The Pricing and Economic Impact of Legal Risk

Abstract

Legal risk is an inherent feature of the market, arising from the institutional foundations that enable economic activity, yet it remains difficult to observe systematically across firms. To address this gap, this paper constructs a text-based measure of firm-level legal risk using earnings call transcripts. Firms exposed to class action lawsuits, regulatory scrutiny related to climate issues and bankings, and cybersecurity threats tend to exhibit higher risk scores. Legal risk has real and financial consequences: a one standard deviation increase predicts a 3–8% decline in future investment and reduces firms’ reliance on debt when facing financing needs, consistent with a precautionary motive. A long-short portfolio that buys high-risk firms and sells no-risk firms earns an annualized return of 4.7% (t-stat: 3.6), increasing to 7.1% (t-stat: 4.9) post-2010 when regulatory oversight intensified. The pricing of legal risk varies across legal origins, reflecting its institutional foundations.

Keywords: Legal Risk, Law and Finance, Natural Language Processing

JEL Classification: G12, G14, K22, K41, C55