The SEC appears to be stepping up scrutiny of the cannabis industry’s financial reporting and disclosures in connection with the purchase and sale of securities...
With cannabis companies already facing a long list of regulatory challenges, it is time to add another SEC fraud complaint to the expanding list. The SEC appears to be stepping up scrutiny of this growing industry’s financial reporting and disclosures in connection with the purchase and sale of securities.
In September 2018, the SEC issued an ‘Alert’ to investors about an “uptick” of fraud in the early-stage capital raise cannabis offering space. This warning reminded investors to carefully examine offering materials and issuer disclosures, including a description of the investment, its risks, and benefits. Since that time, many others have issued reminders about the importance of performing adequate due diligence prior to making investment decisions. Notwithstanding the SEC’s warnings, financial fraud continues to be discovered and prosecuted by the SEC involving not only issuers, officers, promoters, but also accountants and accounting firms for violations of Securities Act of 1934 Sections 4C and 21C and Rule 102(3)(1)(ii) and (iii) of the SEC’s Rules of Practice.[1]
On August 12, 2020, the SEC’s OCIE issued a Risk Alert identifying six categories of Covid-19 related compliance risks and considerations for broker-dealers and investment advisors.[2] The six categories are:
Protection of investor assets
Supervision of personnel
Practices relating to fees, expenses and financial transactions
Investment fraud
Business continuity
Protection of investor sensitive information
Concerning investment fraud, the SEC reiterated the importance of member firms conducting due diligence and that Firms have an obligation to supervise their personnel through “tailored” policies and procedures that are specific to the firm’s business activities and operations. Additionally, Firms should upgrade and reassess their policies and procedures during this COVID-19 period of working remotely.
Since 2017, the SEC has brought eleven enforcement actions in federal court against cannabis companies.[3] Most recently on July 27, 2020, the agency filed suit in California against six individuals and their companies, alleging that they committed offering fraud in connection with two cannabis businesses.[4]
Securities Fraud Involving Cannabis Businesses
According to the SEC’s Complaint, between September 2017 and February 2019, the defendants raised over $25 million from more than 400 investors in two separate cannabis-related businesses in California, a marijuana farm and a cannabidiol (CBD) extraction facility.[5] The SEC alleged that the defendants misled investors to believe they would receive a guaranteed annual return on their investments of 100% or more. In its 272-count complaint, the SEC charged the defendants with violating the antifraud provisions of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 thereunder, and the registration provisions of Section 5 of the Securities Act. Several defendants also face charges of violating the broker-dealer registration requirements of Section 15(a) of the Exchange Act. The SEC sought permanent injunctions, disgorgement of ill-gotten gains, plus prejudgment interest, and civil penalties. The SEC further alleged:
The defendants misled and deceived investors about a purported “business loan,” that would be used to develop a CBD extraction facility. Rather than using that business loan for that purpose, the proceeds were used to pay off different investors in an entirely unrelated entity.
The defendants falsely claimed that their company had a business and research relationship with a prominent California university.
The defendants misled and deceived investors by claiming they had made large personal capital contributions to their respective issuers, when in fact they had not.
The defendants made material misrepresentations to investors and prospective investors about their financial and business backgrounds.
The defendants acted as unregistered broker-dealers in connection with the offerings and used general solicitation to attract prospective investors, including via cold calls, Craigslist, Facebook, and other websites and social media.
None of the securities offerings were registered with the SEC. Hence, investors were not provided with the information that a registration statement is required to provide for the protection of investors.
The defendants failed to take reasonable steps to verify the investors’ accreditation status.
Accountants Serving Cannabis Companies Have Been Charged by the SEC
Financial professionals providing services to cannabis companies must be prepared for increased scrutiny. The SEC recently reinstated an accountant’s privilege to practice and appear before the commission after being temporarily barred for his role in the financial misstatements of a cannabis company.[6]
According to the SEC’s order, Tommy Shek, an audit manager at Anton & Chia LLP, engaged in improper professional conduct with respect to his work on the interim reviews of the financial statements of CannaVEST Corp. (CannaVEST) for the first through third quarters of 2013. In performing the interim reviews of CannaVEST’s financial statements, Shek “engaged in improper professional conduct by failing to adhere to standards of the Public Company Accounting Oversight Board and ignoring a number of red flags that indicated that CannaVEST’s financial information contained material misstatements.”
