Commission (SEC). I focus on 2006 because this was the first year the SEC rules on more complete disclosure 3 I do not focus on the magnitude of dividends paid (e.g. dividend yield) because that is a separate issue which occurs after a decision to pay a dividend is made. The focus on a firm's decision to pay dividends is consistent with the propensity to pay paradigm (e.g. DeAngelo et al., 2004; Denis and Osobov, 2007; Fama and French, 2001). However, I consider continuous payout measures such as dividend payout, repurchases, and total payout in additional analyses. 4 Since the new listing rules of the NYSE and NASDAQ became effective, a Business Roundtable survey shows boards comprise at least 80% independent directors with four in 10 boards being completely independent except for the CEO. 5 I acknowledge, as do most prior research (e.g. Coates, 2007; Linck et al., 2008, 2009; Wintoki, 2007) that it is difficult to quantify the costs and benefits of the SOX-led reforms, and even more difficult to expect consistent results across various events of interest to shareholders (e.g., dividend payout, mergers and acquisitions, quality of financial reporting, quality of the audit, and CEO compensation).

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of director compensation data such as stock options became effective and because it is a period relatively free of tumultuous events surrounding SOX, corporate excesses and scandals, and regulatory changes implemented by the SEC and the U.S. exchanges (SEC, 2003a). Such events heighten the spotlight on board governance and may confound the empirical analyses. I limit my analysis to 2006 because of significant hand-collection of director data.6 My empirical model controls the effects of CEO entrenchment such as duality, tenure and ownership, exercisable and unexercisable options held by the CEO, and other firm-level determinants of the propensity to pay dividends such as firm size, leverage, profitability, investment opportunities and company age. The results show that greater board independence and tenure are positive and significantly associated with the propensity to pay dividends, while more equity incentives in the compensation structure of independent directors and busy directors are negative and significantly associated with the propensity to pay dividends. In further tests, I find consistent results when the payout decision is either for cash or share repurchases. However, in relation to the level of dividend and total payout, I find that payout decreases in greater equity incentive in the compensation structure of independent directors. Greater board independence is associated with higher total payout and busy directors is associated with lower dividend payout. For the repurchase test, I find that directors with longer tenure prefer less repurchases while greater equity incentives in the compensation structure of independent directors is associated with higher repurchases. Generally, the results suggest the following conclusions. Independent directors are positively related to dividend payout because they have incentives to signal their reputation and managerial competence to the market (Fama and Jensen, 1983; Linck et al., 2009; Weisbach, 1988) and avoid potential litigation and loss of future directorships (Daily et al., 1998; Linck et al., 2009). Thus, greater board independence improves internal monitoring and facilitates disciplining of management resulting in a higher total payout. However, when these independent directors receive greater equity compensation and are too busy they are more likely to not recommend a dividend payout, and if they do, the payout is lower. Such findings are consistent with Linck et al. (2009) recently proposing that greater equity compensation and multiple directorships are not conducive to effective governance. The independent director equity incentive compensation results extend Lambert et al.'s (1989) findings related to management. I show that independent directors receiving more equity incentive compensation influences them to not prefer a cash payout because cash payouts reduce the value of their options and increase the cost to the directors recommending a cash payout. In summary, I document that board independence and director tenure mitigate agency conflicts between management and shareholders in relation to the propensity to pay dividends, while greater equity incentive compensation and busy directors exacerbate such agency problems. The study's unique contribution to the literature extends the dividend propensity model by providing the first evidence of the theoretical and empirical association between the characteristics of independent directors and the propensity to pay dividends. I provide evidence that characteristics of independent directors are often as important as economic characteristics of the firm and CEO entrenchment factors in explaining the propensity to pay dividends. Inclusion of independent director characteristics enhances our understanding of boardroom dynamics and may help explain the inconsistent results in the prior board independence literature. The remainder of the paper is organized as follows. Section 2 outlines the prior research and develops the hypotheses. Section 3 describes the sample and model specifications. Section 4 reports the results. Section 5 concludes the study and identifies limitations and opportunities for future research.

2. Prior research and hypotheses development 2.1. Agency problem and dividend payout policy Agency theory posits management is self-serving; they maximize their own personal wealth at the expense of the wealth of the shareholders (Easterbrook, 1984; Jensen and Meckling, 1976). For example, research has long argued that CEOs engage in empire building (Williamson, 1964), take exorbitant compensation and perquisites (Wan, 2003), and invest free cash flow in negative present value projects (Easterbrook, 1984). Easterbrook (1984) argues that dividends may also arise because of agency problems between managers and shareholders due to monitoring and risk aversion preferences. When management finances projects out of internally generated funds rather than through the financial market, they reduce their personal and debtholders' risks but increase the risk borne by shareholders. Dividend payout reduces the available free cash flow and forces management to finance projects through the financial market. As rational suppliers of capital will monitor and provide ongoing discipline to management, dividend payout becomes an effective implicit mechanism to control managerial discretion over the use of excess cash flow (Easterbrook, 1984). The risk aversion perspective suggests that managers have a lower appetite for risk than shareholders would prefer because managers have significant personal wealth tied up in the firm. Managers can alter the risk of the firm through the mix of projects and altering the debt to equity ratio. A lower debt to equity ratio reduces the risk of firm bankruptcy and thus costs to managers and debt providers. Managers can lower debt to equity by financing projects from retained earnings which transfers wealth from shareholders to debtholders. Easterbrook (1984) then argues that to avoid being taken advantage of by debtholders, shareholders would prefer dividend payout because it would reduce retained earnings and force managers to obtain external funds. Even if managers do not raise new capital, dividends increase the debt to equity ratio and help protect shareholder wealth. Leveraging on the monitoring and risk aversion perspectives, Easterbrook (1984) concludes that the dividend mechanism could serve to mitigate agency conflicts between management and shareholders. 6

I reviewed the biographical and compensation data of approximately 10,200 directors.

