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INSIDER POLICING: SECURING COMPLIANCE AND MAINTAINING TRUST IN FINANCIAL MARKETS

PhLLp Stenning, CeiWnd Sheaking, Swan Addevtio

BF 575 .T7 S9 1985

LIDRArly MINISTRY OF THE SOLtotTOR

GENERAL OF CANADA

NOV 9 :98

INSIDER POLICING: SECURING COMPLIANCE AND MAINTAINING

TRUST IN FINANCIAL MARKETS*,- ,,.

Philip Stenning, Clifford Shearing & Susan Addario •

1-- --,

DICUOTHÈQUE rtimerËnE DU SOLLICITeR

GÉNÉRAt. bu CANADA o

."

. /e,v...\ .,..'r ARIO

i This iE a revised version of a paper originally presented at

the 1985 Annual Meeting of the American Society of Criminology,

13th-17th November, 1985, San Diego, California. Funding for the

research on which this article is based has come from the Social

Sciences and Humanities Research Council of Canada (Grant #410-

84_329) and from the Ministry of the Solicitor General of Canada

(Grant #1700-22) and through its Contributions Program.

The views expressed in this article article are those of the

authors and do not necessarily reflect those of either of the

agencies which contributed to the funding of the research on

which it is based. We are particularly grateful for the comments

of Professors Nancy Reichman and Susan Shapiro in response to an

earlier draft of this paper.

Poulantzas (1978: 186-7, 210, 212) has argued, with refer-

ence to "authoritarian statism,' that one of the factures of the

ongoing constitution and re-constituticn of captialist society is

the emergence of parallel control structures; one recognized, the

other hidden (see Jessop, 198599-100 for a discussion of this

distinction). The existence of parallel structures has also been

recognized at the economic level as this special issue bears

witness.

Unfortunately, just as there is an enormous knowledge vacuum

with respect to the hidden economy, so there is with respect to

hidden control structures. Consequently, although this duality

is important to the maintenance of the distance and relative

autonomy of the economic and political spheres within capitalist

societies and may as Poulantzas has argued, be generic to the

new fore of the capitalist etate, only the more visible official

control processes within the political sphere have received sus-

tained attention from scholars, including Marxists. The result

has been a failure to grasp adequately the processes through

which contemporary captitalist economies are ordered (Shearing

and Stenning, 1983).

This neglect of unofficial parallel structures is not simply

problematic with respect to specific topics (such as the nature

of policing or the economy) but suggeets a failure to recognize

this as a general feature of society that needs to be examined in

its own right. What research has, and is, being done is frag-

mented and reflects the skewed vision of myopic analysis: a

failure tc see the wood for the trees. To understand the duality

1

that unoffical parallel structures reveal, it is necessary to

stretch across the several spheres in which this duality is

revealed by making it the object of inquiry. It is this require-

ment that makes the hidden features of capitalist policing rele-

vant to the informal economy; both fors part of a larger pattern

of parallel structures. An undertanding of the hidden economy

requires an understanding of hidden control structures and vice

versa.

Fortunately, in pursuing this cross fertilization, it is

possible to draw upon a growing literature on hidden policing and

the hidden economy that is beginning to reach general conclusions

about the nature of these secluded processes. One such conclu-

sion with respect to policing relevant to the conceptualization

of unofficial economies, for example, is that the appropriate

opposition is not between formal and informal policing but be-

tween state and non-state policing and furthermore that this

structural distinction is shaped ideologically by the liberal-

democratic distinction between public and private spheres.

In this paper ne do not seek to review the contribution that

the policing literature can make to an examination of offical and

unofficial economies in general terms. Rather, we will display

important features of this literature through a concrete analysis

of one element of a formal system of priate policing that orders

a critical institution of the visible economy, the stock market.

The Research

Our paper arises out of an ongoing three-year ethnographic

study of three major North American stock exchanges. The study

has focused on the Exchanges' regulatory activities, many but not

all of which are the responsibility of their regulation depar-

tments. As a result, the initial data collection was focused

within these departments. Data collection has taken the form of

observation of regulatory employees, file analysis and extensive

open ended interviews in which employees of the Exchanges were

asked to review their recent activities with the researchers.

The present paper focuses on the work of one of the sub-

divisions within the regulation departments, the Compliance Divi-

sions. The analysis is based on the accounts compliance officers

in one of the Exchanges gave of their activities during

interviewe with them. These interviews were of two kinds.

First, each officer participated in an initial interview in which

the philoeophy and work of the Compliance Division was discussed

in general terms. This was followed by one or more interviews in

which these officers reviewed their activities via a discussion

of particular cases. In addition to the interviews with

compliïnce officers, interviews were conducted in all three

exchanoes with supervisory personnel, to enable the researchers to

'play back insights gained and hypotheses formed during the

first round of in ,..erviews. 'A quantitative analysis of the files

produced during the course of compliance work was also done.

These last data, however, have not been used as the basis for the

analysis presented here.

The Policino Environment

The activities of the Compliance Divisions are one element of

a complex structure of regulatory control over the stock market

which includes both public and private, state and non-state,

visible and "hidden" components.

Although they have legislative recognition, the Stock

Ex changes we have been studying are private organisations

established an run by and on be -half of their member firms The

trading of securities, which ie of course the primary business of

the Exchange, is regulated by state legislation. the

responsibility for the administration of which has been assigned

to state and federal Securities Commission.

While the Exchange is required by lao to operate in confor-

mity with this securities leoislation, the actual policing of the

activities of members of te Exchange has in fact (for reasons

which will become clearer as we proceed) been largely left to the

Exchange itself. This ie structured through the enactment by each

Exchange of a by-law governing the conduct of its members, and

the establishment within the Exchange of a Regulation Department

which reports directly to a Vice-President of the Exchange. The

Regulation Department is responsible for ensuring that the,

conduct of members, in their trading and related activities, is

articulated oith the Exchange's by-law and with applicable state

securities legislation.

Within each Regulation Department are divisions which deal

with the approval and registration of securities personnel; the

auditinu of the financial position of member firms; the mainte-

nance of members procedures and practices in conformity with the

bylaw; the scrutin'.' of companies applying for listing on the

Exchange; the investigation of complaints and allegations of

misconduct by members and their personnel; and disciplinary pro-

• ft cedures against those suspected of wrongdoing.

