Insights
Cannabis Directors and Officers Liability: Cause for Optimism?
June 24, 2021
Cannabis companies are confronted by the twin challenge of warding off an increasing number of expensive lawsuits brought against their directors and officers armed with inadequate available insurance policies to respond to those suits. Securities litigation, shareholder and investor disputes, allegations of mismanagement and actions by regulators have proliferated in an environment of challenging regulatory compliance and market volatility for the cannabis industry.
Meanwhile, the market for directors and officers (D&O) insurance currently is difficult for all industry sectors, but D&O insurance for cannabis companies rightly has been called “a hard market within a hard market.” Available polices have been exceptionally expensive with inadequate coverage limits, problematic exclusions and lack of reinsurance. The dearth of D&O insurance results in companies that are more exposed to volatility from risky decisions and less able to attract top executives whose personal assets may not be fully indemnified or protected when litigations are protracted.
The Vicious Cycle of Cannabis Directors and Officers Liability
This dynamic has led to a vicious cycle. Because traditional financing options remain unavailable to cannabis companies due to federal illegality, most have instead obtained capital through the use of private investment, foreign exchanges, an initial public offering, a special-purpose acquisitions company (SPAC) or a reverse takeover of an existing public company. Disclosure of risks to investors through private placement memoranda or other means can be a significant challenge for cannabis operators, who are confronted with a regulatory minefield. When faced with pressure by investors to turn a profit, some cannabis companies have been tempted to violate state regulations as they weigh strict regulatory compliance versus growth with only limited sources of new capital available.
These perceived omissions and outright regulatory violations have given rise to substantial management liability exposure that, to date, has been largely uninsured or underinsured. As the losses pile up and insurers retreat from the market, cannabis companies wishing to attract badly needed talent cannot locate the insurance coverage demanded by would-be directors and officers. This has resulted in a predictably vicious cycle of management errors, claims, losses, insurance premium hikes, policy renewal declinations and carriers exiting the market.
Although volatility and uncertainty will continue to trouble the cannabis industry for some time, there are signs of an emerging paradigm that may help to break this cycle and allow for cannabis companies and their insurers to return to an intended symbiotic relationship. Below, we discuss what coverage is afforded by D&O insurance policies, the genesis of D&O lawsuits filed against cannabis companies, and how federal legalization and other trends may impact future cannabis D&O exposures.
Key Elements of the D&O Insurance Policy
D&O insurance policies provide three separate types of coverage, called Side A, Side B and Side C coverage.
- Side A is liability coverage for the individual directors and officers, where the insurer agrees to indemnify the individual directors and officers for all loss that those individuals become legally obligated to pay arising out of wrongful acts committed in their capacity as an officer or director. Side A coverage typically responds to reimburse the personal liabilities of the covered directors and officers where the company cannot or will not provide indemnification.
- Side B includes coverage for the payments a corporation makes on behalf of its directors and officers for loss resulting from a claim alleging a wrongful act.
- Side C, known as entity coverage, reimburses the insured company for liability that arises out of defined claims brought against the company. Side C coverage was created by the need to avoid costly disputes over allocating limited policy proceeds between the company and individually named directors and officers. One often sees Side C coverage triggered in the context of securities claims brought against publicly held entities.
D&O policies are “claims made” policies that provide coverage for claims made (and reported in the case of “claims made and reported” policies) during the applicable policy period. D&O policies typically contain a “retroactive date” that restricts coverage only to claims that arise out of wrongful acts occurring after a certain date before policy inception. “Related claims” provisions, which provide that a series of claims arising from related facts or transactions constitute a single claim for purposes of coverage, are often included. These provisions may either narrow coverage (for example by limiting two or more related claims to a single claim) or expand coverage (by covering claims based in part on acts or events that occurred outside the policy period).
Genesis of Cannabis D&O Lawsuits
Though marijuana’s classification within Schedule 1 of the Controlled Substances Act (CSA) continues to plague the cannabis industry with unique legal and business challenges, most lawsuits that have targeted cannabis companies and their management are not related to the federal illegality of cannabis. Most are based instead on allegations of mismanagement, losses caused by noncompliance with state regulations, or failure to adequately disclose risks to investors and shareholders. Examples are described below.
Types of Cannabis D&O Lawsuits
Litigation against corporate directors and officers may be brought by company shareholders or by third parties.
