Critical Perspectives on Accounting (1992) 3, 359-388

READING THE REGULATORY TEXT:

REGULATION AND THE NEW
STOCK ISSUE PROCESS
DEAN NEU
Faculty of Management, University of Calgary

Stock markets and the new stock issue process are ubiquitous. Yet,
previous research has not really considered whether the new stock issue
process is functional for all classes of participants. The current study adopts
a different perspective. I use a case study to consider the social conse-
quences of a stock failure in the new stock issue process. More specifically,
the analysis examines how regulations in the new stock issue process work
and who benefits from these regulations. It is hoped that this study of a
disconfirming instance will challenge the taken-for-granted assumption that
stock markets are efficient for all classes of participants.

Introduction
Ideologically, the notion of free markets is central to our conception of
Western, industrialized society. Free markets are what differentiate capitalist
economies from the increasingly challenged planned economies of central
and eastern Europe. Indeed, as proponents of capitalism often argue, it is the
presence of free markets that are responsible for the success of the Western,
industrialized world.
The ideological importance of free markets within the concept of capitalism
is evident in the academy. Entire programs of research have developed
around the notion of “efficient” markets. These research programs have
sought to demonstrate the allocative efficiency of markets (Baumol, 1965;
Stiglitz, 1972). They have also “confirmed” that markets are efficient with
respect to publicly available information (Ball & Brown, 1968; Fama 1970).
And perhaps most importantly, these research programs have gone so far as
to suggest that regulatory intervention in markets is unnecessary (Benston,
1985, 1982), thus providing an academic justification for the deregulation
activities of the Reagan and Thatcher years (Tolchin & Tolchin, 1983).
Despite assertions that less regulation is needed, the number of stock
failures that one reads about in the popular press raises questions about the
stock market’s ability to regulate itself. Unless one is willing to explain these
failures as the consequence of risk/return trade-offs that investors have
consciously made, one is left with a nagging sense of contradiction-how is it
that seemingly over-regulated stock markets continually produce dysfunc-
tional consequences for certain groups of investors?
Perhaps, as Marx and Engels (1978, p. 154) suggest, this contradiction is a

Address for correspondence: Professor Dean Neu, University of Calgary, Faculty of Manage-
ment, 2500 University Drive N.W., Calgary, Alberta, Canada T2N lN4.

Received 3 April 1991; revised 6 July 1997, 5 November 1997; accepted 2 August 1992.
359

1045-2354/92/040359 + 30 $08.00/O fi 1997 Ararimnir Prncc I imitnrl

360 D. Neu

consequence of our social location as researchers within capitalism. The

ideological importance of markets within the concept of capitalism has
encouraged us to go “from heaven to earth”, to assume a priori that markets
are efficient for all societal participants. I recognize that efficiency and equity
are often treated as being analytically distinct. However, common usage of
the term usually assumes that efficiency resuls in equity. As a result,
researchers within this tradition have prejudged the research outcome,
emphasizing the functional aspects of markets without specifying functional
for whom?
The current study adopts a different perspective. Instead of concentrating
on mass samples that disregard the social consequences of particular
instances (Merino & Neimark, 1982, p. 431, I examine the social consequences
of a single stock failure in the new stock issue process. This analysis
considers the institutions that regulate the new stock issue process in
Ontario, Canada. More specifically, the analysis examines the questions of
how the regulations processes work, and who benefits from current
regulations. It is hoped that this study of a disconfirming instance will
challenge the taken-for-granted assumption that stock markets are efficient for
all classes of participants-where efficiency refers to social efficiency instead
of the tautological economic definition (Tinker, 1980) or the informational
efficiency definition utilized by accounting academics (Beaver, 1981).
After this introduction, I situate the current research endeavour within
previous studies of regulation: in particular, I consider the investor omnis-
cience and political coalition perspectives on regulation. This review is used to
argue that a political economy approach to regulation is more sensitive to
socio-political issues. The following section then uses the outlined political
economy perspective to frame the interpretation of a case study of Plastic
Engine Technology Corp. (PETCO). The final section considers the implica-
tions of the study for our understanding of the role and functioning of
institutions that comprise the regulatory framework.

Two Perspectives on Regulation

Within Western capitalist economies, stock markets are ubiquitous. Yet, from
a theoretical perspective the new stock issue process is problematic. As
Akerlof (1970, p. 490) implies, problems of asymmetric information and moral
hazard should lead to a modified version of Gresham’s law, whereby “bad”
stocks drive “good” stocks out of the market until the market fails: bad stocks
being used to denote the shares of companies that are inferior for structural
or managerial reasons. Thus, a central concern within the academy has been
to rationalize the pervasive nature of stock markets by explaining how the
problems of information asymmetry and moral hazard in the new stock issue
process have been resolved.

Investor Omniscience Perspective

One school of thought, what I shall refer to as the investor omniscience

perspective, argues that investors anticipate these information asymmetries
 Reading the regulatory text 361

and take action to protect themselves. For example, Jensen and Meckling
comment that:

“Prospective minority shareholders will realize that the owner-manager’s

interests will diverge somewhat from theirs, hence the price which they
will pay for shares will reflect the monitoring costs and the effect of the
divergence between the manager’s interests and theirs” (1976, p. 313).

They go on to provide a theorem which states that as long as the stock market
is characterized by such “rational expectations”, potential buyers will price-
protect themselves against information asymmetry problems (p. 318).
One of the ways for potential investors to price-protect themselves is to pay
a lower amount for the shares. Thus, in the absence of monitoring and
bonding devices which serve to align the interests of current and potential
shareholders, potential investors assume an expected amount of opportunism
on the part of incumbent owner-managers and thereby decrease the offering
price (Jensen & Meckling 1976, p. 318). However, since the market is assumed
to be competitive, owner-managers have incentives to voluntarily incur such
bonding costs in order to convince potential shareholders that their opportun-
ism has been mitigated (p. 325).
The preceding line of argument posits that intermediaries provide a partial
solution to problems of information asymmetry and moral hazard. Following
from Akerlof (1970, p. 500), who suggested that intermediaries may help
prevent the market from unravelling, and from Jensen and Meckling (1976),
who suggested that bonding devices mitigate opportunism, researchers
working from this perspective have proposed that auditors and underwriters
mitigate problems of information asymmetry in the new stock issue process.’
For example, Benston argues that public accountants provide potential
investors with the assurance that opportunism has been mitigated (1985, p.
39), whereas Beatty and Ritter (1986) and Hughes (1986) suggest that
investment bankers provide similar assurances.
A central feature of these explanations is the assumption that inter-
mediaries sell their reputation and therefore have incentives to act as neutral
referees (Benston, 1985, p. 38). It is also assumed that security regulations
interfere with the operation of the market for intermediary services. These
factors lead Benston (1985) to conclude explicitly that there “seem to be few
valid arguments for additional regulation in the public interest” (p. 75) and to
implicitly conclude that less regulation would be beneficial (p. 57).
Although the investor omniscience perspective does provide an explanation
for the presence of intermediaries along with a suggestion that regulation is
unnecessary, a closer reading highlights several problems with this perspec-
tive. First, the assumption that self-interest can be truncated at the level of the
immediate exchange participants appears inconsistent with the emphasis that
this perspective places on opportunistic behaviour (Armstrong, 1991, p. 12).
As Armstrong comments, monitors (such as intermediaries) are also agents
who often have incentives to collude with the current owner-managers.
Similarly, Neu (1991c) notes that the institutional context encourages
intermediaries to privilege the interests of owner-managers at the expense of
other stakeholders. Thus, it appears that this perspective doesn’t really
explain how the problem of information asymmetry is resolved. Rather, the
362 D. Neu

notion of intermediary reputation is used to conceal interest and power

issues, two of the more important aspects of the information asymmetry
problem.
The economic reductionism of this perspective is also problematic. Follow-
ing from the work of Alchian and Demsetz (1972), proponents of this
perspective reduce the problem to one of optimal contracting (Jensen &
Meckling, 1976, p. 309; Benston, 1985, p. 39). Implicit is the assumption that
potential investors decide whether the configuration of price, intermediary
reputation and other bonding devices are satisfactory. If the configuration is
acceptable, potential investors will purchase shares, otherwise they will not.
Summing up the implications of this perspective, Lev (1988) states that:
“uninformed investors are far from defenceless . . . at the extreme, suspecting
gross information asymmetries, uninformed investors may quite rationally
withdraw from trading in specific securities” (pp. 6-7).
While investors undoubtably do consider these items when deciding
whether to invest or not, these factors are not considered in isolation. Rather,
economic exchanges are embedded in social relations of which institutional
practices are but one example. These relations are not only a necessary
prerequisite for exchange but also serve to construct the subjectivities of the
exchange participants: subjectivity being used to refer to “the conscious and
unconscious thoughts and emotions of the individual, her sense of herself and
her ways of understanding her relation to the world” (Weedon, 1987, p. 32).
For example, it has been suggested that common background expectations
and trust are prerequisites for contracting (Neu, 1991b). Neu refers to this as
“the irony of contracting” in that:
“Contracting requires the presence of trust. However, when high levels of
trust are present, the introduction of a contract may result in a breakdown
of trust. Conversely when low levels of trust are present, contractual
devices are needed to align expectations, yet these devices are not likely to
be effective given the lack of common starting expectations upon which to
base such contracts” (p. 247).

