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Corporate governance and dividend policy inSoutheast Asia pre- and post-crisisJulia Sawicki

a

aAdvance Research Centre, ISEG Universidade Tcnica de Lisboa, Lisboa

PortugalVersion of record first published: 05 Feb 2009.

To cite this article: Julia Sawicki (2009): Corporate governance and dividend policy in Southeast Asia pre-and post-crisis, The European Journal of Finance, 15:2, 211-230

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The European Journal of Finance,

Vol. 15, No. 2, February 2009, 211230

Corporate governance and dividend policy in Southeast Asia pre- and post-crisis

Julia Sawicki

Advance Research Centre, ISEG Universidade Tcnica de Lisboa, Lisboa, Portugal

The relationship between dividends and corporate governance in five East Asian countries over the period19942003, comparing the outcome and substitute models, is investigated. Evidence of a pre-crisis neg-ative relationship between dividends and governance indicates that dividends act as a substitute for othercorporate governance mechanisms during this exuberant period. A strong positive relationship betweengovernance and dividends emerges post-crisis, consistent with substantial improvements in governanceempowering shareholders. The relationship is incremental to the effect of the legal regime, confirming thatshareholder protection at the firm level is important to forcing firms to disgorge cash in an outcome modelof dividends.

Keywords: corporate governance; financial crisis; dividends; emerging markets

1. Introduction

Dividends and corporate governance are clearly related. That which is not clear is the nature

of the relationship: are dividends complements to, substitutes for, or the outcome of governance

practices? In the sense that corporate governance is a set of mechanisms that ensure a proper return

to investors, high dividends are evidence that the mechanisms are working properly. However,

investors returns are also in the form of capital gains and as Miller and Modiglianis (1961)

classic work shows, investors are indifferent between the two and dividend policy is irrelevant.

Frictions like information asymmetry do not exist in Miller and Modiglianis model however, so

a question arises of their role in the presence of agency conflicts. The LintnerGordon bird-in-

the-hand theory becomes relevant when investors face expropriation.1 Poorly governed firms may

find that dividend payout can be value-enhancing by, for example, soaking up free cash flow that

insiders might otherwise squander.

Several monitoring and control practices act as governance mechanisms which protect minority

shareholders from expropriation by corporate insiders. Their effectiveness, especially in countries

with weak institutions and little protection of property rights, is not well researched or understood.

Dividend payout is of particular interest in unraveling the effects of external and internal corporate

governance.

We pursue the investigation into governance and dividends in a particular setting: SoutheastAsia during a 10-year period surrounding the 19971998 financial crisis. This period and the

exogenous shock of the crisis provide a special opportunity for studying the relationship between

governance and dividends. Southeast Asian governments initiated programs of structural reforms

to remedy the inadequacies of governance mechanisms which are widely accepted as a major

Email: [email protected]

ISSN 1351-847X print/ISSN 1466-4364 online 2009 Taylor & FrancisDOI: 10.1080/13518470802604440http://www.informaworld.com

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212 J. Sawicki

cause of the crisis (Harvey and Roper 1999; Stiglitz 1999). Our study tracks changes in practices

at the firm level through annual governance scores computed for each firm across the 19942003

period, providing evidence of particular changes in governance pre- and post-crisis. In addition

to documenting changes in practices, we specifically investigate dividend payout and its role

pre- and post-crisis in providing returns to minority shareholders at risk of expropriation.

An interesting picture of dividend policy emerges. Evidence of a negative relationship betweengovernance and payout pre-crisis suggests that dividends substitute for good governance practices.

Dividends are very high in many firms during this period of high growth and large inflows of

financial capital. The evidence that poor governance is related to high dividends supports the

substitute theory where poorly governed firms use dividends to establish trust which is important

in raising future equity.

The picture changes post-crisis. The onset of the crisis prompted a radical cut in dividend pay-

out in response to capital outflows and fall in profits. We find evidence of a positive relationship

between governance and payout, consistent with dividends as an outcome of good governance. The

post-crisis dividend role-reversal suggests that improvements in shareholder protection empow-

ered minority shareholders with the ability to extract cash from corporate insiders. We also find

that country-level governance is significantly related to payout, illustrating the importance of legalregime where common law countries better protection of investor rights is associated with higher

dividends.

An important aspect of our results is that firm-level governance is incremental to legal regime

effects. Prior to the crisis firm-level governance is not significant, whereas the legal regime is

related to dividend payout. Both levels of governance are significant post-crisis, suggesting that

improvements in internal governance are important in shaping the nature of investor protec-

tion. This result indicates that dividends are an outcome of both legal and internal mechanisms

protecting minority shareholders interests.

The article proceeds with a discussion in the following section of the literature relevant to the

Asian financial crisis and governance theme of our study with particular focus on dividend policy.

