Enforcement News: Cannabis Company Charged with Perpetrating a Long-Running Scheme to Defraud

• Posted on: Mar 20 2023

By: Jeffrey M. Haber

“Legal cannabis is an emerging industry, which makes it prime hunting ground for financial predators who will use every trick in the book to lure investors into their schemes,” said Cari Fais, acting director of the New Jersey Division of Consumer Affairs (here). The Securities and Exchange Commission (“SEC” or the “Commission”) recognized this problem in 2014, when it issued an investor alert about investing in cannabis companies (here), and in 2018, when it issued a second investor alert about marijuana-related investments (here).

In the 2014 alert, the SEC warned investors about the risk of fraud and market manipulation when deciding whether to make an investment in a cannabis company: 

Fraudsters often exploit the latest innovation, technology, product, or growth industry – in this case, marijuana – to lure investors with the promise of high returns.  Also, for marijuana-related companies that are not required to report with the SEC, investors may have limited information about the company’s management, products, services, and finances.  When publicly-available [sic] information is scarce, fraudsters can more easily spread false information about a company, making profits for themselves while creating losses for unsuspecting investors.

To underscore the foregoing, the SEC noted that it issued trading suspensions against cannabis companies which allegedly provided false information to their investors. Of the companies whose trading was suspended, the SEC said that several were targeted because of concerns about the accuracy of how they described their operations, while others were targeted because of market manipulation and unlawful sales.

On March 16, 2023, the SEC announced (here) that it charged American Patriot Brands Inc. (“APB”), a cannabis cultivation and distribution company, its chief executive officer (“CEO”), and five other entities and individuals for their participation in a long-running scheme in which they raised more than $30 million from more than one hundred investors across the country and took millions of those funds to enrich themselves.

According to the complaint filed by the SEC in the United States District Court for the District of Puerto Rico (here), since at least mid-2016, APB, its CEO Robert Y. Lee, and current and former executives Brian L. Pallas and J. Bernard Rice made a series of false and misleading statements to investors about various aspects of the company, including its financial condition, the scope of its operations, the value of its Oregon cannabis farm, and the safety and security of investing in APB. 

In particular, the SEC alleged that as part of its offerings, APB urged investors to act quickly to invest before APB made its securities more widely available, an event APB claimed was imminent. In fact, said the SEC, the registration APB needed for widespread public trading was in jeopardy and was revoked in the midst of an offering. Nevertheless, alleged the SEC, APB told investors that it had multistate and worldwide operations when it had no operations outside of Oregon.

Additionally, although APB produced only a small amount of sellable cannabis a year, it promoted itself as one of the largest cannabis farms in the country and provided wildly inflated financial information to support extremely high revenue projections. To make the investment appear even more attractive, APB allegedly promised that investments would be secured by a lien on APB’s cannabis farm, at times when the farm likely did not have enough equity to secure investments. 

The SEC alleged that all of the misrepresentations and omissions were material because they would have been important to an investor in deciding what to do with APB securities (e.g., whether to invest in the company, to convert their promissory notes (pursuant to which they loaned APB money) to APB stock, or to exercise an option to buy APB stock.

The SEC further alleged that accurate information about past and projected revenues was relevant to the risk of the investment and the size of potential returns, as was information about the scope of APB’s operations, whether it owned other farms, historical harvests, and the amount of acres licensed for cultivation. As noted, according to the SEC, APB produced only a small amount of sellable cannabis a year. 

Moreover, said the SEC, information about competing valuations of the Oregon farm would have allowed investors to assess whether the high valuations provided by APB were accurate. Coupled with information about the liens on the Oregon farm, the competing valuations would also have allowed investors to assess whether APB had sufficient revenues to pay its operating expenses and whether a lien on the Oregon farm would fully secure promissory note investments. The SEC also said that accurate information about the status of APB’s efforts to become compliant with SEC reporting requirements would have been relevant to the competency of APB’s management, the eligibility of APB securities to continue trading on OTC Link, and the likelihood that APB securities would qualify for listing on an American exchange. 

Finally, the SEC alleged that the individual defendants misappropriated millions of dollars in investor proceeds to themselves and the relief defendants.

Commenting on the enforcement action, Carolyn M. Welshhans, Associate Director of the SEC’s Enforcement Division, stated: “As the SEC complaint alleges, American Patriot Brands Inc. and some of its senior executives fabricated business profits and prospects to entice investors with falsehoods that in the end left investors with essentially worthless securities. This action reflects the SEC’s ongoing commitment to holding accountable those who seek to profit through lies and deception.”

The SEC charged defendants with violating the antifraud provisions of the federal securities laws. The SEC seeks permanent injunctive relief, disgorgement with prejudgment interest, civil penalties, and officer and director bars against certain individual defendants. The SEC also seeks disgorgement with prejudgment interest from three affiliated entities (as relief defendants) that allegedly received millions in investor proceeds.

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. 

This article is for informational purposes and is not intended to be and should not be taken as legal advice.