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Insider Ownership and Dividend Payout Policy: The Role of Business Cycle

We investigate how the relationship between managerial stock incentives and the dividend payout policy is impacted by the business cycle by using the data of S&P 1500 companies during 2000-2018. We find a strong negative relationship between managerial stock options and annual dividend payouts of companies for the full sample. Although the direction of the relationship is also negative for the recession period, the coefficient is found to be insignificant. We also find that the mentioned relationship may vary during the recession depending on the size of the company. The impact of stock options on the dividend payout is negative for medium-sized companies and the coefficient is both economically and statistically significant. The direction of impact changes for large-cap companies indicating to deterioration of the CEO voting power in those companies and less agency problem. We also determine that the percentage of shares held by the CEO has a positive impact on annual dividends distributed for large-cap companies, whereas this relationship changes in times of recession.


Introduction
The impact of managerial stock incentives on the dividend payout decision of companies depends on individual components of the compensation package. It has been suggested by the literature that stock options contribute negatively to the dividend distribution, whereas the impact of shares held by management and other forms of compensation were found to be ambiguous or insignificant (Fenn and Liang, 2001). However, the literature does not explain how this relationship changes in times of economic contraction and expansion and their impact on managerial incentives. What is the role of the business cycle in how managerial stock incentives impact the dividend payout decision of companies?
In times of economic expansion, when shares prices are performing well, the probability of options to be out-of-the-money is low. Consequently, management who holds stock options does not have a stimulus to undertake risky investments. In contrast, economic contraction is associated with large volatility in stock prices and returns. The high sensitivity of the value of the managerial compensation portfolio, especially stock options, to stock price and return incentivize managers to undertake risky investments and distribute less dividends to improve the chances of their options to be in-the-money. This may not always serve shareholders' best interests (Coles et al, 2006).
The signaling power of dividends is found to be stronger in times of economic contraction as investors value dividend-paying companies more in a declining market environment. Moreover, dividend-paying companies are found to outperform non-dividend paying companies at all stages of the business cycle and this difference is even significant in a downturn period (Fuller and Goldstein, 2005). Although the economic contraction period is associated with excessive positive sentiment of investors to dividend payouts in comparison with the period of advancing markets, the management may choose to decrease dividend payments, thereby freeing up cash to finance risky investments. Thus, it is crucial to investigate how the business cycle impacts managerial stock incentives and agency problems in the company.
To analyze the role of the business cycle in how managerial stock incentives impact the dividend payout policy of the company, we use the data of S&P 1500 companies. We collect the data regarding the number of shares and exercisable stock options held by the CEO, which are the variables that measure insider ownership, from Execucomp database. Next, we collect the data regarding the dependent variable, an annual dividend cash distribution of the company, from CRSP database. We exclude financial, telecommunication and utility companies, and companies with special/residual dividend distribution from the sample. We also include other firm-specific determinants of dividend policy such as profitability, investment, leverage and the growth rate of the company. The total final number of companies used in the analysis is 1038. The date of observations ranges from 2000-2018. Next, we incorporate the business cycle variable in my analysis by a using dummy variable to be equal to 1 if the recession was experienced in that year and 0 otherwise.
The hypothesis of this paper is to determine whether stock options negatively impact the annual dividend payout of companies during a recession. As for methodology, we focus on the OLS regression model with year and industry fixed effects. The advantage of this method is that it eliminates time-invariant year and industry effects and presents more robust results. The results of this paper will be useful for institutional investors who prefer dividend distribution, especially during contraction, and will help them to determine a more appropriate investment portfolio.
There are two main findings of this paper. First, the findings of this paper support the existing literature by determining a negative impact of stock options held by a CEO on a percentage change of annual dividend distribution for the full sample period. Although this impact is still negative for the recession period, the coefficient was found to be statistically insignificant. A possible reason behind the insignificance of the coefficient is the varying degree of the voting power of CEO depending on company size, which leads to the second finding of the paper. We find evidence supporting the change in the direction of the impact of options held by CEO on dividend distribution during the recession period depending on company size. This relationship is significantly negative for medium-sized companies and positive for large-sized companies. This indicates to possible loss of CEO voting power over the dividend distribution decision of the company.
The paper is organized as follows: Section 2 discusses existing relevant theory and research papers in the literature, Section 3 outlines the econometric model and methodology used for the analysis, Section 4 presents data description and variables used, Section 5 highlights the main findings of the paper and Section 6 concludes.

