Politically connected directors and investor protection: Revisiting
dividends as an agency mechanism.
Debby Withag
Master’s Thesis International Financial Management, Management Accounting & Control Student number: 3070883
Supervisor: dr. S. Mukherjee Co-Assessor: dr. H. Gonenc
Date: 07-01-2021
Word count excluding references, tables and appendix: 8,843
ABSTRACT
This thesis examines the effect of politically connected directors on the relationship between
investor protection and dividend payout. Using a sample including 26 countries for the period
2002-2015, I find evidence that dividend payouts are lower for politically connected firms
compared to non-connected firms when these firms are in countries with weak minority
shareholder rights protection. Besides, my results demonstrate that during financial crisis
dividend payouts for politically connected firms are even lower compared to non-connected
firms in countries with weak minority shareholder rights protection. Further investigation
shows that the main results hold regardless of whether the connection is through a minister or
bureaucrat. My results are in line with the view that politically connected firms perceive lesser
need to respond to market pressures.
1. Introduction
What are the benefits and costs associated with firm political connections and how do these
relate to dividend payouts in different institutional environments? Do the benefits and costs,
and as such dividend payouts differ between different institutional environments? The
influence of political connections on firms is an ongoing topic that draws attention from many
researchers. This is not surprising since many firms across the world have political
connections (Chaney, Faccio and Parsley, 2011). More specifically, Faccio (2006) shows that “connected firms represent 7.72 percent of the world’s stock market capitalization”. Prior literature demonstrates benefits for firms from being politically connected, such as reduced
financial constraints (Cull et al., 2015; Chan, Dang and Yan, 2012; Faccio, 2010; Boubakri et
al., 2012), lower taxes and stronger market power (Faccio, 2006). However, Shleifer and
Vishny (1994) argue that by channeling resources towards these firms, firms’ political
connections will interfere in corporate activity and business decisions. According to You and
Du (2012), this suggests that political connections influence internal corporate governance
mechanisms. In their study, You and Du (2012) report that politically connected CEOs are
less likely to be dismissed, which indicates poor monitoring of the management for the
shareholders.
Corporate governance entails the mechanisms a country or firm has in place to minimize
agency problems (see Shleifer and Vishny, 1997). In contrast to internal corporate governance
mechanisms such as the board of directors and ownership structure, “external corporate
governance mechanisms consist of an active takeover market, a solid legal infrastructure, and
financial market development” (Huyghebaert and Wang, 2012). An example of a solid legal
infrastructure is minority shareholder rights protection (Boubakri, Cosset and Guedhami,
2005). Although the effect of political connections on agency and corporate governance
environment characterized by weak minority shareholder rights protection, differences
between politically connected and non-connected firms are greater.
To explore how the benefits and agency issues associated with political connections relate to a country’s corporate governance mechanisms, i.e. investor protection, I will consider
dividends, an agency tool. Therefore, this study will examine how political connections affect
the relationship between minority shareholder rights protection and dividend payouts.
Arising from the ability of controlling shareholders (insiders) to use their decision-making
authority to benefit themselves at the expense of minority shareholders (outsiders), agency
issues comprise a conflict of interest between corporate insiders and outside shareholders
(Jensen and Meckling, 1976). In this line La Porta et al. (2000a) discuss minority shareholder
expropriation which occurs when a company’s management diverts corporate wealth to
benefit themselves rather than the outside investors. However, by paying out dividends, cash cannot be used by a firms’ insiders for the purpose of extracting private benefits (Easterbrook, 1984). Furthermore, the reduction in available free cash flows will force firms to finance
investments externally (Easterbrook, 1984). Consequently, the risks of suppliers of capital
increase which fosters monitoring and in turn reduces the agency problems.
According to La Porta et al. (1997), cross country differences in agency problems to which
minority shareholders are exposed relate to variations in the institutional protection of these
shareholders. As such, a country’s institutional environment is an explanation that is often
used in the literature for differences in dividend payouts between countries (La Porta et al.
2000a; Faccio, Lang and Young, 2001; Mitton, 2004; Brockman, Tresl and Unlu, 2014). The
legal protection of shareholders is part of government policy, regulation and enforcement, a
major force in the external environment of firms (Mahon and Murray, 1981; Shaffer, 1995;
Marsh, 1998; Hillman, Zardkoohi, and Bierman, 1999). Therefore, firms’ investors are
Pfeffer and Salancik, 1978). Pfeffer (1972) suggests that firms should create connections with
these sources of external dependency, i.e. institutions.
By establishing connections between the firm and politicians, many firms have sought to “coopt” government (Carney and Child, 2012; Morck, Wolfenzon and Yeung, 2005).
According to Hillman (2005), governmental resource co-optation often implies employment
or appointment of individuals with access to or influence on the government. By doing so,
firms try to create suitable conditions for themselves in the external economic environment
through political mechanisms (Hillman, Withers and Collins, 2009). This is especially relevant since a country’s institutional environment is considered an important source of external dependency and uncertainty for business (Hillman, 2005). More specifically, Hillman
and Keim (1995) argue that government co-optation can be considered as a function of country’s institutions. In such a context, analyzing the dividend payouts of politically connected firms in institutional environments characterized by different levels of minority
shareholder rights protection may prove interesting since the institutional environment have
been felt to be associated with political connections (Faccio, 2006; Faccio, 2010) as well as
with dividend payouts (Brockman and Unlu, 2009; Byrne and O’Connor, 2012; Shao, Kwok
and Guedhami, 2013; John, Knyazeva, and Knyazeva, 2015; Guedhami, Kwok and Shao,
2017; Ye et al., 2019). López-Iturriaga and Santana-Martín (2019) examine the relationship
between political ties and dividend policy in the Spanish institutional environment, which is
characterized by low external investor protection. Their findings indicate that political
connections increase cash dividend payouts and share repurchases. Although López-Iturriaga
and Santana-Martín (2019) provide some evidence on dividend payouts of politically
connected firms in countries with weak minority shareholder rights protection, to the best of
my knowledge, cross-country studies on this topic do not exist.
which financial institutions fail and governments intervene in the market in an endeavor to
rescue their institutions and economy (Moshirian, 2011). Johnson et al. (2000) define a
financial crisis as “an exogenous shock lowering expected return on investment opportunities”. The negative impact on a firm’s investment opportunities increases the incentives of controlling shareholders to commit funds to unprofitable projects that provide
private benefits (Lemmon and Lins, 2003). As a consequence, expropriation of minority
shareholders by managers is more likely to occur and agency problems are more pronounced
(Tran, Alphonse and Nguyen, 2017). Although literature argues that corporate governance
mechanisms mitigate agency problems in the normal course of events (Shleifer and Vishny,
1997), Judge (2012) questions whether these mechanisms hold in times of financial crisis.
