In addition to grappling with the challenge of marketing a substance that is still illegal at the federal level—but permitted for medical use in 37 states and the District of Columbia and for adult use in 19 states—cannabis companies are addressing the growing concern that they and their directors and officers (D&Os) have to be better corporate citizens. These challenges often result in cannabis companies making environmental, social, and corporate governance (ESG) pledges.
While such pledges often are received very favorably by investors and the public, these commitments can be ticking time bombs of future liability. D&Os of a cannabis company are fiduciaries of that organization who are required to discharge the duties of their respective positions in good faith and with diligence, care, and skill. As such, it is important for the D&Os of cannabis companies to understand the risks they take when making ESG pledges and trying to implement the accompanying goals.
ESG Pledges
Corporate ESG pledges by cannabis companies can take many forms. Some companies focus on just one of the ESG factors. For example, Canadian cannabis company HEXO Corp. made pledges about climate change and obtaining carbon neutrality, and edible CBD maker Wyld made statements regarding its compostable and biodegradable packaging.
Other companies such as Trulieve have created dedicated ESG reports covering multiple factors, such as having an ESG board committee, establishing carbon emissions targets, and supporting local committees on matters of diversity and inclusion. There are other organizations such as DrazCanna Inc. that are less formal with their ESG pledges, as reflected in the company's May 2022 press release that included a statement setting environmental and social equity commitments.
These examples reflect the growing efforts to show ESG commitments by cannabis companies, but like other corporate filings, such corporate statements can lead to regulatory scrutiny and litigation.
Governmental Landscape
The D&Os of cannabis companies have to address some unique regulatory compliance issues. There is a patchwork of statutes to understand since it has been the states—not the federal government, which classifies cannabis within Schedule 1 of the Controlled Substances Act—leading the charge regarding cannabis legalization. Cannabis companies have been waiting for such reform at the federal level, and while there have been several significant proposed legislations, they have not passed.
One such piece of legislation is the Secure and Fair Enforcement (SAFE) Banking Act, which would create a safe harbor for financial institutions—including banks, credit unions, and insurance companies—to provide financial services to a cannabis-related business. The SAFE Banking Act has been passed six times by the US House of Representatives, including in 2022, but has yet to be considered by the US Senate.
Another bill that was passed by the House in 2022 is the Marijuana Opportunity Reinvestment and Expungement Act (MORE Act). Among other things, the MORE Act institutes a tax on cannabis, with the proceeds designated to fund programs such as job training, legal aid, and youth mentoring.
While the Senate has not put forward the MORE Act for consideration, in July 2022 it did introduce the Cannabis Administration and Opportunity Act (CAOA), which would legalize cannabis at the federal level while creating Food & Drug Administration (FDA) monitoring requirements similar to those that already exist for tobacco and alcohol. The bill also includes other public safety measures and regulations, modifies cannabis tax policy, requires additional federal research on the impact of cannabis use, and removes drug testing for federal workers in most cases. The CAOA is at its early stages, and it remains to be seen what traction it will make going forward.
While cannabis companies await legislative movement at the federal level, regulatory issues from agencies such as the FDA and the IRS remain omnipresent. In May 2022, for example, the IRS sent warning letters to cannabis companies for selling products labeled as containing Delta-8 THC in violation of the federal Food, Drug, and Cosmetic (FD&C) Act. There have been lawsuits involving the IRS regarding tax liabilities not only against the cannabis companies themselves, but also the individuals who invest in them. Under section 280E of the Tax Code, as an example, the IRS does not permit deductions or credits for typical business expenses with respect to cannabis business operations.
With a void left by the federal government, the states have been taking into their own hands how they want to address, regulate, and control cannabis. Certain states, such as Colorado, a pioneer in the early medical and adult use legislation, have a more robust regulatory framework. States that have only recently allowed for cannabis use in some capacity, such as Oklahoma, New York, and Connecticut, are in the early stages of addressing how their specific cannabis policies will work in their respective states.
Thus, as state and federal laws regarding what a cannabis operator can conflict, this puts D&Os of such companies under additional scrutiny.
General Litigation Issues
Cannabis company D&Os face litigation similar to that of corporations in other sectors. This can include contractual disputes between private companies concerning unjust enrichment claims, such as FDAS Ventures, LLC vs. Moriel Elmalem, et al., Docket No. 22STCV15530 (Cal. Super. Ct. May 10, 2022) or cases such as Dynasty Capital 26 LLC v. Lily's Green Garden, Inc. et al, Docket No. 1:22-cv-02507 (E.D.N.Y. May 02, 2022) that involve contractual guarantees.
In such a growing space, D&Os are also being named in securities litigation over proposed mergers, such as Eddy v. Columbia Care Inc., et al., 1:22-cv-03773 (S.D.N.Y. May 09, 2022) or allegations of fraud, such as Mallozzi v. Innovative Industrial Properties Inc. et al., Docket No. 2:22-cv-02359 (D.N.J. Apr 25, 2022) where it is alleged that a cannabis-focused real estate investment trust is actually operating as a marijuana company lender. In these examples, the D&Os are accused of making misleading statements to induce investments, with the plaintiffs in Mallozzi alleging of violations of section 10(b) and Rule 10b-5, and in Eddy alleging violations of sections 14(a) and 20(a) of the Exchange Act.
This type of litigation focuses on the fiduciary duty owed by the D&Os to other businesses, such as in contractual litigation, or the duty owed to shareholders, such as in securities litigation. When D&Os make statements about ESG pledges in securities offerings, as an example, these same types of potential claims regarding misleading statements are possible if the ESG pledges are not attempted as disclosed. While the subject matter of these types of actions involve cannabis, they are not otherwise specifically unique to the cannabis industry.
