Journal of Corporate Finance 30 (2015) 1–10

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Journal of Corporate Finance

journal homepage: www.elsevier.com/locate/jcorpfin

Majority support of shareholders, monitoring incentive, and

dividend policy
Naoya Mori a,⁎, Naoshi Ikeda b,1
a
Nihon University, College of Commerce, 5-2-1 #429 Kinuta, Setagaya-ku, Tokyo 157-8570, Japan
b
Tokyo Institute of Technology, Department of Industrial Engineering and Management, 2-12-1 W9-51 Ookayama, Meguro-ku, Tokyo 152-8552, Japan

a r t i c l e i n f o a b s t r a c t

Article history: As an alternative version of the side-payment model, this paper presents a demonstration of how
Received 5 January 2014 the necessity of winning majority support of shareholders influences the relation between a
Received in revised form 12 October 2014 blockholder's monitoring incentive and a firm's dividend policy. When dividend-averse individ-
Accepted 13 October 2014
uals collectively hold a majority stake in a dispersed ownership structure, a dividend-seeking
Available online 28 October 2014
blockholder might be compelled to propose lower dividends than the tax-optimum to dominate
the zero-dividend proposal. Under such circumstances, the blockholder has an incentive to
JEL classification: provide unprofitable monitoring activity as long as the private benefits of tax-saving are greater
G35
than the pecuniary loss from the monitoring activity.
G32
© 2014 Elsevier B.V. All rights reserved.
G34
Keywords:
Ownership structure
Corporate governance
Tax preferences

1. Introduction

The existence of a blockholder can be an effective corporate governance mechanism for resolving free-rider problems among
shareholders. Grossman and Hart (1980) argue that a small investor has insufficient incentive to monitor the firm managers' discre-
tion because collecting monitoring costs on personal accounts is usually impossible. Therefore, investors with small shareholdings
have a strong incentive to free-ride the benefits of other shareholders' monitoring activities in a dispersed ownership structure. In
contrast, holders of sufficiently large stakes find it profitable to discipline managers to enhance the firm's value.2
Individual investors with small shareholdings and corporate and institutional investors with large shareholdings are mutually
complementary because these two players are expected to have different capabilities. Individuals as a group typically have a majority
stake in a dispersed ownership structure. For that reason, they can force the firm to distribute favored amounts of dividends. Further-
more, they can remove managers for lack of concern. Nevertheless, they have insufficient capability of evaluating managers' perfor-
mance properly. In contrast, corporations and institutions have excellent monitoring capability and hold sufficiently large stakes to
collect monitoring costs on personal accounts. Nevertheless, it is impossible for them to affect the payout policy without depending
on individuals' voting power in a dispersed ownership structure.

⁎ Corresponding author. Tel.: +81 3 3749 6833; fax: +81 3 3417 1681.
E-mail addresses: [email protected] (N. Mori), [email protected] (N. Ikeda).
1
Tel.: +81 3 5734 3606.
2
According to Shleifer and Vishny (1997), a minority shareholder whose stake in a firm is 10–20% has sufficient incentive to gather information and to act as a mon-
itor of management. Admati et al. (1994) and Maug (1998) argue that investors with large shareholdings tend to engage in monitoring activities in spite of the fact that
investors with small shareholdings enjoy the benefits as free-riders.

http://dx.doi.org/10.1016/j.jcorpfin.2014.10.015
0929-1199/© 2014 Elsevier B.V. All rights reserved.
2 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10

