"The Broken Windows Theory" and Goldman Sachs

William K. Black uses the broken windows theory in describing what the banks did to bring about the financial crisis.  Goldman Sachs is one of those banks which became the model to which all other banks aspired.  Goldman pushed against legality, ethical behavior and fiduciary duties in order to maximize profits and increase bonuses.

The brokenness of the financial system is not limited to just the banks:  regulators of the banks were infected; the justice system became more accommodating of white collar crime so that even the state's attorneys general were convinced by government to make a monetary settlement rather than pursue the criminal behavior that securitization, for example, represented; the Treasury was infected; the rating agencies lied; mortgages became predatory, and so on.

Like the circular waves produced when a pebble is dropped into a pond, criminogenic behavior flowed around and through all levels of society leaving only a few hardy individuals asking that the corruption be investigated and prosecuted.

Wall Street's Broken Windows
By William K. Black - New Economic Perspectives

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“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.
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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. 

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