CannTrust Breach Erodes Industry Trust, Emboldens Black Market, Experts Say

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Courtesy of Superette.
July 19, 2019

The recent regulatory crackdown on the cannabis company CannTrust is likely to cause collateral damage to the marijuana industry as a whole and potentially scare off institutional investors, insiders say.

CannTrust ($CTST) revealed last week it was given a Non-Compliant rating from Health Canada for growing cannabis in unlicensed rooms in its Pelham, Ontario, facility. Since then, its troubles have only spiraled. Health Canada seized the product it found at the facility, and CannTrust placed a voluntary hold on the rest of its inventory ⁠— as much as 28,000 pounds. CannTrust warned in a statement that its customers will experience "temporary product shortages," due to the hold on cannabis.

The company's stock has tumbled more than 40 percent, as Health Canada tests its product and decides whether to leverage punishment which could include suspension or even cancellation of the company's federal license. For its part, CannTrust has said that the cannabis produced in its unlicensed rooms passed testing by the company and by Health Canada.

Although things look bad for CannTrust, they look worse for the young industry, according to the experts.

Mimi Lam, the CEO and founder of Superette, a kitschy cannabis shop in Ottawa, Ontario, said the incident has been very hurtful for the reputation of the legal cannabis industry.

"People look at industry players as someone to look up to," Lam said. "Something they did intentionally that tarnishes their reputation and the reputation of the industry makes groups like institutional investors scared. They are a little more conservative when looking at the space."

A whistleblower within CannTrust alleged that the company went to extremes to hide its unlicensed grow, like hanging false walls in the warehouse to hide the unlicensed plants in staged photos for Health Canada, the Financial Post reported.

CannTrust said in a statement it "acknowledged the findings of Health Canada's report, which are focused on two key overarching issues that Health Canada identified," including "employees who provided inaccurate information to Health Canada inspectors."

"Some of these instances revolved around information that was provided about the unlicensed growing rooms, as well as our documentation practices, a spokesperson added. "We are taking these observances very seriously."

If the whistleblower's allegations prove true, Lam wondered, "what else shady is going on?"

Lam said her dispensary hasn't been badly hit by the hold on goods from CannTrust, from which she formerly sourced products like pre-roll joints, oils, capsules, and flower, but it has impacted the "operational and inventory level." Although Superette still has products from CannTrust brands, like Liiv, Xscape, and SYNR.G, listed on its site, the shop stopped ordering from CannTrust when it heard about potential regulatory trouble and has since disassociated from the brands, a spokesperson clarified.

Of course, for Canadian shops, a few missing SKUs (or numbers assigned to retail products to identify things like price and manufacturer) aren't out of the ordinary. Cannabis shortages, due to lack of supply and regulatory red tape, plagued the young industry after recreational sales went online last October. At the time, experts projected the shortages could last for up to three years. They've improved ⁠— with the provincial regulator of Alberta, one of the provinces worst hit by shortages, even cautiously announcing it would begin permitting new stores at the end of May, Marijuana Business Daily reported. A spokesperson for Alberta Gaming, Liquor & Cannabis said that in spite of the hold the agency placed on CannTrust's cannabis, the province has "a healthy supply of product" from as many as 31 licensed producers.

Still, Lam says it isn't out of the ordinary for products to be missing from her Ontario dispensary, one week to the next.

"The way we look at the supply problem is inconsistency of supply and shortage of certain SKUs means we might not be able to purchase something one week to the next. It's something that is frustrating when trying to build loyalty," Lam said.

For retail shoppers, shortages might be inconvenient, but for medical patients it could be downright devastating.

CannTrust has said its patient registry consists of more than 70,000 medical cannabis patients. When there's a freeze on its cannabis, what happens to those patients who need their medicine? As accesss narrows, some could very well turn to the illicit market, said Robert Galarza, CEO of TruTrace Technologies, a company that makes blockchain-based cannabis and intellectual property tracking software.

"If you’ve got 70,000 people who no longer have access to their medicine, they could jump to other LPs or...we could see possibly a pullback to people going and just buying from dispensaries or buying from the illegal grey market, which is unfortunate," he said.

Canada's black market is still thriving, despite legalized cannabis. As in states like California, the black market still accounts for the majority of cannabis sales ⁠— about 66 percent, according to Statistics Canada's latest data. That's actually an improvement: about 79 percent of sales were reported from the black market in Q4 of 2018, down from 90 percent the previous quarter.

If trust and supply in the legal industry erodes, that could send consumers back to the black market where they can purchase cannabis for significantly cheaper.

The breach also throws into question the safety and legitimacy of the cannabis grown in those unlicensed rooms, some of which has made its way as far as Denmark. It's one thing for there to be a regulatory breach with recreational cannabis, but medical cannabis is supposed to be, well, medicine.

"You've now got a trust issue related to medicine," Galarza said.

But beyond supply issues, patient trust, and the safety of medical cannabis, Galarza said the CannTrust breach showcases that the industry is really quite fragile, especially in the United States, where the battle over legalization rages on.

On a call with media earlier this week, Cowen analysts underscored Galarza's fear, emphasizing that issues in Canada, whether CannTrust's regulatory breach or fraud in the broader market, could undermine legalization efforts in the U.S.

"Canada is often described as the model that U.S. policymakers are looking at so the more there's problems north of the border, the more that is going to complicate efforts here," Jaret Seiberg, Cowen Washington Research Group's financial services and housing policy analyst, said on the call.

As for CannTrust, the company faced a Thursday deadline to respond to Health Canada's inspection report. Its cannabis is undergoing testing by the agency.

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