Thus, the implicit assumption that the broader context is unimportant and that
regulation is superfluous to the stock issue process appears to ignore the very
factors that make exchange possible.
The investor omniscience perspective also ignores the role that inter-
mediaries and regulators play in constructing the subjectivities of all new
stock issue participants. As Weedon (1987, p. 37) comments, institutional
practices influence what come to be taken as appropriate, although often
contested, social values. In the case of the new stock issue process, these
practices help to convince potential investors that stock promoters will adhere
to “norms of fairness” (Neu, 1991a). It is also likely that these practices have
some influence on the behaviour of stock promoters as we often observe
individuals pursuing self-interest by comparatively gentle means (cf. Grano-
vetter, 1985, p. 488; Kahneman et a/., 1986). Finally, it has been suggested
that institutional practices construct the subjectivity of the members engaged
in these practices (Knights & Morgan, 1991). These comments suggest that it
is impossible to talk about rational expectations without considering the
impact that institutional practices have on these expectations. Stated
 Reading the regulatory text 363

differently, it appears that the notion of rational expectations, which drives

Jensen and Meckling’s analysis, is itself socially constructed.
This alternative reading implies that the investor omniscience explanation
of the new stock issue process is a partial one. The decision to use
intermediary reputation as the solution to problems of information asym-
metry and moral hazard obscures that intermediaries are also agents and that
intermediaries are not necessarily neutral. Failure to consider the broader
context causes proponents of this view to disregard the role that institutions,
including intermediaries and regulators, play in constructing subjectivity. As a
consequence, the investor omniscience perspective downplays the role of
regulators and misplays the role of intermediaries. While intermediaries are
important to the new stock issue process it is not because they are neutral
referees. Rather, it is because intermediaries, along with regulators, construct
the appearance of a fair game. The subsequent section on political economy
considers these issues of interests, subjectivity and power in greater detail.

Political Coalition Perspective

A related view of regulation, what I shall refer to as the political coalition

perspective, attempts to explain the workings of regulators. The starting
assumption is that regulation is “a fulcrum upon which contending interests
seek to exercise leverage in their pursuit of wealth” (Peltzman, 1976, p. 212).
In Stigler’s (1971) original formulation, the central issue was the optimum size
of effective political coalitions. According to Stigler, the costs of political
lobbying lead to a situation where the interests of a small group come to
dominate the interests of a larger group with more diffused interests (p. 13).
Applied to the new stock issue process, Stigler’s insights would suggest that
regulators are more likely to be “captured” by a small number of owner-
managers than by the more dispersed group of potential investors.
Perhaps because of the anti-democratic implications of Stigler’s original
work, Stigler and his followers were less than satisfied with some of the
conclusions (cf. Peltzmann, 1976, p. 211). This led Peltzman to extend Stigler’s
work. Peltzman (1976) restores the democratic element to regulatory theory
by showing “that regulatory agencies need not become the captive of a single
interest but must be responsive to a plurality of support because in order to
win elections, political entrepreneurs must entice members of losing coali-
tions into their charmed circle” (Tinker, 1985, pp. 59-60). For Peltzman,
regulators are assumed to behave like elected politicians who arbitrate
among competing interests groups in an attempt to maximize votes (Hirshle-
ifer, 1976, p. 241). As a consequence, it is no longer certain that the interests
of a small minority will always come to dominate the interests of the majority
(Peltzman, 1976, p. 240).
Although the political coalition perspective seeks to provide a “positive”
theory of regulation (Peltzman, 1976, p. 212), normative implications are still
forthcoming. Consistent with the investor omniscience perspective, Peltzman
(1976, p. 211) agrees with the statement that regulation may have “engen-
dered more resource allocation than it cured”. And as Tinker notes, the
conclusion that special interest groups sometimes “capture” the regulatory
364 D. Neu

process is used by proponents of the investor omniscience perspective (i.e.

Jensen & Meckling, 1980) to argue that encroachment on “free market
processes in Western democracies, and the emergence of organized interest
groups, could lead to ‘the destruction of Western civilization and its institu-
tional heritage”’ (1985, p. 59).
The political coalition perspective does refocus our attention on the role of
interests within the regulatory process. However, similar to the investor
omniscience perspective, its starting assumption regarding the functionality of
markets, prejudges the problem (Lehman & Tinker, 1987, p. 505). For example,
this perspective also truncates the issue of interests at the regulatory level.
While interest groups are assumed to pursue wealth, regulators are assumed
to pursue votes. However, as Hirshleifer (1976, p. 241) notes, “regulators
themselves constitute an interest group” who likely pursue vote maximization
as part of a strategy of wealth maximization. While I do not agree with
Hirshleifer’s emphasis on wealth maximization, it does appear that, similar to
the notion of intermediary reputation, the notion of vote maximization
deflects us from the important issue of regulatory interests.
Not surprisingly, this perspective also reduces complex socio-political
issues to economic issues. For example, Tinker (1985, p. 62) comments that
the emphasis on individual striving disregards the issue of group or class
interests which are influenced by modes of production. Thus, if one accepts
that capitalism produces and reproduces social relations (Marx, 1976, pp.
272-275), this broader context and its impact on the regulatory process
cannot be ignored. Hirshleifer makes a similar point about this implicit
reductionism, albeit only in terms of the unconsidered wealth maximization
interests of other individuals, when he comments that “different types of
constitutionally empowered agents on the political scene-bureaucrats,
judges, legislators and elected executives-each bring distinct motivations,
authorities and constraints into the process of political exchange that leads to
the final regulatory outcome” (1976, p. 242).
While further criticisms of the two aforementioned perspectives are
possible, hopefully the tenor of my concerns is clear. Specifically, I have
attempted to suggest that both of these perspectives prejudge the issue by
starting from an economistic and reductionist view of the world. In attempting
to explain the pervasiveness of stock markets, these perspectives have
assumed that markets are functional and therefore that regulation results in a
misallocation of resources. Both perspectives come to this conclusion by
forestalling questions of interest and by ignoring the broader socio-political
context in which markets operate along with the role that this context plays in
constructing subjectivity. In doing so, these perspectives implicitly conclude
that less regulation would be in the public interest. However, such a
conclusion appears to get ahead of itself. Perhaps, it is better to go “from
earth to heaven”-to examine the social consequences of a particular instance
instead of deciding a priori that deregulation is in the public’s interest. The
next section outlines the frame of reference that will be used to do this.

A Political Economy Approach to Regulation

In this section, I would like to propose that a political economy perspective
provides us with an alternative reading of the regulatory process. This
 Reading the regulatory text 365

interpretation is more sensitive to the socio-political context of regulation, the

role that interests play in the regulatory process, along with the socially
constructed nature of investor perceptions. The following outlines the central
features of such a perspective.
In The German Ideology, Marx and Engels urge us to start our analysis from
the historical and material conditions in which individuals are situated:
“The fact is, therefore, that definite individuals who are productively active
in a definite way enter into these definite social and political relations.
Empirical observation must in each separate instance bring out empirically,
and without any mystification and speculation, the connection of the social
and political structure with production” (1978, p. 154).
Elaborating on this statement, Marx and Engels go on to state that an
adequate understanding of social relations is not possible without considering
the struggles that occur over the means of production and reproduction (p.
161).
The suggestion that we consider historical and material conditions focuses
attention on the intertwined issues of interests, power and subjectivity. For
example, acknowledging that struggles over the means of production and
reproduction occur, draws our attention to the conflicts that exist among
different groups in society. However, these struggles are not restricted to the
sphere of production. Also contested is control over social institutions. As
Weedon (1987, p. 37) comments, institutions have become a particularly
important site of conflict given the ability of such institutions to structure
individuals’ subjectivity.
In an attempt to meld the insights of Marx and post-structuralist writers
such as Foucault, Weedon suggests that institutional practices and the
discourses that these practices create and/or sustain play a large role in
constructing subjectivity (pp. 30-35). Institutional practices and the associated
discourses articulate and legitimate particular social relations. However, these
discourses are not to be viewed as being interest-free. Rather, Weedon
argues that they “reflect particular values and class, gender and racial
interests” (p. 36). For these reasons institutions are an important site of
struggle, especially since institutional practices serve not only to construct
subjectivity, but also impact on struggles over the means of production and
reproduction (Dupre, 1983, p. 234).
While the preceding discussion outlines some of the general features of a
political economy perspective, the work of Merino and Neimark (1982)
provides us with an example of such an approach in practice. Merino and
Neimark (1982) examine the events surrounding the introduction of American
security regulations. They propose that American security legislation was a
response to a crisis of credibility in the wider social system (p. 47). According
to their interpretation, the Securities Acts of 1933 and 1934 sought to convince
small investors (members of the middle class) that security markets were fair
while at the same time maintaining the status quo that benef’ted market
insiders such as owner-managers (pp. 48-49). Merino and Neimark conclude
that:
“Our sociohistorical analysis suggests that the securities acts were de-
signed to maintain the ideological, social and economic status quo while
restoring confidence in the existing system and its institutions” (p. 49).
366 D. Neu

