Legal risk refers to the potential financial loss due to bankruptcy or non-compliance with regulatory obligations. Lenders and corporations face legal risks, but they can minimize them by imposing strict qualifications and complying with regulations. However, it is impossible to eliminate legal risk completely, so companies invest resources to withstand it and recover from losses.
Legal risk is a term used to describe the potential to suffer some type of financial loss due to a reversal in circumstances leading to bankruptcy, or the failure of a company to operate in compliance with regulatory obligations that apply to 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 a possibility that government agencies will change banking laws in a way that results in some type of loss to the institutions. For this reason, legal risk is also sometimes known as regulatory risk or credit risk.
There are several different situations where a legal risk may exist. In a sense, every lender assumes 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 the inability to pay the debt. In the event the debtor files for bankruptcy, the chances of the lender recovering the entire balance owed on a loan or credit card account are extremely slim. For this reason, lenders tend to impose strict qualifications to obtain credit in any form, which limits the legal or credit risk involved and minimizes the contractual risk associated with the business.
At the same time, corporations of different types also bear some legal risk in terms of compliance with laws and regulations set by different government agencies. The risk may consist of incurring sanctions or some other type of punitive action in the event that those regulations are not complied with in accordance with 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 always to comply with current regulations and to take steps to develop contingency plans that preserve the financial integrity of the company in the event that some type of new or amended regulation is put in place.
While there are ways to minimize the possibility of having to deal with lawsuits, breaches of contract and debt obligations, and even changes in laws and regulations, there is no real way to stay in business and completely eliminate legal risk. For this reason, many companies invest a great deal of time and resources to ensure that the business can withstand a certain amount of this type of risk, regardless of the source of the adverse events. Doing so improves the chances of weathering a difficult financial period due to any combination of these risk factors and eventually being able to recover from losses with as little disruption to business operations as possible.
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