Wood product companies in a growing number of jurisdictions around the world can be held legally liable if they are found to be trading in material that was illegally harvested and/or illegally traded at any point in the supply chain prior to them taking possession of the product. This includes forest management plans that were fraudulently inventoried, logs that were harvested without corresponding permits, lumber that was invoiced in a manner to reduce tax liabilities, and so on. Efforts to monitor these infractions are growing increasingly advanced and penalties of prosecution are becoming more severe. While the direct costs of commercializing illegal wood products such as fines, legal fees, and inventory losses often receive the most attention from company risk-management strategies, the cost of reputational risk can be far greater than these combined.
What is reputational risk?
Reputational risk, or reputation risk, is a risk of loss resulting from damages to an enterprise from an adverse or potentially criminal event. Damages may include:
- the loss of revenue;
- increased operating, capital, or regulatory costs; or
- destruction of shareholder value
Because extreme cases can lead to bankruptcy, and a trustworthy reputation is the basis of any business relationship, reputational risk is often cited as a key concern of business owners.
How do you calculate the cost of reputational risk?
It’s hard to calculate the cost of reputational risk. One method is to compare the stock performance of a firm before and after a hypothetical reputational risk damaging event occurs. But for most wood products enterprises that are not publicly held corporations, this is not an option. Some companies are experimenting with monitoring social media for negative opinions. Neither is this option practical for most wood products enterprises. While it’s difficult to measure the financial cost of reputational risk in the wood products industry, a historical analysis of comparable events in the industry can shed some light. For example, for finished wood product companies with a nationally recognized brand based in the United States, the case of Lumber Liquidators stands out.
The reputational risk cost case of Lumber Liquidators
On October 8, 2013 the Environmental Investigation Agency (EIA) released a report accusing Lumber Liquidators of engaging in the commercialization of illegally harvested wood. Two years later the company plead guilty to related environmental crimes and agreed to pay more than US$ 13 Million. While this sounds like a large amount of money, it’s less than 1% of what the company lost in market capitalization following the EIA report.
After October 2013, Lumber Liquidators market cap decreased an astounding 90% – from US$ 3.226 Billion to just US$ 303.12 Million in February of 2016. This loss of US$ 2.923 Billion in market cap makes the $13 Million that Lumber Liquidators paid in fines seem inconsequential. The reputational risk cost appears to far exceed the direct costs. While other factors most certainly contributed to this enormous loss in market cap, the reported accusation of illegal trade in wood products would seem to be one significant contributor to the sudden turn in the companies fortune.
Understanding reputational risk should be a key component in the risk management strategies of wood product companies. To get a feel for the costs of this risk, look around at comparable cases in your market segments. Are there cases where a company was perceived to be guilty, or found guilty of illegally harvesting or trading in wood products? What effect has this had on their business? How would that translate to your experience? While coming up with definitive numbers for the financial cost of reputational risk is not necessary, it is probable that you will find examples where the reputational cost of allowing illegally harvested and/or traded wood products to enter supply chains exceeds that of the direct penalties.
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