Political Connections and the Informativeness of Insider Trades

• Author: GAIZKA ORMAZABAL,DAVID F. LARCKER,DANIEL J. TAYLOR,ALAN D. JAGOLINZER
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/jofi.12899
• Published date: 01 August 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 4 •AUGUST 2020

Political Connections and the Informativeness of

Insider Trades

ALAN D. JAGOLINZER, DAVID F. LARCKER, GAIZKA ORMAZABAL,

and DANIEL J. TAYLOR∗

ABSTRACT

We analyze the trading of corporate insiders at leading financial institutions during

the 2007 to 2009 financial crisis. Wefind strong evidence of a relation between political

connections and informed trading during the period in which Troubled Asset Relief

Program (TARP) funds were disbursed, and that the relation is most pronounced

among corporate insiders with recent direct connections. Notably, we find evidence

of abnormal trading by politically connected insiders 30 days in advance of TARP

infusions, and that these trades anticipate the market reaction to the infusion. Our

results suggest that political connections can facilitate opportunistic behavior by

corporate insiders.

AN EXTENSIVE EMPIRICAL LITERATURE EXAMINES the relation between managers’

political connections and firm value. Most of this research suggests that po-

litical connections are associated with a wide range of shareholder benefits,

including preferential access to capital and an increased likelihood of win-

ning government procurement contracts (e.g., Faccio (2006), Goldman, Rocholl,

∗Alan D. Jagolinzer is with the Judge Business School at University of Cambridge. David F.

Larcker is with the Graduate School of Business at Stanford University. Gaizka Ormazabal is

with the IESE Business School at University of Navarra. Daniel J. Taylor is with the Wharton

School at University of Pennsylvania. We thank Stefan Nagel (editor), an anonymous associate

editor, two anonymous reviewers, and seminar participants at Cornell, Northwestern, SUNY-

Binghamton, TexasA&M, UC-Davis, University of Chicago, University of Minnesota, University of

Southern California, University of Utah, and the Securities and Exchange Commission. We thank

Joseph Grundfest and several officials at the U.S. Treasury, Federal Bureau of Investigation,

and Department of Justice for helpful comments and suggestions. We thank Michelle Gutman,

Adam Bordeman, Vikram Dhawam, John Kepler, Richard Knapp, Alex Yuan, Jessica Weber, and

Ruizhong Zhang for outstanding research assistance, and Ran Duchin and Denis Sosyura for

sharing their data on political connections. We thank our respective schools for financial support,

and acknowledge funding from the Winnick Family Faculty Fellowship at Stanford University,

the Marie Curie and Ramon y Cajal Fellowships at IESE, and the Dean’s Research fund at The

Wharton School. We have read The Journal of Finance’s disclosure policy and have no conflicts of

interest to disclose. Data on TARP application amounts and dates used in the paper were obtained

from the U.S. Treasury and are provided in the Internet Appendix that is available in the online

version of the article on The Journal of Finance website.

Correspondence: Daniel J. Taylor, Wharton School, University of Pennsylvania, Philadelphia,

PA 19105; e-mail: dtayl@wharton.upenn.edu.

DOI: 10.1111/jofi.12899

C2020 the American Finance Association

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1834 The Journal of Finance R

and So (2009), Cooper, Gulen, and Ovtchinnikov (2010)). However, while the

shareholder benefits of political connections are well documented, evidence

on whether political connections facilitate opportunistic behavior by man-

agers and directors (hereafter “corporate insiders”) is scarce. In this paper,

we examine whether political connections facilitate one particular form of

opportunism—informed trading.1

We examine the relation between political connections and informed trading

by corporate insiders within the context of government intervention during the

2007 to 2009 financial crisis. The unprecedented magnitude of the interven-

tion, the substantial impact of the intervention on firm value, and the political

nature of the intervention provide a powerful setting in which to examine our

research question. It is now well known that deliberations on government in-

tervention took place largely in private meetings between government officials

and corporate insiders of leading financial institutions. Moreover, details re-

garding the application and qualification process for funds from the Troubled

Asset Relief Program (TARP) were not publicly disclosed, and political con-

nections appear to have played a role in the allocation of these funds (e.g.,

Sorkin (2009), Duchin and Sosyura (2012)). Thus, politically connected insid-

ers at leading financial institutions were in a position to be disproportionately

privately informed about the scope of government intervention and how this

intervention would affect their firms, for example, through the receipt of any

forthcoming TARP monies.

