Mitigating Incentive Conflicts in Inter-Firm Relationships: Evidence from Long-Term Supply Contracts

Abstract

Using a sample of long-term supply contracts collected from SEC filings, I show that hold-up concerns and information asymmetry are important determinants of contract design. Asymmetric information between buyers and suppliers leads to shorter term contracts. However, when longer duration contracts facilitate the exchange of relationship specific assets, the parties substitute short-term contracts with financial covenants in order to reduce moral hazard. Covenant restrictions are more prevalent when direct monitoring is costly and the products exchanged are highly specific. Finally, I find that buyers and suppliers are less likely to rely on financial covenants when financial statement reliability is low.

Keywords: Contracting, Covenants, Financial Reporting Quality, Hold-up, Information Asymmetry, Relationship Specific Assets

JEL Classification: D20, D82, G32, L14, L15, L22, M41