Literature Review
This research will contribute to three areas of literature: managerial stock incentives and dividend policy, managerial stock incentives and risk-taking, dividend policy and factors impacting it. Related researches about the mentioned areas of literature are presented and discussed below. Bhattacharyya (2007) develops a model that suggests that insider ownership is expected to be negatively correlated with dividend payout policy of companies. According to the model agents (i.e. management) are divided into high-ability and low-ability types such that high-ability agent has access to profitable investments that company can invest in, whereas, a low-ability agent does not have enough skill to have access to those investment opportunities. The model assumes that principals (i.e. shareholders) know the type of the agent and construct such a compensation portfolio that high-ability agent gets high managerial stock incentives and lowability agents get low managerial stock incentives. As a result, high-ability agents who possess a high degree of insider ownership invest available excess cash to profitable projects and distribute less dividend to principals, whereas, low-ability agents with low insider ownership choose to distribute excess cash in the form of dividends as they lack the access to profitable investments. Bhattacharyya et al (2008) found empirical evidence that supports Bhattacharyya (2007) by applying the model to US data. They use the earnings retention rate (which equals 1 minus dividend payout rate) as a dependent variable and regress it on various components of managerial compensation, dividend distributed and retained earnings of the company. The results of the Tobit regression conclude a statistically significant positive impact of insider ownership on the retention rate. This implies that companies with high insider ownership experience a high earnings retention rate and low dividend distribution to shareholders. The results were unchanged even after adding control variables such as capital expenditures of company, market to book value ratio and debt to equity value ratio. The same analysis and model were applied to publicly traded companies in New Zealand (Anderson et al, 2018). The results of the paper were consistent with the theory developed by Bhattacharyya (2007)  The existing literature about the impact of managerial compensation on dividend policy is the following: if stock options constitute a large fraction of compensation package, the impact of the managerial stock incentives on dividend policy is expected to be negative, whereas, the impact of salary and other bonuses are expected to be either positive or insignificant. The goal of this research paper is to extend existing literature and investigate the role of the business cycle in the relationship between insider ownership and dividend policy. The underlying motivation to investigate this question is the role of stock incentives in managerial appetite for risk-taking.

Managerial stock incentives and risk-taking
Managerial compensation is usually constructed such that the value of the compensation package fundamentally depends on company stock performance and return. Coles et al (2006) conclude that the more sensitive the value of the managerial stock compensation to stock volatility, the higher the possibility of risky policy choice by management. The authors analyze the US publicly traded companies during 1992-2002 by selecting a percentage change in the dollar value of managerial wealth for every 0.01 change in the stock price of the company returns as a sensitivity variable; and research and development expenditure, capital expenditure, segmentation of company earnings and degree of leverage as a proxy for firm risk. The authors found that the higher the sensitivity factor, the more management implements risky policies by investing more into R&D, employing a high degree of leverage and spending less into property plant and equipment. This indicates to increase in risk-taking.
The existence of stock options in the managerial compensation package is determined to be the major reason for risk-taking. The fundamental structure of an option is such that the value of it can be either zero (when the stock price drops below a specified threshold) or some positive amount (which is equal to the difference between stock price and conversion price determined by the contract). As the associated loss with options is limited (which is zero), management will undertake risky investments and policy choices to keep the price of stock high, which implicitly leads to high option value. Options incentivize management to use share repurchases, which leads to an increase in stock price and option value, in an excessive and improper manner. In contrast to stock options, the potential loss in share value is not limited. Thus, a larger portion of stock shares in compensation portfolio will also result in the expansion of firm risk by management (Wright et al, 2007).
The literature suggests that managerial stock incentives, especially, stock options are associated with large risky investments and policy choices. This is also true at large fractions of stock shares held by management. Although downside loss of risky investments is limited under good economic conditions, in times of economic downturn, when management wants to keep the share price high, those investments may be realized at the expense of dividend distribution to shareholders. Thus, the impact of managerial stock incentives on dividend policy is expected to change depending on the stages of the business cycle.

