Derivative Lawsuits Hit Publicly Traded Cannabis Companies

By Greg Kaufman and Amanda Oliveira

Did you know, that as an officer or director of a company, you can be sued by shareholders for actions or inaction in violation of your fiduciary duties?

Anyone watching the cannabis space is aware of the significant increase in class action litigation involving publicly traded cannabis-related businesses. These class action cases typically involve securities-related claims for failing to disclose material information or making false or misleading statements. Colloquially these actions are referred to as stock-drop suits. Other types of cases involving cannabis-related businesses include allegations of data breaches and violations of the Telephone Consumer Protection Act. CBD companies have been particularly susceptible to class allegations of improper marketing of CBD products. One area of exposure that has not received adequate attention is the threat of a derivative lawsuit involving publicly traded cannabis companies.

Derivative lawsuits are not new inventions, but these types of suits are beginning to impact relatively young public cannabis companies. As cannabis companies seek to develop new products and grab market share at breakneck speed, while navigating the complex regulatory environment they are subjected to, good corporate governance and careful communications with the investing public can be less of a priority. Derivative lawsuits, in addition to shareholder class actions, could be awaiting those that fail to fully appreciate the obligations imposed on public company officers and directors.

What are Shareholder Derivative Lawsuits?

Shareholders bring derivative suits when they believe officers and directors have taken certain actions, or failed to take actions, in breach of the fiduciary duties owed, resulting in harm to the corporation.  Officers and directors owe duties of loyalty and due care to the corporations and shareholders they work for. Derivative suits attempt to hold officers and directors accountable for such things as accounting errors, material misstatements/omissions, self-dealing, individual misconduct and other forms of corporate trauma. These suits are brought on behalf of the corporation against officers and directors of the corporation and seek remedies that inure to the benefit of the corporation itself.

Shareholder class actions differ in that they are brought by shareholders individually and as representative of other shareholders suffering similar injuries, seeking redress for such injuries to the class, not the corporation.  While these types of actions are different, shareholder class actions often spawn follow-on derivative actions.  Further, while successful class actions usually result in significant monetary settlements, in derivative suits, the damages are typically nominal, with the corporation agreeing to implement policy changes or corporate governance reform.

Pending Derivative Actions in the Cannabis Space

Three separate derivative suits have been filed by shareholders of companies in the cannabis space.  Shareholders have alleged the making of false statements, insider trading and the misleading of investors.

KushCo Holdings, Inc.

KushCo Holdings, Inc. is a marijuana packaging company. In May 2019, KushCo shareholders filed a derivative suit against the company’s officers and directors for allegedly misleading investors regarding material accounting errors.[1]  Specifically, the complaint alleges that the company failed to account for the costs of several mergers with other cannabis companies, taking place in 2017 and 2018, misclassifying company liabilities as equity and hiding stock volatility from investors. However, in its motion to dismiss, KushCo’s auditing company argued that this classification is permitted by relevant accounting principles. Further, the US Securities and Exchange Commission conducted an investigation into these allegations and decided against pursuing an enforcement action against the company.

The case has been consolidated with a related class action case and stayed (a request by KushCo) pending the resolution of a motion to dismiss in the class action case.[2]

Tilray, Inc.

Tilray, Inc. is a Canadian cannabis company incorporated in the US.  In 2019, Tilray entered a deal with Authentic Brands Group where the company would develop, market, and sell consumer cannabis products made with Tilray supplied cannabis.  A Tilray shareholder filed a derivative suit in Delaware against the company’s CEO, CFO and several board members for breaching their fiduciary duties regarding said deal.[3]  The complaint alleges that the company, through the defendants, made false and misleading statements about the deal and overstated its benefits while the agreement was in fact underperforming. And, that company leaders sold their shares with the insider knowledge that the partnership had been overhyped.  The case was filed on June 8, 2020.

CV Science, Inc.

CV Sciences, Inc. is a life sciences company that develops products using CBD.  Its lead product is a chewing gum containing CBD and nicotine, called CVSI-007. In June of this year, a CV Sciences shareholder filed a derivative suit against the company’s officers and directors in the Southern District of California, alleging breaches of fiduciary duties.  Specifically, the company has been accused of failing to inform its investors of a patent rejection that occurred in 2017.  The complaint alleges that while the company made claims of a market estimated at “greater than $2 billion” for CVSI-007, this estimate was based on the premise that it was patent-protectable.[4]  It is alleged, however, that even after the company’s patent was rejected, the company failed to inform investors of this fact, and continued to represent this value. According to the complaint, the price of CV Sciences’ stock plummeted following news of its alleged failure to disclose the rejection.

How do Derivative Actions Work?

