Managing the Liability Risk of KI Inc.

You have just been hired as risk manager of Kicass Industries, Inc. (KI) at a huge salarydouble the amount paid by comparable firms.The previous two risk manager quit within a year of being hired.

KI is a ten-year old, medium-size manufacturer of high-tech water filtration systems.About 2 years ago the company developed a patented, low- cost system that removes arsenic from water and since then sales have taken off.To date earnings are still lagging but hopes for growth are high among management and the financial community.Here are the latest financials:

KI Inc.

Income Statement

Five Year Summary

Operating Data

2019

2018

2017

2016

2015

Sales

112,482,900

82,430,000

65,000,000

59,752,640

52,345,600

Cost of sales

49,439,400

36,269,200

29,600,000

26,291,162

22,508,608

% sales

0.44

0.44

0.46

0.44

0.43

Selling and admin exp

53,447,600

39,147,700

27,350,000

26,480,375

21,985,152

% sales

0.48

0.47

0.42

0.44

0.42

Other exp

2,562,100

1,962,300

475,000

290,000

150,000

Operating profit

7,033,799

5,050,799

7,574,999

6,691,102

7,701,839

Corporate Governance

The board of directors consists of four insiders (CEO, VP Manufacturing, Treasurer & Secretary, VP Sales) and five outsiders.All the outsiders are retired executives from companies that conducted business in the US only.None of them has extensive financial or legal experience.Three were in marketing/sales before becoming CEO and one rose through administrative ranks primarily in systems and human resources.

Operations

Plant.KI is located in a "rust belt" state.In 2014 it was able to lease its 85,000 square foot manufacturing plant and storage warehouse at a very favorable rate.In addition, the site has a modern 12,000 square foot office facility and a large yard where weather-resistant items are stored and vehicles are parked.

The VP Manufacturing is very effective at producing goods.However, he is prone to cut corners on maintenance so the plant looks a bit shabby.It doesn't have the polished look that it had under previous occupants, some of the fire safety equipment has not been checked in more than a year, and spare parts, trash and other detritus gather in corners.

Equipment.From the beginning, the company's success has depended on its patented products (which can easily be reverse-engineered) and its manufacturing equipment which is a trade secret.In addition to its manufacturing equipment, it has the following assets:

Four executive automobiles

One company plane (Cherokee)

One 30 foot cruiser on the Kicass River

6 forklifts

4 pickups

3 vans

The company does not have large delivery trucks.All goods are shipped by rail or independent truck lines.A railroad spur abuts the plant.

Workforce.Many skilled workers are available to assemble the filtration systems that the company manufactures.Because employees are wedded to the area through family and/or sentiment they work for lower wages than comparable workers in any other statewhether union or right-to-work. Currently the workforce consists of:

Plant:

o6 foremen

o80 skilled blue collar workers

o5 unskilled blue collar workers

20 white collar workers at various levels from clerical to manager

3 sales people who sell mostly through manufacturers representatives around the US

Four executives, including the CEO

Securities History/Issues

For most of its history KI has been closely held by CEO, his family, and his executive team.Until recently, operations were financed through CEO's inheritance and bank loans.In the last quarter of 2017, KI floated a public stock offering and was listed on the NASDAQ.Investor response was favorable and even though they bought the stock at the upper end of the underwriter's estimate it increased in value by as much as 45% in the first few weeks of trading.

Although sales have grown rapidly during the past 2 years, profits have lagged.A small minority of securities analysts are beginning to express doubts about the company's ability to grow profitably and word on the street is that at least one large hedge fund manager is shorting the stock.As a result, the price of the stock has been trending down and is about where it first traded as a new issue.

J. P. Morgan will soon host a press conference for the CEO so that he can inform analysts about the company and its prospects.The conference will be available by webcast.

Strategic Developments

KI's very rapid sales growth in the past two years has taken place primarily in India, Bangladesh, China, and Philippines.To some extent; all these countries have problems of arsenic in the water, and it shortens by decades the lifespan of farmers and others in the countryside.KI is represented in all Asian markets by P. Chow and Associates (PCA), a well-connected Hong Kong firm.PCA has experience and a reputation for success in dealing with government officials on which a high percentage of sales depends.

Recently PCA has been urging KI to move manufacturing capacity to Bangladesh.Labor costs there are less than 10% of the cost in the U.S.PCA has offered to take over the manufacturing of products under a royalty agreement.KI management has been resisting for several reasons: (1) the company has a family culture and the workforce is very loyal, (2) the manufacturing process involves some devices that are protected by trade secrets that have not yet been reverse-engineered by the competition, (3) US management will lose control over quality.

The CEO of KI has recently taken several extended trips to Asia where PCA executives have shown the hospitality for which Asia is famous.Upon returning to the company after the last two trips he has remained distant and moody.He seems to be softening on his stance concerning relocating manufacturing to Bangladesh and lashes out when his executive staff argues against it.

Over drinks the CEO was heard to tell VP Sales that PCA wants to create KIAsia, a subsidiary that would be an equal partnership between a few executives in KI and PCA.KIAsia would market all KI's products in the region and once it became highly profitable they would float it on the Hang Seng Exchange or in Shanghai.Shareholders would make a fortune.This arrangement, he said, would provide an ever greater incentive for PCA to market KI's filtration systems even more aggressively than it currently is doing and thus benefit stockholders.

For the following situations, please identify all possible liabilities and the correct risk management technique for each liability.