While there are good reasons to suspect that politically connected insiders

had private information in this setting, it is not obvious that insiders would

trade based on this information. Opportunistic use of political connections for

personal gain carries significant risks. For example, unlike other market par-

ticipants, corporate officers and directors have a fiduciary duty to shareholders

to “disclose or abstain (from trading),” that is, if officers or directors had private

information that their firm would receive government monies, their fiduciary

duty requires that they either disclose that information or abstain from trading

until such time as the information becomes public. In this regard, our tests are

joint tests that political connections provide an information advantage and that

insiders trade based on this advantage. We expect the former—the opportunity

for informed trading—to be more pronounced during the crisis than during

other periods.

We examine the relation between political connections and the trading of

corporate insiders using a comprehensive sample of all open market purchases

and sales of Section 16 officers and directors (“insiders”) at 497 publicly traded

financial institutions (“banks”) between 2005 and 2011. Following prior re-

search, we identify political connections based on whether a board member

has current or previous work experience at the Federal Reserve, Treasury

1Throughout the paper, we use the term “insider” or “corporate insider” to refer to officers and

directors covered by Section 16(b) of the Securities and Exchange Act of 1934, which requires that

such insiders disclose their trades on Form 4 filings with the Securities and Exchange Commission

(SEC).

Political Connections and the Informativeness 1835

Department, Congress, or a bank regulator (e.g., Office of Comptroller of Cur-

rency [OCC], Office of Thrift Supervision [OTS], or Federal Deposit Insurance

Corporation [FDIC]). We then measure the “informativeness” of insider trades

based on their predictive ability for future performance.

We begin our analysis by examining trades prior to the crisis. Consistent

with the notion that managers were unable to predict the effect of the forth-

coming crisis on their firm (e.g., Fahlenbrach and Stulz (2011)), we find no

evidence that insider trades predict future performance over the 24 months

leading up to the crisis or during the crisis period before the creation of

TARP (i.e., prior to October 2008). Moreover, we find no evidence of a rela-

tion between political connections and informed trading during either period.

These findings are consistent with the notion that when political connections

play less of a role in influencing firm-level outcomes (e.g., prior to large-scale

government intervention), they also play less of role in influencing trading

decisions.

In contrast, over the nine months after the creation of TARP (i.e., the period

over which TARP funds were disbursed), we find a sharp increase in the pre-

dictive ability of insider trades for future performance. During this period, the

average one-month-ahead future return following purchases (sales) is 1.84%

(−2.87%), a difference of 4.71%. Strikingly, we find that the increase in predic-

tive ability is concentrated almost entirely in the trades of politically connected

insiders. During the period over which TARP funds were disbursed, the differ-

ence in one-month-ahead future returns between purchases and sales of insid-

ers with (without) political connections is both economically and statistically

significant, at 8.89% (2.81%).2

These findings are robust to a battery of sensitivity analyses, for instance,

using various fixed effect structures to control for firm-specific characteristics,

changes in market conditions, and a differential effect of market conditions

on firms with and without politically connected insiders. Our analyses suggest

that within a given firm, those officers and directors with political connec-

tions significantly outperformed their peers during the crisis. These results

are consistent with political connections providing insiders with an informa-

tion advantage, and with insiders opportunistically trading to exploit that

advantage. The results indicate that political connections are more likely to

influence trading decisions during periods in which the government plays an

active role in capital markets (i.e., during periods of large-scale government

intervention).

While our findings are consistent with politically connected insiders having a

significant information advantage during the crisis and opportunistically trad-

ing to exploit this advantage, they do not speak to the source of this information

2During this period, politically connected insiders made 3,058 trades that amounted to over

$324 million in trading volume. Average trade size was $105,987 and the average trade earned

market-adjusted profits of $22,251; aggregating across all trades yields $68 million in profits.

Market-adjusted profits are calculated as the signed dollar value of the trade multiplied by the

market-adjusted buy-and-hold return over the subsequent 180 days (Ravina and Sapienza (2010),

Jagolinzer, Larcker,and Taylor (2011)).