Scholars examining dividend payouts during financial crisis mainly focus on banks (Abreu
and Gulamhussen, 2013; Floyd, Li and Skinner, 2015), which are the dominant supplies of
external capital (Demirgüc-Kunt and Levine, 2001) and part of the institutional environment.
However, these studies indicate mixed results and often focus on a single country, i.e. one
institutional environment. Overall, literature considering dividend payouts of non-financial
firms during the financial crisis is limited, and more interestingly, does not take governmental
resource co-optation into account. Since governments become pro-active in the market during
financial crisis, the impact of governmental resource co-optation might change. As an
illustration, Moshirian (2011) asserts that governments introduce regulations for their national
financial systems, offer guarantees to their depositors and creditors, become owners of banks
and firms and ask their central banks to act as market stabilizers.
Whereas on the one hand resources become scarce, on the other hand agency issues become
more pronounced during financial crisis. Thus, the role of political connections during the
financial crisis is undetermined. By investigating the impact on the relation between investor
politically connected directors.
Agency literature indicates that establishing a reputation is important in countries with weak
institutions (La Porta et al., 2000a). La Porta et al. (2000a) argue that weak investor protection
provides an incentive for firms to build a reputation of fair treatment of minority shareholders
in the financial market by paying out dividends. Accordingly, dividends can be considered as a “substitute” for weak governance, i.e. weak investor protection. My findings confirm prior literature regarding the substitute model, showing a negative association between investor
protection and dividend payout. This implies that by paying out dividends “firms bond to greater protection of their shareholders” (Brockman and Unlu, 2009). Establishing a reputation is also important for politically connected firms since these firms are subject to greater public
scrutiny (Choi and Thum, 2009; Chaney, Faccio and Parsley, 2011; López-Iturriaga and
Santana-Martín, 2019). Drawing on agency incentives, I argue that politically connected firms
in countries with weak investor protection face multiple incentives to payout dividends in
contrast to countries with strong investor protection. Therefore, I hypothesize that the effect of
investor protection on dividends is more negative in politically connected firms compared to
non-connected firms. As political connections serve as safeguard during financial crisis, I
hypothesize that this relationship is less negative in times of financial crisis.
To test all my hypothesis, I construct a large international sample comprising observations
from 18,076 firms in 26 countries over the period 2002 to 2015. Surprisingly, I find that firm
political connections weaken the negative relationship between investor protection and
dividends since the moderating effect of firm political connections is significantly positive.
The findings are robust to alternative measures of dividend payout. The results contrast the
view of Bona-Sánchez, Pérez-Alemán and Santana-Martín (2019) that politically connected
firms pay more attention to minority shareholder interests in countries with weak institutions
these countries. Rather, the results suggest that firms with politically connected directors on
the board payout less dividends when in countries with weak minority shareholder rights
protection. Therefore, the need to establish a reputation does not explain the dividend payouts
of politically connected firms in countries with strong minority shareholder rights. Thus, I
eliminate that it is simply the case that dividends are paid by politically connected firms to
establish a reputation of fair treatment of minority shareholders. Consequently, the question
becomes why politically connected firms in countries with weak minority shareholder rights
protection pay out less dividends than non-connected firms. It could be that politically
connected firms in countries with weak minority shareholder rights protection face less
incentives to payout dividends due to the advantages of being politically connected. Chaney,
Faccio and Parsley (2009) argue that politically connected firms are less subject to market
pressures. As such, the importance of having a reputation of fair treatment of minority
shareholder in order to be able to raise equity capital in the future, might be less for politically
connected firms. In a similar vein, Faccio (2010) argues that in countries with weak
institutions the political connections provide benefits that allow politically connected firms “to more than compensate for any lack of management skills”, i.e. agency issues. This is line with the view that a weak institutional environment encourages firms to establish political
connections (Faccio, 2006).
The empirical findings also reveal that the financial crisis positively affects the role of
politically connected directors. The findings indicate that politically connected firms payout
even less dividends in countries with weak investor protection during financial crisis
compared to normal times. This suggests that politically connected firms are even less subject
to market pressures during financial crisis. It is consistent with the argument by Faccio,
Masulis and McConnell (2006) that politically connected firms can rely on “implicit
In further empirical analysis, I use another global sample and find additional support for the
substitute model.
With this study, I contribute to the literature on dividend payout and politically connected
firms in three ways. In the first contribution, I provide a global and holistic perspective on the
effect of politically connected directors on dividend payout. Although López-Iturriaga and
Santana-Martín (2019) explored this link, the study focuses on a single country and thus
entails only one institutional environment. In general, research about the link between firm
political connections and dividend payout is scarce and to the best of my knowledge,
cross-country studies incorporating the institutional environment, political connections and
dividends do not exist. By using a global sample, I show that having politically connected
directors on the board for firms located in countries with weak minority shareholder rights
protection has more effect on dividends than for politically connected firms located in
countries with strong minority shareholder rights protection. Thereby, I extend the argument
made by Faccio (2010) that differences between politically connected and non-connected
firms are greater in a country with weak institutions. My study illustrates the encounter
between firm political connections and investor protection, and the incentives firms
consequently face to payout dividends. More specifically, the positive effect of minority
shareholder rights protection on dividend payout in politically connected firms indicates that
the substitutability of weak corporate governance by paying out dividends does not hold when
a firm is politically connected. As such, I add to the literature that examines the need of
politically connected firms to respond to market pressures.
