Customer-Supplier Relationships and Strategic Disclosures of Litigation Loss Contingencies

Abstract

In a customer-supplier relationship, when a third party sues the supplier, the resulting litigation loss contingency may trigger the principal customer’s concerns regarding supply chain risks. We find that customers are likely to hedge against such supply chain risks by weakening or terminating relationships with dependent suppliers who are being sued. Having established the existence and quantified the level of potential proprietary costs in this setting, we next show that dependent suppliers being sued make strategic disclosures regarding loss contingencies in their financial statements in order to avoid relationship disruption. Relative to firms with no principal customers, dependent suppliers tend to promptly reveal their good news and strategically withhold their bad news. This pattern is stronger when customers face lower switching costs. Our findings are useful to the SEC, which would like to see clearer disclosures of potential losses from litigation in financial statements.