The Marijuana Industry and the Securities Laws

by Ballard Spahr LLP


Part Three of a Three-Part Series

In the third and final part of this series on marijuana-related businesses (“MRBs”), we explore how the Securities and Exchange Commission (“SEC”) and the Department of Justice (“DOJ”) have commenced actions against MRBs and operators for allegedly fraudulent and deceptive securities practices.  The sample of such actions which we discuss here serve to demonstrate not only the risks the investing public may face in investing in MRBs, but also as a reminder to MRBs seeking to capitalize on the industry’s explosive growth of the exacting standards of the securities laws and the government’s commitment to enforcing them in this industry.

Although the cases we discuss here are not tied specifically to AML/BSA enforcement cases, but rather to traditional allegations of securities violations, the practical point is that anyone who is considering wading into this industry should remember that there are multiple federal agencies which may pursue their own enforcement agendas relating to MRBs. Although we previously have noted during this series that the Financial Criminal Enforcement Network issued guidelines giving banks the go-ahead to work with MRBs, and although the 2013 DOJ Cole Memo seems to suggest that financial institutions can serve MRBs under certain circumstances, our discussion here reflects that there still are other government agencies which may have their own notions regarding what is acceptable conduct by a MRB.  As to the SEC specifically, these actions also are consistent with the recent trend of the SEC inserting itself into AML-related enforcement.

The rapid financial growth of the legal marijuana market is as unmistakable as it is unsurprising. According to a report by Arcview Market Research, the legal marijuana market has experienced significant double-digit growth since the legalization trend commenced in earnest in 2014, rising from $4.6 billion in 2014 to $5.7 billion in 2015 to $6.7 billion in 2016.  This trend is expected to continue as the current market grows and matures and wider legalization efforts continue with North American marijuana sales projected to top $20.2 billion by 2021.  Naturally, any industry with such a demonstrated and projected upward trajectory will attract significant investor interest. The marijuana industry is no exception.  Its rapid growth and expansion has launched a green-rush of investors looking to capitalize, if not directly in the industry, then through marijuana-related securities and, conversely, MRBs looking to take advantage of the investing public’s significant appetite for marijuana-related stock.

However, as a securities market, the marijuana industry, while uniquely valuable, is uniquely risky. Due to a number of factors, there often is limited verifiable information concerning MRBs offering stock to the investing public and few safeguards in place to ensure the accuracy of what information is available.  The sector is largely populated by smaller companies that are subject to less stringent disclosure requirements by the SEC.  Moreover, due to the size of most MRBs as well as marijuana’s continued federal criminalization, most MRBs are barred from being traded on major stock exchanges, such as the New York Stock Exchange, and instead are traded on the less-regulated over-the-counter stock markets.  Additionally, many MRBs are financed through private placements involving shares exempt from the SEC’s registration requirements.  These factors combine to make the marijuana securities market particularly opaque and, thus, particularly ripe for potential fraud.  And the SEC has taken notice.

As early as May 16, 2014, the SEC issued an Investor Alert explaining that “[t]he SEC has seen an increase in the number of investor complaints regarding marijuana-related investments” and began issuing stop trade orders against MRBs due to “questions regarding the accuracy of publicly-available information” and “potential illegal activity.”

The stop-trading order was merely an opening salvo. The SEC’s investigations into these companies and others would go on to yield numerous enforcement actions and criminal prosecutions against MRBS themselves, individual officers and directors, and professionals, including attorneys, engaged by MRBs related to stock sale schemes and market manipulation.  The following examples illustrate the depth and scope of the government’s securities-related actions involving the marijuana market.

FusionPharm Inc.

The SEC’s investigation into FusionPharm, Inc. yielded administrative and criminal proceedings against the company, its individual owners and attorney. FusionPharm was a company that focused on the development, production and sales of “PharmPods cultivation container systems,” which are refurbished shipping containers used primarily to grow marijuana.  The SEC brought a cease-and-desist proceeding against it claiming that the company and its owners engaged in the unlawful sale of unregistered securities and committed securities fraud.  The government alleged that the FusionPharm owners sold in multiple transactions $12.2 million in unregistered FusionPharm securities to entities they controlled then funneled the proceeds of those sales back into the company while fraudulently reporting those funds as revenue from product sales.  Investors, encouraged by what was purported to be a strongly performing company traded in significant quantities of FusionPharm stock driving the stock price as high as $8.70 before the owners’ fraudulent conduct was discovered.

First, the government addressed the company’s liability. In an administrative proceeding, the SEC found, on September 16, 2016, that FusionPharm violated Sections 5(a) and (c) of the Securities Act (which prohibits the direct or indirect sale or offer for sale, respectively, of securities unless a registration statement is in effect) and also Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder for engaging in fraudulent conduct in the offer or sale of securities.