In the second contribution, I extend the literature on agency problems and corporate
governance during times of economic uncertainty. Although prior literature agrees on the
upturn of minority shareholder expropriation during financial crisis (Lemmon and Lins, 2003;
connections during financial crisis are scarce. López-Iturriaga and Santana-Martín (2019)
show that the financial crisis does not impact the role of political connections. However, my
results indicate that the role of political connections is more pronounced during financial
crisis. More specifically, the positive effect of financial crisis on politically connected firms
indicates that political connections could be especially beneficial in times of macroeconomic
shock.
In the third contribution, I demonstrate that the interaction of firm political connections and
dividends is positive irrespective whether the connections are through ministers or
bureaucrats. By including another type of political agent that runs the government, namely
bureaucrats, I respond to the recent call for research including political connections beyond
former politicians on the board (e.g., López-Iturriaga and Santana-Martín, 2019). Prior
literature on governmental resource co-optation mainly focused on politicians as primary
source of political connection (Shaffer, 1995; Rajwani and Liedong, 2015). However, Stigler
(1971) posits that several types of political agents run the government. Therefore, many
studies ignore other political agents who can also have access to or influence on the
government process (Mukherjee, 2020). Whereas politicians are regarded as the most visible
political agent vested with fiduciary duties (Natelson, 2004; Leib, Ponet and Serota, 2012)
and public authority (Weingast, 1984; Bendor, Taylor and van Gaa, 1987; Moe, 2006),
Mukherjee (2020) argues that bureaucrats exercise their power and authority. Bureaucrats
manage government institutions, formulate and administratively help pass legislation and
occasionally cancel corporate regulations in order to maximize the politicians’ public support
(Stigler, 1971). By including not only formal board-based political connections relating to
politicians, but also formal board-based political connections relating to bureaucrats, this
research adds to Mukherjee’s (2020) encouragement to study bureaucrats. Although my
am not finding any different result between firms that have political connections through a
minister and firms that have political connections through a bureaucrat. It implies that
ministers and bureaucrats might bring different resources to the firm as argued by Mukherjee
(2020), but that these different resources do not explain why politically connected firms
payout less dividends compared to non-connected firms in countries with weak minority
investor protection. Therefore, the relevance of treating ministers and bureaucrats differently
as encouraged by Mukherjee (2020), can be questioned.
The thesis is structured as follows: Section 2 develops the research hypothesis drawing on
literature, and then Section 3 details the research design. Section 4 presents the results,
including robustness tests and an additional sample analysis. Finally, Section 5 concludes the
paper.
2. Literature
2.1. Agency conflicts of interests and dividends
An important firm decision over which corporate insiders and outside investors have
conflicting interests, is the board’s decision to declare dividends and approve share
repurchases programs. Although both dividends and share repurchases can be considered as
mechanisms to distribute excess cash back to its shareholders in order to reduce the potential
agency costs (Easterbrook, 1984; Jensen, 1986), the drivers between both payout methods are
fundamentally different (Andriosopoulos and Hoque, 2013)1 and agency risk becomes quite
different at the end of the transactions (Golbe and Nyman, 2013). Golbe and Nyman (2013)
find that share repurchases tend to make outside ownership less concentrated. This decreases
outside shareholders' influence over firm decision-making and thus changes agency risks.
Accordingly, this study will focus solely on dividends.
In contrast to controlling shareholders, minority shareholders would prefer to disgorge cash
flows (i.e., dividends) in order to restrict insiders from using the cash for the purpose of
extracting private benefits (La Porta et al., 2000a). As a tool to address this conflict of
interest, dividend is a topic that is often examined in combination with a countries’ protection
of minority shareholders. Minority shareholders protection concerns “corporate and other law
that provide outside investors certain powers to protect their investment against expropriation by insiders” (La Porta et al., 2000b). Examples of minority shareholder rights to protect themselves from expropriation are the right to receive dividends on pre-specified terms, to sue
directors for suspected expropriation and to vote for directors (La Porta et al., 2000b).
La Porta et al. (2000a) developed two agency models that draw on differences in a countries’
legal protection of investor to explain dividends, the outcome model and the substitute model.
The substitute model suggests that firms located in countries with weak investor protection
pay higher dividends and by doing so, substitute for weak governance (La Porta et al., 2000a).
This model is based on the assumption that firms need to issue equity in the future. In order to
be able to raise equity capital when needed, firms establish a reputation with potential buyers
of their common stock by paying dividends (Ye et al., 2019). The reputation of fair treatment
of minority shareholders in the financial market should in turn reduce the cost of capital and
ease financial constraints (Byrne and O’Connor, 2012). Especially in countries with weak
investor protection building such a reputation is important, since shareholders cannot rely on
Therefore, in countries with strong investor protection firms will not need to payout dividends
for reputational purposes. While La Porta et al. (2000a) find support for the outcome model,
more recent studies find a negative association between investor protection and dividend
payout, supporting the substitute model (Jiraporn and Ning, 2006; Brockman and Unlu, 2009; Byrne and O’Connor, 2012; Shao, Kwok and Guedhami, 2013; John, Knyazeva and
Knyazeva, 2015; Guedhami, Kwok and Shao, 2017; Ye et al., 2019). For example, Guedhami,
Kwok and Shao (2017) find that minority shareholder rights protection, measured by the
revised anti-director rights index, negatively relates to the amount of dividend payouts.
Since the bulk of recent studies seeking to explain dividends find a negative association
between investor protection and dividends, I believe the substitute model is more likely to
rationalize dividend payouts. Therefore, this study will build on the substitute model for
developing hypothesis.
2.2. Background on firm political connections
In their paper assessing RDT, Hillman, Withers and Collins (2009) discuss multiple strategies
to tackle the sources of dependency in the external economic environment, i.e. institutions,
among which corporate political action. According to Hillman, Keim and Schuler (2004), literature defines corporate political actions as “corporate attempts to shape government policy in ways favorable to the firm” (Baysinger, 1984). Although several forms of government co-optation exist, such as election campaign contributions (financial) and
lobbying, petitions and comments (informational) (Rajwani and Liedong, 2015), this study
focusses on appointing politically connected directors since the board of directors serves a
governance function by monitoring management and providing advice (Jensen and Meckling,
1976; Baysinger and Hoskisson, 1990). Due to measurement issues related to friendships,
1999; Johnson and Mitton, 2003), this study adopts a conservative measure by using formal
board-based political connections (You and Du, 2012; Hadani, Doh and Schneider, 2018).