The activities of the Compliance Division are thus but one

element of an intricate policing organisation at the Exchanges

which we are studying in their entirety. We focus on the

Compliance Division in this paper not only because the activities

of this division are critical to the regulation of the market

place, but also because in their proactive, preventative

emphasis, compliance strategies provide a striking contrast to

the reactive, inveatigative policing strategies which dominate

the existing literature on official, visible policing.

Trust - the basis for financial markets

Social order, as we know it, would be impossible without

trust. The essence of trust is a "confident expectation" that

others will act in a proper manner and that one can accordingly

"place reliance" on them "without misgivings" (or at least with

reasonably predictable misgivings). Trust permits action to

unfold in situations in which one party must act before they know

that the other will play their part (Luhmann, 1980; Barber,

1983). The giving of credit in a business transaction provides

an obvious example.

Nowhere is trust more important than in the financial markets

that are the life blood of modern capitalism. In "Cabaret", Joel

Grey sings the famous refrain that "money makes the world go

around'. As many people have pointed out, however, it is not

money, but trust, that "makes the world go around". Indeed, as

Shapiro has noted, it is trust that makes money go around;

[Trust] serves as the laxative that loosens

1 money in the pockets and mattress'es and bank

accounts of potential investors and moves it

along into the coffers of our nation's

corporations. With the demise of trust, this

one-and- one -half-trillion-dollar capitalist fund would surely dry up (1904:2).

Without trust, financial dealings, as they exist presently,

would simply not be possible. As Shapiro has observed (1904:2),

trust is truly the foundation of capitalism.

In a stock market, people are prepared to trade stocks for

cash when they are confident that the market is, among other

things, "fair". People believe in the "fairness" of a market

when they are convinced of two things. First, that the deals

they make will be honoured, and second, that the market is not

weighted against them. The first of these expectations involves

not only that traders are good to their word, but also that

sufficient assets are available to them to meet their obliga-

tions. The second involves the expectation that everyone who is

trading on the market is trading on the basis of comparable.

information (i.e. that no-one is trading with relevant "inside"

information to which others, if they wished, could not be privy).

The two maior trust-based decisions which market investors

make are choosing a broker and choosing what stock to invest in.

In making these decisions, investors have a variety of sources of

"evidence" on which to base their trust, some more reliable than

others (Short, 1904). What dietinguishes the high-roller from the

notorious "little eld lady investing her life savings" is not the

need to "trust the maret", but the amount and type of evidence

they each have available to them, and accept, as the basis for

such trust, Such sources of trust include certification (only

•1 6

trade through a registered trader), association (only trade

through a broker employed by a "reputable" brokerage firm),

reputation (only buy "blue chip" stock, only trade through a

broker who comes recommended by someone you know, etc.), experi-

ence (stick with the stocks you know), and intuition or "hunch"

(a source commonly cited by those who claim ta have a "feel" for

the market). Others - the amateur and professional market ana-

lysts - look ta more "ecientific" sources of evidence upon

which to base their trust, and concentrate on the "performance"

of stocks in much the same way that racetrack enthusiasts study

the "form" of the racehorses on which they bet. Trust in the

market can thus be to a great extent self-generating, in the

sense that investors confidence in the market increases with

each "positive" trading experience which they have.

It is this that makes market confidence bath a secure and a

fragile business. The trust is secure because evidence of its

is constantly Provided by the market;

because when that evidence proves negative, market confidence

can and does, evaporate very quickly. Maki no sure that experi-

ence of trading is consistent with confidence in the market, and

that negative evidence is quickly neutralized, is the essential

task of market regulation. Policing of the Exchange, then, is

primarily concerned with constructing, maintaining and erotecting

the essential conditions for 'trust in the market". Compliance

officers 2t the Exchange are front-line "guardians of trust"

(Shapiro, forthcoming) who are charged with fulfilling this task,

The Comaliance Process

validity it is fragile

7

1

The process within the ComplianCe Division is relatively

straightforward, although its execution requires a high level of

skill and expertise on the part of compliance officers. It in-

volves in-depth visits to the offices of each member firm of the

Exchange. Each firm which is within the Exchange's audit juris-

1

diction , is subject to a compliance review on an annual basis.

About half of the Exchange's member firms fall into this cate-

gory. In the case of the larger firms with branch offices, com-

pliance reviews include audits at selected branch offices in

addition to the firm's head office operations. To perform such

examinations, the Compliance Division has a staff which fluc-

tuated during the period in which we undertook our research

between 8 and 4 compliance officers supervised by two managerial

officers:

Following a review of a member firm's files at the Exchange

Kincluding the report of the last vieit from the Compliance

Division, a check with Member Registration to see who has been

recently registered and approved at the firm. and a check on the

status of any outstanding complaints againet the firm or its

reoresentativee), the compliance officer visits the firm, armed

with an e x tensive 'checklist", and proceeds to intervlew all

thoEe at the firm who are designated as being responsible for

ensuring that the firm's procedure:- are in compliance with the

bv-law. fhere follows a selective sampling of the firm'e files

on "actie" accounts, to assess whether procedural and

dooumentary requirements are being met. Attention to proper

s central to this review, since documentation

provides the eeeential 'paper trail" through which compliance can

documentation

of the review, the undertakings for corrective action findings

be monitored and, if things go wrong, violations can subsequently

be detected and investigated.

The time taken by such on-site reviews varies greatly,

depending upon a number of factors including firm size , number of

branch offices, volume of trading, and the number of compliance

officers assigned to a particular review. Reviews of some of the

larger firms may take as long as three or four weeks and involve

two or three compliance officers. Reviews of smaller firms may be

concluded by a single compliance officer within a matter of days.

Once the review of files iE complete, the compliance officer

"findings" informally with the responsible

officers. At this stage agreement is soueht about the extent and

nature of non-compliance at ne firm, the corrective actions

which need to be taken, and the time-frames which can reasonably

be suggested for compliance to be achieved.

There follows a formal "exit interview" with the senior

responsible officers of the firm, at which time the informal

conclusions of the review are confirmed and, if necessary,

discussed further. Finally, the compliance officer returns to the

Exchange and writes a review letter, setting out formally the

discusses his

which have been requested and received, and the timeframes agreed

upon. This letter is then sent to the chief executive officer of

the firm, with copies to the respective officers responsible for

compliance within the firm.

