The marijuana industry continues to develop and expand at a rapid pace. With that expansion comes the need for capital. The lack of access to traditional financing, however, means that most of the capital comes from either individual investors or private equity groups. The use of investor money comes with inherent risks for both the investor and the companies benefiting from those funds. These risks can materialize into actual disputes at any time, but they surface most often when the economy falters or the business fails to perform as expected.

Authored By Zane Gilmer[1]

Partner STINSON LLP
1050 17th Street Suite 2400
Denver CO 80265
303 376 8416


BIO: With a background in securities, banking and compliance, Zane is an experienced litigator representing financial services firms and others in highly regulated industries. Clients seek his advice on emerging legal issues to learn how existing frameworks will apply to new industries, such as legalized cannabis. Zane’s wealth of experience and his keen interest in developing areas of law make him a highly sought after commentator, writer, speaker, and lecturer.

Zane represents individuals and companies in high-stakes litigation involving business and investment disputes, banks and other financial institutions, cannabis investors, and others. He handles class actions and cases involving fraud, mismanagement and regulatory compliance. Additionally, Zane serves on the firm’s Pro Bono Committee. MORE

 

ARTICLE

Not surprisingly, over the last year, we have seen an increase in disputes between marijuana entities and their investors, ranging from one-off lawsuits to wide-scale putative class actions, including so-called “stock drop” lawsuits. These lawsuits typically allege that the entity’s management committed some form of misconduct, either in connection with the solicitation of the investor’s investment, or afterwards, which misconduct caused the investor to lose part, or all, of their investment. Many of the investors assert claims for securities fraud, common law fraud, mismanagement, and theft. These lawsuits show no sign of slowing and, in fact, will likely increase in frequency given the uncertainty with the economy and volatility within the marijuana industry itself.

While these lawsuits cannot be completely eliminated, following the steps below should help reduce the existence of the common issues which often lead to investor disputes, by lessening the risk that those disputes will turn into litigation.

 

Understand and Disclose the Risks

Investments of all types involve risks. Many investment risks are similar or the same, regardless of the type of investment at issue, while other risks are unique to the particular investment. Indeed, the marijuana industry is no different: many of the risks to investors are similar to those that exist related to other investment opportunities, but there are many unique risks associated with marijuana investments. Regardless of whether the risk is unique or not to a particular investment, the key is that the investor understands those risks. Ensuring that the investor understands the risks involved with an investment is generally a shared responsibility between the investor and the company. A breakdown in due diligence or disclosure from either side can result in a lawsuit.

Investors must be prudent in conducting due diligence related to prospective investment opportunities and evaluate the associated risks before deciding whether to invest. Investors should endeavor to gather as much information about the company as possible. Of course, the type of information and the amount of due diligence an investor should conduct will depend in large part on the size of the deal and complexity of the company involved. That said, the more information an investor gathers, the more information can be analyzed and considered in deciding whether the potential benefits of a particular investment outweigh its risks. That certainly involves an evaluation of the prospectus or other investment offering documents that are provided to the investor by the company. However, that should generally be the start and not the end of the investor’s due diligence. Depending on the type of investor involved (e.g., accredited vs. non accredited), the investor may have reason to do more than just accept the information provided by the company. Instead, the investor may have an incentive to take reasonable steps to learn more about the company, analyze the information provided by the company and otherwise vet that information. Failure to do so could affect the investor’s ability to argue later that they were defrauded in connection with the solicitation of the investment.

On the other hand, it is important to remember that there are a number of state and federal laws that are implicated when a company seeks investments from an outside source. Generally speaking, companies are required to disclose to prospective investors anything that a reasonable investor would want to know in making their decision to invest. That broad standard can often create difficulties in determining exactly what and how much to disclose about a particular business and the risks associated thereto. That said, prudence often dictates that when in doubt, you should err on the side of disclosure, especially if there is any sense that the information could be viewed as material to an investor’s decision to invest or not. A helpful way to think about disclosure is to ask yourself whether the fact at issue is something you would want to know about in deciding whether to invest. Of course, if the answer is yes, then you should disclose it.

Company disclosures can relate to many things, from the company’s financials, management, operations, assets, debt, past performance, how investor money will be used, and in the marijuana context specifically, the fact that the business itself is engaged in activity that is illegal under federal law. The analysis of whether something must be disclosed or not is often difficult regardless of the size of the company and operations involved, but that analysis gets increasingly challenging as the size and complexity of the operations increase. For that reason, it is best to retain counsel with experience in the marijuana industry and with investment offerings to assist in developing the proper disclosures.

