On June 27, 2016, the Supreme Court dramatically changed anticorruption law and enforcement in the United States. In McDonnell v. United States, the court reversed the corruption conviction of the former governor of Virginia and considerably constricted the legal definition of “bribery.” As a result, many corruption cases were decided in favor of defendants, and federal and state prosecutors declined to bring many anti-bribery cases that would have been filed pre-McDonnell.

McDonnell represents a unique, exogenous decrease in the probability of corruption enforcement in the United States. In a new paper, we argue that this decrease led to the creation of a “protection racket:” Heavily regulated firms in high-corruption states increased their cash reserves after McDonnell, presumably to bribe local politicians. We hypothesize that these companies are the most likely to be affected by increased bribery since they are dependent on government contacts and are located in states with high levels of public corruption. These firms experienced negative abnormal returns around the time of the Supreme Court decision and saw the value of cash decrease. Consistent with the protection hypothesis, regulated firms in high-corruption states also became less likely to be penalized by government agencies after the decision. More specifically, local agencies in corrupt states are less likely to penalize heavily regulated firms after McDonnell, while the probability of federal agency enforcement remains the same.

Taken together, our results indicate that the firms most vulnerable to political expropriation – regulated companies in high-corruption states – suffered a net decrease in value after anticorruption enforcement was reduced. It is not obvious that less antibribery enforcement would be good or bad for these firms, since our results show that it has benefits (reduced penalties from government agencies) and costs (holding excess cash, presumably to pay bribes). However, these firms’ negative abnormal returns and decrease in the value of cash holdings strongly indicate that the costs of bribery exceed the benefits of less government enforcement for regulated companies in high-corruption areas.

Our results persist in a battery of robustness tests. We use two different measures of firm regulation in all our specifications, and include firm fixed effects. Our findings are unchanged in specifications allowing for industry-specific or state-specific time trends. Placebo and pretrend tests reveal that the increase in cash ratio for regulated firms in high-corruption areas is concentrated in the aftermath of McDonnell rather than alternative time periods. The results also cannot be explained by the election of Donald Trump more than four months after the court case, since our treated firms (regulated firms in high-corruption areas) showed negative abnormal returns after McDonnell but not after the 2016 election, increase in cash ratios appeared uncorrelated with regulated industries being located in states with high levels of support for Trump, and the slowdown in government enforcement was restricted to state and local agencies (over which Trump had little or no control). The findings persist when we rerun our specifications after matching our treatment firms (heavily regulated companies in high-corruption states) with comparable firms from the control group. We also find limited evidence that treated firms receive greater subsidies from state and local governments in exchange for participation in the protection racket. Finally, we see no evidence that treated firms used excess cash after McDonnell to gain political influence through official legislative lobbying rather than illicit payments.

Our paper uses a novel identification strategy centered on the McDonnell decision and adds to many areas of scholarship. First, it contributes to the literature on corruption. One could imagine firms vulnerable to political expropriation decreasing cash ratios when corruption became more likely, since they would want to avoid losing assets to public officials. Indeed, this is what the few papers on the relationship between corruption and cash policy have argued. These previous studies, however, did not have the advantage of an exogenous shock to corruption levels to address the possibility that firms established headquarters in areas with different levels of corruption. We use the sudden shift in anticorruption law and policy brought about by McDonnell and find a result opposite to that of the current literature: Firms most affected by an increase in bribery increase their cash ratios, presumably to buy political protection. We also assess both sides of the ledger when estimating the effects of reduced anticorruption enforcement: Firms vulnerable to political extortion had to keep excess cash to presumably bribe officials but also benefited from reduced government enforcement. Our event study results and analysis of the amount of corporate cash holdings allows us to conclude that regulated firms in high-corruption areas suffered a net decrease in value from participating in the post-McDonnell protection racket. Therefore, while it is theoretically plausible that our treated firms respond to reduced corruption enforcement by reducing cash holdings, we instead find that they participate in a protection racket and increase cash.

Second, the paper adds to work on regulated industries and their strong dependence on government for various approvals and other assistance. Our findings are consistent with a “corruption tax” on firms dependent on public officials.

Third, our paper adds a “protection racket” explanation to the literature on why corporate misconduct is detected at varying rates in different locations and time periods. State authorities in high-corruption areas became more likely to demand (and receive) bribes without fearing anticorruption enforcement after McDonnell. In return, regulated firms located in these areas benefited from fewer governmental investigations and penalties for their misconduct. Therefore, higher levels of corruption can hamper the detection of corporate malfeasance, since government agencies responsible for penalizing companies may turn a blind eye in return for bribes.

Finally, our paper adds to the literature on governmental federalism and its effects on private enterprise. Scholars have argued that the ability of each state to set its own policies fosters innovation. Our results present a less attractive feature of federalism in the United States: Since some states have more entrenched cultures of corruption, a decline in anticorruption enforcement leads to capital structure distortions for regulated firms located in those areas. The federalism literature also notes that elected officials, regulators, and judges working for the federal government typically have better credentials, higher integrity, and are more competent than their state and local counterparts. Our results on the decline in government enforcement against regulated firms in high-corruption states are consistent with these observations: The decrease in enforcement is concentrated in actions by local agencies, not federal authorities. This could be because federal agencies are less corruptible or more willing to bring enforcement actions even after McDonnell.

This post comes to us from Dhruv Aggarwal, a PhD candidate at Yale University School of Management, and Professor Lubomir P. Litov at the University of Oklahoma’s Michael F. Price College of Business. It is based on their recent paper, “Corruption and Cash Policy: Evidence from a Natural Experiment,” available here.