Minority shareholders' protection in Romanian capital markets: evidence on dividends

Minority shareholdersâ protection in Romanian capital markets:
evidence on dividends

∗
Victor Dragotã

Abstract



Recent studies in Finance suggest dividends’ role as monitoring mechanism, which allows
minority shareholders to control the managers or larger shareholders’ decisions. This paper tests this
hypothesis on listed companies at Bucharest Stock Exchange, in 2000-2003 period, from the legislation
perspective, but, also, using dividend ratios. Even the regulations and the enforcement of the law seem to
guarantee an effective protection for minority shareholders, dividend policy is different from company to
company, depending on shareholders structure. However, companies can fund their operations by banks,
which could explain the relative indifference for minority shareholders proper treatment.

Keywords: Dividend policy, Agency problem, Minority shareholder’s protection, Emergent capital
markets, Romania.

JEL classification: G35


∗ Victor Dragotă, Academy (University) of Economic Studies, Faculty of Finance, Piata Romana, No. 6,
Room 1104, Bucharest, Telephone: 0040-0722.52.33.18; e-mails: victor.dragota@fin.ase.ro,
victordragota@yahoo.com.
1

---

In the perspective of market economy system enlargement, a study on minority
shareholders rights could be useful for practitioners and for academics, too, in order to
understand financial markets mechanisms in emergent ex-communist countries. In this
context, I choose Romanian capital markets as an example, some of the results being
possible to be extended to the other countries included in this category. I focus on
minority shareholders rights as a premise for capital markets developing, as a financing
source for listed companies. If minority shareholders feel their rights are protected, they
will assume shares issued on capital markets as an attractive investment. In the opposite
case, a lack in this area could be considered as a possible explanation for the slowly
developing of capital markets in these countries.
We suppose that, even if the regulations permit the development of capital
markets, the enforcement of them is very important, too. This implies not only the law
to be respected, but also to understand every opportunities and rights. For this reason, I
presented for the beginning the status of shareholders rights, but I preferred for my
conclusions to interpret the dividend policy in companies controlled by larger versus
minority shareholders. There are some discussions about the opportunity of dividend
payments on companies with growth opportunities. However, if we are taking into
account the asymmetrical information, existent between insiders (those could be
managers or larger shareholders) and the minority shareholders or the outside investors,
dividends could serve as a signalling mechanism, clearing up to the financial market the
minority shareholders interests are respected. If companies do not operate dividend
payments, this decision could cause a lack of credibility for potential investors on the
market, and future shares issues will be very probably unsuccessful.
2

---

In my study, I find for 2000-2003 period a significant difference between the
dividend ratio for companies with shares owned in more than 50% by larger
shareholders and the other companies. Practically, minority shareholders benefit by
dividends only if they own a large number of shares. Of course, I could not conclude
this is the only main cause for the slow development of capital markets in Romania, or
in other emergent ex-communist countries. There are some other reasons that could
explain lower dividend ratios, for example investors’ psychology, which could accept
“present pain for future happiness”. More, it is possible, even in the case the minority
shareholders interests are not respected, this fact to do not alter very much the
companies’ main decisions, because of the existence of alternative sources of financing
as banks’ loans.
The paper is structured in 5 sections. In Section 1 there are discussed the main
topics related to dividends as a mechanism for minority shareholders to monitor the
decisions of larger shareholders. Section 2 lights some considerations about the
Romanian general economic situation and specific legislation. In Section 3 there are
analysed the main attributes of Romanian shareholders and database for the study. The
results are presented in Section 4, and the conclusions and new directions for the study
in Section 5.

1. A short survey on financial literature about dividends as mechanisms to monitor
the corporate insiders decisions
Dividend policy remains an open research field in Finance: between the persons
who reject the idea that dividends have any importance and these ones who write
hundreds of pages trying to explain this reality, many results appear, very different one
3

---

from another... Beginning with Miller and Modigliani [1961] Dividend Irrelevance
Theorem demonstration, it was confirmed in time that are some assumptions which
must, at least, be taken into account in order to explain the reality of capital markets. In
this category we could include the impact of taxes and transaction costs, the
informational asymmetry, the agency problems, and the particularities in investors
behaviour. This study focuses on the explanation of dividends as a mechanism in
monitoring larger shareholder decisions in their agency relation with minority
shareholders.
Whatever the Financial Theory proclaims about the independence between
economics and politics, a complete analysis about the reality on corporate management
level must take into account the investors’ behaviour related to financial decisions,
inclusive the impact of organisational culture. Acting in a field under the influence of
subjective decisions, the fashions’ influence is present, too, in Corporate Finance
practice and Theory. Some time the optimal decision is translated from time to time,
and some time the old theories are rejected only because of their political component. In
this context, the East European financial markets could be an interesting field of study.
Before 1989, the year of Romanian Anticommunist Revolution, the individual
property was discouraged, and the financial surpluses were oriented to investments,
decision which, in dividend policy terms, means retained earnings. This optic remains
legitimate after 1989, because, even the legal system became different, the general
mentality remained the same (for example, on every elections after 1989, excepting
1996-2000 period, the political elections were dominated by Socialist Parties).
Even in developed market economies, some time the research could not be
conducted rational. For instance, in an interview, there is a very low probability that a
4