Shareholder Litigation
Shareholders may sue on their own behalf or in the name of the corporation, which is called a derivative suit. Shareholder suits frequently allege breach of the director’s or officer’s fiduciary duties of care and loyalty to the company. This type of litigation often results in issues of conflict between the shareholders, the company, and the individual director and officer defendants. Complex securities litigation results when shareholders sue a publicly traded company.
Third-Party Litigation
The plaintiffs in third-party litigation often are the company’s employees, business partners, competitors, creditors, or governmental regulators and other authorities. Third-party suits typically name both the corporation and individual directors and officers, who are often aligned with the company in their collective defense of the case.
Cannabis Securities Litigation
Publicly traded companies listed on U.S. exchanges are prohibited from making false or misleading statements or omitting information in connection with the sales of securities. Securities lawsuits against cannabis companies are becoming more frequent and more costly. According to Stanford Law School's Securities Class Action Clearinghouse, 28 securities class action lawsuits were filed against U.S. and Canadian cannabis businesses within the past seven years. The majority of those were initiated in the past two years alone.
Recent examples include securities lawsuits brought against:
- Canopy Growth Corporation for alleged failure to disclose weak demand for softgel and oil products.
- HEXO Corp. for allegedly misstating its inventory and failing to report other operational problems.
- Chronos Group for issuing a revised earnings report that caused the company’s stock to drop.
- Trulieve Cannabis Corp. for allegedly misleading investors about the risks of crop contamination with mold.
- Tilray Inc. for alleged omissions in a proxy statement regarding key financial figures tied to a proposed $3.8 billion merger with Aphria Inc. to create the world’s largest cannabis venture.
Federal Legalization’s Impact on Cannabis D&O Litigation
Despite a new administration and Democrat-controlled House of Representatives, broad federal legalization in the form of the Marijuana Opportunity Reinvestment and Expungement (MORE) Act or the “Schumer/Booker/Wyden” Bill still is relatively unlikely at this time. That delay may actually prove to be a good thing for the cannabis D&O insurance market, which would likely benefit more in the short term from the Secure and Fair Enforcement (SAFE) Banking Act than a broad legalization bill. Although the removal of marijuana from the CSA should have a significantly positive impact on cannabis D&O exposures in the long term by allowing the industry to mature like other regulated markets, one should expect a tumultuous transition period following legalization.
Reconciling the Intrastate Model with Interstate Commerce
Though it may seem counterintuitive, the risk of securities lawsuits and other D&O litigation may actually proliferate in the wake of marijuana’s removal from the CSA. The primary reason is the need to reconcile the vastly differing state regulatory models with interstate commerce.
The collision between interstate commerce and intrastate cannabis regulatory structures will result in additional legal uncertainty and compliance hurdles. The intrastate model was born out of necessity due to the federal illegality of marijuana. Each adult-use and medicinal state has developed its own unique regulatory structure, with more recent legalized states employing lessons learned by implementing or discarding the more experimental ideas of the early states. As a result, many states use starkly different regulatory approaches.
Regardless of the variations between states, the intrastate model means that all cannabis operations are independently self-contained within each state, with no cannabis products allowed to cross state lines. This requires multistate operators to recreate entire supply chains in each new state, resulting in difficult problems with product uniformity and quality control and the inability to scale operations due to inefficiencies caused by duplication of overhead and labor costs.
Many seem to believe that the state models will be swept away by the stroke of a pen in Washington; this is simply not the case. The state regulations will continue to exist – and be enforced – the day after Congress passes marijuana legislation. Products that are compliant in the state of origin may fall out of compliance upon crossing the border of a new state. Fortunately, the various state cannabis regulators are now communicating with each other to attempt to facilitate this inevitable transition. Interstate commerce will nevertheless certainly result in a period of increased confusion as companies attempt to realign their operations to stay compliant in a starkly transformed regulatory environment.
Interstate commerce also will eventually tear down the artificial supply-and-demand forces created by the intrastate regulatory model. So-called “export” states will cultivate and transport marijuana to “import” states that have high consumer demand but limited ability to grow large amounts of high-quality marijuana. Meanwhile, cannabis manufacturing operations should gravitate to locations with the most competitive property prices, labor costs and tax rates, similar to the way other industry sectors choose to locate their businesses.
