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In a new business, it is nearly inevitable that mistakes will be made. As it relates to reporting, mere calculation errors happen all the time. However, when a company is operating as a reporting issuer, these errors can potentially lead to losses for its shareholders. It is important when operating any business to ensure that all documents being released to stakeholders accurately reflect the company’s position. If the documents are incorrect it may lead to shareholder disputes.

Class action involved a cannabis corporation that performed several exchange transactions with third party

The dispute in Badesha v Cronos Group Inc revolved around the eligibility of shareholders to bring an action based on misrepresentations against Cronos Group Inc. The shareholder who brought the action, Badesha, alleged that Cronos’s public filings in 2019 contained nearly 7,500 separate misrepresentations. When the alleged misrepresentations occurred, the price of Cronos’s shares dropped.

Cronos focuses on “the cultivation, manufacturing and marketing of cannabis and cannabis-derived products for medical and recreational purposes.” Its products are sold in Canada and in countries abroad where cannabis is legal. In March 2019, Cronos had two transactions with a third party where Cronos supplied cannabis dry flower in exchange for cannabis resin. Cronos reported revenue for these two exchange transactions at the end of Q1, ending March 31, 2019, as well as Q2, on August 8, 2019.

In September 2019, another exchange transaction took place between Cronos and a third party. Once again, the cannabis company reported the revenue from these transactions for Q3 on November 12, 2019.

Cannabis corporation updated its financial statements to exclude millions from previously reported revenue

In February 2020, Cronos announced that it had to delay its 2019 Q4 financial statements. In a press release in March 2020, it was stated that “Cronos was unable to complete the report on time due to several bulk resin purchases and sales of products through the wholesale channel and the appropriateness of revenue from those transactions.” Cronos’s share price subsequently dropped 8.10%. The same month, another press release was issued stating that the unaudited financial statements from Q1, Q2, and Q3 from 2019 were to be reissued and restated. After this disclosure, the share price dropped an additional 8.40%, and then a further 13.46% days later.

The company sought to reduce the reported revenue for Q1 and Q3 by $2.5 million and $5.1 million, respectively. By the end of March 2020, Cronos had released restated documents for Q1, Q2, and Q3 of 2019. In its 2019 Management Discussion and Analysis, it explained the weaknesses within its internal controls with regard to financial reporting. This document also outlined measures the company intended to adopt to remedy the identified shortcomings. After this disclosure, the share price dropped yet again by 10.24%.

Shareholder alleges cannabis corporation felt pressure to inflate revenues

One of Cronos’s shareholders filed a statement of claim to bring a class action on behalf of all shareholders who held shares during the relevant period. The key shareholder, Badesha, alleged that Cronos “orchestrated a scheme to inflate its reported revenue figures” due to pressure to show increased revenue and sustainable growth. 

In the quest for inflating revenues, Badesha’s claim alleged that Cronos failed to account for the inventory transferred in the transactions when reporting revenue for 2019 Q1 and 2019 Q3. The claim attributed these failings to a series of nearly 7,500 misrepresentations made by the company.

The motion judge denied leave to proceed with the claim

At the initial hearing before the motion judge, Badesha’s claim was denied for two reasons. First, Badesha had not shown that each alleged misrepresentation was a material contributor to the decrease in share price. Instead, the motion judge attributed the drop to the COVID-19 pandemic. Second, the motion judge held that there was no cause of action because none of the alleged misrepresentations were made by the individual defendants.

The appeal of this decision was heard by the Ontario Court of Appeal. Unlike the motion judge, the Ontario Court of Appeal found that there was a “reasonable possibility of success” in Badesha’s claim.

The motion judge erred in dismissing the claim based on technical grounds

The Court of Appeal considered the test for obtaining leave under the Securities Act. Under the Act, any person or company who acquires or gets rid of an issuer of shares in a specified time period after a misrepresentation occurs, has a right of action. 

In the case where multiple misrepresentations are similar, they can all be treated as a single misrepresentation. Therefore, the Court found that the motion judge erred by requiring that every single alleged misrepresentation (nearly 7,500) needs to be explicitly held to have contributed to the drop in share price.

Whether the misrepresentations were to be treated as separate misrepresentations or as a single misrepresentation was not a decision of the motion judge to make. Rather, it is an issue for trial. However, the motion judge should have conducted its analysis as if the claim were based on a single misrepresentation as well. 

The Court of Appeal explained, “The…test is about weeding out unmeritorious claims. It is not about dismissing potentially valid claims on technical grounds.” The Court then applied the test to determine whether leave could be granted to move forward with the action.

The motion judge’s assessment was tainted by his error

The Court of Appeal determined that if the motion judge assessed the claim properly, he would have determined that “there is a reasonable possibility that [Badesha] will succeed in the action.” Although there is a requirement for the Court of Appeal to show deference to the motion judge’s assessment, in this case, the assessment had been affected by the motion judge’s understanding of the claim, resulting in a flawed discussion about his view of the pleading. The determination did not touch on whether the evidence demonstrated that leave should be granted. 

The appeal was allowed and the Court of Appeal granted leave to proceed with the misrepresentation action under the Securities Act. The Ontario Superior Court of Justice will decide on the matter of whether the action qualifies as a class proceeding.

Contact the Bader Law in Mississauga for Support with Your Cannabis Enterprise 

Bader Law helps businesses navigate the complexities of the cannabis industry in Ontario. Our knowledgeable business lawyers assist clients in obtaining Retail Store Authorizations and ensuring ongoing compliance with the shifting changes in cannabis regulation. We create dynamic, creative legal solutions for cannabis newbies and experienced operators. We also represent clients with corporate financing and information technology law, amongst other areas. Our firm proudly serves clients in Mississauga and throughout the Greater Toronto area. To schedule a consultation, call us at 289-652-9092 or reach out online.