Next, that same day, the United States Attorney for the Western District of Colorado filed criminal charges against FusionPharm’s owners under 18 U.S.C. § 371 for conspiracy to defraud the United States and commit securities, mail and wire fraud related to their fraudulent securities scheme. That case is pending.

Finally, on March 21, 2017, the SEC concluded an administrative proceeding against Fusion Pharm’s attorney, concluding that he also violated Sections 5(a) and (c) of the Securities Act. When unregistered shares are sold, the accompanying stock certificate must include a legend indicating they are restricted shares.  FusionPharm’s attorney had issued ten separate attorney opinion letters to FusionPharm’s stock transfer agent certifying that the FusionPharm shares sold by the company’s owners, though unregistered, could be transferred without the required restrictive legend.  Explaining that Sections 5(a) and 5(c) are strict liability offenses, the SEC held that the attorney thereby violated these provisions indirectly because his opinion letters facilitated the prohibited transactions.

In May 2017, FusionPharm issued a press release explaining that “[p]ending legal proceedings have made it impossible for the Company to continue operations” and it therefore is liquidating and dissolving the company.

Notis Global (Medbox)

In March 2017, the SEC charged, in the Central District of California, a California-based marijuana company Notis Global (formerly “Medbox Inc.”) and its founder Vincent Mehdizadeh with engaging in sham transactions with a secret affiliate, and then misrepresenting those proceeds as industry-leading revenues in order to mislead actual and potential investors.

Capitalizing on the trend of legalization of prescription marijuana for medicinal use, Medbox Inc. claimed to provide an innovative and secure form of product delivery by selling “Medbox” vending machines: marijuana-dispensing kiosks sealed with biometric locks and accessible only to prescription-holders. The SEC alleged that Mehdizadeh created a shell corporation, New-Age Investment Consulting, installed his fiancée as its CEO, and used it to engage in illegal stock transactions involving shifting money and stock back and forth between Medbox and New Age, then listing the proceeds from these transactions in Medbox’s books as revenue from kiosk sales – a possible scheme referred to as “round-tripping.” According to the SEC, Medbox trumpeted these “revenues” as groundbreaking earnings, creating an aura of commercial viability for the company despite the fact that only about ten percent of its stated 2014 Q1 revenue actually came from sales of its products.  Due to the inflated revenues generated from the scheme, Medbox stock traded for as much as $98 a share.  The SEC’s complaint asserted, among others, claims for securities fraud under Section 10(b) of the Exchange Act and Rule 10b-5, securities fraud under Sections 17(A)(1), (2) and (3) of the Securities Act, violating Rule 13b2-2 of the Exchange Act by lying to company auditors, and violating Section 13(a) of the Exchange Act by filing false and misleading periodic reports.

Mehdizadeh has settled the SEC’s claims against him without an admission of guilt, but agreeing to both disgorge more than $6 million in profits and pay a civil penalty of more than $6 million. Having settled with the SEC, Mehdizadeh has sued his former attorneys in federal court for legal malpractice, asserting that his allegedly fraudulent actions resulted from the legal advice he had received.

CV Sciences (CannaVEST)

In June 2017, the SEC charged Las Vegas-based hemp oil company CV Sciences, Inc. (formerly “CannaVEST Corp.”) and its CEO, Michael Mona Jr., with fraud connected with the material overstatement of the company’s total assets in quarterly reports for the first half of 2013.

The SEC alleged that CannaVEST purchased hemp company PhytoSphere for a reported price of $35 million, despite knowledge that that price was “substantially inflated,” and that this price was agreed to only because it could be paid for with low-value CannaVEST shares. The company then reported that inflated purchase price in Q1 and Q2 of 2013, and in doing so overstated its total assets.  In the third quarter, however, CannaVEST obtained a third-party valuation of PhytoSphere, which stated that the company had been worth only $8 million at the time of purchase.  According to the SEC, CEO Mona had CannaVEST wrote down the value of the acquisition in the Q3 Form 10-Q, but did not disclose the inflation of the original value or the material overstatement of the first and second quarter balance sheets.  Indeed, he allegedly allowed those filings to stand uncorrected until April 2014, when the company restated its 2013 quarterly filings (at the behest of the company’s new auditors) to reflect the accurate value of PhytoSphere.

Cannavest and Mona are charged with, among other violations, securities fraud under Section 10(b) of the Exchange Act and Rule 10b-5 for disseminating false information to investors about its earnings, failing to file accurate quarterly reports under Section 13(a) of the Exchange Act, failing to maintain accurate auditing controls in violation of Section 13(b)(2)(B) of the Exchange Act, and violating Rule 13b2-2 of the Exchange Act for making false statements to its auditors.

Thus, and as noted, this sampling of enforcement actions highlights both the risks the investing public may face in investing in MRBs, and the fact that MRBs face potential legal threats beyond the Bank Secrecy Act, money laundering statutes, and federal drug laws.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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