In this line of argument, two important models are useful to examine the relation between dividend policy and monitoring incen-
tives of corporate and institutional investors. Shleifer and Vishny (1986) hypothesize that small individual investors compel the firm
to distribute dividends as inducements to large corporate investors to become owners of the firm as monitors. Similarly, Allen et al.
(2000) present a model including the assumption that institutional investors who are attracted to dividend-paying stocks mitigate
agency conflicts between shareholders and managers. Within these models, based on corporate/institutional investors' tax prefer-
ences, positive dividends serve as a side payment from individuals who delegate monitoring tasks to the blockholder. Benefits from
monitoring activities are distributed among all shareholders.
However, these models incorporate the assumption that individual investors are homogeneous. Shleifer and Vishny (1986) dem-
onstrate that positive dividend policy is acceptable as long as the individuals' tax burden, considered collectively, is less than the added
value attributable to a blockholder's monitoring service. Allen et al. (2000) assume two groups of investors (i.e., individuals and insti-
tutions), and consider dividend policy from the perspective of two representative investors. In each group, all investors are identical.
In reality, individual investors are heterogeneous in the sense that they have different marginal tax rates, although their tax-
optimal dividends are unanimously zero. Because of the difference of tax status, as our model reveals, the dividend level at which
an individual investor switches her approval from the zero-dividend proposal to the monitoring-based dividend proposal is not iden-
tical to the dividend level at which another individual investor switches. Given a proposal with a certain level of dividend payment,
some individuals support this, but other individuals do not. To control dividend policy, a dividend-seeking blockholder must win
the majority support of shareholders.
Earlier models have not examined the effects of internal conflicts among individual investors on the size of monitoring activity pro-
vided to a firm. Shleifer and Vishny (1986) regard the added value as exogenous, and do not derive the optimization condition of a
blockholder's monitoring service. Although Allen et al. (2000) demonstrate the optimum, they do not consider the influence that
the necessity of winning the majority support of shareholders exercises on it. Eckbo and Verma (1994) show that shareholders
with large holdings use voting power on dividend policy in an attempt to impose costs on other shareholders. The level of dividend
payments varies with the relative voting power of different shareholders (corporations/institutions versus manager–owners in
their analysis) who have opposite preferences (i.e., higher dividends versus lower dividends). Nevertheless, their concern is not the
blockholder's monitoring incentive.
This paper presents an alternative version of the side-payment model of dividend policy. Our concern is to examine how the
necessity of obtaining majority support of shareholders influences the relation between a blockholder's monitoring incentive and
the level of dividend payment. The model development presented in this paper reveals that the optimal level of monitoring activity
depends not only on the blockholder's monitoring efficiency, but also on the tax status of the median shareholder, who casts the
deciding vote on the blockholder's dividend proposal.
First, the model presented herein formulates that the winning proposal in a majority-rule voting contest determines the level of
dividend payment. Assuming conditions of dispersed ownership, a dividend-seeking blockholder competes against the zero-
dividend proposal for tax-savings benefits. To increase the number of votes they receive from dividend-averse individual investors,
the blockholder might be compelled to propose lower dividends than the tax-optimum level. Such a concession engenders lower
dividend payments under the assumption that individual investors as a group have a majority stake in the firm.
Second, we examine the blockholder's incentive compatibility condition. It makes no sense for a blockholder to compromise on the
dividend level if accepting the zero-dividend proposal becomes the better alternative. On such an occasion, the blockholder loses an
incentive to offer monitoring services for the benefit of all shareholders. An inefficient blockholder gives up controlling dividend
policy, but an efficient blockholder dominates the zero-dividend proposal.
Third, we derive the maximization condition of a blockholder's after-tax return from monitoring activity and dividend policy. The
analysis demonstrates that monitoring activity not only adds market value to the firm; it also alters individual investors' voting behav-
ior, and thereby influences a blockholder's tax burden. The dividend-seeking blockholder has an incentive to provide unprofitable
monitoring activity if the private benefits of tax-saving are greater than the pecuniary loss from the monitoring activity. Therefore,
the optimal degree of monitoring activity becomes greater.
The remainder of this paper is organized as follows. Section 2 presents the model structure. Section 3 describes development of the
model. Section 4 shows some theoretical and empirical implications of our model for future studies. Finally, Section 5 concludes this
paper with a summary of these arguments.

2. Model structure

We assume that investors hold all types of stocks to benefit fully from risk diversification. Generally speaking, a portfolio with
fewer assets implies a higher-risk portfolio. The complete exclusion of sub-optimal dividend-paying stocks therefore engenders
ineffective diversification. Risk-averse investors would be expected to assign priority to risk-sharing rather than single-mindedly
pursuing tax-saving opportunities. This tendency is expected to be the central cause of insufficient clientele effects of dividends.3
By assumption, heterogeneous shareholders, who are expected to have different tax preferences, are expected to hold shares in a
firm. Therefore, internal disagreement would emerge around the issue of the dividend payment level. In such a situation, investors
might pursue minimization of tax burden to the greatest degree possible. Nevertheless, preventing the waste of resources attributable
to inefficient corporate governance might pose a more severe problem than tax saving. Our concern is to consider the effects of

3
For example, Richardson et al. (1986) investigate trading volume around the announcement date of changes in dividend policy. They conclude that shareholder
clientele adjustments are small. Eckbo and Verma (1994) present evidence of stable shareholder clientele over time using data of Canadian firms.
 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10 3

internal conflicts between individual investors on the blockholder's monitoring incentive and the level of dividend payments. To
concentrate on this issue, we are not concerned with the effect of uncertainty. In addition, debt financing is assumed away.
Investor i's tax burden fluctuates in response to the dividend payment change. Under many prevailing tax codes, marginal tax rates
on dividends tiD are higher for individual investors, but they are lower for corporate investors. Conversely, marginal tax rates on capital
gains tiG are usually higher for corporate investors, but are lower for individual investors. Based on static tax-clientele framework (e.g.
Allen and Michaely, 2003), individual investors (i.e. tDi N tGi) prefer lower dividends whereas corporate investors (i.e. tDi b tGi) prefer
higher dividends.4 Taxed institutions belong either to the category of individuals or to the category of corporations.5
As Shleifer and Vishny (1986) have done, this study analyzes a set of circumstances in which only one blockholder can undertake a
monitoring function in a firm. Concretely, this model incorporates a dividend-seeking blockholder x (i.e. tDx b tGx) competing against the
zero-dividend proposal in a majority-rule voting contest. The case of a dividend-averse blockholder (i.e. tDx N tGx) or a tax-exempt
blockholder's (i.e. tDx = tGx = 0) undertaking is discussed later in Section 4. Within the model presented herein, individual investors
collectively have a majority stake in a dispersed ownership structure by assumption, which implies that a single corporate or
institutional investor cannot control the firm's dividend policy without asking for individual investors' approval.
Regarding tax-savings, dividend-averse individuals (i.e. tDi N tGi) unanimously support the zero-dividend policy. In this context,
dividend-seeking blockholder x (i.e. tDx b tGx) is burdened with higher taxes. It is rational for blockholder x to offer monitoring services
for the benefit of all shareholders, provided that individuals compromise on the level of dividend payment. Even if individuals as a
group command a majority vote, they might find it reasonable to tailor positive dividend payments to satisfy blockholder x's prefer-
ences instead of their own tax-minimizing zero-dividend policy. This setting is identical to that of the central ideas presented by
Shleifer and Vishny (1986) and by Allen et al. (2000).
The model developed in this paper comprises three decisions. First, all shareholders determine the firm's dividend policy in a
majority-rule voting contest. Second, a blockholder chooses the level of monitoring activity in a firm. Third, the blockholder decides
whether it is favorable to undertake a monitoring function or not. To determine the optimal level of monitoring activity, the dividend
level at which the blockholder wins a voting contest is necessary information. Similarly, the dividend level at which the blockholder
gives up undertaking a monitoring function is necessary. Therefore, our analysis proceeds first by consideration of a majority-rule
voting contest.
The algebraic symbols used for this study are presented below.

