Legal Risk

Updated on January 5, 2024
Article byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

Legal risks occur from negligence or a deliberate failure to comply with client obligations. It comes under the purview of the regulatory framework (Basel II and III) that governs standards for products, clients, and business activities. From an investor’s perspective, potential risks are associated with tax law violations.

Legal Risk

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If a business fails to comply with governmental regulations, it may face penalties or prosecution. In extreme cases, top-level managers are arrested. These risks are further subdivided into regulation, litigation, and contract risks. In business management, a breach of contract is the most common infraction.

Key Takeaways

  • Legal risk is when a business fails to comply with regulations or contractual terms. It is caused by internal errors, flawed processes, and deliberate infractions.
  • Every firm performs a risk analysis before investments and managerial decisions. Risk analyses are conducted both internally and externally.
  • In banks, risks include claims against institutions, documentation defects, defamation, and fines.
  • Most medico-legal risks are associated with clinical negligence—incorrect medication prescriptions, misdiagnosis, surgery mistakes, and inadequate anesthesia administration.

Legal risks arise from noncompliance or breach of contract. Every detail counts when the stakes are high; legal risk management is a crucial component of business, finance, banks, and economics.

It is a broad niche and is, therefore, closely associated with other forms of risk. It analyzes all potential threats that could cause monetary losses or a loss of reputation. The threats arise from infractions, inactions, internal and external factors, mismanagement, administrative failures, customer dissatisfaction, or faulty products.

Again, if any of these infractions are proven in a court of law, a business could face legal actions and penalties. These risks are not necessarily a consequence of willful wrongdoing. To run a business, a business needs to follow federal laws and guidelines set by governing authorities. A lack of awareness could cause massive legal troubles. Therefore, startup founders must check legal and environmental practices before forming an institution. Established firms also need to keep up with changes in regulations.

Therefore, all firms conduct risk analyses. Based on the analyses, they formulate risk management systems. Upon subsequent analyses, they tweak the system to avoid legal trouble. Compliance failures are not feasible for any firm—lawsuits, contract breaches, or policy change risks can cost a lot.

In many cases, businesses go bankrupt when they are unable to pay penalties. If a firm attempt deliberate misappropriation, it risks discovery and potential whistleblowers. Not to mention regulatory bodies that exist to capture violators.

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Types

There are three types of legal risks.

#1 – Contract Risks

A contract risk primarily relates to two situations—damage caused by either party not fulfilling contract terms or damage caused by poor performance. That is, sometimes a party fulfills contract terms but offers poor service or product quality.

Legal troubles are a big hassle; involved parties lose business and reputation. Moreover, a contract is a legal document—a proof of agreement, the parties are liable to fulfill it; if not, they invite risks and penalties.

For businesses, reputation is a tricky aspect; even after getting acquitted, they might not recover their brand image. Therefore, risk analyses are highly recommended.

#2 – Litigation Risks

Litigation risk occurs when an individual, company, or entity’s action or inaction causes damage. Such risks have a high likelihood of legal action.

In most cases, business litigation risks involve a product or service. But, again, firms go to great lengths to avoid legal troubles, as it significantly damages reputation, trust, and goodwill.

#3 – Regulatory Risks

Firms need to comply with federal laws and regulations. Compliance violations immediately result in lawsuits and penalties. Compliance regulations vary between different segments.

Firms must oblige to the applicable governing body. In addition, firms must respond to inquiries promptly and offer full cooperation if a regulatory body conducts an investigation.

Regulatory risks are also referred to as policy risks. These oversights increase operational costs and administrative duties. Therefore, firms must update employees with changing regulations.

Examples

Let us look at some examples to understand legal risk better:

Example #1

Let us assume that a furniture company manufacturing wooden doors is looking for a metal latch supplier.

The company manufactures 900 doors every month and, therefore, requires 900 metal latches. After extensive research, the firm zeroes in on one supplier to provide the required quantities of metal latches monthly. Finally, the furniture company and latch supplier enter a contract—the door manufacturer has to pay an advance monthly.

Unfortunately, the latch supplier failed to meet the mentioned quantity at the end of the month. The door manufacturer tries to contact the latch supplier, but the problem repeats every month. The latch supplier consistently fails to meet the targets outlined in the contract.

The latch supplier is in breach of contract. As a result, the door manufacturer cannot deliver doors to its customers. The door manufacturer files a lawsuit against the latch supplier to compensate for the damages.

Example #2

Policy change is an example of regulatory risk. Usually, this is witnessed when a government policy change impacts business severely.

In 2012, Cargill Inc. sued the Mexican government for excessive taxation that protected Mexican sugar producers by excluding high-fructose syrup from the soft-drink market.

The North American Free Trade Agreement (NAFTA) awarded Cargill $77 million in damages along with interest and legal costs.

Cargill Inc is an American food corporation. It is situated in Minnetonka, Minnesota, and incorporated in Wilmington, Delaware. In terms of 2021 revenue, it was the largest private corporation in the United States. In 2021, the firm reported $134.4B in revenues.

  • Legal risk management evaluates processes and operations based on potential risks.
  • With the help of efficient risk management systems, companies can avoid noncompliance penalties and lawsuits.
  • Risk management should predict potential risks for the foreseeable future and prevent them from happening.
  • It improves the decision-making process.
  • The risk management team educates employees to create awareness about regulations and amendments.
  • Legal risk indicates potential legal actions against a company. In contrast, compliance risk results in material loss and financial forfeiture.
  • A lawsuit is an example of a legal risk. Whereas failing to deliver or comply with government regulations is a compliance risk.
  • Legal risk is a broad niche and can sometimes overlap with compliance issues. Compliance issues, on the other hand, are streamlined and do not affect other legal issues.

Frequently Asked Questions (FAQs)

1. Does operational risk include legal risk?

Yes, it does. For example, operational risks arising from the failure of internal tasks, internal processes, disrupted policies, and uncompelled regulations can lead to legal action. However, strategic risk and loss of reputation do not come under the purview of lawsuits.

2. What is legal risk management?

Risk management systems are a must for every company. The risk management team studies legalities, standard operating procedures, applicable laws, bylaws, regulations, and policies established by federal authorities or governing bodies. Risk analyses ensure that the firm is operating within legal boundaries.

3. What is legal risk in banking?

Risks associated with banks are as follows:
– Claims against the institution.
– Damages, penalties, and fines.
– Documentation defects.
– Record keeping errors.
– Loss of reputation.

This article has been a guide to what is Legal Risk. We explain its types, examples, and benefits and compare it with compliance risk. You can learn more about it from the following articles. –

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