Hemp, marijuana execs' pasts raise concerns in investor community

Editor’s Note:This story is the fourth part in a series of articles and video documentaries that surveys the state of the legal marijuana and hemp industries.To read the previous article on stocks that have been suspended by the Securities and Exchange Commission, go here.

In the burgeoning public market targeting the U.S. marijuana and hemp industries, top brass don’t always boast a squeaky clean record.

Consider the founder of Medical Marijuana Inc., whom the media reportedly dubbed “The King of Pot." Bruce Perlowin spent nine years in the federal penitentiary for smuggling marijuana into San Francisco from Columbia. Perlowin got into the pot business in high school selling nickel bags of dope and earned more than $100 million by the time he was 30 years old, according to his Facebook page. Perlowin now runs another business, Hemp Inc.

“Fast forward to today. That experience. That benefit of knowledge of medical marijuana and industrial hemp has served me very well in the public sector," Perlowin told Bloomberg TV.

Hemp Inc. said Perlowin has never concealed his background from the public. “Hemp Inc. has made it clear to everyone that its operations are only in Hemp products and has nothing to do with the cannabis sector or medical marijuana," said Jerry Cornwell of Bristol Media, Ltd., which has an investor relations contract with the company.

Perlowin isn’t the only industry exec who has attracted regulatory interest. Michael Llamas, the former president of Medical Marijiuana Inc., stepped down in September 2012 after the U.S. Justice Department announced an indictment against him and several other defendants in connection with an alleged mortgage fraud that caused around $10 million in losses; Llamas has pleaded not guilty and his case is set for trial.

Although Llamas remains a shareholder, he has no executive or operational role at the company, said Andrew Hard, a spokesman for Medical Marijuana.

Alan Brochstein, an independent research analyst who has studied stocks in the marijuana market, expressed skepticism when asked if individuals who manage cannabis companies are trustworthy.

“I have met people I trust," said Brochstein, founder of 420 Investor, an online community for the cannabis sector. But “on average I would say no. In other words, don’t assume they are all crooks but bet they might be. Opportunist is a better word than crook."

Hard credits Llamas with helping the company grow and move away from its roots as a consulting firm. He said Medical Marijuana is the largest supplier of CBD oil in the world. The company reported first-quarter sales revenues of $4.01 million.

“Mike did help us build this national, international pipeline and distribution line to become what the company is," Hard said.

In the Eastern District of California, Llamas is scheduled to go to trial on Oct. 6. The government has produced so much discovery that the paper “would stretch from the Earth to the Moon," according to court documents filed by Llamas’ attorneys. Citing the complexity of the case, Llamas is seeking a continuance of the trial until May 2015.

“The quantity of information Mr. Llamas must review to prepare for trial threatens his Fifth and Sixth Amendment rights to effective assistance of counsel and to present a complete defense," Llamas’ lawyers wrote last month in a motion requesting a continuance of the trial.

The Justice Department recently moved to dismiss eight wire fraud counts against Llamas, although three counts of mail fraud and 13 counts of wire fraud are still pending against him, according to court records. Llamas contends he was a victim of a fraud perpetrated by the main defendant, Lee Loomis.

Llamas and other defendants face a maximum statutory penalty for each violation of mail and wire fraud of 20 years in prison, a $250,000 fine, and a three-year term of supervised release, the Justice Department said at the time the indictment was disclosed.

Medbox is another marijuana-related company whose founder has clashed with law enforcement. The company offers machines that dispense herbal and prescription medications based on biometric identification.

In 2013, Medbox founder Pejman Vincent Mehdizadeh pleaded no contest to various criminal charges and agreed to pay $450,000 to victims after he had been suspected of posing as a lawyer for a referral service that sent working-class clients to a law firm that billed them for work but never finished the job, according to Southern Investigative Reporting Foundation. The Sept. 30, 2013 article also cited public records in the Los Angeles area in which Mehdizadeh was arrested or pleaded no contest to breaking and entering, solicitation, trespassing and credit card fraud.