G accrued capital gain in a firm with no monitoring activities, G N 0

Mx level of monitoring activity in the firm provided by blockholder x, Mx = 0 or Mx N 1;
α blockholder x's efficiency in monitoring activity, 0 b α b 1 / 2
v(Mx) market value added to the firm by blockholder x, v(Mx) = (1 / α)Mαx
γ marginal cost of monitoring activity, γ N 0;
Dx monitoring-based dividend proposal by blockholder x in the firm, 0 ≤ Dx ≤ G + v(Mx)
θ percentage of investor's shareholdings in the firm, 0 b θ b 1
tD marginal tax rate on dividend income, 0 b tD b 1
tG marginal tax rate on accrued capital gain, 0 b tG b 1
R after-tax return, R N 0

3. Model

In Section 3.1, we formulate that a dividend-seeking blockholder competes against the zero-dividend proposal in a majority-rule
voting contest. In Section 3.2, we consider the blockholder's incentive compatibility condition, with a demonstration that the firm
distributes positive dividends in general if the dividend-seeking blockholder takes a monitoring position. In Section 3.3, we assess
the process by which the optimal level of monitoring activity is derived.

3.1. Voting contest

The model presented herein formulates that the winning proposal in a majority-rule voting contest determines the level of the
dividend payment. Each investor chooses between the monitoring-based dividend proposal D = Dx by a blockholder x and the
zero-dividend proposal D = 0 as the initial consensus of dividend-averse individual investors.
Similarly to that described by Allen et al. (2000), the Mx unit of the monitoring activity provided by blockholder x adds market
value of v(Mx) = (1 / α)Mαx to the firm, where 0 b α b 1 / 2 (i.e., v′(Mx) N 0, v″(Mx) b 0). The optimization problem of monitoring service

4
Within an intertemporal setting, Mori (2010) demonstrates that corporate investors prefer consumption-optimal dividends that are consistent with their liquidity
needs because excessive payment causes intertemporal double taxation on reinvested dividend income. Based on this view, corporate investors do not necessarily pre-
fer higher dividends. Nevertheless, it is not our purpose to argue this point here. Therefore, we assume that corporate investors simply prefer higher dividends based on
a traditional tax-preference view.
5
Institutional investors do not face the same tax status. See, for example, Desai and Jin (2011) for several methods of categorization. According to them, about 40% of
institutions were dividend-averse during 1981–1997.
4 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10

is examined later in Section 3.3. For the moment, the level of monitoring activity Mx is regarded as an exogenously assigned
parameter.
When the firm adopts a zero-dividend policy (i.e. D = 0), the after-tax return of individual investor i (i.e. tiD N tiG) in this case is R0i,
as expressed in Eq. (1). By assumption, the zero-dividend proposal has no monitoring activity (i.e. v(0) = 0).


i i i
R0 ¼ 1−t G θ G ð1Þ

In contrast, when the firm adopts a monitoring-based dividend policy (i.e. D = Dx), individual investor i's (i.e. tiD N tiG) after-tax
return is Rim, as shown in Eq. (2).6 The added value (1 / α)Mαx attributable to a blockholder x's monitoring service is a shared benefit
for all shareholders. In addition, individual investor i's extra tax burden is (tiD − tiG)θiDx.

   
1


i i i α i i i
Rm ¼ 1−t G θ G þ Mx − t D −t G θ Dx ð2Þ
α

Shareholders, each of whom is assumed to have one vote for each share held, support a policy that proposes a higher after-tax re-
turn. It is noteworthy that individual investors are heterogeneous because of different marginal tax rates. If Rim N R0i, then individual
investor i votes for a monitoring-based dividend proposal (i.e. D = Dx). In contrast, if Rim b R0i, then individual investor i votes for the
zero-dividend proposal (i.e. D = 0).
Although the better course of winning for blockholder x is to receive D = G + (1 / α)Mαx , such a favorable plan is not usually equiv-
alent to a policy that gains a majority vote. As a concession, lowering the level of dividend proposal increases the number of individual
investors i (i.e. tiD N tiG), whose status switches to Rim N R0i. When arranging all shareholders according to the level at which they switch
their votes, the shareholder in the middle casts the deciding vote. That is to say, blockholder x's victory hinges upon the median
shareholder's vote. Individual investors in these analyses have a majority stake as a group. Therefore, the median shareholder is a
dividend-averse individual investor.
The condition of the median shareholder's (i.e. i = μ) support for blockholder x's dividend proposal (i.e. D = Dx) is expressed in
Eq. (3) as follows. Given the monitoring value (1 / α)Mαx , Dμx is defined as the dividend level at which blockholder x seizes the median
shareholder μ's vote from the zero-dividend proposal, as Fig. 1 shows. It depends on the magnitude of blockholder x's monitoring ac-
tivity and the median shareholder μ's tax status.
 
