Wall Street’s Broken Windows

By William K. Black

James Q. Wilson was a political scientist who often studied the government response to blue collar crime. The public knows him best for his theory called “broken windows.” The metaphor was what happens to a vacant building when broken windows are not promptly repaired. Soon, most of the windows in the abandoned building are broken. The criminals feel little compunction against petty destruction because the building’s owners evince no concern for the integrity of their building. Wilson took social norms, community, and ethics seriously. He argued that as community broke down fewer honest citizens were active in monitoring and policing behavior. The breakdown in community was criminogenic – it led to widespread serious blue collar crime. He urged us to take even minor blue collar crimes and breaches of civility seriously and to demand that they be contained through social pressure and policing.

New York City’s police strategy embraced “broken windows.” The police increased the priority with which they responded to even minor offenses that upset the community – “squeegee men,” graffiti, and street prostitution. Reported blue collar crime fell in New York City. It also fell sharply in most other cities, which did not implement “broken windows” programs, but Wilson and the NYPD got the credit and popular fame for the sharp fall in reported blue collar crime in New York City. Wilson became one of the most famous blue collar criminologists in the world.

Wilson’s broken window theory remains controversial among many blue collar criminologists. As a celebration of his life and research I offer this discussion of applying “broken windows” theory and policies to elite white-collar crime.

Wilson was strongly conservative. His research focus in criminology was almost exclusively blue collar crime. That was a shame because “broken windows” theory is most compelling in the context of elite white-collar crime and because the application would reveal interesting twists in the theory’s potential. Such an application, however, would have been outside Wilson’s comfort zone. Wilson tended to use the word “crime” to refer exclusively to blue collar crime and his emphasis was on very low status criminals. In a book entitled, Thinking About Crime, Wilson argued that criminology should focus overwhelmingly on low-status blue collar criminals.

This book [does not deal] with “white collar crimes”…. Partly this reflects the limits of my own knowledge, but it also reflects my conviction, which I believe is the conviction of most citizens, that predatory street crime is a far more serious matter than consumer fraud [or] antitrust violations … because predatory crime … makes difficult or impossible maintenance of meaningful human communities (1975: xx).

I am rather tolerant of some forms of civic corruption (if a good mayor can stay in office and govern effectively only by making a few deals with highway contractors and insurance agents, I do not get overly alarmed)…. (1975: xix).

Notice that Wilson’s explanation is antithetical to his “broken windows” reasoning. There are, of course, relatively minor white-collar crimes. Wilson emphasized that it was the willingness of society to tolerate relatively minor blue collar crimes that led to social disintegration and epidemics of severe blue collar crimes, but he engaged in the same willingness to tolerate and excuse less severe white collar crimes. He predicted in his work on “broken windows” that tolerating widespread smaller crimes would lead to epidemic levels of larger crimes because it undermined community and social restraints. The epidemics of elite white collar crime that have driven our recurrent, intensifying financial crises have proven this point. Similarly, corruption that is excused and tolerated by elites is unlikely to remain at the level of “a few deals.” Corruption is likely to spread in incidence and severity precisely because it undermines community and the rule of law and it is likely to grow more pervasive and harmful the more we “tolera[te]” it.

“Broken windows” theory, in the white collar crime context, would lead us to make the prevention and deterrence of consumer frauds and anti-trust violations through prosecutions a high priority because of their tendency to produce a “Gresham’s” dynamic in which businesses or CEOs that cheat gain a competitive advantage and bad ethics drives good ethics out of the markets. These offenses degrade ethics and erode peer restraints on misconduct.

The ongoing crisis demonstrates that anti-consumer frauds are a direct assault on community. Mortgage fraud – and it was overwhelmingly the lenders and their agents who put the lies in millions of liar’s loans – physically and socially destroy community by producing mass defaults, homelessness, and vacant homes.

Taking Wilson’s “broken windows” reasoning seriously in the elite white collar crime context would require us to take a series of prophylactic measures to restore integrity and strengthen peer pressures against misconduct. Indeed, we have implicitly tested the applicability of “broken windows” reasoning in that context by adopting policies that acted directly contrary to Wilson’s reasoning. We have adopted executive and professional compensation systems that are exceptionally criminogenic. We have excused and ignored the endemic “earnings management” that is the inherent result of these compensation policies and the inherent degradation of professionalism that results from allowing CEOs to create a Gresham’s dynamic among appraisers, auditors, credit rating agencies, and stock analysts. The intellectual father of modern executive compensation, Michael Jensen, now warns about his Frankenstein creation. He argues that one of our problems is dishonesty about the results. Surveys indicate that the great bulk of CFOs claim that it is essential to manipulate earnings. Jensen explains that the manipulation inherently reduces shareholder value and insists that it be called “lying.” I have seen Mary Jo White, the former U.S. Attorney for the Southern District of New York, who now defends senior managers, lecture that there is “good” “earnings management.”