Although, the board of directors can thus be considered as an important corporate governance
mechanism, politically connected directors are appointed to the board to “coopt” the
government rather than their monitoring abilities (Boyd, 1990; Hillman, 2005). Prior studies
confirmed advantages to firms with political connections. For example, Khwaja and Mian
(2005) find that that firms with a director participating in an election have higher levels of
debt, but also higher default rates compared to other firms, indicating that connected firms
enjoy greater access to debt financing. In addition to higher leverage reflecting access to
credit, Faccio, Masulis and McConnell (2006) find that politically connected firms are more
likely to be bailed out. Literature repeatedly confirmed the more flexible financing constraints
for politically connected firms (Cull et al., 2015, Chan, Dang and Yan, 2012; Faccio, 2010;
Boubakri et al., 2012). Moreover, politically connected firms pay lower taxes and have
stronger market power (Faccio, 2006). Furthermore, Chaney, Faccio and Parsley (2011) find
that the earnings reporting quality of politically connected firms is significantly lower than
non-connected companies, resulting from a reduction in the perceived need to respond to
market pressures for increasing earnings reporting quality.
Although politically connected directors benefit firms with their resources, literature also
finds that they utilize these resources for their own benefit, i.e. they extract rents from the
companies they manage (Jensen and Meckling, 1976; De Soto, 1990; Shleifer and Vishny,
1994). In addition to political connections’ interference in corporate activity and business
decisions (Shleifer and Vishny, 1994), this expropriation suggest that appointing politically
connected directors to the board increases agency issues. Fan, Wonga and Zhang (2007)
support this view by demonstrating that firms led by politically connected CEOs are more
is in line with the argument by Hillman (2005) that politically connected directors are
appointed to the board of directors for their resources rather than their monitoring abilities.
Faccio (2010) argues that on average, literature has shown that the benefits associated with
firm political connections exceed the costs. However, the magnitude of the benefits depends
on the specific country (Faccio, 2010).
2.3. Politically connected directors, investor protection and dividends
Since firm political connections might increase agency issues, it could be argued that in
countries with weak minority shareholder rights protection politically connected firms face
double incentives to payout dividends. In their paper examining the relationship between director’s political ties and dividend policy in a sample of listed Spanish firms, López-Iturriaga and Santana-Martín (2019) show that in the Spanish institutional environment with
low minority shareholder rights protection, political connections increase cash dividend
payouts and share repurchases. The authors draw on increased public scrutiny associated with
political connections and state that politically connected firms may focus more on establishing
a trustworthy reputation by paying dividends.
When a firm is politically connected, information asymmetry between investors and managers
exacerbates (Chen, Ding and Kim, 2010). As an illustration, Chaney, Faccio and Parsley
(2011) assert that politically connected firms might care less about information disclosure
quality since they are protected from penalties following the disclosure of low quality
accounting information. Resulting from the information asymmetry, politically connected
firms are not only subject to greater scrutiny from the electorate and other stakeholders (Choi
and Thum, 2009), but also receive more attention from analysts and mass media (Chaney,
Faccio and Parsley, 2011). As a result, establishing a trustworthy reputation might be of great
According to Bona-Sánchez, Pérez-Alemán and Santana-Martín (2019), the relevance of trust,
reputation and the long-term stability of dominant owners in weak investor protection
countries can mean more attention being focused on minority shareholder interests by
politically connected firms.
Besides the relevance of establishing a reputation for politically connected firms, politically
connected firms might payout more dividends because they have more funds available. Qian,
Pan and Yeung (2011) argue that incentives to expropriate minority shareholders can be
provided by the possibility of obtaining funds outside the financial market. Since politically
connected firms are able to influence the institutional environment and as such enjoy softer
financial constraints (Chan, Dang and Yan, 2012; Song, Ai and Li, 2015; Cull et al., 2015),
these firms rely less on internal cash flows to fund investments. Therefore, firm political connections shape dominant owners’ incentive to expropriate minority shareholders (Qian, Pan and Yeung, 2011).
Especially in countries with weak minority shareholder rights protection where firms face
more financial constraints (McLean, Zhang and Zhao, 2012), political connections encourage
dividend payouts. Qian, Pan and Yeung (2011) find that the minority shareholder
expropriation resulting from political connections’ resources to easily obtain funds outside the
financial market is more severe where the banking industry is less efficient. This indicates that
in countries with weak institutions, i.e. countries with weak minority shareholder rights
protection, politically connected firms face more minority shareholder expropriation and thus
more incentives to payout dividends.
Thus, resulting from the increased public scrutiny and additional minority shareholder
expropriation, politically connected firms face multiple incentives to establish a reputation of
fair treatment of minority shareholder by paying dividends when in countries with weak
Therefore, I hypothesize:
Hypothesis 1: The effect of investor protection on dividends is more negative in politically
connected firms compared to non-connected firms.
2.4. Financial crisis
It is argued that agency problems are under pressure during financial crisis (Johnson et al.,
2000; Mitton, 2002; Lemmon and Lins, 2003; Tran, Alphonse and Nguyen, 2017). According
to Lemmon and Lins (2003), the financial crisis negatively influences investment opportunities,
since expected returns on investment opportunities are reduced. This implies that an adverse
shock to investor confidence occurs (Johnson et al., 2000). As a consequence, expropriation of
minority shareholders by managers is more likely to occur (Lemmon and Lins, 2003). Tran,
Alphonse and Nguyen (2017) find evidence that shareholders expropriation is more severe
during financial crisis, which implies that agency problems are larger.
Agency problems make countries, especially those with weak institutions, vulnerable to the
effects of an abrupt loss of investor confidence (Johnson et al., 2000). According to Johnson et
al. (2000), “outside investors reassess the likely amount of expropriation by managers and adjust the amount of capital they are willing to provide” in countries with weak minority shareholder rights protection when even a small reduction of confidence occurs. However,
Faccio, Masulis and McConnell (2006) find evidence that “political connections influence the
allocation of capital through implicit government guarantees of a bailout when politically
connected companies become financially distressed”. Consequently, politically connected
firms are more likely to be bailed out than non-connected firms (Faccio, Masulis and
McConnell, 2006). This implies that political connections can be regarded as a safeguard
minority shareholder rights protection. Therefore, minority shareholder expropriation might be
less severe in politically connected firms compared to non-connected firms in countries with
weak minority shareholder rights protection during financial crisis.