Under the terms of the SEC’s order, Shek’s work before the SEC must be reviewed by the independent audit committee of any company he works for, or in some other manner acceptable to the Commission. He must also obtain permission if he wants to serve on an audit committee or as an auditor.
Lessons for the Cannabis Industry
For cannabis company founders, principals and officers, as well as accounting firms, engagement partners and auditors retained by Cannabis company principals, the SEC’s latest enforcement action highlights the importance of providing truthful and complete information to current and potential investors. As the industry grows, companies should expect SEC scrutiny to continue. To avoid unintended liability, businesses should work with experienced counsel to ensure that any securities offerings and related investor communications comply with federal and state securities regulations.
For accountants and other professionals that provide services to the cannabis industry, you can also expect the SEC to be looking over your shoulder. Accordingly, it is imperative to verify that you and your clients are also following all applicable laws and accounting standards.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further, please contact Paul Lieberman, Dan McKillop or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
Disclaimer: Possession, use, distribution, and/or sale of cannabis is a Federal crime and is subject to related Federal policy. Legal advice provided by Scarinci Hollenbeck, LLC is designed to counsel clients regarding the validity, scope, meaning, and application of existing and/or proposed cannabis law. Scarinci Hollenbeck, LLC will not provide assistance in circumventing Federal or state cannabis law or policy, and advice provided by our office should not be construed as such.
[1] See, SEC Exchange Act Release No. 83622/July 12, 2018; Accounting and Auditing Enforcement; Release No. 3951; July 12, 2018, describing the December 4, 2017 SEC administrative cease and desist proceeding against Anton & Chia, LLP and two of its CPAs. This firm performed the interim reviews and CannaVest Corp., which was charged on June 15, 2017 with securities fraud, books and records, and accounting control provision violations involving its overstatement of the value of its assets used in an acquisition of a raw hemp acquisition business.
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The SEC is Increasing Scrutiny of the Cannabis Industry
Author: Daniel T. McKillop
The SEC appears to be stepping up scrutiny of the cannabis industry’s financial reporting and disclosures in connection with the purchase and sale of securities...
With cannabis companies already facing a long list of regulatory challenges, it is time to add another SEC fraud complaint to the expanding list. The SEC appears to be stepping up scrutiny of this growing industry’s financial reporting and disclosures in connection with the purchase and sale of securities.
In September 2018, the SEC issued an ‘Alert’ to investors about an “uptick” of fraud in the early-stage capital raise cannabis offering space. This warning reminded investors to carefully examine offering materials and issuer disclosures, including a description of the investment, its risks, and benefits. Since that time, many others have issued reminders about the importance of performing adequate due diligence prior to making investment decisions. Notwithstanding the SEC’s warnings, financial fraud continues to be discovered and prosecuted by the SEC involving not only issuers, officers, promoters, but also accountants and accounting firms for violations of Securities Act of 1934 Sections 4C and 21C and Rule 102(3)(1)(ii) and (iii) of the SEC’s Rules of Practice.[1]
On August 12, 2020, the SEC’s OCIE issued a Risk Alert identifying six categories of Covid-19 related compliance risks and considerations for broker-dealers and investment advisors.[2] The six categories are:
Protection of investor assets
Supervision of personnel
Practices relating to fees, expenses and financial transactions
Investment fraud
Business continuity
Protection of investor sensitive information
Concerning investment fraud, the SEC reiterated the importance of member firms conducting due diligence and that Firms have an obligation to supervise their personnel through “tailored” policies and procedures that are specific to the firm’s business activities and operations. Additionally, Firms should upgrade and reassess their policies and procedures during this COVID-19 period of working remotely.
