Sydney Law Review
Despite the importance of the dividend decision, Australia’s corporate laws play only a minor role in regulating dividends. This can lead to problems because of the signalling implications of dividends and potential conflicts of interest arising from the dividend decision. Mandatory corporate disclosure of the dividend decision is found to be the most appropriate solution to overcome these problems. Mandatory disclosure is necessary in light of empirical findings that there is not adequate voluntary disclosure of the dividend decision by Australian companies.
The dividend decision for any company involves a delicate balancing act. Companies must periodically decide what proportion of earnings should be retained to finance the company’s operations and what proportion should be distributed to shareholders in the form of dividends. In 1996, listed Australian companies paid over $10 billion in dividends,  so determining the appropriate balance is clearly important for both companies and shareholders, as well as economists and legal regulators.
Despite the economic significance of dividends, Australia’s corporate laws give directors an almost unrestrained discretion to determine whether to pay dividends, when to pay them and what amount to pay. Directors are not required to justify or explain why a particular level of dividends has been chosen. In some cases the level of dividends declared may seem puzzling and leave shareholders confused, for example when dividends increase despite a fall in earnings. There may also be ulterior motives underlying the dividend decision, including a conflict of interest between managers and shareholders, which managers do not want disclosed to the market. 
This article argues that mandatory disclosure provisions should be introduced to require managers to clarify the reasons underlying the dividend decision, thereby resolving any ambiguity in the decision. In addition to drawing upon existing economic and legal literature, empirical tests are conducted to show that the current legislative provisions regulating dividends are inadequate when an ambiguous dividend signal is sent to the market.
Section 2 of this article outlines the provisions of the [Corporations Law] dealing with dividends and the common law position in relation to dividends. It shows that directors presently have wide discretion in the declaration of dividends. Sections 3 and 4 explore reasons why directors should not have this wide discretion unless they can explicitly justify their dividend decision to the market. In particular, Section 3 describes the economic importance of the dividend decision and the signalling implications of dividend announcements. Empirical testing is conducted to determine the relevance of dividend signalling theories to the Australian market. Section 4 then discusses the potential conflicts of interest associated with the dividend decision.
As a solution to the concerns canvassed in the above sections, Section 5 proposes the introduction of mandatory corporate disclosure of the reasons behind the dividend decision. Mandatory disclosure is found to be necessary given the results of further empirical testing which shows that Australian companies do not voluntarily disclose the reasons underlying the dividend decision in situations where the market would desire such disclosure. Alternatives to mandatory disclosure are explored in Section 6, although mandatory disclosure is found to be the most preferable route for dividend reform.
Section 201(1) of the Corporations Law states that dividends are payable only out of profits or pursuant to section 191. Section 191 basically requires that dividends must not be paid out of capital. The term “profit” is not defined in the Corporations Law, but case law suggests that profit means the increase in a company’s assets over a financial period.  Furthermore, where a dividend payment would result in the company being unable to pay its debts as they fall due, the dividend must not be declared. Directors who recommend the declaration of a dividend in such circumstances, or who contravene section 201(1), may be personally liable for the amount of the dividend. 
Once a final dividend is declared it becomes a debt owed by the company to shareholders, and shareholders may enforce this just like any other contractual debt.  The directors may also declare an interim dividend when they believe the company’s profits justify such a payment. Unlike a final dividend, an interim dividend can be rescinded after it is declared but before it is actually paid.  Therefore, shareholders cannot enforce payment of an interim dividend, even if it has been declared.
In terms of disclosure, sections 304 and 305 of the Corporations Law require the directors of Australian companies, other than certain “small proprietary companies’, to report details of the amount of dividends paid in the past financial year and the amount of any dividends which are proposed. Whilst corporate laws require directors to state the amount of dividends paid, there is no requirement for directors to state why that amount was paid.
This brief overview of the law on dividends demonstrates that there is still only minimal regulation of dividends in Australia,  despite the fact that the Corporations Law now imposes increasingly onerous obligations on companies.  This is largely the result of an unwillingness by courts and regulators to depart from the traditional broad discretion that directors have been allowed in declaring dividends.  Arguably lawmakers have not needed to depart from the traditional position on dividends because there are other mechanisms already in place to ensure that directors do not abuse this discretion. For example, directors have fiduciary duties both under the general law and section 232 of the Corporations Law to ensure that they act in good faith and in the best interests of the company when making corporate decisions, including the dividend decision.
However, without adequate disclosure directors may be able to act in conflict of interest situations and hide behind the guise of making a corporate decision which is genuinely in the interests of the company.  Courts are usually reluctant to question this.  Thus, fiduciary duties alone may not be sufficient to curb management abuses arising from the dividend decision. The following two sections show that there may be good reasons for requiring directors to state why a particular level of dividends has been declared. This type of disclosure would help clarify any uncertainty associated with the “signal” accompanying a dividend declaration, which in turn would make capital markets better informed.  Mandatory disclosure would also help prevent managers from acting in conflict of interest situations.  Given that fiduciary duties are likely to be ineffectual in these areas, compulsory disclosure of the underlying reasons behind the dividend decision may be necessary to make dividend laws more effective.
Although in a world with perfect capital markets dividend policy is irrelevant and has no impact on a company’s market value,  in practice the dividend decision will be important to both shareholders and the company itself.
The trade-off between paying out earnings as dividends or retaining earnings to fund internal projects is clearly important to corporate managers, who will usually prefer earnings to be retained rather than making large dividend distributions. Excessive dividends force companies to rely on the external capital market for project funding. The transaction costs involved in raising external equity, including a high discount to the market price which in turn dilutes the value of existing shares, creates a clear incentive for companies to retain earnings rather than distributing earnings as dividends. 
Agency costs also explain why companies may prefer low dividend payouts.  Managers may be reluctant to enter the external equity market because they will be required to disclose various pieces of information as part of the fundraising process. Thus, managers will be subject to greater monitoring and discipline from external capital markets if they have to raise funds from institutions or the public, and to avoid this they may prefer to retain earnings rather than pay generous dividends to shareholders. 
However, there is an offsetting agency cost argument. The payment of higher dividends, by reducing the amount of retained earnings that managers can utilise, inhibits the ability of managers to consume excessive perquisites, invest at below the cost of capital, or waste the excess funds through organisational inefficiencies.  Therefore, managers may want to pay high dividends in order to “bond” with shareholders, which in turn reduces agency costs arising from the shareholder-manager conflict.
Companies must balance these competing agency cost arguments when deciding what level of dividends to pay. There is evidence that companies do in fact act to minimise agency costs when choosing their dividend payout rate. 
In summary, dividend policy is important for companies because it interacts with capital budgeting and investment decisions. For example, paying out more dividends as earnings reduces the company’s ability to take on new projects if financing those projects through external capital markets is too expensive. Corporate financing and investment decisions, along with agency costs, underlie the company’s share price, which in turn may affect managers’ remuneration and job security in the future. Therefore, the dividend decision, by interacting with budgeting and investment decisions, is clearly important for both companies and their managers.
Shareholders may have a preference for either retaining or distributing corporate profits, particularly where there are market imperfections such as taxes and transaction costs. Even where a company itself prefers retention, it may still pay dividends to appease shareholders and thereby reduce agency costs, as well as to send a positive signal to the market about the company’s future prospects.
