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Canada: Quebec Court Dismisses Proposed Class Action Against Cannabis Company

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On January 23, 2023, the Quebec Superior Court denied leave to pursue a class action against HEXO Corp. The proposed class action raised various allegations of misrepresentation and breaches of disclosure obligations over the period of April 2018 to March 2020.1

The decision determined that the announcement of negative news followed by a decline in a public issuer’s stock price is not enough on its own to satisfy the requirements of claims for statutory misrepresentation. Arguments based on backwards reasoning with the benefit of hindsight will not meet the evidentiary burden on plaintiffs to show a reasonable possibility that the action will be resolved in their favour.

A.       Factual Background

i.        Supply Agreement

In April 2018, HEXO issued a press release announcing that it entered into a supply agreement with what became the Société québécoise du cannabis (the “SQDC“) to be the preferred supplier of cannabis products in Quebec for five years (the “Supply Agreement“). The press release stated that the Supply Agreement required SQDC to purchase 20,000 kilograms of product in the first year following the legalization of cannabis. It disclosed that the SQDC had the right to terminate the agreement under certain circumstances and included cautionary language regarding the reliance on forward-looking statements.

The company’s Management Discussion and Analysis (“MD&A“) underscored the strategic importance of its relationship with SQDC and estimated that potential revenue under the Supply Agreement could reach $1 billion.

ii.       Corporate Acquisition

In March 2019, HEXO issued another press release announcing that it would acquire Newstrike, another publicly traded cannabis company. With that acquisition, HEXO estimated its net revenues from the sale of cannabis in Canada would be more than $400 million.

The announcement included that the acquisition of Newstrike would add approximately 470,000 square feet of additional production space in Ontario’s Niagara Region and achieve annual synergies of approximately $10 million.

The day after this announcement, in a call with analysts, the company stated that 250,000 square feet of the Niagara production space was licensed and operational.

iii.      Revenue Estimates

Following the announcement of the acquisition, the company made statements about estimated revenues. For example, in the company’s MD&A dated June 12, 2019, it estimated that revenues would double in Q4 2019 because of, among other things, the Supply Agreement and the Newstrike acquisition.

iv.      String of Bad News

Over the course of the following nine months, the company issued a series of negative announcements that caused repeated drops in the company’s stock price. These announcements included:

  • The company was withdrawing its revenue guidance of $400 million and was right-sizing its operations, including winding down operations at the Niagara facility acquired from Newstrike.
  • “Block B” of the Niagara facility (approximately 17 per cent of the facility) was discovered as not being adequately licensed. Cultivation and production activities in the unlicensed space were immediately stopped. The company subsequently announced it would sell the Niagara facility.
  • HEXO’s Q4 2019 financial results were approximately 40 per cent lower than forecasted.
  • HEXO recorded three separate impairments on inventory in the range of $265 – $280 million. The company identified material weaknesses in its internal controls of its financial reporting in various areas including its year-end inventory count.
  • SQDC failed to purchase its 20,000-kilogram commitment under the Supply Agreement in the first year and HEXO was not going to enforce this commitment because of its overall business relationship with the SQDC and its position in the Quebec market.

B.       Alleged Misrepresentations

Owing to the decline in the company’s stock price, the plaintiff sought authorization to institute a secondary market claim against HEXO, filed under the Quebec Securities Act, and further sought leave to pursue a class action against the company for damages arising from statutory and civil misrepresentations.

The plaintiff alleged HEXO misrepresented that:

1. The Supply Agreement guaranteed revenues associated with the sale of 20,000 kilograms of cannabis in the first year;

2. The acquisition of Newstrike:

a. included fully licensed and operational facilities;

b. would generate more than $10 million in annual synergies;

c. along with the Supply Agreement, would result in the doubling of HEXO’s net revenue between Q2 and Q4 in 2019;

3. HEXO would achieve revenue of greater than $400 million for the 2020 fiscal year;

4. HEXO’s inventories were accurate and its internal controls were effective.

C.       Why the Suit Failed

i.        Supply Agreement

The Court disagreed that HEXO’s statements regarding the SQDC’s purchase commitment of 20,000 kilograms of cannabis amounted to a “guarantee” of first-year revenue under the Supply Agreement. The impugned statements were found to simply provide a description of the SQDC’s purchase commitment in the first year under the Supply Agreement. The Court expressly commented that courts do not make assessment with the benefit of hindsight. The fact that the SQDC did not fulfil its first-year purchase commitment or that the defendants decided not to enforce the take-or-pay feature are not evidence that the public statements were untrue or misleading at the time they were made.

