Utah Cannabis Investment Fraud: Know Your Securities Laws

11 Nov Utah Cannabis Investment Fraud: Know Your Securities Laws

It is trite of me to say so, but the current “gold rush” in the U.S. has prospectors dreaming of double-fisting cannabis buds and greenbacks, and that makes for fertile fraud soil. In this green rush, investors are voraciously putting money into cannabis ventures that are, in some instances, producing vast amounts of cash and garnering valuations at 10x (and more) EBITDA when potential purchasers come knocking (and they are knocking) (see here and here for posts on cannabis business valuations). But this frothy business market means the fraudsters are also salivating en masse about would-be investors, and securities regulators are keeping close tabs on these securities transactions. Regardless of which side of the investment equation you are on, you do not want your company, yourself, or someone you care about to be involved in securities fraud. This post focuses on Utah, which is infamous (pronounced IN-fame-us) for being one of the fraud capitals of the U.S., but the principles are widely applicable to cannabis ventures in established cannabis markets like Colorado, Washington, Oregon, California, Maine, and beyond.

I recently attended Utah’s annual securities law workshop with some heavy-hitting headliners: Ben McAdams from Utah’s Congressional delegation; the chief accountant for the SEC’s enforcement division; and the head of Utah’s Division of Securities, Tom Brady (the slightly less famous one). Mr. Brady confirmed for me that Utah has more than its fair share of fraud and that the fraud has a particular Utah flavor, with confidence schemes dominating the landscape, often perpetuated by fraudsters who work their church, neighborhood, and family connections in a state that rivals China for its interconnectedness (in Chinese it’s called guanxi (gwon shee) – 关系). Many of Mr. Brady’s examples of fraud perpetuated in Utah began with a hot tip provided by a well-regarded businessperson who was extremely likeable and therefore seemed trustworthy. Utah has a very trusting population, and it also has a growing elderly population, both of which are vulnerable to fraud. Although it is currently only appearing as an intermittent blip on the radar of Utah’s Division of Securities, the Utah cannabis scene is ripe for fraud opportunities. Caveat investor.

Utah is on the cusp of rolling out its medical marijuana program. The Utah Department of Health will begin issuing medical marijuana cards no later than March 1, 2020. Even before Utah voters passed the ballot initiative on November 6, 2018, the green rush had already started in Utah, with would-be investors looking at getting in on the ground floor in Utah’s new marijuana marketplace. Heavy cannabis investments are happening in all the states where we have attorneys: Washington, Oregon, California, and Utah, which means that bogus investments (not just bad investments) are also being shopped to would-be investors as an alternative to the evergreen oil-and-gas venture fraud in the West. How can prospective investors in a Utah cannabis venture avoid losing their money in a fraudulent scheme? It helps to ask the right questions and to know what the right answers sound like.

Is the company or individual raising funds using a law firm to help with the transaction? Does that law firm know both securities and cannabis?

These questions are partially self-serving, but I put this point first because you do not want to dabble in securities law, whether you are a company, an individual businessperson, an investor, or a lawyer. Whatever your role in business, if money is changing hands between investors and a business venture, the investor is investing in securities being offered by the company. Even if it is “just” a promissory note or you are “just” loaning some funds to a friend or family member, unless you do not care about getting your money back, make sure there is a qualified securities attorney involved. There are a lot of great attorneys in Utah. There are at least two good cannabis attorneys in Utah. I am not aware of any other lawyers in Utah who know both securities and cannabis. You need good securities attorneys representing the company and each investor.

If the company is using an intermediary to solicit investments, is that intermediary licensed to solicit investments? Are they registered with the SEC, FINRA, or the State of Utah? Has the intermediary been disciplined by any of these entities?

Intermediaries or “finders” are (by definition) not involved with the day-to-day operations of the company that is soliciting investment, and they must be registered with state and federal regulators because they are in the trusted position of soliciting funds for investment. If the intermediary is not registered as a broker or investment advisor, they should not be soliciting investments unless they have a direct and substantial role with the company. If the company thinks the intermediary is registered but the intermediary is not registered, you should think twice about investing with the company. If the company does not know that their intermediary needs to be registered, you should also think twice about investing with the company.

What type of investment registration statement is the cannabis venture required to file?

The company either has to register its investment securities or qualify for an exemption from registration. If the company owners do not know what a securities offering is, you should think twice before investing with the company unless the company is willing to get competent advice from a securities lawyer. If the company or its attorney has not heard of Reg D, Rule 4(a)(2), or Rule 506, you should probably walk away or insist a qualified securities attorney get involved.

What parts of a cannabis business can be invested in, or what are the limits to the company’s business purpose?

Some states (like Arizona) allow full integration of marijuana business activities; others (like Washington) do not. If, for instance, the company seeking investment plans to develop a cannabis testing facility and have a fully integrated cannabis business (cultivate, manufacture, distribute/transport, and retail sales), but you know that the company can only do what its license permits, then you may want to look for another company to invest in. In Utah, only eight companies have been authorized to grow medical cannabis: Dragonfly Greenhouse, Harvest of Utah, Oakbridge Greenhouses, Standard Wellness Utah, True North of Utah, Tryke Companies Utah, Wholesome Ag, and Zion Cultivars. There will initially be only up to 14 privately-operated medical cannabis pharmacies licensed by the Utah Department of Health, but the RFP for applications has not yet been issued.

What can be found out about the principal owners and operators of the business by (1) word of mouth, (2) a simple Google search, and (3) checking with state and federal securities regulators?

I cannot tell you how many instances of investment fraud could have been avoided by doing a simple Google search. This was stressed recently in another conference I attended with the Washington State securities regulators. Do your homework or pay someone else to do your homework. In the legal world, that homework is called “due diligence,” which is a crucial part of any business transaction.

When it comes to investing in cannabis, know your counterparts, know their business, and know their flaws and weaknesses. Know all of this before you invest.