Raising money in the cannabis industry, like most everything else in the space, is no walk in the park and presents a landmine for those tasked with raising and spending capital. This month, two federal district court opinions reminded capital raisers of these truths and the dire consequences of violating securities laws. In the first opinion, a federal judge in Michigan allowed the plaintiffs claiming to be defrauded investors to maintain securities-fraud claims against the operators of a marijuana dispensary, rejecting the idea that a federally illegal business is immune from fraud claims. In the second, a federal judge in California hit a cannabis holding company and its executives with more than $30 million in disgorgement and civil penalties in an SEC enforcement action, along with permanent officer-and-director injunctions.

Case One: A Marijuana Investment Gone Sideways in Michigan

In Guys Management, Inc. v. Great Lakes Holistics Muskegon, Inc., a group of five investors (“5 Guys”) wired $1.5 million to buy a 22.5% stake in a Muskegon dispensary joint venture. The investment involved a private placement memorandum (PPM) and a series of representations from two officers of Redbud Roots, the venture’s part-owner. The problem, according to 5 Guys, was that the money did not go to the joint venture but instead landed in the parent company’s accounts, where it covered payroll (including roughly $250,000 in salaries for each of the founders) and other operational expenses. Ultimately, the dispensary failed, and 5 Guys lost most of its investment.

In response to 5 Guys’ lawsuit asserting securities fraud and related claims, the defendants raised the “illegal contract” defense often seen in cannabis litigation. That defense asserts that because marijuana remains illegal under the federal Controlled Substances Act, the whole enterprise was an illegal contract that federal courts should not enforce. This illegal contract defense, known as the Kaiser Steel doctrine, is legitimate (see Kaiser Steel Corp. v. Mullins, 455 U.S. 72, 77 (1982), but Chief Judge Hala Y. Jarbou drew a careful line through it.

The court held that the illegality defense barred the claims that would have required the court to validate the illegal venture itself, such as 5 Guys’ breach of fiduciary duty and shareholder oppression claims. The court dismissed those claims, finding that awarding damages on those theories would effectively bless the illegal enterprise by treating the defendants as if they owed and should have honored the duties of a lawful cannabis company.

The court held, though, that the fraud claims survived the illegality defense. It reasoned that ordering the return of a defrauded investment is not enforcing an illegal contract but rather constitutes restitution. The court also rejected an argument that a marijuana company’s assets are categorically untouchable in federal court, noting that such a rule would make every cannabis company “immune from liability in federal court on any claim.” Notably, the court found the PPM’s provision disclaiming reliance on prior statements did not automatically defeat the investors’ reliance, and it viewed the operators’ undisclosed 10% “cut” of the venture’s revenue as the type of half-truth that could support a fraud claim.

Case Two: The SEC Collects in California

The second decision, SEC v. American Patriot Brands, Inc., shows what it looks like for those committing securities fraud to face the music. American Patriot Brands (APB), previously a food-truck company called “The Grilled Cheese Truck, Inc.,” raised more than $50 million from investors across four securities offerings to begin operating in the marijuana space. The SEC had already won summary judgment that APB, its subsidiaries, and its CEO and COO violated the anti-fraud provisions of the federal securities laws. This latest order was about punishment.

Judge Anne Hwang ordered the entity defendants to disgorge nearly $24 million (including prejudgment interest), and ordered the CEO to disgorge more than $2.6 million tied to inflated compensation and a litany of personal expenditures, including hotels, spa visits, clothing, flights for non-employees, and prepaid cards for family members, all found to be funded with investor money. The court entered permanent injunctions, a conduct-based injunction barring the two executives from participating in securities offerings except for their own personal accounts, and permanent officer-and-director bars against both. It then assessed civil penalties of more than $2.6 million against the CEO, nearly half a million against the COO, and third-tier per-violation penalties against the entities in excess of $8 million.

Two notable findings of the court were, first, that tens of millions in “legitimate business expenses” should not offset any disgorgement because those expenses were used “to perpetuate a fraudulent operation.” Second, the court denied a portion of the SEC’s disgorgement request because the SEC couldn’t prove the relief defendant actually received (rather than merely passed along) the funds. Even the government must trace the money.

How Cannabis Businesses Can Avoid a Similar Fate

• Treat every raise as a securities offering.
  • Assume the securities laws apply, line up an available exemption, and make sure your PPM and investor decks are accurate and complete.
• Spend the money where you said you would.
  • If investors are told their capital funds a specific entity or project, route it only there and be able to prove it.
    • Diversion, even to an affiliated company for “operations,” was a fatal fact for 5 Guys.
• Disclose the whole truth.
  • Related-party fees, management cuts, revenue skims, and non-pro-rata distributions all need to be on the table.
  • A technically true statement that leaves investors with a false impression can be actionable silent fraud.
• Don’t count on boilerplate language to save you.
  • Non-reliance and disclaimer language is not impenetrable; courts treat it as one factor, not a complete defense to affirmative misrepresentations.
• Keep clean books and pay yourself reasonably.
  • Excess compensation and personal expenses funded by investors are the first things a disgorgement analysis targets, and “legitimate expense” offsets evaporate when the expenses derive from fraud.
• Get securities counsel before, not after.
  • Both cases were eminently avoidable with disciplined disclosure, fund segregation, and governance up front.

Cannabis may occupy a legal gray area, but fraud does not. As these two decisions confirm, courts and regulators won’t hesitate to hold cannabis operators to the same standards as everyone else who asks the public for money. And the “it’s all illegal anyway” argument is far more likely to cost operators than to save them. Expect plaintiffs’ lawyers and the SEC alike to keep citing both.