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In a sample of 365 firms from 19 countries, I show that firms with stronger corporate governance have higher dividend payouts, consistent with agency models of dividends. In addition, the negative relationship between dividend payouts and growth opportunities is stronger among firms with better governance. I also show that firms with stronger governance are more profitable, but that greater profitability explains only part of the higher dividend payouts. The positive relationship between corporate governance and dividend payouts is limited primarily to countries with strong investor protection, suggesting that firm-level corporate governance and country-level investor protection are complements rather than substitutes.

In the United States, the debate surrounding dividend policy has traditionally centered on the question of why firms pay dividends, given that the tax disadvantage of dividends appears to be large. But in countries where investor protection is weak, a more fundamental question regarding dividend policy might be more relevant: How can shareholders hope to extract dividends from firms, given that the legal environment of the country and the governance mechanisms of individual firms offer investors relatively few protections? Agency theory suggests that outside shareholders have a preference for dividends over retained earnings because insiders might squander cash retained within the firm (see, e.g., Easterbrook, 1984, Jensen, 1986 and Myers, 2000). This preference for dividends may be even stronger in emerging markets with weak investor protection if shareholders perceive a greater risk of expropriation by insiders in such countries.1La Porta et al. (2000) show that dividend payouts are higher, on average, in countries with stronger legal protection of minority shareholders. This finding lends support to what La Porta et al. (2000) call the “outcome” agency model of dividends, which hypothesizes that dividends result from minority shareholders using their power to extract dividends from the firm. If protection of minority shareholders does have a positive impact on dividend payouts, then shareholder protection should help explain not just country-level differences in dividend payouts, but also firm-level differences in dividend payouts within countries. Indeed, while country-level investor protection is an important factor in preventing expropriation, firm-level corporate governance could carry equal or greater importance. And corporate governance practices can vary widely even among firms in the same country operating under the same legal regime. This paper uses firm-specific corporate governance ratings developed by Credit Lyonnais Securities Asia (CLSA) for 365 firms from 19 emerging markets to study the impact of firm-level corporate governance on dividend payouts. It is important to note, as do La Porta et al. (2000), that the outcome model does not hinge on investors holding specific rights to dividends. Rather, what is important is that the country's laws—or the company's governance practices—allow minority shareholders more rights in general, which rights may then be used to influence dividend policy. For example, observers have noted that Russian firms are more commonly electing independent directors to their boards, despite a legal system that does little to define or enforce board independence (Nicholson, 2003). Mark Mobius, elected as an independent director to the board of Russia's LUKoil in 2002, later acted on behalf of shareholders to propose a minimum-dividend policy that LUKoil's board approved in 2003 (Investor Protection Association, 2003). Using the CLSA data, I first show that firms with higher corporate governance ratings have higher dividend payouts. The effect appears to be economically meaningful as well as statistically significant; regression results imply that a one-standard deviation increase in a firm's corporate governance rating is associated with an average 4% point increase in dividend payouts (the average payout ratio is about 30%). A move from the worst governance (in this dataset, Indonesia's Indocement) to the best governance (in this dataset, Hong Kong's HSBC) would imply, on average, a higher dividend payout ratio of some 22% points. This result is consistent with the hypothesis of the outcome agency model that investors that are afforded stronger rights use those rights to extract dividends from the firm. This result is also complementary to the findings of Faccio et al. (2001). Interpreting dividends as a means for limiting expropriation, they study East Asian and Western European firms and find that dividend payouts are significantly impacted by the vulnerability of a firm's minority shareholders to expropriation by controlling shareholders.2 Even when shareholders are well protected, however, they may not prefer higher dividend payouts if they believe the firm has good investment opportunities available for excess cash. Indeed, La Porta et al. (2000) find that, in countries with strong investor protection, there is a stronger negative relationship between growth opportunities and dividend payouts. That is, it appears that, when shareholders perceive that their rights are well protected, they are more willing to let firms with good growth opportunities retain cash, being confident that they will share in the payoff from good projects later on. In contrast, if shareholders know that investor protection is poor, they may be more haphazard in their desire for dividends, trying to extract whatever value they can—regardless of the firm's growth opportunities—before being