Over the last decade or so, the international cannabis industry has come a long way. While it is still largely considered a “fledgling” industry, significant legal and regulatory changes now mean that more businesses than ever are launching into the sector. As a result, global cannabis companies are now becoming as established as many of their non-controversial counterparts – particularly when it comes to medical cannabis and CBD-centric businesses. But that isn’t to say that the industry is now completely without risk. In fact, Due Diligence remains one of the most important considerations for all businesses working within the cannabis industry. So, why is adequate Due Diligence so important, and what can happen if it is not carried out?
In a recent article, we looked at the now infamous JuicyFields scandal – an alleged Ponzi scheme that scammed thousands of investors out of potentially billions of dollars. In that article, we aimed to assess how more effective Due Diligence may have thrown up a number of warning signs. But how does an effective Due Diligence process actually work? We’re going to be taking a look into why it’s needed and what should be included in effective Due Diligence.
What is Due Diligence?
Put simply, Due Diligence is a process of reasonable steps that are carried out to determine the legality/legitimacy, viability and integrity of a company and its associated persons, when establishing and maintaining a business relationship.
It is essentially an audit or review to confirm the details surrounding a company. Conducting appropriate Due Diligence allows an investor or company to mitigate risks associated with a business or investment decision and avoid becoming involved with potentially illegal activities such as money laundering and fraud. Many business owners may be mistaken in thinking that Due Diligence – particularly high-level Due Diligence – is only required for businesses in the financial services sector; however, it is the responsibility of all businesses – no matter what sector they work in – to ensure compliance with anti-money laundering, sanctions and other legal and regulatory requirements are being met.
Due Diligence can essentially be separated into three key areas for assessment: legality, viability, and integrity.
Legality/Legitimacy – Know Your Customer (KYC)
Ensuring the legality and legitimacy of a company is an important first step in Due Diligence. This involves identifying the company and its associated persons (i.e., directors, shareholders, beneficial owners) and verifying these details. This is known as Identification and Verification (ID&V).
Verifying the identity of a business can include collecting official documentation from public bodies such as Companies House (UK) or the equivalent in other countries. Company details required for verification commonly include; Registered Name, Registered Address; Date of Incorporation; Number of Registration; and Nature of Business. Official company documentation can also be useful in identifying the directors and other persons associated with the company in question. However, it is also essential to verify the individuals – usually by obtaining proof of identification and proof of address for each associated person.
It is also crucial to identify the Ultimate Beneficial Owners (UBOs) of a company – that is, a natural person who has ultimate ownership (directly or indirectly) and control of the company. Most industries usually identify UBOs as individuals who own a minimum of 10-25% of the company’s shares or voting rights, depending on the jurisdiction. Again, the identity and address of UBOs, in addition to their share ownership, should be verified as part of the Know Your Customer (KYC) pillar of Due Diligence.
Viability – Risk Assessment
Once the identity of a company and its associated persons has been verified, the viability of the company should be assessed. This can be achieved through a thorough risk assessment. This evaluates the inherent Money Laundering/Terrorist Financing (ML/TF) and Sanctions risk and the associated factors that could impact that risk, which generally include the entity type and structure, the sector in which the company operates, its distribution channels, and the jurisdictions in which it operates.
A company’s overall risk rating can be affected by each of these considerations. For example, companies operating within the cannabis sector are typically considered high-risk, due to the legality of the product and the patchwork nature of global regulations. Other sectors that are generally considered high-risk include banking and investment, cryptocurrency, and mining.
As stated, the country or countries in which a company operates or is associated can have an impact on their risk rating. Amongst other reasons, this is due to the fact that there are jurisdictions with weaker measures to combat ML/TF. Due Diligence procedures should include a country risk rating, which can be determined using several sources, including Tax Haven status, Human Rights records, Basel Governance rankings, Financial Action Taskforce (FATF) evaluations, and Transparency International Corruptions Perception Index.
Integrity – Screening
The final pillar of effective Due Diligence is proving the integrity or upstanding character of a company and its associated persons. This typically involves determining whether a company, its owners, shareholders or beneficiaries are subject to sanctions, law enforcement actions, regulatory enforcement, or are connected to politically exposed persons (PEPs).
This screening will also inform whether any potentially inappropriate, or unethical activities have been carried out by the company which may be inconsistent with the values held by the company conducting Due Diligence. This includes any activities or dealings that may damage the company’s reputation by association.
Why is Due Diligence so important in the cannabis industry?
As we mentioned in our analysis of the JuicyFields case, Due Diligence takes on an especially important role within the cannabis industry. While the global sector has undoubtedly come a long way over the last decade or so, there is no denying that it is still a relatively new industry – one with which regulatory practices are yet to catch up in many countries. This makes cannabis a high-risk sector.
Nonetheless, we are increasingly seeing cannabis-centric businesses launch onto stock exchanges around the world, make valuable acquisitions, and receive significant investments. This only makes effective Due Diligence practices even more important.
Due Diligence Reporting
As you can see, a lot of work goes into conducting comprehensive Due Diligence – but the hard work is definitely worth doing. Ensuring appropriate Due Diligence is conducted before establishing any business relationship – particularly within high-risk sectors like the cannabis industry – can save companies and their owners from being defrauded, becoming involved with or associated with money laundering, the financing of terrorism, or other illegal activity.
Shweed offers comprehensive Due Diligence Reporting that covers each of the categories above, giving clients peace of mind and helping to ensure their ongoing compliance and financial safety.