Merino and Neimark’s analysis of the regulatory process is a useful

starting point for considering the role of regulation within the new stock issue
process. However, several lacunae in their analyses indicate the need to
supplement their interpretation of the regulatory process. For example,
Merino and Neimark tend to view capitalists as being homogeneous. Al-
though this may have been an appropriate assumption in the context that
they examined, within the new stock issue process it appears important to
differentiate among capitalists-for example between the current owner-
managers and the potential shareholders. As Marx’s comments on the
differing interests of current and would-be capitalists indicate (1976, pp.
938-9391, the homogeneity of capital cannot be specified a priori but depends
on the situation being examined. As a consequence, I return to this issue in
the case study itself.
In addition, although Merino and Neimark suggest that security regulations
provide a means of ensuring the stability of the market system, their analysis
does not attend to how regulation accomplishes this function. The following
proposes that regulation helps to ensure market stability by creating the
perception that information asymmetries have been resolved.
Smith (1990, pp. 8-10) suggests that regulations be viewed as a textually-
mediated discourse. According to Smith, social consciousness is increasingly
organized by texts, documents and electronic information (p. 8) and that the
social relations of contemporary society are increasingly structured and
reflected by these discourses. In Smith’s words:
“The social relations of textually-mediated discourse intersect and penetr-
ate organizational structures constituted as complex entities with
differentiated functions, corporations, government agencies, universities,
and so on.. . Social consciousness exists now as a complex of externalized
social relations organizing and coordinating contemporary society” (p. 8).
Like Smith, Lehman and Tinker (1987) indicate the importance of situating
discourse, such as that constructed by regulation, within broader societal
discourses. For example, they comment that the persuasiveness of a dis-
course depends on its ability to echo, harmonize with and amplify other
prevailing societal discourses (p. 509). Smith (19901, along with Lehman and
Tinker (1987), recognize that discourses are not only rooted in material
relations but also influence both social consciousness and material relations.
Therefore, for these theorists, discourses such as the discourse of regulation
are important because while they embody certain interests (cf. Marx & Engels,
1978, p. 172), they have the ability to construct a social consciousness that
appears independent of these interests (cf. Smith, 1990, p. 10). In addition, by
explicitly recognizing that the relationship between subjectivity and material
conditions is not unidirectional, these theorists avoid the reductionism that
caricatures of Marxist analyses usually stress (Engels, 1978, p. 760; Neimark,
1990, p. 108).
Applied to the new stock issue process, this previous work suggests that the
textually-mediated discourse of regulation creates the appearance of a fair
game. By echoing the general societal belief in the neutrality of public
institutions (cf. Solomons, 1991; Tinker, 1991), this discourse helps to
convince potential investors that securities markets are fair (Neu, 1991a, p.
 Reading the regulatory text 367

188). Similarly, the reliance on regulation as a guide to behaviour harmonizes

with society’s increasing reliance on rules as opposed to moral discernments
(Preston er al. 1991, p. 39). Stated differently, regulation, by echoing broader
societal discourses, reassures investors that anything detrimental to their
interests will be prevented. Therefore, regulation in conjunction with other
societal discourses constructs the appearance that information asymmetries
have been mitigated.
The preceding commentary posits that regulations, even though they are
rooted in material relations which tend to benefit incumbent capitalists,
construct the appearance of a fair game for potential investors. I would like to
propose that the distinctive character of regulatory texts allows for the
reconciliation of these conflicting interests. However, I would also like to note
that the sustainability of this reconciliation is always in question.
As mentioned previously, Merino and Neimark (1982) comment that the
introduction of regulation helped convince potential investors that securities
markets were fair. Yet, at the same time, these regulations were consistent
with the interests of market insiders. One interpretation is that the incomplete
nature of regulatory texts allowed these competing objectives to be
reconciled.
Regulatory texts are incomplete in the sense that interpretation and action
are required before the texts become operational. As a result, potential
investors may interpret the texts in a manner that indicates the presence of a
fair game-especially if other societal discourses support this interpretation.
However, these regulations will only be contrary to the interests of owner-
managers if regulators interpret and apply the regulatory text in the same
manner that potential investors would. Therefore, a stringent regulatory text
(because of its ability to create the appearance of a fair game) will be in the
interests of owner-managers if the owner-managers have the ability to
control the regulatory process.
Control of the regulatory process by owner-managers is not a fait accompli,
however. On the one hand, empirical observation suggests that the regulated
have significant influence over the regulators. For example, Vaughan (1990, p.
228) observes that regulators depend on the entities that they are regulating
to help in the gathering and the interpretation of regulatory data. They also
depend on “seconded” staff to provide the expertise necessary for the
regulatory process to work (Pfeffer & Salancik, 1978, p. 210; La Rochelle, 1991,
p. 5). As a consequence, the interests of the regulated undoubtably influence
the interpretation and application of the regulatory text.
On the other hand, to ignore both the interests of the regulators and the
influence of broader societal discourses would be remiss. Although the
interests of regulators and owner-managers are likely to be complementary,
they will not be identical since the social location of these two groups
differ-for example the professional mobility project of the accounting
profession complements but isn’t identical to the interests of capital (cf.
Larson, 1977; Lehman & Tinker, 1987, p. 518). Similarly, regulators and
owner-managers do not exist outside of the discourse of regulation nor
outside of other societal discourses. Thus, these various discourses not only
convince potential investors that a fair game exists but also influence the
368 D. Neu

behaviour of regulators responsible for enforcing the regulations and the

behaviour of owner-managers selling shares.
The preceding outline proposes that the regulatory texts of the institutions
involved in the new stock issue process are, in part, the outcome of struggles
among the participants in the process. These regulatory texts, by echoing
other societal discourses, construct the perception of a fair game thus
convincing potential investors that problems of information asymmetry have
been mitigated. However, the question of whether or not a particular stock
market is fair is equivocal. Control of the regulatory process appears to be a
“contested terrain” (Edwards, 1979) with owner-managers, potential inves-
tors and regulators each bringing different interests and resources to bear on
the process. As a result, it is not possible to state a priori that a particular
stock market is fair or unfair from the perspective of potential investors.
Rather, as Marx and Engels (1978, p. 155) suggest, we must consider a
particular instance prior to coming to any conclusions. To this, I now turn.

The Case Study: an Overview

Plastic Engine Technology Corp. (PETCO) was a Kingston, Ontario, company
that promised to build a revolutionary plastic engine:
“It was a small internal-combustion engine, only 3/4 horsepower, with
components made not of metal but of plastic-a space age, carbon-fibre
reinforced thermoplastic that is stronger, cleaner, cheaper and lighter than
aluminum. . . (PETCO) became a speculative favourite on the Toronto Stock
Exchange, catering to the public’s-and the media’s-wishful and
romantic attitudes toward those who would build better mousetraps”
(Fetherling, 1989, p. 80).

On 28 October 1986 the public company PETCO was born from the merger
of a public company shell (Media Inc.) and a private company (the predecessor
Petco). PETCO was the progeny of Gerry McKendry, a former civil servant,
and Leon Lilley, a former racing car mechanic. McKendry and Lilley along
with their spouses (Tia and Francis) and a group of initial investors created
PETCO for the purpose of producing and selling “the world’s first throwaway
plastic engine” (McKendry quoted in Hogben, 1986, p. 12).
On 15 November 1986 the shares of PETCO started trading on Ontario’s
over-the-counter (OTC) market. Throughout 1987 and early 1988, the company
completed a number of private placements of shares amid continually
glowing reports about the feasibility of and the company’s progress in
producing an engine comprised of 70% plastic parts by volume:
“Behind the locked grate of a back room.. . , a small plastic engine hums
continuously. And with each additional hour it clocks, the ambitious plans
of a new Kingston company come closer to the test.. . Petco says its
lower-cost and lightweight engines could create a new market for truly
portable outdoor power equipment. But its longer-term goal is to produce
bigger engines, and ultimately one for the small car market” (Benmergui-
Perez, 1987, p. 21).