As the assumptions which underlie perfect capital markets do not apply in practice, the dividend decision may impact on the extent of taxes and transaction costs incurred by shareholders. The Australian tax system creates a bias towards dividends for most shareholders because the company tax rate of  per cent applies to all corporate earnings, regardless of whether these earnings are retained or distributed as dividends. If earnings are in fact distributed, the dividends will carry “imputation credits” to the extent of the company tax already paid. This means that shareholders with a personal tax rate which is lower than the corporate tax rate would not have to pay any additional tax on their dividend, and could in fact utilise their imputation credits to offset tax payable on other income.
Conversely, retention of earnings results in a loss of imputation credits for shareholders. The company’s share price will be boosted if earnings are retained because the retained earnings can be used to fund projects which will generate future profits for the company. Thus, when the shares are sold there will be a relatively larger capital gain than there would have been if higher dividends had been paid. In turn, a greater amount of capital gains tax will be payable than there would have been if the funds had earlier been paid out as dividends. Hence, most shareholders will favour dividends over capital gains, because earnings retention leads to double taxation – once at the corporate rate and then again at the taxpayer’s marginal personal tax rate when the shares are sold.  This tax bias in favour of dividends led Nicol to conclude that the optimal dividend policy is for companies to pay dividends to the limit of their franking account balance, because this will maximise after-tax returns to shareholders. 
Transaction costs may also create a bias for particular shareholders towards either dividends or capital gains, depending on their liquidity preferences. If low dividends are paid, those shareholders who rely on dividends as an important source of income are forced to sell shares (and incur the associated brokerage and stamp duty costs) if the dividends are insufficient to meet their cost of living. Conversely, some shareholders do not need dividends as a regular source of income, and would rather see their share of earnings be ploughed back into the company. To achieve this end, these latter shareholders would be forced to buy more shares in the company with their dividend income.  Therefore, particular shareholders may want their company to adopt a particular dividend policy for both liquidity and tax reasons.
Sections 3A and 3B showed that the dividend decision is important for companies, managers and shareholders. However, the dividend decision is also important to all of these groups, as well as capital markets generally, for one other important reason – the signalling consequences which flow from dividend changes. Dividend signalling arises because of information asymmetries which exist between managers and the market generally.  That is, management may use their discretionary power to change the dividend rate, either up or down, in an attempt to reveal their inside knowledge about the company’s future performance to the market.
Why do not managers explicitly state the message underlying the signal rather than using dividends as a signalling mechanism? The major reason is that all rational managers would like their company’s share price to increase, so simply announcing that the company’s future prospects are strong is unlikely to carry much weight in the market.  As Woolridge and Ghosh note, the dividend signal:
... lends credence to the belief that “actions speak louder than words.” Higher dividends, because they impose future financing constraints, effectively “bond” management’s expression of confidence in the future in a way that statements alone probably cannot.
Thus, the credibility of the dividend signal lies in the fact that if management increases dividends without expecting a corresponding increase in future earnings, the company will have difficulty sustaining the dividend increase.  Eventually management would be forced to reduce dividends and incur the wrath of the market. 
However, there are two alternative dividend signalling theories, both of which are outlined below. In the absence of additional information from corporate managers, the market may be unsure about which theory applies in a particular case. This means that an ambiguous dividend signal may be sent to the market, causing confusion and probably leading to the company’s securities being mispriced.
(i) Dividends as a Signal of Future Earnings
It has already been said that managers may be hesitant about increasing dividends unless the increase can be sustained, because if it cannot be maintained the company will be forced to reduce the dividend rate in the future and be penalised in the market at that time. Therefore, an increase in the dividend rate signals that managers are confident that the company will show sufficient profitability to sustain the dividend increase in future years.
Conversely, a drop in the dividend rate may signal to the market that the company’s future is rather bleak. It suggests that future profits are not expected to be high enough to allow the previous dividend rate to be maintained, and hence if financial results are mediocre this year it is unlikely that they will improve in the near future. Therefore, dividend changes may provide the market with new, useful information about the company’s future earnings prospects. This view is confirmed by several empirical studies using data from both Australia and the United States.  Indeed, Carroll found that dividend changes reveal information about the next five quarters of future earnings. 
(ii) Dividends as a Signal of Investment Opportunities
The dividend signal for future earnings outlined in Section 3C(a) works in the opposite direction to the dividend signal arising from the investment decision. An increase in the dividend rate may signal that management has no profitable investments on the horizon, and therefore is returning excess “free cash flow”  Whilst this may represent an efficient allocation of resources, it may also signal to the market that the company’s prospects are not particularly bright. Therefore, if the investment opportunities signalling theory is accepted, a dividend increase would be interpreted as “bad news”.
Conversely, if there are profitable positive net present value (NPV) investments the company may wish to cut dividends, thereby boosting retained earnings to fund these investments.  Of course, these profitable projects could be funded from the external capital market rather than via dividend reductions. However, companies may prefer internal earnings retention because of the negative market perception associated with raising finance in the external capital market. Myers’ “pecking order theory” states that because of information asymmetry between managers and external capital markets, companies prefer internal finance to external finance.  A new external equity issue, for example, will signal to the market that managers believe the company is overvalued and they are taking advantage of this by selling equity while it is “expensive”.  To prevent this negative perception in the market, companies with ample investment opportunities would prefer to utilise (internal) retained earnings, and accordingly would adopt a low dividend payout policy.
(iii) Reconciling Ambiguous Signalling
The theories underlying both the future earnings signal and the investment opportunities signal demonstrate that there may be differing managerial motives for increases or decreases in dividends. Empirical evidence generally suggests that the market places more weight on the future earnings signal contained in the dividend decision than the investment opportunities signal.  In other words, the market will generally view a dividend increase positively and a dividend reduction negatively.
However, in some cases the investment opportunities signal will, in reality, have more importance than the future earnings signal, and a dividend cut should be viewed positively. For example, Woolridge and Ghosh found that, consistent with the investment opportunities hypothesis, companies cutting dividends generally outperformed the market over the year following the dividend reduction.  Despite this finding, Woolridge and Ghosh also discovered that the market, on average, pays greater heed to the adverse effects of a dividend reduction than to management’s positive signal of profitable investment opportunities. 
If the market cannot distinguish between these signals, in many cases it will attach too much weight to the future earnings signal, particularly where the investment opportunities signal in fact dominates, because on average the future earnings signal is more important.  Woolridge and Ghosh suggest that better financial communication by management to the investment community can help to minimise confusion in the market regarding the correct interpretation of the dividend signal.  One means of facilitating this communication is to require managers to make mandatory disclosure of the reasons underlying the dividend decision.
(iv) Australian Evidence on Signalling Theory
Empirical testing was conducted to determine whether Australian and New Zealand markets interpret a signal in dividend changes. The study was confined to: companies in the top 100 ASX listed companies based on market capitalisation as at 1 March 1996; New Zealand companies in the Trans Tasman 100 index at that date; and companies in the ASX100 Index at that date. Given that some companies were in some or all of these indices, this produced a sample of 119 companies. 