Fiduciary duties are critical means of preventing broken windows from occurring and making it likely that any broken windows in corporate governance will soon be remedied, yet we have steadily weakened fiduciary duties. For example, Delaware now allows the elimination of the fiduciary duty of care as long as the shareholders approve. Court decisions have increasingly weakened the fiduciary duties of loyalty and care. The Chamber of Commerce’s most recent priorities have been to weaken Sarbanes-Oxley and the Foreign Corrupt Practices Act. We have made it exceptionally difficult for shareholders who are victims of securities fraud to bring civil suits against the officers and entities that led or aided and abetted the securities fraud. The Private Securities Litigation Reform Act of 1995 (PSLRA) has achieved its true intended purpose – making it exceptionally difficult for shareholders who are the victims of securities fraud to bring even the most meritorious securities fraud action.

The Supreme Court has held that banks and other entities that aid and abet securities fraud are immune from suit by the victims of securities fraud. Only the federal government may sue those that aid and abet fraud. The federal government has cut the number of financial fraud prosecutions by over one-half over the last twenty years even as financial fraud has grown massively. No elite CEO leading a control fraud that helped drive the current crisis has even been indicted. Elite CEOs can defraud with near impunity and become wealthy. Elite white collar fraud is a “sure thing” – the only strategy likely to make a mediocre CEO wealthy and famous.

Because Wilson did not research elite white collar crimes he did not direct his formidable intellectual energies and expertise to the study of who could prevent the breaking of corporate windows and repair those that were broken. This was a great loss because his studies of varieties of police behavior in response to blue collar crime are justly famous among criminologists. The central truth he would have quickly recognized had he thought of seeking to reduce elite white collar crimes is that only the financial regulators can serve as the “regulatory cops on the beat.” The police do not deal with elite white collar crimes. A small cadre of FBI special agents works on elite white collar crimes. There are roughly three special agents assigned to white collar crime investigations per industry in the U.S., so they never “patrol a beat.” They investigate only when someone brings a possible white collar crime to their attention. That means whistleblowers, but it overwhelmingly means criminal referrals from the federal financial regulators. Financial institutions may make criminal referrals against their customers, but they will virtually never make them against their CEOs. Only the regulators can make the thousands of criminal referrals against elite white collar criminals essential to a successful prosecutorial effort against the epidemics of accounting control fraud that drive our worst financial crises. In the lead up to the ongoing crisis we gutted the federal regulators, preempted the state regulators, and appointed anti-regulators to head the agencies. A majority of the U.S. House of Representatives is trying to further gut the Commodities Futures Trading Commission (CFTC). If we want to stop the criminals who are destroying our economy and our communities by breaking windows on an epic scale the first step is to rebuild a regulatory force committed to serving as the essential “cops on the beat.”

I listened in stunned amazement to the presentations of law professors who specialize in white collar crime and securities law at the two annual meetings that followed the ongoing financial crisis. Virtually every speaker in these sections presented arguments calling for reducing white collar criminal liability and liability for securities fraud. At the time they were speaking, the Justice Department had already ceased prosecuting major firms and the SEC brought a pathetically high percentage of its small number of enforcement actions against tiny firms with fewer than 10 employees.

We have systematically reduced effective peer restraints in our most important controls against financial fraud. Law firms, audit firms, and investment banks used to be professional partnerships. Each partner was potentially liable for any firm misconduct, which maximized the incentive to insist on higher levels of integrity. These firms are now virtually all corporations or limited liability partnerships. The incentive of partners to monitor other partners’ actions to ensure their integrity has largely been lost.

In the elite white collar crime context we have been following the opposite strategy of that recommended under “broken windows” theory. We have been breaking windows. We have excused those who break the windows. Indeed, we have praised them and their misconduct. The problem with allowing broken windows is far greater in the elite white collar crime context than the blue collar crime context. The squeegee guys make tiny amounts of money and are hated and politically powerless. The mediocre financial CEO who engages in accounting control fraud because it is a “sure thing” causes the bank to report record (albeit fictional) profits and becomes wealthy and politically powerful. He uses his wealth to make charitable and political contributions that make him far harder to sanction. He claims that any crackdown on him is “class warfare” by “neo-Bolsheviks.” Incredibly, the Wall Street Journal continues to serve as the cheerleader and apologist for those who become wealthy by breaking windows, communities, and economies.

Wilson warned of blue collar “super predators.” He called them “feral” – wild animals. These criminals are in fact dangerous, but they are odd candidates for the title of “super predators.” Wilson noted that they were disproportionately black and that they were confined almost entirely to the poorest neighborhoods in America where their pickings are poor. Accounting control frauds occupy Wall Street and other financial centers – the richest neighborhoods in the world. Their “take” from fraud is extraordinary. The blue collar criminals that occupied Wilson’s attention late in his career were politically and socially powerless. The fraudulent CEOs that drive our recurrent, intensifying financial crises are wealthy and socially and politically dominant.

Wilson had a fabulous career and added greatly to the policy debate about how to respond to blue collar crime. Our most fitting tribute to him and contribution to his legacy would be to apply his “broken window” theory to the elite white collar crimes and criminals that drive our financial crises. The troubling paradox is that the strongest proponents of “broken windows” theory and policies in the blue collar crime context are the strongest opponents of applying analogous policies in the elite white collar crime context. The Wall Street Journal is the most prominent example of this class-based incoherence.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack