Corporate Governance and Payout Policy: an Analysis of the Impact of the Sarbanes-Oxley Act

Abstract

In this study I examine the effect of the tightening of corporate governance on the payout policy choice of companies following the passage of the Sarbanes-Oxley Act of 2002 (SOX). Given the endogeneity in the relationship between governance and payout, I employ a differences-in-differences approach to examine the relative change in payout for firms that were less compliant versus more compliant with the SOX corporate governance provisions in the pre-SOX period. The use of an exogenous shock to corporate governance avoids this endogeneity issue that has been an enduring concern of previous research and allows not only the detection of a relationship but also the causal direction. I find results that support the substitution hypothesis, whereby corporate governance and payout are used as substitute control mechanisms to reduce the agency costs of free cash flow. Total payout incidence and level decrease following the enactment of SOX. Further, firms decrease the proportion of dividends in payout. This is consistent with the substitution hypothesis that predicts firms move to a less restrictive payout policy following the tightening of corporate governance. Both the level and incidence of repurchases decrease following the enactment of SOX. No significant effect is observed for dividend incidence or level. Consistent with previous research, the effect is more pronounced for less compliant small firms compared to less compliant large firms. These results indicate that the enactment of SOX had a material effect on corporate payout policy, thus suggesting a significant relationship between governance and payout.