Shareholder derivative suits are filed pursuant to state law and are unique and procedurally different from shareholder class action suits.  Typically, the decision to litigate on behalf of a corporation is reserved for the board of directors or the majority of shareholders.  Therefore, to bring a derivative suit on behalf of the corporation against its officers and directors for breaches of their fiduciary duties, shareholders must first demonstrate the necessity for their taking control and initiating the litigation.

To establish standing, shareholders must show that prior to filing the suit they either (1) made a demand on the corporation that its officers and directors act specifically to address the alleged harm to the corporation, which it wrongfully rejected, or (2) show that making such a demand would have been futile.[5]

Upon receipt of a demand or once shareholders file a derivative suit (arguing demand was futile), the board of directors often forms what is called a Special Litigation Committee (SLC). SLCs are tasked with taking adequate time to investigate the alleged wrong and determining whether the litigation is in the best interest of the corporation.  Most importantly, SLCs must be comprised of independent and financially disinterested directors.  In determining whether or not to comply with the demand, SLCs consider the magnitude and merits of the claim, the likelihood of recovery of damages or other relief, any possible detriment to the corporation (including indirect costs) and any remedial steps that were already taken and that could be taken to prevent reoccurrence of the alleged wrongs.[6]

At the conclusion of the investigation, the SLC provides a report with its recommendation. If the SLC determines that the suit is not in the corporation’s best interest, the board will reject shareholders’ demand. If the SLC determines that the suit is in the corporation’s best interest, it will recommend that the board take control over the suit.  However, the board may not remain neutral.

Demand was made, denied, and a derivative suit has been filed…

When the SLC determines that the derivative suit is not in the corporation’s best interest, the board typically will move to dismiss the complaint based on the Business Judgement Rule (BJR). The BJR shields directors’ decisions from judicial scrutiny by creating a strong presumption that the board acted on an “informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company.”[7]

Courts must determine whether SLC members were independent, acted in good faith and had a reasonable basis for the decision. Courts will dismiss complaints under the BJR where shareholders are unable to allege particular facts showing the SLC’s decision not to litigate was wrongful because it showed bad faith, lack of due care or fraud.  This often occurs with a showing that the process of investigation undertaken by the SLC was reasonable.[8]

Shareholders can avoid application of the BJR only by showing that in making its business decision, a majority of the board or SLC was not independent or was interested in the transaction.[9] Further, under Delaware law, if shareholders can prove an interested transaction occurred, the BJR will still apply if: a majority of disinterested directors or committee members approved the transaction through affirmative votes while aware of the material facts concerning the conflict of interest; shareholders, in good faith and with knowledge of the material facts concerning the conflict of interest, voted to approve the transaction; or the transaction was fair to the corporation at the time it was approved.[10]

Demand was futile and a derivate suit has been filed…

Alternately, shareholders can file a derivative suit without making demand on the corporation if making such demand would be futile.[11] In response, the board may, following an investigation by the SLC, move to dismiss the suit or choose to join the litigation.

Demand is considered futile, where the majority of the directors were either interested or not independent in relation to the alleged wrongdoing. There are two tests of demand futility, which depend on what is being challenged and the composition of the board.[12]

Where no specific board decision is being challenged, in order to establish demand futility, shareholders must make particular allegations in the complaint, raising reasonable doubt that a majority of the board on whom demand would have been made could have impartially considered such demand.[13]

Where a board decision is being challenged, and the directors who made the decision are the same as those to whom shareholders would have made the demand, shareholders must show that the board on whom demand would have been made is interested and dependent, or that the challenged transaction was not a valid exercise of the BJR to establish demand futility. The Supreme Court of Delaware provided that “where officers and directors are under an influence which sterilizes their discretion, they cannot be considered proper persons to conduct litigation on behalf of the corporation. Thus, demand would be futile.”[14]

If shareholders fail to demonstrate that demand was futile, the court will evaluate the motion to dismiss under the BJR.  However, if demand futility is found, the court will analyze the board’s attempt to dismiss by focusing on the board or SLC who made the decision to seek dismissal. The court will consider whether the directors or committee members involved were, in fact, disinterested and independent, or whether the investigation conducted provided a reasonable basis for the decision to move to dismiss. Under New York’s approach, courts are not permitted to consider the conclusions reached by the committee. Delaware law, however, allows a two-step test to evaluate SLC recommendations, providing that after examining the SLC’s independence and good faith, courts may consider matters of public policy in addition to the corporations’ best interest.[15]

If shareholders succeed in proving lack of independence and, when applicable, can overcome the court’s independent business judgment, the motion is denied, and shareholders get their day in court.

Additional Considerations Involving Parallel Lawsuits

The factual allegations supporting claims brought in derivative suits are similar or identical to the factual allegations brought by class action plaintiffs, which often results in parallel lawsuits against corporations.  Defending against two actions simultaneously can create disadvantages to the corporation and its officers and directors. Consequently, defendants may seek to stay the later filed lawsuit, which is typically the derivative action. Where SLCs believe its position in a derivative suit will negatively impact the corporations’ defense in parallel class action suits, it can request that the court stay the derivative suit until the class action has been resolved.

