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Journal of Financial Services Research

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01-06-2015

Outside Director Stock Options and Dividend Policy

Authors: Anwar Boumosleh, Brandon N. Cline

Published in: Journal of Financial Services Research | Issue 3/2015

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Abstract

Agency theory suggests that dividends can be used to mitigate agency problems between shareholders and managers. If director stock options are granted to align the interests of directors with shareholders, we anticipate that there will be less need for external governance mechanisms such as dividends. Examining the association between outside director stock options and dividend policy, we show that outside director option compensation indeed varies inversely with dividend distribution. This result suggests that incentivizing outside directors reduces the need for external market monitoring through dividends. Controlling for the sensitivity of options to changes in dividends, we illustrate that the lack of dividend protection for stock options is not a sufficient explanation for the reduction of dividends. We also show that while investment policy might dominate the decision to offer a dividend, director stock options play an important role in determining the level of dividend paid in firms that pay dividends.

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Beginning in 1995 the National Association of Corporate Directors has recommended that boards pay directors solely with options and cash, and that at least 50 % of pay come in the form of equity (NACD 2010a).

Examples of recent work on director compensation are Perry (2000), Bryan et al. (2000), and Brick et al. (2006). Perry (2000) reports positive association between director incentive compensation and CEO turnover in poorly performing firms. Bryan et al. (2000) identify the economic determinants of director compensation, and Brick et al. (2006) argue that the positive relation between CEO and director compensation suggests weak monitoring.

The NACD (2010b) finds that the median pay for corporate directors is $75,490 at ‘smaller companies’ ($50 M–$500 M), $108,836 at ‘small companies’ ($500 M–$1B), $131,054 at ‘medium companies’ ($1B–$2.5 B), $164,455 at ‘large companies’ ($2.5 B–$10B), and $216,186 at ‘Top 200 companies’ (>$10B).

An alternative argument is that the lack of dividend protection for stock options decreases the likelihood of a firm paying a dividend. This view is theoretically and empirically developed in Section 4.4.

In our analysis we also recognize that a high degree of correlation exists between CEO and director compensation and thus control for this interrelation by including both factors in the tests. Consistent with Boumosleh et al. (2013), stock option grants might provide different incentives for directors and CEOs. It could be that directors receiving more stock options are more likely to pursue disciplinary action against the CEO. Fluck (1999) and Zweibel (1996) offer a similar argument.

For robustness firm fixed effects are also used. These are reported in Section 5.1.

Section 5.3 provides a separate analysis and comparison of financial firms.

Our sample includes 191 firms that initiate a dividend during our period of study. In untabulated tests, we compare firms that pay no dividend to those that chose to initiate a dividend. Consistent with the results reported in Table 3, we find Dir PSO to be significantly lower for firms choosing to initiate a dividend.

We also examine other proxies for payout like dividend yield and dividend to sales. The results are not tabulated for brevity, but are qualitatively unchanged from those shown.

For robustness we also create an indicator variable for the presence of director incentives, where PayDir is set equal to one if the firm pays stock options to outside directors. Interacting the director incentive dummy with the continuous XS Cash variable yields results consistent with those reported in Table 4.

We also run tests on the decision to initiate a dividend. The results are consistent with those reported in columns (1) and (2) on the decision to pay. Namely, the coefficients on director incentives are negative and significant and the interaction between director incentive pay and excess cash remains insignificant. We thank the referee for suggesting this addition to the paper.

As in the previous models, we include our CEO variables since Jiraporn et al. (2012) show that CEO dominance can influence leverage decisions.

Interestingly, the CEO interaction variable of PayPer * XS is positive and significant.

In another specification we drop year 2001 and the results were unchanged.

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Title: Outside Director Stock Options and Dividend Policy
Authors: Anwar Boumosleh
Brandon N. Cline
Publication date: 01-06-2015
Publisher: Springer US
Published in: Journal of Financial Services Research / Issue 3/2015
Print ISSN: 0920-8550
Electronic ISSN: 1573-0735
DOI: https://doi.org/10.1007/s10693-013-0174-2

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