 μ 1
1−t G Mx α
μ μ α  μ
Rm ≥R0 ⇔Dx ≤ μ μ ≡ Dx ð3Þ
t D −t G

Given monitoring value (1 / α)Mαx attributable to a blockholder x's monitoring service, the after-tax return Rμm of median sharehold-
er μ (i.e. t μD N tGμ ) is negatively related to blockholder x's dividend proposal Dx. If blockholder x proposes Dμx, then median shareholder μ
switches her vote to the monitoring-based dividend proposal (i.e. D = Dx) from the zero-dividend proposal (i.e. D = 0).
Consequently, the monitoring-based dividend proposal Dw x which can just dominate the zero-dividend proposal is expressed in
Eq. (4) as follows: the winning point. For Dxμ b G + (1 / α)Mαx , if blockholder x proposes Dxμ, then the median shareholder μ switches
μ μ α
her vote to the monitoring-based proposal (i.e. Dw x = Dx ). In contrast, if Dx ≥ G + (1 / α)Mx , then blockholder x wins the voting contest
α
by proposing x's tax-optimal dividend with no concession [i.e. Dw x = G + (1 / α)Mx ].

   
w μ 1 α
Dx ¼ min Dx ; G þ Mx ð4Þ
α

Proposition 1. To win a voting contest against the zero-dividend proposal (i.e. D = 0), dividend-seeking blockholder x (i.e. tDx b tGx) must
μ μ
propose the monitoring-based dividend proposal (i.e. D = Dw
x ) by which blockholder x seizes median shareholder μ's (i.e. t D N t G) vote from
the zero-dividend proposal.

This analysis is an application of the famous two-party model of public choice. According to the median voter theorem in political
competition (e.g., Black, 1948 and Downs, 1957), a dominant position exists at the median in majority-rule voting on a single issue if
all voters' preferences are single-peaked. In general, the possibility exists that multiple-peaked preferences engender impossibility in
identifying a dominant position, which is the voting paradox.7 The voting paradox does not arise in the model presented herein be-
cause all shareholders' preferences are single-peaked. The additional value coming from monitoring services is constant by assump-
tion. In addition, this is majority-rule voting on a single issue. Therefore, it can be modeled as a simple one-dimensional choice.

6
When a firm distributes positive dividends Dx as a whole, investor i's dividend income is (1 − tiD)θiDx on an after-tax basis, whereas ex-dividend capital gains are
(1 − tiG)θi{G + (1 / α)Mαx − Dx} on an after-tax basis. Rearranging these two components, we obtain Eq. (2).
7
See, for example, Hirshleifer et al. (2005) for a brief discussion of the voting paradox.
 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10 5

1
1−

Fig. 1. Dividend level at which blockholder x seizes median shareholder μ's vote from the zero-dividend proposal.

3.2. Incentive compatibility

We are now ready to consider blockholder x's (i.e. tDx b tGx) incentive compatibility condition. Of course, it makes no sense for
blockholder x to compromise on the dividend level if it becomes more favorable to accept the zero-dividend proposal D = 0.
Under such circumstances, blockholder x loses incentive to offer monitoring services for the benefit of all shareholders.
If blockholder x accepts the zero-dividend proposal (i.e. D = 0), then blockholder x's after-tax return R0x is expressed in Eq. (5) as
follows. By assumption, the zero-dividend proposal is with no monitoring activity (i.e. Mx = 0). Although blockholder x usually bears a
heavier excess tax burden, the monitoring cost is reduced.

x  x x
R0 ¼ 1−t G θ G ð5Þ

However, if blockholder x undertakes a monitoring function (i.e. D = Dx), then blockholder x's after-tax return Rxm is expressed in
Eq. (6) as follows. The monitoring activity provided by blockholder x adds market value of (1 / α)Mαx . The added value is a shared ben-
efit for all shareholders. In contrast, the monitoring cost γMx is the expenditure on personal account only for blockholder x. The tax
burden is eased by virtue of the blockholder's control over dividend policy.

   
x  x x 1 α x x x
Rm ¼ 1−t G θ G þ M x −γMx þ t G −t D θ Dx ð6Þ
α

Therefore, if R xm ≥ R0 x , then blockholder x wishes to undertake a monitoring function. Conversely, if Rxm b R0 x , then
blockholder x loses incentive to control dividend policy. The incentive compatibility condition of blockholder x is expressed
in Eq. (7) as follows. Here, Dgx is defined as the dividend level proposed by blockholder x when blockholder x gives up under-
taking a monitoring function, which demonstrates that the giving-up point depends on monitoring activity and blockholder x's
tax status.
 
 1
γM x − 1−t xG θx Mx α
x x α  g
Rm ≥R0 ⇔Dx ≥ x ≡ Dx ð7Þ
t G −t xD θx

The current analysis suggests that seemingly unprofitable monitoring activities also make sense as long as the private benefits of
tax-saving are greater than the pecuniary loss from the monitoring activity. As Fig. 2 portrays, if γMx ≥ (1 − txG)θx(1 / α)Mαx , then
Rxm ≷ R0x. Therefore, blockholder x might take a monitoring position even if the monitoring cost is higher than the added
value on personal account. In contrast, if γMx b (1 − txG)θx(1 / α)Mαx , then Rxm N R0x. Such an efficient blockholder x always under-
takes the monitoring activity, and necessarily dominates the zero-dividend proposal. In this case, monitoring activities are
profitable.
Fig. 2 presents the case of γMx ≥ (1 − txG)θx(1 / α)Mαx exclusively (i.e. Dgx N 0). Given monitoring value (1 / α)Mαx and monitoring
cost γMx, the after-tax return Rxm of blockholder x (i.e. txD b txG) decreases as the dividend proposal Dx ≥ 0 decreases. Alternatively,
blockholder x can enjoy after-tax return R0x by accepting the zero-dividend proposal D0 = 0. If Rxm b R0x, then blockholder x loses in-
centive to undertake a monitoring function.
6 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10

1
(1 − )

( − )

Fig. 2. Dividend level at which blockholder x decides to accept the zero-dividend proposal.