Although the "checklist" is designed to ensure a degree of

standardization in the compliance review process, all the

9

compliance officers to whom we spoke stressed that compliance

reviews are tailored to the parti cular characteristics of the

firms under review, and deEigned to minimise unnecessary

disruption of firms' operations. Compliance r. eview was described

to us by one officer as a more "subjective" form of policing than

the policing undertaken by other Exchange personnel (such as

investigators and examiners). This, he said, was because

compliance is less "black and white", and "you've got to weigh so

many different things". The extent of the formality of the review

process (and in particular the role of the checklist), however,

were the subject of some tension between the compliance officers

themselves (most of whom have prior experience working within the

industry) and the senior management of the Compliance Division at

the time of the interviewing (whose backgrounds included law and

accounting).Between these two croups is a significant level of

disagreement over the advisability terms of the effectiveness

and credibility of the compliance prooess) of the current

p olices which favour a shift in emphasis from a predominantly

"educational" and "assistiven approach to a more pure. 'audit"

approach. The managers, in this case, seem to be attempting to

achleie a change in the overall "workplace culture" (cf. Strauss,

19S2z Manning, 1983) of the Compliance Division which is the

subject of resistance by the compliance officers who are working

the "street" . We have more to Eay about this below.

The role of ordPr and rulP=

The primary formal definition of order which compliance

officers draw on in their review process is provided by the

1.1?)

TI

Exchange by-law. AlthOugh the state Securities Commission ap-

proves the by-law and an',' amendments to it, the drafting of the

by-law and amendments is undertaken by the Exchange itself and

its content is finally determined by the Exchange's Board of

Governors (which is made un of members of the Exchange). The by-

law is thus private law in the most literal sense, although as

with most other forms of private law, the state (in this case

through the Securities Commission) seeks ta insist that its

provisions are at least not directly inconsistent with those of

applicable state law.

It would be a mistake, however to suggest that the by-law

is the only, or perhaps even the most significant, source of

order definition used by compliance officers in the review pro-

CeSE. In practice, as they all acknowledge, its provisions are

overlaid with a host of more or less agreed interpretations and

glosses which derive from :he 'street (i.e. the industry itself

as s result of its members' experience of the "realities" of

doing business) and from the experience of past compliance re-

views,

In the essential business of promoting trust, the by-law

appears te be viewed as a set of guidelines specifiying the usual

conditions required for trust, rather than as a set of hard and

fast standards. The formal written standards are frequentiv

ameliorated. They are also, however, someti mes exceeded when

activit1es which mav be consistent with the bylaw are identified

as being nevertheless detrimental to trust. In explaining to us

the objectives of compliance policing at the Exchange, one of the

compliance officers mentioned that even apparentiv minor documen-

11

tary deficiencies which are not technically violations of the

Exchange's by-law may be regarded as serious problems if they

threaten to expose the member firm to potentially serious finan-

cial risk. This concern with preventing firms from exposing

themselves to serious financial risks is not simply a paternal-

istic one, or even a reflection of the Exchange's concern to

protect investors investments as such, but rather a concern to

protect the viability of the securities industry as a whole.

Compliance officers often reminded us that this industry, has

historically been thought of as a "business of trust". As one

officer put it:

"...one of the most important things for a securities firm that deals with the public is its reputation. It's guarded very jealously by most of, I would say all of

them... It would cost them a lot of money to get adverse publicity."

More importantly, however, such adverse publicity shakes public

confidence in the industry as a whole, and it is to protect such

public confidence that the by-law and the compliance policing

associated with its enforcement are principally directed, The

saine officer, in speaking of one of the more technical rules of

the bv-law this case the rule tnat clients' orders must be

fi lied before those of brokers themselves), noted that current

thinking in the industry is that such a rule is not really nec-

eesary to protect clients or the public interest generally, and

that there is therefore an inclination to abOlish the rule. He

added, however, that:

"The main problem is that it's always been some comfort to the general investing public that there is such a

rule, and it has more of an impact on public confidence, if you will, than any real practical

difference in terms of the e .xecution of orders.'

The definition of the order with which compliance officers

seek compliance is thus an ongoing process involving both formal

amendments to the by-law itself, and informal revisions of the

interpretations applied to it, in the light of the changing

realities of 'the street'. As one compliance officer explained it

to us:

"Interpretation here nas sort of been modified over the last few years to recognize the practicalities of the

moment, and it doesn't make sense to have a by-law

requirement if it can't be enforced. "

Many of the rules which must be applied are couched in very

general terms, leaving much room for discussion and negotiation

as to how they apply to parti culer industry practices. Good

examples of such rules are the so-called "know your client' or

'suitability" requirements, according to which a broker, before

trading on behalf of a client, is required to obtain a substan-

tial amount of information from the client and make an assessment

as to what particular kinds of investments are "suitable' for

that particular client. Exactly what kind of information, and now

much of it, brokers must obtain from their clients in order to

coàlply with these requirements is a matter of judgment and as

such is inevitably a matter which is potentially open to negotia-

tion between the compliance officer and the member firm under

review. In such instances - and there are many of them

decisions as to what does or does not constitute non-compliance

are essentially negotiated outcomes rather than imposed defini-

tions.

Our interviews with compliance officers make it clear that

II

the discretion they exercise in this regard involves not simply

interpretation, but occasionally actual evasion (or turning a

blind eye) in the case of rules which are perceived as being

"unworkable" on the "street". Thus, for instance, the rule that

accounts must be reviewed b a "designated person' at a firm's

head office, is seen to be impractical for some of the larger

firms which are operating 'hundreds of thousands' of accounts.

Compliance officers admit to "overlooking" delegations of this

review function in the larger firms even though such delegations

are technically in violation of the by-law. Where rules such as

this are seen to be unrealistic, and by-law reform is perceived

to be necessary, compliance officers sometimes actively encourage

fi ras to complain to the Exchange about such rules in the hope

that this will exoedite the reform process.

Power in shapino the definition of order

The ongoing evolutionary character of the definition of

order and the elusive quality of many of trie rules at any given

time, ensure that the relative power of the comoliance officers

and the firms they are policing is often a critical factor in-

fluencing the manner in which discretion is exercised in the

compliance process. This reality of policing in the Stock Exch-

ange context in turn dictates the kinds of skills which are

required of compliance officers to be able to do the Job effect-

ively and the kinds of strateoies which they employ to achieve

compliance. The significance of the power relations between the

compliance officers and the firms being policed is further heig-

htened by the low visibility of compliance policing in this

14

context, which is also largely dictated by the power of at least

some firms to resist successfully more highly visible policing

tactics.