Section 3 describes the data and methodology, followed by trend/comparative analysis and results

of regression tests in Section 4. Section 5 concludes with an overview of our findings, limitations

of the study and suggestions for future research.

2. Background

Poor corporate governance is often cited as a major cause of the breakdown of several East Asian

economies during the 19971998 financial crisis. Solid macroeconomic fundamentals like low

budget deficits, low inflation and high GDP growth during the years preceding the crisis obscured

weak corporate governance and structures inappropriate to open economies. The lack of proper

disclosure and auditing exacerbated minority shareholders exposure to abuses by controlling

families and/or governments. Claessens and Fan (2002) provide a comprehensive picture of

corporate governance in the region, confirming the lack of protection of minority rights as a majorissue, in an environment of low transparency, rent-seeking and relationship-based transactions,

extensive group structures and risky financial structures.

Many studies report evidence of the role of corporate governance in the Asian financial crisis.

Johnson et al. (2000) provide a direct link between governance and exchange rate and stock

market depreciation, with evidence that governance measures provide a stronger explanation for

the currency and equity declines than standard macroeconomic measures. Lemmon and Lins

(2003) capture the potential for expropriation by insiders with a ratio of cash flow rights to

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The European Journal of Finance 213

control rights. They find a positive relation between the ratio and value erosion during the crisis,

confirming the vulnerability of minority shareholders to expropriation.

The Asian financial crisis of 19971998 presents a unique opportunity for studying agency

conflicts and their effects. As Lemmon and Lins (2003) point out, endogeneity problems arising

from the joint determination of many of the relationships being tested in this literature weaken the

reliability of tests. As an exogenous event, the crisis offers the potential to allay these concerns.This article investigates changes in governance over a 10-year period surrounding the crisis,

with a focus on a particular relationship: dividend payout and governance quality. Dividends have

been shown to play an important role in corporate governance. In early work Rozeff (1982) models

dividends as a function of growth, beta and agency costs. Underlying the model is the visibility

that dividend payout creates.2 Rozeff uses ownership concentration as a proxy for agency costs,

reasoning that more highly dispersed owners have more difficulty monitoring and controlling man-

agers. His evidence of a negative relationship between dividends and concentration confirms the

importance of payout policy in managing managers. Jensen, Solberg and Zorn (1992) corroborate

this using a system of equations to capture the simultaneous determination of ownership structure,

debt and dividend policy. In recent work, Kose and Knyazeva (2006) find that firms with weak

governance pay higher dividends and the relationship is stronger for firms with high free cash flow.

3

Ownership concentration has been shown to be negatively related to dividends in Asia as

well (Faccio, Lang, and Young 2001). However, this has been interpreted as a result of agency

conflicts, rather than an alignment of interest. The preceding examples are in the context of

dispersed ownership, typical of firms in the United States and the United Kingdom where agency

problems arise in a traditional shareholder-versus-manager conflict. However, an alternative view

is more pertinent in countries where family and state ownership are common: outsiders have

cash flow rights but few control rights and need to protect themselves from expropriation by

controlling shareholders. The real conflict in these countries is between outside investors and

controlling shareholders who control the managers (La Porta et al. 2000). Supporters for this

view include Claessens, Djankov, and Lang (2000) who show that risk of expropriation is the

major principalagent problem for firms in East Asia as opposed to empire building.

La Porta et al. (2000) present two models that can help in explaining dividend policies in the

emerging markets: the outcome model and the substitute model.According to the outcome model,

dividends are a result of the effective pressure by minority shareholders to force insiders to pay out

profits. Governance practices such as the power to change directors, induce payout, sue directors,

or liquidate the firm and receive the proceeds are some of the mechanisms that protect minority

shareholders. In such firms, shareholder insistence on the distribution of excess cash is less likely

to fall on deaf ears than in firms with attributes associated with managerial entrenchment or

weak governance. The correct dividend policy is the outcome of the governance regime in this

view because managers of firms with good governance are more likely to act in the interests of

shareholders and pursue value-maximizing policies, such as the payment of dividends when the

firms fundamentals warrant such a policy, than are managers of firms with weak governance.

On the other hand, the substitute model predicts that weaker minority shareholder rights areassociated with higher dividends. According to this model, insiders can use dividend payout to

establish a reputation for decent treatment of minority shareholders. In this sense dividends act

as a pre-commitment or bonding mechanism.4 An important element in this view is the need for

firms to access funds in capital markets. Lowering the cost of future funds provides the incentive to

establish a positive reputation with minority shareholders. In this sense, payout is more valuable

in countries with weak legal protection since outsiders do not have other protective measures

on which to rely. Stronger shareholder protection lessens the need to establish a reputation via

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214 J. Sawicki

dividends. Thus in the substitute model, a negative relationship is expected between payout and

governance quality.