Besides safeguarding politically connected firms during financial crisis, politically connected directors’ lack of managerial discretion (Hillman, 2005) could be argued to be beneficial during times of financial crisis. According to Van Essen, Engelen and Carney (2013), stringent corporate governance mechanisms “comprise management’s ability to respond appropriately to macroeconomic shock”. More specifically, they argue that board characteristics associated with “vigilant oversight” cannot only constrain managerial discretion but also board’s “capacity to respond to the contingencies of a financial crisis” (Van Essen, Engelen and Carney, 2013). Since politically connected directors are appointed to the board of directors for their resources
rather than their monitoring abilities (Hillman, 2005), it could be argued that politically
connected firms are better able to respond to issues arising from the financial crisis. This implies
that firm political connections can be considered as assets during financial crisis, a period in
which resources become scarce.
Thus, resulting from the expropriation and the benefits of weak corporate governance for
politically connected firms during financial crisis, politically connected firms face less
incentives to payout dividends when in countries with weak minority shareholder rights
protection in financial crisis.
Therefore, I hypothesize:
Hypothesis 2: The effect of firm political connections on the relationship between investor
protection and dividends is less negative during financial crisis compared to normal times.
3. Research design
In this research, the financial and accounting data are from the Worldscope database available
on Datastream. Country-level variables in this database are from the World Bank’s online
database. The minority shareholders’ rights data is from Guillén and Capron’s (2016) website.
The cross-country director profiles are from the BoardEx database. The initial sample of
directors who have worked in the government are from the “Director Profile – Employment”
files available from BoardEx. Due to incompleteness of this director employment data, I hand
collect the missing information on an individual-level perspective by performing manual
internet search techniques (Faccio, 2006). Due to privacy concerns, I do not use directors’
private social media channels. Instead, I collect most data using professional websites such as
LinkedIn or standard online sources. To ensure that the governmental employment of the
directors are in the past, I exclude all politically connected directors for which the end of their
tenure could not be identified. A director must hold an elected office, either at the federal or at
the regional level, in order to qualify as a Minister. To qualify as Bureaucrat, a director must
hold a senior position in the administration, such as CEO, Chair or Directors of public
institutions. Furthermore, a Bureaucrat cannot be a Minister in the past, i.e. hold an elected
executive office in the government.
Guided by prior literature (Ye et al., 2019; Tran, 2020), I apply some sample selection
criteria. The sample consist of the years 2002 to 2015, because this period includes the global
financial crisis of 2008 and 2009, but possibly avoids the effects of the Asian financial crisis
(Tran, 2020). Moreover, I exclude countries with less than 100 observations due to the risk
that these countries might spuriously affect the results. Since dividend payouts might not be
considered as a decision made by the board of directors in countries that legally require firms
to pay out a certain fraction of net income as dividends, I exclude Luxembourg and
mandatory dividend countries: Brazil, Chile, Colombia, Greece and Venezuela (La Porta et
4900-4950) firms from my sample based on SIC codes. Since these firms operate in a
different regulatory environment and have considerable governmental shareholdings, dividend
decisions might be a byproduct of regulation (Fama and French, 2001). Lastly, I exclude firms
with a negative value for dividends and firms with net income exceeding revenues based on
Ye et al. (2019). When firms’ net income exceeds revenues, the main earnings are from
non-operating sources. As a result, dividends cannot be considered an outcome of non-operating
resources. I winsorize all corporate financial variables at the 1% level in order to reduce the
impact of potential outliers (Chen, Leung and Goergen, 2017).
The sample selection criteria resulted in 55,968 firm-year observations from 17,972 unique
stock-exchange listed public firms over 24 countries around the world between the years
2002-2015.
3.2. Variables
3.2.1. Dividend payout
In line with prior research, I measure dividend payout as the percentage of net income that
firms pay to their shareholders (Faccio, Lang and Young, 2001; Al-Naijr and Hussainey,
2009; López-Iturriaga and Santana-Martín, 2019; Ye et al., 2019). For robustness tests I use
alternative measures of dividend payout, including whether the firms pay dividends and
dividends over total assets (Ye et al., 2019).
3.2.2. Investor protection
Following Ilhan-Nas et al. (2018) and Chen, Musacchio and Li (2019), I measure investor
protection using the newly developed protection of minority rights index by Guillén and
Capron (2016). Their measure of protection of minority rights ranges from 0 to 10 and is
based on the sum of the scores for each of the ten legal provisions (powers of the general
facilitated, prohibition of multiple voting rights, independent board members, feasibility of directors’ dismissal, private enforcement of directors’ duties, shareholder action against resolutions of the general meeting, mandatory bid, disclosure of major share ownership). In
contrast to the anti-director rights index developed by La Porta et al. (1998), Guillén and Capron’s protection of minority rights measure is time varying and has a broader coverage including subnational laws. Since this study uses a panel dataset from a more recent time
period (2002-2015), the Guillen and Capron’s index is more suitable for this study. I will use
the natural logarithm of Guillen and Capron’s index.
3.2.3. Politically Connected Director
I use proportions per Board Size to calculate the firm-level measures of Politically Connected
Directors on the board, Ministers and Bureaucrats on the board.
3.2.4. Financial crisis
In line with Ye et al. (2019), I measure financial crisis using a dummy variable which equals 1
during the years 2008 and 2009, and zero otherwise.
3.2.5. Control variables
As suggested by the literature (Fauver et al., 2017; Ye et al., 2019) I include several firm-,
board-, and country-level controls to ensure that observable omitted features do not drive the
results.
