Abstract
The dividend puzzle of economic theory asks why firms pay substantial dividends, given the classical tax rate preference for capital gains and deferral of capital gains taxation until realization. A new dividend puzzle arises at the level of practice in the wake of The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the JGTRRA), which aligns tax rates on shareholder capital gains and dividend income at a maximum 15 percent even as it leaves in place the capital gains deferral. The new tax regime puts a difficult question to corporate boards: Whether, assuming payout, dividends hold out relative advantages over stock repurchases as the mode of payment. Prior to rate parity, a sequence of justifications supported a growing preference for open market stock repurchases (OMRs) over dividends: (1) OMRs held out the capital gains rate shift for the selling shareholders, along with a tax deferral and rate shift for nonselling shareholders. (2) OMRs signaled good news and supported the firm's stock price in the market. (3) Because OMRs suited management's preferences, they facilitated payout and reduced the risk of suboptimal earnings retention. (4) OMRs increased earnings per share by reducing the number of shares outstanding. (5) Managers executing OMR programs could take advantage of information asymmetries to execute repurchases at bargain prices. Old fashioned dividends, in contrast, carried a tax disadvantage for most shareholders, did nothing for earnings per share, did less than OMRs to support the stock price, and overly constrained cash flow management. Rate parity under the JGTRRA removes the first of the five justifications in substantial part. Indeed, tax considerations influenced payout practice only marginally even given a rate differential. The shift in the tax regime invites reconsideration of the weight to be accorded justifications (2) through (5). As to (2), the Article shows that signaling value is too weak to explain or justify the shift to repurchases. As to (3) and (4), management flexibility and earnings per share enhancement, the Article makes a three-part response. First, the shift to repurchases diminishes the disciplinary benefits of dividends, complicating any justificatory resort to agency theory. Secondly, the shift to repurchases proceeded in tandem with the 1990s shift to stock option compensation, as firms repurchased stock to offset the dilutive effect of option exercises on earnings per share. An OMR program's value to long term holders accordingly depends on the option plan's success as incentive compensation. Thirdly, dividends do not have to be sticky. Sporadic free cash flows can be distributed as dividends without triggering unjustified market expectations if management draws on the practice of a half century ago and declares a special dividend. As to (5), bargain repurchases, there are two countervailing factors. First, any bargain repurchase possibility depends on the framework of market regulation. The securities laws allow firms to time repurchases in secret, letting them take advantage of market volatility. In a regime of imposed transparency, the bargains for the most part would disappear. Secondly, management can be wrong in viewing its stock as undervalued. To the extent that an OMR program sweeps up overvalued stock, it benefits selling shareholders to the detriment of long-term holders who suffer dilution. This possibility mattered little under the classical tax regime, because the tax benefit tended to make up for the dilution risk. With rate parity, adverse selection becomes a more active possibility respecting OMR programs. The Article concludes that the shift to repurchases should not be read as a governance success story. Since repurchases held out tax benefits for most shareholders prior to the JGTRRA, there was no reason for outside monitors to ask hard questions about flexibility and adverse selection or to inquire further about the motivational effects of stock option valuation. With rate parity, the governance system needs to start the questioning process. The bargain repurchase possibility must be weighed against the adverse selection possibility, with the balance depending on the state of the market. Taxation remains a consideration: Repurchases and capital gains still hold out deferral value for long term, taxpaying shareholders. Finally, special dividends hold out advantages of transparency with the possible spillover of improved executive compensation policy. More generally, the JGTRRA poses a cost-benefit puzzle to be solved firm-by-firm, case-by-case. Unfortunately, the corporate governance system still rubber stamps management payout decisions, and so probably will fail to confront the questions. Governance reform is needed to assure that the payout decision is uncoupled from perverse incentives stemming from stock option compensation and reformulated in light of rate parity. It follows that payout should join management compensation in the emerging regime of governance by independent director committee.