Is Wall Street Guilty?

“If Wall Street is bilking Main Street on such simple deals–basic trade execution-and yet the only way to recover is to sue, what real chance do individual investors have of getting a fair shake in the financial markets? And what if you add sophisticated computer models, derivatives structuring technology, and secret Cayman Island companies to the mix? Do we have any chance at all?” — Frank Partnoy (1998) in his postscript to F.I.A.S.C.O.

A couple of weeks ago, Bloomberg BusinessWeek ran a story by Roger Lowenstein, entitled “Wall Street: Not Guilty,” that largely absolves Wall Street of criminal culpability for the financial crisis. 


This courageous conclusion—and if nothing else one must concede it is courageous—runs counter to popular opinion that malfeasance on Wall Street was an integral cause of the crisis, if not the chief cause. The story widens the debate at a time when a number of vocal critics (including Inside Job director Charles Ferguson and New York Times contributor Jesse Eisinger) are calling for criminal prosecutions.

Putting aside the accuracy of Mr. Lowenstein’s supporting arguments[1], we find it interesting to consider Mr. Lowenstein’s argument against criminal prosecutions from a legal, economic and philosophical perspective.

Society criminalizes conduct to achieve many policy goals, above all, prevention and punishment. (Of course, punishment should have a deterrent effect but it retains significance without regard to its deterrent effect.) Juridically, the primary goals of punishment center on the protection of society from criminal conduct, the stigmatizing of the conduct and the serving of justice to the victim(s).

The economic argument is simple, as it relates to the protection of society. From an economist’s viewpoint, punishment can be described as the “price” a criminal must pay to society for breaking the law, for criminal conduct. This “price” has two elements: the severity of the punishment on the books and the likelihood of its imposition in practice. In proper balance, they work together as deterrents to criminal activity, reducing its incidence. But what happens if we introduce an imbalance between these elements, if our laws create stiff penalties that are never imposed? We already know the answer to this question: when potential criminals believe ex ante that misconduct will not be punished, the marginal wrongdoer is incentivized to seek economic rents from misconduct.

Mr. Lowenstein agrees that “[t]o prosecute white-collar crime is right and proper, and a necessary aspect of deterrence.” However, in the current crisis, he sees a wrong but no wrongdoer: “[T]rials are meant to deter crime—not to deter home foreclosures or economic downturns. And to look for criminality as the supposed source of the crisis is to misread its origins badly.” But the hunt for wrongdoers in this crisis is no mere quest for a scapegoat. Rather, it proceeds from the need to protect society from future crises. This will only happen if punishment deters (or incapacitates) the specific wrongdoer from repeated misconduct and deters the general public from similar misconduct by the example of the punishment of the wrongdoer.

The philosophical analysis is more complex—but worth exploring in a wider context. It forces us to examine how well our present regulatory system is capable of dealing with the special types of problems presented by the complex and opaque world of derivatives dealing, problems with which is it is repeatedly and increasingly being required to cope.

Mr. Lowenstein doesn’t quite make the best philosophical argument against criminal prosecutions in this crisis, but he might have suggested the following: any criminal conduct in this crisis was so wide-spread that no wrongdoer’s action stands alone. If any one wrongdoer had not acted improperly another one would have. In other words, where everyone is guilty, no one is.

In other words, while well-constructed derivatives provided certain wholesome benefits, the opportunity to benefit from abusing derivatives was not limited to a single bank or even a single type of financial institution. Rather it transcended the banks and hedge funds and included all types of market participants, from the buy-side to sell-side to the rating agencies and beyond, and all types of individuals working for those participants. In the end, the entire profit maximization motive and the human nature from which it proceeds must be put on trial, so that ultimately we all find ourselves sitting right next to every other defendant in the dock.

Thus, a defense might argue that the “system” seems to have encouraged (and rewarded) wide-spread misconduct and that, given the existence of such a dysfunctional dynamic, one ought to excuse a defendant's acting as a willing participant (or instrument) in this unjust system, if for no other reason than to advance his or her self interests, or lofty ambitions.

The philosophical response may simply be this: an abyss exists between actual wrongdoing and potential wrongdoing. Those who kill while part of a mob really are different from those who are just part of the mob.

But while philosophically that response might appear to suffice, legally there remain certain challenges. Among other things, a prosecutor has to prove both components of a criminal act: criminal conduct and the requisite mental state. The requisite mental states—intentional, knowing, reckless or even negligent conduct—may vary by jurisdiction and they may pose a barrier to the extent they require a determination of the defendant’s level of deviation from that of the ordinary person in a similar environment. (The similarly improper conduct of many or all parties surrounding the defendant may obscure the analysis of a “punishable mental state.”)

But they should not prevent prosecution: the critical question is not “Shall we prosecute?” but “Whom shall we prosecute?”

Nor does the argument hold weight that a subordinate can excuse her role as a mere functionary carrying out the role of her superior. Whether the defendant was only a tiny cog in the machinery, or the motor driving the faulty operation, the relative importance to the resulting order of magnitude of the misconduct serves only to help define the gravity of the sentence imposed—not the probability of its imposition.

17th century Dutch jurist and statesman Hugo Grotius, paraphrasing an earlier Roman authority, explained that "punishment is necessary to defend the honor or the authority of him who was hurt by the offence so that the failure to punish may not cause his degradation."

Given the continued proliferation of improper derivatives dealing, it is punishment alone that can protect our society for future wrongdoing—through stigmatizing the improper acts and by serving as a material deterrence for potential wrongdoers. In this way, restitution will meet the material concerns of the victims of these crimes—the tax-payers.

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[1] The facts have been argued by, among others, Ryan Chittum and Prof. William Black.