Cannabis and SPACs: the potential convergence of growing industries and opportunities for D&O underwriters to assess risk
Legal sales of cannabis in the United States set a new record of US$17.5 billion in 2020. This market is projected to grow to US$70 billion annually by 2028 according Grand View Research. The increasing size of the legal cannabis market has drawn more investors and corporations into this industry. Rather than go through an initial public offering (IPO), investors and cannabis companies increasingly turn to special purpose acquisition companies (SPACs) to enter the public market. The convergence of these potentially high risk trends is likely to be of interest to D&O insurers and their underwriting and claims professionals.
SPACs’ growing share of public listings
A SPAC is an “empty-shell” publicly-traded company that raises capital through an initial public offering. The SPAC then identifies and uses the investments to negotiate with and purchase a privately-held company to bring the privately-held company to the public market to fill the shell of the SPAC. Upon the SPAC’s completion of the acquisition of the privately-held company (referred to as a “de-SPAC transaction”), the SPAC’s investors typically have the option to swap their SPAC shares for shares of the newly merged public company, or redeem their SPAC shares to recoup their original investment plus interest.
There has been a significant and well-publicized increase in SPAC IPO transactions in 2020 and 2021. SPACs have attracted companies in industries that struggled to raise capital through traditional means or those that may not be willing to engage in the lengthier and costlier IPO process.
SPACS in the cannabis industry
Due to long-standing federal prohibitions on the production and sale of cannabis and cannabis-related products, the industry is regarded as capital starved. Cannabis industry observers project that the industry has incredible growth potential. These two factors make cannabis companies attractive targets for SPACs.
The perceived opportunity for SPACs in this industry is evidenced by the US$3.6 billion raised in SPACs that aim to acquire cannabis companies. Approximately half of that, or nearly US$2 billion, has gone through a de-SPAC transaction.
For example, one of the first cannabis SPACS involved MTech Acquisition, the SPAC, which acquired cannabis technology company MJ Freeway LLC and formed Akerna (NASDAQ:KERN) in 2018. Akerna stock reached a high of US$72 on 1 June 2019, before dropping down to trade at approximately US$3 per share by the end of Summer 2021.
Cannabis and SPAC shareholder litigation
Publicly-traded cannabis companies are frequent targets of securities class action lawsuits in the United States. The early waves of cannabis shareholder lawsuits were against Canadian domiciled cannabis companies that were duel listed on the Canadian and United States exchanges. These early actions largely alleged misconduct related to issues in the company’s operations, transactions, financial guidance, or financial restatements and internal controls.
Despite an overall decrease in shareholder litigation in the first half of 2021, SPACs have been one of the few sectors to see an increase in federal securities class actions. Before 2019, federal securities class action lawsuits related to de-SPAC transactions were rare. According to Cornerstone’s 2021 midyear assessment of securities class action filings, the first half of 2021 saw more securities class action lawsuits filed against SPACs than in 2019 and 2020 combined. Eight of the 14 securities class action lawsuits filed against SPACs in the first half of 2021 alleged that the SPAC’s targets misrepresented their products viability before the merger took place which harmed investors when they relied on those representations. If securities class action filings continue at the current rate, de-SPAC transaction related litigation could end up comprising up to 17% of the total securities class action filings in 2021.
Most SPAC-related securities lawsuits are at the pre-motion to dismiss or motion to dismiss stages, although some have settled. This includes Akazoo, a streaming media company that merged with a SPAC named Modern Media in 2019, which reached a partial US$35 million settlement with shareholders in ongoing litigation.
“CannaSPAC” risks for underwriters to consider
The SEC highlighted some of the liability risk that SPACs are subject to under the securities laws in its public statement titled “SPACs, IPOs and Liability Risk under the Securities Laws”. In that statement the SEC analyzed the legal liability that attaches to disclosures in connection with a de-SPAC transaction. Specifically, the SEC noted:
[A]ny material misstatement in or omission from an effective Securities Act registration statement as part of a de-SPAC business combination is subject to Securities Act Section 11. Equally clear is that any material misstatement or omission in connection with a proxy solicitation is subject to liability under Exchange Act Section 14(a) and Rule 14a-9, under which courts and the Commission have generally applied a “negligence” standard. Any material misstatement or omission in connection with a tender offer is subject to liability under Exchange Act Section 14(e). De-SPAC transactions also may give rise to liability under state law.
Thus, “CannaSPACs” would be subject to the same reporting obligations under the above laws as any other IPO or proxy statement when they IPO. The question becomes whether or not CannaSPACs, or any other SPAC, would be subject to private civil liability for forward-looking statements made when the de-SPAC transaction occurs. The SEC did not commit to any action in its public statement but less than two months after issuing the statement, the US House Committee on Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a hearing and debated a draft bill that would change the Private Securities Litigation Reform Act of 1995 (PSLRA) to specifically prevent SPACs from taking advantage of the safe harbor.
Directors’ and officers’ (D&O) insurance in the cannabis space is evolving. In 2020, many insurers did not offer cannabis D&O insurance policies due to the industry’s perceived risks and the fact that cannabis was not legal under U.S. federal law. The reticence is understandable when one considers that the cannabis industry is (i) rapidly evolving with the regulations that govern it; (ii) remains illegal both federally and in more than 30 states; and (iii) the stock price volatility associated with cannabis companies. D&O insurers have been actively involved in underwriting SPACs.
As these dynamics evolve along with the rapidly changing state and federal laws concerning cannabis, insurers may become more eager to explore those risks. de-SPAC transactions involving cannabis companies, which potentially present attractive targets for SPACs, may also present risks, including those risks inherent to the SPAC formation, negotiation and the merger process. Underwriters may wish to consider the risks of SPACs that specifically seek to operate in the cannabis space, if that industry focus is mentioned in the SPAC IPO materials. Both trends are rapidly evolving and so too will the D&O market for both areas.