Chained Innovation: Response to Customer Covenant Violations
66 Pages Posted: 2 Sep 2020 Last revised: 15 Jun 2023
Date Written: June 15, 2023
Abstract
This paper examines whether financial constraints relax customer inhibitions to share nonmonetary incentives with suppliers (e.g., proprietary information that is difficult to codify in bankruptcy) to enhance competitiveness and foster supplier innovation. Using United States data, we find that suppliers of customers violating loan covenants become more innovative, specialize in niche areas, and exhibit greater tendencies to cite and coordinate their own innovation with customers. These benefits are more pronounced when frictions to information flows between trading partners are lower and when customers perceive a lower value of protecting proprietary information. Furthermore, innovative suppliers have more durable relationships with covenant violating customers. We substantiate our empirical results with a survey. Overall, our evidence shows how mechanisms (i.e., debt covenants) to address one set of incomplete contracts between lenders and borrowers can spill over to another set of incomplete contracts (customer-supplier) and in the process, affect relationship-specific investments such as innovation.
Keywords: Innovation, Customer-Supplier Relationship, Debt Covenant Violations, Firm Performance
JEL Classification: O30, L14, L24, G32, G33
Suggested Citation: Suggested Citation