The positive press received by PETCO translated itself into an increase in

stock value. Share prices increased from $2.00 on the initial day of OTC
 Reading the regulatory text 369

trading to around $5.00 in September 1987. Unfortunately, the mini stock

market crash of October 1987 intruded, decreasing the value of PETCO shares
to around $2.25-the level at which the stock remained until the stock was
listed on the TSE in May 1988.
In January 1988, additional financing was raised through an offering
memorandum (Micromedia MIS, 1988-4/4).3 Institutional investors purchased
$3.5 million worth of common share warrants. Subsequently, in April 1988,
the company raised an additional $1.35 million through the sale of units
(common shares plus warrants) to the public via a prospectus offering
(Micromedia PRO, 1988-21/2). Then, on 12 May 1988, the TSE approved
PETCO’s application to become a publicly-traded company.
Throughout PETCO’s early history, people in the Kingston community were
some of the companies biggest supporters. Kingston’s local newspaper, The
Whig-Standard, provided ample and effusive coverage of PETCO. Local
investment brokers were on record stating that PETCO was a good investment
for someone with risk capital (cf. Hutchinson, 1987, p. 15). Members of the
community responded to this positive press by advancing credit or by
investing in PETCO shares, many of the investors being employees or other
so-called small investors.
Subsequent to these financings, PETCO encountered a number of operating
problems. First, a new plant necessary for expansion of production was
delayed by construction strikes (Anderson, 1988). Next, problems on the
plant floor hindered the company’s ability to produce the conventional small
engines necessary to sustain cash flows until plastic engine prototypes could
be brought into production:
“The gleaming new plant on the edge of Kingston was designed to produce
2,000 or more engines a day but had trouble reaching 250 a day. Even then,
customers screamed about defects, former employees recall. ‘We’d ship
them 500 engines and literally 200 engines would come back.. . and they’d
say, These things are junk”’ (Saunders, 1989).
The operating problems encountered by PETCO necessitated the infusion of
additional capital. Although the company was able to raise some funds
through sale and leaseback arrangements (Globe & Mail, 1988), PETCO was
unable to secure enough additional equity financing. Throughout February
1989 a number of bridge-financing deals were announced, only to collapse at
the last minute (Globe & Mail, 1989a,b). Consequently, on 14 March 1989 the
company filed for trusteeship and restructuring under the Bankruptcy Act,
attempting to buy time to put together a workable financing package
(Hutchison, 1989a).
To this point in time, PETCO’s management and members of the investment
community were publicly optimistic that PETCO would live to produce its
plastic engine. However, in April 1989 Kingston’s local newspaper, The
Wig-Standard, published the results of an investigation into PETCO. These
stories reported on the share trading activity of company insiders who had
been disposing of PETCO stock over the course of the company’s short
history (Hutchison, 1989b). In addition, they disclosed that McKendry had
been associated with a previous failed company and that he had served time
in prison resulting from a criminal offense-information that was not reported
370 D. Neu
Table 1. Chronology of events

Date Event

18 October 1986 Merger of shell company and predecessor Petco to form PETCO
15 November 1986 PETCO stock begins to trade on OTC market
11 January 1988 $3.5 m. new capital raised through offering memorandum sale of warrants
to institutional investors
25 April 1988 $1.35 m. new capital raised through prospectus sale of units
12 May 1988 Stock begins trading on TSE
Februarv 1989 Bridge financing deal falls through
14 March 1989 PETCO files for trusteeship and restructuring under Bankruptcy Act
22 and 26 April 1989 Information on insider trading along with promoter’s past history dis-
closed in press
29 April 1989 Attempts to reorganize company are abandoned

in the offering memorandum or prospectus (Hutchison, 26 April, 1989c).

Subsequent to these stories, attempts to reorganize the company were
suspended and the TSE indefinitely suspended trading in PETCO shares
(Globe and Mail, 1989c). At the time of PETCO’s demise, the promised plastic
engine remained just that-a promise.
Table 1 provides a chronology of these events.
The PETCO saga seemed like a promising site for considering the questions
of how the regulatory process works and who benefits from current
regulations. During the unfolding of this case, I was a graduate student at
Queen’s University in Kingston, Ontario. Judging from the reactions of
members of the community, the failure of PETCO appeared to come as a
complete surprise, bringing with it dysfunctional consequences for the local
investors, employees and creditors who “bought” into the PETCO dream. In
addition, the later revelations regarding the workings of the regulatory
process and the responses of the individuals affected by the failure indicated
that the new stock issue process did not work quite as these individuals
expected (cf. Hutchison, 19894, p. 1). These factors suggested that the
PETCO story would be an appropriate location for exploring the workings of
the new stock issue process.

The Regulatory Text

In Ontario, the Ontario Securities Commission (OSC), the Toronto Stock

Exchange (TSE) and the Canadian Institute of Chartered Accountants (CICA)
are the primary institutions involved in monitoring the new stock issue
process (Neu, 1991a, p. 192). The OSC is the primary regulator although it
cedes responsibility in certain areas to the other two institutions. For example,
OSC regulations require that certain TSE and CICA standards be satisfied
before corporations can sell shares in Ontario (p. 192).
Similar to other security commissions, the OSC has a number of regulations
dealing with the disclosure of insider transactions (OSC, 1990, R101-135).4
These regulations are intended to provide non-insiders with timely informa-
tion regarding the activities of insiders. For example, OSC regulations define
“insiders” as “every director or senior officer of a reporting issuer” or “any
 Reading the regulatory text 371

person or company who beneficially owns.. . more than 10% of the voting
rights attached to all voting securities of the reporting issuer” (OSC, 1990,
Rl.l(l7)). These insiders are required to file a report within 10 days of the
end of the month summarizing any changes in stock holdings (OSC, 1990,
R102.2).
OSC regulations also define “associates” as individuals that have a
relationship with company insiders by way of marriage, a common home or
other family ties (OSC, 1990, R1.1(2)). Regulations pertaining to the distribu-
tion of securities via a prospectus (OSC, 1990, Form 12) require material
transactions involving associates to be disclosed. However, associates are nor
considered to be insiders and thus are not constrained by insider disclosure
regulations unless they meet the aforementioned criteria.
The initial distribution of PETCO shares appears to have been structured to
take advantage of these regulations. During the formation of PETCO, the
spouses-Tia McKendry and Francis Lilley-each received 440000 shares for
a consideration of $0.00002 per share (Micromedia PRO, 1986-21/2). At this
time, each associate held 8.3% of the outstanding shares thus just falling
below the 10% criteria for being considered an insider.
Over the period October 1986 to February 1988 (when PETCO was trading
on the OTC market), these two associates decreased their shareholdings by
340000 and 402 750 shares, respectively. As Figure 1 and Table 2 suggest,
these liquidations occurred over time periods where PETCO’s shares were
trading at relatively high values.
From the promoters’ perspective, the OSC’s definition of an insider was a
beneficial one. By structuring the initial shareholdings so that their associates
held less than 10% of the shares, the promoters were able to circumvent

136 250 share

No! 86 Feb I 87 I 87 1 87 Nov I 87 Feb I I I I I
May Aug 88 May 88 Aug 88 Nov 88 Jan 85
Date

Figure 1. PETCO OTC and TSE prices (with associates shareholding). Source: OSC documents and
Globe & Mail price data. The associate share holdings line was constructed from the discrete data
repotted in Table 2.
372 D. Neu

Table 2. Share trading activity of associates

Net change Net receipts

Tia McKendry in shares held at average price (in brackets)
Initial holdings 440 000
Dee 86-Nov 87 period $ 746260 ($3.55)
Nov 87-Dee 87 period (f:EE,) $ 20559 ($2.06)
Jan 88-Feb 88 period (120000) $ 277978 ($2.32)
340000 $1044 797*
Ending position 100 000
Francis Lilley

Initial holdings 440 000

Ott 86-Dee 86 period (137500) $ 351 850 ($2.56)
Dee 86-Jan 88 period (115000) $ 382069 ($3.32)
Jan 88-Feb 88 period (151250) $ 352091 ($2.33)
403750 $1 086 OlOt
Ending position 36250

*At maximum and minimum price for each period, net receipts would be $1 599243 and
$656 993, respectively.
?At the maximum and minimum price for each period, net receipts would be $1 519 179 and
$784 492, respectively.
Source: OSC documents and the Globe & Mail.