As one compliance officer explained to us, some of the firms

within his juriediction are so powerful that they are virtually

enforcement-proof:

"But certainly, I mean there is a firm that everyone

knows about. Not only should we ding them, the

Exchange should ding them, the [other self-regulatory

body] should ding them. But no one

...If you look at the make-up of [this firm] you're

talking about the most powerful men in [the province].

[Interviewer: In the financial community?]

Just in [the province] generally, not only in the

financial community, but you know they have a great

deal of power."

This officer described how

"—they say sure, you know, corne here, and you go up

there, you soend two weeks minimum, maybe longer

because it's a larde firm. And you say this, this,

this, vou know "Yeah, that's fine", and you walk out,

and they just throw it in the garbade. I mean they

won t even let the Exchange in.

[Interviewer: And you have no lever or power?]

Well, we do. I mean by the by-laws, but they just

tote-Ali ignore us and there's nothing that anyone will

do abour. it."

Such resistance to policing has a ripple effect, making it

difficult to enforce the by-laws against brokers in other firms

in the same jurisdiction:

"Ever ,/ broker in the place says, well, you know, if you

make me :amply with the by-laws I'll just pack up my

bags and go to [the firm just discussed]."

Such threate by brokers can similarly inhibit even the firms for

whom the' work from attempting to discipline them internally, for

fear of losing a valued broker who maybe "produces half a million

dollars' worth of commission a year, you know".

Not all firms, of course, are perceived as being as powerful

as this. Effective resistance to policing, we were told, is more

likely to come from the larger firms. Speaking of another firm

which he had reviewed, this same officer said to us:

"Why did we ding [X firm]? Because we had no fears of

LX firm] at the Exchange. Nobody [from X firm] was

sitting on the Board [of Governors of the Exchange],

the' didn't have the clout on the street and we could

suite easily po in there and kick their ass and there's

not much they could Jo apout it."

Compliance officers, however, regard it as an important part

of their Job to avoid enoendering resistance and confrontation.

Although there is a right in member firms to appeal decisions

made in the Compliance Division to the Exchange's Board of Gover-

nors, we learned that such appeals are in practice never taken,

so strong lE the desire within the Compliance Division to resolve

matters without confrontations with the member firms. It i5 to

eome extent the fear of confrontation and resistance, and the

resultant loss of credibility and effectiveness which the regula-

tory agency would suffer, that predisposes the Exchange towards a

compliance mode of policino, and dictates the particular strate-

gies which are adopted to achieve compliance.

Compliance strategies

The principal effect of this cOntext on policing strategy is

to force compliance officers to adopt strategies of persuasion

rather than coercion. One officer characterised the compliance

process to us as "an ongoing co-operative effort between the

Exchange and the firm to get into compliance." As another put

it:

"Don't forget one very important aspect here that we

haven't really dwelt on and that is that a compliance

officer is using to a large extent moral suasion in

getting members to comply. We do not threaten them in

any wav. And that's where experience is very important

in this particular job, because you can outline all the

different types of consequences that could happen to a

registered representative, a branch manager, a director

of the board of directors of the firm, the firm itself

if they allow this situation to continue because

obviously we don't want to charge another firm for non-

compliance if we can avoid it because it's very costly

to start off the disciplinary process at the Exchange.

We have to get our investigators involved, we have to

have a slate of lawyers involved, plus committees, plus

the board of governors. So a large measure of the

succese of all this is the degree of moral persuasions,

moral suasion Ulat we use at the time of the exit

interview. In other words we get them to agree. We

can't force them to agree, right? So you have to use

the right arguments to get them to."

Our interviews with compliance officers make it very clear that

the 'right arguments' for this purpose are almost always

arguments which will demonstrate to non-compliant ‘irms that

conti:lued non-compliance i5 not in their own business interests,

or rather, that compliance is in their own best interests.

Another compliance offic'er describes how he found the "right

arguments" to persuade a senior officer of the firm he was

ta secure compliance within the firm with the

documentation requirements of the "know your client" rule in

respect of clients who had been friends of his for many years:

"X, who kept digging his heels in, eventually turned

out alricht, you know, and [they] did what they were

asked to do and but he was quite, he insisted on being

in on my exit interview. And he immediately started on

about, y ou know, the bureaucracy of the whole thing and

so on and so forth, you know, and how could we make him

fill out a new account application form and get

documents when he's known someone for 25 years and ,it's nonsense that, vou know. And actually what shut him up

reviewing

1. 7

is that I said well, that's fine, but I said obviously

you're not concerned about the continuity of your

business. And he said, well how do you mean? I said,

well you go out to lunch and get hit by a truck. I

said, do these people know who you, your friends for the last 25 years? And he says, well you do have a good

point there, and from that point on, he left, well

shortly afterward he left the meeting, and ne got

everything straiohtened out, and they're doing quite

well now.'

Compliance officers at te Exchange stressed to us that in

order to be able to do this job of negotiating definitions of

non-compliance and finding the "right arguments" to convince

-firms to comply, it is essential 'for a compliance officer to have

a high level of 'street sense" (or "industry sense", as one

officer described it);

...you know, you need to have a little bit of

knowledge about what the hell's going on and, working

in a [brokerage] house, it does, it sure as hell does

make a, it certainly isn't going to hurt. And I don't

think that, you can more, see it more from their point

of view. You know, tney are there to make money and

regardless of what some people say at the Exchange, the

yast maJority of people out there are honest, and most

people are not going to rip people off, you know. But

you've oot to oiye them a little bit of leeway, you

know. '( ou can't completely tie them up, you know. But

then, again, common 5ense is the only way."

nother officer out it this way:

"Well, first of all, you have to be able to talk the

lingo of the industry, to know all the nuances of a

particular term. If a person gives the impression tnat

you don't know that, well, you lose credibility, you lose respect, and your chances for having success in

negotiation are considerably reduced. Secondly where

experieoce CDMES in is that you can put a problem in

the right context within that firm's, withio that

industry, and you can always do that when you have

considerable iosioht into how the industry works. You

have to know, not the rules itself, anyone can learn

the rules and 52y oaragraoh so and so, section so and

ED I subsection so and so, it says this and that. Now if

'fou can't apply that in a practical context, how can

you successfully negotiate something with a firm and

make them really understand the extent of the problem?'

