by John Wojtowicz (Director - Law Central Legal)

When setting up, expanding or buying a business financial risk is foremost in most people’s mind. The risk reward analysis has been embedded into every business operator since time immemorial. However legal risk often takes a back seat to financial risk when making an assessment on buying, expanding or establishing a business. This article discusses legal risk and the need to have legal risk management in some form in each business, big or small.

What is Legal Risk?

There is no standard definition of legal risk. However under the Basel II standard (Basel II: The International Convergence of Capital Measurement and Capital Standards - A Revised Framework Initially published in June 2004) legal risk is classified as a category of Operational Risk.

Roger McCormick in his book “Legal Risk in the Financial Markets”, Oxford University Press discusses legal risk as a risk of loss primarily caused by:

1. a defective transaction; or
2. a claim (including a defence to a claim or a counterclaim) being made or some other event occurring which results in a liability for the institution or other loss (e.g. as a result of the termination of a contract); or
3. failing to take appropriate measures to protect assets (e.g. intellectual property); or
4. change in law.

In practical terms, legal risk to a business can be put into 3 categories:

1. being sued,
2. being prosecuted by a government or quasi government authority, or
3. being barred or restricted by law in operating the business in a particular way or even at all.

Growth in the Law

The growth of the law in both volume and complexity has elevated the need to attend to legal risk management more and more. One only has to look at the Income Tax Assessment Act (Cth) since its inception in 1937 to illustrate this point.

Chris Berg, in his report “The Growth of Australia Regulatory State: Ideology, accountability and the mega-regulators” 2008 notes in relation to legislative activity in the period from 1980 to 2006 that “there was more than five times the number of pages of legislation passed than there had been in the eight decades before this period.”

On top of Acts of Parliament being passed, the case law in turn has increased in volume as well.

Legal Risk Management

Legal risk management is different to financial risk management. Businesses primarily exist to make profit for their owners. Accordingly, financial risk is undertaken the very moment the Business opens its “doors” for business. Business owners will make assessments as to what activities or strategies should be undertaken to increase profits or to protect the current value of the Business.

Establishing new business locations, entering new markets, incurring debt, acquiring a new partner or stake holder, employing new staff are some common examples of financial risk. When undertaking these financial risks it follows that new legal risks present themselves.

Legal risk also exists the very moment the Business opens its “doors”. It is at this point that each Business needs to address its legal risk through some form of process or management.

Legal Risk Management Factors

When addressing legal risk various factors come into play:

1. Awareness of legal risk;
2. Identifying legal risk;
3. Assessing legal risk;
4. Prioritising which legal risk needs addressing before others; and
5. Mitigating or minimising legal risk.

Awareness of Legal Risk

Business owners need to be aware through their advisors or education that legal risk exists in their Business at all times from establishment of the Business to future activities conducted by the Business. Without this awareness, legal risks will not be addressed.

Identifying Legal Risk

Again the business owner’s advisor should address this issue. The list of potential legal risks will vary from business to business and from activity to activity. The Law Central Basic Legal Health Check for Businesses or Advanced Legal Health Check for Businesses may help in this regard.

Assessing Risk and Prioritising Risk

Assessing legal risk has 2 aspects:

1. the likelihood and foreseeability of such legal risk manifesting itself, and
2. the size or magnitude of the consequences of the legal risk occurring.

Gold Platinum members read on for a breakdown on assessing legal risk.

Mitigating or Minimising Legal Risk

The business advisors play a pivotal and essential role here in assisting the business with legal risk issues. Advice should be obtained on all potential legal risks. Each advisor has different methods and ways of approaching legal risk.

Gold and Platinum members read on for some suggestions towards mitigating legal risk.

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. Law Central Legal recommends you seek professional advice before taking any action based on the content of this Bulletin.