On deciding the firm's dividend policy D, it is reasonable for managers to be loyal to the dominant proposal because shareholders
in the winning party have sufficient power to remove managers for a lack of concern if the firm does not adopt the proposal. Based on
Eqs. (3), (4), and (7), the firm's dividend policy D is selected as expressed in Eq. (8).
 w w g
Dx if Dx NDx
D¼ w g ð8Þ
0 if Dx bDx

If Dw g w
x N Dx, then the incentive compatibility condition of blockholder x holds. In this case, when blockholder x proposes Dx , the
w w g
median shareholder μ switches her vote to the monitoring-based proposal (i.e. D = Dx ). However, if Dx b Dx, then the incentive com-
patibility condition does not hold. In this case, blockholder x accepts the zero-dividend proposal (i.e. D = 0). When a blockholder gives
up undertaking a monitoring function, the existence of large shareholdings cannot be an effective mechanism for the resolution of
free-rider problems among shareholders.

Proposition 2. If the incentive compatibility condition holds (i.e. Dw g x x

x N Dx), then dividend-seeking blockholder x (i.e. tD b tG) has an
w
incentive to undertake a monitoring function. Therefore, the monitoring-based dividend policy (i.e. D = Dx ) is adopted. Otherwise, the
zero-dividend policy (i.e. D = 0), which minimizes the tax burden of dividend-averse investors (i.e. tiD N tiG), is adopted.

3.3. Optimal monitoring activity

Although we have regarded the added value (1 / α)Mαx as an exogenously given parameter in Sections 3.1 and 3.2, this
section describes derivation of the optimum monitoring activity Mx⁎. As explained already in Section 3.1, we assume that
the Mx unit of the monitoring activity provided by blockholder x adds market value of v(M x ) = (1 / α)Mαx to the firm,
where 0 b α b 1 / 2 (i.e., v′(Mx) N 0, v″(Mx) b 0). That is to say, α denotes blockholder x's efficiency in monitoring activity.
This assumption is the same as that used by Allen et al. (2000).8
Unfortunately, if we allow the range of monitoring activity be 0 b Mx b 1, then the market value added v(Mx) = (1 / α)Mαx becomes
a monotonically decreasing exponential function of blockholder x's efficiency in monitoring activity α. To avoid this and make the
issue tractable, we assume that Mx N 1 in the case of blockholder x's undertaking a monitoring function (i.e. ∂v(Mx) / ∂α N 0), whereas
Mx = 0 in the case of no monitoring services (i.e. ∂v(Mx)/∂α = 0).
Blockholder x is assumed to maximize the after-tax return Rxm subject to Eqs. (3), (4), and (7), as shown in Eq. (9). In contrast to the
formulation presented by Allen et al. (2000), the newly added third term represents the private benefit from tax saving when under-
taking a monitoring function. The magnitude of the after-tax return depends not only on monitoring activity but also on the dividend
proposal.
   
 x x 1 α x x x w x
max 1−t G θ G þ M x −γMx þ t G −t D θ Dx ≡ Rm ð9Þ
Mx α

Differentiating Eq. (9) with respect to Mx, we obtain the first-order maximization condition of the after-tax return, as presented in
Eq. (10) as follows (i.e. ∂Rxm / ∂Mx = 0). The first term of the left-side is designated as direct effects because the monitoring activity

8
Strictly speaking, in the original formulation presented in Allen et al. (2000), the level of monitoring activity in the aggregate is an increasing function of the pro-
portion of multiple blockholders. This paper differs from theirs in terms of the assumption of a single monitor as in Shleifer and Vishny (1986). The proportion θx is not of
multiple blockholders, but of a single blockholder.
 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10 7

(1 − ) −1

+( − ) ∙

(1 − ) −1

Fig. 3. Optimal monitoring activity.

directly enhances the after-tax return Rxm. The second term is designated as indirect effects because the monitoring activity alters
dividend policy, and thereby indirectly influences the after-tax return Rxm.

 x x α−1 x x x ∂D
w
1−t G θ Mx þ t G −t D θ  x ¼ γ ð10Þ
∂Mx

When the left-side of Eq. (10) is smaller than the right-side at any Mx, the optimal level of monitoring activity must be zero as a
corner solution (i.e. Mx⁎ = 0). Otherwise it is positive as an interior solution (i.e. Mx⁎ N 1). As described in Eq. (8), if Dw g
x b Dx, then
blockholder x accepts the zero-dividend proposal (i.e. D = 0) and provides no monitoring activity (i.e. Mx⁎ = 0).
Nevertheless, we specifically examine the case in which the optimal level of monitoring activity is positive hereinafter (i.e. M⁎x N 1).
Solving Eq. (10), we obtain the optimal level as shown in Fig. 3 and Eq. (11) as follows. In this case, blockholder x's optimal monitoring
activity is an increasing function of blockholder x's monitoring efficiency (i.e. ∂M⁎ x / ∂α N 0).
9

