The payment of dividends imposes costs on the firm's shareholders in the form of higher taxes (relative to capital gains) and issuance costs arising from the dividend-induced need to acquire external equity, given the firm's investment and capital structure policies. Why, then, do firms pay dividends? In particular, why do the more capital intensive electric utilities have a dividend payout rate more than twice that of industrial firms? In simpler terms, why are utilities among the largest suppliers of dividends and simultaneously among the largest sellers of common stock? In this study, we provide some possible insights into the larger dividend puzzle through an empirical investigation of the seemingly extraordinary dividend payout policies of regulated electric utilities. In the face of known costs associated with dividend payments, the supply of, and demand for, dividends is rational only if off setting benefits exist. This study focuses on the possible monitoring benefits associated with high dividends as an explanation for the apparently costly payout policies of electric utilities. According to the monitoring rationale, a firm pays costly dividends to increase the likelihood that it will have to sell common stock. The issuance of new equity will trigger an investigation of the firm's decision-makers by investment banks, the securities exchanges, the SEC, and the suppliers of new capital. Thus, sufficiently high dividends will raise the probability of this capital market monitoring, thereby disciplining corporate decision-makers. This monitoring activity adds value because it reduces the agency costs from conflicts of interest between shareholders and the firm's decision-makers. In the regulated utility, shareholder welfare is affected by the decisions of managers and by the decisions of the regulatory agency supervising the utility. Thus, in addition to the standard shareholder-manager conflict, there exists a potential shareholder-regulator conflict. Regulators are charged with providing ''fair'' regulation that ensures ''confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital'' [Supreme Court decision in Federal Power Commission vs. Hope Natural Gas Co.]. However, as elected officials or political appointees, regulators may also act as ratepayers' agents, being responsive to the pressures they face to keep rates ''low.'' This view of regulation highlights the need for monitoring of the shareholder-regulator conflict. However, compared to the case of industrials, alternative mechanisms for aligning interests of shareholders and decision-makers, such as incentive-based compensation, insider holding, and takeover threat, are less prevalent for utilities and generally ineffective for controlling shareholder-regulator conflict. Thus, the role of dividends in eliciting capital market monitoring takes on increased importance in the case of regulated utilities. The issuance of dividend-induced equity when regulation is ''unfair'' to shareholders reveals publicly the regulators' failure to meet their mandate to preserve the financial integrity of the utility. Such revelations, in the form of lowered commission ranking, increased cost of capital, and reduced access to capital markets, reduce the value of the regulators' reputational capital. A knowledge of an impending underwritten equity offering will, therefore, exert pressure on regulators to provide stockholders with a fair return on their capital. Thus, in the case of electric utilities, because potential agency costs arising from shareholder-manager and shareholder-regulator conflicts are higher compared to industrials, so are the benefits from dividend-induced capital market monitoring. At the same time, the costs of such monitoring to shareholders are lower, since at least part of the issuance cost is passed on to ratepayers in the regulatory process. Two sets of empirical implications emerge from the monitoring hypothesis. First, the utility industry is expected to have a higher payout ratio than industrials, reflecting the higher marginal benefits of dividend-induced monitoring at lower marginal costs. Second, within the utility industry there should be cross-sectional regularities relating dividend payout ratio to severity of (1) the stockholder-regulator conflict, as measured by the commission ranking, with high ranking reflecting low conflict; (2) the stockholder-manager conflict, as measured by share ownership concentration; and (3) the cost of monitoring these conflicts, as measured by the utility's flotation cost of new equity. All these variables are predicted to have negative effects on the dividend payout ratios. Empirical tests carried out over two separate periods, 1981-1985 and 1986-1990, fully support both sets of predictions. The study finds support for the monitoring rationale for dividends and has relevance for both practitioners and regulators. It makes evident to the utility executive that dividend policy can be an effective tool for inducing monitoring, reducing agency costs, and increasing firm value, especially when alternative monitoring mechanisms that may be available to unregulated firms are not available or are ineffective. With regard to regulatory policy, the study clearly highlights regulation as an additional source of conflict and agency cost. Analyses of the regulation of the utility industry should consider further the benefits of reduced agency costs as an offset to the welfare loss from any potential increase in monopoly power of the utilities.