ESG-Related Litigation
While it is hard to quantify the most common ESG-related litigation that cannabis companies currently face, notable matters the industry faces include those relating to social issues, cyber security, and environmental claims.
Like many industries, cannabis companies have received complaints of racial and general discrimination. In Jones v. Blair Wellness Center LLC et al, No. ADC-21-2606, 2022 BL 125058 (D. Md. Apr. 11, 2022), the plaintiff alleges racial discrimination against a cannabis retailer and owner in connection with an employee's treatment and later termination. In April 2022, the court denied the defendants' motions to dismiss based, in part, on "allegations of multiple instances of plaintiff's negative treatment as a Black employee in contrast to her white coworkers permit the court 'to infer more than the mere possibility' of discrimination."
In Rivadeneyra v. Toluca Lake Collective, Docket No. 22STCV14074 (Cal. Super. Ct. Apr 28, 2022) the plaintiff brought allegations of gender discrimination against a California dispensary. Specifically in this case, it is claimed that female employees were fired for objecting to unlawful employment practices including inappropriate comments in the workplace, such as "not to get pregnant, that pregnant women were not allowed to work for Defendants and would immediately be terminated."
While the Jones and Rivadeneyra cases do not appear to be atypical to gender and racial discrimination cases against cannabis and other companies in years past, they are another reminder that this type of litigation remains prevalent.
Cannabis companies are also faced with cybersecurity concerns. For example, the Ontario Cannabis Store (OCC) announced in May 2022 that the Ontario Provincial Police was investigating the theft of some of its sales data, which was "misappropriated, disclosed, and distributed unlawfully." The OCC did advise that this incident was "no failure of IT security or systems," but on August 5, 2022, one of OCC's logistical partners was the subject of a cyber-attack.
In Cannaco Research Corp. v. Militello, Docket No. 21STCV13314 (Cal. Super. Ct. Apr 07, 2021) a cannabis grower brought a complaint against an employee for assuming improper administrative privileges on the company's email accounts and making unauthorized changes to the company's keycard lock system and email accounts to lock out certain company leaders. Cannabis companies are still the potential target of a traditional cyberattack, such as revealed in the class action Warshawsky et al. v. cbdMD, Inc., Docket No. 3:20-cv-00562 (W.D.N.C Oct 09, 2020), which involves the compromise of personal information of customers who purchased cannabidiol products. In July 2022, the parties in Warshawsky filed a motion for final approval of a $300,000 settlement for the class.
The action Acerra v. Trulieve Cannabis Corp., Docket No. 4:20-cv-00186 (N.D. Fla. Apr 14, 2020) included an environmental claim as part of a securities matter. While the Northern District of Florida dismissed the class action complaint, the court did find that the company's description of "climate controlled" involving "an outdoor facility in Florida with no heat or air-conditioning does not measure up" was a "sufficient allegation of a material misstatement." Though the alleged environmental claim against the cannabis company was insufficient to sustain the action, environmental ESG claims may pop up in securities litigation in the future.
Steps to Consider
D&Os are the face of their companies and have great responsibility. The potential for liability for D&Os has evolved over the years, and the ever-changing landscape in connection with cannabis only heightens that exposure. While ESG pledges may come from a place of good intention, they may end up as another basis for scrutiny of D&Os.
The potential social concerns involving cannabis companies often relate to labor issues, so being a good employer and having a process in place to address employee concerns, which can be outlined in employee contracts and personnel handbooks, can assist in the long run with creating workplace harmony. Cannabis companies should take care to shift their focus from beyond obtaining licenses towards the makeup of their workforce in order to achieve their long-term goals.
Employers of cannabis organizations of all sizes should understand their own electronic data and its importance to the company. A local cannabis retailer may not believe that a cybercriminal would want their data, only to end up appreciating their reliance on company computer systems after they are shut down. Aside from the costs of potential notification requirements in handling a breach of personally identifiable information (PII) or protected health information (PHI), there can be the expense of recovering data and/or paying a ransom. Staying up to date on cybersecurity developments and what a company can do to be proactive in this space will assist in allocating the appropriate resources to protect company data and IT systems.
Though cannabis companies often are assumed to be "green," making representations without knowing how environmentally friendly their operation is could end up being a point of contention. Growers, like many others in the agricultural sector, use a significant amount of water in maintaining their crops and experience pressure reduce their water use and energy consumption—especially with certain Western states experiencing water shortages. Before D&Os make statements without knowing the consequences, they should understand the environmental impact of about water recycling, low-volume irrigation methods, and optimization of water usage.
Cannabis companies need to understand the importance of insurance. In general, corporations and their D&Os should supplement insurance with a dedicated risk mitigation strategy. This is especially important in the cannabis industry where the neophyte insurance market on such products as cannabis D&O insurance have certain limitations on coverage resulting from the unknown track record of the operators in the space. Given the potential regulatory and litigation exposure, insurance coverage may assist in lightening potential costs. Employment practices, general liability, and D&O and crime policies may be an additional expense that cannabis companies need to anticipate.
Conclusion
The ESG risks related to environmental concerns, social issues, and corporate governance do not show any signs of slowing down. The greater societal focus on ESG puts additional scrutiny on all organizations, and cannabis companies are not an exception. Keeping some of these concerns in mind will hopefully result in decreased ESG-related litigation against cannabis companies, but D&Os should remain nonetheless vigilant. Cannabis companies are looking to become more than a fringe industry and changes in the cannabis industry will continue to impact those D&Os that lead their respective operations, for better or worse.
Originally published by Bloomberg Law.
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