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Although management may pay out excess cash in the form of dividends to mitigate agency problems (DeAngelo et al., 2004; Easterbrook, 1984; Jensen, 1986), they still retain discretion over payout policy. 7 Easterbrook (1984) argues that since dividends decrease the amount of discretionary funds available inside the firm, management may manipulate dividend payout policies to ensure excess earnings are retained in the firm for their own private benefit, ceteris paribus. Excessive compensation (Wan, 2003), the declining propensity to pay dividends over time (Fama and French, 2001), and the Enron led accounting scandals and corporate bankruptcies heighten the imperative for continuous improvements to corporate governance practices in order to curtail agency conflicts. The SOX (2002) led corporate governance reforms suggest independent directors can mitigate the agency conflict between management and shareholders over dividend payout. As guardians for the shareholders, independent directors are in a unique position to monitor dividend policies because management requires board approval prior to announcing dividends to the market (Easterbrook, 1984; White, 1996). Independent directors consider various factors before approving a dividend payout. They consider factors such as the firm's growth opportunities, debt levels and potential emergencies when determining dividend policy. Consequently, independent directors have the capacity to reduce the agency conflict between management and shareholders over dividend payout policies. I describe next the role of independent directors and how their specific characteristics are related to dividend payout. 2.2. Independent directors and the propensity to pay dividends Fama and Jensen (1983) and regulators such as the SEC argue that independent directors are in a better position to perform critical decision control functions and thus mitigate agency conflicts between management and shareholders. Independent directors face strong incentives to exercise judgment independently and free of management influence (Fama and Jensen, 1983). Independent directors have incentives to signal their reputation and managerial competence to the market (Fama and Jensen, 1983; Linck et al., 2009; Weisbach, 1988). They are receiving heightened attention by current and potential shareholders, the directorial market, regulators and the public. A failure to act in the interests of the shareholders and the firm, and thus a failure to protect their reputation may result in potential litigation and loss of future directorships (Daily et al., 1998; Linck et al., 2009). With respect to dividend payout, Kaplan and Reishus (1990) report that the opportunity to serve on additional board seats is significantly reduced for board members in dividend reducing firms. Consistent with the preceding argument, the NYSE and NASDAQ predicate that independent directors enhance the quality of board oversight and weaken the possibility of conflicts of interests between management and shareholders. One such conflict is payout policy. DeAngelo et al. (2004), Easterbrook (1984), Jensen (1986), Jensen and Meckling (1976) and Williamson (1964) posit that management can abuse free cash flow for their personal benefit (perquisites, risk aversion, empire building) and they can achieve this by manipulating dividend payout policies. Because of information asymmetry and dispersed ownership, shareholders are often not able to directly monitor management, they appoint a board of directors to protect their interests. Independent directors could effectively constrain management's opportunistic dividend policies that benefit them and other stakeholders (such as debtholders) at the expense of shareholders. In recent years, the proportion of independent directors on the board has been increasing because of the imperative to protect shareholders from managerial abuse and to maximize firm value (Linck et al., 2009). Linck et al. (2008, 2009) argue that the governance reforms following SOX not only imposed new requirements for directors, it also expanded their roles and altered how they should behave. Hence, if as expected by regulators and proposed by agency theory, greater board independence improves internal monitoring and facilitates disciplining of management, then it is expected that, ceteris paribus, the propensity of a dividend payout will increase with greater independent director representation on the board. This is so because in the post-SOX world, independent directors are cognizant of the reputational and litigation implications of not protecting shareholders' interests. I test this association using more recent data by specifying the following hypothesis: H1. There is a positive association between the percentage of independent directors on the board and the propensity to pay dividends. Although Hypothesis 1 predicts a positive association between board independence and the propensity to pay dividends, independent directors are likely to face varying sets of incentives; that is, the set of incentives facing independent directors are not constant across directors and boards. I discuss next how three sources of incentives I examine in this study, longer board service, multiple-directorships and equity compensation in director pay structure, are related to the propensity to pay. 2.3. Characteristics of independent directors and the propensity to pay dividends 2.3.1. Tenure of independent directors Social network theory posits that individuals develop and strengthen their friendship and social ties with each other through extended interpersonal interactions both in formal and informal group settings (Harris and Helfat, 2007). In a group setting such as the board of directors, independent directors develop and solidify their friendship or social ties with management as their tenure on the board increases. One implication of the close social nexus and strong affiliation independent directors have with 7 In the absence of investment opportunities, if shareholders do not receive free cash flow via dividend payout, then management can be punished via retrenchment or other ex post adjustments (Easterbrook, 1984). Easterbrook (1984) argues that the dividend mechanism is probably more efficient than other ex post adjustments.

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management is the potential weakening of their responsibility to discipline management. Independent directors with long tenure are potentially more likely to ratify management decisions that could compromise the interests of shareholders (Boeker and Goodstein, 1993; Kesner et al., 1986; Wade et al., 1990). For example, Vafeas (2003a) documents a positive association between independent director tenure and CEO pay. He concludes that independent directors with longer tenure, particularly 15 years and more, compromise shareholder interests by ratifying higher CEO compensation under unwarranted circumstances. Activists and researchers such as the NACD (1996), CII (1998), U.S. Senate (2002) and Vafeas (2003a, 2003b) are also concerned about director tenure. They have long argued that longer tenure does not bode well for monitoring management and as such, suggest tenure limits. These activists suggest that board tenure should be limited to a maximum of 15 years to eradicate entrenchment and bring in fresh ideas. The U.S. Senate (2002) investigations into the corporate scandals that eventually led to the enactment of SOX support this view. The Senate reported that directors with longer service on the board were just as culpable as management because they failed to effectively monitor management. An alternative view suggests a potential benefit of longer board service. The managerial talent paradigm suggests directors accumulate considerable experience and skill as their tenure on the board increases (Buchanan, 1974; Salancik, 1977; Vance, 1983). Longer board service cultivates more experienced, committed and competent directors because these independent directors have valuable knowledge about the firm and its environment. In addition, such directors are more confident and more likely to challenge management when necessary. Therefore, longer tenure has the potential to strengthen independent directors' ability to discipline management. The new SEC rules following SOX mandate that independent directors be nominated by a nomination committee followed by ratification from the shareholders. 8 This appointment process suggests that independent directors may have greater incentives to protect shareholders' interests because shareholders are paying closer attention to directors and becoming more active in the director selection and ratification processes. Recent research supports this view. Fischer et al. (2009) demonstrate that shareholder votes for uncontested director elections have a significant association with director turnover. Cai et al. (2009) show that shareholder votes significantly affect director performance and Ertimur et al. (2010) find that shareholder pressure through proposals significantly affects the likelihood of directors losing their board seats. These studies suggest that shareholder activism is gaining strength and boards appear to be sensitive to shareholders' concerns. Furthermore, Linck et al. (2009) argue that in the post-SOX world independent directors face significantly greater reputation and litigation risk. Such pressures together with heightened regulatory and public scrutiny would induce directors to demonstrate their independence from management and thus maintain their board seats. Maintaining a current board seat is particularly efficient from a director's perspective because the learning curve related to understanding a new company (e.g., business environment, strategies, policies and procedures, internal controls, financial reporting and assurance process) would impose significant information acquisition and processing costs on the director (Linck et al., 2008). In an efficient market for directors, longer serving directors are those who best protect shareholders, and one way such independent directors can signal their effectiveness to shareholders and the directorial market is to mitigate management and shareholder conflicts over dividend payout. However, given the competing theoretical explanations, I hypothesize a null association: H2. There is no association between the tenure of independent directors and the propensity to pay dividends. 2.3.2. Multiple board seats held by independent directors Board service demands significant involvement from the directors. Directors not only attend board meetings that average seven per annum (Monks and Minow, 1996), but are required to be more active, increase their understanding of financial statements and knowledge about the firm including its strategies, risk management processes, and internal and external environment (NACD, 1996). Corporate governance activists such as the CII (1998) and the NACD (1996) criticize firms for appointing directors with multiple directorships. They argue that effective monitoring by directors requires a commitment of time and resources and directors serving on multiple boards are incapable of effective monitoring. Directors serving on multiple boards are often labeled ‘busy’ or ‘overboarded’ directors. Academic research also criticizes busy independent directors. For instance, Carpenter and Westphal (2001) argue that because busy independent directors are stretched thin, their limited information processing capacity could induce information overload. Consequently, busy directors may experience negative socio-cognitive externalities from their other directorships leading to ineffective monitoring of management. Ferris et al. (2003) label this the ‘busyness hypothesis.’ Management that is not effectively monitored might impose greater agency costs on the firm manifesting in a lower propensity to pay out cash dividends. To enable directors to perform their fiduciary duties more effectively, the NACD (1996) recommends a limit on board seats. The NACD determines three (six if retired) other board seats as the point beyond which the effectiveness of independent directors decreases. Although empirical research appears to support this determination (e.g. Core et al., 1999; Vafeas, 2003b), the BRT (1997) disagrees. The BRT (1997) argues that limiting the number of board appointments restricts the diversity of experience directors obtain from participating in multiple boards. Fama and Jensen (1983) propose that multiple board appointments could signal the quality of the director. Directors could be offered more board appointments following successful performance of the firm