Using the natural logarithm of total assets, I control for the positive association of dividends
with Firm Size (Cuny, Martin and Puthenpurackal, 2009; Shao, Kwok and Guedhami, 2013;
Tran, Alphonse and Nguyen, 2017). Ye et al. (2019) argue that in contrast to small firms,
funds for due performance and to repay debts, these firms have less internal funds available to
payout dividends (Ye et al., 2019). Therefore, I use the debt ratio to control for the negative
association of dividends with Leverage. To control for Profitability, I use return on assets
(ROA). Firms with greater profitability are more likely to payout dividends (Denis and
Osobov, 2008; Chen, Leung and Goergen, 2017; Ye et al., 2019). Firms with many growth
opportunities have large cash requirements and thus pay low dividends (Fama and French,
2001). Using MB ratio (market-to-book) as proxy for investment opportunity, I control the
negative association between investment opportunity and dividends (Denis and Osobov, 2008;
Cuny, Martin and Puthenpurackal, 2009). Since mature firms have higher profitability, but
lower investment opportunities, these firms are more likely to pay dividends (DeAngelo,
DeAngelo and Skinner, 2004; Denis and Osobov, 2008). As such, I control for the Firm Age
using the natural logarithm of firm age. Using Cash, I control for cash holdings. Higher cash
holdings provide incentives to payout dividends in order to reduce the cash available to the
management and prevent expropriation (Easterbrook, 1984). As argued, share repurchases is a
common way of distributing excess cash back to shareholders. Firms that payout less
dividends, initiate more share repurchases (Jagannathan, Stephens and Weisbach, 2000; Fama
and French, 2001; Grullon and Michaely, 2002). Therefore, I use Share Repurchases to
control for this association.
Since managerial entrenchment relates to dividend payouts (Hu and Kumar, 2004; Chen,
Leung and Goergen, 2017), I will include Board Size, Board Independence, CEO Duality and
Female Directors to capture the board’s power and the quality of corporate governance.
Lastly, to control for country differences, i.e. differences in levels of consumption and trust in
institutions, I follow Fauver et al. (2017) using GDP per Capita.
3.3. Research model
In order to test Hypotheses 1 I perform OLS regressions using Equation 1. In this model, i
denotes firm, c denotes country, j denotes industry and t denotes year. All variables are as
defined in Appendix A. The interaction term captures the moderating effect of being a
politically connected firm on the relationship between investor protection and dividend payout.
To control for time invariance, i.e. to capture systematic differences across industries, I use
industry fixed effects, denoted as Industry (Fauver, 2017). In addition, I use year fixed effects,
denoted as Year, to capture common macroeconomic shocks (Fauver, 2017).
𝐷𝐼𝑉𝐸𝐴𝑅𝑁𝑖,𝑡 = 𝛼 + 𝜷𝟏𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑃𝑟𝑜𝑡𝑒𝑐𝑡𝑖𝑜𝑛𝑐,𝑡
+ 𝜷𝟐𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑃𝑟𝑜𝑡𝑒𝑐𝑡𝑖𝑜𝑛𝑐,𝑡× 𝑃𝑜𝑙𝑖𝑡𝑖𝑐𝑎𝑙𝑙𝑦 𝐶𝑜𝑛𝑛𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑖,𝑡
+ 𝜷𝟑𝑃𝑜𝑙𝑖𝑡𝑖𝑐𝑎𝑙𝑙𝑦 𝐶𝑜𝑛𝑛𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑖,𝑡+ ∑ 𝜷𝒙𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠𝑖,𝑡
+ 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 + 𝑌𝑒𝑎𝑟 + 𝜀𝑖,𝑡 (𝐸𝑞. 1)
In order to test Hypotheses 2 I perform OLS regressions using Equation 2. The triple interaction
term captures the influence of financial crisis on the moderating effect of firm political
𝐷𝐼𝑉𝐸𝐴𝑅𝑁𝑖,𝑡 = 𝛼 + 𝜷𝟏𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑃𝑟𝑜𝑡𝑒𝑐𝑡𝑖𝑜𝑛𝑐,𝑡 + 𝜷𝟐𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑃𝑟𝑜𝑡𝑒𝑐𝑡𝑖𝑜𝑛𝑐,𝑡× 𝑃𝑜𝑙𝑖𝑡𝑖𝑐𝑎𝑙𝑙𝑦 𝐶𝑜𝑛𝑛𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑖,𝑡 + 𝜷𝟑𝑃𝑜𝑙𝑖𝑡𝑖𝑐𝑎𝑙𝑙𝑦 𝐶𝑜𝑛𝑛𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑖,𝑡 + 𝜷𝟔𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐶𝑟𝑖𝑠𝑖𝑠𝑡 × 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑃𝑟𝑜𝑡𝑒𝑐𝑡𝑖𝑜𝑛𝑐,𝑡+ 𝜷𝟕𝐹𝑖𝑛𝑐𝑖𝑎𝑙𝐶𝑟𝑖𝑠𝑖𝑠𝑡 + 𝜷𝟖𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐶𝑟𝑖𝑠𝑖𝑠𝑡 × 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑃𝑟𝑜𝑡𝑒𝑐𝑡𝑖𝑜𝑛𝑐,𝑡 × 𝑃𝑜𝑙𝑖𝑡𝑖𝑐𝑎𝑙𝑙𝑦 𝐶𝑜𝑛𝑛𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑖,𝑡+ ∑ 𝜷𝒙𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠𝑖,𝑡 + 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 + 𝜀𝑖,𝑡(𝐸𝑞. 2)
In all models, I calculate the robust standard errors clustered by the firm (Chen, Leung and
Goergen, 2017; López-Iturriaga and Santana-Martín, 2019; Ye et al., 2019).
3.4. Descriptive statistics
I report the sample descriptive statistics, including the mean value, standard deviation, and the
25th, 50th and 75th quartiles in Table 1. Table 1 shows that close to 50 percent of the sample
firms payout dividends and that on average the sample firms payout 20 percent of net income.
As Table 1 shows, on average about 5 percent of the board seats of the sample firms are held
by Politically Connected Directors. Whereas, Ministers hold on average 0.4 percent of the
seats, Bureaucrats hold on average 4.4 percent of the board seats of the sample firms. Other
firm characteristics are similar to prior studies (Chen, Leung and Goergen, 2017; Ye et al.,
2019).