continuous disclosure requirements. This loophole allowed the initial share-

holding families to liquidate a portion of their shareholdings without inform-
ing the general public. Indeed, when asked in 1987 whether or not the
promoters were selling PETCO shares, Gerry McKendry was able to state that
“neither he nor the company trades in Petco shares” (Hutchison, 1987, p. 15).
OSC regulations also state that it is illegal for individuals such as associates
to trade on material facts that have not been disclosed to the general public
(OSC, 1990 R131.2). In other words, associates are expected to trade
independently and without access to insider information. However, as one
commentator noted, “perhaps he (Mr. McKendry) does not talk in his sleep”
(quoted in Hutchison, 1989a). Thus, as the comment suggests, it is virtually
impossible to enforce such a regulation since regulators are not privy to
“bedside” conversations between insiders and associates.
The ability of the stock promoters to exploit the regulatory text for their own
advantage makes visible several implications. First, it highlights that the
regulatory text is incomplete in not one, but in two ways. Previously, it was
mentioned that the regulatory text depends on interpretation and action to
make it operational. In addition, the regulatory text is incomplete in that it is
impossible to write a set of regulations that completely eliminate opportunis-
tic behaviour. Rather, Granovetter’s (1985) comment that regulations en-
courage Hobbesian behaviour can be taken one step further. By encoding
regulations in a legalistic language that is inaccessible to lay people, the
regulatory text exacerbates, rather than alleviates, the information asymmetry
problem.
The OSC’s regulations, by not considering spouses to be insiders unless
they hold more than 10% of the shares, appears biased in favour of
owner-managers. Further, this bias is amplified by the legalistic regulatory
 Reading the regulatory text 373

language. For example, in only one of the documents that PETCO filed with
the OSC was reference made to the shareholdings of the spouses. In all other
documents, they were simply referred to as associates. As a consequence, the
regulatory language obfuscates and exacerbates the original bias by making it
more difficult for potential investors, especially those that cannot afford
high-priced legal advice, to read between the regulatory lines.
One could, as Lev (1988) does, argue that potential investors recognize the
biases implicit within the regulatory text and structure their affairs accord-
ingly. However, the reaction of investors to the disclosure of the divestment of
shares by Tia and Francis suggests otherwise. For example, one investor
remarked:
“The early sale of shares by insiders may have been legal, he said, but ‘they
were not totally above board. It leaves a bad taste in your mouth”’
(Cuthbertson quoted in Hutchison, 198941, p. 2).

Another commented that:

“It would have been ‘fair ball’ if Petco’s inside group had waited until the
company was up and running before they sold their stock ‘but to take their
profits before that is to some extent not fair to the other stockholders”’
(quoted in Hutchison, 1989d, p. 1).

From the comments of these investors, it doesn’t appear that these in-
dividuals saw through the regulations in the manner that Lev suggests.
Rather, these investors assumed that regulations resulted in a fair game and
were surprised when subsequent events called this assumption into question.
The ability of stock promoters to take advantage of the regulations also
highlights the contradictory role that investment houses play in the new stock
issue process. On the one hand, investment houses qua underwriters have
incentives to bring new issues to market since this generates underwriting
commissions. Therefore, underwriters (who require new issues) and owner-
managers (who require additional financial capital) are mutually dependent.
This suggests that underwriters, as agents of owner-managers, have incen-
tives to undertake actions that are consistent with the interests of owner-
managers.
Investment houses qua stock brokers are responsible for selling the shares
that are underwritten. In the case of a firm commitment offering, the
investment house agrees to purchase the unsold portion of the new stock
issue. As a result, stock brokers have incentives to act as agents of
owner-managers at the expense of potential investors-i.e. by not informing
potential investors of biases within the regulatory text that would discourage
potential investors from purchasing shares.5 However, on the other hand,
continued brokerage fees depend on continued investor satisfaction suggest-
ing that stock brokers also have incentives to act as agents for potential
investors. Thus, the preceding analysis implies that tensions exist between
the role of bringing new stock issues to market and the role of satisfying the
longer-term needs of investors. How these contradictory roles are mediated
likely determines which set of interests are privileged.
In the case of PETCO, the interests of owner-managers appeared to win out
over the interests of potential investors. The investors quoted in The
314 D. Neu

Whig-Standard article implied that their stock broker did not inform them that
the distinction between an insider and an associate allowed the promoters to
circumvent insider trading regulations. These investors also explicitly or
implicitly stated that “my broker did not know” about these regulatory
loopholes (Hutchison, 19894, p. 1). However, when questioned directly, the
response of a local stockbroker was more ambiguous. Instead of indicating
whether she was aware of this regulatory bias, Nancy Foster states:

“I would personally consider the wives to be insiders. If the law doesn’t,

maybe it should be changed”.

And:

“She was not concerned that insiders sold shares early. That, she says, is
‘normal for a very speculative, start-up situation.’ Their shares can be
considered like a venture capital investment, an area where only one
company in five succeeds. ‘They knew the risk was extreme’, she said, and
selling some shares reduced an insider’s risk. ‘Our real problem was our
failure to assess risk properly”’ (quoted in Hutchison, 198941, p. 1).

In other words, from her perspective, it was not the failure of stockbrokers to
inform their clients of regulatory loopholes that created the dysfunctional
consequences; rather the dysfunctional consequences resulted from the
failure of stockbrokers and their clients adequately to assess the risk of the
investment. However, since the risk faced by potential investors is partially a
function of the information asymmetries between owner-managers and
potential investors, one could argue that knowledge of potential regulatory
loopholes would have decreased this risk.
In the absence of additional information it is not possible to unequivocally
conclude that the power of capital vis a vis potential investors encouraged
investment houses to privilege the interests of owner-managers at the
expense of potential investors. For example, stockbrokers may, through
oversight, not have known about this regulatory loophole. Alternatively, they
may have known but inadvertently neglected to inform their potential clients.
Or perhaps some brokers may have informed their clients and these
individuals chose not to purchase shares or were not interviewed by The
Whig-Standard. However, these caveats notwithstanding, it appears that
some investors were not aware of the biases inherent in the regulatory text
because stockbrokers neglected to inform them.
The preceding analysis suggests that the regulatory text indirectly
contributed to the dysfunctional consequences experienced by the investors.
Biases within the text provided owner-managers with the opportunity to
minimize their risk without informing potential investors. This bias was
exacerbated by the legalistic regulatory terminology which obfuscated the
distinction between insiders and associates. In addition, some stockbrokers
did not inform their clients of these inherent biases. Thus, contrary to the
expectation that the regulatory text creates a fair game, it appears that the
regulatory text in conjunction with stockbroker intermediaries constructed the
perception of a fair game while concealing the biases in the regulatory text
that benefited owner-managers.
 Reading the regulatory text 375

Interpreting the Regulatory Text

Prior to the mini stock market crash in October 1987, PETCO continued to be
one of the more attractive OTC stocks. Positive press pushed shares prices up
to a high of $5.63 in August 1987 and also led company officials to
contemplate a new share issue and a listing on the more prestigious Toronto
Stock Exchange (Benmergui-Perez, 1987, p. 31). However, after the mini crash,
potential investors shunned common stocks. As a result, PETCO delayed
attempting a new share issue, instead using an offering memorandum to sell
warrants to institutional investors in January 1988. However, in February 1988
PETCO issued a preliminary prospectus for a public share issue. At the end of
April 1988, the OSC issued a final receipt for the prospectus and the common
shares were listed for trading on the TSE.
One of the OSC’s primary concerns with respect to prospecti is full
disclosure:

“A prospectus shall provide full, true, and plain disclosure of all material
facts relating to the securities issued or to be issued and shall comply with
the requirements of this Act and the regulations” (OSC, 1990, R55.1).

Regulation 55.1 provides the regulatory ideal underlying OSC disclosure

requirements pertaining to new stock issues. Other regulations translate this
ideal into practice by specifying the information that must be included in a
prospectus filed with the OSC. For example, Form 12 specifies the financial
and non-financial information that must be disclosed. As Neu (1991a, p. 196)
comments, some of this information-e.g. the past histories of the promoters,
officers and directors-is used by potential investors to determine whether or
not to trust the stock promoters.
Regulations also require company insiders and intermediaries associated
with the company to provide certificates regarding the information disclosed.
For example, R57.1 requires the chief executive officer, the chief financial
officer and any two directors to sign a certificate stating that the full, true and
plain disclosure requirements have been satisfied. The underwriter is also
required to sign a similar certificate (OSC, 1990, R58.11, whereas the auditor’s
certificate is limited to financial matters (OSC, 1990, S23.3). Therefore, these
certificates should provide some additional guarantees that all relevant
information has been disclosed.
Although the foregoing regulations appear to indicate that company
insiders and intermediaries share joint responsibility for disclosure, the
ultimate decision on what to disclose remains with the OSC. As S36.3 states,
“the information required to be disclosed in answer to any item of a
prospectus.. . may be omitted if such information is, in the opinion of the
Director (of the OSC), immaterial” (emphasis added). Thus, the ultimate
responsibility for interpreting the regulatory text rests with the OSC.
In the case of PETCO, subsequent events indicated that public documents
filed with the OSC omitted details of Gerald McKendry’s past business history.
In particular, these documents did not disclose: (1) his dismissal from the
civil service for breaches of conduct; (2) his criminal record resulting from the
same incidents; and (3) the failure of a previous company of which he was the
376 D. Neu