Failure to provide proper disclosure to an investor of a material issue or fact concerning the investment can be grounds for an investor lawsuit alleging common law fraud, securities fraud, and/or misrepresentation. Typically, investor lawsuits alleging fraud in connection with the actual investment seek damages in the form of the lost investment, which can include the return of the entire investment itself, including possible attorneys’ fees and costs related to any lawsuit initiated to secure the return of the investor’s money. Making matters more problematic, these lawsuits may not even surface until months or years after the initial investment. Not surprisingly, these issues typically arise when the company is doing poorly, there has been some other issue within the company, or a falling out between the investor and company management. By making proper and thorough disclosures on the front end, companies can help avoid unexpected losses by investors and ultimately either avoid or defend against future investor lawsuits.

 

Make Only Well-Founded Representations

In addition to making thorough disclosures, companies must also take care not to make unfounded statements or representations to prospective investors. It is not uncommon for a company representative—either in writing or orally—to hype up or overstate the quality of the company’s products or their performance, the company’s facilities, the company’s financials, either past, present, or future, or some other issue related to the company. Often times these overstatements are more of a result of being overly enthusiastic about the company or its products rather than a result of an intentional effort to provide false or misleading information to prospective investors. However, regardless of the motives behind the inaccurate statements, there can be real consequences resulting from such conduct. Investors are not always in a position to know whether or not a particular statement is fully or partially true, overstated, or completely false. It is for that reason that investment and securities laws are generally designed to protect investors if the statements are provably false or otherwise misleading. As a consequence, company representatives must use caution when making statements to investors to ensure that what those investors are being told is accurate and not misleading. Companies should thoroughly evaluate all statements, representations, and other public-facing information that prospective investors are provided or have access to from the company to ensure that the information is accurate and not misleading. In addition, because information changes, companies should regularly evaluate these statements to ensure no amendments or corrections are needed.

 

Ensure Everything is Properly Documented

Many investment disputes arise as a result of the parties failing to document either any or all of the terms of the agreement. This is not an uncommon problem in the marijuana industry, especially because many businesses were started on little more than a handshake and a general understanding among friends. Some transactions can be quite complex, involving multiple businesses, licenses, real estate, intellectual property, and management. As such, it is vitally important to create these documents at the outset to avoid fighting about the non-existence of them later.

Well-documented agreements are important for a number of reasons. The primary benefit of documenting the agreement is to ensure that everyone knows the terms of the deal and what each party’s respective rights and obligations are. While it may seem like overkill or unnecessary to document everything at the outset, especially before you even get things off the ground, waiting too long often means the deal never gets documented at all. It is much easier to get everyone to document the terms of an agreement at the beginning of the relationship when everyone is getting along. It becomes much more difficult to get everyone to cooperate and document the prior agreement when tension between the investors and company arise, the business has unexpected success or it starts to falter, friendships start to fade, or other disagreements emerge. Once any of these circumstances occurs, it is often too late to begin documenting what everyone previously agreed to, either because not everyone is willing to cooperate or the parties now disagree about what the deal really was. The lack of a written agreement often makes it very difficult for investors and companies to sort out disagreements between themselves without litigation.

 

Ensure Proper Accounting and Management of Entity Assets

Many disputes either start over, or end up including, allegations that the company and its management improperly used or accounted for company assets. For instance, a common argument by investors is that company management either overpaid themselves, used company assets for their own personal benefit, or otherwise operated the company in a way that harmed the investors. To help safeguard against these claims, company management should ensure that company expenses are well founded, both in terms of having a connection to legitimate company business, and also ensuring that the amount and type of expenses are generally in line with industry standards. It is helpful to employ outside accountants and/or auditors to ensure that expenses are properly accounted for as part of the company’s financials.

It is also prudent to develop and enact internal policies and procedures regarding company finances and the use of company funds and assets. These policies and procedures should include some form of a checks-and-balances and oversight system related to the company’s financial affairs, to ensure that not only one single person has access to, and decision-making authority over, of all the company’s finances. These checks and balances can avoid both intentional and inadvertent misuses of company assets, decreasing management’s and the company’s possible exposure to investors. It is imperative, however, that whatever policies and procedures are implemented are actually followed. Having policies and procedures that are not followed is usually worse than not having any policies and procedures at all. Indeed, investors will no doubt use any violation of these policies and procedures as evidence of the company’s and/or management’s alleged misconduct.

 

Communicate with Investors

One of the most basic ways to avoid getting into disputes with your investors is to keep them reasonably informed about company affairs and, importantly, their investment. Unlike active investors and company management, passive investors are not involved in the day-to-day activities of the business. They rely almost exclusively on updates from company management to learn about how the company is doing and, ultimately, how their investment is doing. Failing to communicate with investors leaves them in the dark and can cause unnecessary tension with management, which can lead to unwanted scrutiny or even lawsuits.

[1] Zane Gilmer is a partner with the national law firm of Stinson LLP. Zane practices out of the firm’s Denver, Colorado office. He represents individuals and companies in high-stakes litigation involving business and investment disputes. He handles class actions and cases involving fraud, mismanagement and regulatory compliance. He is also the chair of the firm’s cannabis practice group.