What precisely determines the power of minority shareholders? La Porta et al. (1997, 1998)

focus on the legal regime: laws and the effectiveness of their enforcement. When the rules (such

as the voting rights of the shareholders) are properly enforced, minority shareholders are well

protected and are willingto finance firms. However, when the rules and their enforcement are weak,minority shareholders are exposed to expropriation and tunneling. La Porta et al. (2000) document

evidence consistent with the outcome model. In countries with weak investor protection, minority

shareholders receive lower dividends than in countries where investor protection is relatively

strong.

Protection of minority shareholders depends not only on country-level governance but also

on firm-level governance practices. La Porta et al.s (2000) investigation is conducted at the

country level, comparing dividend payouts across governance systems provided by different legal

regimes. They do not control for governance differences at the firm level. This article furthers

the investigation, applying their framework to a setting where firms in different legal regimes

have attributes that offer shareholders a differential voice in the governance of the corporation

depending upon proper/improper governance practices of the firm.Considerable variation in firm-level governance mechanisms in Southeast Asian countries

makes this an ideal laboratory to relax La Porta et al.s (2000) implicit assumption of within-

country consistency. Prior literature has used firm-level governance differencesto explain different

aspects of firm performance. For example, Mitton (2002) uses the differences in firm-level cor-

porate governance mechanisms to explain firm performance in Indonesia, Malaysia, Thailand,

South Korea and Philippines. In a study looking at governance and investor protection in emerg-

ing markets, Klapper and Love (2004) confirm that better operating performance and valuation

are related to better governance in these countries.

We use these differences to explain another aspect of firm performance, dividend policy. The

article is similar in spirit to Mitton (2004) who uses Credit Lyonnais Securities Asia (CLSA) 2001

corporate governance ratings for firms from 19 emerging markets to study the impact of firm-

level corporate governance on dividend payouts. He shows that the firms with higher corporate

governance ratings have higher dividend payouts during the following year, 2002. The study

extends Mitton (2004) to a 10-year period spanning the Asian financial crisis providing important

time series evidence of the relationship pre- and post-crisis.We also document changes in dividend

policy and governance across the period. The tests are described in the following section.

3. Data and methodology

Five countries are represented in this study: Indonesia, Malaysia, Thailand, Hong Kong and

Singapore. The countries were affected by the Asian financial crisis to varying degrees and differ

with respect to corporate culture, national personality and priorities. Data for 20 listed firms of

each country cover a 10-year period, 19942003. Firm selection is based on three criteria: (1)current market capital (USD) of each firm greater than the country median; (2) availability of

annual reports; (3) financial data on dividend payout ratio, return-on-investment (ROI), profit,

beta, sales, total asset and equity reported in the Thomson One analytical database.

The governance index constructed to measure corporate governance is based on nine criteria

identified in Table 1.

The criteria capture various aspects of a firms structure, policies and practices that constitute

good governance practices.5 A total score for each firm is calculated each year. Each question is

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Table 1. Criteria used in estimating the governance index.

Board of Directors One-third independence of the board, as measured by the number of independentdirectors divided by total number of directors

Chairman and CEO separationLargest directors shareholding (as measured using direct interest and deemed

interest divided by total issued shares) below 5% of issued capitalAudit Existence of an audit committee

Disclosure of frequency of audit committee meetingExpertise of audit committeeEngagement of Big Six auditors

Remuneration Existence of a remuneration committee

Nomination Existence of a nomination committee

This table identifies the criteria used in constructing the governance index. Each question is constructed in a manner suchthat the answer yes adds one point to the governance score. The rating is on a scale of zero to nine, with a higher scoreindicating better governance. A total score for each firm is calculated each year.

constructed in a manner such that the answer yes adds one point to the governance score. Thus,

the rating is on a scale of zero to nine, with a higher score indicating better governance. All of the

information is from the annual report and a company is deemed not to have followed a practice

if the fact is not explicitly stated in the annual report or cannot be inferred clearly from other

information provided in the annual report.

Descriptive statistics of the data by country classified into pre-crisis (19941996), crisis

(1997and 1998) and post-crisis 19992003 are reported in Table 2.

The scores indicate improvements in corporate governance with means of 3.08, 3.48 and

5.66 in the respective sub-periods. Malaysias average of 3.85 is the highest rating in the first

period, whereas Thailands average of 2.12 ranks last. From period two, Singapore holds the top

spot and Indonesia falls to the lowest rating, where they remain. Singapores rapid improvement

accords with its reputation for efficiency and responsiveness to changing conditions. On the other

hand, Indonesia has been long plagued by cronyism and corruption to which the country finally

responded with a coup deposing the long-time ruler Suharto in 1998. The country continues to

struggle with slow reforms and improvements.6

Table 3 compares the average values for payout, profitability and growth in the pre- and post-

crisis periods.

