What Can We Learn From CannTrust? A Lot

CannTrust Holdings Inc. CTST had a really bad week. The New York Stock Exchange and the Toronto Stock Exchange stopped trading the security on the morning of March 31, 2020 when the company announced that it filed for bankruptcy protection and looks to be throwing in the towel as a public company. CannTrust may no longer try to fix its public disclosure statements by filing additional reports as required under the Canadian and US securities laws.

The bankruptcy filing was the end result of a downward spiral that started in July 2019 when regulators found unlicensed grow rooms and that CannTrust provided them with false and misleading information. Within five (5) days, CannTrust’s stock dropped 48% and the company lost over $174 million in market value. Shareholders quickly filed a class-action lawsuit on July 10, 2019 alleging that the company failed to disclose to investors that it was growing cannabis without regulatory approval and that it did not comply with regulatory requirements.

On August 8, 2019, the NYSE flagged CannTrust as deficient for failing to file audited financials in a timely manner. CannTrust last submitted financials to the securities regulators on March 30, 2019. To date, those are the last financials available. CannTrust suggests that it will go private as it “does not intend to devote additional time or money towards curing its public disclosure defaults by completing and resuming the filing of required reports under Canadian and United States securities laws.” CannTrust closed its last day of trading at $0.638 which is far lower than the $7.47 price that it was trading in July 2019.

What accelerated CannTrust’s decline:

The most critical aspect of CannTrust’s fall was Health Canada’s decision not to reinstate the licenses needed by CannTrust to generate revenue. CannTrust’s recent announcement shows that the company is still remediating issues related to its Vaughan Facility and it is addressing other compliance matters.

Regulatory approval is needed to stay in business and to continue growing. Losing credibility with a regulator has long term implications for creditors and shareholders. Once a regulator questions your credibility, this provides shareholders with the right to question all of a company’s disclosures.

The second downfall for CannTrust was the shareholder class action. There has been an increase in shareholder class actions in the cannabis industry over the last year. The claims against CannTrust are different in that shareholders allege that they had a right to know that the company was cultivating cannabis without a license. CannTrust really has no defense to this allegation since Canada Health agreed that it happened.

The final accelerant was the failure to promptly perform an internal investigation and issue restated financials. Without the mea culpa, a company’s credibility is questioned from all sides including shareholders, creditors, vendors, and regulators. Each day that passes erodes the goodwill and reputation that a company built over time. This is evident in that CannTrust is filing for creditor protection even though it still has $145 million in cash.

What lessons can be learned from CannTrust?

Businesses should take away the basic fact that the regulator can make or take your business. A regulatory investigation or formal action is a serious matter. When a regulator finds an issue, companies should act quickly to investigate, understand weaknesses, remediate with vigor, and acknowledge the issue.

What are some of the basic ways that public companies handle these types of situations?

1) Perform an internal investigation. If a regulator opens an inquiry or shuts down your business, hire an independent third party that has the expertise and knowledge to identify how, when and why the incident occurred. An independent director or committee should be in charge of the investigation and the final work product. Use the report to fix internal weaknesses and to adopt processes that will prevent further problems.

2) Supervisory accountability. Management and supervisors control their employees. Supervisors should be held accountable for their employee’s actions, which can include suspensions or termination. Supervisors and employees must understand that violating regulations or fudging disclosures hurt shareholders and are firing offenses.

3) Review the governance structure. Everyone needs a boss including the CEO. The board of directors is charged with protecting investor interests by being fully engaged and keeping an eye on the big picture. The board must monitor high-risk areas such as financial reporting and regulatory compliance for anomalies or other warning signs. By including independent board members, a company can demonstrate to investors that it values a fresh eye on the company to ensure that it has adequate controls and a culture of compliance.

4) Create a culture of compliance. A culture of compliance is worth its weight in gold. Culture can help a company mitigate the risk associated with internal threats posed by employees. Employees must be supervised and trained on the risks facing the company and how the employee’s actions can either exacerbate or mitigate this risk. A rogue senior management team can cause fast and loose practices to leach through an organization leading to the failures witnessed at CannTrust. Investors want a culture of compliance that will protect their investment.

5) Test, test, test. Companies must test operating procedures and controls to make sure they work. Operating procedures are designed to instruct employees on how the business is operated in a way that mitigates risk. By reducing risk, a company can ensure it maintains the value of its inventory and services and provides trustworthy financial statements. Companies that periodically test the controls and processes that are used in the operating procedures can demonstrate their effectiveness of the control framework to the board of directors and regulators.