8 I acknowledge that directors are seldom not ratified by the shareholders. However, there is mounting evidence of increased shareholder activism in the director appointment process with evidence of removal or non-ratification of directors and increased shareholder participation at corporate annual meetings. See Cai et al. (2009), Fischer et al. (2009) and Ertimur et al. (2010) for a comprehensive discussion of the shift in shareholder activism in the post-SOX period.

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they serve on. Ferris et al. (2003) call this the ‘reputation effect’. Ferris et al. (2003), Harris and Shimizu (2004) and Shivdasani (1993), report results consistent with this view. However, all of the above studies were conducted prior to the SOX-led corporate governance reforms. These reforms substantially expanded the responsibilities and workload of the directors, and consequently their litigation and reputational risks. The pressure on companies to appoint more independent directors to satisfy the SOX-led reforms has intensified because directors are reluctant to serve on more boards (Linck et al., 2008, 2009). Linck et al. (2009) report that to better manage their workload, and litigation and reputational risks, directors are reducing the number of boards they serve on. One source of the workload is increased sub-committee work. They find that the percentage of independent directors who sit on all sub-committees of the board increased six-fold between 1998 and 2005 coupled with significantly more frequent meetings particularly those held by board sub-committees. 9 To address potential threats to an independent director's availability to fulfill his or her responsibilities, U.S. exchanges (e.g., NYSE) require boards to adopt and disclose their compliance with corporate governance guidelines which include limiting an independent director's board seats to four public boards. 10 The required disclosures of the number of board seats held by the director will assist the market in assessing the effectiveness of a director. While boards are becoming more independent in the post-SOX period, boards with independent directors serving on more than four board seats may be ineffective at monitoring agency conflicts between management and shareholders. Consequently, I posit that in the post-SOX period, as the proportion of independent directors with board seats exceeding four in total increases (busy directors), their ability to monitor dividend policy deceases. 11 H3. There is a negative association between the proportion of busy independent directors on the board and the propensity to pay dividends. 2.3.3. Independent director compensation structure The BRT (2003) argues that compensation is the primary tool for attracting, retaining, motivating and rewarding management and employees at all levels. I extend the BRT's economic concept to independent directors. The SOX-led reforms have substantially increased the demand for independent directors with appropriate competence. The Economist Intelligence Unit (2003) reports that almost two-thirds of the companies surveyed believe top quality independent directors are harder and more expensive to recruit. Executive search firms such as Pearl Meyer and Partners, and Spencer Stuart report that eligible directors are increasingly turning down appointments to other boards. These firms recommend greater compensation to attract, motivate and reward high quality directors. The belief is that the level of independent director compensation should be commensurate with the demands of the role and the quality of independent directors. Farrell et al. (2008) and Linck et al. (2009) provide the most recent evidence that companies have substantially increased director compensation to fill their board seats created by the SOX-led reforms. Moreover, these researchers report that the equity incentive component in director pay is much greater and has increased the most between the pre-SOX and post-SOX periods. Linck et al. (2009) also show that this increase in director pay was greater than that of the CEO following the enactment of SOX. Given such changes in the structure of director pay, Linck et al. (2009) suggest future research examine how compensating directors with equity is related to board monitoring. They posit that giving higher equity compensation to directors could lead to unintended consequences symptomatic of ineffective board governance. 12 Greater equity incentive component in a director's compensation structure can influence dividend policy. First, agency theory posits that providing equity stakes in the company to directors helps align directors' interests with those of the shareholders thus reducing various agency conflicts, including overinvestment, between management and shareholders (Allen, 1981; Beatty and Zajac, 1990; Finkelstein and Hambrick, 1989; Holderness and Sheehan, 1988; Schleifer and Vishny, 1986; Tosi and Gomez-Mejia, 1989). Accordingly, Fama and French (2001) propose that increasing equity ownership by directors could reduce the benefits of dividend payout to mitigate agency problems between management and shareholders. Second, although greater equity compensation may serve to align a director's interest with those of the shareholders, incentive compensation, in the form of stock options, paid for monitoring management may not bode well for shareholders in the post-SOX period. The corporate scandals at the turn of the century suggest that independent directors given stock and stock options failed to effectively fulfill their monitoring responsibilities because they sought to gain through higher stock prices (Archambeault et al., 2008; Brick et al., 2006; U.S. Senate, 2002,). Equity incentives such as stock options may encourage directors to support or even pursue high risk investments proposed by management. Option holders face little downside risk from investments in risky projects. They have not much to lose if the investment is sour but can gain significant wealth if risky investments return a profit (Bebchuk and Fried, 2003). In addition, because the usage of stock options also benefits directors when management manipulates the timing of option grants, directors compromise their independence and thus undermine their monitoring effectiveness

9 For my sample of 944 firms in fiscal 2006, the average (median) board meetings per year is 8.33 (8.00) which is significantly (p b 0.01) greater than the average of 6.4 reported by Linck et al. (2009) for 30 randomly selected large companies in 2004. 10 See NYSE listing rule 303A.09 Corporate Governance Guidelines, and www.nyse.com_corporate _governance_guidelines.pdf for details. 11 This view assumes that more dividends imply more external monitoring as in Easterbrook (1984). 12 I focus on equity in independent directors' compensation structure because Linck et al. (2009) argue that giving greater equity incentive as compensation incentivizes directors to not effectively perform their governance responsibilities. It is the value of the equity in the total compensation structure that is of interest since the compensation is designed to attract and motivate directors to serve on the board at a time when the supply of directors are decreasing but their workloads are increasing (Linck et al., 2009).

