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Tetiana Bui
Candidate of Economic
Sciences, Associate Professor
National
university of Kyiv-Mohyla academy
Olena Primierova
Candidate of Economic
Sciences, Associate Professor
National
university of Kyiv-Mohyla academy
ISSUES OF LEGAL RISKS AND LAWSUITS
AND THEIR IMPACT ON THE VALUE OF COMPANIES
One
of the most familiar, but least understood,
intangible
assets is a firm’s reputation.
Simon
Cole [1, p. 47]
Introduction. The concept
of company value is one of the central in corporate finances. The maximization
of the market valuation of the entire capital of the company is considered in
corporate finance as a primary. However, the process of identifying of value
factors is not as simple as it seems at first glance, because in recent decades
the gap between the value of enterprises recorded in their financial statements
and the assessment of this value by investors has significantly widened.
Different companies' researches have shown that about 40% of market value is
not reflected in the reporting - investors do not pay for current assets, not
for current period profits, but for the possibility for generating cash flow
and profit in the future [2, p. 11]. Consequently, the issues of image and
business reputation of companies are becoming increasingly important in the
context that they are considered by investors in their assessment of the
attractiveness of investments in companies.
As it follows
from the definition and characteristics of the business reputation of the
business entity, its essence is the prestige of the firm (commercial) name,
trademarks and other relevant subjects of intangible assets in the environment
of consumers of goods and services of such entity. As it is stated in paragraph
5 of the Information Letter of the Supreme Economic Court of Ukraine of March
28, 2007, No. 01-8 / 184 "On certain issues of the practice of applying
economic laws to information law", the monetary equivalent of a business
reputation can be expressed in the form of goodwill [3].
In developed countries reputational capital is valued
for at least as tangible assets; it is taken on an equal footing with
intellectual and marketing assets. As of 1 January 2012 it accounted for close
to 26% of the total market capitalization of the S&P500, US$3,190bn of
shareholder value. At the same time it was delivering US$770bn of value across
the FTSE100 and US$67bn across the FTSE250 [1, p. 59]. There are firms,
especially in PR business, whose reputation reaches 80% of the market value of
the company. The drop in the reputation index of the company by only 1% leads
to losses in the share price by 3-5% [4, p. 54]. A loud scandal may even drop
the price of the company on the market. Therefore, communication and
PR-activity in many companies comes for the first place, overstating the
importance of production itself. And reputation management has become a major
task for companies, especially those who seek to conquer new markets and rely
on long and successful work in the business community.
Business reputation of the company determines the idea
of the company as a business entity. Business reputation of the
company contains moral and ethical and business features of enterprise
management, stable partnerships with suppliers, attraction and maintenance of
professional personnel, personnel management system.
Recently the issues of legal risks and court decisions
and their impact on the value of companies are becoming particularly important.
Therefore, it is important and relevant to consider legal and judicial risks
for the image and value of companies.
Main part.
Legal risk could be defined as the risk of financial or reputational loss that
can result from lack of awareness or misunderstanding of, ambiguity in, or
reckless indifference to, the way law and regulation apply to the business,
their processes, products and services.
Legal risk can take many forms, beyond losses from
lawsuits or criminal and regulatory penalties. Some companies decide to settle
litigation rather than be subject to prolonged court cases. Settlement is designed
to limit negative publicity and avoid prolonged reputation damage. The
peculiarities and concrete forms depend on national legislation and may
differentiate in different countries.
The four major categories of manifestation
of legal risk are contractual, structural, regulatory, and litigation risk. In
this paper we will focus on litigation risk. Litigation
exposure can result from either company-initiated or external-party-initiated
lawsuits. Company-initiated litigation occurs when company management initiates
legal proceedings for such reasons as to enforce contract rights.
External-party-initiated litigation occurs when an action has been threatened
or initiated against the company. This litigation may involve allegations of
errors, omissions, violations of law, damages, or personal injury caused by the
company, its management, or its staff.
Risks associated with the participation of the
organization in administrative, criminal or civil proceedings combine both
legal cases for counterparty claims, and those initiated by the companies
themselves, as well as state authorities. In the allocation of such risks,
specific grounds for actions, the amount of the claim or the assigned penalty
may be taken into account. In the opinion of psychologists, "the very fact
of recognizing the corporation as "criminal" also matters, as a
result of which it is morally condemned, loses creditors' trust, loses clients,
may face a boycott of its goods, and lose the opportunity to receive government
orders" [5]. In modern conditions when the advent of streaming news and
social media means that local company’s issues can become global concerns in
minutes. The nature of risk is evolving, and more than ever, companies need to
be prepared to manage problem situations with law suits faster [6].
Litigations could be a reason of a negative public
opinion. A damaged reputation may affect the company’s ability to establish new
relationships or services or to continue servicing existing relationships,
which may adversely affect current and future earnings. Widely publicized
litigation, regardless of its ultimate outcome, can affect a company’s
community standing, limit its business opportunities, and reduce its value [7].
There are many evidences of such development of events. For example company Texaco suffered
huge shareholder losses and consumer boycotts as a result of disclosure
of apparent violations of antidiscrimination laws [8, p. 352].
Alexander Kotlyar, the head
of the control and legal department of the industrial equipment company of Danfoss LLC is sure that participation in court proceedings
should be considered as a very topical risk and companies should seek ways to
reduce it [5]. After all, the availability of litigation is actively covered in
the business press and negatively affects the attitude of investors. For
example, Samsung stocks lost in value 7.7 percent in the first hours of trading
on the Seoul stock exchange on Monday, August 27. The fall in the share price
of Samsung became the largest since October 2008. A sharp drop in Samsung's
stock quotes occurred after late in the evening on Friday, August 24, a trial
in San Jose, California, which dealt with a patent dispute between a South
Korean corporation and Apple, decided in favor of the latter [9]. Thus,
investors' reaction to news about lawsuits and court decisions can very quickly
affect the real value of the stocks and lead to a significant loss of the
company's value.