In sum, interstate commerce will bring significant new disruptive market forces that will increase uncertainty, complicate compliance, realign supply with demand, and result in surprising winners and unforeseen losers. That is a potentially ripe environment for D&O litigation.
Impact of the SAFE Banking Act
The SAFE Banking Act is more likely to pass in Congress this year than a broad legalization bill for cannabis. The bill creates a safe harbor for financial institutions, including banks, credit unions and insurance companies, which would not be liable or subject to federal forfeiture action for providing financial services to a cannabis-related business.
If passed, the SAFE Banking Act should have a meaningful impact on the factors that have prevented most large commercial insurance carriers – and particularly those that are publicly traded – from underwriting cannabis D&O and other management liability policies. This will benefit cannabis businesses through more competition among insurers, lower premiums and deductibles, higher limits, more choice in specialty coverages such as D&O insurance, and reinvigoration of an anemic cannabis reinsurance market.
Alternative insurance models such as captives and risk retention groups also may help underwrite future D&O risks. Up to now, few cannabis captives have been formed due to fundamental problems − states have refused to domicile cannabis captives and there has been a lack of fronting carriers and reinsurance. These barriers largely have been lifted, with several states and offshore jurisdictions now domiciling cannabis captives, and an increased availability of fronting paper and reinsurance. Passage of the SAFE Banking Act should assuage any remaining concerns by regulators who are asked to approve cannabis captives and risk retention groups, and by cannabis companies looking at a potential offshore captive domicile. The captive model for D&O coverage presently exists in Canada; it has been reported that Canadian cannabis company HEXO Corp. has set aside $24 million in an insurance captive that it estimates will save up to $12 million in annual premiums.
The SAFE Banking Act also should benefit the insurance industry by reducing the frequency and severity of cannabis D&O insurance claims and losses. This may be achieved by disrupting the “vicious cycle” described earlier in this paper. Specifically, banking reform will help to normalize the business operations of cannabis companies and provide access to commercial bank loans and other sources of capital that are currently limited or unavailable. If the cannabis industry is seen as the next unicorn in the business world, we can expect to see a greater pool of talent for prospective directors and officers, who likely will demand robust D&O insurance coverage. Cannabis companies should find better stability with access to top talent and the full suite of risk management tools available to other market sectors. These banking and insurance protections are good for cannabis companies, their insurers and the millions of consumers who have embraced regulated cannabis products.
Compliance and Communication Are Important
Although insurance is an important part of any company’s risk management strategy, regulatory compliance and effective communication are critical to mitigating risks from management liability. As highlighted above, it can be a delicate tightrope to walk in connection with the regulatory scrutiny on the state and federal levels involving a cannabis-related business. The smart recommendation would be to establish clear chains of responsibility within the organization for regulatory compliance.
It also is important to follow best practices when making public statements about a company's performance and future prospects. The company should speak with one voice when communicating with investors, consumers, regulators and the public. Designating someone to act as chief information officer can be helpful, even in an informal role. Companies may wish to establish vetting procedures for public statements and rely on the assistance of qualified in-house and outside counsel before important information is disclosed to investors and the public. These public statements readily can become the basis of the cannabis securities litigation described above.
The importance of clearly communicating the cannabis company’s business operations and potential exposures also applies when shopping for a D&O policy. With a limited D&O insurance market, the greater the amount of transparency provided to underwriters by insureds, the better the insurers can serve their insureds. This is especially important with D&O insurance, as the typical lower limits and sub-limits could place the personal assets of the director or officer more at risk. To that end, insureds should read their insurance policies carefully and understand the coverage provided.
Conclusion
The growth of the cannabis industry has been steady over the past couple of years, but with growth comes growing pains. The limitation on insurance available for cannabis companies has been most notable when it comes to available coverage for directors and officers. As the legalization of cannabis expands, regulatory and litigation risks will evolve. Proposed legislation, such as the SAFE Banking Act, should result in increased insurance capacity in the cannabis market.
Development of the D&O insurance market hopefully will lead to greater insurance protection for the future leaders of the cannabis industry. One should expect the removal of marijuana from the CSA to have a significantly positive impact on cannabis D&O exposures in the long term, despite a likely tumultuous transition period following legalization while companies adjust to a new operating environment. Although the risks likely will continue to be greater for directors and officers at cannabis companies compared to traditional companies, there should be optimism for greater capacity of D&O insurance as the cannabis industry moves into its next phase of growth.