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(Bebchuk et al., 2006). Linck et al. (2009) also recognize potential monitoring problems associated with the increasing use of equity incentives in director pay in the post-SOX period, and conclude that it may be a ‘bad’ governance practice. Third, I posit that greater equity incentive compensation could induce directors to curtail or not initiate a dividend payout. However, there is no prior research examining the compensation structure of independent directors and dividend payout. Research on executive compensation structure and dividend payout shows that incentive compensation using stock options are negatively related to dividend payout (Cuny et al., 2009; Fenn and Liang, 2001; Kahle, 2002; Lambert et al., 1989). The findings in these studies suggest that the usage of stock options can lower dividend payout and thus potentially exacerbate the free cash flow problem because dividend payout reduces the value of the stock option to a manager. Extending this line of reasoning to independent directors suggests that dividend payout will decrease the expected value of equity incentives, and in particular stock options, and increase the costs (at the margin) to a director. As a result, the director may have an incentive to reduce dividends if there are greater equity incentives including stock options in the compensation arrangement. If directors are driven by incentives similar to executives, then greater equity incentive compensation in a director's compensation structure will be negatively related to dividend payout. The above discussion suggests that regardless of the mechanism through which equity incentives in the compensation structure of independent directors operates, greater equity incentives in the compensation structure of independent directors is likely to result in lower propensity to pay dividends. H4. There is a negative association between greater equity incentive compensation in independent director compensation structure and the propensity to pay dividends. 3. Research method 3.1. Model specification and variables I specify the following model to empirically test the four research hypotheses. The test variables are italicized. The measures for the test variables are contained in Table 1. Consistent with the propensity to pay dividend literature (e.g. DeAngelo et al., 2004; Denis and Osobov, 2007; Fama and French, 2001), the dependent variable is the likelihood of the firm paying dividends (LIKE_PAY) and is set to 1 if a cash dividend is paid, and 0 otherwise. Since the dependent variable is binary, I employ a Logit function where the probability of LIKE_PAY is estimated using the functional form π(x) = e g(x) / 1 + e g(x). P ðLIKEXPAY Þ = f Vα + β 1 INDEP + β 2 TENURE + β 3 BUSY + β 4 DIRXEQUITY + β 5 MKTXBOOK + β 6 LNXTA + β 7 LEV + β 8 ROA + β 9 COYXAGE + β 10 CEOXTENURE + β 11 DUAL + β 12 CEOXOWN + β 13 CEOXOPTEX + β 14 CEOXOPTXUNEX + β 15 INDUSTRYCONTROLS + εi g

ð1Þ

I include control variables that have been found statistically significant in the prior literature. These relate to CEO entrenchment variables and traditional economic determinants of the propensity to pay dividends. I include variables that capture a powerful CEO (CEO_TENURE, DUAL, CEO_OWN), options held by the CEO (CEO_OPT_EX, CEO_OPT_UNEX), growth opportunities (MKT_BOOK), and leverage (LEV) because these are negatively related to dividend payout (Core et al., 1999; DeAngelo et al., 2004; Fama and French, 2001; Fenn and Liang, 2001; Fich, 2005; Hu and Kumar, 2004; Kahle, 2002; Wan, 2003). Larger (LN_TA), more profitable (ROA) and mature companies (COY_AGE) are positively associated with a payout (Cuny et al., 2009; DeAngelo et al., 2004; Denis and Osobov, 2007; Fama and French, 2001; Fenn and Liang, 2001). The inclusion of growth opportunities, leverage, and CEO incentive compensation also helps control for potential mechanisms through which independent directors could influence dividend policy (Cuny et al., 2009; Fenn and Liang, 2001). 13 Table 1 defines the control variables and provides references to the prior literature from which they are sourced. 3.2. Sample description I begin with S&P 1500 index firms trading on NYSE and NASDAQ. Availability of dividend and financial data in Compustat for fiscal 2006 reduces the sample size to 1088 firms. Because I hand-collect board, CEO and company age data from proxy statements filed with the SEC, I exclude 144 firms with missing proxy statement disclosures. This process brings the final sample size to 944 unique firms. I examine data for fiscal 2006 because this is the first year the SEC rules mandating more comprehensive and detailed disclosure of compensation became effective. In addition, fiscal 2006 is relatively remote from the tumultuous period surrounding SOX and thus less subject to confounding effects (Linck et al., 2009). Finally, restricting the sample to one fiscal year is conducive to extensive hand collection of director data from the proxy statements. Nevertheless, the sample is sufficiently large to ensure satisfactory statistical power in the tests.

13

I am grateful to the anonymous reviewer for this suggestion.

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Table 1 Definitions of dependent and independent variables. Dependent variable

Definition

Likelihood of a cash dividend payout (LIKE_PAY) Cash Dividend vs Repurchase

Dummy variable equals 1 if firm pays a cash dividend, 0 otherwise. Dummy variable equals 1 if firm pays only a cash dividend without any repurchase, 0 if a firm repurchases shares or does not pay a cash dividend. Dividend payout is measured as cash dividends on common stock divided by the market value of common stock. Repurchases is equal to the dollars spent on repurchases during the year that is defined as Compustat's dollars spent on repurchases minus any decrease in the par value of preferred stock, divided by the market value of equity (MVE). Total payout is measured as repurchases plus dividends on common stock scaled by the MVE.

Dividend Payout Repurchases

Total Payout Independent variable

Definition

Prior Studies

Percentage of independent directors (INDEP)

Percentage of independent directors is calculated as the number of independent directors divided by the total number of directors on a firm's board. Information is obtained from a firm's annual proxy statements filed with the SEC. An independent director is defined following the SEC approved rules (SEC 2003b) as explained in the text. Tenure of the independent directors is calculated as the percentage of independent directors whose tenure is greater than or equal to 15 years. Information on tenure is obtained from a firm's annual proxy statements filed with the SEC. Busy independent directors is calculated as the percentage of independent directors who serve on a total of four or more public company boards. Following the NACD and NYSE guidelines, an independent director is considered to serve on excessive board seats if s/he sits on more than three other public boards (six if retired). Other board seat information is obtained from a firm's annual proxy statements filed with the SEC. Compensation of independent directors is measured as the average equity to average total compensation paid to independent directors. Director compensation information is obtained from a firm's annual proxy statements filed with the SEC that includes the value of equity options and all cash compensation. Market value of equity over book value of equity to proxy for growth opportunities. Data extracted from Compustat.

Farinha (2003), Hu and Kumar (2004), White (1996)

Tenure of independent directors (TENURE) Busy independent directors (BUSY)

Equity component in compensation structure of independent directors (DIR_EQUITY) MKT_BOOK

Natural Logarithm of total assets (LN_TA) Leverage (LEV)

Natural logarithm of total assets to proxy for firm size. Total asset data is extracted from Compustat. Ratio of long-term debt to book value of assets is extracted from Compustat. Proxy for leverage.

ROA

Return on assets for the current period extracted from Compustat. Proxy for profitability.

