For companies in the cannabis industry seeking to raise capital, legal compliance is particularly important. Not only is this a highly regulated industry but offers and sales of securities of companies within the industry are generally subject to enhanced scrutiny by State and federal securities regulators.
It appears that the Securities Exchange Commission (SEC) is increasing its scrutiny of the financial reporting and disclosure requirements of cannabis businesses in connection with the offer and sale of securities.
In September of 2018, the SEC issued an “Investor Alert” pointing to increased fraud in early-stage capital raise cannabis offering space. The “Investor Alert” directed investors to carefully examine offering materials and disclosures, including descriptions of the investment, its risks, and benefits. Despite the SEC’s warnings, financial fraud continues to exist with the offer and sale of securities by cannabis and cannabis-related businesses. These fraudulent acts involve the issuers, their officers, promoters, and financial professionals.
Since 2017, the SEC has brought eleven enforcement actions in federal court against cannabis companies. The SEC’s latest enforcement actions highlight the importance of providing truthful and complete information to current and potential investors. The SEC and State securities enforcement divisions have vigorously pursued enforcement actions against cannabis issuers, investment advisors, and broker-dealers for alleged securities violations.
Examples of these alleged securities violations include false statements of material facts or omissions of materials information byan issuer in its offering documents, , as well as the offer and sale of unregistered securities. Other alleged violations also include the improper sales of securities to non-accredited investors and the use of unregistered broker-dealers, investment advisors, or unlicensed representatives.
Successful offerings by cannabis-related businesses have the same business and securities legal compliance as any other private company. However, due to uncertain market conditions, cannabis businesses need an even greater eye on structure and compliance. This means ensuring that their corporate and governance structure are set up correctly ; that they are formed in a State that permits cannabis businesses; and they have obtained their State cannabis license prior to making the offer and filing with the SEC. This is especially true where the SEC has made the foregoing some of the factors to consider when regulating offers by cannabis businesses.
Likewise, the cannabis business needs to pay particular attention to their disclosure materials, especially the financial disclosures, and to ensure that they are disclosing all of the particular risk factors of engaging in the business of cannabis, including the fact that the cannabis industry is still illegal at the federal level and in most States.
Risk factors for a cannabis business can include any pertinent regulatory information, including State and federal rules, up-to-date copies of all relevant licenses and related applications, as well as any memorandums regarding how the company and its affiliates are structured. According to Bloomberg Law, companies should also anticipate and prepare cannabis-specific due diligence requests from investors.
As stated and unlike other private companies , cannabis businesses have the additional hurdle of informing prospective investors of the risks of investing in a federally illegal operation. This may cause a great concern for prospective investors and therefore, may make it harder for the cannabis business to raise the capital that it needs. Although there may be ways that the cannabis business owner may convince the prospective investors to invest in the business despite its illegality, , it is not advisable for these businesses to try to convince investors that their investments are entirely legal or without risk from a securities compliance or other federal compliance perspective, such as banking compliance.
In order to minimize risk, cannabis companies should pay close attention to the investors that they seek out. Selecting the right investors is a critical step. According to Bloomberg Law, the best investors are those that have previously made cannabis investments or are comfortable with the heightened risks and regulatory requirements involved.
Likewise, cannabis companies can provide comfort to prospective investors by mitigating certain risks such as engaging in a regulatory compliance analysis at the outset that shows a clear pattern of stringent regulatory compliance with State and federal laws, including adherence to certain regulatory guidelines. Another tactic that a cannabis company can do to mitigate investment risks at the outset is to wean out prospective investors who are particularly uncomfortable undergoing a background check or being disclosed to State or local regulators as a potential investor. Cannabis companies should also avoid relying on investment commitments from first-time cannabis investors until they have cleared these background checks and other investment concerns.
Raising capital can be challenging in any industry, and this is especially true for the businesses within the cannabis industry due to a highly regulated, uncertain, and ambiguous legal environment.. However, many of these challenges can be mitigated by identifying, understanding, and disclosing the unique issues that exist among cannabis and cannabis-related businesses. These challenges can also be mitigated by either addressing or preparing for them in advance, such as preparing a regulatory compliance analysis that can help ease the worries of prospective investors, as well as the SEC. As such, cannabis businesses should hire a competent securities attorney who can help ensure that any securities offerings and related investor communications comply with federal and State regulations as it regards both the offering of securities and the relatively-new (and somewhat legal) cannabis business.
If you are interested in raising capital for your cannabis or cannabis-related business, then schedule a ,consultation with us today. We are happy to help! the
*with edits by Managing Attorney, Elizabeth L. Carter, Esq.