---

manager to answer his objective is to maximise his own welfare or his own utility, and
not the shareholders welfare. In the end, the shareholders decide if the manager will
remain or not in position. In some countries, he could accept his objective is to
harmonise the stakeholders’ interests, with an explanation focused on social
responsibility, but, again, not to maximise his own welfare. In these conditions, it could
exist a significant difference between the declarations and decisions, reason for that we
are aware of some indubitable conclusions.
The main stream in Finance Theory suggest rational investors follow
maximisation of their utility, even if this objective acts contrary the interest of the
others (see Cyert and March [1963], Williamson [1963], Jensen and Meckling [1976]
etc.). In this context, the rational agent is defined as a calculator, permanently making
comparative studies between different existing opportunities, and practically, he is
amoral when is taking decisions (only the other agents monitoring activity induce his
morality). On the other side, some theories declaim individuals are only the product of
the social environment. When these particular conditions are favourable, agents will act
for satisfying the interest of the community, in this case the interests of the company.
Both of these theories contain some truth, but remain only theories when we have to
take control over some considerations like legislation, financial resources for
investments, the attitude toward risk, and other attributes of the countries where the
study is made. In fact, every Theory related to the objectives of Corporate Finance must
take into control the response of the other stakeholders, even if we analyse only the
interest of shareholders: an adverse response could cause a decrease of the company
performance. Stiglitz [1985] pointed that, in large corporations, the separation between
ownership and control became a reality. However, since there is some cost associated
5

---

both with obtaining information to find out whether a manager is a good manager and
with evaluating alternative management teams, and there is a negligible benefit, no
rational shareholder should spend the financial resources required voting intelligently.
In these circumstances, as long as the companies plan to obtain financial resources from
capital markets, they must signal to outside investors that they assure a good treatment
to minority shareholders.
In the absence of other restrictions, practically, managers must only to signal to
shareholders everything is going well, and be careful to do not transmit to the public the
bad news. Of course, there are some mechanisms by which shareholders could monitor
the managers’ decisions, like dividends payment and capital structure. Nevertheless, the
agency problem between managers and shareholders still exist in reality and it is studied
by financial literature (see Easterbrook [1984]). However, this situation is present only
in very few countries, like US, Great Britain, Canada, Australia, generally the
economies characterised by very low percents in corporate equity detained individually
by investors. In these countries, investors are protected not only by laws, but also by the
custom that the companies to finance corporate operations by equity issuing. Here, as
La Porta, Lopez-de-Silanes, Shleifer and Vishny [1998] suggest, “shareholders receive
dividends because they can vote out the directors who do not pay them, and creditors
are paid because they have the power to repossess collateral. Without these rights,
investors would not be able to get paid, and therefore companies would find it harder to
raise external finance”.
In many countries, this potential conflict between managers and shareholders is
generally replaced by the agency problem between larger and minority shareholders. In
these cases, the control is under a little number of investors (La Porta, Lopez-de-
6

---

Silanes, Shleifer and Vishny [1998], Gomes [2000]). This situation could be explained
not only by traditions, but by the requirements of a good management, too. Controlling
shareholders adapt their policy in order to protect their interests, cause of poor investor
protection. For example, La Porta, Lopez-de-Silanes, Shleifer and Vishny [1998] find
that “poor investor protection in French-civil-law countries is associated with extremely
concentrated ownership. The data on ownership concentration thus support the idea that
legal systems matter for corporate governance and that companies have to adapt to the
limitations of the legal systems that they operate in.”.
The best dividend policy dilemma, even we accept the main objective of
financial management to be to maximise the shareholders’ wealth, does not offer an
indubitable answer. It is not so clear what is the best decision: to retain earnings in order
to assure a significant growth in the future, or to pay dividends, in order to create a good
reputation on financial market. In these circumstances, it is a very large field of debates
what is the best choice for the company. More, on a market without a large experience
in investment in capitalist conditions, the little investors could be easy manipulated.
In Eastern Europe ex-communist countries, appear some particularities related to
transition process. For example, as Shleifer and Vishny [1997] mention, “in less
developed countries, including some of the transition economies, corporate governance
mechanisms leads to substantial diversion of assets by managers of many privatised
companies, and the virtual non-existence of external capital supply to companies.”
In ex-communist countries, there were adopted some organisational structures
from developed countries, but they didn’t always possessed the proper mechanisms to
implement them into a functional way. As a result, it was created a heterogeneously
system, in which coexist simultaneously structures and institutions characteristic for
7

