The cannabis industry is continuing to expand throughout the United States as increasingly more states, and jurisdictions legalize the use of recreational marijuana. Massachusetts legalized recreational marijuana in 2016, causing an increase in cannabis industry activity. Subsequently, the Massachusetts Secretary of State, William Galvin, and the Massachusetts Securities Division (the “Division”) announced that they will put a halt to practices within the cannabis industry that violate the state’s securities laws. On June 19, 2019, Galvin announced that the Division initiated a wide-scale sweep into businesses raising money through investments in the state’s cannabis industry.¹ The sweep aims to warn cannabis companies that they can potentially face liability for failures to follow state securities laws, including securities offering and registration requirements, as well as for providing misleading information and inadequate disclosures of conflicts of interest related to the distribution of those securities interests. Although the Massachusetts Securities Division recently announced the sweep, federal regulators had previously provided guidance in this space.
A. Regulation at the Federal Level
The Massachusetts warning to investors is similar in scope to the warnings that the Securities and Exchange Commission (SEC) and FINRA have released in the past few years. Due to the increase in a number of investor complaints related to marijuana investments, on May 16, 2014, the SEC’s Office of Investor Education and Advocacy issued an Investor Alert to warn investors about potential risks that involve investments in marijuana-related companies.² Echoing the SEC’s concerns, FINRA released its own Investor Alert, “Marijuana Stock Scams,” to warn investors of the potential for fraud in investing in marijuana related stock.³
Both FINRA’s alert and the SEC’s alert identify the same general areas for the potential scams. First, both alerts implore investors to research whether the company has registered its securities and are in compliance with the registration requirements. Second, the alerts caution the industry to be wary of scams, including companies giving investors misleading information and disclosures regarding returns and profits within the cannabis industry. Already, the SEC has suspended trading in companies whose operations relate to the marijuana industry because of questions regarding the accuracy of publicly-available information about the companies’ operations or potential illegal activity such as unlawful sales of securities and market manipulation. Similarly, FINRA has entered into settlements through Letters of Acceptance, Waiver and Consent (AWC) with member firms for similar issues involving investment scams related to cannabis.
B. The Massachusetts Sweep
The sweep announced by Secretary Galvin will examine securities offerings by cannabis businesses to determine whether the offerings have complied with state securities regulations. Issuers of unregistered securities offerings, as well as the distributors of unregistered securities offerings such as broker-dealers and investment advisors, face liability from both state and federal securities regulators.
The sweep does not, however, include a review of the cannabis products themselves. Rather, the focus is on scrutinizing general securities compliance in the cannabis industry, particularly regarding the impact on investors that may have been misled by certain sales practices.
C. The Sweep’s First Action
On the same date as the sweep announcement, Galvin’s office also brought charges against a cannabis-related company and its president for violations of the Massachusetts securities laws and regulations.⁴ The complaint alleges that the president launched a recreational cannabis cultivation facility with a plan to lease part of it to other cannabis businesses. In doing so, the president and the company illegally marketed and sold $1.3 million of unregistered securities to at least 25 Massachusetts investors, as well as other investors located outside of Massachusetts. Furthermore, the president and the company failed to verify whether the investors were “accredited”⁵ in accordance with Rule 506 under Regulation D of the Securities Act of 1933.
The complaint also alleged that the company violated the anti-fraud provisions of the Massachusetts securities laws by making misrepresentations to investors regarding the funds they provided to the company. For example, the company informed investors that the funds received from investors would be placed in escrow accounts, however, the president and the company commingled the funds with the company’s business operation expenses in violation of their explicit escrow representations.
The complaint sought rescission of the investor assets, a fine and an order permanently barring the president from the securities industry.
D. Prior Charge Against the Cannabis Industry
The Division was looking into the cannabis industry practices related to securities offerings and misleading statements before the announcement of the sweep. In April 2019, the Division filed a complaint against a registered investment advisor and its CEO, seeking to bar the advisor from the securities industry after allegedly soliciting millions of dollars from over 100 investors, despite lacking a proper license or an actual marijuana dispensary.⁶ The CEO aimed to fund medical marijuana dispensaries, which were ultimately never opened. The complaint alleged that one client gave the investment advisor $3 million, while the adviser also raised more than $8 million from other investors. The complaint stated, “[the CEO’s] entire relationship with the emerging cannabis industry has been an improvised effort to learn as he goes, utilizing client funds and firm resources to experiment. He utterly failed to uphold the fiduciary duty…and took advantage of his advisory relationship to pursue these projects.”
The CEO failed to disclose conflicts of interests when making recommendations to one high net worth client and failed to disclose key risk factors in the cannabis industry. The complaint seeks to censure the CEO and the investment advisor from registering as an investment advisor or broker-dealer in Massachusetts. It also seeks an administrative fine and restitution to get money back into the hands of the harmed investors.
E. Securities Regulatory Violations
Both enforcement actions allege multiple violations of sections of the Massachusetts Uniform Securities Act (the “Act”). More specifically, Section 101 of the Act generally prohibits untrue statements of material facts or omissions of material facts in connection with the offers, sale, or purchase of a security. This general anti-fraud statute mirrors similar prohibitions under the federal securities laws.
In addition, Section 201 of the Act governs the registration requirement for broker-dealers distributing securities and effecting securities transactions for the accounts of others. Broker-dealers effecting securities transactions must register with the state of Massachusetts, which, among other things, typically entails filing a Form BD with the Securities and Exchange Commission and notice filing the form with the Massachusetts securities regulators. Only registered broker-dealers may effect securities transactions for customers in the state of Massachusetts. The enforcement actions related to the Massachusetts sweep include violations of this broker-dealer registration requirement, as the securities interests in certain cannabis businesses were distributed by unregistered persons.
Finally, Section 301 of the Act prohibits the offer of any unregistered security. As a practical matter, securities registered under the Securities Act of 1933 are considered “federal covered securities,” and are generally exempt from the requirement to register under the Act. In this instance, the securities interests in certain cannabis businesses were not registered with either the federal or state regulators. Cannabis companies seeking to sell interests in their businesses should ensure they have complied with both federal and state securities registration requirements, which typically entail a full regulatory review of the offering in the case of a public offering.
F. Impact of the Sweep
The Massachusetts securities regulators are not alone in their concern regarding company failures to comply with complex regulatory requirements. In an interview, Galvin stated, “We’re concerned that people are attracted to these businesses, but because they’re non-banked entities, it’s very hard to determine whether they’re real or worthy of investment.”⁷
If a company is planning to sell securities or solicit investors in the cannabis industry, the company should carefully review the regulatory requirements for registering the securities, ensuring that conflicts of interests are adequately disclosed and that there are no misleading advertisements and false representations to investors regarding the cannabis industry.