Regression analysis was conducted to test the hypothesis that current dividend changes are a signal of future earnings. In particular, increases or decreases in annual dividends for the sample companies over the period 1992–1995 were identified. The change in dividends per share (Do) was regressed against changes in earnings per share for both the corresponding period (Eo) and for the next year (E1). Both dividends and earnings figures were adjusted for capital changes. Annual data was used because this already incorporates interim results and many companies do not pay interim dividends, regardless of their profitability. Only one year of future earnings was examined because this allowed more recent data to be used relative to an examination of two years of future earnings. Further, evidence from the United States suggests that most of the future earnings signal is reflected in the first year after the dividend change.  Small dividend changes (less that 0.2 cents per share) were excluded because they were often a result of minor capital change adjustments, such as dividend reinvestment plan allotments, which would not have sent any pertinent signal to the market.  This left 140 observations in the sample. 
Initially, dividend changes were regressed against corresponding changes in current earnings and, as expected, there was a significant positive relationship between these variables at the 1 per cent level of significance. 
However, consistent with the investment opportunities signal theory (and inconsistent with the future earnings signal theory), when dividend changes were regressed against future earnings changes a negative relationship was found, and this was significant at the 5 per cent level. However, when the sample was further broken up into “correct” and “incorrect” signals there was support for the future earnings signal hypothesis. A signal was deemed to be “correct” where an increase in the dividend per share was accompanied by an increase in earnings for the following year, or if dividends decreased and earnings also declined in the next year. Thus, a correct signal is consistent with the future earnings signal hypothesis. A signal was deemed to be “incorrect” if dividends increased but earnings decreased in the following year, or if a dividend cut was followed by improved future earnings. “Incorrect” signals may have been due to wrong future earnings expectations, or alternatively they may be viewed as consistent with the investment opportunities signal.
It was found that 99 of the 140 observations, or 71 per cent, were in fact “correct” signals, and these signals were significantly positive at the 1 per cent level. This finding suggests that the 29 per cent of companies sending incorrect signals to the market were driving the overall signal result because of the relatively large magnitude of their signals. The majority (71 per cent) of Australian and New Zealand listed companies appear to signal in accordance with the future earnings hypothesis. However, a significant minority sent signals inconsistent with the future earnings hypothesis, which may be due to the offsetting investment opportunities hypothesis.
Data was then collected to determine whether the market was able to successfully differentiate between correct and incorrect signals. If these signals cannot be distinguished, it would indicate that the market cannot successfully differentiate between the future earnings signal and investment opportunities signal. Such a result would suggest that there is a need for companies to clarify the dividend signals they send to the market. ASX Datadisk was used to identify the announcement dates of the earnings and dividend results for each company in the sample, and Equinet was used to collect daily share price data for the companies over the relevant period. Difficulties in identifying precise announcement dates or collecting share price data meant that the sample was reduced from 140 to 127 companies. To estimate the daily return for each company, the natural logarithm of the last sale share price on that day divided by the last sale share price on the previous day was used.  This was done five times for each company to provide a five day window of returns for each of the 127 companies, from two days prior to the announcement until two days subsequent to the announcement. The sample was then broken into four categories, based upon the direction of the dividend signal and whether or not it was “correct”. 
Table 1 in the Appendix shows the average daily returns, as well as the cumulative returns for the entire five day window, for each of the four categories. From Table 1 it appears that for dividend increases, which accounted for 82.7 per cent of the sample, the market was unable to successfully differentiate between correct and incorrect future earnings signals at the time of the dividend announcement. In fact, the return on the announcement date and cumulative return columns show that the market actually favoured companies who turned out to have lower earnings in the future. For those companies signalling correctly with dividend increases, the market actually responded negatively on the announcement date, although this may be due to the strong positive returns on the day prior to the announcement, suggesting some information leakage immediately before the announcement. Table 1 suggests that the market is able to successfully differentiate between correct and incorrect signals when dividends fall, although the small sample sizes for dividend reductions limit the generalisability of this result. On the announcement date, the market responded negatively to dividend drops where future earnings also fell, but where future earnings in fact increased the market responded positively despite the drop in dividends.
However, further statistical analysis revealed that this conclusion is not necessarily valid, and in fact the market is not able to differentiate between correct and incorrect signals in the case of both dividend increases and dividend reductions. Table 2 in the Appendix shows the result of t-tests and z-tests that were conducted to test for significant differences in the market reaction to correct and incorrect signals.  The null hypothesis underlying these tests is that the two samples (incorrect and correct signals) were drawn from populations having the same mean.  If this is in fact the case and the null hypothesis is accepted, it can be concluded that the market is not able to differentiate between correct and incorrect signals.
The only statistically significant result was at D–2 in Table 2.2. This can possibly be explained by information leakage (which turned out to be wrongly founded) prior to the announcement of correctly signalled dividend reductions.  Alternatively, the small sample sizes for dividend reductions may be driving this result.  In any case, the most important finding in Table 2 is that no other tstatistic or z-statistic was significant. Hence, the null hypothesis can be accepted and the results suggest that the market cannot differentiate between correct and incorrect signals, regardless of whether dividends increase or decrease.
This finding from Table 2 shows that the market cannot, on average, determine whether a dividend increase (or decrease) means future earnings will rise (or fall). The results also give some suggestion that the market cannot differentiate between the future earnings hypothesis and the investment opportunities hypothesis. This highlights the need for companies to elucidate the dividend signal they send to the market, because without further clarification the market will generally not be able to correctly interpret this signal. These findings help to justify mandatory disclosure of the dividend decision to resolve signalling ambiguity, provided companies do not already make voluntary disclosure. 
(v) Other Signalling Justifications for Mandatory Disclosure
There are other circumstances where a dividend announcement may be ambiguous. Whilst dividends tend to be relatively stable, earnings may fluctuate significantly from year to year. Therefore, even if the same dividend per share is paid, the payout rate may vary significantly from period to period.  Consider the case of earnings increasing from $10m last year to $30m for this financial period. As a result, directors decide to raise total dividends paid from $5m to $6m, or 5 cents per share to 6 cents per share assuming 1 million shares have been issued. Despite this dividend increase in absolute terms, which according to the future earnings signalling hypothesis should be perceived positively by the market, the dividend payout rate has dropped from 50 per cent to 20 per cent. Does the market view this dividend change positively or negatively? The answer is not clear and this is likely to be a further source of ambiguity unless the company makes adequate disclosure to reconcile the different magnitudes of the earnings and dividend increases. 
Further, signalling is important simply because the market may perceive a signal, even if the company is not trying to send one. The market sets the share price on the ASX, and if the market perceives a signal to exist then the share price will adjust accordingly. This is one of the most important justifications for requiring mandatory disclosure; disclosure helps to overcome signalling biases that are imposed by the market, but which really do not exist. Hence, disclosure helps to ensure that security prices are accurate and fair. Non-disclosure in these circumstances breaches one of the most fundamental objectives of securities laws and share markets – to ensure an efficient, well-informed and competitive market where prices are true and unbiased. 
Section 3 showed that the preferred dividend policy for a company will not necessarily be the preferred dividend policy for its shareholders, and different shareholders may favour different dividend policies. In choosing the company’s dividend policy, management must balance these interests, and this will often involve a value judgment which shareholders should be informed about. Furthermore, the dividend decision will often involve a conflict of interest between the duties owed by directors to the company and their own personal interests. The result may be that managers act for their own benefit rather than to maximise shareholder wealth. The possibility of such conflicts helps to justify mandatory disclosure to shareholders of the reasons for the dividend decision. Some examples of these conflicts of interest are outlined below.