Company age (COY_AGE) CEO Tenure (CEO_TENURE)

Natural logarithm of the number of years since a company's inception. Number of years the CEO served as the CEO of the firm, which is obtained from a firm's annual proxy statements filed with the SEC. Dummy variable set to 1 if the CEO is also the chairman of the board, 0 otherwise. Information is obtained from a firm's annual proxy statements filed with the SEC. Common shares owned by the CEO as a percentage of the common stock outstanding. Ownership data is obtained from a firm's annual proxy statements filed with the SEC. Number of CEO options exercisable as per disclosure in a firm's annual proxy statements filed with the SEC scaled by common shares outstanding. Number of CEO options unexercisable as per disclosure in a firm's annual proxy statements filed with the SEC scaled by common shares outstanding.

CEO Duality (DUAL) CEO Ownership (CEO_OWN) CEO options exercisable (CEO_OPT_EX) CEO options unexercisable (CEO_OPT_UNEX)

NACD (1996), Vafeas (2003a)

CII (1998), Linck et al. (2009), NACD (1996)

This study

Fama and French (2001), Fenn and Liang (2001), Kahle (2002) Cuny et al. (2009), Fenn and Liang (2001) DeAngelo et al. (2004), Fenn and Liang (2001), Kahle (2002) DeAngelo et al. (2004), Fama and French (2001) Denis and Osobov (2007) Fich (2005), Wan (2003) Core et al. (1999) Hu and Kumar (2004) Kahle (2002) Kahle (2002)

4. Results 4.1. Descriptive data Table 2 presents summary statistics for the full sample (N = 944), and for sub-samples of 556 dividend payers and 388 nonpayers. Tests of mean differences are also presented. The mean (median) independent directors on the board (INDEP) for the full sample is 70.4% (71.4%), 70.7% (72.7%) for payers and 69.9% (71.4%) for non-payers. The mean (median) percentage of independent directors with tenure of at least 15 years (TENURE) for the full sample is 15% (11%), 17% (13%) for the payers, and 13% (9%) for the non-payers. The mean (median) percentage of independent directors serving on at least four public boards (BUSY) for the full sample is 4% (0%), for payers it is 4% (0%), and for non-payers it is 5% (0%). The average (median) percentage equity incentives in the compensation structure of independent directors (DIR_EQUITY) is 0.63 (0.65), 0.60 (0.63), and 0.66 (0.69) for the full sample, payers and non-payers, respectively. Tests of mean differences show that TENURE is significantly (p b 0.01) greater in payers while BUSY and DIR_EQUITY are significantly (p b 0.10, p b 0.01, respectively) greater in non-payers. Growth opportunities (MKT_BOOK) also significantly (p b 0.01) greater in non-payers (mean = 1.695) relative to payers (mean = 1.250). Company size (LN_TA), profitability (ROA) and company age (COY_AGE) are also significantly (p b 0.01) greater for payers relative to non-payers.

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Table 2 Univariate results. Full sample (n = 944)

INDEP (+) TENURE (?) BUSY (−) DIR_EQUITY (−) MKT_BOOK (−) LN_TA (+) LEV (−) ROA (+) COY_AGE (+) CEO_TENURE (−) DUAL (−) CEO_OWN (−) CEO_OPT_EX (−) CEO_OPT_UNEX (−)

Payers (n = 556)

Non-payers (n = 388)

Mean

Median

Std. dev.

Mean

Median

Std. dev.

Mean

Median

Std. dev.

t-value

0.704 0.150 0.040 0.626 1.433 7.721 0.182 0.050 3.448 7.430 0.587 0.026 0.009 0.004

0.714 0.110 0.000 0.650 1.077 7.588 0.143 0.052 3.434 5.000 1.000 0.003 0.005 0.002

0.148 0.171 0.072 0.203 1.291 1.571 0.178 0.107 0.888 7.495 0.492 0.126 0.014 0.005

0.707 0.170 0.040 0.601 1.250 8.203 0.181 0.064 3.668 7.360 0.611 0.027 0.007 0.003

0.727 0.130 0.000 0.626 0.920 8.135 0.157 0.054 3.806 5.000 1.000 0.002 0.003 0.001

0.150 0.176 0.070 0.203 1.212 1.558 0.158 0.066 0.925 7.645 0.487 0.155 0.011 0.004

0.699 0.130 0.050 0.661 1.695 7.028 0.184 0.030 3.131 7.540 0.554 0.023 0.012 0.005

0.714 0.090 0.000 0.691 1.320 6.950 0.1196 0.050 3.135 5.000 1.000 0.003 0.008 0.003

0.146 0.160 0.076 0.197 1.355 1.312 0.204 0.145 0.726 7.283 0.497 0.066 0.016 0.006

0.836 3.952*** 1.290* 4.510*** 5.286*** 12.148*** 0.239 4.819*** 9.564*** 0.348 1.764* 0.490 6.181*** 5.150***

*, **, *** = p b 0.10, p b 0.05, p b 0.01, respectively are directional as indicated by the predicted sign in parenthesis following the variable name, and two-tailed otherwise.

The percentage of payers with a CEO who also chairs the board (DUAL) is significantly (pb 0.10) greater compared to (mean= 0.611) non-payers (mean= 0.554). Tests of mean differences show that the percentage of exercisable and unexercisable options held by the CEO (CEO_OPT_EX, CEO_OPT_UNEX) are significantly (pb 0.01) greater in non-payers. The differences between the payers and nonpayers for leverage (LEV), CEO tenure (CEO_TENURE) and CEO ownership (CEO_OWN) are not statistically significant. 4.2. Pearson correlations Table 3 reports the correlation matrix. The dependent variable, LIKE_PAY, is significantly and positively correlated with TENURE, LN_TA, ROA, and COY_AGE. It is negatively correlated with DIR_EQUITY, MKT_BOOK, CEO_OPT_EX and CEO_OPT_UNEX. The highest absolute correlation between the explanatory variables is 0.365 which is considerably less than the 0.80 threshold above which multicolinearity threats could arise (Gujarati, 2003). 14 4.3. Binary logistic regression analysis of the propensity to pay dividends Table 4 reports the results of the binary Logistic regression model containing the four test and control variables, and untabulated industry controls. The Nagelkerke pseudo R 2 is 48% and the model χ 2 is significant at p b 0.01. Table 4 shows that firms with a greater percentage of independent directors (INDEP) are more likely to make a cash dividend payout, which is consistent with Hypothesis 1 and agency theory that posits independent directors help mitigate conflicts between management and shareholders over dividend policy. 15 The tenure of independent directors (TENURE) is also positively related to the likelihood of a dividend payout and suggests that independent directors with longer tenure on the board are likely to recommend the payment of a cash dividend. This result suggests rejection of the null effect in Hypothesis 2. Since independent directors are appointed by the shareholders for their protection and are subject to more intensive shareholder activism in the postSOX period, longer serving directors have incentives to ensure a firm does not omit dividends. The evidence from this study does not support the management friendliness or social ties hypothesis, and neither do they support calls for limiting the tenure of independent directors. Table 4 shows that busy independent directors (BUSY) are associated with a lower propensity to pay cash dividends, which is consistent with Hypothesis 3. Such results suggest that directors serving on multiple boards are unable to effectively mitigate agency conflicts between management and shareholders. Multiple directorships may lead to shirking because of the significant workload in the post-SOX period (Linck et al., 2009). This result supports reformists calling for setting limits to the number of other board seats held by independent directors (e.g., CII, 1998; NACD, 1996). Finally, the results indicate that the likelihood of a dividend payout reduces in increasing equity incentive component in independent director compensation (DIR_EQUITY). This final result is consistent with Hypothesis 4 and implies that equity incentives motivate independent directors to constrain dividend payout. Analyses of the economic significance of these hypothesized results suggest the following. The odds of a cash dividend payout increases by about 338% and 283% if there is a unit change in the percentage of independent directors and percentage of independent directors with greater tenure (≥15 years), respectively. Conversely, the odds of a payout decreases by 84% and 81% if the percentage of busy (≥4 public boards) independent directors and proportion of equity in directors' compensation structure 14 Unreported Variance-Inflation-Factor (VIF) analyses for all tests show that the highest VIF is 1.84, well below 10; the threshold beyond which multicolinearity may be a concern (Gujarati, 2003). 15 When I include percentage gray (or inside) directors, I find it is not significant and does not alter the conclusion related to independent directors.