The differences pre- and post-crisis reflect the severity of the impact of the crisis and speed of

recovery of firms in the various countries. Indonesia, Thailand and Malaysia were among the hard-

est hit, whereas Singapore and Hong Kongs economies were less affected. Although the impact

on the region was severe, many countries (with the exception of Indonesia) rebounded rapidly.

The dividend payouts are consistent with the substitute model in the pre-crisis period. In this

model, dividends provide evidence of fair treatment (i.e. investment returns) of minority sharehold-ers. This is especially important in raising future capital on reasonable terms. During the pre-crisis

period, the highest dividends are paid in the Thailand and Indonesia with the lowest governance

scores (2.12 and 2.72, respectively, compared with around 3.5 for the others). This weakness

in firm-level governance is compounded by poor legal protection of minority shareholders and

corruption in these countries. In addition, the growth rates are very high.

The changes in the post-crisis period indicate support for the outcome model. Dividends fell

dramatically in Thailand and Indonesia, where the generous dividends were no longer sustainable,

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nor valuable in creating a bond lowering cost of capital. Dividends in Singapore, Hong Kong

and Malaysia rise in the post-crisis period, and their governance scores improved dramatically.

Profitability and growth are lower post-crisis in all counties.

The governance scores are used to investigate the relationship between governance and div-

idends over the decade. We compare the La Porta et al. (2000) outcome and substitute models

of dividends. In the former, dividends are expected to be related positively to governance qual-ity, which gives minority shareholders power to force insiders to hand over cash. The latter

model predicts a negative relationship where dividends substitute for the lack of other governance

mechanisms. These predictions are tested with the following model:

Divi,t = 0 + 1(Govi,t)+ 2(Pr ofiti,t)+ 3(Betai,t)+ 4(Gri,t)+ 5(Szi,t)+ 6(Peri,t)

+

cCtrc +

sInds (1)

where:

Divi,t dividend payout firm i, time t= Dividends(Cash)

Net Income Preferred Dividend 100,

Govi,t index score for firm i, time t, determined by measures identified in Table 1,

Profiti,t ROI firm i, time t=Net Incomet

(ShEquityt1 + ShEquityt)/2,

Betai,t proxy for risk (operating and financial leverage) of firm i, time t,

Gri,t % change in assets firm i, time t=TotalAssetst TotalAssetst1

TotalAssetst1,

Szi,t size firmi (logarithm of market value of common equity, USD millions, year t),

Per binary variable partitioning pre-crisis (19941996) and post-crisis (19992003) periods,Ctr binary variable to distinguish between countries,

Ind binary variable to distinguish between industries (consumer, industrial, basic materials,energy, technology, utilities and financial).

Equation (1) specifies the relationship between corporate governance and dividends, while

controlling for other interactions. The main variable of interest is the governance score, Gov.

The outcome model predicts a positive coefficient, indicating that dividend payout increases with

minority shareholder ability to force dividends through better corporate governance. The alter-

native model predicts a negative governance coefficient with dividends increasing as governance

becomes weaker. In the substitute model, insiders use dividends to signal fair treatment of minor-

ity shareholders, which they deem important to raising funds on reasonable terms in the future.

Poorly governed firms have a greater need for this payout bond.

Critical to the tests of the alternative models is the time period. The exchange rate depreciationsand stock market declines in East Asian countries in 19971998 interrupted a period of robust

growth and profitability. The radical changes in the investment and financing opportunities, as

well as corporate governance, call for specific consideration. The pre-crisis environment of easy

access to capital, rapid growth and abundant investment opportunities, coupled with weak gov-

ernance, favors the substitute model. Less-established, growing firms without a reputation for

proper treatment of minority shareholders would be inclined to use dividend payout as a means

of sending this signal and establishing trust. Important to the substitute model is the foresight of

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218 J. Sawicki

raising future capital, which is also apropos to the optimism and growth of the Asian tigers. A

negative coefficient for the governance variable would confirm this.

The crisis stimulated change in corporate governance. Rapid improvements are seen in the

governance scores reported in Table 2. In addition to this, investment opportunities, growth and

profitability were severely eroded. Although dividends are predicted to lose their substitute role,

it is not clear whether the empowerment of shareholders was sufficient to drive an outcome role.If so, a positive relationship post-crisis (supporting an outcome model) is expected.

A binary variable is included in the equation to distinguish between time periods. This allows

the regression estimates to reflect different levels of dividends (due to profits, growth investment

opportunities and capital flows) and governance quality in the two periods. A further step is taken

in estimating separate regressions for the pre- and post-crisis period.