Jensen and Meckling state that there is a potential conflict of interest between managers and shareholders because managers may be inclined to “empire build”.  More particularly, in order to gain control over more resources and possibly attain higher remuneration packages, managers may decide to accept negative net present value (NPV) projects, even though such expansion takes the company beyond the size which maximises shareholder wealth.  Empire building may also reduce the probability of insolvency, because expansion generally stabilises cash flows, particularly if the company expands into different industries. This is less beneficial for diversified limited liability shareholders than for managers, who have much of their wealth tied to the company in the form of human capital and hence are relatively risk-averse. Thus, corporate growth generally enhances the job security and remuneration of managers, but will diminish shareholder wealth if it results in unprofitable projects being accepted.
Myers’ “pecking order theory” suggests that managers will prefer to expand through internal sources of funds rather than going to external capital markets, and in order to boost internal funds they may pay a suboptimal level of dividends.  Once internal funds have been retained, the company can then expand internally by improving existing operations, or externally by acquiring outside operations, for example though takeovers.  Takeovers literature suggests that the market interprets takeovers as one form of empire building and penalises acquirers accordingly. In particular, empire building may be one factor responsible for the zero or negative abnormal returns for bidders following takeover announcements,  so shareholders of bidder companies appear to have an aversion to empire building. Fischel claims that studies in other areas contradict the empire building hypothesis. For example, he says that managerial compensation studies show that profitability, rather than growth or other variables, determines managerial compensation.  Therefore, managers do not benefit from growth, but rather from “maximising profits and thus shareholder welfare”.  However, empirical evidence shows that, on average, larger companies have higher levels of executive compensation.  Further, even if a company’s compensation directly tied remuneration to profitability, executive compensation plans can usually be manipulated by bringing forward or deferring revenues and expenses between periods.  Thus, rarely will compensation plans perfectly align managerial incentives with shareholder interests.
In the event of a takeover bid, or where a bid looks likely, the directors of a target company may actually want to pay high dividends in order to reduce the likelihood of the bid succeeding, and in turn keep their jobs. Takeovers are often motivated by an excess of cash reserves in the target which could be put to a more efficient use elsewhere, and therefore excess cash lying dormant in the target is a potential source of synergistic gains to the bidder. In the event of a takeover, or if a takeover is being considered, target directors may channel funds out of the company via extraordinarily high or special dividends to make their company a less attractive target. This may not be in the best interests of shareholders, who may not need the liquidity provided by these dividends and will miss out on a healthy takeover premium if the director’s takeover defence tactic achieve its desired result.  Such a tactic will, however, enhance the directors’ job security by reducing the attractiveness of the company to potential acquirers.
There may also be a conflict of interest if managers have been issued share options which can be exercised at some future date. These usually take the form of a call option, meaning the bearer profits with share price increases, and they are commonly issued to executive directors in Australian companies as part of their compensation package.  Theoretically, ignoring market imperfections and information asymmetries, for every cent of dividends per share paid out the company’s share price will fall by one cent.  As the shares which underlie these options have usually not yet been issued, no dividends will be paid on these securities until they are converted. However, by declaring low levels of dividends, managers can make the price of ordinary shares higher than they would be if greater dividends were paid. This means that managers will earn greater profits when they exercise their options if they do not pay out high dividends on ordinary shares prior to exercising their options. Empirical evidence suggests that companies with share-option plans do in fact pay lower dividends than other companies, supporting the above hypothesis. 
It would also be open for directors to suppress dividends when their options had long maturity horizons, and then boost dividends immediately prior to or after the option expiry date in an attempt to artificially boost the share price by sending a positive signal to the market, via the dividend decision, about the company’s future prospects.  Indeed, whenever managers hold shares in their employer companies, which is often the case given the prevalence of executive share schemes,  there is a potential conflict of interest. In such circumstances there are incentives for managers to raise dividends in order to send a positive dividend signal to the market and falsely boost the share price.  Managers could then sell their shares at an artificially inflated price.
Fischel claims the argument that executive share options may create a conflict of interest is not convincing.  He bases this assertion on the fact that if low dividends are paid and the additional retained funds are not used profitably, the share price will fall to the detriment of the managers with options or shares.  This may be true in some circumstances, but very often it will not be the case. The market will take time to penalise the resulting bad investments, and by the time it does the options may have matured and manager may have already pocketed their profit. Alternatively, if the manager has not yet sold their shares, the additional cash surpluses or bad investments would make the company a likely takeover target, which may actually benefit a manager with newly converted shares because of the associated takeover bid premium.  Takeovers may also benefit executives who have “golden handshake” contracts with their company. 
Fischel’s argument also ignores the possibility that management may have sufficient positive NPV projects available to ensure that the share price will not fall. Indeed, on average this appears to be the case, because Smith and Watts found that companies with more growth options (that is, greater access to positive NPV projects) make greater use of share-option plans.  Further, in practice executive share schemes do not perfectly align the interests of shareholders and managers, because such plans can usually be exploited by short-term management “manipulation”, as described Section 4.A. Fischel’s claim has some merit, because executive share or option schemes usually help to align manager and shareholder interests, at least to some extent. However, the above examples illustrate that the existence of executive share options will often give rise to a conflict of interest.
The conflicts of interest outlined in Sections 4A–C support the imposition of a requirement on management to outline the reasons why a particular level of dividends was declared. This type of mandatory disclosure would give managers less scope to go unnoticed if they took advantage of their position via conflicts. For example, if managers wished to reduce dividends in order retain earnings for empire building, they would have to find some other valid, plausible explanation to justify lowering dividends. Similarly, if they wished to increase dividends to obstruct a takeover and keep their jobs, they would have to use some other credible explanation for the higher dividend payment. If other plausible explanations do not exist, it may be highly infeasible for managers to engage in any of these conflict activities to any material extent. The result would be a reduction in the incidence of conflicts of interest.
Arguably these conflicts could usually be covered up as directors would often be able to find other plausible explanations for the dividend decision. However, directors are unlikely to act in a conflict of interest situation if, as a consequence of that conflict, they will have to make a false statement in the company’s annual report to hide a breach of their duties.  Directors would also be aware that any statements made in the annual report will be scrutinised by investors and analysts, and if a breach of directors duties is alleged, the statements may be scrutinised by courts in trying to determine whether the breach has occurred. Therefore, not only would disclosure in the form of an annual dividend statement make directors less willing to engage in conflicts because the risk of getting caught would be higher, but it would also be easier for judges to convict directors as there would be more evidence upon which to base a conviction.
Shareholders in a listed companies cannot usually physically monitor the performance of managers, and hence they rely on the provision of corporate information to assess managerial performance. Managers may reciprocate by disclosing this information in an attempt to “bond” with shareholders. The result is a reduction in agency costs arising from the shareholder-manager conflict, and consequently an increase in the value of the company.  In this sense, disclosure is an important step in achieving management accountability.
