Lit Review: Investment Theory — Critical Realignments and Elections
The second key relationship that can be explored is that of policymakers and firm contributions. Major studies have demonstrated positive relationships between firm donations and policymaking that benefit the firms, including supporting critical realignments of the United States’ political system and more lenient oversight by the federal government. This latter demonstration was replicated for the French political system, which demonstrated that investment theory is neither unique to the United States nor any individual federal or legislative body.
Critical Realignments and Elections
Investment theory was first theorized by Thomas Ferguson in 1983 and expanded on in Ferguson (1995) in detail. Ferguson (1995) focused on analyzing how U.S. firms used their economic clout to drive policy development and political change through three critical realignment periods: the New Deal, the Reagan era and the 1988 election, and the 1992 election and the Clinton era. In the lead-up to the 1932 election and the rise of Franklin D. Roosevelt, Ferguson noted that two ideological business groups were vying for dominance in order to control the direction of the country. The more labor-intensive firms formed a nationalist group that successfully used its economic clout to keep the United States out of the League of Nations and other Wilsonian bodies (Ferguson, 1995). The more capital-intensive firms, which included Chase National Bank and energy firms such as Standard Oil of New Jersey, formed an internationalist group that helped Roosevelt win the 1932 election and which eventually transformed the Democratic Party and established a public-private coalition that governed through the mid-1970s (Ferguson, 1995).
With Roosevelt’s victory, Chase National Bank was able to lobby for the passage of the Glass-Steagall Act, which supported Chase National Bank’s rise to national prominence and provided investment funding for the energy sector at a time when global prices and demand levels were wreaking havoc on the financial solvency of the industry (Ferguson, 1995). Standard Oil of New Jersey, in particular, was instrumental in using its finances to pressure the United States to move away from the gold standard, which later played into Roosevelt’s petroleum price control scheme in 1935 and the stabilization of the hydrocarbon industry (Ferguson, 1995). This stabilization would support the global endeavors of the petroleum sector, including the Iranian nationalization embargo. Over the rest of the decade, as Ferguson noted, it would be big business that used its economic power to pick winners and losers in party politics to run in the 1936 election, who chose the winner of the general election and who set monetary policy during the recession of 1937–1938 (1995).
Ferguson discussed in lesser detail the shifts of support between the Democratic and Republican parties during the Reagan and Bush/Clinton eras. The first of these was the shift to Ronald Reagan and the Republican Party, which had previously been the party of protectionism, following the recession of 1977–1978. Reagan returned the favor of support by funneling “broad rivers of cash” to the business community in the form of deregulation, renewed militarization, National Labor Relations Board changes, and tax cuts (Ferguson, 1995, p. 246). Moreover, the Reagan administration pushed the world to adopt the same economic policies that benefited his business supporters, which led to the rise of globalization and played into the direct benefit of U.S. firms that had been protected by Reagan in trade negotiations (Ferguson, 1995). The Reagan administration, notably, also used its political clout to force markets to open to U.S. firms, and the U.S. business community would, just as in the New Deal era, choose the winner of the 1988 primaries of both major political parties and in the general election in order to protect its economic position (Ferguson, 1995). The support of U.S. firms shifted back to the Democratic Party under the Clinton coalition due to George H. W. Bush’s unelectability and the maverick campaign of Ross Perot, who provided an easy path to the White House for the Clinton coalition with a minority of the popular vote, some 43% (Ferguson, 1995). Ferguson did note that his analysis of the Clinton era was limited due to being completed shortly after the reveal of Clinton’s economic policy and thus was not able to analyze the full coalition and its implications for investment theory (1995).
Investment theory is not limited to presidential elections, though. Akey (2015) applied the theory to legislative elections and identified that the market reacted to firms based on the election result of the candidates that they supported, which were stronger for special elections than for general elections (2015). Using abnormal returns, Akey was able to determine that congressional committees related to the finance, defense, agriculture, and small business sectors, as well as activities such as appropriations and taxation, were more significant and bore more weight on returns for firms contributing to candidates sitting on them (2015). The market reaction for winning candidates on these committees was quantified at an average gain of $263m at the 2.2% confidence level, while the reaction for losing candidates was quantified at an average loss of $372m at the 2.1% confidence level (Akey, 2015). These market reactions were associated with cash-flow implications in the form of future sales adjustments, and, noting that they were too large to be solely the result of campaign contributions, Akey (2015) identified that firms engage in both direct and indirect methods of support for congressional candidates. These methods include direct lobbying and hiring former government staffers. Akey identified that two out of three firms from the most active lobbying industries engage in the practice while nearly one out of three engage in the direct hiring of former staffers (2015). These practices serve to diversify firm political investments and, as Akey (2015) noted, do not represent agency issues.