The Court reached its decision after considering these factors, which effectively qualified the alleged misrepresentation:

(i)    HEXO disclosed that the SQDC could terminate the Supply Agreement under certain circumstances rebutting any notion of guaranteed sales;

(ii)   HEXO’s statements about “strong business certainty through Year 1 post-legalization” referenced several factors and not just the SQDC’s commitment under the Supply Agreement;

(iii) HEXO’s press release contained cautionary language that forward-looking statements “should not be read as assurances of future performance or results”; and

(iv) the plaintiff was aware that this was a “new and volatile market.”

ii.        Newstrike Acquisition

Although the plaintiff alleged HEXO misrepresented the Niagara facilities were fully licensed and operational since March 2019, the plaintiff’s evidence demonstrated that the licensing deficiency only became known around July 30, 2019, which is when HEXO disclosed they were made aware of the deficiencies.

In respect of the impugned statements that operations at the Niagara facility would be licensed for cannabis production, HEXO announced on October 24, 2019, it had temporarily suspended its operations at the Niagara facility as part of cost-cutting measures. Hence, the fact that one section of the facility was not adequately licensed could not reasonably be expected to have any impact after October 24 on an investor’s decision to buy or sell HEXO securities.

The Court further noted that the mere fact that projected synergies failed to be realized was not evidence that the impugned statements were misrepresentations of material facts at the time they were made. In any event, HEXO clearly disclosed the risk that the synergies may not be achieved so that investors would not rely on the projections.

As for the fact that HEXO’s Q4 revenues were lower than forecasted and the lowering of HEXO’s financial guidance, the documents in question contained the assumptions underlying the forecasts and cautionary language that specifically warned readers that projections are not guarantees of future performance or results.

iii.        Impairment Loss on Inventory and Internal Controls

In terms of the impairment loss on inventory, the Court found that the plaintiff failed to link any of the subsequent disclosures on impairment to a previous misrepresentation of a material fact at the time the statement was made. Although there was a restatement of certain financial statements, the Court accepted that the impairment loss was due to subsequent events and new and available third-party information about circumstances surrounding the ongoing development of cannabis use.

The plaintiff also failed to establish that the impairment disclosure concerned a material fact. The Court found the plaintiff failed to lead evidence that ties the decline in HEXO’s share price to the disclosure of the adjustments to the impairment loss on inventory.

The Court further determined that the plaintiff failed to identify any HEXO public statements which contain alleged misrepresentations regarding its internal controls. The company disclosed in October 2018 that it was implementing a new enterprise resource planning system and cautioned that the related design and testing process could result in errors and/or inaccurate information for management and financial reporting.

D.       Conclusion

The Court’s decision demonstrates that courts will look deeper than simply pointing to a negative news release and corresponding stock price drop to demonstrate reasonable probability of success for leave to bring a statutory, secondary market claim for misrepresentation. The decision also highlights the importance of using robust safe harbour language for forward-looking statements and risk disclosures in MD&As.

Footnote

1. Dionne c. Hexo Corp., 2023 QCCS 162 (CanLII)

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.

https://www.mondaq.com/canada/cannabis–hemp/1278752/quebec-court-dismisses-proposed-class-action-against-cannabis-company?email_access=on



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Wait? My CBD Business May Be Racketeering? A Potential Existential Crisis We Have Been Warning About

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Even the most responsible hemp operator should understand that it operates in a world full of risk. But I doubt many of them believe they might be accused of racketeering. Last week, the U.S. Supreme Court heard arguments about whether to sanction a commercial trucker’s attempt to bring a racketeering claim against CBD companies, whose allegedly mislabeled products the trucker claims led to his firing.

As always, Sam Reisman at Law360 distills the issue nicely:

The case concerns an allegation that companies sold CBD products with detectable amounts of THC, purportedly costing plaintiff Douglas J. Horn his job as a commercial trucker after he tested positive on a drug test. Oral arguments on Tuesday hinged largely on whether Horn’s claims stemmed from a personal injury — which would be excluded from the Racketeer Influenced and Corrupt Organizations Act, or RICO — or whether his firing was an economic injury and therefore redressable under RICO.

In taking the case, the U.S. Supreme Court could resolve a 3-2 circuit split over whether the civil prongs of the RICO statute allow a plaintiff to seek damages for economic harms stemming from injuries to their person.

Again, from Reisman:

During oral arguments on Tuesday, the liberal wing of the high court expressed skepticism with the CBD companies’ rendering of the case, which they said foregrounded Horn’s ingestion of the product as the source of the injury, as opposed to his firing for a positive drug test.

Lisa Blatt, an attorney for the CBD companies, told the justices that agreeing with Horn’s interpretation of the statute would open the door for virtually limitless personal injury cases under civil RICO, as long as plaintiffs could allege some connection between their ingestion of a product and a loss to their business or property: “Respondent’s rule also leaves the personal exclusion [in civil RICO] toothless, since virtually all personal injuries result in monetary loss,” Blatt said. “It is utterly implausible that Congress federalized every slip-and-fall involving RICO predicates. Personal injuries are serious and may support state tort claims, but they are not the stuff of RICO.”

