Unveiling the contagion effect: How major litigation impacts trade credit

Trade credit serves as a vital source of external financing, especially during challenging times, by redistributing credit from financially stronger firms to weaker ones. However, the traditional redistribution perspective does not fully explain changes in trade credit when firms face major litigation. Using firm-level data from China, we find that major litigation triggers a dual trade credit response: firms extend more credit to retain customers while simultaneously demanding more credit as a substitute for market-based financing. Notably, this “credit contagion effect” propagates risk along the supply chain, as firms face increased accounts receivable risk while shifting risk to upstream firms by delaying payments. Besides, this effect is more pronounced for non-state-owned enterprises and firms with weaker financial and supply chain situations. Our findings offer novel insights into how major shocks reshape trade credit behavior, highlighting the fragility and interdependence of supply chain relationships under stress.