Lobbying
As Akey (2015) identified, firm lobbying is a key feature in their political investments. Ramanna (2008) corroborated this by demonstrating that firms donate to policymakers aligned with their objectives. Examining the development of the FASB ruling that eliminated accounting in business combinations (pooling), Ramanna demonstrated that congressional representatives in favor of maintaining pooling received more funds from firm and industry political action committees (PACs) in favor of pooling than from those that did not (2008). Moreover, this relationship was strongly positive, suggesting that a change of two standard deviations in funds received from PACs in favor of pooling could be used as a strong predictor of a vote in favor of pooling with a probability of 29.5% (Ramanna, 2008). Additional studies have noted similar positive correlations between lobbying efforts and policymaker activities, in particular concerning oversight leniency. Yu & Yu (2011) used lobbying data from the period 1998 to 2004 to demonstrate a direct correlation between lobbying expenditures and decreased hazard rates for fraud detection across all industries. These lower rates were quantified to 117 additional days of fraudulent activity and an overall 38% reduction in regulator detection (Yu & Yu, 2011). Additionally, Yu & Yu identified that firms engaged in fraudulent activities expended more lobbying efforts, and these efforts were increased during periods of fraudulent activity (2011).
These findings were corroborated in Fulmer, et al. (2013), which identified that lobbying efforts influence the severity of oversight and the consequences thereof. Fulmer, et al. hypothesized that firms donate to congressional representatives as an investment for future favors, which they call upon when under investigation for fraud (2013). The study concluded that this hypothesized “iron triangle” relationship existed but could not provide specifics due to the unobservable relationship in practice (Fulmer, et al., 2013). The study was, though, able to quantify the price of influencing the severity of enforcement as $10,000, which was associated with a 0.47-year reduction in officer bans, a 0.19-year reduction in probation, a 0.32-year reduction in prison time, and a 10% reduction of likelihood for the most severe penalties from applicable regulators (Fulmer, et al., 2013). Correia (2014) further corroborated the findings in both Yu & Yu (2011) and Fulmer, et al. (2013) by identifying that the length of time that financial relationships exist between PACs and firm lobbying efforts and congressional representatives is negatively related to higher rates of enforcement.
Moreover, Correia identified that PAC expenditures represent a greater determinant in receiving a lesser penalty than lobbying efforts, which were found to not be associated with lower penalties on average (2014). These quantifiable relationships are not limited to the United States, either. Bourveau, et al. (2014) explored the returns of politically connected firms in France following the 2007 election of President Nicolas Sarkozy. Bourveau, et al. identified that firm directors connected to Sarkozy experienced larger abnormal returns from stock purchases following the election than did directors not connected to Sarkozy, which they attributed to a greater likelihood for politically connected directors to engage in insider trading (2014). Moreover, Bourveau, et al. noted that politically connected directors were more likely to break reporting timeframes to the AMF, the French stock market regulator, and concluded that directors are more likely to experience “a sense of impunity” and engage in fraudulent behavior when they are more politically connected (2014, p. 19).
Voting Behavior
In addition to exploring campaign contributions and lobbying expenditures to identify firm benefits from political investments, it is possible to identify firm benefits from the voting records of congressional representatives associated with specific industries. Cohen, at al. (2013) explored the relationship between firm market performance and the voting records of congressional representatives favorable to industries present in their constituencies. Using the underlying assumption that congressional representatives vote for firms that benefit their constituents in order to win reelection, Cohen, et al. examined the complete voting records for legislation in the period 1989 to 2008 to determine which legislation related to specific industries. Positive or negative values were assigned to the legislation based upon the voting record of congressional representatives who would associate the industry with their district (2013). This data was used to create a long/short portfolio associated with the legislation’s positive or negative value to learn the market performance of the industry; it determined the average spread yielded an abnormal return of 96 basis points each month (Cohen, et al., 2013). Moreover, Cohen, et al. identified that the voting records of congressional representatives associated with industries impacted firm performance positively, leading to an 8% increase in profitability and a 25% increase in sales growth compared to market averages (2013).