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Table 3 Pearson correlation matrix (n = 944).

LIKE_PAY (1) INDEP (2) TENURE (3) BUSY (4) DIR_EQUITY (5) MKT_BOOK (6) LN_TA (7) LEV (8) ROA (9) COY_AGE (10) CEO_TENURE (11) DUAL (12) CEO_OWN (13) CEO_OPT_EX (14) CEO_OPT_UNEX (15)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

0.027 0.128 − 0.042 − 0.145 − 0.170 0.368 − 0.008 0.155 0.297 − 0.011 0.057 0.016 − 0.197 − 0.165

− 0.311 0.146 0.094 − 0.035 0.103 0.037 − 0.065 0.004 − 0.200 0.156 − 0.093 0.059 0.052

− 0.155 − 0.075 0.040 − 0.060 − 0.157 0.035 0.207 0.353 − 0.052 0.079 − 0.004 − 0.084

0.066 − 0.040 0.168 0.092 − 0.083 − 0.076 − 0.074 0.051 − 0.036 0.035 − 0.022

0.198 0.066 − 0.011 0.100 − 0.096 − 0.031 − 0.066 − 0.054 0.070 0.047

− 0.365 − 0.261 0.356 − 0.054 0.046 − 0.061 0.057 − 0.010 0.017

0.169 0.031 0.110 − 0.092 0.142 − 0.108 − 0.255 − 0.224

(8)

(9)

(10)

(11)

(12)

(13)

(14)

− 0.190 0.080 0.116 − 0.063 0.039 0.067 0.041 0.001 0.060 0.267 − 0.056 0.038 0.013 0.258 0.055 − 0.011 − 0.047 − 0.086 0.085 0.030 − 0.019 0.049 0.009 − 0.055 − 0.033 − 0.034 0.003 0.174

Correlations significant at p b 0.05 are in bold. The variables are defined in Table 1.

increase by one unit, respectively. Comparatively, the odds of a payout decreases by 100% if there is a one unit change in CEO unexercisable and exercisable options. Overall, it appears that board independence and tenure have the most pronounced effects towards supporting a cash payout. While equity incentives provided to the CEO and independent directors conjunctively reduce a cash payout, they do not appear to totally counter the board independence and tenure effects. The results for the control variables are generally consistent with the prior literature. Firms with growth opportunities (MKT_BOOK), higher leverage (LEV) and both greater exercisable (CEO_OPT_EX) and unexercisable (CEO_OPT_UNEX) options held by the CEO are less likely to pay cash dividends. In contrast, larger (LN_TA), more profitable (ROA) and mature firms (COY_AGE) have a higher propensity to pay dividends. A powerful CEO (DUAL, CEO_TENURE) and greater CEO ownership (CEO_OWN) are not significantly related to the propensity to pay dividends. 4.4. Additional analyses 4.4.1. Percentage independent director thresholds I explore various thresholds of independent directors' representation on the board and the propensity to pay dividends. I do this because prior studies use different percentage cut-offs to determine majority independent directors on the board. I compute seven levels of independent representation on the board; (i) less than 40% independent directors, (ii) greater than or equal to 40%

Table 4 Binary logit regression analysis of the determinants of propensity to pay dividends. Variable

Like_Pay Predicted sign

INDEP (H1) TENURE (H2) BUSY (H3) DIR_EQUITY (H4) MKT_BOOK LN_TA LEV ROA COY_AGE CEO_TENURE DUAL CEO_OWN CEO_OPT_EX CEO_OPT_UNEX Industry controls Pseudo R2 Χ2

+ ? − − − + − + + − − − − −

Cash dividend vs repurchases

Estimate

z-statistic

Estimate

z-statistic

1.476 1.344 − 1.858 − 1.686 − 0.253 0.452 − 1.157 7.787 0.616 − 0.003 − 0.182 0.508 − 15.478 − 30.467 Yes 0.48 426.25⁎⁎⁎

4.940⁎⁎⁎ 8.657⁎⁎⁎ 2.199⁎⁎ 14.094⁎⁎⁎ 7.302⁎⁎⁎ 34.231⁎⁎⁎ 4.056⁎⁎⁎ 23.529⁎⁎⁎ 33.582⁎⁎⁎

1.332 1.751 − 2.598 − 2.540 − 0.230 0.353 − 0.429 4.636 0.749 0.013 − 0.063 2.430 − 9.656 − 41.799 Yes 0.23 128.10⁎⁎⁎

2.477⁎⁎⁎ 6.216⁎⁎⁎ 3.779⁎⁎⁎ 14.618⁎⁎⁎ 3.804⁎⁎⁎ 11.905⁎⁎⁎

0.064 0.919 0.358 4.799⁎⁎⁎ 4.285⁎⁎⁎

0.313 4.722⁎⁎⁎ 33.630⁎⁎⁎ 0.383 0.063 1.174 1.830⁎⁎ 3.757⁎⁎⁎

The table presents the results for the likelihood of a firm paying cash dividends for 944 firms during 2006. Like_Pay equals 1 if a firm has a cash dividend payout, 0 otherwise. For the cash dividend vs repurchase model the dependent variable equals 1 if a firm makes only a cash dividend payout without any repurchase, and 0 if a firm repurchases shares in the open market or does not make a cash payout. The sample for this analysis is 926 firms due to missing repurchase data in Compustat. All the explanatory variables are defined in Table 1. ***, **, and * indicate significance at the 1%, 5% and 10% levels, respectively.

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and less than 50%, (iii) greater than or equal to 50% and less than 60%, (iv) greater than or equal to 60% and less than 70%, (v) greater than or equal to 70% and less than 80%, (vi) greater than or equal to 80% and less than 90%, and (vii) greater than or equal to 90%. I include k − 1 categories in the empirical model and find the coefficients on four categories (60% and above) of majority independent representation are significant (p b 0.05 or better). These results suggest that in the current corporate governance landscape, the board effectively oversees dividend payout policies when majority independent representation exceeds 60%. This is well beyond the 40% threshold reported in Hu and Kumar (2004) based on data prior to the corporate governance reforms introduced by the SOX (2002) and the SEC in conjunction with the NYSE and NASDAQ.

