The Motley Fool

6 Major Types Of Investment Risks: Part 6

In this final part of the investment risk series, I will talk about the legal risks facing a company. You can check out the previous part here which discusses the social risks surrounding a company. Note that all these different categories of risks should be looked at holistically for a company and industry to build a picture of whether the company makes for a safe investment.

1. Are there numerous legal restrictions affecting the company and the way it operates?

If a company is hampered by legal restrictions, it would severely impact its business prospects. This may apply to a company which intends to sell its product in a new region or territory which is subject to a different set of laws compared to its home country.

The investor should find out whether a company may be subject to laws which prevent it from operating normally, and this may include aspects such as 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 of which the outcome may result in significant financial or reputational loss?

The annual report of the company should have a note on any existing litigations or lawsuits, and the investor should definitely check for these as such events could have a significant and material impact on the company. The disclosure would 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 a loss on the company’s financial position and reputation. There could be cases where the financial impact is small, but the reputational impact may be severe and could cost the company a lot of future business if customers start to avoid the company and switch to competitors instead. Other cases may result in a hefty fine or settlement which 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, the investor 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 its purported health effects) and pharmaceuticals (as this involves patients’ health and lives). Other industries which in recent years have been subject to increased legal scrutiny would include the social media industry, with allegations of spying, tampering with elections and fake news abound. Companies which breach regulations may be heavily sanctioned or fined. Banks are also being subject to more legal suits by the central banks as some are accused of unethical practices or had committed fraud (e.g. the Libor scandal).

