Shareholder Dividend Options

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Center for Contract and Economic Organization


Center for Law and Economic Studies


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.' 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. 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 avoid even the indirect disciplining influences of the market for corporate control. 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! 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

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