Cannabis Securities Litigation: SDNY Dismisses Fraud Case Arising from Canadian IPO

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One of the cannabis litigation trends we discussed in a recent webinar was the increasing number of lawsuits alleging some type of fraud by cannabis companies during the capital-raise phase of their businesses.  For most businesspeople, raising capital to fund their new business is essential. Just as essential is making sure that you comply with federal and state securities laws. We’ve been writing about the intersection of these issues for several years.

Perhaps the most critical thing for cannabis entrepreneurs to know is that federal law and state counterparts define the term “security” quite broadly. So broadly that nearly any method of raising capital for a business venture falls under the rubric of offering a security that is subject to stringent rules and regulations. As Jonathan Bench helpfully summarizes, “[i]n the cannabis industry, a ‘security’ is any type of financial interest in any business venture for any amount over any period of time, even if that business is not a formally registered company.”

This blog post discusses a recent decision by the Southern District of New York dismissing a securities fraud lawsuit filed against a Canadian company that sought to raise money as part of an international hemp-CBD business plan and strategy. The case is SUN, A Series of E Squared Inv. Fund, LLC v. Sundial Growers Inc., No. 1:20-CV-03579 (ALC), (S.D.N.Y. Sept. 30, 2021).

Background

The lawsuit demonstrates the global nature of the cannabis industry. (Something our international and trade and customs lawyers can confirm.) Plaintiffs were comprised of an investment fund based in New York, a hedge fund based in Israel, and other companies based across the United States. Defendant was a licensed producer of cannabis based in Canada.

(The background here is from the allegations in the complaint)

After the legalization of cannabis in Canada in 2018, Defendant sought to raise US$50 million prior to its initial public offering (“IPO”) to fund the acquisition of another company (the “Target Company”). Plaintiffs met with Defendant in early 2019 in Toronto where Defendant presented information that the Target Company had a hemp license allowing the cultivation, processing, and export of finished product to the United Kingdom. The Target Company allegedly would provide scalable growth for only C$20 million in capital expenditures and would generate C$256 million in revenue and C$115 million of EBITDA in 2020.

Not long after the meeting in Toronto, Defendant released an investor presentation indicating Defendant sought to raise C$70 million to fund the Target Company acquisition. The investor presentation highlighted that the fully operational Target Company would allow Defendant to be “the first mover in mass-scale, global hemp-derived CBD products” and that the Target Company had a hemp license. The investor presentation stated that the offering would be in the form of convertible unsecured promissory notes wherein the holder would have the option to convert the notes into common shares upon a qualifying IPO at a discount depending on when the IPO occurred. (This is the “security” at issue).

Plaintiffs agreed to invest $7 million in the pre-IPO round.

In July 2019, Defendant filed a Registration Statement on Form F-1 with the SEC. (Side note: Form F-1 is the standard registration statement filed with the SEC by foreign private issuers of securities and by private foreign companies seeking to go public and be listed on a U.S. Stock Exchange). The Registration Statement was amended twice in later July and the Risk Factors stated that the Target Company currently held a company cultivation license through December 31, 2021 and that Defendant would renewal of the license with the United Kingdom Home Office prior to expiration. Defendant warned that the ability to recognize the strategic objective of their acquisition of the Target Company could be materially adversely affected if the Home Office delayed or did not renew the license.

In August 2019, Defendant filed its Prospectus with the SEC, pursuant to which Defendants made its IPO of common stock. Defendant offered 11 million shares of common stock at an initial price of $13.00 per share. Defendant raised US$134.4 million and Plaintiffs converted their notes into shares at a price of C$13.84 per share.

After the IPO, Defendant held an investor call in which one of the placement agents stated “I know that there’s a couple of licenses you’re waiting for before you can start really converting and growing hemp at [the Target Company’s] facilities.” Later, a research analyst for the same placement agent stated the Target Company “requires key licenses and we expect there will be a natural ramp and learning curve associated with the conversion of [the Target Company’s] greenhouses from growing herbs and ornamental flowers to growing hemp.” The analyst estimated revenues of C$98 million on 2020 and C$243 million in 2021.

(Side note: A “placement agent” is a registered broker-dealer that assists a company in structuring its capital raise and acts as a sort of intermediary between the company and prospective investors)

On August 16, 2019, Defendant’s stock opened at $10.54 per shared. By the end of the month it had declined approximately 25%.

Plaintiffs alleged that the placement agent visited the Target Company in October 2019 and discovered the company was only growing hemp in a limited capacity under a license that did not allow the hemp to be sold or the flowers to be extracted into CBD. The placement agent reported the Target Company had applied for a  license to permit the extraction of and that there was “no indication as to if, or when” the Target Company would receive the necessary licenses.

