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Legal Risk in the Context of Risk


Management
Published on February 7, 2019

Legal risk is one of the most difficult kinds of risk for organizations to measure and
manage.The risk of legal claims arising is commonly referred to as legal risk. Under Basel
II, legal risk was classified as a subset of operational risk in 2003. This conception is based
on a business perspective, recognizing that there are threats entailed in the business
operating environment . The idea is that businesses do not operate in a vacuum and that, in
the exploitation of opportunities and their engagement with other businesses, their activities
tend to become subjects of legal liability and obligations.

One of the primary reasons why legal risk is associated with operational risk involves fraud
since it is recognized as the most significant category of operational loss events and
considered to be a legal issue as well.

Categories of Legal Risk

There are four broad categories of legal risk, or four areas of legal uncertainty: structural,
regulatory, litigation, and contractual.
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The objective of a legal risk management process is to map the legal risks facing a1 company. Try Premium Free
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Legal risks highlights in what way or to what extent various legal risks interact, potentially
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accumulating risk, sometimes referred to as the ‘snowball effect’.
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A legal risk management process will also help any organization draft and implement a
forward-looking legal risk management strategy to make sure:

To get a better picture of the total risk exposure;

To ensure that an organization does not accept any risk in conflict with the agreed risk
strategy;

that both management and employees understand the risk strategy; and

that there is an acceptable cost-(risk)-benefit ratio behind every risk an organization


chooses to accept.

Types of Legal Risk

There are four broad categories of legal risk, or four areas of legal uncertainty: structural,
regulatory, litigation, and contractual.

Litigation Risk

Litigation is the most discussed legal risk in organizations. Litigation risk is the
possibility that legal action will be taken because of an individual's or corporation's
actions, inaction, products, services or other events.

Litigation risk can be regarded as an individual's or corporation's likelihood of getting taken


to court. In a litigious society, all members are at some risk of litigation. Large firms with
deep pockets can be especially prone to litigation risk since the rewards for any plaintiffs
can be considerable. Corporations typically have measures in place to identify and reduce
risks, such as ensuring product safety and following all pertinent laws and regulations.

Companies can face litigation from customers who claim displeasure with services and
products, disruptions and loss of service, or injury and harm that relates to the company’s
operations, staff, products, and services. A corporation may also be confronted with lawsuits
over its contracts with other businesses and individuals or intellectual property and patents
the company makes use of in its products.

The financial performance and related bookkeeping at a company may be recurring risks for
potential litigation. For instance, if shareholders become displeased with a company’s
earnings in a given quarter or over a longer period of time, and they believe management is
at fault for their action or inaction. Should a company need to restate its earnings due to an
error, or intentional misrepresentation of material elements that affected the company,
shareholders might sue the company for the lack of disclosure.
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A contract risk definition is typically one of two things:

1. The chance of facing losses as a result of the buyer not fulfilling the terms of a contract,
not including if the buyer is incapable of paying.

2. The chance of facing losses from the deal performing poorly. Sellers face the most danger
in fixed-price contracts and the least in cost-type contracts.Contracts are a fundamental part
of all industries, with organizations outsourcing parts of their value chain, building alliances,
establishing critical supplier relationships and licensing intellectual property to generate
value. Contract risk is the most damaging and difficult to track among legal risks. The
traditional approach to contract risk focuses on a breach of contract by one party and the
extra-contractual liabilities that might arise. This approach treats each contract individually
and in isolation.

Most organizations focus their contract risk management strategy on drafting effective
agreements. Quality contract drafting is necessary, but not sufficient to manage contract risk.
There are cases where one contract can create significant risk, such as:

An exceptional share of revenue is tied to one contract,

Procurement or service contracts for critical components allow for disruption or price
escalation, and

The counterparty does not indemnify us for damages that carry exceptional
consequences like unpaid taxes and environmental problems.

In most cases, however, individual contracts often do not, on their own, have the gravity of
litigation. The substantive, common and difficult to track risk is the uncertainty that arises
from the contract portfolio in its entirety. Systemic under-management of contracts creates
expense leakage and missed revenue opportunities.

STRUCTURAL RISK

Structural legal risk is rare for most organizations. Structural legal risks arise from
uncertainty about the underpinnings of a particular industry, technology or method
of doing business.

The scope of a structural legal risk is broad and it usually alters the competitive landscape.

Structural legal risks can arise from sources other than legislation. Antitrust litigation can
significantly alter pricing in an industry or key business relationships. Consumer protection
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enforcement actions can also change the fundamental assumptions of an industry, 1but Try Premium Free
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rendering a marketing practice (multi-level marketing, for example) unacceptable.
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uncertain about the change from a regulated to a deregulated industry. The
potential effects are varied, some are positive; some are negative. A structural change can
benefit one organization while harming another.

REGULATORY RISK

Regulatory risk is the risk that a change in laws and regulations will materially impact a
security, business, sector or market. A change in laws or regulations made by the
government or a regulatory body can increase the costs of operating a business, reduce the
attractiveness of an investment, or change the competitive landscape.

Financial institutions face regulatory risk with respect to capital requirements, services and
products they are allowed to engage in, and disclosure practices. Salient to investors that
brokers serve would be a change in the amount of margin that investment accounts are able
to possess. If margin requirements are tightened, the impact on the stock market could be
material, as this would force investors to either meet the new margin requirements or sell off
their margined positions.

When it comes to legal risk many organizations implicitly adopt a "zero tolerance" policy.
Unfortunately, "zero tolerance" does not create zero risk. The zero tolerance preference is
counterproductive, because it leads to the misallocation of precious risk management
resources.

Closing Remarks

In the usual context legal risk management relates to how boards can be satisfied that risks
and liabilities within an enterprise are being addressed. Boards, with personal liability as
directors of the company, want to be satisfied that any issues which may give rise to
personal liability have been adequately addressed within the enterprise. Legal risk
management is vital to any business as it can remove any uncertainties in relation to the
business operation of an entity, thereby preventing legal liability in the future. An effective
legal risk management program will ensure that the business can avoid costs associated with
any financial risks. With a strong risk management progress in place, businesses have the
capability to decrease their financial and legal exposures and are in a superior position to
make clear and well informed business decisions.

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Gavin Lawrence • 2nd 3d
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Risk Manager

I recollect trying to interest lawyers in simulating legal cases using DPL and probabilistic estimates over
twenty years ago. Lawyers just didn’t get it. They talk about the balance of probability but haven’t a clue
what it means. I co-authored a paper on simulating litigation which was published on-line by Risk World.
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Gavin Lawrence • 2nd 3d


Risk Manager

Riskworld.com seems to have changed and I couldn’t find any of the published papers that it used
to have.

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riskworld.com
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October 9–13, 2017, Ft. Co…

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Esther M. • 2nd 3d
Value Driven Quality Decision Making Process, Assurance Strategy, Operational Risk, Lean Systems, a…

Do you happen to hv a soft copy of it to share?


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Esther M. • 2nd 4d
Value Driven Quality Decision Making Process, Assurance Strategy, Operational Risk, Lean Systems, and Tinti…

Interesting topic. Recently had a very lively discussion on legal risk where it felt that it failed to present
itself on the strategic plateau as oppose to restrictively operate on operational level. The effect is more
of a reactive. Legal was involved only after a strategic decision has been made. Instead of being part of
the strategic team lying out foundation for robust operation in a new venture, they act more as a justifier
resulting on lots of rework org structure wise. Context: expansion of manufacturing facilities to …see more
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