Legal Risk (Part 2)

We identified several types of legal risk in our previous post, including the risk of litigation, the risk of legal liability (both civil and criminal), and the risk of reputation loss, but what can a business firm do to mitigate or reduce such risks? There are three possible solutions: contracts, insurance, and internal controls. Let’s examine each risk-reduction method below:

  1. Contracts. Whenever possible, a firm should employ well-drafted contracts before entering into a relationship with another party, such as a customer, an employee, or a supplier. Contracts are an ideal way of allocating risks, including the risk of litigation. By way of example, consider Facebook’s terms of use dated May 24, 2007. (You can read the whole thing here.) These terms create a contract between Facebook and each one of its users at the time. Among other things, they contain an arbitration clause. In brief, if there is a dispute between Facebook and any of its users, they will submit their dispute to private arbitration, and the decision of the arbitrator (a private judge) will be final and binding on both parties. This clause allows Facebook to avoid the time and expense of going to court.
  2. Insurance. There are many types of business insurance. Product liability insurance, for example, is designed to protect a firm against claims of personal injury or property damage caused by products sold or distributed by the firm. Another example is premises and operations insurance, which covers personal injuries or damages that occur on a firm’s property or during its operations.
  3. Internal controls. A firm should work with legal counsel to establish internal policies designed to deal with risks that are specific to the firm. Many large firms also employ compliance officers, whose job it is check whether the firm is complying with applicable laws and regulations and with its internal policies.

One last point. These risk management solutions are not mutually exclusive. In fact, a risk averse firm will employ all three methods to various degrees, depending on the probability and severity of the legal risks it faces.

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Image Credit: Connor James

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One Response to Legal Risk (Part 2)

  1. Kathy H says:

    As an accountant, I am a big believer in internal controls. Prevention is the best way to avoid pain.

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