promoter. While it is difficult to unequivocally state that this information was

material, in hindsight it appears so.
On 31 July 1972 Gerald McKendry was dismissed from his position as a
senior official of the Department of Regional Economic Expansion for
breaches of conduct (Jolliffe, 1973, p. 13). Prior to this time, he had been the
Director of the Special Analysis Group that was responsible for analysing and
approving grants to companies that proposed to expand or modernize
production facilities in economically depressed areas (pp. 61-62).
According to the adjudicator’s report dealing with McKendry’s dismissal,
three breaches of conduct led to the dismissal action (Jolliffe, 1973). All three
breaches pertained to the events surrounding the approval of grants to Silver
Shield Mines Inc. and Cat-tier Mint Inc. of $119 970 and $617 000, respectively
(p. 63). Both of these companies were controlled directly or indirectly by Mr
Norton Cooper.
As the adjudicator’s report states:
“(The first charge relates to McKendry’s) purchase of shares of an applicant
company after offers of grants had been made by the Department and
during the period between the date on which the general offers were
accepted and the date on which the general public was made aware of
them. The employer’s position (was) that in the circumstances such
purchases were in conflict with the principle that public servants must not
seek to profit by use of ‘information to which they have access by reason of
their official duties”’ (p. 84).
The second charge related to McKendry’s acceptance of expense-paid trips to
Florida from Cooper during the period that the grant applications were under
consideration (p. 141). And, finally, the third charge pertained to negotiations
between McKendry and Cooper for the presidency of Car-tier Mint Inc. during
the period that the grant applications were under consideration (p. 159).
Also not disclosed in OSC documents were the criminal charges resulting
from these events. In 1977, McKendry was found guilty of “receiving benefits
from Mr. Cooper and was sentenced to six months in jail” for these activities
(Hutchison, 26 April, 1989). The sentence was served in a halfway house;
afterwards McKendry moved to Florida and incorporated Pocon Inc., a
company involved in energy management (Hutchison, 1989c).
Pocon Inc. was formed in 1979 to manufacture computerized thermostats to
cut heating and cooling costs in factories and office buildings (Saunders, 1989,
p. 89). However by 1984, Pocon Inc. had, in the words of one director, “ran out
of money” (Hutchison, 1989c, p. 2). As a result, “Pocon was ‘involuntarily
dissolved’ by the Florida Secretary of State after the company failed to file its
1984 annual report for investors and regulators” (p. 2).
The disclosure of Gerry McKendry’s past business dealings appears to have
caught investors by surprise. For example, one investor comments that:
“[I invested in Petco shares because] the hype from Mr. McKendry was
there, and there was nothing to lead you to believe there was anything
unsuccessful in their careers. I definitely think the shareholders and the
general public should have been told about Mr. McKendry’s past”
(Struthers quoted in Hogben, 1989, p. Bl).
Similarly, the regulator’s interpretation of materiality surprised local
 Reading the regulatory text 377

stockbrokers:
“Certainly we should have been given the right of stock brokers to pass on
the information to our clients. I believe that information should have been
made available to shareholders. We could have made our own decision
whether this information would have made any change in our current
holding of the stock or intention to buy [the shares of] the new company”
(Beauregard quoted in Hutchison, 1989e, p. 2).
For both investors and their stockbrokers, the manner in which the OSC
interpreted the regulatory text appears to differ from the manner in which
these two groups would have interpreted it.
When queried about its interpretation, the OSC responded that:
“(T)he commission does not require disclosure of a criminal conviction
when a pardon has been received. ‘The legal consequences of a pardon is
to eliminate for all purposes the consequences of having a conviction”’
(quoted in Hutchison, 1989e, p. 2).
In other words, from the OSC’s perspective, it is as if the criminal conviction
had not occurred. However, this response does not explain the failure to
disclose the civil service firing and the failure of Pocon Inc.
In addition to questioning the OSC’s interpretation, investors and stock-
brokers wondered why the TSE did not require disclosure of this information
(Hutchison, 1989e, p. 2). In response, a representative of the TSE acknow-
ledged that they were aware of McKendry’s past:
“The decision to list Petco on the exchange was approved by the stock
listing committee which is made up of 13 senior staff from the brokerage
companies that are members and owners of the exchange.. . ‘There was no
reason to think that the management of this company would not comply
with our rules and would not act in the best interest of the
shareholders.. . the little guys too”’ (quoted in Hutchison, 1989e. p. 2).

They also noted that the responsibility for full disclosure rested with the
OSC not the TSE. However, they conceded that they had in the past forced
another senior company executive to send a letter to shareholders revealing
that he had been convicted and later pardoned for breach of trust (Hutchison,
1989e).
In responding to questions about its interpretation of the regulatory text, the
OSC adopted a legalistic position implying that its interpretation of full
disclosure requirements is subordinate to other 1aws-e.g. pardon legislation.
While the appropriateness of this interpretation is uncertain, this response
does not address the OSC’s decision to interpret the other information as
being immaterial. The TSE’s response to these questions was two-fold. First,
they noted full disclosure was not their responsibility, rather the OSC’s. And
second, they implied that, at the time, McKendry’s past history did not appear
material to the proposed exchanges.
In hindsight, it is always easy to state that the suppressed information
would have made a difference in investor behaviour. However, in this case it
appears that, at the very least, the information might have made potential
investors more cautious. In particular, while many investors would subscribe
to the notion caveat emptor, an idea of what one should beware of is often
helpful. For example, the adjudicator’s report notes that “I do not think he (Mr.
378 D. Neu

McKendry) had any consciousness of wrongdoing; he seems to remain

genuinely convinced that he did nothing dishonourable or discreditable”
(Jolliffe, 1973, p. 203). In other words, from McKendry’s perspective, these
breaches of regulations were not problematic. Similarly, the disregard for
satisfying security filing regulations in the case of Pocon Inc., when coupled
with the previous disregard for civil service regulations, may have raised
questions about the ability of regulations to influence behaviour. And, in
hindsight, investors may have been less surprised about Tia McKendry’s and
Francis Lilley’s shareholdings, and their ability to sell their shares without
filing insider reports if they had known about previous charges pertaining to
Gerry McKendry’s improper use of “inside” information.
Although it is impossible to determine why the OSC and TSE chose to
interpret the regulatory text in the manner that they did, several factors seem
salient. For the OSC, the timing of PETCO’s new stock issue appears to be
important. As alluded to previously, regulators depend on the regulated for
their continued existence. At the time that PETCO issued its preliminary
prospectus in early 1988, there were very few new stock issues occurring
(TSE Review, November 1987-February 1988). Therefore, from the OSC’s
perspective, potential new stock issues may have been looked upon quite
favourably.
Intertwined with this, was the hyperbole surrounding PETCO. As one of the
previous quotes from an investor implied, Gerry McKendry, with help from
the media, was a consummate salesperson. Throughout 1987 and 1988,
stories in the media glowingly reported McKendry’s prognosis for PETCO. For
example, media statements such as the following were commonplace:
“Many people have tried to develop a plastic lawnmower engine, but credit
for doing it first looks as if it has gone to a small Kingston, Ontario
company. The engine is Petco PE-237 and $10 million worth of the little
machines have been sold in the month since production started” (Bet-tin
1987).6
“Lilley’s design is a world-wide breakthrough in engine technology that will
affect the internal combustion engine forever” (McKendry quoted in The
Globe & Mail, 1987).
“Petco is confidently forecasting consolidated revenue of $6.4 million (with
a $1 million loss) for the fiscal year ending June 30, 1988. Sales are
expected to rise six-fold to $35.5 million (with a $5.6 million profit) in fiscal
1989” (Banks, 1988, p. 16).
As Fetherling (1989, p. 80) suggests, the hyperbole of Gerry McKendry as
echoed and reinforced by the media catered to the public’s and, perhaps, the
regulators wishful and romantic attitudes toward technical innovators.
The preceding implies that the OSC was, in some sense, captured by the
hype surrounding PETCO’s apparent technical innovation. However, even with
all the hyperbole, the OSC’s actions also suggest that they were not entirely
convinced that the undisclosed information was immaterial. For example, the
OSC restricted the January 1988 warrant issue to blocks of $150 000 with the
intention of ensuring that “only experienced investors would be involved in
the speculative investment” (Hutchison, 1988, p. 6). Thus, although the OSC
chose not to disclose McKendry’s history, they did prevent small investors
 Reading the regulatory text 379

from purchasing the warrants (although PETCO’s shares could be purchased

on the OTC market). However, this restriction on purchases by small investors
was relaxed when the February 1988 preliminary prospectus was filed. One
interpretation of these actions is that, in the absence of any subsequent
disconfirming information on McKendry or PETCO, the OSC decided not to
jeopardize the possible success of PETCO’s plastic engine by requiring the
disclosure of fvlcKendry’s past history.
One could argue that the TSE’s decision was influenced by the same
circumstances and hyperbole that influenced the OSC. For example, the
previous instance where the TSE forced the stock promoters to provide
additional disclosures occurred at a time when new listings were more
prevalent (Johnson & Lilley, 1987, p. 88; TSE Review, 1983). However, the
interests of the TSE’s listing committee also made it easier for them to believe
in PETCO. A previous quote noted that the TSE’s listing committee was made
up of 13 senior staff from brokerage companies and that there was no reason
to believe that the owner-managers would not comply with TSE rules
(Hutchison, 1989e, p. I). A possible interpretation of this quote is that
members of the listing committee, whose primary occupation is selling
shares, were more willing to believe in PETCO’s owner-managers than a
more disinterested individual might have been. In addition, the OSC’s
decision not to disclose this information made it easier for the TSE’s listing
committee to arrive at a similar conclusion.
The preceding analysis suggests that the manner in which the regulators
interpreted the regulatory text differed from the manner in which potential
investors would have interpreted it. The interpretation adopted by both the
OSC and TSE favoured PETCO’s owner-managers at the expense of potential
investors. However, the analysis is not meant to imply that it was only the
power of owner-managers vis a vis the power of potential investors that
encouraged this interpretation on the part of the regulators. Rather, it appears
that the regulators themselves, because of their location within the financial
capital system, had incentives to encourage the continued viability of the
stock market by encouraging new stock issues in the period subsequent to the
mini stock market crash. Further, the enthusiasm surrounding PETCO’s
plastic engine appears to have influenced the regulator’s interpretation of
materiality. After all, how important can past business history be given the
apparent importance of PETCO’s technical innovation?

