The cannabis industry, like any other rapidly growing industry, is no stranger to litigation. Cases of former executives fighting over wrongful termination, product quality issues resulting in recalls and class actions, and shareholder claims against companies and their officers and directors who allegedly misappropriated capital have all made their way into the news and onto the filings of some of the sector’s largest public companies.
Many of the claims filed against public cannabis companies will take years to determine what happened, and who, if anyone, will be on the hook for a payout. Despite the long tail on a potential cash settlement, due to accounting rules, lawsuits can find their way onto the financial statements and directly impact a company’s earnings and share price long before they are settled.
The costs of legal actions can be sudden, dramatic, and blindside investors.
While the rolling tide of cannabis legalization has created many exciting opportunities, investors should recognize that lawsuits are a risk that should be on their radar. As in other industries, the costs of legal actions can be sudden, dramatic, and blindside investors who haven’t been diving into the financial statements and following the latest developments — and the cannabis industry is no exception.
Given both the potential for these lawsuits to have a material impact on share prices and the spate of recent claims made against public cannabis companies, investors should take stock of how these claims are accounted for on the financial statements and just how fluid and subjective their treatment can be.
Diligent owners of cannabis stocks listed in Canada are most likely familiar that these companies report their financial statements under International Financial Reporting Standards (IFRS). If a company that uses IFRS has a claim or legal action initiated against it, the way a company must treat these events for financial reporting purposes is covered by IAS 37 — Provisions, Contingent Liabilities and Contingent Assets. Under this framework, companies are provided with rules and guidelines that determine whether the event will be recorded on to the financial statements, relegated to the footnotes, or in some cases, given no mention whatsoever.
If IFRS rules warrant that a legal action should be recorded directly onto a company’s financial statements, it will be classified as a provision, and the result is an appreciable negative impact on the company’s financial results. While no cash may have changed hands (yet), the company is required to book a non-cash expense for the estimated future outflow, and correspondingly increase the company’s liabilities to match this expense.
The effect of this classification will not only directly impact the company’s net income and its corresponding ratios (e.g. earnings per share) that many investors have come to rely on; but the increase in the company’s liabilities can also make it more difficult, if not more expensive, to secure additional financing. For cannabis companies that have managed to secure debt financing, this may also compromise the financial covenants they are required to maintain in order to remain in good standing with their lenders.
Given the potential financial consequences of recording a provision on the books, IFRS has a three-condition test meant to ensure that companies are not required to book arbitrary provisions which could make an otherwise profitable company appear as a debt-laden economic disaster. (One can only imagine that if companies were forced to book losses for the full amount demanded of every frivolous lawsuit filed against them, no one would look profitable.)
The first component of this test simply dictates that the obligation must be the result of a past event. While this condition is relatively straightforward, the second condition that addresses the probability of a future economic outflow and the third condition that requires a reliable estimate of that future economic outflow are far more subjective.
Under IFRS, the probability test has come to be interpreted as a more than 50% probability (“more likely than not”) that an outflow of economic benefits will be required to settle an obligation. In other words, if a company was sued and it was unlikely they would have to make a payout, they wouldn’t need to book a provision.
Many cannabis companies have cited this standard to avoid booking provisions from lawsuits in their own filings, such as MedMen Enterprises Inc. MMNFF, +1.37% , which noted that the lawsuit filed against them by their former CFO, James Parker, didn’t have a probable outcome in his favor. The third and final component of the provision test concerns the ability to produce a reliable estimate of what the economic outflow would be. Given that managers often rely on their experience with similar precedents from other companies in their industry, producing a reliable estimate for a nascent industry can be an exceptional challenge for any company. This helps explain why many cannabis companies take this position in their own filings, such as Canopy Growth Corp., CGC, +5.51% WEED, +5.63% which stated that it could not determine a reliable estimate for the litigation brought about from the use of banned pesticides at their since rebranded subsidiary Mettrum Health Corp.
Ultimately, when a legal action fails to meet any of the prescribed conditions of the provision test, it is classified by IFRS as a contingent liability and typically relegated to the footnotes. In cases where the likelihood of any outflow is “remote,” such as a completely frivolous lawsuit, companies do not need any disclosure.
Investors should note that just because a legal action has found its way to the footnotes due to its inability to meet the conditions of the provision test, it does not mean it will stay there. As new information comes to light, new evidence is discovered, or new assessments are made, contingent liabilities that were or were not mentioned in the footnotes can effectively be upgraded to provisions and, in turn, make their way on to the financial statements. Simply put, just because MedMen and Canopy’s legal claims have been confined to the footnotes for now, it does not mean they should be forgotten.
An important consideration when poring through the notes and reviewing a company’s provisions and contingent liabilities is just how subjective the tests are in determining these classifications. What makes a payout “probable” and what can be interpreted as a “best estimate” for an economic outflow are highly subjective, especially when one considers the interests of the managers who influence these decisions. Managers, who are often incentivized with stock options and who frequently receive bonuses based on quarterly results, have an unapologetic interest in minimizing both the risks that might threaten the value of their securities as well as any expenses that might impact their bonuses.
While managers are highly influential in this classification, investors can take solace in knowing that they are not given complete free rein in making this decision. If the company’s auditors, who will request a legal letter reviewing the company’s outstanding claims against it, fundamentally disagree with management, they can refuse to sign off on the company’s audit. This exceptional, though not unprecedented, action carries enormous gravity, as the announced withdrawal of an auditor can be shocking to a company’s share price.
It is ultimately up to investors to examine these risks and incorporate this information into their trading decisions.
While managers may have a strong incentive to downplay the impact of potential outflows from legal actions, it is ultimately up to investors to examine these risks and incorporate this information into their trading decisions.
Analysts historically tended to shy away from legal claims found in the notes, with many noting the difficulty of incorporating the innumerable variables into their analysis. This all changed, however, when the building supply company Manville Corporation filed for bankruptcy on August 26, 1982, as a result of the company’s overwhelming exposure to asbestos-related personal injury suits. While current claims in the cannabis industry may have nowhere near the same financial gravity as historic asbestos claims which bankrupted billion-dollar companies, this does not mean that the potential economic outflows will not have a material impact on the cannabis industry’s equity investors. In the end, rather than rely solely on the financial disclosures provided by public companies for guidance on this issue, investors should conduct their own research in conjunction with these statements to determine where best to put their money.
Michael Miller is director of finance at White Sheep Corp., a cannabis investment and operating company with assets in North America, Australia, and Southern Africa. He also co-authored “‘High’ Profits From Accounting For Cannabis Plant Inventory,” the first cannabis accounting case for business schools that was published by the University of Cambridge’s Judge Business School.