However, whilst this analysis demonstrates that there are incentives for managers to disclose information, Sections 3 and 4 showed that there are also incentives for them not to disclose certain information. Without adequate disclosure, shareholders will be unable to properly assess the performance of managers. If the company has performed poorly, non-disclosure may be to the advantage of managers, because with full disclosure they may have lost their jobs or had their remuneration reduced. Where these incentives are so great that disclosure is not made, there is a strong case for the imposition of mandatory information disclosure.
Adequate disclosure is also necessary to safeguard investor confidence and ensure that securities markets are efficient and unbiased.  These objectives underlie the introduction of the continuous disclosure provisions in sections 1001 A–D of the Corporations Law and Listing Rule 3.1. The introduction of these continuous disclosure requirements highlight the importance that corporate regulators are placing on mandatory disclosure. This trend towards mandatory corporate disclosure, in turn, helps to justify the recommendation in this article that the dividend decision should also be subject to mandatory disclosure provisions.
However, in determining whether disclosure of the dividend decision should be mandated, it is first necessary to consider whether market forces already ensure that companies adopt optimal dividend policies and make voluntary disclosure. It is also necessary to assess the costs and benefits of mandatory disclosure and the type of mandatory disclosure that should be required. These issues are considered below.
Fischel says that if dividend policy is important, managers who make suboptimal dividend decisions will reduce the value of their services in the managerial labour market, the company’s value on the share market and its position in the product market.  There are clearly some market incentives for managers to make the right dividend decision. However, this conclusion is not fatal to the argument for mandatory disclosure. Without disclosure of the rationale behind the dividend decision, markets may not punish managers because market participants will not have the necessary information to know whether optimal dividend decisions have been made. Therefore, shareholders and markets need clarification of the reasons lying behind the dividend decision, and not simply an assurance from management that they have set the optimal dividend policy.
Additionally, the benefits for managers which arise from the conflicts mentioned in Section 4 may outweigh the penalties imposed by markets for not adopting an optimal dividend policy. This is particularly the case because the dividend decision conveys future information, and without additional disclosure the market will not know whether or not the dividend decision is an optimal one until several years later. Hence, there is a window of opportunity for managers not to be penalised for suboptimal dividend decisions, which is particularly significant for managers who are intending to leave the company in the near future.
The case for mandatory disclosure of the dividend decision implicitly assumes that companies do not already make adequate voluntary disclosure of the dividend decision. Fischel asserts that if dividends coupled with disclosure provides a more efficient signalling device than dividends alone, companies would habitually make voluntary disclosure to remove any ambiguity about the dividend decision.  Various markets, particularly the capital and labour markets, would penalise companies and managers that do not voluntarily disclose this information.
Advocates of voluntary disclosure argue that if markets are efficient then it will be in a company’s interests to ensure that it discloses all relevant information about itself to the market,  including the dividend decision. They suggest that companies will even disclose bad news, since it is in a company’s best interests to protect their reputations as providers of all information, not just good news.  If they do not disclose, the market will assume a worst-case scenario.
However, there are several reasons why voluntary disclosure may not occur. In some cases the market’s worse-case perceptions may in fact be relatively rosy compared to the true situation, in which case disclosure incentives are mitigated. Directors may also have incentives not to disclose if non-disclosure helps them to cover up abuses arising from conflict of interest situations. In these cases, the penalties on the company imposed by various markets may only have a small, indirect effect on managers, but the personal penalties associated with conflict of interest abuses by managers may be substantial. Additionally, Coffee argues that because information has many characteristics of a public good, others can free ride on the information provided by the company, and as a result corporate information will tend to be underprovided. 
Fischel acknowledges that this issue involves a trade-off between the immediate gains of false signalling against potential long-term losses.  Undoubtedly for some managers the short-term gains will outweigh the long-term costs of false signalling. It has, for example, been shown that the executives near retirement adopt a myopic view and take decisions for their short-term benefit. 
Further, refraining from voluntary disclosures might help a company avoid litigation. Lev says that shareholder litigation should be viewed as a potential cost of disclosure, and that such costs may be considerable in some cases.  Lev also states that optimistic statements are particularly hazardous because expectations often fail to materialise, but he finds that dividend signals conveyed to investors are not associated with litigation frequency.  These results demonstrate why managers may wish to signal information via dividends, but not provide a voluntary explanation of this signal.
Disclosure is imperative if a particular dividend action might mislead or confuse public investors.  For example, the market generally assumes that a dividend signal is a sign of future earnings, because in a majority of cases this signal will be “correct”.  However, investors may be interested in the consistency of the dividend signal and a signal contained in the current earnings figure.  If these signals do not reconcile with each other, this may lead to confusion in the market. Therefore, where a dividend increase is accompanied by poor earnings in that period, or a dividend decrease has accompanied high earnings, there is a clear need for managers to explain the inconsistency and outline the underlying reasons for the level of dividends they have chosen.
Empirical testing was conducted to determine whether companies in fact made adequate voluntary disclosure of the dividend decision in such circumstances. Whilst many articles have dealt with corporate disclosure generally, this study specifically tests the adequacy of voluntary disclosure to reconcile “ambiguous dividend signals”. An “ambiguous dividend signal” is defined as a situation where current earnings per share (EPS) decreases but dividends per share (DPS) increases, or vice versa. Of the 119 companies examined during the period 1992– 1995, there were 40 ambiguous dividend signals.  Annual reports, and other information sent to shareholders of these companies, were used to determine what level of disclosure was made to reconcile these apparently ambiguous signals.
The results, which are presented in Table 3 of the Appendix, undermine any argument that there is already adequate voluntary disclosure in relation to the dividend decision. In not one case was there specific reconciliation of the inconsistent dividend and earnings signals. That is, not one company both acknowledged there to be an inconsistency and explained why the dividend and earnings results had changed in opposite directions.
In two cases, both involving ERA, specific reasons were given for dividend changes. ERA’s 1993 and 1995 annual reports both recognised that changes to DPS and EPS were inconsistent, but the annual reports only provided reasons for the dividend decisions (there was no specific reconciliation of the inconsistent dividend and earnings signals). In 1993, despite an increase in EPS, the company did not pay a dividend “in order to retain cash and repay debt thereby improving the Company’s flexibility to meet future market opportunities”.  Despite a drop in earnings, a final dividend was reintroduced in 1995 because “the Company’s debt is now at an acceptable level”, and a special dividend was also paid. 
In the remaining 95 per cent of cases, no specific reason for the dividend change was given and there was no voluntary disclosure of information to reconcile the earnings and dividend signals. In 16 cases, the earnings and dividend signals were presented to shareholders as consistent. This was a result of companies using different EPS and/or DPS definitions to the definitions used by the ASX.  The most common difference was a definition of EPS in company’s annual reports which did not take into account abnormal items. However, in some cases it was unclear what definitions of EPS and DPS were being used, or the definitions were not adjusted for capital changes. 
In 15 cases, the changes in EPS and DPS were presented as inconsistent, but this inconsistency was not reconciled. This lack of disclosure can only leave investors confused about the future prospects of the company, and these are prime examples of situations where further elaboration of the dividend decision should be required.
In five cases, the earnings and dividend signals were presented as neither consistent nor inconsistent, because either EPS or DPS were shown in the annual report as unchanged from the previous period. In two cases, the previous year’s EPS and DPS figures were not presented to shareholders. This in itself illustrates insufficient voluntary disclosure to shareholders. The empirical results in this section therefore plainly demonstrate that companies are not disclosing relevant information to clarify ambiguous dividend signals.
