The liability of directors and officers in the cannabis industry has created a dangerous cycle. Due to federal illegality, cannabis companies have turned to private investment, foreign exchanges, SPACs, or reverse takeovers to obtain capital. However, disclosing risks to investors is a challenge, as cannabis operators face a regulatory minefield. Some companies, under pressure to turn a profit, have violated state regulations. This has led to substantial management liability exposure that is largely uninsured or underinsured. As losses accumulate and insurers withdraw from the market, cannabis companies struggle to attract talent due to the lack of insurance coverage for directors and officers. This cycle of management errors, claims, losses, premium hikes, policy renewal declinations, and carrier exits is predictable.
However, there are signs of a shift in the industry that could break this cycle and allow for a symbiotic relationship between cannabis companies and insurers. This article explores the coverage offered by D&O insurance policies, the genesis of D&O lawsuits filed against cannabis companies, and how federal legalization and other trends may impact future cannabis D&O exposures. Although volatility and uncertainty will continue to be issues, this emerging paradigm offers hope for a more stable and secure future for the cannabis industry.
D&O insurance policies offer three types of coverage: Side A, Side B, and Side C. Side A provides liability coverage for individual directors and officers, indemnifying them for losses resulting from wrongful acts committed in their capacity as officers or directors. Side B covers payments made by a corporation on behalf of its directors and officers for losses resulting from a claim alleging a wrongful act. Side C, or entity coverage, reimburses the insured company for liability arising from defined claims against the company.
These policies are “claims made” policies, meaning they only provide coverage for claims made (and reported, in the case of “claims made and reported” policies) during the policy period. D&O policies typically have a “retroactive date” that limits coverage to claims arising from wrongful acts occurring after a specific date before policy inception. “Related claims” provisions, which consider a series of claims related to facts or transactions as a single claim, are often included. These provisions can either narrow coverage, such as limiting related claims to a single claim, or expand coverage by covering claims based on acts or events occurring outside the policy period.
Understanding the Origins of Cannabis Directors and Officers’ Lawsuits
Although marijuana’s Schedule 1 classification under the Controlled Substances Act continues to present unique legal and business challenges for the cannabis industry, most lawsuits targeting cannabis companies and their management are not related to federal illegality. Instead, they often stem from allegations of mismanagement, noncompliance with state regulations, or inadequate disclosure of risks to investors and shareholders. Shareholders or third parties may bring litigation against corporate directors and officers.
Shareholder litigation, brought either on behalf of the shareholders or the corporation, often alleges breach of the director’s or officer’s fiduciary duties of care and loyalty. Third-party litigation typically involves employees, business partners, competitors, creditors, or governmental regulators and authorities, naming both the corporation and individual directors and officers. Cannabis securities litigation is becoming more frequent and costly, with 28 securities class action lawsuits filed against U.S. and Canadian cannabis businesses in the past seven years.
Recent examples include securities lawsuits against companies like Canopy Growth Corporation, HEXO Corp., Chronos Group, Trulieve Cannabis Corp., and Tilray Inc. Some shareholder class actions filed in 2020 were prompted by 2019 revenues falling short of expectations. A pandemic-induced lull delayed or killed deals that might have otherwise resulted in litigation, but a surge of shareholder suits into 2022 remains a reasonable expectation due to the recent uptick in new deals and ongoing consolidation of the cannabis market.
Despite these challenges, the cannabis market is expected to continue growing in the United States and globally, with forecasts predicting U.S. sales reaching $41.3 billion within five years at a compound annual growth rate of 15%.
The Future of Cannabis D&O Litigation in the Wake of Federal Legalization
Although broad federal legalization of cannabis through the Marijuana Opportunity Reinvestment and Expungement (MORE) Act or the “Schumer/Booker/Wyden” Bill is unlikely at this time, the Secure and Fair Enforcement (SAFE) Banking Act is more likely to pass in Congress this year. The SAFE Banking Act would create a safe harbor for financial institutions, including banks, credit unions, and insurance companies, allowing them to provide financial services to cannabis-related businesses without fear of liability or federal forfeiture action.