On the other side, conservative justices attempted to discern how to draw a line between bona fide economic claims and personal injury claims pleaded as economic claims.

Easha Anand, arguing on behalf of Horn, said the vast majority of personal injury claims, such as those alleging pain and suffering or emotional distress, would still be excluded even if Horn was permitted to pursue his RICO claim against the CBD companies: “In your average slip-and-fall case, you’re not going to be able to prove a predicate act, let alone a pattern of predicate acts, let alone a pattern carried on through a racketeering enterprise,” Anand said.

Justice Neil Gorsuch observed, “There’s a failure to warn that this product contains ingredients that your client didn’t know about and should have known about and had a right to know about. I would have thought that that would have been kind of a classic personal injury.”

The Takeaway

This is pretty scary stuff for CBD and other hemp operators. RICO is no joke and carries very serious penalties (both civil and criminal depending on who is bringing the suit).

From the perspective of a CBD manufacturer, it seems unfair to hold the manufacturer responsible to control how its products are used and, as in this case, the implications of that use (here, an alleged economic injury).

If the Court rules that CBD and other hemp manufacturers are subject to RICO charges simply by selling their products to people who do things outside of the manufacturers’ control, it could pose an existential crisis to the industry with potentially unlimited civil (and maybe even criminal) liability. We have warned about this before.

That said, while it’s always difficult to predict how the Supreme Court will vote on any issue, I do not believe the Court will push the hemp industry to the brink. I suspect the Court will either rule that the claims in the present case are personal injury claims excluded from RICO and/or provide guidance for how lower courts should examine such “mixed” claims.

We’ll of course provide additional information once we hear from the Court. Stay tuned.



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What ‘material’ about therapeutic goods is considered advertising?

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It is important to note that advertising health services is subject to different regulations than advertising therapeutic products. Consequently, advertisers, manufacturers and sponsors must evaluate whether their business name could be interpreted as an advertisement for therapeutic goods. If so, they should consider whether the business name, including company or trading names, could be viewed as a ‘reference’ that draws the audience’s attention to medicinal cannabis, as any mention or similar terms to ‘cannabis’ are likely to have that effect. It is essential to recognise that the impact of promoting the use or supply of medicinal cannabis does not depend on a single promotional element but rather on the overall promotion. This includes all components of the promotional information and materials that accompany the name or branding. Advertising can result from the combination of separate statements, images or designs that collectively promote the use or supply of therapeutic goods.

Advertising

The prohibition on advertising medicinal cannabis to the public is determined by the context in which the material is perceived. When evaluating whether information about therapeutic goods qualifies as advertising, it is essential to consider the broader context of the material’s presentation. This encompasses various factors that influence the conveyed message, including the context of the information or activity, the intended audience and their likely interpretation of the message, as well as the presence of non-verbal and unwritten cues, such as visual elements. These factors can significantly affect communication and may alter the message perceived by consumers. 

For example, if an advertisement for a health service, such as a pain treatment service, includes references to medicinal cannabis, even in the company name or trading name, a reasonable consumer may conclude that the advertisement seeks to promote both the use of medicinal cannabis for pain relief and the pain treatment service itself. Including a disclaimer, such as advising the consumer to consult a health professional regarding suitable treatment options, does not exempt the advertiser from complying with legislative requirements.

The distinction between promoting a health service and the therapeutic product utilised in its delivery can be nuanced. Therefore, it is crucial for advertisers to consider how a typical consumer might perceive their advertisement in relation to the promotion of the therapeutic product.

Legal Compliance

To ensure legal compliance in promoting a business or service, advertisers should focus on the health services they provide and avoid referencing medicinal cannabis. For instance, stating “Our clinic offers consultations related to pain management” is a more compliant approach. The Therapeutic Goods Administration’s interpretation of advertising for medicinal cannabis is broad, covering all methods of promoting its use or supply. This includes company names, product names, abbreviations such as CBD and THC, colloquial terms, and any imagery related to cannabis. Any combination of statements or images that implies medicinal cannabis can be considered advertising, even in the absence of explicit promotional language.

Summary

In summary, it is prohibited to mention prescription medications in advertisements for therapeutic goods. If content discusses health conditions and consumers can reasonably infer, either from the context or through direct or indirect references, that medicinal cannabis or any other prescription medication is intended for use concerning these conditions, the content may be deemed an unlawful advertisement for therapeutic goods. Not all information related to therapeutic goods is classified as advertising. However, if the content aligns with the definition of ‘advertise’ as outlined in the Therapeutic Goods Act 1989 (Cth)—which includes anything that is directly or indirectly intended to promote the use or supply of therapeutic goods—then the relevant legislative requirements for advertising such goods must be complied with.

