After nearly two years since the recreational cannabis industry has been in operation, we are seeing a rise in securities class actions and regulatory activity relating to cannabis companies. Since legalization, the growth of the sector has been fast and furious. The initial excitement and high investor interest has been recently overshadowed by compliance breaches at Canadian cannabis issuers coupled with market volatility fueling event-based securities litigation.
A surge of securities class actions were filed on behalf of disgruntled investors in 2019 against a number of Canadian cannabis issuers for prospectus and secondary market misrepresentation. NERA Economic Consulting released a report noting that the cannabis industry accounted for five of the fourteen new Canadian securities class action filings (36%). Securities class actions commenced against cannabis companies generally involve circumstances of:
- misleading and inaccurate prior public disclosures;
- non-compliance with applicable laws and licensing requirements;
- misrepresentations related to quality of the product or the status of inventory;
- overstated forward-looking statements concerning demand and potential for sale;
- undisclosed related party transactions or benefits; and
- failure to disclose weak demand for the product or the expected decline in revenue and profits.
The recent class action against Cronos Group Inc., an Ontario-based cannabis company that cultivates, manufactures and markets cannabis and cannabis-derived products for the medical and adult-use markets, provides an illustration of the types of claims that have arisen. The claimant, Badesha Harpreet, resides in Surrey, British Columbia. Mr. Harpreet purchased 885 Cronos shares on the secondary market.
The claim alleges that Cronos failed to disclose adverse information regarding its business and operations and made materially false and misleading statements. Specifically, it alleges that Cronos orchestrated a scheme to inflate its reported revenue figures by entering into simultaneous transactions with third parties to sell them dried cannabis and purchase back cannabis resin and tinctures and then inappropriately recording these sales as revenue instead of accounting for the transactions at the carrying value of inventory transferred by Cronos. The claim further alleges these transactions represented more than 35% of Cronos’ reported revenue for the first and third quarters of 2019, which resulted in Cronos securities trading at artificially inflated prices during the class period.
While a whistleblower reportedly raised the alarm about the inflated revenue internally, Cronos announced in February and March of this year that it would delay its release of fourth quarter and fiscal year earnings and requested a 15-day extension from the U.S. Securities Exchange Commission to file its annual report. Cronos attributed the delay to a review by its audit committee and outside counsel of several bulk resin transactions through the wholesale channel and the appropriateness of revenue recognized from those transactions. These statements resulted in a sharp decline in Cronos’ stock value.
Even if the alleged misrepresentations are found to be untrue at the time they were made, Cronos and its directors can avoid a finding of liability with respect to such statements by demonstrating that they took reasonable care to ensure their accuracy, and with respect to forward looking statements, that there was a reasonable basis for making them.
While securities class actions will always remain a risk of accessing capital markets, the flurry of class actions is a reminder that given the new and complex regulatory hurdles in the cannabis industry, companies and their directors must take steps to prioritize regulatory compliance, establish strong quality controls, and carefully review any statements made to prospective shareholders. Fostering a culture of compliance and taking proactive measures, such as anonymous whistleblowing systems and employee education on obligations under securities laws and the Cannabis Act, will be important to mitigate the risk of such class actions.
Notwithstanding the COVID-19 pandemic’s disruptive impact, there is likely be a continued upward trend of new securities class action filings as the cannabis sector remains volatile and regulatory scrutiny remains high. Time will tell whether the surge of securities class actions will lessen as the cannabis industry matures and companies develop better experience with the various regulatory schemes.