Of course costs of reputational damage can verify and
depends on different factors such as: publicly disclosed facts; facts of the
crime and seriousness of crime; compliance, self-reporting, cooperation; information on nexus between crime
and counter parties; information on quality internal governance;
mandates imposed; post-crime reforms [10]. Presence or absence of these factors can affect the
reputational cost. But in the broad sense the criminal
activity or non-compliance with laws, all violations
always influence the business reputation and image both from the economic and
everyday points of view. It is can be described as some instinct - a reaction
to the word "criminal": the reader will always pay attention to the
publication of the new criminal case. Given that the cost of goodwill is often
estimated at millions of dollars and the fact that it affects the value of the
company's stocks, it is clear that, in addition to the legal punishment, the
legal entity will have other consequences: negative impact on the business
reputation included in intangible assets, expressed in quite a material loss of
hundreds or millions of dollars.
In our opinion, it can be said
that the criminal liability of a legal entity affects not only business
reputation and image, but in general the whole company activity. The society,
consumers, business partners form their attitude to the company, its products,
and provided services based on information provided by both the company itself
and the media. As an example, we can consider the case from the Indian drug
manufacturer Ranbaxy Laboratories (India - the fourth-largest producer of
medical products in the world). The US Food and Drug Administration (FDA) took
measures against the company. The FDA limited the import of the goods produced
by the company in Toans (for 6 years the FDA imposed
a ban on the import of goods from four factories of Ranbaxy). This decision was
made as a result of a check conducted in January 2014, during which a large
number of violations were found, including it was found that the laboratory
staff presented the results of testing that were not true. The media already
attribute Ranbaxy to corporate criminals: in 2013 Ranbaxy paid a fine of $ 500
million and pleaded guilty to seven criminal points in connection with the sale
of counterfeit medicines to deceive and conceal the fact that these medications
did not match certification and knowingly false statements to the government.
Despite the efforts of the company's advertising department, public statements
about the introduction of new technologies, management methods and a strict
code of conduct, information is regularly received that Ranbaxy stocks fell by
9%, 18%, 20% [11, p. 86].
Some companies were involved
in such high-profile scandals that it was the reason for their closure.
Reputation is a very important characteristic in the financial services market.
Having gained reputation due to violation of standards and legislation can become
dramatic for companies. Thus, Arthur Andersen (LLP, formerly one of the
"Big Five" accounting firms) in 2002 voluntarily surrendered its
licenses to practice as Certified Public Accountants in the United States after
being found guilty of criminal charges relating to the firm's handling of the
auditing of Enron.
Finally,
even if a firm can avoid legal liability, ‘‘market liability” provides another
obstacle to the effective use of judgment proof agents. A firm’s reputation may
be placed in jeopardy if it is known to be involved in criminal or illegitimate
activities. Reputations matter very much. That is why firms often overcomply with regulations, spending millions of dollars
on self-promotional ventures to improve their image with consumers and regulators [12].
One of the most significant in this context is
the example of the trial of McDonald's Corporation against environmental activists Helen Steel and David Morris [1997], which is known as "the McLibel case”. This process (it counts 313
court sessions) became the longest in English history. And as he gained
strength, the press paid him more and more attention. Millions of people
watched this trial. And the more delayed the process was, the more harm it
brought to McDonaid’s. As a result, accusations of
food poisoning, contributing to the spread of cancer and the robbery of third
world countries were considered groundless. However, this victory in court
could not compensate for the losses suffered by the company because of such a
long judicial time and harmful information spread by TV, radio and
newspapers [13, p. 86-89].
Conclusions. The issues of
legal risks and court decisions and their impact on the value of companies are
becoming particularly important today. All of possible results of corporate law violations can be very harmful for company,
including steep monetary penalties, suspension or termination of contracts, and
as a result - plummeting share price. So companies should pay much attention in
managing legal risks.
The method of
mitigation of such risks is the maintenance of statistics of court cases and
analysis of the reasons for their occurrence and their elimination - there may
be a gap in the logistic system of the company or there are no standard forms
of contracts, or there is no feedback from consumers and an effective pre-trial
way of resolving claims. The criminal liability of a company always influences
its business reputation and image both from the economic and everyday points of
view. In addition to the legal punishment, the legal entity will have other
consequences: negative impact on the business reputation included in intangible
assets, expressed in a loss of hundreds or millions of dollars.
Companies in the
modern world should closely monitor compliance with laws and regulations. There
is little doubt that legal proceedings pose a large risk to firms. Event
studies report significantly negative stock market reactions upon the
announcement of lawsuits [14, p. 2]. To avoid losses due to lawsuits, it is
better to proactively monitor the activities and information that appears in
the press. May be the presence of legal risks and their strong influence on the
value of companies will lead not only to better management in the companies
themselves, but to greater compliance with laws in general.
References:
1.
Cole, S. (2012) The
Impact of Reputation on Market
Value.
World Economics,
Vol. 13, No. 3, pp. 47-68.
2.
Ostrovskaya,
G., Seredinskaya I. (2009) Review
of theoretical concepts of strategic
management based on the growth
of value. Galician Economic Bulletin,
No.
1, pp.
10-18.
3. Information letter of the Supreme Economic Court of
Ukraine dated March 28, 2007, No. 01-8 / 184 "On certain issues of the
practice of application by economic courts of information law”.
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Buryak, G., Kovalchuk
Yu.,
(2012) International Management By Reputation
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