---

capitalist markets, but, also, for socialist ones. Moreover, the situation is deteriorated by
the communist mentalities of many individuals. Romania could serve as an example for
the situation in most of the Eastern Europe ex-communist countries.
La Porta, Lopez-de-Silanes, Shleifer and Vishny [1998] define the “outcome”,
respectively, “substitute” models. According to the “outcome” model, dividends are the
result of effective pressure by minority shareholders to force corporate insiders to
disgorge cash. According to the “substitute” model, insiders interested in issuing equity
in the future choose to pay dividends to establish a reputation for decent treatment of
minority shareholders. The first model predicts that stronger minority shareholder rights
should be associated with higher dividend payouts; the second predicts the opposite. La
Porta, Lopez-de-Silanes, Shleifer and Vishny [1998]’ tests on a cross-section of 4000
companies from 33 countries (in this list do not appear East European ex-communist
countries) with different levels of minority shareholder rights support the outcome
agency model of dividends.
In accordance with opinions exposed in Easterbrook [1984], Zwiebel [1996],
Fluck [1999], etc., this study also assumes that dividend policies address agency
problems between corporate insiders and outside shareholders. Agreeing to these
studies, unless profits are paid out to the shareholders, the insiders may divert them for
personal use or for unprofitable projects, which provide private benefits for the insiders.
As a consequence, outside shareholders have a preference for dividends over retaining
earnings (see, also, La Porta, Lopez-de-Silanes, Shleifer and Vishny [1999]).
In a world of significant agency problems between corporate insiders and
outsiders, dividends can play a useful role. By paying dividends, insiders return
corporate earnings to investors and hence are no longer capable of using these earnings
8

---

to benefit themselves. Dividends (“a bird in hand”) are better than retained earnings (“a
bird in the bush”) because the latter might never materialise as future dividends (“can
fly away”). In addition, the dividends payment exposes companies to the risk to raise
external funds on the capital markets in the future, and hence gives outside investors an
opportunity to exercise some control over the insiders at that time (Easterbrook [1984],
La Porta, Lopez-de-Silanes, Shleifer and Vishny [1999]). However, there are some
inconveniences related to this point of view. As Stiglitz [1985] pointed, this mechanism
is efficient only in the case in this capital must be raised on the capital market, because
the managers have considerable discretion over the company cash flow. Moreover, the
interests of the larger shareholders may well not coincide with the interests of the small
shareholders. Shleifer and Vishny [1997] suggest “This cost of concentrated ownership
becomes particularly important when others – such as employees or minority investors
– have their own firm-specific investments to make, which are distorted because of
possible expropriation by the large investors. Although large investors can be very
effective in solving the agency problem, they may also inefficiently redistribute wealth
from other investors to themselves.”.
It could be argued the companies must be interested in create a reputation on the
market because they must be interested to achieve financing resources in the future, by
issuing shares. However, as Gomes [2000] pointed, the reputation effect is not
significantly dependent on the company’s growth opportunities as long as the company
can rise debt financing or the owner-manage is not constrained by credit conditions. A
related point of view appear in La Porta, Lopez-de-Silanes and Shleifer [1999]: “Firms
in “bank-centred” financial systems might rely on debt finance, making it unnecessary
9

---

for controlling shareholders to sell their equity to raise funds, but also making legal
rules protecting minority shareholders less essential.”

2. Some considerations about the Romanian economic situation and legislation
We showed in Dragotã and Mitricã [2004] that, after a half century of
dictatorship, the post-communist Romanian Governments tried to promote reform
programs in almost every sector: politics, economics, civil rights, local administration,
etc., but these changes were characterised by slowness. Establishment of modern capital
markets is an important measure in the programs promoted after 1989 (the year of
Romanian anticommunist revolution). The capital markets development was founded on
the Privatisation Mass Program, process in which shares in more than 5000 companies,
property of the Romanian State, were granted gratis to the population. Has the
privatisation in Romania a political or an economic purpose? Some East-European
developed capital markets before individuals to need the assets transfer. This is one
explanation for a very low liquidity on the capital markets. In this situation, there is a
very minor concern on minority shareholders’ protection: companies generally do not
need financial resources on the capital markets, by issuing shares, and if they do, the
market is not able to interpret in a coherent analysis the companies’ perspectives.
In a financial system where companies are not forced to issue shares on the
market, for financing resources, there is very possible not to pay dividends (see La
Porta, Lopez-de-Silanes and Shleifer [1999], Gomes [2000]). Practically, the top
management pays dividends to create a good reputation in order to obtain cash if the
companies’ perspectives require this. It is not the case if this practice is not usual. In
Romania, in October 28, 2004 were listed 60 companies (17 at the first category, and 43
10

---