Legal risk is a term used to describe the potential for sustaining some type of financial loss due to a reversal in circumstances that leads to bankruptcy, or the failure of a business to operate in compliance with regulatory obligations that apply to the jurisdictions in which the company is established. The term is also sometimes used to identify the types of financial risk that banks and other financial institutions assume when there is the possibility of government agencies amending banking laws in a manner that results in some type of loss to the institutions. For this reason, legal risk is also sometimes referred to as regulatory risk or credit risk.
There are several different situations in which legal risk may exist. In a sense, every lender takes on this type of risk when credit is extended to a borrower. The risk is that the financial circumstances of the borrower or debtor may change, resulting in an inability to repay the debt. In the event that the debtor files bankruptcy, the chances of the lender recovering all of the balance due on a loan or credit card accounts are extremely slow. For this reason, lenders tend to impose strict qualifications for obtaining credit in any form, thus limiting the legal or credit risk involved and minimizing the contract risk involved with the business deal.
At the same time, corporations of different types also take on some amount of legal risk in terms of compliance with laws and regulations put in place by different government agencies. The risk may be in the form of incurring penalties or some other type of punitive action in the event that those regulations are not followed according to the letter of the law. At the same time, there is also some risk that the regulatory agency may amend, repeal, or create new regulations that adversely affect the financial condition of the business. Here, the goal is to always stay within compliance with current regulations and take steps to develop contingency plans that preserve the financial integrity of the company in the event that some type of new or amended regulations are put in place.
While there are ways to minimize the possibility of having to deal with lawsuits, defaults on contracts and debt obligations, and even changes in laws and regulations, there is no real way to remain in business and totally eliminate legal risk. For this reason, many companies invest a great deal of time and resources in making sure the business can weather a certain amount of this type of risk, regardless of the origin of the adverse events. Doing so improves the chances of weathering a rough financial period that comes about due to any combination of these risk factors and managing to eventually recover from the losses with as little disruption in the business operations as possible.