Can Firms Build Capital-Market Reputation to Compensate for Poor Investor Protection? Evidence from Dividend Policies

The existing literature on law and finance generally assumes that firms are passive recipients of the influence of investor protections on their ability to raise external financing. In this paper, we empirically identify a commitment mechanism, i.e., dividend payouts, which firms use to establish a reputation for better treatment of outside shareholders in order to compensate for country-level weak protection of shareholders and to obtain better access to equity markets. We show that, in weak-protection countries, firms with growth prospects tend to initiate dividends earlier and pay a higher level of dividends not only as compared to their counterparts in strong protection countries but also as compared to low-growth firms in the same legal regime. As evidence of better access to capital markets, in weak-protection countries, growth firms with a good dividend history (e.g., three years of consistently high dividend payouts) attain higher stock market valuation and raise more equity financing. JEL Classification: