Financial Contracting and Organizational Form: Evidence from the Regulation of Trade Credit

• Published date: 01 February 2017
• Author: ANDRES LIBERMAN,EMILY BREZA
• Date: 01 February 2017
• DOI: http://doi.org/10.1111/jofi.12439

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 1 •FEBRUARY 2017

Financial Contracting and Organizational Form:

Evidence from the Regulation of Trade Credit

EMILY BREZA and ANDRES LIBERMAN∗

ABSTRACT

We present evidence that restrictions to the set of feasible financial contracts affect

buyer-supplier relationships and the organizational form of the firm. We exploit a reg-

ulation that restricted the maturity of the trade credit contracts that a large retailer

could sign with some of its small suppliers. Using a within-product difference-in-

differences identification strategy, we find that the restriction reduces the likelihood

of trade by 11%. The retailer also responds by internalizing procurement to its own

subsidiaries and reducing overall purchases. Finally,we find that relational contracts

can mitigate the inability to extend long trade credit terms.

ARICH LITERATURE IN ORGANIZATIONAL economics studies how the institutional

environment affects the boundary of the firm and the scope for trade with

external parties (e.g., Coase (1937), Williamson (1973), Grossman and Hart

(1986)). In particular, when contracts are not feasible or enforceable, vertical

integration, that is, expansion in the vertical boundary of the firm, may replace

arm’s length transactions with suppliers. Empirical evidence of a link between

the contracting environment and the organizational form of the firm and its

supply chain has been largely limited to observational case studies or industry-

level analyses (Bresnahan and Levin (2013), Lafontaine and Slade (2013)). In

general, the confluence of factors that jointly determine the scope of contracting

institutions, financial markets, and the choice between trade and integration

renders causal inference quite difficult. Further, it is impossible to observe

∗Emily Breza is at Columbia University and Andres Liberman is at New York University. An

earlier version of this paper circulated with the title “Trade Credit and Organizational Form: Evi-

dence from the Regulation of Buyer-Supplier Contracts.” We thank two anonymous referees, Elias

Albagli, Jean-Noel Barrot, Effi Benmelech, Charles Calomiris, Vicente Cunat, Wouter Dessein,

Ray Fisman, Xavier Gabaix, Rainer Haselmann, Andrew Hertzberg, Laurie Simon Hodrick,

Harrison Hong, Wei Jiang, Leora Klapper, Tomislav Ladika, Rocco Macchiavello, Brian Melzer,

Holger Mueller, Justin Murfin, Daniel Paravisini, Mitchell Petersen, Michael Roberts (Edi-

tor), Phillipp Schnabl, Amit Seru, Vikrant Vig, Laurence Wilse-Samson, Daniel Wolfenzon, and

seminar and conference participants at the AEA meetings (San Francisco), Banco Central de

Chile, Baruch, EFA (Lugano), ESSFM (Gerzensee), Finance UC Conference (Santiago), Fordham,

Harvard Business School, Kellogg, LBS Summer Symposium, NYU Stern, SFS Cavalcade (At-

lanta), UNC-Duke Corporate Finance Conference, WFA (Seattle), and The WorldBank. We thank

the Superstore and the Chilean tax authority for providing the data. All errors and omissions are

ours only. Both authors confirm that they do not have any relevant material or financial interests

related to this research.

DOI: 10.1111/jofi.12439

291

292 The Journal of Finance R

the latent contract that a vertically integrated firm would offer to an external

supplier.

This paper provides the first causal evidence that the contracting environ-

ment affects the organization of the supply chain and the boundary of the firm.

We focus on the ability of upstream and downstream firms to write trade credit

contracts with one another. Trade credit, or delayed payment for intermediate

goods, is one of the most common financial contracts in procurement rela-

tionships, and estimates suggest that it finances roughly two-thirds of global

trade.1A large literature examines the determinants of trade credit terms be-

tween buyers and suppliers.2First and foremost, trade credit is characterized

as an efficient financing arrangement whereby credit flows from relatively un-

constrained buyers to more financially constrained suppliers. In line with this

view, Murfin and Njoroge (2015) document that the smallest decile of Com-

pustat firms use by far the most trade credit. However, it is not uncommon

to also observe credit flowing from small, constrained suppliers to large cor-

porations with access to international capital markets.3Indeed, Murfin and

Njoroge (2015) document that firms in the top two size deciles are also net

trade credit borrowers. In these settings, little is known about the role trade

credit and other financial contracts may play to facilitate trading relationships

with external suppliers.

We exploit a natural experiment in Chile that limited the trade credit terms

that a large buyer (the “Superstore”) could obtain from over 1,000 of its small

suppliers. In this specific context, it is unlikely that trade credit reflects a rela-

tive advantage of suppliers in external financing terms.4Fearing the outsized

market power of the country’s two large discount retailers (including the Su-

perstore), in December 2006, the Chilean government entered into an accord

with the Superstore (the “Agreement”). The Agreement reduced the maturity

of trade credit contracts that the Superstore could write with a subset of sup-

pliers (the “affected” suppliers) to 30 days from the pre-Agreement status quo

of 90 days.5The government chose to impose the regulation only for firms with

sales below an arbitrary cutoff of UF 100,0006to roughly $4.0 million. Both the

1See Bank for International Settlements (2014).

2See Petersen and Rajan (1997), Biais and Gollier (1997), Ng, Smith, and Smith (2002), Fisman

and Raturi (2004), Fabbri and Klapper (2008), Cu˜

nat and Garcia-Appendini (2012), Giannetti,

Burkart, and Ellingsen (2011), Klapper, Laeven, and Rajan (2012), Costello (2014), Antras and

Foley (2014), among others.

3See Wilson and Summers (2003) Fabbri and Klapper (2008), and Klapper, Laeven, and Rajan

(2012). See also recent coverage in The New York Times (Stephonie Strom, “Big companies pay

later, squeezing their suppliers,” The New York Times, April 6, 2015).

4The Superstore is orders of magnitude larger than the privately held suppliers in our sample,

and has the ability to raise capital in the public market. In contrast, the suppliers in our sample are

all privately held firms with annual sales between $1 million and $24 million and most likely face

substantially higher borrowing costs than the buyer. Further,small firms in an emerging market

like Chile are probably even more financially constrained than small firms in developed markets

(e.g., Rajan and Zingales (1998), Banerjee and Duflo (2014)).

5The government struck a similar accord with the other large retailer in mid-2008.

6UF,which stands for “Unidad de Fomento,” is an inflation-linked currency unit updated daily.

Its value is published by the Banco Central de Chile. 1 UF is worth roughly $40.

Financial Contracting and Organizational Form 293

timing and the eligibility criteria of the Agreement are essential components

of our empirical strategy.

We use proprietary product-supplier-level procurement data obtained from

the Superstore and regulatory status data from the Chilean tax authority to

document three margins of adjustment by the Superstore in response to the

Agreement. First, we find that the restriction to the set of feasible contracts

makes trade with affected suppliers less likely. In our baseline empirical strat-

egy, we compare changes in the procurement of each product sold by Treated

firms, defined as firms with total revenues below the UF 100,000 cutoff, before

and after the Agreement relative to the same product sold by Control firms,

defined as firms with total revenues above the UF 100,000 cutoff. We control

nonparametrically for firm size by focusing on firms whose 2006 yearly rev-

enues were within a relatively tight range above and below the cutoff.7We

find that the probability that a Treated supplier sells a product to the Super-

store falls by 11% after the Agreement relative to the same product sold by

a Control supplier. Second, the Agreement makes vertical integration more

likely. The probability that the Superstore procures from a wholly owned sub-

sidiary increases by 4% from a baseline of 21% for products that were mostly

procured by affected firms (above-median market share). Third, total procure-

ment of products that were mostly purchased from affected firms is reduced

after the Agreement. We interpret this as evidence that the Superstore is not

fully able to replicate the preperiod market equilibrium by shifting procure-

ment to its subsidiaries or to unaffected firms. This result suggests that the

vertical integration stemming from the Agreement is costly (consistent with

Baker, Gibbons, and Murphy (2001)).8

We include several robustness checks to ensure that our results are not

simply capturing a differential trend between small and large firms. First, we

detect no differential pretrends in any of our specifications or in the universe of

Chilean firms of the same size. Second, a placebo test on firms unaffected by the

Agreement does not replicate our main results. Third, our results continue to

hold in a specification with time-varying firm fixed effects, where we identify off

of differential exposure to the Agreement by product type within Treated firms.

In this specification, the likelihood of observing trade is lower for products that

compete mostly with firms unaffected by the Agreement. Because the effects

vary across products within each Treated firm, they cannot be driven only by a

differential exit rate of smaller relative to larger firms.

Many relational contracting models (e.g., Baker, Gibbons, and Murphy

(2002)) predict that relationships are more resilient (i.e., can be more easily

sustained by the threat of termination) when they are more exclusive, in the

sense that the outside options of the parties are low. Consistent with this idea,

7DuetodatarestrictionsfromtheChileantaxauthority,wedonotobservetotalrevenuesto

all clients. It is therefore impossible to implement a fully nonparametric regression discontinuity

design.

8Of course, it is also likely that the Superstore adjusts by shifting procurement to unaffected

suppliers, including Control firms and also even larger suppliers.