 w 1−α
1
  x x x ∂D x
Mx ¼ 1−t G þ t G −t D  x θ =γ ð11Þ
∂M x

Fig. 3 presents the case of ∂Dw ⁎

x / ∂Mx N 0. The optimal level of monitoring activity Mx is obtained at the point where the marginal
benefit of monitoring activity, (1 − txG)θxMxα−1 + (txG − txD)θx{∂Dw x / ∂Mx}, equals the marginal cost of monitoring activity γ. Within
the area between M⁎ x
⁎ and Mx⁎, the direct effects of additional monitoring effort produce marginal losses of γ − (1 − txG)θxMxα−1.
Nevertheless, selecting M⁎ x
⁎ is not a reasonable solution because indirect effects (txG − txD)θx{∂Dw
x / ∂Mx} are not used completely.
Based on Eq. (4), if Dμx b G + (1 / α)Mαx , then blockholder x must lower the level of the dividend proposal to dominate the zero-
μ
dividend proposal (i.e. Dwx = Dx). The increased monitoring activity raises the dividend level at which blockholder x seizes median share-
holder μ's vote from the zero dividend proposal (i.e. ∂Dw x x
x / ∂Mx N 0). Subsequently, this action reduces blockholder x's (i.e. tD b tG) tax
burden. The optimal level of monitoring activity is the following.
"( μ
!) # 1  
  x x x 1−t G x
1−α
μ 1 α
Mx ¼ 1−t G þ t G −t D μ μ θ =γ if Dx bG þ Mx ð12Þ
t D −t G α

In this case, the monitoring-based dividend proposal Dw

x which can just dominate the zero-dividend proposal is rewritten from
Eqs. (4) to (13) as follows.

μ  "( μ
!) #α
w 1−t G 1  x x x 1−t G x
1−α
 μ
Dx ¼ μ μ  1−t G þ t G −t D μ μ θ =γ ≡ Dx
t D −t G α t D −t G ð13Þ
 
μ 1 α
if Dx bG þ Mx
α

However, if Dμx ≥ G + (1 / α)Mαx , then blockholder x wins the voting contest by proposing full dividends with no concession [i.e.
Dw
x = G + (1 / α)Mαx ], as demonstrated in Eq. (4). Therefore, the marginal effect of increased monitoring activity on the dividend

9
Within our model, there exists no possibility that ∂M⁎x / ∂α b 0. If {(1 − txG) + (txG − txD)(∂Dw x
x / ∂Mx)}θ is smaller than γ within Eq. (11), then the left-side of Eq. (10)
is always smaller than the right side because Mxα−1 ≤ 1 under the assumption that 0 b α b 1 / 2. In this case, no monitoring service should be provided (i.e. M⁎x = 0).
Therefore, ∂M⁎x / ∂α = 0.
8 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10

level at which blockholder x seizes median shareholder μ's vote from the zero dividend proposal is zero (i.e. ∂Dw
x / ∂Mx = 0). The op-
timal level of monitoring activity is the following.
( ) 1  
 1−t xG θx 1−α μ 1 α
Mx ¼ if Dx ≥G þ Mx ð14Þ
γ α

In this case, the monitoring-based dividend proposal Dw

x which can just dominate the zero-dividend proposal is rewritten from
Eqs. (4) to (15) as follows.

 ( )α  
w 1 1−t xG θx 1−α μ 1 α
Dx ¼ G þ if Dx ≥G þ Mx ð15Þ
α γ α

Proposition 3. As long as the indirect effects of monitoring activity [i.e. (txG − txD)θx{∂Dw x / ∂Mx}] reduces the tax burden sufficiently,
dividend-seeking blockholder x (i.e. txD b txG) has an incentive to exert additional monitoring effort in an attempt to affect firm dividend policy,
even if the direct effects of monitoring activity (i.e. (1 − txG)θxMxα−1) produce a marginal loss.

In short, a dividend-seeking corporation or institution with higher ability in monitoring activity is more likely to exercise greater
monitoring activity Mx in an attempt to raise the winning point Dw x . Comparative static analysis reveals that blockholder x's optimal
monitoring activity is an increasing function of (i) blockholder x's efficiency in monitoring activity in the case of blockholder x's un-
dertaking a monitoring function (i.e. ∂M⁎ ⁎ x
x / ∂α N 0), (ii) the percentage of blockholder x's shareholdings in firm (i.e. ∂Mx / ∂θ N 0),
⁎ x x
and (iii) the tax differential for dividend-seeking blockholder x (i.e. ∂Mx / ∂(tG − tD) N 0). However, blockholder x's optimal monitor-
ing activity is a decreasing function of (iv) the marginal cost of monitoring activity (i.e. ∂M⁎x / ∂γ b 0), and (v) the tax differential for
dividend-averse median shareholder μ (i.e. ∂M⁎ μ μ
x / ∂(tD − tG) b 0).

