The media, investors, and regulators often consider trading by corporate insiders to be a signal of firm value, given that insiders know their business better than do others. Although trading on material, non-public information can be illegal in the U.S., insiders may still attempt to profit from their informational advantage, as evidenced by dozens of insider trading enforcement actions each year.
Research also suggests that politically connected firms may avoid investigations by, or receive lower penalties from, regulatory agencies. And since insiders are the ones who decide to build political connections for the firms, they may do so to seek both corporate and personal benefits. In a new study, I find that politically connected corporate insiders are more likely to engage in risky insider trading. This may stem from the belief that their political connections provide some protection from the SEC.
I use political contributions as a proxy for political connections. Corporate insiders can build these connections personally (i.e., individual contributions) or through their firms (i.e., PAC contributions). For each publicly traded firm and each of its corporate insiders, in each election cycle from 1988 to 2016, I compute political connection measures based on political donation history as well as the power of the political candidates supported. Overall, about 10 percent of the firms make some political contributions to at least one candidate in an election cycle. Firms also support more candidates than do individual insiders. While a typical firm donates to about 50 candidates in each cycle, a typical insider donates to only two candidates. To examine the trading activities of these insiders, I use the sample of all their trades from 1988 to 2016.
If politically connected insiders are more likely to trade on their private information, their trades should be more profitable than those of their counterparts. Consistent with this prediction, my results show that sales by connected insiders, on average, are followed by lower returns compared with sales made by their non-connected counterparts. However, returns for politically connected and non-connected insider purchases are not significantly different. One explanation for this could be that the SEC is more likely to investigate insider sales. If political connections have some impact on insider trading, the effects should be greater for insider sales since the connections are more likely to protect them from the legal risks.
Among corporate insiders, directors and officers are more likely to possess nonpublic information relative to blockholders and outside associates. The higher insider trading profit associated with political connections is indeed concentrated among insiders classified as directors and officers. The profit is even higher for groups of senior officers who also hold a director position. This is consistent with the theory that having a CEO also serve as a director erodes the quality of corporate governance, which in turn gives insiders more opportunities to trade on their private information.
Campaign finance data show that, on average, Senate candidates receive more total dollar contributions from companies and are supported by a larger number of firms and individuals. The effect of connections to Senate candidates on insider trade performance is greater than the effect with respect to House candidates. That is, insiders appear particularly concerned with connections to Senate candidates. This may be because the Senate have more control over the selection of SEC commissioners and judges.
Data also show that Republican candidates get more political contributions from firms and individuals. However, a lot depends on which political party is in control of the government. When the Republican (Democratic) party controls both House and Senate, connections with that party are more strongly related to the trade performance of the connected insider. When there is a separation of control (e.g., Democratic House, Republican Senate), the effects of connections with these two major parties are approximately similar.
The evidence of politically connected insiders being more likely to trade on their private information is not limited to the profitability of their trades. I also find that political connections are related to the timing of their trades. The periods before major corporate events are compelling to investors, media as well as regulators since the information asymmetry is usually high. The vast majority of charged insider trades occurs just prior to these price-sensitive firm events. However, with their connections to the politicians, insiders trade closer to these events, for example, before earnings announcements. Moreover, my evidence shows that insiders with political connections are more likely to violate the SEC trade reporting deadline.
With possible protection from politicians, corporate insiders may benefit personally from engaging in other risky activities. The main conclusion I draw from my study is that politically connected insiders are more likely to trade on their private information. This behavior often leads to poor corporate governance. Political contributions are an expense for shareholders, but they may not be in shareholders’ interest.
This post comes to us from Thuong Harvison, a PhD candidate at the University of Arizona’s Eller College of Management. It is based on her recent article, “Political Connections and Insider Trading,” available here.