An important element of the compliance process is the review

letter (nowadays usually sent to the chief executive officer of

the member firm) which follows the visit of the compliance off-

icer, and which spells out in detail, and formally, the areas of

non-compliance which have been found and the deadlines which have

been agreed upon by which the firm must bring itself into com-

pliance. Although resources devoted to following up these review

letters, and monitoring the extent to which firms do in fact

achieve compliance within the deadlines set, are evidently rot as

adequate as compliance officers feel they need to be, some follow

-ups are done, and firms are expected to inform the Compliance

Division (usually in writing, but sometimes by telephone) of

their progress in meeting compliance deadlines etc. Compliance

officers stressed to J.E that "industry experience" is critical

here, too, in en,Ablind compliance officers to a==f==s the quality

of such responses. and whether the progress which firms are

reporting really is being made.

The setting of such deadlines for compliance is another

aspect of the compliance process in which compliance officers

stress the importance of knowlege of the industry. Officers

stress that, to have any hope of being achieved, deadlines must

be 'realistic", and the assessment of what is realistic requires

a detailed knowledge of the realities of the industry, and of the

market at the relevant time. As one officer explains, the market

itself has a direct influence on the compliance process. This is

because in some cases, especially when rules are amended and

tightened, achieving compliance can involve considerable cost,

1 9

especially to the larger firms. Compliance with the documentation

requirements of the "know your client" rule was cited to us as a

particular example of this problem:

"...it has become a very expensive undertaking to be

able to say to the [ Exchange], well we have all of the

necessary documentation on file for all of our

accounts. And the only way that you could do that would

be to review all the client accounts, and we've gct a

large number of firms ta do that. It's been very

expensive, it's been a very expensive project for

member firms but they've done it, they've completed it,

most of them. This firm. that project still has to be

done and they have a very large client base because

it's a retail brokerage fi ris. So, unfortunately it's

something that the [Exchange] just didn't follow up on.

And we agreed with them that they should get another

extension for the completion of this project. They also

had problems in this particular area because they had a

reduction of staff. and that's not unusual when the

markets slow down. Member firms have a tendency to cut

back on staff. So it's a fact that our industry must be

one of the mcst cyclical industries in the country.'

When asked what factors influence the determination of deadlines

for compliance, this officer cited such matters as: the number of

client accounts the firm has; the amount of physical space

available in the firm'e office ito handle large volumes of files

etc.); the availability of "proficient' compliance personnel

within the firm , and the current workloads of such personnel; the

extent to which certain parts of the compliance task can be

assigned to other, less qualified, personnel; the overall

financial situation of the firm; and the risks to the firm Un

terms of "exposure") of continued non-compliance. This last

factor. in particular, orovides a measure whereby compliance

requirements can be prioritized;

"...based on a comprehensive review of client accounts

at selected branches to see whether there is any

particular exposure, what type of agreements are

missing, that type of thing, we can work out an

agreement with them that, "your exposure is largest in

this particular ares, 50 that's where we have to place

priority. Get that straightened out first, and then do

the rest". Or, in some cases there is really no choice

but to do all accounts at once. In other words, take

one account after the other. Take one branch, do that

branch, and then g0 on to the next one.'

In determining such priorities, the question of whether accounte

are "active" (i.e. regular trading 15 taking place or "inactive'

is critical, since "exposure" is obviously greater in the case of

"active" accounts.

It is the need for industry experience in effectively

negotiating so many matters in the compliance process, that

compliance officers cite as the reason why they are convinced

that self-regulatory policing of the industry iE likely to be

more effective than state regulation. As one officer put it:

"—there are very few of the (Securities Commission

people] who really understand sales compliance, because they don't have any people in the [Securities Commission] who have been in sales or, as far as I know, that have even been [in] the brokerage industry aer se. They have only been on the regulatory side of the business. Therefore, it is extremely difficult for them to understand sales compliance. They would have a fair idea about many of the areas of sales compliance

from administering complaints, but that is a very much different situation from reviewing the overall, to

assess the overall quality of a firm's sales compliance with that backgrDund."

This officer noted that state securities commissions tend to hire

ex-policemen as investi gators to do their regulatory work, and

that such people bring a different mind-set to the policing of

the industry than that of compliance oficers at the Exchange,

who have more direct experience of how the industry "works".

The Philosophy and Objectives of Comaliance Policing

Although not directly stated, the opinion of compliance

officers on this issue appeared to be that the difference between

state regulation and self-regulation is not simply a matter of

the different qualifications and experience which regulatory

staff bring to the job, but rather a different approach to the

task of policing - state regulators, for a variety of reasons,

adopting a reactive investigative approach, while self-regulatory

organisations place greater emphEisis on a proactive, preventa-

tive, negotiatory compliance approach.

The ultimate objective of compliance policing is not essen-

tially different from that of any other mode of policing; it is

to secure, among those policed. behavioural conformity to a

particular prescribed order. What distinguishes compliance poli-

cinq from other modes of policing iE rather the general philos-

ophy which underlies it with respect to how this ultimate objec-

tive can be most effectively achieved within the particular

environment in which policing must be undertaken, and taking into

account the particular characteristics of the population to be

policed. At the heart of this philosophy is the notion of . pre-

yention - that policing will be most effective if it can pre-

vent breaches of order from occurring, rather than simply respond

te such breaches after they have occurred (Hawkins, 1984; Reiss,

1985; Manning, forthcoming). This preventative philosophy has a

number of important implications for the way in which breaches of

order (violations) are perceived and responded to by those who

adopt a compliance-oriented policing strategy. In the first

place. violations , when detected, are of interest to compliance

officers primarily as indicators of the likelihood of future

violations which need to be prevented, rather than as evidence of

past wrongdoing which oupht to be puniehed. This perspective is

important to the way the seriousness of violations is assessed.