4. Implications

When a blockholder must make a concession to win a voting contest [i.e. Dμx b G + (1 / α)Mαx ], the necessity of obtaining majority
support reduces individuals' respective tax burdens because the blockholder must lower the dividend proposal. Benefits from this are
shared by individuals at the expense of the blockholder. Reduced dividends imply reduced side payments from individuals to the
blockholder.
Furthermore, the necessity of obtaining majority support elicits additional monitoring effort because the blockholder attempts to
raise the level of the dividend proposal. Benefits from this effect are free-ridden by individuals at the expense of the blockholder. How-
ever, individuals bear additional expenses of increased tax burdens. Additional dividends serve as additional side payments from in-
dividuals to the blockholder.
The model presented in this paper provides several empirical implications. First, the changes in ownership structure or marginal
tax rates are expected to exercise influences on dividend policy. In the case of Eq. (13), blockholder x's winning point is a decreasing
μ μ
function of dividend-averse median shareholder μ's tax differential (i.e. ∂Dw x / ∂(tD − tG) b 0). Under a system of progressive taxation,
higher income tax rates are levied on investors in the higher income group. Therefore, we predict that the level of dividend payments
is lower in firms that have many investors in higher income brackets.10 Nevertheless, testing this prediction directly would be ex-
tremely difficult because the shareholders' income distribution for each stock is unobservable.11
Second, dividend policy depends on the degree of the blockholder's monitoring efficiency. Based on Eqs. (13) and (15), a dividend-
seeking corporation or institution with higher ability in monitoring activity seizes the median shareholder's vote at a higher winning
point (i.e. ∂Dw
x / ∂α N 0). Therefore, we predict that a firm recruiting an efficient dividend-seeking monitor is more likely to distribute
higher dividends. According to Chen et al. (2007), independent institutions with long-term investment horizons are expected to have
superior monitoring abilities. Gaspar et al. (2013) report that institutions making long-term investments compel firms to pay more
dividends. Apparently, our model provides a theoretical explanation for this phenomenon.
Additionally, we predict that a firm with a high managerial stake distributes little or no dividends. In the model developed for these
analyses, we assume that a blockholder's monitoring activity mitigates agency conflicts between shareholders and managers, and
therefore increases the market value. However, if the firm has no potentially severe agency problems, then it has little room for im-
provement of its value from the blockholder's monitoring services. The less severe the agency conflict becomes, the lower the
blockholder's efficiency in monitoring activity α becomes. In this case, the possibility of satisfying condition Dw g
x b Dx and paying no
dividend is increased because the level of (1 / α)Mαx is low. Even if the condition Dw g
x N Dx is satisfied, the dividend payments adopted
by the firm with less severe agency conflicts are expected to be low (i.e. Dw x is low). Empirical results show a negative association

10
For example, Dong et al. (2005) conduct a questionnaire targeted at individual investors in the Netherlands and report that the high income group has less prefer-
ence for dividends under that system of progressive taxation.
11
Chetty and Saez (2005) find increased dividend payments after the U.S. tax reform of 2003, which reduced marginal tax rates on dividend income. Korkeamaki et al.
(2010) examine the effect of the dividend tax increase around the 2004 tax reform in Finland, and show that dividend payment decreases across all firms after the re-
form. These empirical facts are consistent with our prediction, although they are not firm level evidence.
 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10 9

between managerial ownership and the dividend payment (e.g., Ang et al., 2000; Eckbo and Verma, 1994; Jensen et al., 1992; and
Short et al., 2002).
Third, we predict that a corporation or institution with a larger tax differential is more likely to dominate the zero-dividend pro-
posal (i.e. Dw g
x N Dx). Based on Eq. (13), dividend-seeking blockholder x's winning-point is an increasing function of the tax differential
(i.e. ∂Dw x x
x / ∂(tG − tD) N 0). In contrast, based on Eq. (7), blockholder x's giving-up point is a decreasing function of the tax differential
g x x
(i.e. ∂Dx / ∂(tG − tD) b 0). This implication is the most characteristic of the current model. In a new light, our model might provide fresh
insight into the dividend controversy arena.
Fourth, the relation between a dividend-seeking blockholder's stake and the level of dividend payments is expected to be positive.
The winning-point Dw x is an increasing function of the percentage of dividend-seeking blockholder x's shareholdings in the firm (i.e.
∂Dw x
x / ∂θ N 0) because the optimal level of monitoring activity is increased with an increase in the blockholder's stake. Some empirical
studies provide evidence that the level of corporate/institutional ownership is positively associated with dividend payments
(e.g., Eckbo and Verma, 1994; Moh'd et al., 1995; and Short et al., 2002). Our model seems consistent with this empirical evidence.
Fifth, asymmetric information between managers and investors might influence dividend policy. For example, we predict that a
blockholder of a firm in R&D intensive industry confronts a higher marginal cost of monitoring activity because of more severe asym-
metric information. The winning-point Dw w
x is a decreasing function of the marginal cost of monitoring activity (i.e. ∂Dx / ∂γ b 0). Some
empirical reports describe that R&D-intensive firms are likely to pay lower dividends, but hold more cash than non R&D-intensive
firms in an attempt to finance growth opportunities using internal funds (e.g., Bah and Dumontier, 2001; Bates et al., 2009; and
Gugler, 2003). Our prediction does not contradict these facts, although the reasons for lower dividends differ.
Some empirical studies have revealed that corporate and institutional ownership does not induce firms to increase dividends.
Grinstein and Michaely (2005) report that institutional investors tend to prefer low dividends to high dividends overall. Barclay
et al. (2009) report that corporations and institutions are not attracted to high-dividend paying stocks. Desai and Jin (2011) find no
evidence that corporations affect firm dividend policy, although they do find that managers alter their dividend policy to serve the
interests of dividend-averse institutions.
As described in this paper, a dividend-seeking blockholder's monitoring incentive is an increasing function of a firm's dividend
payment because a corporate or a dividend-seeking institution in a traditional tax-preference framework is assumed to prefer higher
dividends monotonously (e.g. Allen and Michaely, 2003). Within such a one-date framework, it might be puzzling that dividend-
seeking investors do not cause firms to increase dividend payments, in contrast to the intuitive case of dividend reduction tailored
for dividend-averse investors. Grinstein and Michaely (2005) and Barclay et al. (2009) argue that their evidence is difficult to reconcile
with the monitoring-based theory of dividend policy (e.g., Allen et al., 2000 and Shleifer and Vishny, 1986).
Alternatively, within a two-date framework, Mori (2010) demonstrates that dividend-seeking investors prefer consumption-
optimal dividends to avoid intertemporal double taxation on reinvested dividends. Based on this view, the dividend-seeking
investor's preference for low dividend payment (e.g. Barclay et al., 2009; Desai and Jin, 2011; and Grinstein and Michaely, 2005) is
insufficient evidence to reject the monitoring-based theory of dividend policy. Although the current paper is not concerned with
intertemporal aspects of investor preferences, the possibility exists that not only the necessity of winning majority support of share-
holders but also a dividend-seeking blockholder's liquidity needs engender lower dividend payments. From the perspective of
dividend-averse individuals, a monitor might be recruited to solve the free-rider problem without using a high dividend payment
as an inducement.
As explained in Section 2, institutional investors of several types are used, although the model developed in this paper exclusively
considers a dividend-seeking blockholder (i.e. txD b txG).12 For dividend-averse individuals (i.e. tiD N tiG), recruiting a dividend-averse
blockholder (i.e. txD N txG), who also prefers zero dividends, or a tax-exempt institution (i.e. txD = txG = 0), that is indifferent to the
level of dividend payment, is apparently a more favorable alternative. This adds a higher threshold for a dividend-seeking blockholder
to succeed in undertaking a monitoring function in a firm. Conversely speaking, a positive dividend policy can be interpreted as a re-
sult of a dividend-seeking blockholder's advantage in monitoring ability over the other two types.
One might infer that the consequence of prudent-man rules is a much simpler explanation for distributing positive dividends by
firms. Some institutional investors must invest in dividend-paying stocks because of their fiduciary duties. Brav and Heaton (1998)
find that institutions tend to stop holding dividend-omitting stocks because they are sensitive to laws governing their actions. Accord-
ing to a survey by Brav et al. (2005), many financial managers pay dividends to attract institutions subject to prudent-man rules. How-
ever, the foregoing argument leaves unanswered the question of how firms determine dividend policy. Institutions might be
motivated to hold dividend-paying stocks for non-tax reasons, but a convincing criterion for determining the level of dividend pay-
ment can be provided by tax reasons, as this paper demonstrates.