Dividends and factors impacting it
The paper will also contribute to broad literature about dividends and factors impacting it.
Thus, the results of the paper may be especially valuable for investors appreciating dividend payments as the dividend is one of the two channels through which shareholders get benefits from their investment to the company. It is especially preferred by institutional investors that individual investors, because of associated get tax benefits (Miller and Scholes, 1982). The fact that institutional investors invest more in dividend-paying companies than non-dividend paying ones creates a "dividend clientele" effect for the company. Moreover, dividend-paying companies are perceived to be better performers and financially healthy which often decreases the need for monitoring by investors (Allen et al, 2000). Fama and French (2001) analyze company-specific characteristics and dividend payout decisions of publicly traded companies during 1926 -1999. Authors use a logit regression model to determine the impact of profitability, growth rate of assets and marketto book value ratio on the probability of dividend payout decision of companies. Companies with large company size and profitability are found to pay more dividends, whereas, companies with large investment opportunities pay less dividends. It is also expected that mature firms will pay more dividends that companies that are in the growth stage of their life cycle. However, the declining trend in dividend distributions has been detected starting from 1978 which indicates to lower propensity to pay among company managers. Even companies with high profitability and company size are found to decrease dividend distributions or not to pay at all. Even share repurchases that became a substitute for dividend distributions cannot explain this large declining trend in dividend payment.
Economic theory suggests a few possible reasons behind declining dividend payments. First, dividend distribution means low retained cash within the company which may force management to issue debt and uses external financing in the future. The second possible problem of dividend payout for management is its sustainability as once the dividend is issued, it requires to be maintained. Meanwhile, it is the existence of stock options held by management that may account for a large decrease in dividend distribution as it has been determined that the value of equity, especially, stock options is negatively correlated with dividend payouts (Lambert et al, 1989).
The theory developed by Miller and Modigliani (1958) assumes that shareholders are indifferent between the dividend distributions, capital gains, and share repurchase. However, the study conducted by Fuller and Goldstein (2005) determined that shareholders pay large attention to a dividend policy of firms and that dividends matter more in the period of economic downturn.

Empirical Model and Methodology
To investigate the impact of the business cycle on the relationship between managerial stock incentives and dividend payout of the firm, we use the following regression model:

Sample Collection
To analyze the impact of the business cycle on the relationship between managerial stock incentives and dividend payout decision, we use the data of 1500 companies listed on S&P 1500.

Dividend payout
WEcollect the data regarding dividend payout from the CRSP database. As mentioned above, special/residual dividend payouts were excluded from the sample and the number of excluded observations is not significant. This indicates that the number of companies that apply residual dividend policy decreased over time and this finding is consistent with DeAngelo et al.

Insider ownership and managerial stock incentive variables
The variables that measure the degree of insider ownership is the number of shares and stock options held by management divided by the total number of shares outstanding. We collected the data from the EXECUCOMP database, and the data is on an annual basis. We used CEO data as a measure of managerial ownership which is a generally used proxy in the literature (e.g. Berger et al [1997], Mehran et al [1998]). The third variable used to measure the impact of managerial compensation on dividend policy is the logarithm of total annual compensation paid to CEO which includes salary, bonus, and other additional payment.
As Table 1 shows, on average CEO holds 2.5% of total shares outstanding, whereas, this number for options is 0.25%. The reason why the percentage of shares is almost 10 times higher than the percentage of options owned is they include only exercisable options. A similar ratio was found by Berger et al (1997) where the percentage of options held by CEO was 0.17% and 15 times less than the percentage of shares held (2.7%).
Managerial Shares are highly positively skewed (Figure 2, a). CEO holding of Shares is between 0-5% of shares outstanding for more than 80% of the sample (Figure 2, b). 5% of the sample holds between 5-10% of shares outstanding and holdings of the remaining 15% are distributed among different percentages. A similar distribution is true for the number of options held by the CEO to the total number of shares outstanding (Figure 3, a). The number of options held by 85% of the sample is between 0-0.5% of shares outstanding (Figure 3

Firms Specific Control Variables
The dividend payout decision also depends on many other firm-specific variables. We use net free cash flow as a percentage of total assets to control for the impact of company earnings on dividend distribution. Jensen (1986) shows that companies with high positive earnings are expected to pay dividends to decrease the probability of investment in projects with non-positive NPV and to decrease agency cost. Moreover, we use the capital expenditure of the company expressed as a percentage of total assets to capture the impact of investment on dividend payout.
Companies in the growth stage of their life cycle tend to invest more in R&D and expand the firm size. As a result, high investment and capital expenditure decrease the probability of dividend payout (Fama&French, 2001).
To control for company growth rate, we use the logarithm of the total assets of the company.
Companies with high growth rates and large company size are anticipated to pay dividends as, usually, they are mature companies with established constant earnings (Fenn&Liang, 2001).
Another firm characteristic that needs to be considered is the proportion of total debt of the company used in the capital structure. We use total debt to total assets ratio of the company to control for leverage. High leverage leads to high sensitivity of firm performance to the business cycle. Moreover, high debt means high-interest expense and high financing costs which lead to low retained earnings available for dividend distribution. Descriptive statistics of control variables are presented in Table 1.