Thue, the measure of seriousness of a violation (or 'non-compli-

ance matter", as it is sometimes called) is not so much the harm

which it haE caused, but the likelihood that it will lead to

future harm if the conditions which gave rise to it are not

corrected. As Shapiro ( 1 984) has pointed out, this perspective

explains why compliance policing often tends to focus on more

technical, rather than subEtantive. violations. This is because a

technical violation of procedures , if left uncorrected, may pro-

vide the opportunity for a significant volume of even minor

substantive violations in the future, which may end up collect-

ively causing more harm than one major, but isolated, substantive

V iolation.

The preventative philosophy of compliance policing, then,

causes it to focus as much on oplortunities for violations to

op. cur as on substantive violations themselves. Creating such an

opportunity especially if it is a major opportunity - it-

self becomes viewed as a major violation or instance of "non-

compliance" requiring corrective measures (Shearing & Stenning,

1983: 50l). Thus. when asked how he determined that a particular

instance of non-compliance with the by-law was not to be regarded

as "serious", one compliance officer whom we interviewed at the

Exchange tDid

'Well , if it car be determined that the deficiency is

not the result of an inadequate procedure and control

at the member firm, it is an isolated instance for

example in one branch office because that branch

administration has chosen to disregard its own firm's

policy, its a bit of a different natter, although one

can say that head office ought to be aware of that and

there is a deficiency in the control at head office

that, letting branch office get away Aith that If, for

example that came about because the responsibilities at

head office had been transferred to a new manager that

was not quite aware of the eituation so he wasn't able

to detect that this bran:h was deficient, we will treat

that as a sen eus matter, but not as serioue as if the

whole firm had a deficiency of this nature."

The "serious problem here was not the technical violation which

had been detected at the branch office, but the deficiency in

management control of which it was thought to be indicative.

By the same token, as another compliance officer explained

to us, complaints against a firm or its indi ,eidual brokers are

seen as relevant to the compliance review process only to the

extent that they are indicative of wider structural problems

within the firm under review:

"So we have a word with the Chief Investigator [at the

Exchange] to find out what complaints they are

currently handling... Eo we know the gist of those

complaints, what area of business they might have an

impact on. We look at them broadly, to see if they can

give us a clue as to au kind of weakness within the

firm or if it's an isolated incident. If its an

isolated incident whereby an PR [registered

representative] has done discretionary trading [which

the by-law prohibits without prior approval from an

approved person] in one or two of hi s, accounts, there is no reason for us to take that problem any further

and suspect the other RR's.... We are using that as a

tool, as I said, to discover any possible weaknesses.

If there seems to be a trend, then we are giving much

more importance to that area do more detailed review

of that area. So that we are satisfied that it is

unlikely that it will happen again. And no doubt firms,

I would think, tnemselves would take a similar action.

I'm not saying in all cases, and we don't really know,

but it's onlv coud management practice when you have a

particular problem in one particular part of your

business the y will tri to remedy that proble.n. That's

good management practice,'

While enforcement of :ompliance with the provisions of the

EHchanoe's by-law is oresented as the central objective of the

activities of Compliance Officers, our discussions with them

suggest that there are other important objectives which the

compliance process seeks to achieve. Most commonly mentioned

among these was the notion that to the extent that they are

able, Compliance Officers are expected ta assist firms and their

managerial staff in improvinp their management and supervisory

programs and practices. An importent objective of the compliance

process, other than enforcement 3S such, is to perform an educa-

tive role. One Compliance Officer stressed to Us that "basically

we're not going in there, I don't think, looking to nail them,"

He noted that Compliance Officers had seen themselves more as

"management consultants". although he acknowledged that current

workloads within the Compliance Division were forcing its offi-

cers to adopt more of an "audit function". Another officer,

emphasizing the potential advant'ages both to the Exchange and the

member firms of a more 'educational" approach, put it this viay:

"I feel sometimes a bit concerned about that we don't have enGugh time to spend on the educational role because I feel that it's really effective to be able to help these people to understand their role so they can

prevent problems from arising rather than us to come in

after to do our pure audit functions, say "hey, you've

pot preblems there and there and there". It will take

mure efforts on our behalf to resolve these problems

with the members and certainly much mare effort on their behalf, their own, to correct all these points

than if we had sport X number of hours perhaps, couple of more hours at the outset.

[Interviewer: So "ou think that in the long run in some cases with some firme it would be a more efficient use

of tille to be a little more preventative in terms of

non-compliance?]

Yeah, that's correct: I really do.

Put another way, compliance officers see their objective as

be'ing ta assist firms to police themselves. As one compliance

officer commented to us:

"Although members no doubt make great efforts at complying with all the by-laws, we have a vast number of new by-laws coming out all the time. And to expect

that a large firm with hundreds of approved people are

all aware is, I think, unrealistic based on what we

have seen in the past. They need that visit from the

Exchange to reinforce those areas that have to be

looked at by the member firm."

As this officer pointed put, an increasing number of firms are

now establishing their own internal compliance departments, or

assignino this function part-time to designated officers.

Educating the firms' own compliance people is seen as a major

objective of the Exchange's compliance officers. As the above

comments indicate, underlying this approach is a recognition that

one hundred per cent compliance is an unrealistic goal to expect

firms to be able to achieve, given the complexity of the rules

and the costs of achieving compliance with them. "One has to use

reason," one officer told us, "one cannot expect a member to

always go the right thing; so long as they do it ninety-nine per

cent of the time,"

Another officer described his objectives' to us in the

following terms;

"I seem to think that the compliance officer's always

more assistive than anyone else, you know. You get him

[i.e. the person being reviewed] into a position where.

well, not the examiners SO much, but where these guys,

the investigators, don't have to come in. And vou can

find where they, where they're weak on things or they

could be exposed, and that's where you try to get them

to strengthen up. so that they can avoid having an

investigation or discipline.'

All the compliance officers to whom we spoke mentioned the

advantages to the member firms themselves of this kind of

approach, and indicated not only that they see their role as

including the giving of advice ta firms ion management and

supervisory strategies etc,), but that firms commonly solicit

such advice from compliance officers in their attempts to avoid

being in a non-compliance situation.

In addition to the function of enforcement, therefore, the

compliance officers act as the medium through which "street

knowledge' is passed on from one firm to another. As a result,

according to compliance officers, most firms welcome their

visits, and some come to depend on them. The experience of

compliance officers counts for a great deal here:

"...they like the idea of us comina in because the fact

that we're in every street, every firm on the street or

across [the country/J. you might say is, that we can

bring ideas to their firm.'