4.4.2. Alternative measures of independent director characteristics I explore the effect of the following alternative measures for the independent director test variables on dividend payout. When independent director tenure is cut-off at 10 or more years, the coefficient on this variable remains positive but is less significant (p b 0.10). Using three total public board seats as the cut-off for busy directors yields insignificant results. Finally, I explore thresholds at which DIR_EQUITY has a significant effect because the agency theory literature suggests that providing equity incentives to independent directors helps align the interests of directors and shareholders but at very high levels of incentive compensation, independent directors could become entrenched. When I include three quartiles of DIR_EQUITY as test variables with the lowest quartile assumed in the constant term, I find that only two quartiles (50th and 75th) are significant and negatively associated with the likelihood of a payout with the 75th quartile being more significant than the 50th quartile. Such results suggest that compared to the lowest quartile, high levels of incentive compensation motivate independent directors to curb the likelihood of a payout. These observations are consistent with the earlier results and suggest that higher equity compensation is related to a lower propensity to pay dividends.

4.4.3. Additional control variables When I include the following additional control variables such as the age of the CEO, CEO is an insider, five percent blockholders, board meetings, and whether a firm is in the S&P 500 index, I find the four test variables retain their significance or become more significant. With the exception of board meetings, none of these additional control variables are significant.

4.4.4. Dividend payout specification 4.4.4.1. Share-repurchases. Since the mid-1980s share-repurchases have increasingly become an alternative to a cash dividend payment and probably explain the decline in the proportion of firms paying cash dividends (Allen and Michaely, 2002). To determine whether the results are sensitive to this alternative to a cash dividend payout, I identify from Compustat firms that make a sharerepurchase in the open market. 16 Following Kahle (2002), repurchases equal Compustat's dollars spent on repurchases minus any decrease in the par value of preferred stock, divided by the market value of equity (MVE). In the LIKE_PAY analysis in Table 4, I examined whether a firm pays a cash dividend or not, where cash payout firms could have also repurchased shares in the open market. Because repurchases can be considered an alternative form of payout but one that has the effect of increasing share values, I perform an analysis where the dependent variable takes the value 1 if only a cash dividend is paid without an open market repurchase, and 0 otherwise (the 0 code captures firms that repurchase common shares or pay no cash dividend). The results from this Logit analysis are shown in Table 4 in the column Cash Dividend vs Repurchases. The results relating to the four test variables, INDEP, TENURE, BUSY and DIR_EQUITY are consistent with the cash likelihood payout results. These results suggest that greater board independence and independent directors with longer tenure are more likely to recommend a cash payout whereas busy independent directors and independent directors receiving greater equity incentive compensation are more likely to recommend a repurchase. Analyses of the economic significance again suggest that a one unit change in board independence and tenure have more pronounced effects, 279% and 576%, respectively. In contrast, a one unit change in busy directors and equity component in the compensation structure of the directors reduces the odds of a cash payout in favor of a repurchase or no payout at all by 93% and 92%, respectively. Similarly, when there is a unit change in the equity incentives paid to the CEO, either exercisable or unexercisable options, the odds of a payout decreases by 100%. The second repurchase test I perform is for a continuous specification where repurchases is defined as in Kahle (2002) noted above and the results reported in Table 5. When repurchases is the dependent variable of interest, I expect DIR_EQUITY to be positively related to repurchases, and a one-tailed test is appropriate. As expected, directors with longer tenure are negative and significantly associated with the level of repurchases and equity incentive compensation is positively associated with repurchases. Busy directors and percentage independent directors are not significantly related to repurchases. A one standard deviation increase in tenure (113% increase relative to the mean) reduces the value of repurchases by 0.325% while a one standard deviation increase (32% increase relative to the mean) in the equity component of directors' compensation structure increases the value of repurchases by 0.223%. Not surprisingly, a one standard deviation increase in CEO exercisable options has a relatively more pronounced effect on repurchases; a 0.432% increase. 16

Due to missing data, the sample size for all tests including repurchases drops to 926 firms.

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Table 5 Regression analysis of dividend payout, repurchases and total payout. Variable

Dividend payout

Repurchases

Total payout

INDEP (H1)

0.002 (0.592) 0.000 (0.117) − 0.009 (1.485)⁎ − 0.008 (3.391)⁎⁎⁎

0.010 (0.803) − 0.019 (2.277)⁎⁎ − 0.016 (0.839) 0.011 (1.304)⁎

0.010 (1.469)⁎ − 0.003 (0.789) − 0.007 (0.669) − 0.013 (2.746)⁎⁎⁎

− 0.002 (3.694)⁎⁎⁎ 0.000 (0.727) 0.007 (2.402)⁎⁎ 0.016 (2.965)⁎⁎⁎

0.001 (0.624) 0.005 (3.557)⁎⁎⁎ − 0.027 (2.710)⁎⁎⁎ 0.030 (1.787)⁎⁎

− 0.003 (3.105)⁎⁎⁎ − 0.001 (1.617) 0.032 (5.619)⁎⁎⁎ 0.076 (7.944)⁎⁎⁎

0.002 (3.017)⁎⁎⁎ 0.000 (1.883)⁎ 0.000 (0.474) − 0.004 (1.256) − 0.049 (1.470)⁎ − 0.080 (1.002) Yes 0.35 13.40⁎⁎⁎

0.000 (0.213) 0.000 (1.103) − 0.004 (1.136) − 0.002 (0.181) 0.308 (2.564)⁎⁎⁎ 0.015 (0.060) Yes 0.05 2.18⁎⁎⁎

0.001 (0.488) 0.000 (0.346) − 0.002 (0.772) − 0.007 (0.969) 0.081 (1.171) − 0.404 (2.808)⁎⁎⁎ Yes 0.16 5.37⁎⁎⁎

TENURE (H2) BUSY (H3) DIR_EQUITY (H4) MKT_BOOK LN_TA LEV ROA COY_AGE CEO_TENURE DUAL CEO_OWN CEO_OPT_EX CEO_OPT_UNEX Industry controls Adjusted R2 F

The table presents the results for dividend payout, repurchases and total payout for 944, 926 and 926 firms, respectively, during 2006. Dividend payout is measured as cash dividends on common stock divided by the market value of common stock. Repurchases is equal to the dollars spent on repurchases during the year that is defined as Compustat's dollars spent on repurchases minus any decrease in the par value of preferred stock, divided by the market value of equity (MVE). Total payout is measured as repurchases plus dividends on common stock scaled by the MVE. All other variables are defined in Table 1. The associated tstatistic is reported in parenthesis and ***, **, and * indicate significance at the 1%, 5% and 10% levels, respectively.

