Mitigating incentive conflicts in inter-firm relationships: Evidence from long-term supply contracts

I examine variation in the design of long-term supply contracts in response to incentive problems between firms along the supply chain. To do so, I hand-collect a large sample of long-term supply contracts from SEC filings. I investigate the potential for adverse selection and moral hazard problems that result from transactions between a separately owned buyer and supplier and find that contracts are designed to mitigate these problems. I find that information asymmetry between buyers and suppliers leads to shorter duration 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 the costs associated with moral hazard. The buyer and supplier are more likely to include financial covenant restrictions when monitoring is difficult and the products exchanged are highly specific. Finally, I show that buyers and suppliers are less likely to rely on financial covenants when contracting with a private party, consistent with private firms having less reliable financial statements than public firms.