The detection of violations with a view to bringing

on investigatory and disciplinary actions is definitely not seen

as one of the objectives of the compliance process. Indeed,

compliance reviews very rarely result in such outcomes, which are

typically triggered by outside complaints rather than, any

discoveries made by compliance officers. The very few cases in

which matters have been "rolled over" from the Compliance

Division to the Investigative Services Division, and in which

disciplinary action has resulted, however, appear to bear

substantial symbolic significance both for compliance officers

and for the firms they police. To the compliance officers, these

cases are seen as but one more indicator of the subtle shift in

recent years away from a predominantly "management consultant"

role to a more purely "audit" function. Dy no means all of the

compliance officers view this as progressive. For the firms,

these exceptional cases provide a "reminder that behind the

Hassistive" posture of the compliance officers lies the potential

for more coercive forms of intervention.

Conclusions

In this paper WE have attempted to summarize some of the

main characterisitics of compliance policing by a private

authority operating within the securities industry. The picture

which emerges iS of a policing strategy in which the emphasis is

on preventative and "assistive" intervention and negotiated

rather than imposed outcomes. The preventative, compliance

policing strategy which has been adopted in this instance has, of

course, been presented to us in its most favourable light by

those who are employing it, and the fact that we have not yet

obtained the perceptions which the "poiiced" have of this process

obviously means that it is premature for us to draw any firm

conclusions about it. Our research 50 far nevertheless raises

some important iESI,EE about the nature of the policino enterprise

in general, and of compliance strategies in particular, which

have hitnerto received insufficient attention in the policing

literature.

Most importantly, our research to date suggest that the

contep: of policing is of critical importance in determining not

only who mav be able ta police most effectively, but what poli-

cing strategy will be most likely te produce results (in terms of

the ultimate obiective of policing. behavioural conformity to

prescribed order). For the Compliance Division at the Stock

Exchange we have been studying, the two critical contextual

E3

elements in this connection seem to be the nature of the securi-

ties market itself, and the relationship between the "police" and

the "policed". Each is cited, with equal conviction, as the

reason why a compliance strategy is likelv to be more effective

than a more enforcement-oriented investigative strategy.

The securities industry itself, and the Stact Exchange in

particular, are enterprises whose successful operation depends on

the existence and maintenance of trust on the part of the "inves-

ting public'. It is the need to construct, promote and maintain

thie basic condition of 'trust in the market" which, more than

anything else, dictates the adoption of a primarily co-operative,

preventative, compliance-based form of policing at the Exchange,

rather than the more well-nown reactive, adversarial form of

policing :ommonly aseociated with the public police forces. This

is because maintenance of trust iE so vital to the operation of

the Exchanoe, ite destruction can occur so easiiv, so quickly and

with such disastroue resulte for Exchange members generally, that

a primarily reactive fgrm of policing, it ie thought, would serve

neither the interests of Exchange members n.or those of investors

effectively. The nature of trust, furthermore, is that it is best

eetablished through an ongoing scrutiny of routine performance.

" prOper " Satisfaction that such performance has been routinely

(i.e. in reasonable conformity with established norms) in the

paEt. ger:erates trust that it will remain so in the future.

The very nature of the business of the Stock Exchange itself

also pre-disposes its members to favour the more co-operative,

negotiatory style which characterises compliance policing. Ira-

ding, negotiating dealg, and gaining the customer's confidence

are the very essence of activity at the Exchange. Althouoh there

is, of course competition on the floor of the Exchange, it is

competition which is characterised more by aggressive and flex-

ible bargaining than by adversarial combat. A policing style

which mirrors the trading style is thus seen as mare reasonable,

more tolerable and more effective than the more rigid, mechan-

istic style of reactive investigations and disciplinary hearings .

Even the enforcement of comdliance seems ta rely, like the enfor-

cement of trades on the floor, more on the honour and integrity

of member firms and their representatives, than on the threat or

invocation of punitive sanctions.

This is rot to suggest , of course, that the maintenance of

trust always and in ail circumstances dictates a policing

strateoy of the kind favoured by the compli.ance officers we have

been studying. It is not hard to see that investors confidence

in the securities market may as easily be shaken by perceptions

of under-enforcement of standards as by evidence that violations

are frequent and sen cuis, The policing of trust, then, like all

policing, requires a delicate balance between the management of

behaviour and the management of appearances (cf. Hay, 1975).

Occasionally, eithe r . or both may dictate a more visible, more

reactive, punitive, exemplary policing strategy. In such

instances, matters are turned over to the investigative division

within the Exchange, the formal disciplinary process and,

occasionally, to outside agencies such as the state securities

commission or the public police for action. In this sense, the

wider policing environment within which compliance policing is

very

3e)

undertaken is of considerable importance.

The other contextual aspect of policing in the Stock

Exchange which is said to favour a compliance-based policing

strategy is the particular relationship between the "police" and

the "policed". In this case, the "policed" are some of the most

powerful individuals and corpurations in the land, and the

"police" are their servants.

In the literature on policing, the assumption has, of

course, often been made that the ability of the powerful to

resist policing makes effective policing of them largely

impossible. Such compliance-oriented self-policing as we have

been examining is often dismissed as a form of window-dressing,

with claims being made that it demonstrates no more than the

ability of the powerful to present the appearance of being

controlled while in fact having "captured" or "co-opted" those

responsible for policing them (see for example, Fellmeth, 1973;

Katz, 1977). The relative absence of publicity, and of

successfully investigated and prosecuted "cases", is cited as

further proof that such policing is purely nominal.

Such arguments are, of course, as hard to refute as they are

to substantiate, since convincing ways of measuring "capture"

have not yet been devised. Clearly, however, evidence of the

presence or absence of successfully prosecuted "cases", is an

inappropriate criterion on which to evaluate the effectiveness of

a policing strategy which does not have the generation of such

"cases " as one of Its central objectives. Nor can the fact that

outcomes are negotiated rather than imposed be seen, by itself,

as proof of 'capture" without some other evidence that desired

3 1

levels of control and compliance are not being achieved. In this

connection, it is of particular interest that the Compliance

Division at the Exchange apparently does not collect statistics

in any aggreaate form either on the nature of non-compliance or

on the extent to which non-compliance is effectively reduced

through the compliance program. When we asked why this was so,

compliance officers told us that there was insufficient time

available for such tasks, that the "subjective" firm-specific

nature of compliance reviews would make such statistical analysis

difficult, and that it wae not thought to be "neceesary" anyway.

