Cannabis Sector Litigation on Rise

The risk of litigation increases as more edible, topical and extract products come to market, while future retailers are lining up for store licences

In a sure sign that it is maturing, the cannabis industry is beginning to face more litigation.

“We’re seeing an uptick in securities class actions and regulatory activity as it relates to cannabis companies,” says Andrea Laing, head of the Toronto Securities Litigation group at Blake Cassels & Graydon LLP in Toronto.

Securities class actions are claims brought on behalf of classes of shareholders, generally after there’s been a share price decline. Cannabis has been volatile as an industry, with share prices starting to drop in 2019.

“There is an opportunistic element to some securities class actions,” says Laing. “So, when there’s a significant share price drop due to a restatement or some form of practice disclosure, it is not unusual in our market to see a class action being commenced,” she says, adding that there are a number of class actions in play now.

The legal cannabis industry is still new in comparison with other industries, and the recreational cannabis industry has been in operation for just two years this October.

“You can start to see . . . some companies having harder times. Some disregarded contractual obligations . . . early on, and companies didn’t have the appetite to sue for many reasons,” says Matt Maurer, head of the Cannabis group for Torkin Manes LLP in Toronto. 

“I think [litigation is] going to continue to increase as time goes on, but right now I’m seeing, too, challenges against regulatory bodies for making decisions or refusing to make decisions,” he says. “I’m seeing regular breach of commercial agreements, as companies are starting to fall on harder times, which many will blame on [COVID-19]. But many were one foot in the grave before COVID came along.”

There has been a “cavalier” attitude by some in the industry as it burgeoned, Maurer says. Now, cultivators are seeing troubles play out more, with three creditor protection applications already filed this year and cannabis businesses trying to sell and close facilities.

These problems will continue, Maurer says, as the attitude is now compounded by financial troubles that will continue from the downturn in the industry that began in 2019. He predicts more insolvencies and bankruptcies, lawsuits launched when suppliers aren’t paid and there are rent defaults, as well as
labour issues if employees aren’t paid.

“It’s going to impact not an insignificant amount of cultivators,” he says, estimating that, of the 250 to 300 cultivators now in Canada, 25 to 50 may be faced with litigation and more.

A proliferation of securities class actions in the cannabis sector last year included many against Canadian companies traded in both Canada and U.S., so companies were sued in both countries simultaneously, says Linda Fuerst, a litigator and senior partner in Norton Rose Fulbright Canada LLP’s Toronto office. This had the effect of increasing companies’ legal defence costs significantly, as well as damage claims.

Securities class actions against cannabis producers are the result of adverse events occurring and circumstances changing, which have a material adverse impact on the company’s valuation. “This could give rise to an allegation that the company’s prior public disclosures were misleading and risk securities class action or, for example, if the company’s financial controls were not
robust enough,” says Fuerst.

One notable class action, although not in the securities sphere, is against Organigram, a licensed producer of medical marijuana, which in 2017 initiated a voluntary recall of multiple lots of cannabis after testing revealed trace amounts of pesticides not authorized for use on cannabis. The company also issued refunds to customers. The plaintiff alleged the cannabis she purchased caused her
nausea and vomiting and initiated a proposed class action, which included claims arising from breach of contract, statutory breaches, negligent design, development and testing, negligent manufacturing, negligent distribution, marketing and sale, waiver of tort and unjust enrichment.

The class was certified by the Nova Scotia Supreme Court in February 2019, but the Court of Appeal overturned part of that decision on April 30, including relating to the negligence claims. The court found there was insufficient proof that the plaintiff’s adverse health effects resulted from a contaminated product rather than from other side effects of cannabis smoking and that the phrase “adverse health consequences” was too general to serve as a description of damages. As a result, class members will no longer be able to bring claims seeking damages for any personal injuries incurred as a result of consuming Organigram’s recalled cannabis.

The case raises consumer protection allegations, says Fuerst, as the plaintiff alleged that the company made misrepresentations about the product being free of unauthorized pesticides and failed to inform consumers of health risks associated with the product.

“As in other industries, companies come under attack if public disclosure is seen to be misleading and people consider whether to take proceedings against the officers and directors,” Fuerst says. “It’s important for cannabis companies, like all companies, to have strong internal compliance and quality controls in place.”

This starts with employee education about a company’s obligations under securities law, and companies should also have anonymous, robust whistleblowing systems.

“It’s always better for a company to find out about a problem from an employee or internal source, rather than from a lawyer bringing a class action against a company,” she adds. Especially in a securities law context, where regulators maintain a credit-for-co-operation policy, a company going to a regulator first to self-report and then self-correcting will be given more leniency for the breach by the regulator.

“That’s why finding out first about a problem is so important.”

There is the potential for litigation over product liability to increase with the introduction of more cannabis products into the market, says Maurer. In October 2019, when cannabis edibles, topicals and extracts were legalized, many new categories of products began “to make their way onto the shelves just before Christmas,” he says, and food products generate more liability than plant products.

“The industry is still new, and I think it’s just a matter of time before litigation over product liability ramps up more,” he says, including as a result of supply chain problems.

Cannabis companies would do well to consider directors and officers liability insurance, says Laing. “I think some of them find it challenging to achieve sufficient liability limits; they are finding D&O liability insurance expensive,” as the cannabis industry does not yet have an established track record, “and generally it’s a hard market right now.”

However, it is critical to ensure officers and directors are properly protected against securities class actions, says Laing, adding that she advises clients to try to acquire more limits when their policies come up for renewal, especially as “there will continue to be a risk due to the additional volatility in the market due to COVID-19.”

It’s clear that securities regulators are paying close attention to the cannabis industry, and D&O liability insurance can be one way cannabis companies protect themselves against balance-sheet exposure and regulatory investigations, says Laing.

Other potential litigation risks arising out of the pandemic are from employees who may allege they didn’t receive sufficient protection or information about risks in the workplace and subsequently became infected with the virus, says Fuerst. And there may even be criminal consequences for incidents prompting a product recall, where the cannabis product may cause serious adverse health effects.

The COVID-19 pandemic also means that cannabis companies — like others that have issued guidance on future financial results — will need to consider whether that guidance needs to be changed or revoked/withdrawn, says Fuerst. Public companies are also required to make material risk disclosures in certain public filings, as applicable, “and that should be revisited in light of COVID-19.”

The pandemic may still have a silver lining for the cannabis industry, though, says Maurer.

Before, cultivators were experiencing growing pains. “They had trouble growing at the scale and at the quality they wanted, they overextended themselves in some instances, they made business decisions that turned out not to be . . . profitable or wise and had to scale back. Then COVID-19 comes along, and cannabis is deemed an essential product by the federal government because of the medical [use], so those businesses are allowed to continue to operate at the processing level, and now there’s a group of companies that are allowing people to continue to work.”

This is also a good time for cannabis retailers, he adds, as provinces such as Ontario moved to “a wide-open licensing system” this year from the original lottery system. “Those businesses are trying to navigate being open and doing curbside pickup” due to COVID-19 and using online payment systems. And hundreds
of businesspeople are in line to be licensed in order to open stores, he says.

His retail clients “are grateful they can pay employees and stay open,” Maurer adds.
“Delivery [service] was not in the cards for these privately owned stores before, but now it’s permitted with COVID. It’s certainly put the cannabis industry in a place where it wouldn’t have been without COVID.”

Lexpert Copyrights © Thomson Reuters Canada Limited