Despite its illegality on the federal level, and a patchwork of legislation at the state and local level, the business of cannabis appears to be booming.
By some estimates, the sector is expected to balloon to $26 billion by 2025. As the industry matures, it has experienced some familiar growing pains: aggressive marketing, overly optimistic projections and some garden variety fraud. This in turn has attracted the attention of both government regulators and private plaintiffs’ lawyers. Investors and industry participants should be aware of these types of claims, as they are not going away any time soon.
Securities Class Actions
It is a fact of life that publicly traded companies regularly face shareholder securities class actions. The cannabis industry, including the federally legal (but still regulated) hemp and cannabidiol (CBD) sub-sector, is no different. As cannabis companies mature and leave the hands of early stage private investors to tap the public markets, they will face such claims.
In July 2019, CannTrust Holdings Inc., a licensed producer of medical and recreational cannabis in Canada that trades on the over the counter (OTC) market in the United States, was sued by investors after its stock dropped more than 22% in a single day. This was the result of a July 8, 2019 disclosure that Health Canada (Canada’s public health agency) quarantined some of CannTrust’s cannabis because CannTrust grew it in an unlicensed facility. Two days later, a class action alleging violations of various federal securities laws was filed in the Southern District of New York.
Although this type of underlying non-compliance fact pattern may be several years off for the mainline cannabis industry in the United States—since no federal licensure scheme is in place while the plant remains illegal—it is not hard to see how it would play out for the hemp and CBD industries. Hemp producers are subject to regulation by the U.S. Department of Agriculture (USDA) and various state and even tribal agencies under the 2018 Farm Bill. Cultivation of hemp must be in accordance with a plan created or approved by the USDA, and noncompliance may potentially subject producers to an escalating menu of penalties, including ineligibility for future participation in the program and referral for criminal prosecution. The potential, therefore, is there for the CannTrust fact pattern to play out for hemp producers stateside.
Claims concerning CBD, which can be extracted from hemp, are already here. With the removal of hemp-derived CBD from Schedule I of Controlled Substances Act (CSA) under the Farm Bill, sales of products containing CBD have exploded, even hitting the shelves of stores like CVS and Whole Foods. Almost immediately, the FDA and the FTC stepped in to remind market participants that CBD is subject to regulation, the FDA considers it an active drug ingredient, and there are too many unsubstantiated claims about its benefits. To date, the FDA and the FTC have opted to deal with violations by sending companies warning letters, which are then made available on the agencies’ respective websites.
On August 5, 2019, the first securities class action lawsuit was filed against the recipient of one such letter, Curaleaf Holdings, Inc. Curaleaf, which is incorporated in Canada, but has operations in the United States, trades on the OTC market. It is a major player in the CBD market, and in March 2019 it was announced that it inked a deal with CVS to carry its products in over 800 stores. It also launched a pet-centric brand of CBD products called Bido. However, on July 22, 2019, Curaleaf received a warning letter from the FDA, stating that the marketing of its products crossed the line into making unsubstantiated health claims and misbranding its products, which the FDA considered to be unapproved human and animal drugs. The revelation resulted in a stock drop of nearly 8%, which was followed by a lawsuit in the Eastern District of New York.
False Advertising and Product Liability Claims
Investors should also be aware of potential claims by consumers against manufacturers, distributors and sellers of cannabis and CBD products. For example, in a recent decision in Horn v. Medical Marijuana, Inc., in the Western District of New York, a truck driver was allowed to pursue claims concerning the marketing and sale of a CBD additive contained in Dixie X Dew Drops, which was allegedly falsely advertised as having no THC, the intoxicating ingredient in cannabis. The driver bought the drops to relieve pain inflammation from Dixie X’s website. He was subject to drug testing as part of his job and allegedly fired after failing a drug test because the drops contained almost double the amount of allowed THC content. He then sued the manufacturer, distributor and the financier, alleging violations of New York’s deceptive business practices statutes, RICO and fraud in the inducement.
Although some of the claims were trimmed at the summary judgment phase, the case serves as a good example of the kinds of claims lurking out there. And investors should be aware that plaintiffs’ lawyers are watching this intently. One plaintiffs’ lawyer noted in a public comment to the FDA that he has 1,000 cases pending against the opioid industry and, “[i]f our dreams come true, we’ll have the same thing going against the marijuana industry in a year or two.”
Fraud and Enforcement Actions
Finally, companies operating at the margins of the cannabis industry are often the subject of enforcement actions and private litigation. These usually stem from false statements related to the company’s operations. The most recent example includes a $200,000 settlement between the SEC and Corix Bioscience Inc., a penny-stock CBD company that made misleading statements about its operations, including access to tribal lands to grow cannabis and hemp.
In June, Massachusetts’ securities division filed an administrative complaint against Positronic Farms Inc., and its principal, over the alleged sale of unregistered securities. And just last month, Namaste Technologies—an e-commerce company operating in the cannabis space—sought approval of a $5 million settlement of a class action accusing its principals of manipulating the stock’s price, evading taxes and selling counterfeit products.
Other examples abound, and as money keeps pouring into the industry, we should expect a lot more litigation.
(Related commentary: Is Investing in Cannabis a Conservative Move or a Risky One?)
Alexander Malyshev is counsel at Carter Ledyard & Milburn and is a member of the firm’s Cannabis, Hemp and CBD Industry Group.