Empirical Results
The empirical results of the regression analysis for the three models outlined in Section 3 are presented in Table 2: OLS regression (column 1), OLS regression with year and company fixed effects (column 2) and OLS regression with year and industry fixed effects (column 3).
Starting with the impact of the percentage of shares held by the CEO on the annual percentage change in dividend distributed, the relationship is found to be positive for all estimation models.
The direction of the impact is economically intuitive and depicts a personal gain of the CEO from dividend distribution; yet, the coefficient is not statistically significant.
The impact of shares on dividend payout changes in times of recession. This negative relation is depicted by all three estimation models; however, coefficients are statistically insignificant. Although the negative impact may be counter-intuitive, the reason behind this change could be the following. The recession period is associated with a decrease in earnings and free cash flow to the firm. To protect the value of shares from further deterioration, the CEO may decide to retain excess cash for feasible losses and expenditures associated with recession rather than distribute it as a dividend.
In contrast to stock shares, stock options were found to have a very prominent impact on dividend payout. The result of OLS regression with year and industry fixed effects (column 3) indicates that a percentage increase in the number of options held by CEO will lead to a 2.8% of decrease in the annual dividends paid by the company. The coefficient is both economically and statistically significant and supports the hypothesis that the existence of stock options in managerial compensation portfolio decreases their dividend distribution incentives.
The underlying economic interpretation behind this relationship is the fact that options are not "dividend protected" which leads to deterioration of the option value in the case of dividend  The coeffects for two control variables, leverage, and profitability, have predicted signs and statistically and economically significant. This supports the agency-based theories of dividend payout (Fenn&Liang, 2001). For example, a percentage change in the profitability of the company decreases annual dividends by 64 basis points, whereas, a percentage increase in leverage decreases dividends by 19% percent. The coefficient for growth variable is found to negatively impact annual dividend change. Companies with high growth opportunities may require funding for investment to sustain the current growth rate of assets which can be realized at the cost of decreased dividend distribution [ Rozeff (1982), White (1996)]. However, the coefficients for both growth and investment variables are statistically insignificant.

The role of company size in the relationship between managerial stock ownership and dividend distribution
It has been determined that to decrease transaction costs, large and institutional investors prefer to invest in large-cap companies. As these investors prefer dividends, they create a "dividend clientele" effect for the company. Consequently, large companies choose to pay dividends, whereas, small companies do not (Redding, 1997  The results of regressions support the hypothesis of the impact of company size on managerial decision power over dividends (Table 3). Both the sign and significance of the coefficient of the main variable of interest, i.e. RecOptions, are found to be changing depending on company size. For small and medium-sized companies, the sign is negative as expected, whereas for large-sized companies it is found to be positive. This indicates to a possible decrease in the voting power of the CEO in large-cap companies. The coefficient is both economically and statistically significant for medium-sized companies which implies that a percentage increase in stock options held by the CEO during a recession will lead to 25% decrease in annual dividends paid.
The impact of CEO shares is especially pronounced for S&P 500 large-cap companies.
The impact is positive and significant for the full sample reflecting the personal gains of the CEO from dividend distribution as an ordinary investor. However, the direction of the impact changes in times of the recession. One of the reasons causing such an impact is the willingness of the CEO to maintain enough cash and liquidity in the company. Varying directions of the impact of the shares and options held by CEO for small-, medium-and large-cap companies indicate to the existing influence of company size on the relationship between managerial stock ownership and dividend payout decisions.

Conclusion
This paper studies how the business cycle impacts the relationship between managerial stock incentives and dividend distribution of companies by using the data of S&P 1500 nonfinancial companies during 2000-2018. The findings of the OLS regression model with year and industry fixed effects support existing literature by determining the negative impact of stock options held by the CEO on dividend payout. However, no evidence has been found to support a significant relationship between variables during a recession period. We also find evidence that company size influences the role of the business cycle in the relationship between managerial stock incentives and dividends distribution. The stock options held by CEOs of medium-cap companies during the recession have a negative and significant impact on dividends, whereas, this impact is positive for large-cap companies. This supports the hypothesis that the business cycle impacts the relationship between managerial stock incentives and dividend distribution, and this impact largely depends on the size of the company.
The results imply that medium-cap companies experience high agency cost problems, as composition of CEO compensation alter dividend policy of the company during economic contraction. The finding is specifically important for dividend-oriented investors in their design of the applicable investment portfolio to match their target dividend gain.

Additional Summary Statistics
Descriptive statistics of the S&P 600 Small-cap, S&P 400 Mid-cap and S&P 500 Large-cap companies are presented in Table 4. On average CEOs of small-cap companies hold the largest number of shares and options as a percentage of shares outstanding in compare with large and mid-cap companies. This is largely because small-cap companies have less shares outstanding and a smaller number of large shareholders. In contrast, on average CEOs of large-cap companies hold the least number of shares and options. One of the reasons causing this is the willingness of large shareholders to decrease insider ownership and limit the voting power of the CEO.