Controls for country differences (crisis severity, recovery and governance) as well as other

variables that have been shown to affect dividend policy have also been included. Dividends are

often modeled as a trade-off between costs of outside financing and agency. Proxies for these costs

that have been shown to be negatively related to dividends include growth (Fama and French,

2001; Smith and Watts 1992), leverage and beta (Jensen, Solberg, and Zorn 1992; Rozeff 1982).

Larger firms greater capacity to sustain dividends results in a positive relationship between sizeand dividends (Fama and French 2001; Redding 1997). Industry has also been shown to be related

to dividend policy (Baker 1988; Michel and Shaked 1986).

4. Results

Country-level governance scores are calculated by the sum of individual firm scores. The maxi-

mum annual score for each country is 180 points (each firm can have a maximum score of nine

points and there are 20 firms in each country). A summary of the overall corporate governance

scores is depicted in Figure 1. Scores for the individual proxies are in Figures 210.

The general level of governance was relatively poor in the earlier years (19941997), with all

countries having scores below the mid-point of 90. Malaysia led in those 3 years with scores of 79,

76 and 78. Thailand on the other hand, has the lowest scores of 43, 42 and 48. The differentiating

factors were greater board independence and the use of Big Six auditors.

Figure 1. Total Governance Score.

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Figure 2. Independence of the board.

Figure 3. CEO-chairman separation.

Figure 4. Director shareholding.

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220 J. Sawicki

Figure 5. Existence of audit committee.

Figure 6. Frequency of audit committee meetings.

Figure 7. Expertise of audit committee members.

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Figure 8. Existence of nominating committee.

Figure 9. Existence of a remuneration committee.

Figure 10. Auditor.

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222 J. Sawicki

Early improvements in governance addressed board independence and auditing with the engage-

ment of Big Six auditors and establishment of audit committees. By 1998, Singapore replaced

Malaysia as the leader with 83 points. Thailands governance also improved tremendously from

48 in 1997 to 70 in 1998, leaving Indonesia with the lowest ranking of 60 points. In general, the

evidence is consistent with the belief that governance was an important factor in the crisis as the

worst hit countries (Thailand and Indonesia) had the lowest pre-crisis scores.Governance scores continue to increase for all the countries after the crisis. The effect of

Thailands rapid economic restructuring and emphasis on governance improvements are evident in

its rise from last position in 1997 to leader in 1999 and 2000, and in being the first country to break

the 100 points barrier. Hong Kong follows an interesting trend. The substantial improvements

immediately following the crisis stall in 2001, while all the other countries scores continue to

improve. By 2003 it had fallen far behind Singapore, Malaysia and Thailand and is on par with

Indonesia.

Doidge, Karolyi and Stulz (2007) present a model that explains firm-level governance improve-

ments in terms of country-level characteristics and is helpful in interpreting the governance

changes documented here. The model relates legal and economic/financial development to the

incentives that firms have to institute good governance. Table 4 presents summary statistics thatare relevant to the model.

Singapore and Hong Kong are very different from the other countries in terms of prosperity (per

capita GDP) and susceptibility to the crisis. There is a clear distinction between the three common

law countries (Singapore, Malaysia and Hong Kong) and the civil law countries (Thailand and

Indonesia) on the basis of ownership concentration, and legal and corruption indices.

Doidge, Karolyi and Stulz (2007) model the effects of minority shareholder legal protection and

the level of economic and financial development on individual firm governance practices. They

argue that the trade-off between the costs and benefits of improved transparency and governance

determine the extent to which the firm will choose to improve on investor protection granted

by the state. In countries with weak development, costs of improvement are high because the

institutional infrastructure is weak. With lower costs of capital, the primary benefits are limited

because capital markets lack depth. They find that country characteristics explain most of the

Table 4. Factors relevant to governance improvements.

GDP perAverage capita USD % GDP

score (000s) growth

Pre P ost 1997 1996 1 998 Ownership Judicial Rule of law Corruption

Singapore 3.67 6.45 15.47 7.6 0.4 29.9 10.0 8.57 8.22

Hong Kong 3.07 5.36 12.44 4.5 (5.1) 34.4 10.0 8.22 8.52Malaysia 3.85 6.19 3.39 7.5 (7.5) 28.3 9.0 6.78 7.38Thailand 2.12 5.92 1.87 5.5 (10.0) 53.5 3.25 6.25 5.18Indonesia 2.72 4.36 0.78 8.0 (13.7) 61.7 2.50 3.98 2.15

This table summarizes the average governance scores, measures of economic performance and institutional environment.Sources: World Bank Statistics, Claessens, Djankov and Lang (2000) and La Porta, Lopez-de-Silanes, Shleifer (1999).Ownership concentration= the percentage of control among the top 15 families.The indices rank from 0 to 10 (worst to best). The judicial index assesses efficiency and integrity of legal systems as itaffects business, especially foreign firms.

