Cannabis Company Cops to SEC Accounting Fraud Charges

22 November 2022 Legal News: Cannabis Industry Publication
Author(s): Victoria Stockton Breese Brooke D. Clarkson James G. Lundy

On October 24, 2022, the Security & Exchange Commission (SEC) issued settled orders against Cronos Group, Inc. (Cronos), a Canadian cannabis company, and its former Chief Commercial Officer. Cronos cultivates, manufactures, and markets cannabis and cannabis-derived products. Although Cronos is incorporated in British Columbia and headquartered in Toronto, its status as a foreign private issuer subjects it to certain provisions of the U.S. federal securities laws.

Background, SEC Violations, & Restatement

According to the settled orders, in 2019, Cronos embarked on a significant business expansion, seeking to enter the cannabis vaporizer market; however, Cronos lacked the requisite familiarity with applicable accounting requirements as well as the appropriate internal accounting controls to prepare financial statements that complied with U.S. reporting requirements. As a result, in three separate quarters between 2019 and 2021, Cronos submitted financial statements with the SEC that contained material errors related to, among other things, revenue recognition and goodwill impairment. The orders also alleged that in one of the quarters, the former Chief Commercial Officer entered into an oral agreement that was neither known nor accounted for by Cronos and which involved selling raw material in one quarter and purchasing product in the following quarter. This agreement and the corresponding $2.3 million accounting error were discovered by Cronos during an internal investigation.

Cronos subsequently filed restated financial statements for the relevant quarters. In connection with the first and third quarters of 2019, Cronos disclosed that it had materially overstated its revenue by $5.8 million. In connection with the second quarter of 2021, Cronos disclosed that it should have recorded approximately $234.9 million in impairment charges in relation to its U.S. reporting unit. Concerning all three quarters, Cronos disclosed that it had identified material weaknesses in its internal controls over financial reporting.

Cooperation, Undertakings, & No Penalty

Despite Cronos being charged with violating the antifraud, reporting, books and records, and internal controls provisions of the federal securities laws, the SEC determined not to impose a civil penalty due to the company’s timely self-reporting, significant cooperation, and remediation.  In addition to correcting its financial statements, Cronos voluntarily produced documents, reports, and other information learned during its internal investigation and facilitated interviews of current and former officers and employees, including those that resided outside the U.S. Further, Cronos implemented new internal accounting controls, developed new accounting trainings, and hired additional staff experienced with GAAP requirements. Nonetheless, Cronos was required to engage an independent compliance consultant to review, assess, and make recommendations regarding its accounting and financial reporting processes.

Former Chief Commercial Officer

The former Chief Commercial Officer also was charged with violating the antifraud provisions of the federal securities laws, along with aiding and abetting and causing Cronos’ violations of the reporting, books and records, and internal controls provisions. While he avoided being required to pay a civil penalty based on his consent to pay $54,000 to the Ontario Securities Commission for similar conduct, the former Chief Commercial Officer had to consent to a three-year ban on serving as an officer or director of any U.S. publicly traded company. He also was suspended from appearing and practicing before the SEC as an accountant for three years.

Conclusion and Takeaways

The cannabis industry in the United States has grown significantly in recent years and seems poised to continue to grow well into the future. With such growth, however, market participants need to develop and appropriately scale internal processes and procedures to meet regulatory obligations. For companies that fall under the purview of the SEC, that involves compliance with applicable federal securities laws. These resource commitments are particularly important for companies making strategy changes or entering new markets.

The Cronos settlement is a good reminder of the SEC’s reach in the cannabis industry.  It also showcases the significant level of response needed by a company that discovers issues to escape a civil penalty in these situations.