What is Legislative Risk
Legislative risk is the potential that regulations or legislation by the government could significantly alter the business prospects of one or more companies, adversely affecting investment holding in that company. This may occur as a direct result of government action or by altering the demand patterns of the company''s customers.
Investors rarely complain about bailouts and preferential treatment to certain industries, perhaps because they all harbor a secret hope of profiting from them. When it comes to regulations and tax, however, they complain. What subsidies and tariffs can give to an industry in the form of a comparative advantage, regulation and tax can take away from many more. With a single regulation, subsidy or switch of the printing press, they can send shock-waves around the world and destroy companies and whole industries. For this reason many investors consider legislative risk to be a huge factor when evaluating stocks. A great investment can turn out to be not that great when the government it operates under is taken into consideration. (For related reading, see: The Government And Risk: A Love-Hate Relationship.)
Legislative Risk Explained
Legislative risk refers to the tentative relationship between government and business. Specifically, it's the risk that government actions will constrain a corporation or industry, thereby adversely affecting an investor's holdings in that company or industry. The actual risk can be realized in a number of ways - an antitrust suit, new regulations or standards, specific taxes and so on. The legislative risk varies in degree according to industry, but every industry has some.
In theory, the government acts as cartilage to keep the interests of businesses and the public from grinding on each other. The government steps in when business is endangering the public and seems unwilling to regulate itself. In practice, the government tends to over-legislate. Legislation increases the public image of the importance of the government, as well as providing the individual congressmen with publicity. These powerful incentives lead to a lot more legislative risk than is truly necessary.
Real World Examples of Legislative Risk
An example of an industry with high legislative risk is healthcare. Drug manufacturers and healthcare providers both must contend with many ongoing legislative issues related to Medicare, insurance coverage and other customer payment issues.
Another example comes from Wal-Mart Stores Inc., which outlined certain political risks it faces in its annual 10-K filing with the SEC under its operating risk section. In its risks associated with suppliers, Wal-Mart mentioned potential political and economic instability in the countries that foreign suppliers operate, labor problems, and foreign trade policies and tariffs that could be imposed.
In its regulatory, compliance, reputational and other risks section, the company outlines risk 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 and currency regulations. Wal-Mart mentioned Brazil and China specifically, and the complexity of its federal, state and local laws.