CannTrust takeover unlikely (TSX: TRST)

I want to explain why I don’t believe a takeover offer for CannTrust (TSX: TRST) (NYSE: CTST) is likely in the near future. The rumour on Friday was a takeover offer was being planned for the common shares of TRST. The potential suitor said to be interested was Aleafia Health (TSX: ALEF) and the offering price was speculated to be around $4.00 per share in ALEF stock. I recall the all share offer by Green Growth Brands (CSE: GGB) for Aphria (TSX: APHA) (NYSE: APHA) which I said at the time seemed to have two chances for success: zero and none.

In my judgement the risks of what is being described as an “unfriendly takeover” at this time are much too high even if it were from a more credible bidder such as one of the three larger Canadian LPs.

We are learning new and damaging information about TRST with almost every passing day. For example, on Friday we learned that some of the independent directors who made up the independent special committee are not so independent after all. In their report, BNN Bloomberg called the internal relationships ‘awkward dynamics.’ Awkward dynamics, my foot! In plain language there are serious conflicts of interest that have the potential to bias their upcoming report. For example, Mark Dawber is the chair of TRST’s independent committee. Dawber is a director of Gencan Capital listed on the CSE. Mark Litwin is TRST’s vice-chairman and president of Gencan. Litwin’s father is the chair. Litwin’s wife is the niece of Robert Marcovitch, the interim CEO of TRST. How is anyone to believe the “independent” committee’s report when it comes out? I was skeptical in the first place since a director is a director first and independent second. For this reason I indicated such a committee lacked credibility. Given these revelations, I don’t think the committee and its report will be of questionable independence. I suggest a new and truly independent committee must be created to conduct the review anew.

Here are some of the risk factors we already know about.

First there is Health Canada (HC) that controls the licensing that forms the basis for a Licensed Producer’s value. In the past, HC has been a pushover. They allowed Tweed (the previous name of Canopy Growth) and Mettrum to get away with trying to ship illegal cannabis out of Kelowna, B.C. (Kelowna-gate) HC allowed Mettrum to get away with using unapproved pesticides and hiding them from inspectors. They let Aphria (TSX: APHA) (NYSE: APHA) get away with what looked like a variety of transgressions alleged by short sellers Hindenburg Research and Quintessential Capital. You have to believe the majority of allegations made by the short sellers were true since then CEO Vic Neufeld promised a point by point rebuttal and none was forthcoming. HC finally flexed its muscles in the case of Ascent Industries (CSE: ASNT) in a case that is very close to the one involving TRST. Ultimately, ASNT had their licenses revoked and it was announced as the TRST scandal was coming to light. It appears HC will grovel at the feet of the larger public LPs but stomp on the little guys.

The one area in which I let HC off the hook is law enforcement which is not HC’s direct responsibility although there is a section in the Cannabis Act that references criminal activities. So it is at least possible we will see crimes broken of which “illegal growing” and “illegal selling” come immediately to mind. Where is law enforcement in all of this? Based on the feedback following Kelowna-gate, the RCMP caved into pressure to avoid an intergovernmental battle with HC and perhaps the securities regulators. Over the past few years, I have talked with some of my cannabis stock market associates and I can’t tell you how often the phrase, “If the cannabis promoters were in the mining industry, they’d all be in jail…..” In other words, there is a general understanding that there is one set of more lenient rules for the cannabis group and a second more stringent set of regulations for everyone else.

Next, the Ontario Securities Commission (OSC) has commenced an investigation into “…matters and parties related to CannTrust.” This has been confirmed by both the OSC and TRST. The OSC has assigned the investigation to the Joint Serious Offences Team (JSOT) that is part of the OSC enforcement branch. The JSOT is a partnership between the OSC, the Royal Canadian Mounted Police (RCMP) and the Ontario Provincial Police (OPP) Anti-Rackets Branch. The OSC has described its investigation as a “quasi-criminal” case. Even though I think the OSC has wimped out in previous scandals, in this case they are forced to do the right thing because of the information in the public’s hands. We know from the timing of alleged internal e-mails and insider trading reports that Board Chair Eric Paul apparently sold stock on the same day as the original internal e-mail disclosing the illegal growing.

Subsequently Paul, his family, companies in which he and his family have an interest and other Board members and senior executives sold stock in the knowledge there was illegal cannabis being grown, sold and exported. The OSC’s hand is being forced because the one thing they cannot allow is for the public to know that insiders are being allowed to take advantage of non-public information.

Next there is the issue of the information that TRST’s senior management and investor relations people were dispensing to callers. Even if the investor relations people didn’t know, their information flows down from above and obviously senior management was omitting information on the illegal growing. Another issue is the financing that was done by CannTrust in April and May 2019. The offering was done using a preliminary prospectus supplement. If TRST had disclosed the illegal activity to the underwriters, you can sure it would have been included in the prospectus supplement and the issue would have been cancelled. I am not a securities lawyer but it is probably too late to seek recourse for this reason.

As I said, I am not a civil, criminal or securities lawyer. But the courts become the most direct way for investors to seek financial restitution. There is at least one class action suit being organized in Canada and a dozen or more in the U.S. These legal actions will likely focus on the money but also areas such as fraud are bound to arise. The lawyers will probably go after anyone with deep pockets (ability to pay). This is likely to include the company, the management, the directors, the underwriters, the auditor, and anyone related to any of the above. These cases might take years to resolve.

Because I am not a lawyer, I can talk about justice. To me, justice would see TRST have to refund the money raised in the recent equity offering. I think almost $200 million was raised which is more cash than TRST has on hand and it happened when a broad list of executives knew there was illegal activity going on and didn’t disclose it to potential investors. Justice would be that Eric Paul and his family and friends that sold shares regularly since insiders became aware of the illegal activity and the public didn’t, should be made to disgorge their profits on those sales. This is the stock market. You can trace every share that was sold from who sold it right back to who bought each share of the stock. It can be unwound. Justice would be that every TRST shareholder who lost money because of this scandalous behaviour be compensated. I don’t know what assets Peter Aceto or Eric Paul or any of the others have. But why should they be able to return to a life of comfort when their actions caused such financial damage to investors? Justice would be that none of the insiders be allowed to profit in any way from this illegal activity. If you rob a bank, you don’t get to keep the stolen money.

I say all of this knowing most of it won’t happen. But at least you will have a better idea of how much could have been done and how little was actually accomplished.

What will happen? HC has the ability to suspend or revoke licenses and I can’t imagine a circumstance that would justify these penalties more. HC can also levy fines of up to $1 million per violation. It can also cancel the security clearances of any management or employees who were directly involved in this scam.

Unfortunately, I don’t think the spots on HC have changed so they will kneel before the large, public LP and do as they are told. I think at a minimum they should suspend TRST’s licenses and hold a hearing to force TRST to explain why their licenses should not be revoked. This will at least allow the public to see what TRST is being allowed to get away with. Certainly fines will be levied but these will likely be in the range of a few millions of dollars which is peanuts to an enterprise that had a market cap of over $2 billion at the peak. Cancelling security clearances will hurt the employees below the executive suites more than senior management that may escape again with their ill-gotten gains.

The OSC, RCMP and OPP decisions could result in banishment from corporate boardrooms and criminal records that would certainly hurt the senior executives involved, especially if it involved prison sentences. These penalties have been used in Canada but the will to use them does not seem to apply in the cannabis industry as much as elsewhere. In the TRST case there seems to be lots of information to support securities misrepresentation and fraud charges. So it might be precedent setting but I think more likely than seeing serious action on the part of HC.

At the civil level there are also risks especially with the American legal fraternity getting involved. This seems to be the only way for investors to recover some of the money taken from them as financial restitution doesn’t appear likely through regulatory or criminal law.

TRST shareholders face the same risk that is really wiping out Ascent Industries (CSE: ASNT) shareholders. If you do not publish financial statements in a timely manner, the stock exchange will halt trading in the stock until financials are published. That happened to Ascent and their shares have been halted for nearly five months. TRST has announced it will likely not meet the August 14, 2019 filing deadline for publication of its quarterly report. The company is seeking a cease trade order from the Toronto and New York Stock Exchanges through the OSC pending the publication of those results. Based on what I’ve said, if trading is halted and given the number of issues that have to be sorted out with several penalties being raised for the first time, it could be a long time before meaningful financial statements can be produced and trading in TRST shares is restored.

Given all of the uncertainties I have raised, who in their right mind wants to own shares in CannTrust?