It is a Sweetheart of a Deal: Political Connections and Corporate‐Federal Contracting

• Author: David Javakhadze,Stephen P. Ferris,Reza Houston
• Date: 01 February 2019
• DOI: http://doi.org/10.1111/fire.12181
• Published date: 01 February 2019

The Financial Review 54 (2019) 57–84

It is a Sweetheart of a Deal: Political

Connections and Corporate-Federal

Contracting

Stephen P. Ferris∗

University of Colorado, Colorado Springs

Reza Houston

Ball State University

David Javakhadze

Florida Atlantic University

Abstract

We examine whether political connections measured by political contributions influence

the choice of terms included in government contracts awarded to firms. We construct an index

of four “sweetheart” contract terms and find that firms making larger political contributions

more frequently have these favorable terms included in their contracts. We also find that po-

litical contributions have explanatory power for contract design after controlling for lobbying,

negotiation power, and the employment of former government employees. These results are

robust to alternative model specifications, different estimation techniques, various variable

measurements, and adjustments for possible endogeneity.

Keywords: contracting, political connections

JEL Classifications: G32, G38, GT34

∗Corresponding author: College of Business, University of Colorado, Colorado Springs, CO 80918;

E-mail: ferriss@missouri.edu.

Weare grateful for the helpful comments and suggestions by the participants of the 2017 Southern Finance

Association Annual meeting. We also thank the Center for Responsive Politics for providingthe data on

PACcontributions.

C2019 The Eastern Finance Association 57

58 S. P.Ferris et al./The Financial Review 54 (2019) 57–84

A sweetheart deal or sweetheart contract is an abnormally favorable contractual

arrangement.

—–Wikipedia

1. Introduction

A growing literature in finance and economics examines the role of political con-

nections on business behavior and value. Political connectedness can improve access

to government resources and consequently benefit the firm. Existing research shows

that political connections influence corporate acquisition activity (Ferris, Houston

and Javakhadze, 2016), litigation process and outcomes (Abdulmanova, 2016), Se-

curities and Exchange Commission enforcement (Correia, 2013), access to capital

and loan pricing (Claessens, Feijen and Laeven, 2008; Infante and Piazza, 2014),

and stock returns (Cooper, Gulen and Ovtchinnikov, 2010). Alternatively,the intense

competition for government contracts can produce an equilibrium where the govern-

ment receives financial gains, aggravatesagency problems within a firm, and reduces

long-term corporate performance (e.g., Dixit, Grossman and Helpman, 1997; Fan,

Wong and Zhang, 2007).

In this study, we expand the contracting literature by investigating the potential

impact of political connections on federal contracting. More specifically,we examine

whether the presence of political connections extends beyond influencing the awardof

government contracts as reported by Goldman, Rocholl and So (2013) and affects the

contract terms themselves. That is, we explore whether a firm’s political connections

result in the inclusion of contract terms that are highly favorable to the firm and

less apparently so for the government. To undertake our analysis, we construct an

index of four contact terms that we believe are highly favorable to the firm, but not

obviously advantageous to the government. We refer to this index as the “sweetheart

index” since it reflects the extent to which the contract is a “sweetheart” deal. We

then examine the extent to which a firm’s political connections influence the level of

this index.

Our empirical analysis undercovers a number of important relations between

political connections and contracting activity. We confirm that politically connected

firms receive more government contracts. More importantly, we find that the likeli-

hood of “sweetheart” provisions in federal contracts is increasing in political contribu-

tions. We further show that campaign contributions continue to possess explanatory

power after controlling for other political activities such as lobbying and the em-

ployment of former government employees. Our results suggest that Political Action

Committee (PAC) donations provide a unique channel for social connections and the

mutual exchange of favors between a firm and government officials. Our findings

are robust to various model specifications, estimation techniques, and alternative

measurements of key variables.

We use several strategies to overcome possible endogeneity challenges. First,

we follow Akey (2015) and examine the effects of donations made to winning and