4.4.4.2. Dividend payout and total payout. I also test the association between my test variables and dividend payout and total payout. Consistent with Fenn and Liang (2001), dividend payout is cash dividends on common stock scaled by the market value of common stock, and total payout is repurchases plus dividends on common stock scaled by market value of common stock. Both estimates are shown in Table 5. For the dividend payout specification, the results suggest that busy independent directors and equity incentive compensation are negatively associated with payout. For the total payout, the percentage of independent directors on the board is positively associated while equity incentive compensation is negatively associated. Collectively, the results in Tables 4 and 5 suggest that independent directors may face different incentives in relation to variations in dividend policy. Generally, it appears that when board independence is high, some form of dividend payout, cash, repurchase or both, is more likely but when equity incentive in the compensation structure of independent directors is relatively higher, a cash payout is less likely but a repurchase more likely. In addition, independent directors with longer tenure tend to prefer a cash payout. The results in Tables 4 and 5 also suggest that equity incentives in the compensation structure of independent directors has a more persistent impact on payout policy than any other independent director characteristic. This observation raises an interesting question that I pursue further: does the nature of the equity compensation, options or shares, make a difference? Do equity-based incentives paid to independent directors or the CEO have a more profound effect on payout policy? 17 To address these questions, I segregate director's equity compensation into options (DIR_OPTIONS) and shares (DIR_SHARES) and scale each by the number of common stock outstanding. I then re-estimate the equations in Tables 4 and 5. I find that only DIR_OPTIONS is significant but only in the two policy choice specifications per Table 4. That is, it is statistically significant only in the Logit specifications and not in the levels or value of payout specifications as per Table 5. For both the cash dividend choice and cash versus repurchase Logit specifications in Table 4, I find that DIR_OPTIONS is significant (p b 0.01) and so is CEO unexercisable options (p b 0.05). A test of differences in the coefficients indicates that the two coefficients are not significantly different. Since the CEO unexercisable and exercisable options variables are significant in the value of dividend payout specifications (as per Table 5) and the variables for director options and shares are not significant, the results suggest that equity incentives provided to CEOs appear to have a more pronounced impact when the value of payout policy is considered. 17

I thank the anonymous reviewer for this insightful suggestion.

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4.4.5. Endogeneity There may be endogeneity issues between the propensity to pay dividends and the independent director test variables. While the literature currently does not offer if, and why, the propensity to pay dividends may be a determinant of board composition and the characteristics of independent directors, I perform three tests to address the likely presence of endogeneity. First, I estimate Eq. (1) with lagged independent director test variables. 18 The lagged results show that all the test variables are statistically significant. 19 Second, I perform the Hausman test (Gujarati, 2003) by separately regressing each of the four independent director test variables on a set of exogenous determinants to obtain the error term, ύ. These independent director test variable models include explanatory variables drawn from the prior literature (e.g. Linck et al., 2008, 2009; Raheja, 2005; Yermack, 2004). 20 Next I estimate four Logit cash dividend payout models (Eq. (1)) including the error term ύ of each independent director test variable model. The results show that none of the coefficients on ύ are significant, which suggests that there is no evidence of endogeneity between any of the test variables and dividend payout. Finally, I estimate four separate simultaneous systems of equations consisting of a cash dividend payout model and each independent director test variable model. The results of these analyses show that all the coefficients on the test variables are significant, and confirm the earlier results.

5. Conclusion In this study I provide a novel perspective to the propensity to pay dividends model. I extend the payout model by integrating the effects of board independence, independent director tenure, other board seats held by independent directors, and the structure of the compensation paid to them. The analyses show that greater independent director representation on the board has a positive and significant influence on the propensity to pay dividends. The results here reiterate the rationale for the recent sweeping corporate governance reforms aimed at protecting shareholders. After controlling for the percentage of independent directors on the board, I find the following significant effects of independent director characteristics on the propensity to pay dividends. Independent directors with longer tenure are associated with a higher propensity to pay dividends. This observation does not support calls for limiting the tenure of directors. Rather, it suggests that independent directors are cognizant of shareholder activism and to retain their board seats, better protect shareholder interests through a cash dividend payout of excess free cash flow. Equity incentive compensation paid to independent directors has the effect of constraining a cash payout but favoring repurchases. Similarly, busy directors are found associated with lower propensity to pay. The results here highlight that effective monitoring by independent directors can be affected by their length of service on the board, their workload and incentive compensation. The independent director factors examined here explain beyond factors previously studied why firms choose a particular payout policy. For instance, I find that greater equity in a director's compensation structure has the most persistent influence on the choice and level of payout. Supported by the increasing use of greater equity incentives in director compensation in the post-SOX period as documented by Linck et al. (2009), the director equity incentive results here explain the shift in payout mix towards share repurchases. Similarly, the increased workload of directors post-SOX has seen its implications bear out in lower propensity to distribute free cash flow to shareholders. Thus, subject to further empirical analyses by future research, some of the SOX-led governance reforms may have led to unintended consequences for shareholders. An important implication of this study is that future corporate governance research may consider the characteristics of independent directors in addition to simply studying board independence as a proxy for board effectiveness. Such an approach would extend our understanding of the dynamics of the corporate board and help explain inconsistencies in the literature on board independence and various proxies for shareholder interests. The primary caveat is that I study a limited set of characteristics of independent directors. The choice of these characteristics was guided by existing theoretical explanations underpinning these variables, and their potential association with the propensity to pay dividends. Other independent director characteristics that future research could explore include the age, gender, industry experience, educational and professional qualifications, whether the director is a current CEO of another firm, and the influence the independent director has on the firm (measured as the number of board sub-committees the director serves on as a member and/or chair). Second, I assume that the board influences the propensity to pay dividends directly. This assumption is based on the fact that boards specifically approve dividend policies. However, boards may influence dividend policy indirectly through investment opportunities, incentive compensation paid to the CEO, and extent of financing (leverage). While I include investment opportunities, CEO incentive compensation and leverage as control variables, I acknowledge I may not have fully addressed the process by which boards influence dividend policy through other mechanisms. Finally, because of the need to hand collect data from proxy statements, I limited the analyses to fiscal 2006. Future research could examine if independent director characteristics influence long term dividend policy as in Fenn and Liang (2001).

18 Since detailed disclosure of director compensation data was mandated since fiscal year ended 2006, and very few companies reported such details in fiscal 2005, I performed the lagged test by using fiscal 2007 dividend, CEO and company data and lagged 2006 director data. For my sample of 944 in fiscal 2006, I am able to find data on 823 firms of which 498 are dividend payers and 325 are non-payers in fiscal 2007. 19 The coefficient and their p values in parenthesis for the lagged test variables are as follows: INDEP = 1.626 (p b 0.01), TENURE = 1.484 (p b 0.01), BUSY = − 1.517 (p b 0.05) and DIR_EQUITY = − 0.917 (p b 0.01). 20 The explanatory variables include firm size (LN_TA), leverage, performance (ROA, stock returns), growth (MKT_BOOK), firm age (COY_AGE), ceo tenure, duality, ceo ownership (CEO_OWN), board size and director ownership.

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