Litigation Risk: What it Means, Examples

What Is Litigation Risk?

Litigation risk is the possibility that legal action will be taken because of an individual's or corporation's actions, inaction, products, services, or other events. Corporations generally employ some type of litigation risk analysis and management to identify key areas where the litigation risk is high, and thereby take appropriate measures to limit or eliminate those risks. They vary wildly from jurisdiction to jurisdiction.

Understanding Litigation Risk

Litigation risk can be regarded as an individual's or corporation's likelihood of getting taken to court. In a litigious society, all members are at some risk of litigation. Large firms with deep pockets can be especially prone to litigation risk since the rewards for any plaintiffs can be considerable. Corporations typically have measures in place to identify and reduce risks, such as ensuring product safety and following all pertinent laws and regulations.

Special Considerations

Factors organizations must consider when assessing their litigation risk include the costs of mounting a legal defense in court, and whether or not other forms of resolution, such as a settlement, is more feasible. The costs of losing the case in court may have to be weighed against the upside potential for winning the case. For instance, startups frequently face lawsuits from entities who claim to hold patents that they assert have been infringed by the introduction of the product or service they are offering.

With the limited resources available to many startups, such litigation may be too costly for the business to bear, forcing them to seek a settlement or, potentially, cease operations.

Types of Litigation Risk

Companies can face litigation from customers who claim displeasure with services and products, disruptions and loss of service, or injury and harm that relates to the company’s operations, staff, products, and services. A corporation may also be confronted with lawsuits over its contracts with other businesses and individuals or intellectual property and patents the company makes use of in its products.

The financial performance and related bookkeeping at a company may be recurring risks for potential litigation. For instance, if shareholders become displeased with a company’s earnings in a given quarter or over a longer period of time, and they believe management is at fault for their action or inaction. Should a company need to restate its earnings due to an error, or intentional misrepresentation of material elements that affected the company, shareholders might sue the company for the lack of disclosure.

Given the various potential sources for litigation risk, publicly traded companies must include provisions in their budgets to cover their legal costs, according to generally accepted accounting principles (GAAP) as well as international accounting standards.