Political Connections and the Informativeness of Insider Trades

David F. Larcker is Professor of Accounting at Stanford Graduate School of Business (Corresponding Author); Daniel J. Taylor is Harold C. Stott Assistant Professor of Accounting at The Wharton School of the University of Pennsylvania. This post is based on a recent paper authored by Professor Larcker; Professor Taylor; Alan D. Jagolinzer, Associate Professor of Accounting at University of Colorado Leeds School of Business; and Gaizka Ormazabal, Assistant Professor of Accounting and Control at University of Navarra, IESE Business School.

Our paper examines the relation between political connections and informed trading by corporate insiders within the context of the 2007-2009 Financial Crisis. The unprecedented magnitude of government intervention during the Financial Crisis, the substantial impact of the intervention on firm value, and the political nature of the intervention provide a powerful setting to examine the relation between political connections and informed trading. It is now well known that deliberations on government intervention largely took place in private meetings between government officials and insiders at leading financial institutions; details regarding the application and qualification process for funds from the Troubled Asset Relief Program (TARP) were not publicly disclosed; and political connections appear to have played a role in the allocation of these funds (e.g., Duchin and Sosyura, 2012). Thus, politically connected insiders at leading financial institutions were in a position to be disproportionately privately informed about the scope of government intervention, how this intervention would affect their firm, and details of any forthcoming TARP monies.

We examine the relation between political connections and trading of corporate insiders using a sample of open market purchases and sales of over 7,000 officers and directors (hereafter “insiders”) at 497 publicly traded financial institutions (“banks”) between 2005 and 2011. Following Duchin and Sosyura (2012), we measure an insiders’ political connections based on whether a board member has current or previous work experience at the Federal Reserve, a bank regulator (e.g., FDIC, OTS, or OCC), Treasury, or Congress, and measure the informativeness of insider trades based on their predictive ability for future performance.

Consistent with the notion that corporate insiders were unable to predict the effect of the forthcoming Crisis on their firm, we find no evidence that insider trades predict future performance over the 24 months leading up to the Crisis, or during the Crisis before the creation of TARP (i.e., prior to October 2008). In contrast, over the nine months after the creation of TARP, i.e., the period in which TARP funds were dispersed, we find that the predictive ability of insider trades for future performance is greater than during any other period in our sample. Over the entire sample period, we find that the average one-month-ahead future return following insider purchases (insider sales) is 0.23% (–0.82%), a difference of 1.05%. However, during the period TARP funds were dispersed, we find that the average one-month-ahead future return following insider purchases (insider sales) is 1.84% (–2.87%), a difference of 4.71%.

Consistent with the increase in the informativeness of insider trades relating to private information gleaned from political connections, we find that the increase is concentrated entirely among the trades of politically connected insiders. Prior to the Crisis, we find the difference in one-month-ahead future returns between purchases and sales of politically connected insiders is economically and statistically insignificant, –0.37%. However, during the period TARP funds were dispersed, the difference in one-month-ahead future returns between purchases and sales of politically connected insiders is both economically and statistically significant, 8.89%.

Next, we use two distinct sets of tests to investigate whether the information advantage of politically connected insiders relates specifically to TARP capital infusions. In the first set of tests, we repeat our analyses after partitioning the sample based on whether the firm received TARP funds. Within the sample of politically connected insiders, we find that the increase in the informativeness of insider trades is concentrated among politically connected insiders at TARP recipients. We find no evidence of an increase in informativeness of insider trades among the trades of politically connected insiders at firms that did not receive TARP funds. This suggests the information advantage is conditional on the bank receiving TARP funds.

In the second set of tests, we use an event study to identify the relation between insider trades and the timing, amount, and market reaction to TARP infusions. Measuring trading by corporate insiders over the thirty days prior to the announcement of TARP capital infusions, we find that insiders are net buyers (sellers) before 34.8% (20.3%) of infusions in our sample. Moreover, we find that trades over the thirty days prior to the announcement predict the market reaction to the announcement—and that the predictive ability of these trades is concentrated among the trades of politically connected insiders. For infusions where politically connected insiders were net buyers (sellers) over the prior thirty days, the average three-day announcement period return is 4.39% (–5.13%). These results suggest that when politically connected insiders were net buyers (sellers) prior to the announcement, the subsequent announcement was a large positive (negative) surprise to the market. The results from our event study analysis are consistent with politically connected insiders trading in anticipation of the surprise, and are robust to a variety of sensitivity tests.

Collectively, our findings suggest that political connections provided corporate insiders with an important information advantage during the Financial Crisis, that a significant portion of this advantage related to knowledge about government intervention, and that some insiders traded to exploit this advantage. We contribute to the academic literature by documenting one channel through which politically connected insiders can extract rents from shareholders; by documenting the relation between insiders’ political connections and information leakage; and by documenting an important characteristic of directors’ social network that influences their trading decisions.

The complete paper is available for download here.

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