Posted 5:16 PM by Robert

Cost Benefit 101: Holmes' Bad Men

Justice Oliver Wendel Holmes, Jr. had his "bad man theory of the law."

Justice Holmes' thought doing a bad act makes economic sense to an individual bad man if b > p X D, where

b = perceived benefit to the bad man of doing bad act.

p = perceived probability of the bad man getting caught.

D = perceived downside liability to the bad man if he is caught.

Sometimes the bad man loses even if he acts rationally.

Consider tax evasion. Holmes said he enjoyed paying taxes because they are the price of civilization. Not everyone agrees. A cleverly rigged private tax-fraudulent transaction of a type not normally subject to the eyes of auditors, bank representatives or Securities and Exchange Commission investigators is unlikely to be discovered or proved. If it is, the financial tax penalties are substantial but not overwhelming. Criminal tax prosecutions are rare. And, in any event, unless a lot of other things are going wrong at the same time, most people view a taxpayer's problems with the IRS or state tax authorities to be a private matter - rightly or wrongly. So both p and D are low - and b can be high. Of course, tax fraud is one of those crimes that is often a part of a much larger illegal scheme with correspondingly much larger benefits - and so is often particularly inappropriate to consider in isolation from a cost-benefit perspective.

But it can turn out that some clever investigator sees something that makes him investigate - and he may figure out how to prove what he suspects. He may even be angry enough to bring those rare criminal charges (remember Leona Helmsley?). And if enough other things are going wrong - perhaps as consequences of that larger scheme - the tax charges could cost a lot more than was originally perceived as their risk.

Robert Burns often-quoted poem sums it up one way: "The best laid schemes o' mice an' men/ Gang aft agley/ An' lea'e us nought but grief an' pain/ For promis'd joy!"

And Oscar Wilde sums it up another: "Experience is the name everyone gives to their mistakes."

It may be that Mr. Kozlowski is learning all of this first hand right now.

If the allegations and suspicions against Mr. Kozlowski are true, he appears to be a prime example of one of Justice Holmes' economically calculating "bad men." And yet, there are commentators who first apply their characteristic "execution now, trial later" looking-glass logic to conclude that Mr. Kozlowski is guilty as charged and suspected - and then, amazingly, to cite him as a counterexample to Holmes' "bad man" theory of economic incentives. Indeed, if the largest allegations against Mr. Kozlowski are true, he may be a prime example of the dangers of putting a person with no large, independent fortune in charge of a public company (although it can make sense to do that, too). Mr. Kozlowski is not reported to be a wealthy man outside of his Tyco holdings.