Our research nevertheless suggests to us that there is a

need to rethink some of the aseumptione which underlie current

thinking about policing of the powerful and the problem of "cap-

ture". One evi dent weakness of euch thinking at present is that

it displays a crude instrumentalist bias which denies the possi-

bility that an organisation responsible for policing powerful

groups may nevertheless be able to achieve for itself a measure

of autonomy from the control of those being policed. One possibi-

lity raised by our research so far is that self-policing organi-

sations may be more able to secure such "relative autonomy" for

themselves precisely because of, rather than despite, their rela-

tionship to those being policed. Compliance officers at thé

Exchange seem to be able to extract negotiated concessions from

member firms because, by virtue of their experience and 'industry

sense", firms see themselves as being able to benefit from offi-

cers interventions. Furthermore, compliance officers are able to

hold up the alternative of more visible, enforcement-oriented

"bureaucratic" and insensitive intervention by the state as a

further inducement ta firms to co-operate in bringing themselves

into compliance. Galanter's (1981) conception of private

authorities operating "in the shadow of the state" may prove

particularly useful in this connection.

Another assumption which seems ta underlie much of the

thinking of "capture" theorists, is that powerful interests such

as the member fi ras of the Stock Exchange we have been studying

are inherently resistant to policing and control. Our research to

date causes us to question this assumption on two grounds. In the

first place. the members of the Exchange are in fierce

competition with each other. Compliance officers' assertions that

members do complain ta the Exchange about each other's conduct

and business practices suggest that there na'/ be strong reasons

why members would be supportive of and co-operate with a

policing organisation which is perceived bv them as being both

independent and trustworthy. Secondly, the evidence which emerges

about the importance which the industry attaches to 'public

confidence" for maintaining the continued viability of the

industry as a whole, suggests another basis for industry support

for a polloing organisation which is perceived as protecting this

collective industry interest against the more selfish interests

of its individual members,

Such notions are. of course, little more than speculative

suggestions or further inquiry as we continue to examine the

other aspects of policing at the Exchange, the relationship

between the Exchange and the state, and the perceptions of

Exchange members of the policing to which they are subject. They

• 1

although the terms "ef 4 ectiveness", "comoliance" and "standards" 1 this context. Fluidity liquidity" iE actually the term

1

suggest to us, however, that the study of private, compliance-

oriented self-policing of the powerful may yield important new

insights into the necessary conditions for effective policing,

and the role of contextual factors in the selection of effective

policing strategies.

It remains to ccnsider explicitly the particular

significance of the 'hidden' characteristics of the policing we

have been exploring. As we have noted, its practitioners

confidently assert that its "hiddenness" is essential to its

effectiveness in achieving compliance with preScribed standards,

turn out, on closer scrutiny, to be 7,omewhat fluid concepts in

preferred within the industry), however, is universally cited as

one of the two essential conditions - the other is "equity"

for the effective operation of a financial market such as the

Stock Exchange, and the claims cf regulators that more rigid,

visible policing strategies would be counter-productive in this

context cannot be lightly dismissed.

Scraton and South (1994) have rightly aroued that the hidden

economy - and in particular work-related crime - must be

understood in terms of, rather than as a2,tside, the political

economy of production, labour and the formal economy. On the

basis of our research to date, we would have to conclude that the

same insight as equally applicable to hidden control structures.

Our examination of such structures in this paper tends to confirm

Poulantsas' suggestion that "political economy" in this context

3 4

1 1 1

I.

usually implies a "mixed" economy, in which "private" structures

necessarily co-exist alongside the more visible "official ones,

and that such parallelism may be an essential condition of the

ongoing constitution and reconstitution of capitalism.

Exploring the relationship between such hidden, more or less

private, control stuctures and the more visible official ones

will constitute the next Important stage in our research on

the policing of the Exchange. What becomes clear from our

research sa far, however, is that a purely state-centred approach

to understanding this relationship is unlikely to be productive.

Although Exchange regulators acknowledge that they do their

within a framework which includes a role for, and even

some quite direct supervision by, the state (principally via the

securities commission), our findings so far belie any

characterisation of their policing as being purely "under

licence', and suggest the utility of a more genuinely pluralist

conception of policing and control, within which (to borrow

terminology adopted by Henry elsewhere in this issue) public and

private policing institutions "exist in mutually constitutive

relationships with each other".

What our research to date does confirm is that within this

relationship, capital is able and free to exert a considerable

degree of practical autonomy, both collective and individual,

over the nature and scope of the policing of its operations, in

a way that such policing can be shaped to reflect its own

conceptions of "the public interest". Part of the interaction

between those who administer such hidden control structures and

those who administer more public, official control structures

policing

within this market place involves negotiations over just how

"hidden" such private control structures can remain. Yet this is

no simple bargain between a dominant state seeking to make

control manifest and powerful capitalists seeking to keep it

hidden. Each of the participants in this negotiated order have

both ideological and pragmatic interests in pursuing strategies

of control which will remain only relatively "visible". Our task

in future research will be to elucidate more clearly how, when

and why those interests coincide or differ and, when they differ,

how sucn differences are practically resolved.

Erldnote

1. Many members of the exchange are also members of other ex- changes, and of other industry self-regulatory bodies.

These members are able to choose which of the various bodies

of which they are members will have primary responsibility for policing their business practices etc. (designated the

'primary audit jurisdiction"). As a result, some members of

the exchange we are studying are not within that exchange's audit jurisdiction and are therefore not subject to corn-

7 I.

The Logic and Limits of Trust. New Brunswick, N.J.: Rutgers University Press.

Barber, B. 1983

Fellmeth, R. 1973

Galanter, M. 1901

Hawkins, K.

1984

Hay, D.

1975

Henry, S.

1987

Jessop, R. 1905

Katz, J. 1977

Luhmann, N. 1900 Trust and Power. New York; John Wiley.

Manning, P. 1903

Forth-

coming

pliance review visits by the ftimpliance Division of that• exchange. The reference here, then, is ta the policing acti- vities of such other self-regulatory organisations of which the firm in question is also a member.

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