Dividends and Corporate Governance: Canadian Evidence

IntroductionIt has been established in the literature that agency considerations play a significant role in payout decisions (see, for example, Lie, 2000; Aivazian et al., 2003 and 2006; and DeAngelo et al., 2006). As La Porta et al. (2000) (henceforth LLSV) summarize, corporate governance, as the mechanism to mitigate agency problems, can potentially have two opposing effects on payout policies. One possibility is that firms operating under better corporate governance system pay more dividends because of the pressure from shareholders (outcome model). Alternatively, firms operating under poor governance systems and weaker shareholder rights need to pay higher dividends to maintain good reputation with shareholders (substitution model). Although LLSV (2000) examined the aforementioned models by using a cross-country analysis with country-level governance ratings, the arguments can be extended to a specific country setup with firm-specific governance practices. That is, as per the outcome model (substitution model), firms with better governance practices1 would favor higher (lower) dividends. A number of studies have directly or indirectly2 examined these hypotheses. However, the findings are mixed. In general, cross-country studies show support for the 'outcome model' (LLSV, 2000; Faccio et al., 2001; and Mitton, 2004), whereas country-specific studies generally show support for the 'substitution model' (Hu and Kumar, 2004; Jiraporn and Ning, 2006; and Officer, 2006). Further, most of country-specific studies use sample firms from the US. It is not clear whether or not these will hold well in other markets. Kooli and L'Her (2010) thus stress on more studies and posit that international evidence on payout policy will help us to explore the robustness of various US results (p. 58).In this study, we examine the role of corporate governance as a determinant of dividend policy with Canadian data over the period 1997-2004. Examination of Canadian market presents a special case in the study of dividend policy because of the three critical differences between US and Canadian capital market. In Canada, large blockholders have significant ownership levels in various firms. These large blockholders can maintain some influence over public officials and policy decision. In the US, however, the ownership is primarily diffused (Morck et al., 2000). While the mechanisms for protecting investors in countries with high ownership concentration have been questionable, minority shareholders in Canada receive the benefit of strong legal protection. According to Cheffins (1999), Canadian public firms are subject to legal remedies that protect minority shareholders from corporate expropriation. Prior studies have shown that differences in ownership and control structure and legal environment can significantly affect a firm's dividend policy (LLSV, 2000; and Faccio et al., 2001).Second, the Canadian tax system differs from the US system when dealing with investment income. The US imposed double taxation on dividend income till the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, 2003), whereas the Canadian tax system employs the 'gross up and credit' approach for dividends since 1949. Several studies show that taxation influences corporate payout policy (Bolster and Janjigian, 1991; Chetty and Saez, 2005 and 2006; Brava et al., 2005).Third, the Canadian equity market is less liquid than the US market. Lower liquidity is usually accompanied by more information asymmetry which affects dividend level as well. Fourth, the average firm size in Canada is much smaller than that of US. Larger companies have more resources to distribute to their shareholders (Fama and French, 2001). Finally, the corporate governance regime is also different in Canada and US. In Canada, corporate governance regime is largely voluntary; whereas in the US, it is mandatory (see Anand et al., 2006).3 Therefore, it would be interesting to see how the dividend policy is affected by corporate governance practices of Canadian firms. …