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variation in firm governance scores. A small portion of firm governance scores is explained by

firm characteristics, and in less developed countries the relationship is virtually nonexistent.

The evidence is consistent with Doidge, Karolyi and Stulzs (2007) prediction and findings

that the incentives to improve firm-level governance increase with a countrys legal environment,

and financial and economic development. Pre-crisis governance scores for Singapore, Hong Kong

and Malaysia are much higher than Thailand and Indonesia. Increases in scores also accord withthe theory. All of the scores reflect initiatives at both the government and firm levels to respond

to corporate governance weaknesses exposed by the crisis. Singapores rapid rise to top spot

reflects the responsiveness of an efficient, progressive government and an open economy. Despite

its lower level of economic development, Malaysias capital market development and rule of

law are important factors in both the high pre-crisis score and improvements. Thailands low

score pre-crisis shows the most improvement and reflects the government initiatives to improve

governance.

The case of Indonesia can be summed up as the Suharto regime. Underlying the three-decade

rule were political manipulation, corruption and support from armed forces. The severity of the

effects of the crisis and its slow recovery are the results of the countrys failure to develop, for exam-

ple: political institutions, corporate governance, protection of intellectual property rights, definedtransparent bankruptcy laws and supervision of the financial sector. The firm-level governance

scores and improvements are a reflection of the lack of institutions and economic development,

and are certainly consistent with Doidge, Karolyi and Stulzs (2007) model.

The governance scores are used in our investigation into the relationship between governance

and dividend policy over the decade. La Porta et al.s (2000) outcome and substitute models of

dividends provide the framework for the tests. In the former, dividends are expected to be related

positively to governance quality which gives minority shareholders power to force insiders to hand

over cash. The latter model predicts a negative relationship where dividends substitute for the lack

of other governance mechanisms. Parameter estimates of Equation (1) are reported in Table 5.

The first two columns report results of estimating the model over the entire period. Governance

is insignificant when no distinction between pre- and post-crisis is made (column one), but it is

significant and positive when the period controls are added (column two). Investigating further, we

estimate the separate regressions for the pre-crisis (19941996) and post-crisis (19992003) peri-

ods. The negative governance coefficient in column three indicates that lower governance scores

are related to higher dividends, consistent with a substitute role for dividends. The relationship is

no longer significant when the country control variables are included (column four), indicating

that country-level variation replaces the role of firm-level variation in explaining dividend payout.

These dynamics are related to the fact that the countries paying the highest dividends prior to the

crisis, Indonesia and Thailand, tend to have the lowest governance scores. The results suggest that

country-level governance is relevant to explaining dividends and are consistent with the substitute

model pre-crisis. This is further investigated and supported by our subsequent legal regime tests.

The post-crisis results reveal an entirely different relationship. Many firms responded to the

capital flight and currency depreciation by cutting dividend payments drastically. Dividends pre-crisis negative relationship to governance reverses. The positive governance coefficient in column

five is consistent with the outcome model where better governance is related to higher dividends

and the weaker governance firms are paying lower dividends. Also contrasting with the pre-crisis

results is the continued significance of the governance coefficient in column six after adding the

country-level controls. The post-crisis positive relationship between dividends and governance

holds at the firm level, consistent with dividends as an outcome of governance practices adopted

by the individual firm.

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Table 5. Governance and dividend payout.

Entire period Pre-crisis

(1) (2) (3) (4)

Gov 0.04 (1.10) 0.12 (2.64) 0.14 (2.01) 0.03 (0.43) 0.14Profit 0.05 (1.48) 0.04 (1.31) 0.023 (0.32) 0.039 (0.56) 0.05Beta 0.23 (6.63) 0.23 (6.59) 0.27 (4.02) 0.27 (4.05) 0.27Gr 0.05 (1.65) 0.06 (1.76) 0.07 (1.12) 0.06 (1.01) 0.07Sz 0.02 (0.37) 0.01 (0.20) 0.11 (1.45) 0.24 (2.83) 0.28Period No Yes No No

Industry Yes Yes Yes Yes Country Yes Yes No Yes Adj. R2 0.22 0.22 0.13 0.23 0

This table reports regression coefficients estimated with the model:

Divi,t = 0 + 1(Govi,t)+ 2(Pr ofiti,t)+ 3(Betai,t)+ 4(Gri,t)+ 5(Szi,t)

+ 6(Peri,t)+

cCtrc +

sInds

Div is dividend payout. Gov is a score on scale of 09 rating governance quality (Table 1). Profit is return-on-investment, Beta is sysrate of assets and Sz is the log of common equity. Per, Ctr and Ind are period, country and industry binary control variables. t-statistiStatistical significance at 95% confidence level.

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226 J. Sawicki

Table 6. Dividend payout and legal regime.