Mandatory disclosure of the dividend decision would help to clarify any ambiguity in the dividend signal, which in turn is important to ensure that the company’s securities are correctly priced in the market. However, Fischel contends that mandatory disclosure’s potential to “correct” share pricing seems minor and even insignificant.  This view ignores the fact that the dividend signal is a signal about future earnings or investment opportunities, so it would take months and probably years for the market to confirm the dividend signal and fully impound it into share prices.  Surely it would be preferable for the company, via mandatory disclosure provisions, to clarify the dividend signal at the same time as the dividend announcement so that its impact is instantaneously impounded into prices, rather than having the market incorrectly pricing securities for months or years. Even a temporary “wrong” share price is unacceptable. Therefore, mandatory disclosure rules are also justified on the ground that the market is only semi-strong form efficient, meaning it is efficient with respect to public but not private information, so disclosure would help to ensure that private information is made public.  The information would then become impounded in the company’s share price.
Courts have generally given great weight to the discretionary element of the dividend decision, and been reluctant to find in favour of shareholders aggrieved by the level of dividends declared.  This position may be largely the result of a lack of legislative guidelines to help judges determine the appropriateness of dividend decisions by managers. However, the proposed mandatory disclosure rules outlined in this article set down objective criteria to assist judges. 
Further, as judges currently have little or no information about how the dividend decision was made, the presumption that management has acted properly is usually hard to displace. However, with mandatory disclosure, management impropriety would be evident from the mandatory statement made to justify the dividend decision. Courts would not have to assess the dividend decision itself, but only the statement accompanying that decision. Thus, mandatory disclosure provides grounds to help judges better deal with this issue, and would therefore make it easier for disgruntled shareholders to successfully litigate in relation to dividends.
If dividend disclosure is to be made, it must be relevant and in a form that can be understood by shareholders. The nature of the mandatory dividend disclosure regime recommended in this article is outlined below. (i) Mandatory Dividend Disclosure: Who, What and How? The empirical results of this study suggest that companies sending an “incorrect” or “ambiguous” dividend signal to the market should be forced to disclosure the reasons underlying the dividend decision.  Mandatory disclosure may also be warranted if dividends are not altered but current earnings have materially changed or future earnings are expected to.  Disclosure is also necessary if dividends change by a material amount or if special dividends are declared.
As an alternative to disclosure only in particular circumstances, there could be blanket mandatory dividend disclosure for all companies. This approach would overcome the problems associated with determining when an ambiguous dividend signal is being sent to the market, particularly as there are differing levels of ambiguity. There are also varying levels of “(in)correctness” in the dividend signal. For example, unless blanket mandatory disclosure was introduced, disclosure would not be required when the future earnings and investment opportunities signals offset and cancelled each other out. Further, even if a signal is correctly interpreted by the market, the magnitude of the inferred impact of the signal is likely to remain ambiguous without disclosure. Finally, unless blanket disclosure is introduced, companies who are forced to disclose the dividend decision may feel disadvantaged, particularly if their rivals are not required to make such disclosures.
For the reasons outlined in the above paragraph, the approach favoured in this article is a blanket mandatory disclosure requirement. That is, the dividend decision should become part of the company’s compulsory periodic disclosures along with other matters such as directors’ remuneration and related party transactions. To satisfy this dividend disclosure hurdle, companies could only be required to make a short statement in their annual reports about the reasons underlying the dividend decision. For example, sections 304 and 305 of the Corporations Law could be amended to require the Directors’ Report to state not only the amount of dividends paid in the past financial year, but also the reasons for paying that level of dividends. In particular, either the Corporations Law itself or a practice note issued by the Australian Securities Commission could require companies to provide an explanation of why (where applicable):
(1) earnings per share increased but dividends per share decreased, or earnings per share decreased but dividends per share increased;
(2) the percentage change
in dividends per share was substantially different from the percentage change in earnings per share;
(3) there was a material change in the dividend per share declared in comparison to the previous period;
(4) a dividend was omitted or reintroduced during the period; or
(5) a special dividend was declared during the period.
Note that paragraph (2) above could, for example, be satisfied where there is a greater than 60 per cent difference in the changes (for example, if DPS increased 10 per cent, but EPS increased 80 per cent). The materiality requirement in paragraph (3) could be satisfied by a dividend change of more than 20 per cent, either up or down. Additionally, EPS and DPS should be defined in the legislation or practice note, and this definition must ensure that the variables are adjusted for capital changes. A practice note could also provide guidance to help companies formulate the statement in the Directors’ Report. This approach is justified on a cost-benefit analysis of disclosure. Directors should have already considered explanations for the dividend decision, and simply adding a short paragraph into the Directors’ Report conveying these reasons would come at a minimal cost. However, the benefits of clarifying any ambiguity are clearly significant for both shareholders and capital markets. 
It could be argued that this mandatory disclosure should only apply to listed entities, through the ASX Listing Rules. However, in the author’s view a wider range of companies should be forced to comply with the dividend disclosure provisions, in which case the Corporations Law would be a more appropriate vehicle for reform. At a minimum, both listed companies and “unlisted disclosing entities”  should be required to comply with these disclosure provisions.
There are several arguments which support the extension of these mandatory dividend disclosure provisions to both listed and non-listed companies. The cost of mandatory dividend disclosure would be minimal, and so disclosure would not be unduly costly for smaller unlisted companies. Further, the dividend signal from a smaller company will usually impart more new information to the market and have a greater wealth impact than an otherwise identical signal from a larger, more closely monitored company.  Therefore, mandatory dividend disclosure is in some respects even more important for smaller unlisted companies than larger listed ones. The most appropriate means of introducing the suggested dividend provisions therefore seems to be via amendments to sections 304 and 305 of the Corporations Law. These sections will apply to public companies and “large proprietary companies”, but will generally not apply to “small proprietary companies”. 
Non-disclosure may be justified where full disclosure would result in confidential information being conveyed to the market. Fischel uses Texas Gulf Sulphur as a classic example of where disclosure should not be made.  The company in that case had cut its dividend to fund a confidential mineral rights acquisition program.
Fischel says it was clearly not in the best interests of shareholders to receive full disclosure in this instance, because disclosure itself would reduce the value of the acquisitions once competitors knew about them.  Therefore, if disclosure was voluntary, companies could themselves determine whether disclosure was appropriate in the circumstances.
However, this article has demonstrated that voluntary disclosure does not work in a dividend context; companies will simply not disclose rather than deciding whether disclosure is in the best interests of shareholders. Therefore, companies should at least be required to disclose non-confidential reasons for the dividend decision. Additionally, the dividend disclosure requirement proposed in this article does not require disclosure to be so detailed as to inform rivals or other market participants of sensitive information. In relation to any confidential element of the dividend decision, directors should be required to state that specific information is not being disclosed for reasons of confidentiality. For example, the company cited by Fischel could include a broad statement in the Directors’ Report such as:
The dividend has been reduced to fund a major acquisition program that has been undertaken by the company. Given the confidential nature of the acquisitions, further details will be sent to shareholders once it is appropriate to make the information publicly available.
Indeed, Listing Rule 3.1 already deals with the problem of confidential information disclosures. This Listing Rule would ensure that disclosure of pricesensitive information is in fact made by listed companies when the appropriate time for disclosure arises.
