Downstream customer firms’ bargaining power can lead to suboptimal diversification in upstream suppliers’ innovation when customers cannot commit to a long-term relationship. After the revelation of financial fraud by a major customer, suppliers surprisingly outperform a control group in terms of sales growth, Tobin’s q, and survival likelihood over a 10-year period. Our results suggest that, before a fraud revelation, supplier managers’ short decision horizons and aversion to short-term risk enable influential customers to demand relation-specific innovation, leading to suboptimal diversification. When customer importance weakens, suppliers engage in riskier and novel innovation, thereby stimulating sales growth. (JEL G14, G3, L14, L24)

ABSTRACT Firms in bilateral relationships are likely to produce or procure unique products—especially when they are in durable goods industries. Consistent with the arguments of Titman and Titman and Wessels, such firms are likely to maintain lower leverage. We compile a database of firms' principal customers (those that account for at least 10% of sales or are otherwise considered important for business) from the Business Information File of Compustat and find results consistent with the predictions of this theory.