Gov Profit Beta Growth Size Legal Adj. R2

Pre-crisis 0.087 0.019 0.290 0.062 0.044 0.162 0.13(1.20) (0.268) (4.240) (0.977) (0.551) (1.98)

Post-crisis 0.122 0.045 0.236 0.078 0.149 0.252 0.25(2.70) (1.06) (5.03) (1.84) (2.65) (4.42)

This table reports regression coefficients estimated with the model:

Divi,t = 0 + 1(Govi,t)+ 2(Profiti,t)+ 3(Betai,t)+ 4(Gri,t)+ 5(Szi,t)

+ 6(Per)+ 7(Leg)+

sInds

Div is dividend payout. Gov is a score on scale of 09 rating governance quality (Table 1). Profit is return-on-investment,Beta is systematic risk, Gr is the 1-year growth rate of assets and Sz is the log of common equity. Per, Leg and Ind areperiod, legal regime and industry binary control variables. t-statistics are reported in parentheses.Statistical significance.

The significant, positive post-crisis legal coefficient is consistent with La Porta et al.s (2000)

findings and lends support to the outcome model of dividends. It is also reflective of the fact

that the common law countries were also less affected by the crisis and their recovery was much

smoother than countries in the civil law regime.

An important result of these tests is the evidence provided by the governance coefficient.

Its relationship to dividend payout pre-crisis is insignificant; however, post-crisis it is signifi-

cant at a 1% level with a coefficient of 0.122. This result reinforces the view that governance

began to have significant influence on payout only after implementation of good practices. It

also indicates that both country-level and firm-level governance are important to dividends paid

out to shareholders. Although country-level governance sets the overall tone for the economy,

each firm can choose to ignore the prescribed code of governance or even implement addi-

tional measures. The significance of both the governance and legal variables confirms that both

levels of governance play complementary roles in improving transparency, accountability and

protection.

Some comments on limitations and extensions are appropriate before concluding. The sample

comprises 100 large, surviving firms (20 in each of five countries). These large firms would have

less need for external financing in general and their survival suggests robustness not applicable to

the general population of firms, especially during the turbulent crisis period. Also, their size and

visibility would make them more inclined to improve governance. This can be reasoned in the

context of the Doidge, Karolyi and Stulz (2007) model where firms trade-off costs and benefits in

deciding to improve governance. This subset of largest firms would face lower costs (the value of

control rights is lower for these firms due to visibility) and benefits are potentially higher because

they are more likely to be active in capital markets.An important extension would be to expand thedata to include more firms and countries to provide more comprehensive evidence of governance

practices and dividends.

The governance scores are computed using the annual reports and are based on yes or no

answers, rather than inference. Although this provides a degree of objectivity, the information

available depends upon disclosure in the annual reports. If practices are followed but not reported,

results will be biased. For example, it is possible that some of the changes in the governance scores

reflect the post-crisis emphasis on governance prompting firms to report practices that had been

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Table 7. Governance index.

Variable Theory and evidence

Board independence Independent directors are in a better position to protect shareholdersinterest from managerial opportunism due to their independence frommanagement influence (Fama and Jensen 1983)

Firms with a higher percentage of independent directors have highermarket valuation (Dahya and McConnell 2007)

The fraction of stock held by the Board of Directors positively influencesTobins Q at lower levels of ownership and declines at higher levels ofinside ownership (Morck et al. 1988)

CEO duality One person with a dual role as chairman and CEO faces conflicts ofinterest in carrying out these separate roles (Conyon and Peck 1998)

Combined roles concentrate too much power in the hands of the CEO,constraining board independence and reducing its ability to execute itsoversight and governance roles (Finkelstein and DAveni 1994)

Independent directors of the board perform a valuable role in mitigatingthe agency conflicts and protecting minority shareholders interests(Anderson and Reeb 2003)

Largest director ownership At a high level of equity ownership, mangers become entrenched andpursue private benefits. Managerial ownership insulates top executivesfrom internal monitoring (Denis, Denis, and Sarin 1997)

Turnover is less sensitive to performance when officers and directors own525% of the firms shares, than when they own less than 5%. At highlevels of ownership the effects of managerial entrenchment exert anegative influence on firm value (Denis et al. 1997)

Audit committee Audit committees were first recommended by the New York StockExchange as early as 1939. SEC followed suit in 1972 advocatingthe establishment of audit committees. The audit committee is legallybound to protect shareholder investment. Hence the existence of auditcommittee is inseparable element of corporate governance

An effective audit committee is a salient feature of a sound corporategovernance system (DeZoort and Salterio 2001)

Auditor type External auditors have the role of ensuring reliability and fairness of thefinancial statements prepared by management

The Big Six accounting firms are more likely to ensure transparency andeliminate mistakes in firms financial statements because they have agreater reputation to uphold (Michaely and Shaw 1995)

