Cannabis Musings - July 5, 2023
The pains of being a public cannabis company.
Friends, longtime readers of these Cannabis Musings may recall a joke I once made that the cannabis industry had achieved legitimacy when an investor had filed a class action securities fraud lawsuit against a public cannabis company. It was finally being treated the same as every other sector, in an odd sort of way. Friends of the newsletter at Goodwin LLP even produced an extensive report on the topic in 2020. Since then, plenty of securities fraud class actions have been filed against public cannabis companies.
More recent news of Canopy Growth Company being sued in a purported (lawyer-ese for “supposed”) class action for alleged securities fraud reminded me of my delicious bon mot, as well as the art of disclosing the risks of doing business in cannabis to investors. Let me explain.
In the U.S., you can kinda sue anyone for anything. That’s both a feature of, and a bug in, the system. There’s limitations on that, for sure (e.g., plaintiffs and lawyers theoretically face sanctions if they bring a lawsuit that’s too narish (foolish)), but not many. There’s a cottage (more like a “mansion”-sized) industry of lawyers who find investors in public companies to file a lawsuit against the company when the stock price drops after something bad, on the basis that the failure to properly disclose to investors the risk of that something bad happening constituted fraud. My muse, Matt Levine, author of Bloomberg’s Money Stuff, lovingly refers to this as “everything is securities fraud.”
Put another way, the idea is that the public company should have warned investors that there was a risk of the bad thing happening, and they didn’t, and when the bad thing happened, the stock price dropped and investors lost money, and therefore, investors have been defrauded. The Securities and Exchange Commission (SEC) and the courts handed over some of the power to police this activity to investors (and their lawyers). Is that power abused? Sure is! Az me lost a chazir aruf af'n bank, will er af'n tisch (“give a pig a chair, it’ll want to get on the table”). And yet, there’s a genuine public utility in allowing investors to bring these kinds of lawsuits – the SEC doesn’t have the resources to scrutinize every single stock price drop or public announcement, so the right to sue theoretically deters companies from misleading/lying to the public and withholding information.
One way that public companies protect themselves from these lawsuits (not lying to the public is another one) is to warn investors in advance that the bad thing might happen. This is done mostly by companies disclosing “Risk Factors” in their public filings – a parade of horribles of everything that the company, its lawyers, and its bankers could possibly concoct that could go wrong for the company, its industry, the economy, and the world at large. These risk factors tend to be buried deep within 100+ pages of the company’s prospectus or annual report, written in a very formalistic manner to make them fairly unintelligible, mostly by design.
If you think I’m exaggerating, consider my favorite risk factor of all time, written by a former law partner of mine for global electronic dance music concert producer SFX Entertainment, Inc. in its 2013 IPO prospectus:
Activities or conduct, such as illegal drug use, at our properties or the festivals and events we produce may expose us to liability, cause us to lose business licenses or government approvals or result in adverse publicity.
We are subject to risks associated with activities or conduct, such as drug use at our festivals, events or venues that are illegal or violate the terms of our business licenses. Illegal activities or conduct at any of our events or venues may result in negative publicity or litigation. … We have a "no tolerance" policy on illegal drug use in or around our facilities, and we continually monitor the actions of entertainers, fans and our employees to ensure that proper behavioral standards are met. However, such policies, no matter how well designed and enforced, cannot provide absolute assurance that the policies' objectives are achieved. Because of the inherent limitations in all control systems and policies, there can be no assurance that our policies will prevent deliberate acts by persons attempting to violate or circumvent them. Such consequences may increase our costs, result in the loss or termination of leases for our venues by property owners (including governments and other parties that own the land at our venues), result in our inability to get the necessary permits and locations for our events, lower consumer demand for our events, subject us to liability claims, divert management's attention from our business and make an investment in our securities unattractive to current and potential investors, thereby lowering our profitability and stock price.
Apologies for the block quote, but I wanted you to enjoy that in all of its glory. SFX warned its investors that concertgoers might take drugs (which is kind of a thing at EDM concerts) and SFX might get in trouble for that, causing its stock price to drop. See how these things work?
The problem comes when one of the dozens of people working on an issuer’s risk factors fails to think of something that might go wrong in the future. For example, take my favorite public company of all time, Bigfoot Project Investments, Inc. The company acquired a bunch of assets “to establish itself as the most reliable and dependable source for materials including documentaries, physical evidence, and eye witness accounts for the purpose of documenting the evidence of the existence of Bigfoot,” per its 2016 offering document. Really.
If you read the offering document (and you should), you may notice that one particular risk factor is missing – that Bigfoot doesn’t actually exist. Now, I don’t know why they didn’t think to include that risk factor, but maybe they figured that that risk was per se notum, and would an investor would have to prove that Bigfoot doesn’t exist in order to win their lawsuit?
In short, the difference between winning and losing a securities fraud lawsuit may depend upon whether the overworked mid-level associate lawyer who drafted the risk factors at two in the morning was creative enough to think of the most farkakteh thing that could cause the stock price to drop.
Turning back to the cannabis industry, back in my lawyer days, I had the good fortune of drafting risk factors on behalf of cannabis clients, both for public and private investment documents (private companies are subject to the same securities laws about not misleading investors). Because about 97.36% (that’s not a real statistic, but it’s not too far from the truth) of legal drafting is plagiarizing someone else’s prior work, I naturally would turn to precedent, usually pulling public filings made by cannabis companies. Remember that a lot of cannabis companies went public in 2017-2019, and cannabis industry-related risk factors were quite novel, so there were plenty of filings to choose from.
I remember noticing the same language about the potential risks of investing in a U.S.-based cannabis company showing up in a lot of filings (see my fake statistic above). I also remember finding all too often risk factors failing to accurately describe how U.S. cannabis operators, as well as ancillary businesses, were violating U.S. law. It was frankly shocking to me as a lawyer – I never understood why issuers wouldn’t be as alarmist as possible (e.g., “We may sell products into the unlicensed market that may end up being resold out of repurposed food trucks in lower Manhattan”). Most investors don’t even bother to read the risk factors anyway, and, let’s be honest, they’re investing in cannabis. (Absolutely none of this is legal advice.)
The takeaway here is that being a public company is really hard, particularly for one that violates U.S. federal law on a daily basis. These kinds of lawsuits are only going to continue, so companies need to be hypervigilant about avoiding (or at least reducing) the risks and activities that could reasonably give investors a reason to sue in the first place. As I’ve said before, in cannabis, compliance is everything, and plaintiffs’ lawyers help remind us of that fact.
Be seeing you!
Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network and twenty-five years of dealmaking and capital markets experience.
© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form.