Companies and their directors and officers must accept that securities class actions are a reality of accessing the capital markets. For a variety of reasons,1 this risk has proven to be particularly acute in the cannabis industry. NERA Economic Consulting recently released a report noting that cannabis companies were defendants in 36% of the Canadian securities class actions commenced in 2019.2 The same study noted that 67% of the Canadian companies sued in US securities class actions (i.e., cross-listed public issuers) were cannabis companies. Another study revealed that the number of US securities class actions filed against cannabis companies surged by 116% from 2018 to 2019.3
Some pundits have chalked these gloomy statistics up to growing pains and the high volatility and downturn experienced by a nascent industry since early 2019. Respectfully, these explanations are simplistic because they fail to address the root causes of the class actions.
At a high-level, the allegations in securities class actions commenced against cannabis companies and their directors and officers fall within the following categories:
- failures to adequately disclose material facts or material changes, in prospectuses and/or continuous disclosure filings;
- undisclosed related party transactions, including those relating to cross-ownership by insiders;
- unsubstantiated valuations in M&A transactions;
- non-compliance with applicable laws, including licensing requirements;
- exaggerated disclosure concerning operations and growing capacity;
- exaggerated forward-looking information concerning demand and potential for sale; and
- financial restatements, including those caused by failures of internal controls.
To minimize the risks from such class actions, directors and officers should discuss how to implement or improve the following steps with reputable and experienced financial and legal advisors:
- Promote a strong culture of compliance, starting with the 'tone from the top'.
- Empower employees in the compliance, quality control and financial accounting departments and ensure they are able to seek appropriate professional advice from internal or external counsel.
- Review the company's organization charts to prevent or address conflicts of interest and ensure proper reporting lines.
- Consider implementing a regularly scheduled compliance report at audit committee meetings (or similar board sub-committee).
- Create and socialize an anonymous whistleblower hotline to the board (or its audit committee) and periodically remind employees about the sanctity of the hotline.
- Organize ongoing board of directors training on the Cannabis Act and Regulations.
- Encourage directors to make site visits, including unscheduled site visits.
- Organize ongoing employee training on ethics, risk assessment and the Cannabis Act and Regulations.
- Review standard operating procedures, and modify/supplement them as necessary, to ensure that cannabis is produced and distributed only as authorized pursuant to applicable laws.
- Review record-keeping practices to ensure compliance with Good Production Practice and systematic filing procedures.
- Balance the benefits and risks of disclosing forward-looking information after ensuring it reflects the board's and management's documented good faith belief, including with respect to the reasonableness of the underlying assumptions.
Under Canadian securities law, directors and officers are not liable for a misrepresentation to shareholders if they conducted a reasonable investigation that provided a basis for their conclusion that there was no misrepresentation. In addition, corporate legislation permits directors, in discharging their fiduciary duties, to rely in good faith upon reports and advice of qualified professionals. Steps like the ones listed above will better allow directors and officers the opportunity to make a compelling "reasonable investigation" or reliance upon experts defence if they are ever sued. Directors are entitled to these defences if they make reasonable efforts to ensure the company's compliance with its statutory and regulatory requirements.
Although there is no "one size fits all" approach and specific legal advice should be sought, there are two important takeaways:
First, regulatory compliance should be prioritized given the company's need to strictly comply with complex regulations that frequently change, and to make timely disclosure of material non-compliance. This means the company should retain experts in the Cannabis Act and Regulations who have deep relationships with compliance professionals in the cannabis industry and Health Canada.
Second, given the serious potential consequences that may arise from compliance and accounting issues in a cannabis company, which include securities class actions, the company must be prepared to retain an experienced and multi-disciplinary external counsel team who can expeditiously investigate potential issues and provide advice on complex securities law matters, Cannabis Act and Regulations compliance, and class action defence strategies.
Securities class actions will always remain a risk. Public companies, and their directors and officers, can and should proactively take steps to significantly minimize their respective risk profile and enhance the factual and legal defences that may be available to them in securities class actions. McCarthy Tetrault LLP can assist you understand, mitigate and address any residual risk from class actions, and defend you in the event that one is commenced. Our national practice has significant cannabis industry experience in helping companies create appropriate corporate governance protocols and controls to minimize the risk associated with class actions, conducting internal investigations when appropriate, and in acting as defense counsel if companies, directors and officers are sued.
1 Some of the factors contributing to the high incidence of securities class actions in the cannabis industry include a relatively high level of retail investor participation in cannabis financings, the growing pains associated with entrepreneurial management teams working within a highly-regulated and newly legalized industry, and, in some cases, negative market perceptions about cannabis issuers' corporate governance practices, public disclosures and a gap between market prices and intrinsic valuations.
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Originally published McCarthy Tetrault, May 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.