Huie recommends that corporate laws should be revised to encourage or require that up to 100 per cent of a company’s earnings be paid out to shareholders.  This shifts the power of decision away making from management, and shareholders would be free to use the cash dividends as they please, including to purchase further shares in the company. If all earnings were paid out as dividends, managers would have to rely on external finance and justify the use of the funds to the market. Several countries have mandatory dividend rules which require companies to pay a certain percentage of their earnings or net income out as dividends, including Brazil, Chile, Colombia, Greece and Venezuela. 
However, there are several problems with Huie’s approach, some of which are outlined in Section 6C. The countries which have adopted this approach have weak legal protections for minority shareholders, and mandatory dividend payouts are one way of assuring investors that they will not be completely expropriated.  As Australian laws better protect minority shareholders, mandatory dividend payouts do not appear to be necessary for this purpose. Furthermore, Huie states:
This proposal admittedly will involve increased transaction costs as well as reduced flexibility and power for corporate directors, but these burdens are warranted in light of the disastrous effect that recent M&A frenzies have had on American business.
Goshen extends Huie’s recommendation by outlining an alternative dividend regime whereby all earnings are paid out as dividends, with shareholders having the choice of receiving cash or share dividends.  This approach effectively requires companies to maintain a 100 per cent dividend payout ratio and implement a dividend reinvestment plan (DRP). 
Goshen uses agency arguments to support his proposal. Dividends are one mechanism to reduce agency costs arising from the shareholder-manager conflict.  This conflict can be mitigated, the argument goes, by placing the dividend decision in the hands of shareholders, who if they so desire can keep all the company’s earnings as cash dividends.  Conversely, if they believe managers will use the funds effectively, shareholders can elect to take share dividends and earnings will be retained. Mandating this option mechanism is necessary to force inefficient managers to relinquish their discretion. 
There are other agency cost savings flowing from Goshen’s proposal. Given that more cash will usually be paid to shareholders under his proposal than under Australia’s present dividend laws, less earnings will be retained and so there will, other things being equal, be less excess “free cash flow” in companies.  Free cash flow is a major source of shareholder-manager conflict as it gives managers scope to empire build and undertake negative NPV projects.
Furthermore, management’s accountability to external capital markets would be increased under the proposal, so more information about the company would be made available. In this sense, Goshen’s proposal would reduce the degree of information asymmetry between managers and shareholders, which would lower agency costs and increase the company’s value. 
An additional advantage of Goshen’s approach is that minimal judicial supervision would be required, because shareholders would make the substantive dividend decision, not managers.  The major role for courts would simply be to ensure that companies are properly administering their dividend policy as dictated by shareholders. One impediment to the adoption of an option mechanism which is identified by Goshen is that most tax systems, including the United States, are biased against dividends and favour capital gains.  However, in an Australian context the taxation system would not be a impediment to Goshen’s approach, but in fact would be an advantage of the mandatory payout approach. Goshen’s proposal is entirely consistent with Nicol’s suggestion that Australian companies paying fully franked dividends should pay the maximum possible level of dividends.  Where 100 per cent of earnings are distributed, either as cash or shares via DRPs, imputation credits are not “wasted” at the corporate level, as they are if earnings are retained. 
Both Huie’s and Goshen’s proposals suffer from the criticisms noted below.
(i) “Manipulating” the Earnings Figure
Goshen acknowledges that the complexity of the concept of “earnings” and the absence of a concrete definition of the term may make it easy for managers to manipulate the earnings calculation.  For example, companies could engage in
additional research and development, which would enhance corporate growth but reduce earnings. In this sense, managers could artificially retain corporate funds for their own uses.
(ii) Mandatory Payouts Ignore Liquidity
Huie’s and Goshen’s proposals look solely at the earnings figure and ignore the company’s cash flow position, which is critical to the company’s short-term solvency. In an extreme case, these proposals could be a death sentence for a profitable company which simply has short-term liquidity problems. Goshen acknowledges that “[d]ividend options might be a dangerously poor method of determining working capital”, and concedes that his proposal may “impose extreme hardship on some corporations”.  He suggests that such companies should be allowed to retain some fraction of their earnings.  However, it may be quite difficult to determine what companies would come within this exception, and then what minimum level they should be permitted to retain. 
(iii) Lack of Flexibility
There have recently been a number of DRP suspensions among Australian companies,  which suggests that managers want flexibility in the dividend decision and that sometimes it may not be optimal to allow shareholders to take dividends in the form of shares. This, combined with the fact that they ignore the company’s cash flow position, suggests Huie’s and Goshen’s proposals are too inflexible. Huie specifically acknowledges this criticism, but says a lack of managerial flexibility is exactly the point of having a 100 per cent payout requirement.  This may be true from a pure agency cost perspective, but in practice the lack of flexibility may be highly inconvenient and inefficient.
However, under Goshen’s 100 per cent payout approach, management could be given a greater role in determining retention by setting the discount rate at which share dividends are issued.  If managers increased the discount rate, shares would be issued at a lower price and the share option would become relatively more attractive for shareholders. Consequently, more funds would be retained, which could be put towards positive NPV projects. However, if there were few viable projects on the horizon, management could lower or eliminate the discount rate, in which case more shareholders would be likely to take cash dividends. 
(iv) Using Thresholds to Overcome these Problems
Most companies would probably not want 100 per cent of earnings to be retained via share dividends. Nor would they want all earnings to be paid out as cash. It would be possible to impose thresholds so that extreme results such as these do not arise from Huie’s or Goshen’s proposals. 132 For example, the proposals could be amended so that if more than 80 per cent of dividends are taken as shares then each shareholder who takes the share option would have their share dividend reduced on a pro rata basis and receive the difference as cash. Conversely, if too many shareholders wanted cash they could be forced to take some dividends in the form of shares. However, this is only a partial solution. Obviously this threshold adaptation places bounds on the dividend decision and fails to allow shareholders to adopt their preferred dividend choices in certain cases. Additionally, there may be argument about what level of threshold to impose.
In addition to the issues raised in Section 6C, Goshen’s proposal suffers from other problems. Many of the benefits Goshen canvasses for his dividend option approach are unpersuasive and even disadvantageous once his assertions are investigated further.
(i) Confusing Capital Markets and Shareholders
Goshen incorrectly suggests that the reinvestment decision is being handed from management to the capital markets under his proposal. Goshen says capital markets have extensive knowledge about the company, the requisite expertise for reviewing the company’s dividend policy and substantial experience in reviewing corporate investment potential.  This is undoubtedly true, but capital markets are only efficient at the margin, and marginal investors are usually well informed. Under Goshen’s proposal, companies would ask average shareholders, not the share market or primary securities market, to determine corporate dividend policy.  Average shareholders are generally not well informed and do not possess the requisite expertise and knowledge to make the dividend decision.  One solution to this criticism may be to pass the reinvestment decision on to institutional shareholders, and this variation is considered in Section 6E.
