The Effect of Fiduciary Standards on Institutions' Preference for Dividend‐Paying Stocks

Many researchers apparently believe that some institutional investors prefer dividend-paying stocks because they are subject to the “prudent man” (PM) standard of fiduciary responsibility, under which dividend payments provide prima facie evidence that an investment is prudent. Although this was once accurate for many institutions, during the 1990s most states replaced the PM standard with the less-stringent “prudent investor” (PI) rule, which evaluates the appropriateness of each investment in a portfolio context. Controlling for the general decline in dividend-paying stocks, we find that institutions reduced their holdings of dividend-paying stocks by 2% to 3% as thePIstandardspreadduringthe1990s.Studiesofassetpricingandcorporategovernanceshould no longer consider dividend payments when evaluating the actions of institutional investors. Institutional investors play a prominent role in US equity markets by making investment choices on behalf of many savers. These institutions’ share of US equity ownership has risen from 11% in 1960 to more than 50% in 2000, and they account for an even larger proportion of equity trading volume (Griffin, Harris, and Topaloglu, 2003). Historically, a “prudent man” (PM) standard of fiduciary care caused some institutional investors to avoid holding shares that did not pay cash dividends. The PM standard judged the appropriateness of each security position on a stand-alone basis, and the payment of regular dividends became a “safe harbor” indicator of a stock’s “prudence.” The literature contains clear evidence that the PM standard caused bank trust departments to shun non-dividend-paying stocks (Del Guercio, 1996; Schanzenbach and Sitkoff, 2007). Moreover, PM restrictions probably had effects far beyond their narrow applicability to trusts. Legal precedents encouraged other fiduciaries to make similar choices as protection against judicial review of their investment decisions. Yet during the 1990s, most states replaced the PM standard of fiduciary care with the less-stringent “prudent investor” (PI) standard, which evaluates the appropriateness of each investment in a portfolio context. These changes should have weakened or eliminated a restriction on many institutional investors’ opportunity sets. Given the importance of institutional investors to the equity market, researchers must understand the extent to which their behavior was (is) subject to special restrictions. Institutions are typically viewed as rational, informed, and profit-oriented investors. They can provide important For helpful comments on prior drafts of this paper, we thank Max Schanzenbach, Robert Sitkoff, Mike Ryngaert, Chuck Trzcinka, and two anonymous referees. The usual disclaimer applies. This paper was written while Nimalendran was on leave to the Securities and Exchange Commission (SEC). As a matter of policy, the SEC disclaims any responsibility for any private publication or statement of any SEC employee or commissioner. This article expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.