Parallel actions can also implicate the attorney-client privilege, whereby, in certain circumstances, plaintiffs are provided access to documents and information that would otherwise be shielded by the privilege. Several jurisdictions, including Delaware, have adopted a Fifth Circuit rule providing access of otherwise privileged communications between counsel and directors to derivative plaintiffs upon a showing of good cause.[16]  Good cause can be demonstrated by a variety of factors.[17]

Conclusion

 As cannabis companies look to equity markets for much needed capital, the legal risks they are subject to evolve in turn. The threat of shareholder class actions lawsuits is invariably part of the cost of doing business for publicly traded companies.  Recent derivative suits involving public cannabis companies suggest that these types of actions will also become the norm. Effective corporate governance can limit exposure to both types of actions. Nevertheless, lawsuits will be filed. Faced with derivative actions, it is important for corporations, and their officers and directors, to understand the nature and unique characteristics of derivative lawsuits. Proper application of the Best Judgment Rule and avoiding a finding of demand futility can best position corporations when they ultimately request that a court dismiss the derivative lawsuit.

About the Co-Author

Amanda Oliveira is an Associate in Eversheds Sutherland’s Litigation practice. She advises clients on various complex business litigation matters including securities enforcement, financial services, professional liability and commercial litigation.

____________________________________________________________________________

[1]In Re KushCo Holdings, Inc. Stockholder Derivative Litigation, 8:19-cv-00998 (C.D. Cal.)

[2]May v. KushCo Holdings, Inc., et. Al., No. 8:19-cv-00798-JLS-KES (C.D. Cal.).

[3]Lee Morgan v. Brendan Kennedy, et. al., 1:20-cv-00757 (Del.).

[4]Phillip Berry et al. v. Joseph Dowling et. al., 3:20-cv-01072 (S.D. Cal.).

[5]28 Fed. R. Civ. P. 23.1(a).

[6]La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313, 339 (Del. Ch. 2012).

[7]In re Walt Disney Co. Derivative Litig., 907 A.2d 693, 747 (Del. Ch. 2005).

[8]Halpert Enter., Inc. v. Harrison, 2007 WL 486561, at *5 (S.D.N.Y. Feb. 14, 2007) (finding audit committee’s actions were reasonable and in good faith because they hired an independent law firm to conduct a five-month investigation, interviewing dozens of people, reviewing numerous documents and producing a thorough report); United Copper Sec. Co. v. Amalgamated Copper Co., 244 U.S. 261, 264 (1917) (holding that courts should not interfere with a board decision not to pursue litigation unless “directors are guilty of misconduct equivalent to a breach of trust, or where they stand in a dual relation which prevents an unprejudiced exercise of judgment”).

[9]The focus of this analysis is on the board or committee who participated in or approved the allegedly wrongful transaction.

[10]DGCL §144(a).

[11]While a majority of states recognize the “futility” exception to making a demand, a few states’ laws do not provide for such an exception, and shareholder must make a demand prior to bringing the suit. See Warden v. McLelland, 288 F.3d 105, 111 (3d Cir. 2002) (finding “Pennsylvania law no longer recognizes a futility exception”); ING Principal Protection Funds Derivative Litig., 369 F. Supp. 2d 163, 170 (holding “demand must be made prior to the commencement of every derivative case, whether or not the directors are independent with respect to the matter subject to the demand”).

[12]The demand futility test is slightly different for New York. The New York test differs from Delaware in that it requires plaintiffs to allege demand futility with a greater degree of certainty.

[13]Rales v. Blasbank, 634 A.2d 927, 934 (Del. 1993).

[14]Accord Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).

[15]Zapata Corp v. Maldonado, 430 A.2d 779, 788 (Del.1981).

[16]Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970); see alsoIn re Oracle Corp. Derivative Litig.2019 WL 6522297 (De. Ch. Dec. 4, 2019) (finding it would promote Oracle’s best interest for the derivative plaintiff to have the benefit of the SLC’s work, including privileged documents produced to the SLC).

[17]Id. at 1104 (stating presence or absence of good cause can be shown by “the number of shareholders and the percentage of stock they represent; the bona fides of the shareholders; the nature of the shareholders’ claim and whether it is obviously colorable; the apparent necessity or desirability of the shareholders having the information and the availability of it from other sources; whether, if the shareholders’ claim is of wrongful action by the corporation, it is of action criminal, or illegal but not criminal, or of doubtful legality; whether the communication related to past or to prospective actions; whether the communication is of advice concerning the litigation itself; the extent to which the communication is identified versus the extent to which the shareholders are blindly fishing; the risk of revelation of trade secrets or other information in whose confidentiality the corporation has an interest for independent reasons”).