The Hidden Costs of Cliff Effects in Regulatory Regimes

Dr. Manoj Viswanathan
Associate Professor Designate – UC Hastings College of the Law. J.D. and LL.M. – New York University School of Law – S.B. and M.S. – the Massachusetts Institute of Technology

Abstract:

Cliff effects in regulatory regimes trigger sudden consequences when some attribute of the regulated entity exceeds a particular threshold value. By exceeding (or failing to meet) some bright-line standard, the regulated entity is sanctioned. These cliff effects impose consequences, most often financial costs, on the regulated entities experiencing a cliff effect. Thusly, two regulated entities in nearly identical economic situations can face considerably different financial consequences depending on which side of the triggering criterion they fall. In the corporate governance context, for example, cliff effects can be found in metrics such as ownership restrictions, capital revenue requirements, and asset limitations.
Prior scholarship on cliff effects has not analyzed cliff effects in depth. This Article acknowledges potential rationales for cliff effects and identifies when their definitional clarity might compensate for any equity and efficiency losses. Next, a methodology is provided to assess the individual and aggregate costs of a given cliff effect. This Article argues that cliff effects based on an attribute that is out of the control of the regulated entity violates principles of both equity and efficiency if the social utility of the cliff effect does not exceed the financial penalty imposed on the regulated entity by the cliff effect. If this analysis results in a determination that the cliff effect should be altered, a process by which the cliff effect can be changed is provided.

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