In this final part of the investment risk series, we look at the legal risks facing a company.
We had previously covered other aspects of risks in the first five parts of this series, and you can find the respective links below.
Part 1 – Management risks
Part 2 – Industry and competitive moat risks
Part 3 – Political risks
Part 4 – Economic risks
Part 5 – Social risks
Note that all the different categories of risks stated above should be looked at holistically for a company and industry to build a picture of whether the company makes for a safe investment, or not.
1. Are there numerous legal restrictions affecting the company and the way it operates?
If a company is hampered by legal restrictions, this will severely impact its business prospects.
To give an example, a company that intends to sell its product in a new region or territory may be subject to a different set of laws compared to its home country.
You should find out if the company may be subject to laws which prevent it from operating normally.
These may include price ceilings (i.e. inability to raise prices), licensing requirements, product exclusions or legal restrictions on distribution, among others.
2. Is the company currently a defendant in any lawsuits in which the outcome may result in a significant financial or reputational loss?
The annual report of the company should include notes on any existing litigations or lawsuits.
You should check for such events as they can have a material impact on the company’s operations.
The disclosure will normally explain the company’s legal stand and assign a probability of winning or losing the case.
Investors should also take note of the implications or ramifications of losing a lawsuit on the company’s financial position and reputation.
Some cases may result in negligible financial impact but may result in huge reputational damage.
Such a hit to its reputation could result in the company losing future business if potential clients started avoiding the company and switched to its competitors instead.
In other instances, a lawsuit may result in a hefty fine or settlement that may severely cripple the company’s finances.
3. Is the company in an industry which is subject to numerous legal suits and warranty claims (e.g. tobacco, pharmaceutical etc.)?
Finally, you should check if the company exists in an industry which may be subject to frequent lawsuits, litigation or legal disputes.
Some well-known examples would be tobacco (due to cigarettes’ adverse health effects) and pharmaceuticals (as this involves patients’ health and lives).
Other industries which in recent years have been subject to increased legal scrutiny include the social media industry.
Allegations of spying, and tampering with elections and fake news have been rife and have caused considerable reputational damage to companies such as Meta Platforms (NASDAQ: META).
Companies that breach regulations may be heavily sanctioned or fined.
The banking industry is also subject to more legal suits by the central banks as some are accused of unethical practices or had committed fraud, with a recent example being the LIBOR scandal.
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Disclaimer: Royston Yang owns shares of Meta Platforms.