The narrator says that there is no clear distinction between sanity and insanity, and so says that it is up to the reader to decide if Captain Vere was suffering from some bout of madness (as the surgeon momentarily thought). The narrator emphasizes the horrible timing of the event (right after numerous mutinies in the navy) and notes how Claggart and Billy have reversed their roles: the innocent victim Billy is now the perpetrator of a crime, while the evil Claggart has become the victim.
The narrator lets the possibility of Vere's madness remain a rumor of uncertain veracity. The reversal of Claggart and Billy's roles shows how mixed up the case is and how difficult (if not impossible) coming to a just conclusion in the trial will be.
According to the narrator, Captain Vere was not authorized to decide the matter on the "primitive basis" of right and wrong, but had to follow the law. Vere feared that if word of Billy's deed reached the crew, it might stir up dissent and possibly lead to mutiny. Thus, he wanted to handle the matter quickly and secretly.
The narrator draws a contrast between the justice of the law, which Vere must follow, and "primitive" right and wrong. Vere's course of action is also determined by a practical concern to maintain the loyal morale of his sailors, and the fear that the story around Billy's action—the accusation of mutiny and Billy's violent reaction—might produce a real mutiny.
Captain Vere chose the first lieutenant, the captain of marines, and the sailing master to serve in the drumhead court. He had Billy brought in and Captain Vere himself served as the trial's only witness. Captain Vere gave his testimony, describing exactly what had happened with Claggart and Billy. The three members of the court were shocked to hear that Billy had killed Claggart.
The members of the court rely on the truthful accounts of Captain Vere and Billy to make their decision. They are shocked that someone with as gentle a nature as Billy could kill someone.
Billy then spoke. He said that Captain Vere had spoken the truth, that he had not meant to kill Claggart, and that he had no malice toward Claggart. However, he said that Claggart had lied: he never planned any mutiny. Captain Vere then said he believed Billy.
Billy tells the truth, exposing Claggart's lies. Because of Billy's previous loyal behavior and good nature, Captain Vere believes him. (Again, though, one could argue that Claggart may too have been innocent: he may not have knowingly lied; he may have truly suspected Billy).
The court then asked Billy if he knew of any possible mutiny developing onboard the Indomitable. Billy paused and debated saying something, but thought of his own personal honor and duty to his shipmates. Not wanting to be "an informer against one's own shipmates," he answered that he did not know of any plans of mutiny.
Billy again faces a difficult decision: he can either betray his shipmate and report him to the court, or fail to carry out his duty to his captain by not mentioning the after-guardsman. Billy chooses silence, and in doing so becomes a liar and, if there is a mutiny, a kind of accessory to it. It is ironic that Billy will be executed for innocently committing murder when he did indeed lie in court about a possible mutiny.
Billy was then asked why Claggart maliciously lied against him. Billy responded that he had no idea, and his confusion may have seemed to some like a sign of guilt, but the narrator says that it was merely the result of Billy's ignorance of the workings of evil. Captain Vere stepped in for Billy, saying that no one could know the answer to that question but Claggart, and insisted that it was irrelevant anyway.
Billy's confusion might be taken as a sign of guilt, but it is really just an indication of his innocent, naïve nature. (Once more, one could respond to the narrator's intrusion about the meaning behind Billy's confusion and wonder if perhaps Billy really was guilty, though the evidence really does seem to point against such a conclusion.) Vere's dismissal of what could have motivated Claggart is interesting, as much of the story has been devoted to trying and not really succeeding at answering exactly that question. But in matters of justice Vere is asserting that it is not motivation that matters—it is not the thoughts of the individual that matter—but what actually happened.
Captain Vere then said that the court should only consider Billy's deed itself, and that the killing of Claggart demanded an equal punishment—death. Since Claggart was dead, Captain Vere said that his motivations would have to remain a mystery, and the court could only reach a verdict based on Billy's action.
Captain Vere puts aside his individual fondness for Billy and wishes to adhere strictly to the law. He advocates a conception of justice based only on Billy's action, though he is also influenced by a practical desire to conclude the trial quickly.
The first lieutenant asked if Billy had anything more to say for himself. He didn't. Billy was taken out of the room, and the members of the court stood in silence. Captain Vere finally spoke, telling the other members of the court that he knew they were feeling a conflict between "military duty" and "moral scruple." He said that they had to make a practical decision based on maritime law.
Vere summarized their predicament as follows: Billy killed the ship's master-at-arms and deserved the punishment of death. But, at the same time, the court felt that they could not "adjudge to summary and shameful death a fellow creature innocent before God." He concluded that it was the court's duty to follow the law, "however pitilessly that law may operate."
Captain Vere's long argument did more to agitate the troubled court than settle their minds, according to the narrator. Vere then reviewed the facts of the case and the law, telling the court that they had two options: "condemn or let go." A lieutenant asked if they could convict Billy but not punish him, but Captain Vere said that if they did not hold to the law, the ship's crew would learn of it, lose respect for maritime law, and might move closer to mutiny.
The lieutenant wanting to convict but not punish seeks a loophole that would allow honoring justice while also recognizing the facts of the individual before the court. But punishment is a crucial part of the naval justice system, as it deters other sailors from committing crimes. Captain Vere worries that if they bend the law, sailors might be more inclined to behave disloyally, nearing mutiny.
Captain Vere left the court alone to reach their decision. He tells the reader that it is easier to reason about how a battle should have been fought than to figure out what to actually do in the heat of battle. Similarly, it may have been harder for the court to reach a decision than it is for a reader to pass judgment now. Billy Budd was convicted and sentenced to death by hanging.
The narrator leaves the question of whether Billy was justly convicted very open-ended. He is sympathetic to Billy, who is fundamentally innocent, but also notes that it is more difficult to reach a decision in the middle of such a matter, especially as Captain Vere and others had to weigh practical considerations of possible mutiny. The appearance of things shifts when you look back them from when you were in the midst of them.