expropriated. Complementary to the country-level finding of La Porta et al. (2000), I find at the firm level that firms with stronger corporate governance also show a stronger negative relationship between dividends and growth opportunities. In other words, the pattern of dividend payouts seems to make more sense among firms with good corporate governance. I next examine how dividend policy is impacted by the interplay of country-level investor protection and firm-level corporate governance. I find, first of all, that across all countries, both country-level investor protection and firm-level corporate governance have explanatory power for dividend payouts. Of the two, the country-level measures have perhaps greater explanatory power. Next, I find that firm-level corporate governance is positively associated with dividend payouts primarily in countries that offer strong investor protection (as measured by legal origin or antidirector rights). This suggests that firm-level corporate governance and country-level investor protection work as complements rather than substitutes. Firm-level improvements in corporate governance may be most effective when the legal regime of the country also offers a higher level of protection for shareholders. The findings of the paper are robust to many different specifications (although I find some specifications where they are not). The results hold when controlling for financial variables that have been shown previously to be correlated with dividend payouts, namely growth, size, and profitability (see Fama and French, 2001). I show separately that firms with stronger governance have higher profitability, but improved profitability explains only part of the connection between governance and dividends. The results also hold when controlling for industry- and country-fixed effects. In addition, I show that the results hold with or without financial firms, with or without mandatory-dividend countries, and when controlling for the tax advantage of dividends. Nevertheless, as will be discussed further in Section 4, because I lack a suitable instrument for firm-level corporate governance, these results are subject to typical problems of endogeneity, and, therefore, any interpretations regarding causality should be made cautiously. I also use additional data to get a sense as to whether the result holds among a broader sample of firms. Lacking governance ratings for a broader sample, I use variables that have been used in previous work as indicators of good governance. These variables (whether or not a firm is diversified, has a Big Five international auditor, or is cross-listed in the U.S.) are available for a much larger sample (over 14,000 firms). Although these indicators are clearly not as refined as the CLSA ratings, they are generally supportive of the results using the CLSA ratings, suggesting that the findings may be applicable to a broader sample. The results presented here add to the current literature in a few ways. These firm-level findings add confidence to previous country-level findings regarding investor protection and dividends. Because country-level measures of investor protection can be correlated with other important variables, some uncertainty remains about which country-level variables impact dividend policy. Showing that differences in shareholder protection at the firm level also impact dividend policy helps confirm that investor protection is a significant factor affecting dividend policy. In addition, the results add to a growing literature that uses firm-level measures of governance to study the impact of corporate governance on corporations around the world. Such papers (too numerous to list briefly) include those that measure firm-level governance with ratings, with various measures of ownership structure, and with other indicators of governance.3 Finally, the firm-level findings suggest that individual firms are not entirely trapped by the legal regimes of their home country. By improving corporate governance at the firm level, firms can demonstrate a commitment to protecting investors that translates into real economic outcomes. Section 2 describes the data used in the study. Section 3 presents the empirical results. Section 4 discusses robustness and alternative interpretations. Section 5 examines the results with a broader sample using governance indicators. Section 6 concludes.

The ultimate goal of corporate governance is to ensure that suppliers of finance to corporations receive a return on their investment (Shleifer and Vishny, 1997). While suppliers of equity can receive a return through dividends or capital gains, agency theory suggests that shareholders may prefer dividends, particularly when they fear expropriation by insiders. The outcome agency model tells us that when shareholders have greater rights, they can use their power to influence dividend policy. Shareholders can receive greater rights either through a country's legal protection or through a firm's governance practices that may not be mandated by government. This paper shows that firm-level corporate governance, in addition to country-level investor protection, is associated with higher dividend payouts, suggesting that both mechanisms help reduce agency problems. In addition, stronger corporate governance is shown to be associated with a stronger negative relationship between growth and dividends, demonstrating that the pattern of dividend payouts makes more sense among firms with stronger corporate governance. The results suggest that, when shareholders are well protected, either by governments or by corporations themselves, capital can be allocated more efficiently.