Unlike much federal legislation, a 2012 law designed to prohibit insider trading among U.S. Congress members and their employees sounded like a straightforward moral good. The Stop Trading on Congressional Knowledge (STOCK) Act aimed to stop lawmakers from profiting off of their access to nonpublic information about market-related legislation.

“The powerful shouldn’t get to create one set of rules for themselves and another set of rules for everybody else,” President Obama said as he signed the bill.

But the politicians themselves are not the only ones who stand to gain from advanced knowledge of market-moving information. Financial institutions that trade and supply recommendations on this knowledge, which they could get through access to their Congressional representatives, also find it valuable. That is why, in its original form, the STOCK Act did more than just limit politicians’ ability to profit from insider information. It also contained a provision that could have curtailed the flow of privileged information from politicians to those outside the political sphere. This would have hurt large financial institutions such as brokerage houses and investment banks, as well as so-called “political intelligence” firms that obtain information about pending legislation and then sell that information to clients.

That change never happened. Thanks to lobbying by Wall Street, this provision in the STOCK Act was cut before the bill made it to Obama’s desk. Instead, according to The Wall Street Journal, the provision was replaced with “a measure that would call for a government study of the growing political-intelligence businesses.” In other words, instead of stopping the flow of privileged information out of Congress, the law gave the government permission to procrastinate.

Would the brokerages with better access to politicians also be the ones to issue more profitable recommendations?

When Beverly Walther, a professor of Accounting Information and Management at the Kellogg School, and Laura Wellman, now a professor at the University of Utah who was a visiting assistant professor at Kellogg at the time, read about the revised STOCK Act, they saw their next research topic.

“Everyone was focused on politicians trading on their own private information, and ignored this flow of information,” Wellman says. “We started our paper after seeing The Wall Street Journal articles.”

The Benefit of Political Connections

Their research focused on brokerage houses and sought to identify a link between a broker’s level of political connection and the market performance of its stock recommendations. Would the brokerages with better access to politicians also be the ones to issue more profitable recommendations?

They framed their analysis around a “what if” scenario based on data that was observable. If this flow of profitable political information were occurring, Walther explains, “what would you expect to see—and what might be the alternative explanations that we would be able to rule out?”

Walther and Wellman, along with coauthors Dane Christensen at the University of Oregon, and Michael Mikhail at the University of Illinois at Chicago, analyzed more than 30,000 stock recommendations made by 250 brokerages between 1999 and 2010. Of those 250 brokerages, 33 were politically connected, as measured by the brokerage’s campaign contributions to politicians during that timespan.

The researchers found that recommendations from politically connected brokerages were approximately 22 basis points (or 0.22%) more profitable than those from unconnected brokerages. While this may seem like a miniscule amount, it can represent significant quantities of wealth gained or lost as stock market values fluctuate.

Of course, an alternative explanation for these extra-profitable stock recommendations could be that those resource-rich brokerage firms merely employ more talented analysts. “It could be the case that political connections simply signal that this is a different type of brokerage house, with different levels of resources and talent than those brokerage houses that do not form political connections,” Wellman says.

Timely Recommendations

To investigate this possibility, the researchers examined brokerage firms that issued recommendations related to pharmaceutical and health-insurance stocks—in particular, stocks that would be affected by several pieces of healthcare-reform legislation that Congress debated between January 2009 and March 2010.

For each of the healthcare debates or hearings that occurred within that timeframe, the authors designated a three-day window before the event as a “private information period.” They surmised that politically connected brokerage houses would be more likely to issue recommendations on healthcare-related stocks during this period, since non-connected brokerages would not obtain access to the relevant political information until after the legislative event had occurred, no matter how talented their analysts.

Real-world observations supported Walther and Wellman’s predictions. Politically connected brokerages made significantly more stock recommendations during the private information period than non-connected ones, and their recommendations were more profitable as well. “That finding is consistent with our story that political information is more valuable in specific settings, or for politically sensitive stocks,” Wellman says.

A Murky Flow of Information

So if Wellman and Walther have identified a mechanism by which financial institutions can leverage private political information to create value for their clients, what should be done about it?

Here, the authors admit, things get murky. For one, while it may seem unfair, this flow of political information is entirely legal. In fact, it is part of the healthy functioning of a representative democracy. Theoretically, the flow of political information should move both ways in an open democracy: politicians can take the pulse of the electorate so that they can debate and enact policy more efficiently, and constituents can communicate with their representatives to see that their interests are being served.

“It’s part of job to reach out to their constituents to try to get a feel for the potential consequences of pieces of legislation,” Wellman explains.

But in practice, there are limits to how free and open this communication can be. “Unfortunately, while everyone has the same right to be a constituent and the same right to be part of a discussion, the opportunity just isn’t always there,” Wellman explains. “There’s limited time and resources for everyone to be involved in every discussion.”

This incentivizes brokerages to cultivate (or, cynics would say, simply purchase) political connections in order to preserve privileged access to profitable information.

This flow of information is more difficult to regulate than lobbying, which is regulated, because it is traveling in the opposite direction, that is, from politicians to their constituents.

Furthermore, clamping down on this outbound flow of privileged political information (via a strengthened STOCK Act, for example) might level the playing field between brokerages, but with potentially messy consequences. “If you shut down for certain constituents and not others, does that mean that future policy might be less informed, and therefore less optimal, than it otherwise would have been?” Walther asks.

The answers to such questions fall outside the scope of Walther and Wellman’s research. Then again, additional research on political information flow is what Congress asked for when they passed the STOCK Act—and Walther and Wellman’s findings may make it harder for them to continue to punt on the issue.

“It was explicitly stated we don’t know how big of an issue this is, or to whom this is an issue,” Walther says. “We think we’ve shed some light on that question.”