Litigation is commonplace in America. Lawsuits can have an adverse impact on a corporation and, by extension, its shareholders. The impact may lead to significant monetary settlements that materially impact a company's bottom line and may even lead to bankruptcy.

However, there are steps that investors can take to inform themselves about any pending litigation a firm is facing as well as the potential impact the litigation may have. In this article, we will look at how you can identify the litigation risk that companies face and avoid the negative impact this risk may have on your investments.

10-K and Proxy Statement
Investors who are looking for information about pending suits (shareholder and otherwise) should always read the 10-K and the proxy statement because they outline pending litigation in the most detail. Other Securities And Exchange Commission (SEC) documents, including 8-Ks and 10-Qs often contain commentary regarding litigation as well.

You can find this information under the "Legal Proceedings" sections that are included in both the 10-K and the 10-Q. In the 10-K, you can find this in "Part 1" of the filing under "Item 3." This section will also include the entity that is suing the company or the entity the company is suing, details of the disagreement at hand, the financial exposure and any anticipated outcome or conclusion. Note that litigation may also be discussed within the management's discussion and analysis (MD&A) section as well as in the footnotes. (For related reading, see Footnotes: Start Reading The Fine Print and Pay Attention To The Proxy Statement.)

Look For Reserves
When a company anticipates that it may have to settle for large sums of money for a future expense, such as defending itself in a lawsuit, it will sometimes take reserves or charges against earnings so that it is better prepared to deal with the potential liability, reducing the odds of having to take an abnormally large hit to earnings once the litigation is completed.

An example of a company that has booked massive reserves in the past is Merck & Co Inc. (NYSE:MRK). In 2004, the company removed Vioxx, an anti-inflammatory drug, from store shelves because of concerns it might increase the risk of heart attack or stroke. Not surprisingly, soon thereafter the company was sued by many users of the drug. In response, Merck placed hundreds of millions of dollars in reserve over a period of several quarters in order to pay for potential defense costs. Its efforts seemed to pay off because the litigation lingered in the courts for almost four years before it was ultimately settled. Companies that are not as steadfast in setting aside reserves may open themselves up to financial disaster.

Investors can find information on a company's litigation reserves in the quarterly press releases, 10-Qs and the 10-K, which will detail any charges/reserves that were taken and their purpose. Be sure to read all the footnotes in these reports, because companies may bury juicy details in the fine print.

Check the Sell Side
To better understand the potential risks associated with a particular suit, investors should try to get their hands on recent analyst reports. These will often detail the risks from a more neutral point of view than the information that comes directly from company. However, be wary when reading a report that was drafted by a sell-side firm that has done banking for the company - it may be biased in its opinion, or mute when it comes to criticism.

Some analyst reports are often available online for free; others must be purchased. In some cases, the company being covered or the brokerage firm that wrote the report may grant a copy upon request. Consider asking your broker or advisor if he or she has a good source for this information.

Read Press Clippings
Conducting your own online search of the lawsuit is imperative. The sources that may be used are search engines, Reuters and Lexis Nexis. There are many financial websites that may cover this news as well.

Look at the Past
Is there a similar situation that's happened in the past to the company, or to another company that will help you determine the potential outcome? As a suggestion, peruse the news. Also, do an internet search for "shareholder suits" or "corporate litigation" and you might be surprised what comes up. The past is often a good way to gain some insight into what might happen in the future.

The Bottom Line
Corporate litigation can be scary for investors. However, by reading the SEC filings and speaking with the company and/or other major players in the stock, individual investors will be better prepared to deal with such problems.

For more insight on this subject, read Protect Your Company From Lawsuits.

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