(ii) The Shareholder Co-ordination Problem
In choosing between cash and share dividends, shareholders acting individually are unlikely to take into account the company’s cash requirements. Instead they will base their decision primarily on their own personal interests, particularly their own liquidity needs. If, due to the personal liquidity preferences of its shareholder base, a company had 80 per cent of its dividends taken in cash form, this may result in the company passing up positive NPV projects.  In this sense, Goshen’s proposal places the dividend decision on a pedestal above the investment decision. Of course, the company could always go to the external capital market for funding, but this is likely to be costly and may dilute the interests of existing shareholders. Therefore, a valuable financing option may be eliminated if management does not have control over the magnitude of internal earnings retention.
The shareholder co-ordination problem makes it highly unlikely that the company will have an optimal level of retained earnings under Goshen’s proposal. Currently, companies perform a co-ordinating role by balancing dividend policy with corporate cash flow considerations and shareholder interests. Management will be able to balance these considerations even if a DRP is in place, because managers can alter the payout ratio or DRP discount rate (which affects the DRP participation rate) to achieve the desired level of retained earnings. 
Admittedly, shareholders are more likely to take share dividends if they believe the company will be profitable, and if the company is profitable it will need cash to fund positive NPV projects. However, this assumes that shareholders know what level of profitable opportunities exist. Managers, given their inside knowledge of the company, are almost always in a far better position to determine the cash flow needs of the company and what investment opportunities the company has. For example, insiders may know that cash must be retained to avoid insolvency, but outsiders (including most shareholders) will usually only know a company is near insolvency when it is too late. The fact that managers, not shareholders, are in the best position to make the dividend decision is therefore a significant downfall of Goshen’s proposal.  Ironically, in discussing the inability of courts to scrutinise dividend decisions, Goshen acknowledges that determining a company’s dividend policy “requires considerable knowledge of a firm’s internal affairs and its overall economic position”.  He fails to see that, like courts, shareholders also lack such knowledge.
The shareholder co-ordination problem arising from Goshen’s approach may also lead to reduced monitoring of some companies by capital markets. For example, if under Goshen’s proposal 80 per cent of earnings was reinvested and this rate was stable, the company’s management may know they do not have to go to the external capital market in the near future. The use of capital markets as a disciplinary mechanism for management becomes impotent in such a case, raising agency costs and reducing the value of the company.
(iii) Shareholder-Debtholder Agency Costs are Increased
Goshen does acknowledge that his proposal may accentuate the shareholderdebtholder conflict,  which in turn increases agency costs and reduces the value of the company. Smith and Warner show that wealth can be transferred from debtholders to shareholders via excessive dividend payments.  More precisely, the value of debt falls when management increases the dividend payout rate, because this will the reduce the total funds available to service the debt. Goshen’s proposal accentuates this problem by increasing the cash payout ratio to shareholders in most cases.  In other words, by reducing corporate liquidity, Goshen’s proposal may disadvantage debtholders because the likelihood of a default occurring on their interest claim is increased.
Debtholder agency costs are also increased under Goshen’s proposal because debtholders are more likely to have their claims diluted by new corporate debt issues.  Under Goshen’s proposal, more cash is being paid out to shareholders than at present, thereby forcing companies to go to capital markets more frequently. Myers’ “pecking order theory” suggests that if managers cannot raise funds internally, they will prefer to raise funds in the external debt market rather than the external equity market.  This makes it likely that the company will issue new debt, and if this new debt is of equal or higher priority than the company’s original debt, then original debtholder claims become diluted, riskier and hence less valuable.
(iv) Why are Companies not Voluntarily Adopting Goshen’s Proposal Already?
If it was possible to increase the value of the company by adopting Goshen’s proposal, then surely all companies would have a DRP in place and increase their payout ratios to 100 per cent. Under Australia’s current legislation it is certainly possible for companies to adopt Goshen’s proposal, yet none have chosen to do so. The reason appears to lie in the disadvantages outlined above. For example, the gains from lower shareholder-manager agency costs might be offset by higher shareholder-debtholder agency costs.
Goshen acknowledges some of these impediments to his proposal and says this is why companies have not adopted his proposal voluntarily.  Goshen believes the main impediment is the tax distortion in the United States, but even under the Australian tax system, which encourages all corporate earnings to be paid out as dividends, companies have not adopted his proposal. Mandating Goshen’s proposal would reduce the ability of companies to weigh up the advantages and disadvantages of the proposal before deciding on their own optimal dividend payout rate.
Goshen points out that France has recognised, in a modified form, the merits of his suggested approach.  Under French company law, there must be an annual shareholder vote on the allocation of a corporation’s profits. If shareholders decide to distribute profits as dividends, the corporation must give shareholders the choice of receiving their dividends as either cash or shares. 
(v) Passing the Reinvestment Decision on to Institutional Shareholders
To overcome the problem outlined in Sections 6D(a) and (b), Madden suggests that institutional investors could organise themselves to vote annually on their desired dividend payout rate.  Madden asserts that this would be an effective mechanism for distinguishing between corporate investment plans which eventually add value and those which simply waste resources.  He also infers that this approach would curtail empire building because “the reality ... is that the boards of many public companies have neither sufficient knowledge of the business nor the appropriate financial incentives to resist organisational pressures for growth”, meaning management will often not be subjected to vigorous board oversight. 
This may be the preferred solution for some companies, particularly those with a handful of major shareholders who regularly monitor the performance of the company’s managers. However, in most cases executive directors will have more information and knowledge about the company than its major shareholders. Further, institutional investors may prefer to play a passive role in their companies,  and even if they were active they may not act in the interests of smaller shareholders or in accordance with the best long-term interests of the company. Contrast this with the fiduciary duties governing directors and executives to ensure that they act for “the benefit of the company as a whole”, which has been held to mean for the general body of shareholders.  For these reasons, Madden’s proposal is not the preferred route for dividend reform.
(vi) Other Alternatives
Goshen suggests several other methods of shifting dividend policy into the hands of shareholders. These include amending the corporate constitution to transfer voting rights on dividend policy to shareholders, or requiring a particular predetermined dividend payout. Goshen suggests that these are less effective than his dividend option proposal.  Essentially, these alternatives lack flexibility, are administratively difficult and require shareholders to be regularly well-informed, which they usually are not.
With the recent push towards greater corporate disclosure in Australia,  it seems anomalous that the disclosure requirements for one of the most important corporate decisions, the dividend decision, remain minimal. Australia’s current dividend laws do not require directors to explain the underlying reasons for choosing to declare a particular level of dividends. This position is unsatisfactory, and it is suggested that directors should be forced to disclose this information to shareholders and the market generally.
There are several reasons supporting this type of dividend reform. Firstly, this study shows empirically that the market is often unable to determine what signal is being sent when a company changes its dividend rate. The mandatory disclosure proposal suggested in this article would clarify this signal to the market, leading to fewer erroneous security prices and more efficient markets. Secondly, mandatory disclosure would reduce the ability of managers to choose a dividend policy which benefits them personally and involves a conflict of interest. Thirdly, this study has found that voluntary disclosure of the dividend decision is not being made by Australian companies, so it is necessary for the legislature to compel disclosure. The problems associated with other dividend alternatives, such as Goshen’s proposal, mean that mandatory disclosure is the preferred method for reforming Australia’s dividend laws. Mandatory dividend disclosure proposals are outlined to assist in the implementation of the suggestions contained in this article. These proposals are feasible and justified on a cost-benefit analysis, so they would not impose a significant additional regulatory burden on companies.