Passage of the SAFE Banking Act would benefit the cannabis D&O insurance market in several ways. It should reduce the factors that have prevented large commercial insurance carriers, particularly publicly traded ones, from underwriting cannabis D&O and other management liability policies. This would result in more competition among insurers, lower premiums and deductibles, higher limits, more choice in specialty coverages such as D&O insurance, and a reinvigoration of the cannabis reinsurance market.
Alternative insurance models such as captives and risk retention groups may also help underwrite future D&O risks. The passage of the SAFE Banking Act should help regulators and cannabis companies feel more comfortable with domiciling cannabis captives and risk retention groups offshore.
The SAFE Banking Act would also benefit the insurance industry by reducing the frequency and severity of cannabis D&O insurance claims and losses. This is because it would help normalize the business operations of cannabis companies and provide access to commercial bank loans and other sources of capital that are currently limited or unavailable. This would attract top talent to the industry, and prospective directors and officers would demand robust D&O insurance coverage.
However, the removal of marijuana from the Controlled Substances Act (CSA) may result in increased legal uncertainty and compliance hurdles due to the need to reconcile the vastly differing state regulatory models with interstate commerce. This could lead to a period of increased confusion as companies attempt to realign their operations to stay compliant in a transformed regulatory environment, potentially leading to D&O litigation.
In summary, the SAFE Banking Act’s passage should benefit the cannabis industry, insurers, and consumers, but a period of transition may lead to D&O litigation. The removal of marijuana from the CSA should have a significantly positive impact on cannabis D&O exposures in the long term, but a tumultuous transition period is expected following legalization.
While insurance is a crucial aspect of risk management, it is equally important for cannabis companies to prioritize regulatory compliance and effective communication to mitigate management liability risks. Given the regulatory scrutiny faced by cannabis businesses at the state and federal levels, it is advisable for companies to establish clear chains of responsibility within the organization for ensuring compliance. Additionally, it is critical for companies to follow best practices when communicating publicly about their performance and future prospects, as statements that are not carefully vetted can become the basis for costly securities litigation.
To ensure transparency when shopping for a D&O policy, cannabis companies should be forthcoming with underwriters about their business operations and potential exposures. Given the limited D&O insurance market and the lower limits typically offered, insureds must carefully read and understand their insurance policies to ensure adequate coverage for their directors and officers. Designating a chief information officer or relying on qualified in-house or outside counsel can help companies navigate these complex issues and protect their interests. Ultimately, a proactive approach to compliance and communication can help cannabis companies avoid costly management liability risks and attract the talent and capital needed to succeed in this dynamic industry.
The cannabis industry has experienced steady growth in recent years, but has also faced unique challenges, particularly when it comes to insurance coverage for directors and officers. As the industry continues to evolve, so too do the regulatory and litigation risks. However, proposed legislation like the SAFE Banking Act could help increase insurance capacity in the cannabis market, providing greater protection for future industry leaders.
While the transition period following marijuana’s removal from the CSA may be tumultuous, there is reason for optimism regarding the long-term impact on D&O exposures in the cannabis industry. Despite the risks being greater for directors and officers at cannabis companies compared to traditional companies, the D&O insurance market is expected to grow, providing much-needed protection as the industry continues to expand.
Navigating the Waves with Aura Risk: How We Can Help
Aura Risk is committed to providing comprehensive and tailored D&O insurance solutions to meet the unique needs of cannabis business operators, their board of directors, and employees. With our in-depth knowledge of the cannabis industry and its regulatory landscape, we are well-equipped to provide expert guidance and support to help our clients navigate the complex risks associated with managing a cannabis business.
Our team of experienced professionals understands the evolving challenges facing the cannabis industry and is dedicated to delivering innovative and cost-effective insurance solutions that provide maximum protection to our clients. We believe that effective risk management starts with a comprehensive understanding of our client’s operations, exposures, and risk appetite, and we work closely with our clients to develop customized insurance programs that meet their specific needs.
At Aura Risk, we are committed to building long-term relationships with our clients and providing them with the highest level of service and support. We understand the importance of transparency, communication, and collaboration, and we strive to foster open and honest relationships with our clients based on trust, integrity, and respect.
If you’re looking for a reliable and experienced partner to help you manage your cannabis D&O risks, look no further than Aura Risk. We are proud to serve the cannabis industry and look forward to helping you navigate the complex challenges ahead.
Contact us today.