In November 2019, Defendant held an earnings call where it stated it was working with the UK Home Office to secure the necessary licenses and that it anticipated obtaining the licenses by year end.

In its fourth-quarter earnings call, Defendant reported a net loss of C$145.1 million due primarily from the acquisition of the Target Company.

Plaintiffs allege that the Defendant’s accountants determined that the goodwill attributed to the purchase price of the Target Company was “grossly inflated” and that the Target Company’s ability to generate cash flows deteriorated such that the fair value of the goodwill fell below its book value.

In early February 2020, Defendant announced that key members of its management team were leaving he company.

Defendant’s stock dropped 50%—corresponding a market cap drop to roughly $133 million—an 87% decline from the IPO valuation.

In March 2020, Defendant announced its intent to sell the Target Company. In April 2020, Defendant’s sock closed at US$0.50 per share—more than 95% below its $13.00 original list price.

The Alleged Securities Fraud

Plaintiffs filed suit in May 2020 and an amended complaint in January 2021. Plaintiffs alleged that Defendant made “false statements of material facts and concealed/omitted material facts regarding [the Target Company’s] capabilities, specifically, that Bridge Farm had the requisite licenses to “cultivate, process and export” hemp and CBD from the UK.” Plaintiffs also alleged Defendant knew or should have known the Target Company did not have the requisite licenses to cultivate, process, and export hemp and CBD and, therefore, knew or should have known the acquisition would not result in the projected 2020 revenues and growth.

Plaintiffs contended that the individual defendants (former executives of Defendant) were focused on maximizing their individual holdings by completing the IPO quickly and believing the acquisition of the Target Company would make the IPO more successful.

Plaintiffs pleaded that Defendants committed securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934, SEC Rule 10(b)-5, and Sections 12(a)(2) and 15 of the Securities Act of 1933 along with common law claims for breach of contract, fraud in the inducement, and negligent misrepresentation.

Defendants moved to dismiss the Complaint for failure to state a claim.

Heightened Pleading Standard: The Private Securities Litigation Reform Act of 1995 (“PLRSA”)

When a plaintiff alleges fraud—whether under common law or Section 10(b) of the Exchange Act—a “heightened” pleading standard applies under the federal rules and the PLRSA. This means a complaint must state “detail the statements (or omissions) that the plaintiff contends are fraudulent, (2) identify the speaker, (3) state where and when the statements (or omissions) were made, and (4) explain why the statements (or omissions) are fraudulent.”

The PLRSA applies an even more stringent standard. A plaintiff “must (1) specify each statement alleged to have been misleading and the reason or reasons why the statement is misleading and (2) state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”

So pleading claim of securities fraud is no simple matter.

Federal Rules the Plaintiffs Did Not Allege a Material Misrepresentation or Omission

A violation of 10(b) and Rule 10b-5 cannot occur unless an alleged misstatement was false at the time it was made. This means a statement believed to be true, but later shown to be false, is not actionable. This proved fatal to the plaintiffs’ claims.

Here the plaintiffs alleged several misstatements in the investor presentation constituted securities fraud. But none were sufficiently pleaded to be false or misleading “at the time made.” More specifically, plaintiffs did not sufficiently plead that defendants did not believe (at the time) they made representations that the hemp license in place allowed for cultivation, processing, and exportation of finished product from the UK or that it would allow them produce and distribute at a scale more quickly than competitors. Other statements were insufficient to constitute actionable securities fraud because they were forward-looking statements – e.g. projections of revenue and plans and objectives for management of future operations and of future economic performance.  Moreover these forward-looking statements were accompanied by cautionary language along the lines of “actual results could materially differ from those anticipated” because of a number of factors and risks.

Federal Rules the Plaintiff Did Not Adequately Allege Scienter (Knowledge)

When examining whether a plaintiff adequately alleged the prong of a claim, courts examine all of the pleaded facts collectively to decide whether those facts “give rise to strong inference” of scienter. Here, said the court, the plaintiffs conclusorily alleged that defendants “knew or should have known” that the Target Company did not possess the required license. Plaintiffs also alleged a motive of personal profit. But plaintiffs did not allege that defendants benefited in a concrete and personal way from the alleged fraud—such as through the sale of shares. And plaintiffs did not allege that defendants deliberately engaged in illegal behavior or had access to information suggesting their statements were false.

Finally the court dismissed claims brought under Section 12(a)(2) and Section 15. The case is instructive for investors who believe they were misled into cannabis and instructive to companies raising money. Even though the case was dismissed, I am sure it cost the defendants a small fortune to defend.

For more on cannabis securities, see:

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