SECURITIES REGULATION AND IR

With the legalization of recreational marijuana last fall, cannabis has become Canada’s hot commodity for 2019. The demand for recreational marijuana has outpaced supply and driven share price increases for many companies, yet investment in the industry is still perceived as risky. The hesitancy of investors to engage with a novel market can be compounded if some companies in that market are failing to provide the quantity and quality of disclosure information required by securities regulations.

The Canadian Securities Administrators (CSA) released Staff Notice 51-357 in October 2018, which reported on the CSA’s review of reporting issuers with involvement in the cannabis industry in Canada and other countries (Cannabis Issuers). The review found that significant improvements in the disclosure practices of these reporting issuers was needed, especially for licensed cannabis producers and those with U.S. marijuana-related activities. In particular, the following were identified as areas of concern for Cannabis Issuers:

1. Financial reporting by licensed producers – the review indicated that licensed producers (LPs), known as license holders under the post-legalization regime, often did not provide sufficient information in their financial statements and management’s discussion and analysis for investors to understand their financial performance. Cannabis plants have to be measured at their fair value in accordance with International Financial Reporting Standards. The majority of LPs reviewed by the CSA did not separately disclose all fair value amounts, which is necessary information for investors to fully comprehend how much it costs an LP to produce its product.
2. Balanced disclosure and forward-looking information – disclosure is unbalanced where there is a failure to discuss material contingencies and terms relevant to events being announced. For example, a Cannabis Issuer might state its intention to purchase a marijuana dispensary without also identifying that the arrangement is contingent on approval from licensing authorities. The CSA review noted that production estimates and financial projections frequently lacked specificity, especially in regard to quantitative details.
3. Risks related to American operations – the review found that most Cannabis Issuers with U.S. marijuana-related activities were not providing sufficient disclosure with respect to the risks of engaging in state-regulated cannabis industries in light of the conflicting American federal laws. As well as not disclosing possible financial impacts of federal enforcement, Cannabis Issuers also failed to identify ancillary risks to investors, such as increased scrutiny from regulatory bodies and authorities or impacts on an investor’s admissibility to the United States.

Cannabis Issuers that don’t meet their disclosure obligations may be subject to action by securities regulators, such as rejected filings of prospectus offerings, requests for restatements of non-compliant filings and referrals for enforcement action. More importantly, if the general trend of insufficient and misleading disclosure described in Staff Notice 51-357 continues, investors could lose confidence and Cannabis Issuers may find it difficult to attract institutional and stable sources of capital to grow their businesses. In order for the industry to become a stock market leader, Cannabis Issuers need to treat their own disclosure obligations seriously by providing the public with relevant and candid information to support informed investment decision-making. The following are recommended best practices for Cannabis Issuers to keep in mind:

1. Err on the side of disclosure

Disclosure rules apply equally to issuers in all types of industries, but the application of the standards and the rigor with which Cannabis Issuers are required to apply such rules and standards are still a work in progress. Cannabis Issuers that are unsure about whether certain plans, arrangements or changes in the legal and economic landscape meet the threshold level of materiality that requires disclosure should establish a conservative disclosure policy. Shareholders will appreciate the transparency and prospective investors will feel more comfortable engaging with Cannabis Issuers that take an active and informative approach to communications.

2. Avoid promotional and exaggerated claims

While erring on the side of disclosure, Cannabis Issuers need to ensure that any future plans and estimates they disclose are balanced and supported with the assumptions and material factors relating to such projections. Potential risks and obstacles to the realization of any business plans or arrangements should be clearly identified. Investors should be able to understand what stage of development a Cannabis Issuer is at, the steps and approvals that remain to be completed and the predicted costs and timeline required for the whole process. Cannabis Issuers should also note that unfavourable news must be disclosed just as promptly and completely as any favourable news, in accordance with National Instrument 51-201 Disclosure Standards.

3. Take a cautious approach towards U.S. marijuana investments

As noted, the CSA review uncovered a high rate of disclosure deficiencies for Cannabis Issuers with U.S. marijuana activities. Cannabis Issuers with existing indirect, direct and ancillary involvement in the cultivation or distribution of cannabis in states that regulate the production and sale of marijuana should refer to CSA Staff Notice 51-352 (Revised) for the specific disclosure expectations applicable to them. Any companies that are considering investing in U.S. marijuana operations should carefully consider possible financial and legal repercussions of such a decision. The Cole Memorandum, which adopted a policy of federal noninterference with state marijuana laws, was rescinded by the U.S. Attorney General last year. Although this change has yet to see a crackdown on the American cannabis industry, the possibility of enforcement remains a threat. Additionally, Cannabis Issuers should be aware that under the current policy of the TSX and the TSXV, Cannabis Issuers with U.S. marijuana-related activities that violate American federal law do not meet minimum listing requirements of the exchanges and could be subject to a continued listing review.

David Frost is a Partner at McCarthy Tétrault LLP. This article was written with co-authors Bosa Kosoric (Associate) and Lauren Muirhead (Articling Student) at McCarthy Tétrault LLP in Vancouver.