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Southern District Of New York Dismisses Putative Class Action Against Canadian Cannabis Producer For Failure To Plead Falsity And Scienter
03/17/2021On March 9, 2021, Judge Naomi Reice Buchwald of the United States District Court for the Southern District of New York granted a motion to dismiss a putative class action complaint against a Canadian cannabis producer (the “Company”), certain of its officers and directors, and its underwriters that asserted claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”) and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5. In re HEXO Corp. Sec. Litig., No. 19-CV-10965 (S.D.N.Y. Mar. 9, 2021). Plaintiffs alleged the Company made misrepresentations about one of its key supply agreements, a new production facility, and its expected revenue. The Court dismissed the claims under the Securities Act because they were based on impermissible hindsight pleading and the Exchange Act claims for failure to plead falsity and scienter.
In 2017, the Company entered into a supply agreement with a Canadian government-run dispensary (the “Dispensary”). Under the agreement, the Dispensary committed to purchase 20 tons of cannabis within the first year of legalization of adult-use recreational cannabis. The agreement contained a “take-or-pay” (“ToP”) provision under which the Company could demand payment for the full 20 tons even if the Dispensary did not order the full amount. In March and June 2019, the Company acknowledged lower-than-expected demand but stated that it remained optimistic that the Dispensary would meet its obligations under the agreement because the cannabis market was “ramp[ing] up.” At the same time, the Company expressed confidence that it would meet its earnings target for 2020, especially after its recent acquisition of a new production facility. In November 2019, however, the Company disclosed that its newly-acquired production facility was operating without a license, which had forced the Company to suspend operations in July 2019. Moreover, in March 2020, the Company announced that it released the Dispensary from the ToP provision to preserve the business relationship. The Company also withdrew its revenue guidance and announced a significant inventory impairment. Plaintiffs alleged the Company misrepresented (i) the terms of the agreement with the Dispensary; (ii) the failure to obtain licenses for the newly-acquired production facility; and (iii) expected revenue.
The Court first considered the claims under the Securities Act, which included allegations that the offering materials violated Items 105 and 303 of Regulation S-K because they allegedly failed to disclose known risks to the Company. Noting that plaintiffs are not permitted to rely on “hindsight pleading,” the Court held that plaintiffs failed to allege that the Company knew at the time of its IPO—just three months after legalization—that demand for legal cannabis would remain stagnant and that the Company would release the Dispensary from the ToP provision. The Court also held that, even if plaintiffs had adequately alleged a misrepresentation, they would not be actionable under the “bespeaks caution” doctrine because the offering materials contained sufficient cautionary language discussing various “supply risks.” Finally, the Court held that lead plaintiffs lacked standing to bring a Section 12(a)(2) claim because neither plaintiff purchased Company securities on the date of the IPO.
As to the Exchange Act claims, the Court first held that the Company’s statement that it expected the Dispensary to meet its purchase obligations was no more than “misguided optimism.” The Court rejected plaintiffs’ argument that the description of the ToP provision suggested it “amounted to a guarantee” and thus became a misrepresentation when the Company decided not to enforce the provision. Noting that plaintiffs’ argument “border[ed] on the risible,” the Court explained that disagreements about the Company’s business judgment are not actionable and that the Company was under no obligation to inform investors that it might not enforce the ToP—a disclosure the Court noted would disincentivize the Dispensary from honoring the agreement.
With respect to statements concerning the newly-acquired production facility, the Court rejected plaintiffs’ argument that the Company should have disclosed the licensing issues immediately in July 2019. The Court emphasized the “bottom line reality” that plaintiffs’ “entire lawsuit [wa]s premised on insufficient demand for [the Company’s product],” and that there were no allegations that the Company was unable to supply enough cannabis as a result of the facility’s licensing issues. The Court also held that allegations that the company should have made disclosures earlier than it ultimately did is not a basis for a securities claim. With respect to statements regarding expected revenue, the Court held that plaintiffs had not adequately alleged that the Company knew of information that contradicted its disclosures at the time the statements were made.
Finally, the Court considered and rejected plaintiffs’ scienter arguments for the Exchange Act claims, noting plaintiffs’ “abject failure to identify any reports or statements containing adverse facts to which defendants had access at the time of the statements.”