The Accounting Profession

Within the new stock issue process, the role of the public accountant is limited
to ensuring that the financial information included in the offering memoran-
dum or prospectus satisfies full, plain and true disclosure requirements (OSC,
1990, S23.3). With respect to PETCO’s offering memorandum, the public
accountants audited the previous financial statements and reviewed a
forecast of future earnings for the years ending June 1988 and June 1989. The
earnings forecasts estimated that revenues would be $3.3 million for 1988 and
$35.7 million for 1989. A net loss of $1.8 million was forecasted for 1988
whereas a net profit of $4.5 million was forecasted for 1989.
380 D. Neu

OSC regulations allow the inclusion of earnings forecasts in such docu-

ments as long as certain criteria are met (OSC, 1986, P5.8). The forecast must
be prepared and reviewed in accordance with CICA Accounting and Auditing
Guidelines (1983). This review is to be performed by an independent public
accountant. In addition: “a forecast must be reviewed regularly to identify
significant changes that have occurred since the forecast was issued” (OSC,
1986, P5.8). Reviews of earnings forecasts are intended to assess the
plausibility of the forecast assumptions (CICA Auditing Guidelines, 1983, p. 3).
In doing so, the auditor is expected to conduct a review of forecast
assumptions and accounting policies used, undertake review procedures such
as enquiry, comparison, test of computation and compilation, and evaluate
the overall forecast.
At the end of April 1988 PETCO issued additional equity shares via a
prospectus. At this time, an additional 3 months had passed since the original
forecast and only 2 months remained in the forecasted period. In this
prospectus, PETCO made no mention of the previous forecast nor did they
provide a revised forecast. Similarly, on 16 May 1988 interim financial
statements for the period ending March 1988 were released. Included in these
interim statements was the following comment to shareholders: “we have
reviewed our forecast included in our Offering Memorandum dated January
11, 1988, and have no material changes to report” (Micromedia, IFS
1988-23/3). However, when actual results for the period ending June 1988
were released, the net loss was $3.8 million, twice as large as previously
forecasted.
While it is difficult to achieve accurate predictions of future results, PETCO’s
forecast was excessively optimistic by most standards. Studies using similar
types of firms find that, on average, forecasts tend to over-predict earnings by
25% (cf. Neu, 1989). Furthermore, it is unlikely that the additional loss of $2
million over the amount forecasted occurred in the final 6 weeks of the fiscal
period (the time between the date the interim statements were released and
the year-end). As a consequence, it appears that the public accountant
believed that the changes to forecast assumptions were insignificant.
The public accountant’s interpretation of significant changes was consistent
with the manner in which PETCO’s owner-managers would have interpreted
it. This should not be surprising since, at the time of the new stock issue, the
public accountants were acting as agents for the owner-managers. In
addition, the imprecision of earnings forecasts to start with, along with the
empirical observation that Canadian public accountants have rarely, if ever,
been taken to court for their involvement with a misleading earnings forecast,
implies that the public accountants faced little risk in being associated with an
optimistic forecast. Like the investment houses, the public accountants in this
case appear to have had few incentives to consider the interests of potential
investors.

The Body
Throughout the winter and spring of 1989, PETCO desperately sought
additional financing in an attempt to remain solvent. Over the December to
 Reading the regulatory text 381

February period, PETCO officials announced a series of tentative financing

arrangements, all of which fell through at the last moment (cf. Financial Post,
1988; Globe & Mail, 198Sa,b). Then in March, the company actually did run
out of money, failing to meet its payroll (Outhit & Hutchison, 1989). In an
attempt to buy time to arrange a suitable financing package, PETCO filed for
bankruptcy. As newspaper reports noted:
“The move is intended to keep the company going, rather than shut the
doors as is normally assumed with bankruptcy. Mr. McKendry said he is
optimistic the move will buy the company the time it needs to set up a new
financing agreement” (Hutchison, 1989a, p. Bl).
At this time, the TSE halted trading in PETCO shares until the payroll
problem could be resolved (Roman, 1989, p. 623). When no immediate
solution became apparent, the TSE indefinitely suspended trading in PETCO
shares, however, the stock continued to be traded on the OTC market
(financial Post, 1989, p. 1).
On 22 April and 26 April, The Wig-Standard repotter Bill Hutchison made
public the results of his investigation into PETCO. The headlines read “Secret
Profits for Key Petco Insiders” and “Petco Chief hid Criminal Record, Collapse
of Florida Companies”. The following day it was announced that the company
had abandoned its reorganization plan and was filing for bankruptcy. As the
trustee for PETCO commented:
“Until this week Plastic Engine Technolgy Corp. had been attempting to
reorganize under a special section of the Bankruptcy Act. The new filing
means the company will be killed and its assets sold” (Wilson quoted in
Hutchison, 1989e. p. 1).
Up to this point in time, the OSC had been relatively invisible. When queried
about the PETCO failure, a representative of the OSC commented that:
“Joseph Groia, director of the enforcement branch of the securities
commission, stressed that his department is only reviewing information
about Petco, but said anyone with complaints about the company should
contact him.. . Mr. Groia said the commission has a policy of never
revealing when it has launched an investigation. ‘In our experience, merely
commenting on the existence of an investigation can have a serious impact
on reputations and market activity”’ (quoted in Hutchison, 1989c. p. 1).
However, at the beginning of June 1989, the OSC filed charges against Gerry
McKendry and PETCO for issuing a misleading press release in February 1989
regarding a tentative financing package (Dawe, 1989, p. 1). A director of
PETCO was also charged with passing on insider information as was the
individual who traded on the information during the last months before
PETCO’s demise.
The charge against the individual who undertook the alleged insider trading
was settled out of court. This individual, a member of the family that founded
and controls the investment dealer Richardson Greenshields, agreed to an
out-of-court settlement of $500 000 in return for the charges of insider trading
being dropped. As the press release stated:
“Although Mr. Richardson has negotiated a settlement with the staff of the
Ontario and Manitoba commissions, it has been difficult for him to do so
because he strongly believes that he did not know of any material fact or
382 D. Neu
material change about Petco that was not generally disclosed.. . Mr.
Richardson has opted for the settlement to minimize the impact of the
process upon his family” (quoted in Dawe, 1989, p. 2).

In August 1991, the director charged with passing on the insider information
was found guilty (Hemeon, 1991, p. 63). Sentencing is expected in late 1992.
The courts also found Gerry McKendry and PETCO guilty of issuing a
misleading press release. As the newspaper report states:

“The misrepresentation in the press release related to a statement that the

company had commitments in place for $8.5 million on a $10 million
financing. The judge found that no such commitments for funds existed”
(Hemeon, 1991, p. B3).

Again, sentencing is expected in late 1992.

The charges laid by the OSC did not pertain to trading by the spouses nor
did they pertain to the information that was not disclosed. However, this is not
surprising since it was the OSC’s regulatory text and the OSC’s interpretation
of the regulatory text that allowed these events to remain private. Instead, the
OSC’s charges relate to after-the-fact events; events that may have prolonged
the charade but did not initiate it. For example, by the time that the
misleading press release occurred, PETCO stock had already declined to less
than $0.50 per share compared to the initial stock issue price of $2.00. The
behaviour of the OSC appears quite consistent with the observation that
“prosecution is more readily used where there is already a body on the floor”
(Hawkins, 1989, pp. 388-389).

And the Investors

As mentioned previously, investors from the Kingston community were some

of the biggest supporters of PETCO. The types of individuals that invested
varied from three individuals that purchased $1 million of the January 1988
warrant offering to small first-time investors that purchased $100 or $1000
worth of shares. For example, Gerry McKendry comments that:

“There are several hundred Petco shareholders in the Kingston area, he

said, including his barber, his doctor, and the sales staff of two of the larger
furniture stores” (quoted in Hutchison, 1987, p. 15).

