Buyer’s Bankruptcy Risk, Sourcing Strategy and Firm Value: Evidence from the Supplier Protection Act

Author Information:

Karca D. Aral, Syracuse University, Whitman School of Management
Erasmo Giambona, Syracuse University, Whitman School of Management
Ye Wang, University of International Business and Economics

Year of Publication:

Management Science, forthcoming in 2021

Summary of Findings:

Our paper has important implications for corporate executives: right-sizing the supply base can be critical for buyers near financial distress and implementing policies to engage and protect suppliers can be the way out of distress.

Research Questions:

1. On what does the sourcing strategy of a buyer near financial distress depend?
2. What should a distressed buyer’s sourcing strategy be?
3. What are the effects of supplier protection on buyers' sourcing strategy, trade credit, inventory holdings, and firm performance?

What we know:

The pros and cons of a diversified supply base are well documented for the case of financially sound buyers. However, the associated trade-off is more nuanced for a buyer near financial distress. Financially distressed buyers might want to limit the number of suppliers, to contain the risk of costly Chapter 11 reorganization. However, they realize that this strategy can lead to suboptimal procurement quantities, because of the credit limits suppliers impose to contain their exposure in case the buyer defaults. Hence, buyers in financial distress could find it pressing to increase their supply base size. The determination of which of these two conflicting forces will prevail in shaping the sourcing strategy of a financially distressed buyer is the focus of our paper.

Novel Findings:

What should a distressed buyer’s sourcing strategy be? We find that this depends on the dynamics in a potential in-court bankruptcy. Using a unique quasi-natural experimental setting, we find that, following the supplier protection act, the number of suppliers for buyers near financial distress (those most affected by the act, the treated group) increased by nearly 35% relative to financially sound firms (the control group). We also find that this shift allowed distressed buyers to obtain more trade credit, expand inventory holdings, and increase performance, leading to an overall increase in firm value of 7.2%. In turn, these effects led to a sizable reduction in the probability of the affected buyers defaulting and filing for bankruptcy. Our results have important implications for corporate executives: right-sizing the supply base can be critical for buyers near financial distress, and implementing policies to engage and protect suppliers can be the way out of distress.

Novel Methodology:

We combine a quasi-natural experimental setting with a novel sourcing dataset that, for the first time in the literature, to the best of our knowledge, allows us to shed light on the sourcing strategy of distressed buyers. We believe this setting can be fruitful in future research to study other aspects of corporate sourcing policies. We also provide a possible channel explaining our empirical findings in a novel stylized model endogenizing suppliers’ trade credit limits.

Implications for Practice:

Our findings have important implications for corporate executives. For example, the Supplier Protection Act, which is still in effect today, can be reassuring to suppliers evaluating whether they should establish a new supply chain relationship with a distressed buyer amid the current COVID-19 pandemic. Executives trying to establish new relationships with foreign suppliers, for instance, could engage these suppliers’ legal teams to discuss how the Supplier Protection Act would safeguard them in court in case of bankruptcy. More generally, our results highlight that executives should not underestimate the importance of devoting their human and financial resources, which are limited when a company is in distress, to supply chain relationships. In fact, our findings suggest that supplier-oriented decisions could be the way out of financial distress for buyers. Further, because suppliers, as trade creditors, might force distressed buyers into bankruptcy, our results suggest that such buyers should expand their supply base size only when this leads to a significant increase in operating performance.

Implications for Policy:

Our findings have also important implications for the appropriate policy response to the COVID-19 pandemic. As the virus started to hit the world economy, central banks around the globe responded with massive quantitative easing policies to facilitate access to credit. Our findings suggest that these financial interventions can be more effective if accompanied with policy measures to support supply chain relationships directly. For instance, governments could provide temporary guarantee mechanisms for suppliers establishing new relationships with buyers during a pandemic or, more generally, during a financial crisis. Further, although the Supplier Protection Act was intended to protect suppliers, our findings suggest that the act had an unexpected welfare-enhancing effect for distressed buyers, indicating that policymakers need to evaluate effects that go beyond the intended target group to assess the full impact of a regulatory change.

Implications on Research:

Our findings also open opportunities for future research. First, researchers interested in causal tests of existing supply chain theories could benefit from the type of data and empirical design used in this study. Second, future studies could benefit from firm-level financial data on suppliers. Such data could be used to study, for example, the degree to which sourcing strategies depend on the suppliers’ financial strength or the political risk of the suppliers’ headquarters regions. Third, research could benefit from granular data on the quantity supplied by each individual supplier, the type of product, and the price. These data would be useful to investigate, for example, the effect of stronger supplier protection on pricing, quantity, and quality. Finally, it would be interesting to study the causal effect of regulatory changes that increase the protection of other stakeholders (e.g., employees or financial lenders) on operational outcomes.

Full Citations:

Aral, K., E. Giambona, Y. Wang, "Buyer’s Bankruptcy Risk, Sourcing Strategy, and Firm Value: Evidence from the Supplier Protection Act", Forthcoming in Management Science (2021)

Abstract:

What should a distressed buyer’s sourcing strategy be? We find that this depends on the dynamics in a potential in-court bankruptcy. To establish causality, we use a novel sourcing dataset in combination with a unique quasi-natural experimental setting provided by a regulatory shock that significantly strengthened the protection granted to suppliers when a distressed buyer files for bankruptcy: the Supplier Protection Act. We find that, following this regulatory change, the number of suppliers for buyers near financial distress (those most affected by the act, the treated group) increased by nearly 35% relative to financially sound firms (the control group). We also find that this shift allowed distressed buyers to obtain more trade credit, expand inventory holdings, and increase performance, leading to an overall increase in firm value of 7.2%. In turn, these effects led to a sizable reduction in the probability of the affected buyers defaulting and filing for bankruptcy. Our results have important implications for corporate executives: right-sizing the supply base can be critical for buyers near financial distress, and implementing policies to engage and protect suppliers can be the way out of distress.