Quebec Court Dismisses Proposed Class Action Against Cannabis Company
On January 23, 2023, the Quebec Superior Court denied leave to pursue a class action lawsuit against HEXO Corp. The proposed class-action lawsuit alleges various allegations of misrepresentation and disclosure violations during the period from April 2018 to March 2020.1
The decision determined that the release of negative news followed by a decline in a public issuer’s share price is not, by itself, sufficient to satisfy the requirements of statutory misrepresentation claims. Arguments based on backlogged arguments and considered in hindsight will not satisfy the plaintiffs’ burden of proof to demonstrate a reasonable possibility that the lawsuit will be decided in their favour.
A. Factual Background
I. Delivery Agreement
In April 2018, HEXO issued a press release announcing that it had entered into a supply agreement with what later became Société québécoise du Cannabis (the “SQDC“), to be Quebec’s preferred supplier of cannabis products for five years (the “Delivery AgreementThe press release said that the supply agreement required SQDC to purchase 20,000 kilograms of the product in the first year after cannabis was legalized. It revealed that SQDC had the right to terminate the agreement in certain circumstances and contained words of caution regarding the reliance on forward-looking statements.
Management discussion and analysis of the company (“MD&A“) underscored the strategic importance of its relationship with SQDC, estimating potential sales under the supply deal could reach $1 billion.
ii. company acquisition
In March 2019, HEXO issued another press release announcing that it would acquire Newstrike, another publicly traded cannabis company. With this acquisition, HEXO estimated that its net income from cannabis sales in Canada would be more than $400 million.
The announcement included that the Newstrike acquisition would add approximately 470,000 square feet of additional manufacturing space in Ontario’s Niagara region and generate approximately $10 million in annual synergies.
Speaking to analysts the day after the announcement, the company said 250,000 square feet of Niagara manufacturing space was licensed and operating.
iii. sales estimates
After the acquisition was announced, the company provided estimated sales. For example, the Company’s MD&A dated June 12, 2019 estimated that revenue would double in the fourth quarter of 2019 due in part to the supply agreement and the Newstrike acquisition.
IV. set of bad news
Over the next nine months, the company made a series of negative announcements that repeatedly caused the company to fall. These announcements included:
- The company withdrew its $400 million revenue guidance and right-sized its operations, including winding up operations at the Niagara facility acquired from Newstrike.
- “Block B” of the Niagara facility (approximately 17 percent of the facility) was discovered to be underlicensed. Cultivation and production activities on the unlicensed land were stopped immediately. The company subsequently announced that it would sell the Niagara facility.
- HEXO’s fourth quarter 2019 financial results were approximately 40 percent lower than forecast.
- HEXO recorded three separate inventory write-downs ranging in size from $265 million to $280 million. The company identified significant weaknesses in its internal controls over its financial reporting in several areas, including its year-end inventory count.
- SQDC failed to purchase its 20,000-kilogram commitment under the first-year supply deal, and HEXO would not enforce that commitment due to its general business relationship with SQDC and its position in the Quebec market.
B. Alleged Misrepresentations
Due to the decline in the company’s stock price, the plaintiff sought authorization to file a secondary market lawsuit against HEXO, which was filed under the Quebec Securities Actand further sought permission to bring a class action lawsuit against the company for damages for statutory and civil misrepresentations.
The plaintiff alleged that HEXO misrepresented the following:
1. The supply agreement guaranteed revenue related to the sale of 20,000 kilograms of cannabis in the first year;
2. The acquisition of Newstrike:
a. including fully licensed and operational facilities;
b. would generate more than $10 million in annual synergies;
c. would, together with the supply agreement, result in a doubling of HEXO’s net income between Q2 and Q4 of 2019;
3. HEXO would post revenue in excess of $400 million for fiscal 2020;
4. HEXO’s inventories were accurate and internal controls effective.
C. Why the suit failed
I. Delivery Agreement
The court disagreed that HEXO’s statements regarding SQDC’s commitment to purchase 20,000 kilograms of cannabis amounted to a “guarantee” of first-year revenue under the supply agreement. It was found that the contested statements contained only a description of SQDC’s purchase obligation in the first year under the supply contract. The court expressly stated that courts do not judge after the fact. The fact that SQDC failed to meet its first-year purchase obligation or that Defendants chose not to enforce the take-or-pay feature is not evidence that the public statements were untrue or misleading at the time they were made .
The court made its decision after considering these factors, which effectively qualified the alleged misrepresentation:
(i) HEXO announced that SQDC could terminate the Supply Agreement under certain circumstances, belying any notion of guaranteed sales;
(ii) HEXO’s statements of “strong business security through year 1 post-legalization” related to multiple factors and not just the SQDC’s obligation under the Supply Agreement;
(iii) HEXO’s press release contained cautionary words that forward-looking statements “should not be read as a guarantee of future performance or results”; and
(iv) the plaintiff was aware that this was a “new and volatile market”.
ii. Newsstrike acquisition
Although Plaintiff alleged that HEXO misrepresented that the Niagara facilities were fully licensed and operating as of March 2019, Plaintiff’s evidence showed that the lack of license did not become known until around July 30, 2019, when HEXO announced that that they were made aware of the deficiencies.
Regarding the disputed statements that operations at the Niagara facility would be licensed for cannabis production, on October 24, 2019, HEXO announced that it had temporarily suspended its operations at the Niagara facility as part of cost-cutting measures. Therefore, it could not reasonably be expected that the fact that any part of the facility was underlicensed would have any impact on an investor’s decision to buy or sell HEXO securities after October 24th.
The court further found that the mere fact that projected synergies were not realized did not prove that the statements at issue were misrepresentations of material facts at the time they were made. In any case, HEXO has disclosed the risk that the synergies may not be achieved, so investors would not rely on the projections.
As for the fact that HEXO’s Q4 earnings were lower than forecast, and HEXO’s financial guidance being lowered, the documents in question contained the assumptions underlying the forecasts and cautionary language, specifically warning readers that forecasts are not guarantees of future performance or results.
iii. Impairment loss on inventory and internal controls
With respect to the inventory impairment loss, the court found that the plaintiff failed to correlate any of the subsequent impairment disclosures with an earlier misstatement of a material fact at the time the disclosure was made. Although certain financial statements have been restated, the court accepted that the impairment loss arose from subsequent events and new and available information from third parties about circumstances relating to ongoing cannabis use trends.
Nor has the plaintiff demonstrated that the disclosure of the impairment related to a material fact. The court found that the plaintiff failed to provide evidence linking the decline in HEXO’s stock price to the disclosure of the inventory impairment loss adjustments.
The court further found that the plaintiff had not identified any public statements made by HEXO that allegedly contained misrepresentations about its internal controls. The company announced in October 2018 that it was implementing a new enterprise resource planning system, warning that the associated design and testing process could result in errors and/or inaccurate information for management and financial reporting.
The court’s decision shows that courts will look deeper than merely citing a negative press release and a corresponding stock price decline to demonstrate a reasonable probability of success for permitting a secondary market statutory misrepresentation claim. The decision also underscores the importance of using robust safe harbor language for forward-looking statements and risk disclosures in MD&As.