Other newspaper reports told similar stories, indicating that investors

included taxi dirvers, local business people and other members of the
community.
The subsequent disclosures surprised these investors. The biases in the
regulatory text that allowed the spouses to sell shares were contrary to
expectations. Investors commented that this was not how they expected the
“game” of selling shares to be played. For example an investor, the mayor of
Kingston, comments:

“Mr. Gerretson said any investment involves a risk, which is fair as long as
everyone plays by the same rules” (quoted in Hutchison, 1989d. p. 1,
emphasis added).
 Reading the regulatory text 383

Another investor added that:

“if this is the way promoters and developers play the game, it is a sad
statement on what the game is. It does not do much to promote public
confidence” (Cuthbertson quoted in Hutchison, 1989d. p. 1).
From these reactions, it is evident that the subsequent disclosure of associate
trading called into question assumptions about the fairness of the new stock
issue process. More specifically, the disclosure contradicted the discourse of
regulation which implies that regulations are neutral and therefore will
prevent owner-managers from making this type of hidden sidebet. Consistent
with Lev’s (1988) observation that potential investors, suspecting gross
asymmetries, will refuse to participate in the new stock issue process, many
of the investors interviewed by The Whig-Standard indicated that they would
never again purchase shares-however, this realization came only after
losing their investment in PETCO.
Investors were also suprised by the OSC’s decision to withhold information
on Gerry McKendry’s past business history. For example, several individuals
commented that the success of high technology companies like PETCO
depend on the quality and integrity of the management team:
“In a company such as Petco, senior staff are very important, he said. ‘The
management of any new company is the future of a new product”’
(Beauregard quoted in Hutchison, 1988e, p. 2).
As a consequence, investors were surprised that the OSC did not disclose this
information, especially if it was thought to be immaterial. For if the informa-
tion was immaterial to potential investors, public disclosure of the information
would have had no impact on the stock offering.
The preceding implies that the regulatory text and the OSC’s interpretation
of the regulatory text did not work in the manner that potential investors
expected them to. However, to conclude that the regulators were the villians
and the investors were the victims would not be entirely appropriate. While
the regulatory text and the OSC’s interpretation of the text contributed to the
dysfunctional consequences, the investors, like the regulators, appear to have
been captured by the hyperbole surrounding PETCO’s apparent technical
innovation. The continuous positive media coverage received by PETCO
seems to have convinced investors that the company’s plastic engine was a
revolutionary breakthrough that would make all associated with it rich. As a
consequence, investors, in their excitement to be associated with a high-
technology local success story and with the promise of getting rich quickly,
did not attempt to read between the regulatory lines. Stated differently, some
potential investors seduced by the glamour of PETCO, may have chosen to
invest regardless of what the regulators may have said or done.

Discussion
Stock markets and the new stock issue process are ubiquitous. Yet, previous
research has not really considered whether the new stock issue process is
functional for a// classes of participants. Instead, previous research has tended
to prejudge the issue by assuming that stock markets and the new stock issue
384 D. Neu

process are functional. This has led a number of researchers to conclude that
less regulation would be in the public interest.
The current study questions the appropriateness of assuming a priori that
the new stock issue process is functional for all participants. Instead,
following the suggestion that researchers start from the social consequences
of a particular instance (Marx & Engels, 1978, p. 154), a case study of PETCO
was used to examine some of the less-than-functional aspects of the new
stock issue process. More specifically, the case study considered how
regulations in the new stock issue process work and who benefits from these
regulations.
In terms of the institutional context examined, a number of tentative
conclusions are possible. First, the analysis indicated that the regulatory text
is not neutral with respect to distributional issues. Biases within the OSC’s
regulations allowed the stock promoters to circumvent insider-trading regula-
tions. This bias was exacerbated by the legalistic regulatory terminology
which referred to spouses as associates and by the failure of some stock-
brokers to inform their clients of this loophole.
In addition, the analysis suggests that the OSC’s and public accountant’s
interpretation of the regulatory text differed from the manner in which
potential investors would have interpreted it. In both cases, decisions were
made to interpret information as immaterial and insignificant-interpretations
that were consistent with the interests of the owner-managers. Finally, the
analysis proposed that the regulators as well as investors were captured by
the hyperbole surrounding PETCO’s plastic engine. As a consequence, both
groups made decisions that appear, in hindsight, less than rational.
More generally, the analysis contradicts some of the taken-for-granted
assumptions of prior research into regulation. I would like to consider three of
these-the role of intermediaries, the role of regulation and the functionality
of the new stock issue process for all classes of participants.
Proponents of the investor omniscience perspective argue that inter-
mediaries provide investors with assurances that the problems of information
asymmetry and moral hazard have been mitigated. However, as was men-
tioned previously, they do so by truncating questions of interest. In the case
of PETCO, intermediary interests resulted in the investment houses and
public accountants being somewhat less than neutral referees. For example, it
was noted that investment houses require both new stock issues and
potential investors to purchase these issues and that the interests of these two
groups conflict. However, since high technology firms such as PETCO are less
abundant than are potential investors willing to invest in such stocks, it seems
that the investment house had incentives to privilege the interests of the
owner-managers. The investment houses did this by not informing potential
investors of biases in the regulatory text which favoured the owner-
managers-information which may have made it more difficult for the
investment houses to sell PETCO shares. Similarly, the public accountants, as
agents of the owner-managers, had incentives to interpret changes in
forecast assumptions as being insignificant. Thus, the location of both
investment houses and public accountants within the financial capital system
appears to have encouraged behaviour that benefited PETCO’s owner-
managers at the expense of investors.
 Reading the regulatory text 385

Proponents of the investor omniscience perspective also argue that less

regulation would be in the public interest since regulation interferes with the
market for intermediary services. While the provided analysis contradicts the
assertion that intermediaries have incentives to act as neutral referees, the
analysis is more equivocal about the role of regulation. In the case of PETCO,
both the regulatory text and the OSC’s interpretation of the text were
consistent with the interests of the company’s owner-managers. Therefore,
one could argue that less regulation would be in the interest of investors
since investors would then have to take responsibility for their own
investment decisions. Note, however, I am not saying that regulation should
be decreased because it interferes with the functioning of the market for
intermediary services. Rather, I am saying that the removal of regulations
would eliminate the appearance of a fair game thereby making visible to
potential investors how unfair the game really is. Then, perhaps, potential
investors will behave as Lev (1988) suggests and refuse to participate.
While the analysis indicated that the OSC’s interpretation of the regulatory
text was dysfunctional for investors, the analysis also suggested that
circumstances influenced the interpretation adopted by the OSC. At the time
of PETCO’s new stock issue, there were very few new issues. Because of the
OSC’s location within the financial capital system, the OSC appears to have
had incentives to ensure the viability of the system by adopting a more lenient
interpretation. Intertwined with this was the hyperbole surrounding PETCO’s
technical innovation which may have made the promoter’s past business
history seem less important. As a consequence, different circumstances may
have resulted in an entirely different regulatory interpretation. Thus, it is not
really possible to determine whether less, or simply different, regulations and
regulatory interpretation would be in the interests of potential investors.
From the case, it is clear that the stock market was not functional for all
classes of participants. The actions of intermediaries and regulators, inten-
tionally or unintentionally, privileged the interests of owner-managers at the
expense of potential investors. However, to conclude that these institutions
were the villians and that potential investors were the victims would be
overly simplistic. After all, neither the institutions nor the investors exist
outside of the discourses of late capitalism. Rather, the glamour of the
apparent technical innovation convinced institutions and investors alike that it
would be in their interests to “buy” into the PETCO dream.

Acknowledgements
I would like to thank Bill Hutchison for the time and insights that he provided. The
comments of Wai Fong Chua, David Cooper, Duncan Green, David Knights, Norm
Macintosh, Alistair Preston, Alan Richardson, Alison Taylor, Dan Thornton and Tony
Tinker are much appreciated. Finally, the research funding provided by the University
of Calgary and the Canadian CGA’s Research Foundation along with the research
assistance of Chi Lam are gratefully acknowledged.

Notes
1. Although the structure of the analytical models used by the researchers differ somewhat, the
conclusions are all quite similar.
386 D. Neu
3. Public documents filed with the OSC are reproduced on microfiche by Micromedia Inc. All
references refer to the type of document (e.g. MIS) and the year and batch number.
4. OSC regulations and policy statements refer to the 1990 OSC Act and Regulations (OSC, 1990).
Regulations are denoted by “R”, sections are denoted by “S” and policy statements are
denoted by “P”.
5. The word bias is a strong word for describing the investor/associate distinction. It is meant to
contradict the more prevalent assumption that regulatory language is neutral. In addition,
although it is impossible to ascertain the original motivation for this distinction, I do not want
to foreclose the possibility that the distinction was intentional. Past history notwithstanding, at
the current point in time it appears that the regulations are biased in favour of owner-
managers.
6. Subsequent newspaper reports noted that these were not sales but orders that were
contingent on the delivery of a plastic engine. Also, as mentioned previously, PETCO never did
commercially produce a plastic engine.

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