SEC Files Another Financial Fraud Action

Despite an economy in which many firms are reporting favorable results, the Commission continues to ferret out those who try and take a short-cut to good financial performance through fraud. For example, in recent weeks the Commission brought an action based on premature revenue recognition which improperly increased income. In the Matter of Michael B. Hayford, Adm. Proc. File No. 3-18020 (June 9, 2017). In another recent action a supposed corporate turnaround artist tried to transform poor finances into good ones by shifting liabilities to another entity, a tactic reminiscent of the early days of special purpose entities. SEC v. Fuselier, Civil Action No. 1:17-cv-04240 (S.D.N.Y. Filed June 6, 2017).

The SEC’s most recent case in this area centers on improper asset valuation not just of the entity purchased but of the stock used as consideration for the deal. The Commission’s action got a jumpstart from admissions by the promoter who put the deal together –apparently he just had to chat about the fabulous deal he made where nothing for nothing equaled something, at least for awhile. SEC v. CannaVEST Corp., Civil Action No. 2:17-cv-01681 (D. Nev. Filed June 15, 2017).

CanaVEST, was a shell company based in Las Vegas named Foreclosure Solutions, Inc. The firm changed its name following the deal that is central to this action. Defendant Michael Mona, Jr. has been the CEO of the firm since November 2012.

In December 2012 CannaVEST entered into an agreement to purchase all the shares of PhytoSphere Systems, LLC from Medical Marijuana, Inc. or MJNA. Mr. Mona had been a consultant to MJNA, providing advice on its operations and business. At the time of the transaction CannaVEST had no operations, no revenues and $431 in assets.

Mr. Mona negotiated the deal under which CannaVEST acquired PhytoSphere. The terms of the deal called for CannaVEST to obtain the firm’s existing rights under contracts with hemp production and processing facilities. This would put CannaVEST into the hemp and hemp oil business. The purchase price was $35 million in cash and/or CannaVEST shares. Payments would be made in five installments over the course of fiscal 2013.

Under the terms of the deal CannaVEST shares would be valued in a range with a low of $4.50 and a maximum of $6.00 per share. At the time of the deal there was no or little trading in CannaVEST shares on the OTC market. Mr. Mona did not take steps to value the shares, according to the complaint. There is no claim that an appraisal of PhytoSphere was done.

Ultimately CannaVEST paid 5,825,000 restricted shares and $950,000 in borrowed cash to acquire PhytoSphere in 2013. On May 20, 2013 the firm filed its Form 10-Q for the first quarter with the Commission. The financial statements listed about $36.6 million in assets. The acquisition was valued at $35 million. The second quarter filings with the Commission reflected essentially the same values.

The stated value of PhytoSphere dropped to $8 million in the firm’s third quarter 2013 Form 10-Q. In October 2013 an independent contractor requested that CannaVEST obtain a third party valuation of the PhytoSphere business. That valuation concluded that the business was worth about $8 million. The outside auditors resigned.

A second valuation of PhytoSphere, made in March 2014, confirmed the $8 million price of the earlier appraisal. The second valuation was obtained at the behest of the new outside audit firm, retained in January 2014. On April 24, 2014 CannaVEST restated its Forms 10-Q for the first three quarters of 2013 to reflect the correct value of the firm’s assets.

Mr. Mona, discussing the value of the PhytoSphere after the deal, stated that the “$35 million price . . . did not represent the value of the transaction appropriately as [CannaVEST] would never have agreed to that price if it were paid in cash . . .” Amplifying this comment, he stated that “[w]e have always believed that the $35 million purchase price was not a true measure of the value . . . we were wiling to accept the $35 million purchase price demanded . . . [because the stock] was not trading at the time and had little value.”

The complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), 13(b)(5) and SOX Section 304. The action is in litigation.