“Indirect intent” in this context does not refer to the explicit intention of the party responsible for the content, but rather to what a reasonable consumer might infer as the intent behind the content. Terms such as “plant-based medicine,” “plant medicine,” “cannabidiol” and “CBD oil,” which relate to medical cannabis products, may be considered promotional if they suggest a connection to medicinal cannabis. Businesses promoting a health service must ensure they do not inadvertently advertise a prescription medicine in their marketing materials. If the consumer is encouraged to seek out a health service based on the therapeutic goods available, the content is likely to be regarded as an advertisement for those therapeutic goods.

For additional information, the Therapeutic Goods Administration has established the Medicinal Cannabis Hub, accessible at https://www.tga.gov.au/products/unapproved-therapeutic-goods/medicinal-cannabis-hub, and has also provided advertising guidance for businesses involved in the medicinal cannabis sector, which can be found at https://www.tga.gov.au/sites/default/files/advertising-guidance-businesses-involved-medicinal-cannabis-products.pdf. These resources are designed to assist both consumers and industry professionals in understanding their obligations.



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Federal Appeals Court: Pay That Man His Money, Unless That Money Is Illegal Marijuana Money

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Good news, bad news if you’re a cannabis operator that owes money to a creditor. But probably bad news for the rule of law.

A federal appellate court has ruled that a cannabis operator is obligated to repay his debts to an ex-business partner, but it raised questions about whether the money used to repay the debt could violate federal marijuana laws.

What does this mean for a cannabis operator and potential investors?

The Facts

As usual, our friends at Law360 set the stage:

A Tenth Circuit panel has rejected a cannabis entrepreneur’s attempt to undo a $6.4 million judgment in a dispute with an ex-business partner, but it ordered a district court to revisit an enforcement order that could require the entrepreneur to violate federal drug law to pay the damages.

A Maryland federal judge entered a $6.4 million damages award against Mackie A. Barch and his company Trellis Holdings Maryland Inc. for failing to restore David Joshua Bartch’s stake in a Maryland cannabis cultivation and dispensary business, Culta Inc.

When they failed to pay up, Bartch filed suit in the District of Colorado seeking an order that would require Barch and Trellis to sell off their equity in Culta to satisfy the judgment, which the court granted.

Barch and Trellis claimed that their ex-partner lacked standing to seek enforcement of the judgment because the order would require them to engage in conduct in violation of the Controlled Substances Act. Cultivating and selling marijuana is legal under Colorado and Maryland laws, but still prohibited under the federal Controlled Substances Act.

The Ruling

The three-judge panel sided, in a divided decision, against Barch and Trellis. According to the court, Barch and Trellis have no path for relief from the judgment because the law only allows a party to seek such relief for violations of due process.

The rift between the majority and the dissent came down to questions of enforceability and practicality. As Law360 wrote:

The dissent argued that Culta’s business practices – which are illegal under the Controlled Substances Act – should have doomed Bartch’s breach of contract suit from the start. By validating the parties’ contract, the majority has instead decided to “ignore the elephant in the room that is the federally illegitimate business enterprise known as Culta,” Judge Baldock wrote.

“Plaintiff’s cause of action is based entirely upon an illegal contract to establish Culta, notably an enterprise in which federal law recognizes no property interest. I simply do not understand why a federal court would lend legitimacy to any of this,” according to the dissent.

The majority recognized that the trial court’s order could potentially require the violation of federal law but were not willing to overturn the order based on that mere possibility. The majority reasoned that because the order did not specifically require Barch and Trellis to cultivate or sell marijuana, it was at least possible that the debt could be repaid without violating federal law. The case was remanded for further instructions and clarity from the trial court on this point.

The Takeaway

Let’s start with one really obvious point and one just regularly obvious point. First, investors should be extremely cautious when providing funds to marijuana companies. This case illustrates how difficult it can be to recover funds when the source of repayments may largely be the result of federally illegal activity. Second, the marijuana industry is replete with unsavory characters. Sure, many marijuana companies are operated by upstanding businesspeople, but the very nature of the industry and its legal status over the decades make it ripe for those who might not feel compelled to follow the strict letter of the law.

Should you choose to invest in a marijuana company, you should do so with the advice of competent, experienced counsel and you should insist that there are legal methods of recovering your funds should that prove necessary. Doing so may seem a tall task, but with a little diligence you may be able to ensure that your funds are secured by assets that are not subject to the same types of challenges in this case.

And, as with any investment, trust but verify.

Source:  https://www.buddingtrendsblog.com/2024/09/federal-appeals-court-pay-that-man-his-money-unless-that-money-is-illegal-marijuana-money/



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