INSERT TABLE 1 HERE
Table 2 reports the correlations among the variables. The correlation coefficients suggest that
between the proxies for dividend payout and Investor Protection indicates that when the value
of Investor Protection increases, the dividend payout decreases.
INSERT TABLE 2 HERE
In Table 3, I report the descriptive statistics per country for the main variables including
DIVEARN, Investor Protection, Politically Connected Directors, Minister and Bureaucrat and
for the country control variable, GDP per Capita. In columns (1) and (2) I observe that the
United Kingdom, following the United States has the second largest number of firm-year
observations, while Austria has the smallest. Columns (3), (4) and (5) display the
cross-country variation in dividend payout. For instance, the mean dividend payout over net income
is 0.68 in the Philippines, while the average DIVEARN is much lower in Canada and the
United States – 0.18 and 0.14, respectively. As shown in column (6), the level of investor
protection is relatively high in the United States (1.98), while this number is only 1.10 in
Denmark. Column (7) presents the cross-country variation in the average percentage of
Politically Connected Directors. On average, Singapore and France have the largest
percentage of board seats held by Politically Connected Directors, 21 percent and 19 percent,
respectively. By contrast, in the United States 1 percent of the board seats are held by
Politically Connected Directors. The results in columns (8) and (9) indicate that Bureaucrats
are the leading political connection across most countries (close to 10 percent), in contrast to
Ministers with 1 percent. On average, the countries with the highest percentage of board seats
taken by Bureaucrats are Singapore (0.20%) and France (0.18%). The countries with the
lowest percentage of board seats taken by Bureaucrats are Malaysia (0.01%) and Philippines
(0.01%). Column (10) reports the mean GDP per Capita. The mean value ranges from 11.31
INSERT TABLE 3 HERE
4. Results
4.1. OLS Regression
In Table 4, I test the Hypothesis 1 based on the OLS estimator. All columns show that the
majority of the control variables have the expected signs. Column (1) considers the effect of
investor protection on dividend payouts. I find a significant and negative relationship (-0.193)
at the 1 percent level. It implies that firms located in countries with stronger investor
protection have lower dividends payouts. The results are consistent in the other models.
To test Hypothesis 1, the OLS regression in Column (3) includes the interaction Investor
Protection * Politically Connected Director. I find that the interaction coefficient is positive
and significant at the 1 percent level (1.352). The positive and significant estimate of
Politically Connected Director in Column (2) suggests that firms with a politically connected
director on the board payout more dividends.
It implies that in firms that have more politically connected directors, a
one-standard-deviation increase in Investor Protection is associated with a rise in the firms’ dividend
payout of 10.11 percentage points [= (-0.276+ 1.352) 0.094], which represents 16.3 percent
(= 0.101/0.619) of the standard deviation in DIVEARN. The findings in Column (3) do not
support Hypothesis 1. Overall, the increasing R-squared and Adjusted R-squared values in the
models indicate the incremental explanatory power of investor protection and politically
connected directors on corporate dividend payouts.
INSERT TABLE 4 HERE
Appendix B.1 and B.2 examine the impact of minority shareholder rights protection and
DIV, respectively. Overall, the results are consistent with the findings in Table 4.
Using a Tobit analysis, I replicate all regressions and report the results in Appendix B.3. The
findings indicate similar results and the coefficients increase in magnitude. This implies that
the findings are robust.
4.2. Financial Crisis
Next, I consider the effect of Financial Crisis on the role of firm political connections on
minority shareholder rights protection and dividend payout. To test Hypothesis 2, the OLS
regression includes the triple interaction Investor Protection * Politically Connected Director
* Financial Crisis. Table 5 presents the findings of testing Hypothesis 2.
INSERT TABLE 5 HERE
Column (1) of Table 5 shows a significant and negative coefficient for Investor Protection
(-.203) at the 1 percent level. This is consistent with the other models in Table 5 and in line
with the main results. Moreover, the estimates of Politically Connected Director and Investor
Protection * Politically Connected Director in columns (2) and (3) are 0.361 and 1.493
respectively, and both significant at the 1 percent level. These findings suggest that having a
politically connected director on the board weakens the negative association between minority
shareholder rights protection and dividend payout. This is in line with the findings reported in
Table 4. The positive and significant coefficient on Investor Protection * Politically
Connected Director * Financial Crisis (1.549) at the 5 percent level indicates that the positive
effect of having politically connected directors on the board of directors is significantly
stronger during times of financial crisis. Despite the results indicate a positive and significant
4.3. Additional analysis on Politically Connected Directors
In order to analyze whether and which type of politically connected director drives the results,
I break down the identification of Politically Connected Directors into Ministers and
Bureaucrats. In Table 6, I test Hypothesis 1 using Ministers and Bureaucrats. Column (1)
considers the effect of investor protection on dividend payouts. I find a significant and
negative relationship (-0.193) at the 1 percent level. The results are consistent in the other
models.
In Column (3) I include the interaction Investor Protection * Minister and in Column (5) the
interaction Investor Protection * Bureaucrat. I find that both interaction coefficients are
positive and significant at the 5 percent (1.653) and 1 percent level (1.381), respectively. The
positive and significant estimates in Column (2) and (4) suggest that firms with a Minister or
Bureaucrat on the board payout more dividends. The estimates in Column (3) imply that in
firms that have more minister directors, a one-standard-deviation increase in Investor
Protection is associated with a rise in the firms’ dividend payout of 13.58 percentage points
[= (-0.208 + 1.653) 0.094], which represents 21.9 percent (= 0.136 /0.619) of the standard
deviation in DIVEARN. The estimates in Column (5) imply that in firms that have more
bureaucrat directors, a one-standard-deviation increase in Investor Protection is associated
with a rise in the firms’ dividend payout of 10.47 percentage points [= (-0.267 + 1.381) 0.094], which represents 16.9 percent (= 0.105/0.619) of the standard deviation in DIVEARN.
The findings in Column (3) and (5) are consistent with the main findings. In Column (6) I
include the interaction effects of both, Investor Protection * Minister and Investor Protection
* Bureaucrat. This model shows significant results for the interaction of Investor Protection * Bureaucrat, in line with Column (4). Although the results relating to ministers are
interaction Investor Protection * Minister are insignificant.
