Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the "prudent man" (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent "prudent investor" (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as the PI standard spread during the 1990s. Studies of asset pricing and corporate governance should no longer consider dividend payments when evaluating the actions of institutional investors.
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Institutional investors play a prominent role in US equity markets by making investment choices on behalf of many savers. These institutions' share of US equity ownership has risen from 11% in 1960 to more than 50% in 2000, and they account for an even larger proportion of equity trading volume (Griffin, Harris, and Topaloglu, 2003). Historically, a "prudent man" (PM) standard of fiduciary care caused some institutional investors to avoid holding shares that did not pay cash dividends. The PM standard judged the appropriateness of each security position on a stand-alone basis, and the payment of regular dividends became a "safe harbor" indicator of a stock's "prudence." The literature contains clear evidence that the PM standard caused bank trust departments to shun non-dividend-paying stocks (Del Guercio, 1996; Schanzenbach and Sitkoff, 2007). Moreover, PM restrictions probably had effects far beyond their narrow applicability to trusts. Legal precedents encouraged other fiduciaries to make similar choices as protection against judicial review of their investment decisions. Yet during the 1990s, most states replaced the PM standard of fiduciary care with the less-stringent "prudent investor" (PI) standard, which evaluates the appropriateness of each investment in a portfolio context. These changes should have weakened or eliminated a restriction on many institutional investors' opportunity sets.
Given the importance of institutional investors to the equity market, researchers must understand the extent to which their behavior was (is) subject to special restrictions. Institutions are typically viewed as rational, informed, and profit-oriented investors. They can provide important monitoring (governance) services to firms whose stock they hold (Shleifer and Vishny, 1986; Allen, Bernardo, and Welch, 2000). Institutions are also viewed as arbitrageurs who will seek profits by offsetting "irrational" asset price movements. Researchers have suggested that constraints on institutional holdings of nondividend-paying shares limited their ability to arbitrage apparent market inefficiencies (Badrinath, Kale, and Noe, 1995). Mauer and Senbet (1992) indicated that institutional preferences for dividend-paying shares limited their ability to speculate against IPOs' high initial returns. Kamara (1997) asserted that investing constraints limited the ability of well-informed institutions to correct the "Monday effect" in stock returns caused by the irrational behavior of smaller investors. Chung (2000) noted that institutions exhibit a preference for high-quality companies because of prudence concerns.
Corporate finance issues are also interwoven with constraints on institutional investing. Allen et al. (2000) speculated that the PM restriction might be turned to the firms' advantage if introducing dividend payments serves to attract additional institutional investors, which provide valuable monitoring services. In their 2002 survey, Brav, Graham, Harvey, and Michaely (2005) asked 166 executives at dividend-paying firms whether institutional preferences affected their dividend decisions, and reported,
The CFOs do not indicate that institutions as a class prefer
dividends over repurchases, except perhaps the existence of a small
dividend payout that is needed to attract certain types of
institutions. (p. 509, emphasis added)
Grinstein and Michaely (2005, p. 1390) examined the institutional ownership proportions of traded stocks from 1980 to 1996 and presented "clear evidence that institutions prefer dividend-paying firms." They further concluded that "institutions do not show any preference for firms that pay high dividends.... In fact, we find some evidence that institutions prefer low-dividend stocks to high-dividend stocks." Gompers and Metrick (2001) and Bennett, Sias, and Starks (2003) also concluded that a stock's institutional holdings varied inversely with its dividend yield over 1980-1996 and 1983-1997, respectively.
Although the PM standard of fiduciary care once applied to many institutional investors, that standard has been largely replaced in state statutes and Employee Retirement Income Security Act (ERISA). Since 1992, 43 states have substituted the less-restrictive PI standard of fiduciary responsibility, which uses modern portfolio theory to assess an investment's prudence in the context of the overall portfolio. If PM biased institutions toward dividend-paying stocks, the change to PI removed this constraint and should have increased their appetite for non-dividend-paying shares. We present evidence here that the states' removal of PM restrictions led institutional investors to expand their holdings of non-dividend-paying stocks during the 1990s.
1. Dick Fuld
It’s one thing to oversee the collapse of one of Wall Street’s most esteemed firms. But when your hubris triggers a national financial panic as well, you’re a shoo-in for our top prize. Fuld’s reckless risk-taking may have been typical of Wall Street, but his refusal to acknowledge that his firm was in trouble—and take the steps necessary to save it—was beyond the pale. Since filing the largest bankruptcy in U.S. history ($613 billion in debts outstanding), Fuld has been belligerent and unrepentant. Even Bernie Madoff said he was sorry.
THE STAT: Fuld was recently spotted trying to figure out the Jet Blue check-in machines at La Guardia Airport.
THE STAT: Fuld was recently spotted trying to figure out the Jet Blue check-in machines at La Guardia Airport.
2. Angelo Mozilo
Meet the man who made subprime a household word. Once a symbol of self-made accomplishment—a butcher’s son who built the largest mortgage lender in the country—Mozilo became blinded by success and began going after the riskiest and most unsavory of borrowers to boost his company’s market share. In so doing, he legitimized a sector that would ultimately bring down the economy.
THE STAT: Mozilo’s once-secret, now-infamous “Friends of Angelo” program provided loans on favorable terms to politically influential borrowers, including Senators Kent Conrad and Chris Dodd.
THE STAT: Mozilo’s once-secret, now-infamous “Friends of Angelo” program provided loans on favorable terms to politically influential borrowers, including Senators Kent Conrad and Chris Dodd.
3. Ken Lay
When it comes to bad CEOs, Lay was the complete package: He was not only dishonest but disastrously inept as a manager as well. Lay, who founded Enron and turned it into a $70 billion energy company, was uninterested in the day-to-day tasks of running the business. Consequently, he gave free rein to untrustworthy subordinates like Jeff Skilling and Andy Fastow. He also signed off on a maze of convoluted transactions that formed the basis of a massive accounting fraud that would wipe out investors and bring down the corporation. Lay was convicted of securities fraud in 2006. If he hadn’t died soon afterward, he would have faced as many as 30 years in prison.
THE STAT: Enron stock lost 99.7 percent of its value in 2001.
THE STAT: Enron stock lost 99.7 percent of its value in 2001.
4. Jimmy Cayne
Talk about an out-of-touch leader. Cayne was playing bridge when two Bear Stearns hedge funds collapsed in July 2007, and was again the following March when a liquidity crisis at the firm led to its emergency sale to J.P. Morgan. Never mind that its share price was $10 (less than 3 percent of its high of $170); Cayne will spend the rest of his days living down reports that one of his other favorite pursuits was smoking pot.
THE STAT: What a difference a year makes: A share price of $10 doesn’t sound too bad these days.
THE STAT: What a difference a year makes: A share price of $10 doesn’t sound too bad these days.
5. Bernie Ebbers
The ultimate corporate shopaholic, Ebbers bought an obscure telephone carrier in the 1980s and went on a 17-year acquisition binge that turned it into the world’s largest telecom company. Alas, his passion for deal making didn’t translate into the savvy necessary for running the complex business. When telecom stocks went south in 2000, the company’s massive debt was exposed. Ebbers tried to disguise it through fraudulent accounting. In 2005—three years after WorldCom filed for bankruptcy—he was convicted of overseeing $11 billion worth of accounting fraud. He’s now serving a 25-year prison term.
THE STAT: When Ebbers resigned, in 2002, WorldCom stock had fallen to $1.79 from a peak of $64.50 in 1999.
THE STAT: When Ebbers resigned, in 2002, WorldCom stock had fallen to $1.79 from a peak of $64.50 in 1999.
