Monday, June 28, 2010

Legal and Business Risk—an evolving understanding

Assessing legal and business risks in a transaction and handling those risks in deal documents is without doubt the one of the most challenging tasks a lawyer performs. Moreover, academic and professional writings indicate an evolving understanding of risk. For example, an IACCM newsletter in June 2007, noted "a growing body of evidence indicating that traditional legal approaches to the management of risk are too narrow. They can frequently result in unintended consequences that themselves represent risk to the business. Best practice organizations are tackling this by greater integration of the Law Department into the business and through more rigorous evaluations of probability and consequence, undertaken by people or teams with cross-functional skills and perspectives."

The IACCM initiative seeks to address "three core causes of weakness in existing procedures:

1) Predominant focus on consequence, rather then probability;

2) Narrow situational view, rather than assessment on a portfolio basis;

3) Failure to integrate legal decisions with overall business impacts."

In a similar sentiment, Jones Day partners Robert Profusek and Lyle Ganske published an article titled "It's Time To Rethink The Lawyer's Role In Dealmaking: Start By Facing Up To The New Realities." In the article they state "rather than staying mired in the world of cookbook dealmaking, we need to take a page from the private equity playbook. Our clients need to assess risk."

A Framework for Transactional Risk

In a draft paper, Management of Legal Risk by Financial Institutions, Roger McCormick defines legal risk as "the risk of loss to a company that is primarily caused by:

(1) a defective transaction;

(2) a claim (including a defense to a claim or a counterclaim) being made or some other event occurring which results in liability for the company or other loss;

(3) a failure to adequately protect assets owned by the company; or

(4) change in the law."

While lists of types of risk are helpful to understand the overall breadth of a topic, an organizing framework can further organize and categorize the principal risk elements, so that we might better understand the component elements, their scope and importance. A proposed framework divides transactional risk into legal and business risk.

Legal RisksBusiness Risks
Enforceability Risk: Risk of illegality, unenforceability or increased exposure to litigation
Due Diligence
Divergence Risk: Risk of failure to protect assets, rights, or interests
Compliance Risk: Risk of failure to comply with procedural or regulatory requirements
Negotiation Risk: Risk of failure to secure best terms or unintentionally allocate risks.

First, substantive legal risk raises issues of enforceability. It is the risk that failure to conform to statutory or common law norms may render all or a part of an agreement illegal, unenforceable, or increase the probability of dispute or the cost of resolution. Substantive risks also include the danger that contract terms are not read as intended.

Second, procedural legal risk raises issues of process. It is the risk that failure to comply with procedural of regulatory practice may void, delay or increase the cost of a transaction.

Third, business form risk raises issues of due diligence. It is the risk that failure to conform to market practices and include all required terms may not adequately protect each party's interests. For example, a loan agreement may not adequately indentify the collateral, or a software development agreement that lacks an acceptance clause may limit the buyer's options in the event that application does not perform as expected.

Fourth, business negotiation risk raises issues of customization. Each contractual term—price, process, rights, obligations, remedies, etc.—may have neutral weighting or may favor one party or the other. Negotiation risk is the risk that a transaction fails to maximize each party's interest (relative to their negotiating position) or may unintentionally shift risk between the party's (not reflected in the price).

Initial Thoughts

A review of recent articles and posts indicates a slow shift of focus from purely legal risk to a deeper understanding of the business risks in the transactional practice. Over the next few posts, I intend to dig deeper into each risk quadrant and welcome your thoughts and feedback.

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