Legislating Stock Prices

by Lauren Cohen, Karl Diether & Christopher Malloy

Overview — This paper examines the importance of firms' relationships with their legal and political environment, and the actors who form this environment. Governments pass laws that affect firms' competitive landscape, products, labor force, and capital, both directly and indirectly. And yet, it remains difficult to determine which firms any given piece of legislation will affect, and how it will affect them. By observing the actions of legislators whose constituents are the affected firms, the authors gather insights into the likely impact of government legislation on firms. Specifically, the authors demonstrate that legislation has a simple yet previously undetected impact on firm prices. Key concepts include:

The measurement of which firms are materially impacted by a given bill is the crux of this paper.
Focusing attention on the legislators who have the largest vested interests in firms affected by a given piece of legislation gives a powerful lens into the impact of that legislation on the firms in question.
Legislators who have a direct interest in firms often vote quite differently than other, uninterested legislators on legislation that impacts the firms in question.
A long-short portfolio based on these legislators' views earns abnormal returns of over 90 basis points per month following the passage of legislation. These returns show no run-up prior to bill passage and no announcement effect directly at bill passage. The returns continue to accrue past the month following passage.
The more complex the legislation, the more difficulty the market has in assessing the impact of these bills.
The effect the authors document has been becoming stronger over time.

Author Abstract

In this paper we demonstrate that legislation has a simple, yet previously undetected impact on firm stock prices. While it is understood that the government and firms have an important relationship, it remains difficult to determine which firms any given piece of legislation will affect, and how it will affect them. By observing the actions of legislators whose constituents are the affected firms, we can gather insights into the likely impact of government legislation on firms. Specifically, focusing attention on "interested" legislators' behavior captures important information seemingly ignored by the market. A long-short portfolio based on these legislators' views earns abnormal returns of over 90 basis points per month following the passage of legislation. Further, the more complex the legislation, the more difficulty the market has in assessing the impact of these bills. Consistent with the legislator incentive mechanism, the more concentrated the legislator's interest in the industry, the more informative are her votes for future returns.