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.
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.
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.”