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High Times For Fraud

Retail investors hoping to cash in on the legal marijuana industry have not fared well

The legal marijuana business is booming. With medical marijuana laws and pot decriminalization sweeping across the country – voters in Oregon, Alaska and the District of Columbia approved ballot measures in November’s mid-term elections – observers project that over the next five years annual cannabis industry revenues in the U.S. could mushroom to more than $10 billion.

But despite the apparent evolution of marijuana from pariah to legal golden goose, investing in the marijuana business can still be the equivalent of a bad trip.
This has been especially true for retail investors looking to invest in publicly traded companies capitalizing on marijuana related opportunities. According to state and federal regulators, more than a few of these companies are over-hyped concerns that have yet to show profits and are in some cases outright frauds.

Take, for instance, Advanced Cannabis Solutions, a Colorado Springs real estate firm that specializes in leasing commercial space to pot growers and dispensaries. ACS stock rose from $3.30 to over $45 in the winter of 2013-2014 after marijuana was legalized in Colorado. But on March 27, 2014 the U.S. Securities and Exchange Commission (“SEC”) announced it had temporarily halted trading in ACS shares “due to a lack of current and accurate information concerning the securities of Advanced Cannabis. There are questions regarding whether certain undisclosed affiliates and shareholders of Advanced Cannabis common stock engaged in an unlawful public distribution of securities” on the Over-the-Counter Bulletin Board and OTC Link. Today, the stock languishes under $5.70b26dbb-3573-46a3-901e-3f79d121587d

For its part the SEC has been blunt with investors that the newly minted marijuana industry is ripe for fraud and abuse. In May 2014 after it temporarily suspended trading in FusionPharm, a developer of cultivation systems for pot growers, the SEC issued an investor alert, warning that “Fraudsters often exploit the latest innovation, technology, product, or growth industry – in this case, marijuana – to lure investors with the promise of high returns.”

If the marijuana company is a “microcap” that is not required to make regulatory disclosures, the SEC noted, “investors may have limited information about the company’s management, products, services, and finances. When publicly-available information is scarce, fraudsters can more easily spread false information about a company, making profits for themselves while creating losses for unsuspecting investors.”

Overall in 2014, the SEC suspended trading in the shares of seven companies that operate in the “cannabis space,” a broad category of pot industry-related businesses that encompasses nearly 250 companies.

Despite these issues, there are few signs of the so-called green rush abating. The San Francisco-based ArcView Group, which helps deep-pocketed investors find promising cannabis startups, organized a “shark tank” conference at a resort in Henderson, Nevada, last fall where, the Los Angeles Times reported, entrepreneurs hawked next-generation grow technology and mobile apps “to make ordering God’s Gift or Fogg Kush for home delivery as hassle-free as buying dinner on Grub-Hub, the online food delivery service.”

“There is a massive potential,” the co-owner of Poseidon Asset Management, a new pot hedge fund, told the gathering. “It is untapped. It is just sitting there below the surface and it is ready to come above ground.”

Nearby, at the Marijuana Business Conference & Expo in Las Vegas, 142 companies promoted products such as Peanut Budda Buddha cannabis candy bars and FunkSac child resistant pot pouches. More than 3,000 people attended the conference, almost triple the number last year.

Among the companies that have attracted the most attention by government regulators are newly formed concerns that are generally in the business of what might be called pot logistics.

Advanced Cannabis Solutions, for example, went public in August 2013 through a “reverse merger,” a mechanism that helps companies avoid the costs and scrutiny of a public offering. In this case, ACS merged with Promap Corp., an energy-related company, and immediately had access to public markets and investors.

The new ACS bet that it could acquire properties where marijuana is grown or sold, and lease back the facilities to the distributors who are often unable to get lines of credit and loans from banks. But in a recent regulatory filing, ACS stated it owned only two properties and reported a net loss of more than $700,000. And in January, the company announced it was restating its 2014 earnings.

Another “penny stock” pot play was GrowLife Inc. of Woodland Hills, California which provides infrastructure and services to marijuana and hemp businesses. Over the past couple of years, it acquired hydroponic gardening supply retailers in California, Colorado and Maine and obtained in upwards of $40 million in financing from a private investment firm to expand its operations. But in April 2014, the SEC suspended trading in its shares, citing questions about the “accuracy and adequacy of information in the marketplace and potentially manipulative transactions” in the stock. GrowLife is now trading at around 5 cents a share, down from nearly 80 cents before the suspension.

The SEC isn’t the only Wall Street watchdog to raise concerns about stock fraud in the cannabis industry. In August 2013, the Financial Industry Regulatory Authority, which oversees stock brokers, warned that scammers had targeted the cannabis business as a means to dupe investors. The pitches, FINRA explained, “almost always contain hallmarks of ‘pump and dump’ ploys,” with scam artists making “aggressive, optimistic-and potentially false and misleading-statements [to]create unwarranted demand for shares of a small, thinly traded company with little or no history of financial success (the pump). Once share prices and volumes reach a peak, the cons behind the scam sell off their shares at a profit, leaving investors with worthless stock (the dump).”

One company cited by FINRA hyped its move into the medical cannabis space by issuing more than 30 press releases during the first half of 2013. An online promotion for the company claimed the stock “could double its price SOON” and another asserted the stock was “poised to light up the charts!” But according to FINRA, “the company’s balance sheet showed only losses, and the company stated elsewhere that it was only beginning to formulate a business plan.”

Medbox Inc. is a manufacturer of vending machines that dispense medication, including medical marijuana, based on biometric identification. Like many of the publicly traded marijuana companies popping up, it is a “penny stock” that trades on the highly speculative over-the-counter markets. Between December 18, 2013 and January 8, 2014, its shares skyrocketed from about $8 to $93.50. Within two days, the stock had fallen back to earth at $33. These days, Medbox is trading at around $10 and has yet to show a profit.

It turned out, the company had deeper issues. MedBox’s founder, Vincent Mehdizadeh, pleaded guilty in 2013 to selling immigrants bogus legal services. He had been the subject of a three-year investigation by Los Angeles County and avoided prison time by repaying his victims $450,000. Both Mehdizadeh and the company CFO resigned in 2014 and in December the company announced it was restating its earnings.

Other examples of entrepreneurs with questionable backgrounds are not difficult to unearth in the cannabis game.

Bruce Perlowin, CEO of an OTCBB company called Hemp Inc., served nine years in prison for drug smuggling, while Michael Llamas, the former president of publicly-traded Medical Marijuana, was indicted by federal prosecutors in California for his alleged involvement in a mortgage fraud that caused $10 million in losses.

Commentators now generally accept that an irrational speculative bubble developed in the marijuana sector during 2014 and led to an array of abuses.

“There was no reason for the stocks to go up that much. [Marijuana] is a great theme and people were excited about it but the fundamentals weren’t there,” Alan Bochstein, the operator of 420 Investor website, told The Street.

Clearly, over time, the emerging pot industry’s fundamentals will improve, but for now the credo for would-be marijuana investors has to be the same as for those looking to illicitly score weed on the street all these years: buyer beware.