On May 6, 2021, Judge Kevin McNulty of the United States District Court for the District of New Jersey granted a motion to dismiss a putative securities class action against the largest cannabis company in Canada (the “Company”) and several of its officers for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5.  Ortiz v. Canopy Growth Corp., No. 19-cv-20543 (D.N.J. May 6, 2021).  Plaintiffs alleged the Company made numerous false and misleading statements and omissions about the Company’s inventory levels.  Although the Court held that certain of the Company’s representations regarding inventory and revenue in its financial statements were statements of opinion that were actionable, the Court ultimately dismissed these claims because plaintiffs failed to adequately allege scienter.

 

In early 2018, the Canadian government, in advance of the legalization of recreational cannabis later that year, granted the Company licenses to grow cannabis on two large sites in British Columbia.  However, these cultivation sites suffered from lighting and water problems, which meant they could only produce low-quality cannabis suitable for extract products like oils and gel caps.  In August 2019, the Company announced (i) the risk of a market glut of oils and gel caps, (ii) that its supply agreements permitted retailers to return products and negotiate price reductions, and (iii) that it had recorded an $8 million revenue reversal charge against the anticipated return of many of its products.  The Company later announced a $743 million write down for 2019 due to its overproduction of oils and gel caps.  Approximately $132 million of this charge was inventory impairments because the Company had to throw away excess product.  

With respect to the Company’s financial statements, plaintiffs alleged the Company’s inventory valuation was misleading because the Company failed to impair its inventory for expiration or obsolescence, resulting in a material overstatement of its value, and that the Company’s revenue recognitions were misleading because the Company failed to disclose that its sales contracts permitted retailers to return products and force price reductions “essentially at will.”   

The Court first held that the alleged misstatements were statements of opinion because the International Financial Reporting Standards (“IFRS”) accounting principles “make clear that valuations of inventory or revenue are plainly ‘not matters of objective fact’ but rather ‘are inherently subjective and involve management’s opinion.’”  The Court thus decided that the standard set forth in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 575 U.S. 175 (2015), which involved claims under Section 11 of the Securities Act of 1933, applies to claims under Section 10(b) of the Exchange Act.  Under this standard, an opinion statement will be actionable if the statement falsely affirms that the speaker actually holds the stated belief or if the statement contains embedded statements of fact which are false. And an alleged omission related to an opinion may be actionable if defendant “omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion” where those “facts conflict with what a reasonable investor would take from the statement itself.”  

Next, the Court held that, although the Company’s inventory valuation was an opinion, it was actionable under Omnicare because plaintiffs adequately alleged that the Company did not believe the valuation to be true at the time it issued its financial statements.  The Court pointed to a confidential witness’s statement that the Chief Marketing Officer relayed to him eight months before the Company’s first write-down that the Chief Product Officer believed the Company’s inventory could not be sold and should be written down.  The Court also held that the Company’s revenue recognition was misleading because the Company failed to disclose a material fact that “conflicted with what a reasonable investor would take from the statement itself”—namely, that the Company’s sales contracts gave retailers an absolute right of return and the “near-unilateral ability” to renegotiate prices.  

However, the Court ultimately dismissed plaintiffs’ claims for failure to adequately plead scienter.  The Court noted that “[a] statement by a confidential witness relaying secondhand the gist of a statement” was insufficient to establish scienter given that evidence also supported the more benign explanation that the Company produced significant inventory to establish itself as an early market leader but that the cannabis market grew slower than expected.  The Court also noted that plaintiffs failed to establish a “particular, non-generic” motive to mislead investors, pointing out that it would be “economically irrational to knowingly and needlessly produce perishable inventory . . . for no expected benefit.”  Finally, the Court noted that an independent auditor had scrutinized the Company’s financial statements and approved them, which “itself weighs heavily against scienter.”