A firm has better disclosure if its auditor is one if the Big Six internationalaccounting firms (Fan and Wong 2004)

Remuneration committee The absence of independent remuneration committees would appear toallow executives to write their own contracts with one hand and signthem with the other (Williamson 1988)

Companies that have introduced remuneration committees between 1988and 1993 have lower rates of growth in top director pay (Conyon andPeck 1998)

Nomination committee Companies should establish a Nominating Committee to makerecommendations to the board on all board appointments (SingaporeCode of Corporate of Governance 2001)

A Nominating Committee provides an independent opinion andrecommendations for the best candidates to the board. In addition,its existence indicates a formal and transparent process for there-appointment of existing directors and new directors (Singapore Codeof Corporate of Governance 2001)

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228 J. Sawicki

followed but not reported. Also, low scores may reflect poor disclosure and not that a practice is

not followed. To the extent that the overall quality of governance (which our measure is meant to

capture) and disclosure are highly correlated, we do not expect biased results, especially in the

post-crisis period.

The scoring system is based on nine variables that are widely cited and used as proxies of

governance. Increased depth and breadth of criteria could help produce more accurate measures.There remains much scope for investigation into the relationship between country-level and

firm-level governance in examining the interaction between them and their influence on firm

performance, agency problems and dividends. For example, interacting the legal regime with the

governance score would indicate whether the outcome model applies to firms in both regimes in

post-crisis. An important extension of this work would be explicit consideration of changes in the

investment opportunities and the reduction in the need for external funding following the crisis.

Firm characteristics are also helpful in explaining pre- and post-crisis relationships. Ownership

concentration is an important aspect of agency conflicts in the region and could be explicitly

modeled and tested. Also, focusing on dividend events over the period (i.e. whether payout was

maintained, reduced, eliminated or resumed) could yield interesting insights. These are just some

examples. As Claessens and Fan (2002) observe in their survey of corporate governance in Asia:Overall, the understanding of firm organizational structures, corporate governance practices and

outcomes remains limited, however.

5. Concluding remarks

This study investigates dividends and governance in the context of the Asian financial crisis of

19971998 and the expropriation problem that minority shareholders face in countries with an

ownership structure that combines high control rights with low cash flow rights. We address

a question on the nature of the relationship: are dividends substitutes for, or the outcome of

governance practices? The answer in this particular setting: it depends.

In the pre-crisis period, there is a negative relationship between dividends governance. Higher

payout related to poor governance supports the substitute model. This is consistent with theenvironment of rapid GDP growth, large capital inflows and generally poor governance. In the

substitute model, a key element is the incentive to lower the costs of future equity by building a

positive reputation with minority shareholders. Dividend payout is a clear effective mechanism,

especially useful to firms lacking other sources of reputation. Further evidence supporting this

interpretation is that during this period there is a negative relationship between size and dividends.

Smaller firms would have a greater need to establish their reputation with minority shareholders

as well as a higher likelihood of planning to return to capital markets for external funds.

Governance scores improved substantially after the onset of the crisis and dividends fell radi-

cally as the need to conserve cash to deal with the lack of capital and liquidity became paramount.

While dividends could be expected to lose their boom-time substitute role, a reversal in the rela-

tionship between governance and dividends does not necessarily follow. Yet, the results indicatea positive relationship between dividends and corporate governance post-crisis period consis-

tent with the outcome model. After reforms were instituted, higher dividends are paid by better

governed firms, indicating the influence of governance in protecting minority rights by forcing

more cash to be returned to investors.

Finally, the findings indicate that dividends are an outcome of both legal and internal mech-

anisms protecting minority shareholders interests, confirming that both firm- and country-level

governance are important in shaping the nature of investor protection.

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Acknowledgements

The author is grateful for comments from an anonymous referee, Omar Farooq, and Marvin Wee; and for the research

assistance of Ryan Chan.

Notes

1. Lintner (1956) and Gordon (1959) argue that investors prefer dividends (in the hand) to capital gains (risky because

these gains are in the bush). This is moot in the Miller and Modigliani model because reinvestment of dividends at

risk identical to retained earnings.

2. Firms subject themselves to the scrutiny of capital markets by paying dividends and increasing frequency of raising

capital (see Easterbrook 1984).

3. Dividends commit free cash flows, thereby forcing managers to operate more efficiently and avoid unprofitable

projects (Jensen 1986).

4. See Kose and Knyazevas (2006) work on dividends as a pre-commitment.

5. Theoretical and empirical substantiation of the measures as contributors to better corporate governance is provided

in Table 7.

6. Details and discussion of governance changes in all countries are provided in Section 4.

7. Earnings and sales volatility were also used as proxy for risk and we find similar results, not reported here.

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