5. Conclusion

According to Shleifer and Vishny (1986) and Allen et al. (2000), the existence of a corporate or institutional blockholder can be an
effective mechanism for mitigating agency conflicts between shareholders and managers in a dispersed ownership structure. Based
on a corporate or institutional investor's tax preference, positive dividends serve as a side payment from small individual investors
who delegate monitoring tasks to a dividend-seeking blockholder.

12
For example, mutual funds and investment advisors are usually regarded as dividend-averse (i.e. txD N txG) because they pass tax burdens through to their underlying
shareholders, who are typically individual investors. In contrast, banks and insurance companies are usually categorized as dividend-seeking (i.e. txD b txG) because their
own investment can benefit from a dividend tax deduction.
10 N. Mori, N. Ikeda / Journal of Corporate Finance 30 (2015) 1–10

However, existing models do not consider how the necessity of winning majority support of shareholders influences the relation
between a blockholder's monitoring incentive and a firm's dividend policy. In reality, when some individuals support a positive div-
idend policy, other individuals will prefer zero-dividend policy because they have different division points between these two alter-
natives. In this sense, they should be regarded as heterogeneous in spite of the fact that their tax-optimal dividends are unanimously
zero. For undertaking a monitoring function in a firm, a blockholder must win the majority support of shareholders who have various
marginal tax rates. This setting differs from that of previous models.
This paper presents an alternative version of the side-payment model of dividend policy. When dividend-averse individuals col-
lectively share a majority stake in a dispersed ownership structure, a dividend-seeking corporation or institution might be compelled
to propose low dividends to dominate the zero-dividend proposal. Unless the blockholder loses the incentive to undertake a monitor-
ing function, the firm gives approval to the monitoring-based dividend proposal that obtains the majority support of shareholders.
Under such circumstances, the blockholder finds it reasonable to raise the division point at which the median shareholder decides
to support. As long as the tax burden is reduced sufficiently, the blockholder has an incentive to provide unprofitable monitoring ac-
tivities in an attempt to affect firm dividend policy, even if such additional monitoring effort yields marginal losses.
The results obtained from our model present important implications for financial management and corporate governance. The op-
timal level of monitoring activity depends not only on a blockholder's efficiency in monitoring activity, but also on the median
shareholder's tax status. Benefits from additional monitoring effort are free-ridden by individuals. However, additional dividends
serve as additional side payments from individuals to the blockholder. Consequently, the mutually complementary relation between
individuals as a group and a dividend-seeking blockholder is broader than previously recognized.
Finally, we outline some important directions for future research. First, the current model can be modified to demonstrate that
multiple blockholders compete for controlling positions related to dividend policies in a firm. Second, the model presented herein
does not address the manner in which firms use share repurchases with dividend payment. This line of extension presents interesting
avenues leading to a richer analysis of payout policy. Third, empirical tests are reserved for future investigations. As Allen and
Michaely (2003) report, whether investors with large shareholdings are attracted to dividend-paying stocks or not remains as a mat-
ter that has yet to be tested empirically.

Acknowledgements

Authors wish to thank the editor (Jeffry Netter) and an anonymous referee. For helpful comments and suggestions, we also thank
Toshiki Honda, Nobuyuki Isagawa, Katsumasa Nishide, Kazuhiko Ohashi, Wataru Ohta, Takashi Shibata, Masahiko Sugie and seminar
participants at Doshisha University, Hitotsubashi University, Osaka University, Tokyo Metropolitan University, and Yokohama
National University. Financial support from Nihon University (803265-2012) and language help from Brad Fast are gratefully
acknowledged.

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