Since 2017, the SEC has brought eleven enforcement actions in federal court against cannabis companies.[3] Most recently on July 27, 2020, the agency filed suit in California against six individuals and their companies, alleging that they committed offering fraud in connection with two cannabis businesses.[4]
Securities Fraud Involving Cannabis Businesses
According to the SEC’s Complaint, between September 2017 and February 2019, the defendants raised over $25 million from more than 400 investors in two separate cannabis-related businesses in California, a marijuana farm and a cannabidiol (CBD) extraction facility.[5] The SEC alleged that the defendants misled investors to believe they would receive a guaranteed annual return on their investments of 100% or more. In its 272-count complaint, the SEC charged the defendants with violating the antifraud provisions of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 thereunder, and the registration provisions of Section 5 of the Securities Act. Several defendants also face charges of violating the broker-dealer registration requirements of Section 15(a) of the Exchange Act. The SEC sought permanent injunctions, disgorgement of ill-gotten gains, plus prejudgment interest, and civil penalties. The SEC further alleged:
The defendants misled and deceived investors about a purported “business loan,” that would be used to develop a CBD extraction facility. Rather than using that business loan for that purpose, the proceeds were used to pay off different investors in an entirely unrelated entity.
The defendants falsely claimed that their company had a business and research relationship with a prominent California university.
The defendants misled and deceived investors by claiming they had made large personal capital contributions to their respective issuers, when in fact they had not.
The defendants made material misrepresentations to investors and prospective investors about their financial and business backgrounds.
The defendants acted as unregistered broker-dealers in connection with the offerings and used general solicitation to attract prospective investors, including via cold calls, Craigslist, Facebook, and other websites and social media.
None of the securities offerings were registered with the SEC. Hence, investors were not provided with the information that a registration statement is required to provide for the protection of investors.
The defendants failed to take reasonable steps to verify the investors’ accreditation status.
Accountants Serving Cannabis Companies Have Been Charged by the SEC
Financial professionals providing services to cannabis companies must be prepared for increased scrutiny. The SEC recently reinstated an accountant’s privilege to practice and appear before the commission after being temporarily barred for his role in the financial misstatements of a cannabis company.[6]
According to the SEC’s order, Tommy Shek, an audit manager at Anton & Chia LLP, engaged in improper professional conduct with respect to his work on the interim reviews of the financial statements of CannaVEST Corp. (CannaVEST) for the first through third quarters of 2013. In performing the interim reviews of CannaVEST’s financial statements, Shek “engaged in improper professional conduct by failing to adhere to standards of the Public Company Accounting Oversight Board and ignoring a number of red flags that indicated that CannaVEST’s financial information contained material misstatements.”
Under the terms of the SEC’s order, Shek’s work before the SEC must be reviewed by the independent audit committee of any company he works for, or in some other manner acceptable to the Commission. He must also obtain permission if he wants to serve on an audit committee or as an auditor.
Lessons for the Cannabis Industry
For cannabis company founders, principals and officers, as well as accounting firms, engagement partners and auditors retained by Cannabis company principals, the SEC’s latest enforcement action highlights the importance of providing truthful and complete information to current and potential investors. As the industry grows, companies should expect SEC scrutiny to continue. To avoid unintended liability, businesses should work with experienced counsel to ensure that any securities offerings and related investor communications comply with federal and state securities regulations.
For accountants and other professionals that provide services to the cannabis industry, you can also expect the SEC to be looking over your shoulder. Accordingly, it is imperative to verify that you and your clients are also following all applicable laws and accounting standards.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further, please contact Paul Lieberman, Dan McKillop or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
Disclaimer: Possession, use, distribution, and/or sale of cannabis is a Federal crime and is subject to related Federal policy. Legal advice provided by Scarinci Hollenbeck, LLC is designed to counsel clients regarding the validity, scope, meaning, and application of existing and/or proposed cannabis law. Scarinci Hollenbeck, LLC will not provide assistance in circumventing Federal or state cannabis law or policy, and advice provided by our office should not be construed as such.
[1] See, SEC Exchange Act Release No. 83622/July 12, 2018; Accounting and Auditing Enforcement; Release No. 3951; July 12, 2018, describing the December 4, 2017 SEC administrative cease and desist proceeding against Anton & Chia, LLP and two of its CPAs. This firm performed the interim reviews and CannaVest Corp., which was charged on June 15, 2017 with securities fraud, books and records, and accounting control provision violations involving its overstatement of the value of its assets used in an acquisition of a raw hemp acquisition business.