INSERT TABLE 6 HERE
In Table 7, I test Hypothesis 2 using Ministers and Bureaucrats. The results in column (1), (2)
and (3) are in line with the main results. The estimate Financial Crisis is negative and
insignificant in both column (2) and (3). Column (4) presents estimates of a regression that
includes the interactions of Investor Protection with the minister politically connected director
indicator (Investor Protection * Minister) and with financial crisis (Investor Protection *
Financial Crisis), as well as the triple interaction (Investor Protection * Minister * Financial Crisis). The Investor Protection * Minister coefficient is 1.800 and statistically significant at
the 5 percent level, which suggests that having a minister-connected director on the board
weakens the negative association between minority shareholder rights protection and dividend
payout. This is in line with the findings reported in Table 4. The effect of having a
minister-connected director on the board does not change during times of financial crisis, as indicated
by the positive and insignificant coefficient on Investor Protection * Minister * Financial
Crisis. Column (6) shows that the Investor Protection * Bureaucrat coefficient is positive
and significant, consistent with the main results. Column (7) presents estimates of a regression
that includes the interactions of Investor Protection with the bureaucrat politically connected
director indicator (Investor Protection * Bureaucrat) and with financial crisis (Investor
Protection * Financial Crisis, as well as the triple interaction (Investor Protection * Bureaucrat * Financial Crisis). The Investor Protection * Bureaucrat coefficient is 1.324
and statistically significant at the 1 percent level, which suggests that having a
bureaucrat-connected director on the board weakens the negative association between minority
Financial Crisis (1.784) at the 5 percent level, indicates that the positive effect of having
bureaucrat politically connected directors on the board of directors is significantly stronger
during times of financial crisis.
INSERT TABLE 7 HERE
4.4. Propensity score matching
In order to control for differences in characteristics between politically connected and
non-politically connected firms and to mitigate potential selection bias, I run a matching procedure
(Boubakri et al., 2012; Faccio, Masulis and McConnell, 2006; López-Iturriaga and
Santana-Martín, 2019). Moreover, the propensity score matching (PSM) technique will ensure the
robustness of my results (Guo and Fraser, 2015) and reduce endogeneity risks (Hermalin and
Weisbach, 1998).
I choose a matching non-politically connected firm for each politically connected firm in my
sample. Similar to the study by López-Iturriaga and Santana-Martín (2019) the firm must
meet two conditions. First, the non-politically connected firm must be from the same year and
industry as the politically connected firm. Second, employing PSM based on the nearest
neighbour procedure, the firm must be the optimal match (Heckman, Ichimura and Todd,
1998). I match the treatment firms – which appointed a PC director during any year within
the sample – and the control firms – which never appointed any PC directors – using Firm
Size, Leverage, Profitability, MB Ratio, Firm Age, Cash, Share Repurchases, Board Size, Board Independence, CEO Duality, Female Directors. I adopt a conservative matching
technique, such as matching of the treatment and control firms without replacement and using
a caliper of 1 percent.
distributed by year and industry between politically connected firms through Ministers and
Bureaucrats respectively, and non-connected firms.
In Table 8, I report the PSM results of the Logit choice models with in Panel A Ministers and
in Panel B Bureaucrats. In both Panels I find that the majority of the variables are significant
with a considerably large pseudo-R-square. This suggests that the treatment firms are not
randomly selected.
INSERT TABLE 8 HERE
In Table 9, I report the PSM results of the mean-difference tests between matched and
unmatched samples in Panel A Ministers and in Panel B Bureaucrats. I find that the all of the
p-values in the unmatched sample in Panel A and Panel B are statistically significant
(p<0.01). The p-values in the matched samples of the mean-difference test in Panel A and B
are insignificant. This indicates a good match between the samples in Panel A and between
the samples in Panel B.
INSERT TABLE 9 HERE
In Table 10, I report the matched samples OLS models. Although the results in Panel A are
insignificant, the results in Panel B are significant and similar to the ones discussed earlier.
INSERT TABLE 10 HERE
4.5. Additional sample analysis
additional sample analysis is not that heavily influenced by U.S. companies as the main
results are. The findings are in line with the main results and provide support for the substitute
model.
5. Conclusion
The emphasis on firm benefits in research in politically connected firms has left the agency
issues that come with political connections, and more specifically the mechanisms between
these benefits and costs in the different institutional environment co-opted by these
connections unexplored. This study analyzes how firm political connections impact one of the
most examined topics in agency, namely the relation between investor protection and
dividends. Supporting La Porta et al.’s (2000a) substitute model, I document that firms in
countries that provide strong minority shareholder rights protection payout higher dividends
to substitute for weak governance. Politically connected firms payout less dividends
compared to non-connected firms when these firms are in countries with weak minority
shareholder rights protection. During financial crisis, the positive effect of politically
connected directors is stronger. Further analysis suggests that the effect of politically
connected directors is similar across minister-connected and bureaucrat-connected firms.
However, during financial crisis this result is driven by bureaucrat-connected directors.
Overall, by demonstrating the effect of having politically connected directors on the board on
the relation between minority shareholder rights protection and dividend payout, I contribute
to the literature.
However, my study also has some limitations. Although this study focusses on the most
common form of government co-optation, namely formal board-based political connections, I
acknowledge that other forms of government co-optation exist and these channels of political
and lobbying to co-opt with the government (Keim and Zeithaml, 1986). In addition, the
reason why firm political connections exist differs as well between countries. Whereas in East
Asia political ties mainly exist to advocate public-policy actions, in Western Europe political
connections mainly exist for corporate reasons (López-Iturriaga and Santana-Martín, 2019).
Therefore, an interesting issue to address in the future is to explore how other forms of
government co-optation, such as election campaign contributions and lobbying, petitions and
comments, impact the relation between investor protection and dividend payouts. Also, future
research could investigate, for example, how politically connected directors impact board
effectiveness. Although literature indicates that political connections pronounce agency
issues, empirical evidence on how political connections weaken corporate governance does
not exist.
All in all, my study suggests that firms should be aware of the benefits and costs that come
with establishing political connections and how these interrelate in different institutional
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