What is legislative risk?
Legislative risk is the possibility that regulations or laws adopted by the government can significantly change the business prospects of one or more companies. These changes may adversely affect investments in this company. Legislative risk can result from direct government action or from changing demand patterns for corporate customers.
Investors rarely complain about bailouts and preferential treatment in specific sectors, perhaps because they all have a secret hope of profiting from it. However, in matters of regulation and taxation, they complain. What subsidies and tariffs can bring to an industry in the form of competitive advantages, regulations and taxes can benefit many others. With a single law, a subsidy, or a change of printing press, they can send shock waves around the world and destroy entire businesses and industries. For this reason, many investors see legislative risk as an important factor when valuing stocks.
A large investment may turn out to be less important after considering the government under which it operates. (For related reading, see: Government and risk: a love-hate relationship.)
Explanation of legislative risk
Legislative risk refers to the temporary relationship between governments and businesses. More specifically, it is the risk that government actions will constrain a company or industry, thereby negatively affecting an investor’s assets in that company or industry. Real risk can appear in several ways, including anti-trust action, new regulations or standards, specific taxes, subsidies, etc. Legislative risk varies in degree depending on the industry, but each industry is exposed.
In theory, the government acts as a buffer zone to prevent the interests of business and the public from rubbing against each other. It is the role of government to intervene when the industry puts the public at risk and does not seem willing to regulate itself. In practice, the government tends to legislate excessively. This legislation reinforces the public image of the importance of government, as well as publicity among members of Congress. These powerful incentives carry greater legislative risk than is really necessary.
Key points to remember
- Changes in regulatory legislation can change the outlook for a business if the business can no longer serve its customers.
- Imposing taxes and other regulations on an industry can deter investors.
- Governments intervene to regulate industries if the members of this industry do not restrict themselves.
Real examples of legislative risks
The healthcare industry is an example of a high-risk legislative industry. Both drug manufacturers and healthcare providers face many ongoing legal issues related to Medicare, insurance coverage and other payment problems with clients.
Another example comes from Wal-Mart Stores Inc. (WMT). The company described some of the political risks it faces in its annual 10-K report to the Securities and Exchange Commission (SEC) in its section on operational risks. In its section on regulatory, compliance, reputation and other risks, the company describes the risks associated with legislative, judicial, regulatory and political / economic risks. Risk factors mentioned include
- Political instability
- Legal and regulatory constraints
- Local product safety and environmental laws
- Tax regulations
- Local labor laws
- Trade policies
- Monetary regulation.
In its supplier risks, Wal-Mart mentioned potential political and economic instability in the countries where foreign suppliers operate. State labor problems, international trade policies and the imposition of customs duties are also problems. The company specifically cites Brazil and China, as well as the complexity of their federal, state, and local laws.