Has Shanghai got it wrong with dividend regulations?

A measure to restore minority investor confidence is proving problematic

They were designed to make the market fairer and more attractive to smaller investors, but dividend regulations for companies listed on the Shanghai Stock Exchange are creating unintended consequences and in some cases are proving detrimental to company value.

That is one of the conclusions drawn by Kevin Li, a lecturer in the school of accounting at UNSW Business School, who has recently published new research on Shanghai’s unique ‘comply-or-explain’ dividend regulatory regime.

The Shanghai Stock Exchange is the only equities market in the world where companies are required to pay at least 30% of their profits as dividends, or give an explanation as to why they have not done so.

Other exchanges in emerging markets, such as Brazil, Colombia, Chile, Greece and Venezuela have mandatory dividend regulations, but Shanghai is the only one where companies can either pay the dividend, or outline a rationale and a plan to use the funds in other ways.

The measure was announced by state regulator, the China Securities Regulatory Commission, in January 2013 and affected the dividend payouts of listed companies from the 2012 fiscal year onwards.

The regulators were motivated by a need to restore some investor confidence in the Shanghai market, one of two stock exchanges in China and the country’s largest.

For many years, there was a strong perception that minority shareholders in Shanghai listed firms were being poorly treated by corporate insiders who were looking after their own interests and those of investors inside their immediate circle.

The comply-or-explain rules, the regulators believed, would introduce some fairness and transparency into the governance of the listed firms and give small investors greater confidence in the market and encourage more investment.

'We found that state-owned firms are more likely to comply and this is consistent with the idea that political pressure may motivate firms'

KEVIN LI

Increased costs

“We were interested in understanding if the regulation has achieved its objective of increasing dividends in an emerging market with weak investor protection and historically low dividends, and to understand what motivates firms who comply and those who explain,” says Li, who conducted the research with Wen He from UQ Business School.

“It is also possible the regulations have created unintended consequences, and that was also a key part of our research.”

Focusing on a sample of 821 firms, Li and Wen began by comparing two reporting periods on the Shanghai Exchange – the years between 2000 and 2011 before the new regulations and the period immediately afterwards from 2012 to 2014.

The data showed that the regulations had driven a rise in dividends as intended. The percentage of firms with a dividend payout ratio of 30% or above increased from 24.2% in 2011 to 54.6% in 2012.

The dividend rules were not introduced in China’s other stock market in Shenzen, and there was no change in the pattern of dividend payouts on that exchange during the same period, delivering the conclusion that in terms of dividend compliance, the Shanghai rules had had an impact. 

Further analysis showed that while many Shanghai firms increased their cash dividends, there was also a tendency for some to reduce their reported profits and therefore the total dividends they paid out.

“However, the evidence suggests that the comply-or-explain regulation did achieve its purpose of increasing dividends to outside investors,” says Li.

While this objective was achieved, the researchers did find some of the unintended consequences they were looking for, and these were not necessarily all positive.

For example, they found that firms which paid dividends were more likely to raise debt in the following year to cover the payouts, which were not able to be paid out of cash flow or retained profits. This imposed increased costs not only through interest payments, but bank fees and underwriting costs.

“The danger of this is that it increases a company’s gearing level and effectively reduces its ability to fund growth opportunities, having a negative impact on future operating performance,” says Li.

Falls in valuation

There was also a negative impact on company valuation for some firms. This was contrary to the intention of the regulations, which were seen as a way of boosting valuations because the dividends were not able to be appropriated by insiders.

In some cases, however, companies that paid dividends suffered falls in their valuations because compliance resulted in higher debt levels, higher bankruptcy risks, weak operating performance and lower future cash flows.

“We find that, overall, complying firms had a decline in valuation, suggesting that investors perceive the costs of increasing dividends as outweighing the benefits,” says Li. 

“This suggests that increasing dividends might negatively affect the performance of complying firms in the future.”

The researchers were also interested in firms’ motivation to comply. China is a 'command-and-control' economy and one of the drivers for compliance could be political pressure.

“We found that state-owned firms are more likely to comply and this is consistent with the idea that political pressure may motivate firms,” says Li.

Another category of firms which complied and paid dividends were firms with high levels of management ownership, and where management was also the beneficiaries of higher dividends.

Companies where the agency costs were high, where other managers who did not necessarily hold equity put their own financial interest above those of shareholders, were less likely to comply and more likely to take the 'explain' option.

'In many cases compliance is undermining the ongoing sustainability of companies'

KEVIN LI

Operational performance

Another issue which arose from the 'explain' option was one of strategic disclosure. If companies chose to retain funds and use them on investment, their explanations could effectively be giving away their strategic plans to competitors and give them an opportunity to respond, to the detriment of the disclosing company.

The main impact, however, was on the companies that complied. For them, the cost of compliance was significant and varied, often resulting in higher debt and impacting negatively on future performance.

“In many cases compliance is undermining the ongoing sustainability of companies, because they are taking on debt which prevents them sustaining their earnings into the future,” says Li.

The original purpose of the regulation was to protect small minority investors, but in a scenario where the cost of regulation is hampering operational performance the final outcome is problematic.

Compliance with the regulation was a distortion that could make companies more immediately attractive to investors, but in complying many companies were compromising their future performance.

“If the investors see firms paying high dividends they might be attracted to that, but they need to understand it is driven largely by regulation, and is not necessarily a true measure of performance,” Li.

“So investing in those companies may not be such a good thing, and investors should perhaps be wary of companies which comply.”