Growing Problems: Managing Legal Risks for Executives and Board Members

Publicly traded cannabis companies face a heightened risk of securities litigation. D&O insurance, along with a focus on compliance and best practices, helps to mitigate that risk.

Cannabis companies that go public can raise tens of millions of dollars for expansion, product development, mergers, and more in an initial public offering (IPO). But while selling shares can provide financial stability and flexibility, it also exposes executives and board members to a rising risk: securities class action lawsuits.

This type of lawsuit is typically filed against a publicly-traded company and its directors and officers by shareholders who claim they suffered an investment loss related to inaccurate or incomplete statements made by the company about its financial performance or prospects.

Securities litigation against cannabis companies is on the rise

In the past seven years, according to Stanford Law School’s Securities Class Action Clearinghouse, 28 securities class action lawsuits were filed against U.S. and Canadian cannabis businesses. The vast majority—19 cases—were initiated in the last two years alone. These include cases against Canopy Growth Corporation, accused of failing to disclose weak demand for soft gel and oil products; HEXO Corporation, which allegedly misstated its inventory and did not report other operational problems; and Zynerba Pharmaceuticals, accused of making misleading statements about the results of a clinical trial of a CBD gel. Each lawsuit was filed against individual executives as well as the company itself.

Although the past year has seen a pandemic-induced lull in such lawsuits, which saw deals that might have ended in litigation be delayed or killed, experts believe securities litigation in the industry will continue to increase. Ian Stewart, partner at law firm Wilson Elser, said, “A surge in lawsuits later in 2021 remains a reasonable expectation. This is particularly true due to the recent uptick in new deals and ongoing consolidation of the cannabis market.”

The upward trend in securities class actions has already driven up the cost of one of the most important tools for managing the risk of such actions: directors’ and officers’ (D&O) insurance. Why is securities litigation against cannabis companies on the rise, and what makes D&O insurance worth the expense?

Multiple factors aggravate litigation risk  

Publicly traded companies listed on U.S. exchanges must comply with laws—including the Securities Act of 1933, the Securities Exchange Act of 1934, and a proliferation of disjointed state regulations—that prohibit them from making false or misleading statements or omitting information in connection with the sale of securities. The cannabis industry faces a convergence of factors that increase shareholders’ likelihood of accusing companies and their executives of violating these laws.

More companies are entering the industry and going public. Cannabis continues to be an emerging market with massive potential, attracting a “green rush” of new players to the field. More businesses in the market means more opportunity for litigation—especially when businesses launch Initial Public Offerings (IPOs). As prospects for cannabis decriminalization improve in the United States, increasing numbers of companies have announced plans to go public on American stock exchanges. Securities lawsuits can happen at any time in a public company’s life, but the risk is particularly high around its IPO when it courts investors with a wealth of information and projections. In addition, share prices tend to be especially volatile right after an IPO, and volatility itself heightens securities litigation risk.

Market volatility.Volatility and emerging markets go hand in hand. In the cannabis market, regulatory uncertainty, novice investors, and overhyped stock valuations all contribute to volatility. A major catalyst for securities class actions are “stock drops.” When a company’s stock price drops sharply following new disclosures, shareholders may seek to recover losses through a class action, asserting that the disclosures reveal that previous statements or projections were misleading or incomplete. Shareholders expect executives to deliver on their projections. If they don’t, the executives’ next stop could be the inside of a courtroom.

Short-seller activism. Activist short-sellers not only short shares but also push stock prices down by publishing reports revealing fraud, misleading statements, or overvaluation. This strategy has had some success in the cannabis industry. In 2018, for example, Citron Research—one of the best-known activist short-seller firms—published exposé reports on two cannabis companies, resulting in class action suits and significant stock drops.

The risk of bankruptcy or insolvency. Because cannabis businesses have limited access to traditional sources of credit and commercial banking services, they are more likely to suffer from poor liquidity, which, in turn, can lead to bankruptcy or insolvency. But in the United States, where marijuana remains illegal under federal law, cannabis businesses—especially those that “touch the plant”—are generally denied bankruptcy protection; instead, they must liquidate or enter receivership. This leaves directors and officers vulnerable to shareholder lawsuits claiming that executives failed to disclose the company’s gloomy financial outlook or bad decisions (such as investments or acquisitions) that contributed to its insolvency.

Regulatory confusion.There’s good reason to be optimistic that the Marijuana Opportunity Reinvestment and Expungement (MORE) Act—passed by the U.S. House of Representatives and now awaiting action in the Senate—will soon succeed in decriminalizing cannabis and reducing many of the risks faced by cannabis businesses. But securities litigation targeted toward directors and officers is generally unrelated to the federal illegality of cannabis.

Stewart explained, “Those risks [of securities lawsuits] remain and, frankly, may proliferate with broad federal legalization…. We may soon see some neighboring states begin entering interstate compacts that will result in the inevitable march toward interstate commerce. That will certainly result in increased confusion as companies attempt to realign their operations to stay compliant in a new regulatory environment. Interstate commerce will bring significant new disruptive market forces that will create import states and export states, surprising winners and unforeseen losers: a ripe environment for D&O litigation.”

Risks can be mitigated through D&O insurance and best practices

Given the risks in the cannabis market, business leaders need to protect both their companies and themselves from costly lawsuits. D&O insurance is one indispensable tool; another one is following best practices when making public statements about a company’s performance and future prospects.

D&O insurance.The rise in securities class action lawsuits has contributed to steadily rising premiums for D&O insurance across industries. Cannabis companies face exceptionally high costs: they frequently pay premiums triple or more when compared to other industries, in part because there are very few insurers who underwrite cannabis coverage in the United States. Some insurers that do offer coverage add problematic exclusions—such as the exclusion of class actions or bankruptcy—to their policies.

But without adequate D&O insurance, securities litigation can severely erode profits or even bankrupt a company and its leaders. A robust D&O policy will:

  • Protect and indemnify directors’ & officers’ assets
  • Shift legal expenses to the insurance carrier
  • Decrease cash flow volatility
  • Attract top talent to serve on boards and in executive positions
  • Protect the bottom line
  • Increase confidence in taking calculated, strategic risks

A D&O policy should function as a risk transfer product that keeps executives focused on fueling innovation and taking intelligent risks that reward shareholders, executives, and employees alike.

Implementing best practices. As powerful as it is, D&O insurance shouldn’t be a company’s only tool for mitigating securities litigation risks. Compliance with securities regulations is fundamental. “Also important,” said Stewart, “is for the company to speak with one voice when communicating with regulators, investors, consumers, and the public. Designating someone to act as chief information officer can be helpful, even in an informal role. Companies should establish vetting procedures for public statements and rely on the assistance of qualified in-house and outside counsel.”

Opportunity, Threats, and Risk Management

Excitement about the industry’s potential is a powerful motivating force, but the legal landscape’s hazards mean securities litigation will remain a threat for the foreseeable future. This is why a range of tools—including D&O insurance, compliance practices, and careful vetting of communications—are essential for cannabis businesses to control their risks while they focus on growth and innovation.

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