Stephen Hart of Hayden IR, an investor relations consulting firm representing Medbox, said the company has disclosed Mehdizadeh’s criminal history. He didn’t specify whether or not the charges referenced by the Southern Investigative Reporting Foundation were accurate.

Mehdizadeh resigned from the board in April 2014. He remains president/CEO of the company’s two main subsidiaries, Medicine Dispensing Systems and Vaporfection International, according to the company.

In an investor Q&A, Medbox explained Mehdizadeh resigned to strengthen the board and attract institutional investors. “In addition, Mr. Mehdizadeh has acknowledged blemishes on his record from issues occurring prior to founding Medbox, making him a target for ‘Short-Journalists,’" the company stated. “He believes that his resignation from the board will make the company less susceptible to attack."

Brochstein said he has investigated the histories of executives in the cannabis space, which revealed various facts from bankruptcy filings to felony charges.

“I’d be upset if I was charged wrongly with a felony and someone was bringing it up. But you know what, I don’t run a public company," he said.

Securities regulators have raised concerns about the public marijuana sector. The SEC recently temporarily suspended trading on Petrotech Oil and Gas, Advanced Cannabis Solutions, GrowLife, CannaBusiness Group, Fusion Pharm, Alternative Energy Partners, Inc. and SK3 Group, Inc.  

In the various notices, the commission raised questions about the accuracy of publicly available information regarding the companies’ operations and business activities, and concerns about potential unlawful sales of securities and manipulation in the market.

“Fraudsters often exploit the latest innovation, technology, product, or growth industry—in this case, marijuana—to lure investors with the promise of high returns," the SEC stated in a May 16, 2014 investor alert. “Also, for marijuana-related companies that are not required to report with the SEC, 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."

The Financial Industry Regulatory Authority (FINRA), an independent securities regulator in Washington, D.C., warned shareholders in public marijuana companies to research the histories of executives and large stakeholders. “Proceed with caution if you turn up recent indictments or convictions, investigative articles, corporate name changes or any other information that raises red flags," FINRA stated in a notice.

These shouldn’t be the only red flag shareholders should watch out for.

Independent board, dilution of shares

Joseph Hogue, a financial analyst, cautioned investors in marijuana businesses to ensure the majority of directors on a board are independent. That’s important because it limits potential conflicts of interest in which a board member could place his personal interests—such as obtaining stock-related compensation—above his fiduciary duty to maximize shareholder value.

“But a lot of the directors might be suppliers, might be family members of management," said Hogue,  former director of institutional research with High Alert Investment Management, a venture capital and sell-side equity research provider based in Toronto, Canada. “So those directors might not necessarily have the best intentions as far as looking after shareholder wealth and that’s ultimately what a director is supposed to do is look after shareholder wealth, not necessarily be related to the management in some way."

Stockholders also should understand the extent to which their stake in the company could shrink through the issuance of shares to management and the rights of investors with a security interest, such as an investment bank, to convert debt into shares at a very favorable price.  

“This investment bank already has a great deal if they want to convert it to stock," Hogue said in a phone interview in April before High Alert discontinued its research division. “When these loans are converted, you own a much smaller portion of the company than you thought you did."

For instance, consider just a few transactions in one day involving CannaBusiness Group, which had roughly 183 million shares outstanding as of June 30, 2014. On Feb. 13, 2014, the company issued a total of 11 million shares in two separate transactions for past convertible debt at a predetermined rate of $.0001 per share. On the same day, the company issued another nine million shares of common stock for past convertible debt at a predetermined rate of $.0013 per share.

“A lot of these companies have very complicated financial structures," Hogue said. “They have a complicated system of stock compensation and your average retail investor is not going to be looking through the SEC filings from the company and probably not going to understand that the price of those shares may not be all that’s reflected from the compensation and the financial structure."