Additional studies have explored the direct stockholdings of congressional representatives in relation to their voting records to identify what influence, if any, stockholdings have. Tahoun (2014) described this exploration as understanding representative stock purchases and holdings in the context of a “gift” that could signal the beginning of a relationship with the representative as the initiator instead of the firm. In this context, it is possible to associate the duration of stockholding with the continuation of a relationship, given that the representative has the opportunity to divest their shares, with divestment being linked to poor firm performance and the loss of future contracts (Tahoun, 2014). Tahoun identified that congressional representatives are more likely to invest in firms relative to the level of contributions by firm PACs — with Democrats the most likely of the major political parties to invest (2014). The relationship between firms and representative holdings was identified to be stronger relative to the representative’s position and the size of the firm, with smaller firms yielding a more positive correlation than larger firms (Tahoun, 2014). Firms associated with a congressional representative’s committee assignment were not identified to be a strong determinant, and the relationship was found to be stronger with representatives who were not as active as investors or who had smaller portfolios (Tahoun, 2014).
Additionally, Tahoun (2014) determined that personal stockholding amplified firm contributions and that divestments led to a decrease in the probability of receiving future contributions. The quid pro quo relationship ends as congressional representatives retire, though, with divestments identified in contributing firms but not in noncontributing firms (Tahoun, 2014). Building off the Tahoun (2014) study, Tahoun & van Lent (2019) explored the votes leading up to the Emergency Economic Support Act (EESA) and corroborated the 2014 study findings that a correlation exists between policy decisions and the financial interests of congressional representatives.[1] Tahoun & van Lent (2019) determined that representatives were 60% more likely to vote in favor of legislation when it directly impacted their personal finances, even if it ran against constituency stakes and needs, and that personal preference for the financial sector did not impact the results of their study.
References:
Akey, P. (2015). Valuing changes in political networks: Evidence from campaign contributions to close congressional elections. Review of Financial Studies, 28(11), 3188–3223. https://doi.org/10.1093/rfs/hhv035.
Bourveau, T., Coulomb, R., & Sangnier, M. (2014). Political connections and insider trading (Working Paper). https://pdfs.semanticscholar.org/7507/227f02ae0890fe5e8fe272ae8549c301d0fc.pdf.
Cohen, L., Diether, K., & Malloy, C. (2013). Legislating stock prices. Journal of Financial Economics, 110(3), 574–595. https://doi.org/10.1016/j.jfineco.2013.08.012.
Correia, M. M. (2014). Political connections and SEC enforcement. Journal of Accounting and Economics, 57(2–3), 241–-262. https://doi.org/10.1016/j.jacceco.2014.04.004.
Ferguson, T. (1995). Golden rule: the investment theory of party competition and the logic of money-driven political systems. University of Chicago Press.
Fulmer, S., Knill, A., & Yu, X. (2012). Political contributions and the severity of government enforcement (Working Paper). https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=CICF2014&paper_id=532.
Ramanna, K. (2008). The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting. Journal of Accounting and Economics, 45(2–3), 253–281. https://doi.org/10.1016/j.jacceco.2007.11.006.2.
Tahoun, A. (2014). The role of stock ownership by US members of Congress on the market for political favors. Journal of Financial Economics, 111(1), 86–110. https://doi.org/10.1016/j.jfineco.2013.10.008.
Tahoun, A., & van Lent, L. (2019). The personal wealth interests of politicians and government intervention in the economy. Review of Finance, 23(1), 37–74. https://doi.org/10.1093/rof/rfy015.
Yu, F., & Yu, X. (2011). Corporate lobbying and fraud detection. The Journal of Financial and Quantitative Analysis, (46)6, 1865–1891. https://www.jstor.org/stable/41409670.
Footnotes:
[1] There were three final votes on legislation leading up to the passage of the EESA: H.R.3397 in the House of Representatives on September 1, 2008, which was a draft bill, and H.R.1424 on October 1, 2008, in the Senate and October 3, 2008, in the House of Representatives.
