As a type of short-term financing, trade credit allows the upstream firm in a supply chain to finance the downstream firm. Empirical evidence suggests that trade credit is an important source of external financing. For example, the Financial Times reports that in 2007, 90% of world merchandize trade is financed by trade credit, with a value of approximately $25 trillion. Because of its wide usage, researchers in economics and finance have proposed many theories explaining the role of trade credit.
Recognizing the intrinsic connection of trade credit and supply chain contracting and inventory management, Yang and Birge (2010) propose a theory suggesting that trade credit serves as a risk-sharing mechanism between parties in a supply chain, hence enhancing supply chain efficiency. In that paper, the authors assume bank debt is senior to trade credit. That is, when the retailer (the debtor) is unable to meet all of his debt obligations, the trade creditor will not receive anything until the bank debt is fully repaid.
In practice, however, priority rules are more complicated. On the one hand, priority can be determined in the form of a contractual agreement. For example, in a debt covenant, the initial creditor could specify that any future creditors must have low priority related to her claim. On the other hand, there are certain priority principles (see Schwartz 1997) that bankruptcy judges normally obey. Therefore, even if a priority rule is written in a contract, it may be overruled by bankruptcy judges as it may violate some of these general principles.
More interestingly, the legal statutes that govern priorities change constantly over time. Recently, for example, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) has strengthened the supplier’s right of reclamation. That is, the supplier, when qualified, could receive (part of) the trade credit claim before other unsecured or secured creditors. Intuitively, these changes of law, together with different priority rules mutually agreed upon by the creditor and the debtor, may change the terms and usage of trade credit, as well as supply chain efficiency. In this paper, we try to develop a deeper understanding of this impact.
Specifically, we try to answer the following questions: first, under different priority rules, how do the terms of trade credit and institutional funding change? Are suppliers willing to extend as much trade credit as retailers need? How do those changes influence the retailer’s order quantity and other investment decisions? Among different priority rules, which one is most favorable for the supplier (the trade creditor), the retailer (the debtor), the supply chain, and/or end customers? Are the current legal rules efficient? Finally, given the flexibility judges have in bankruptcy rulings, how should they take different factors into consideration?
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Trade Credit in Supply Chains: Multiple Creditors and Priority Rules
