Revelations yesterday that Canntrust (TSX:TRST)(NYSE:CTST)‘s production had been supplemented by rooms at their facility that had yet to be blessed as kosher by Health Canada sent a shock wave through the cannabis space, giving investors pause. If the government can just walk in to an LP and declare product illegal, including – apparently – product that has already been shipped, then does any company truly “have” the inventory that they’ve reported?

Very few companies actually publish their inventory in weight anymore, and that includes Canntrust, so perhaps the narrative focusing on the 5,200 kg seized and 7,500 kg that the company has put on a “voluntary hold,” is understandable; it’s the closest thing we’ve got a number. So far, nobody’s thought to ask what portion of the company’s available inventory that represents. As obsessed as we are with denominators, it doesn’t matter enough to call IR for the inevitable, “I don’t know.” Inventory or no inventory, Canntrust is cooked.

The Financial Post‘s Vanmala Subramaniam extracted a defensive mea culpa from Canntrust CEO Peter Aceto yesterday, amid an explanation that the illicit flower had been grown in rooms ready for licensing, before they were licensed, and that the former ING Direct exec is going to do better with his enterprise, etc. The author of Globe and Mail bestseller “WEOLOGY: How everybody wins when we comes before me,” doesn’t strike us as the kind of guy ready to take responsibility for the operation’s shortcomings alone.

Aceto told the Post that one employee was terminated in relation to the unlicensed growing, but that a “root-cause analysis” would be conducted by the company, with the help of third-party firm, Quality and Compliance Consulting Inc., to determine exactly who was responsible in sanctioning the growing of cannabis in yet-to-be-licensed rooms.

There’s no telling if this is the beginning of some kind of crackdown or an isolated incident, but the company’s reaction suggests the later. Canntrust’s public statement on the infraction has them growing in five rooms that were licensed in April 2019 as far back as October of 2018, and some careful observers have pointed out that that isn’t the first time they tipped us to this unlicensed back-room grow.

“Mr. Aceto? Some guy named Bruiser to see you… says he’s here to administer a beating?”

Smart Money Gains ran an extensive piece of original reporting by twitter fixture and Harvest Moon Cannabis’ own Betting Bruiser, which is well worth the read. The Bruiser’s very well-sourced and well-reported work puts the June surprise inspection that started all of this down to an internal snitch (who apparently didn’t read Aceto’s book) tipping Health Canada off to the unlicensed activities. Bruiser has some key specifics about the infraction that can help us figure out what went on in Pelham, and what to do with this mess.

The rooms in question were part of the 200,000 square foot Phase 2 expansion and seemingly weren’t licensed until April 2019. However, CannTrust touted that the construction of the Perpetual Harvest Facility was substantially completed in the first quarter of 2019. CannTrust noted a substantial increase in the fair value of biological assets recorded during that period they claimed was due to “the ramp up of production at the Perpetual Harvest Facility following approval from Health Canada of the final rooms from Phase 2”. Populating unlicensed areas with plants would create an uptick in volume in biological assets as represented in the March filings.

-Can’tTrust: Products seized, license suspension incoming, Smartmoneygains.com July 8th 2019 (emphasis added)

The details matter, and we were surprised to learn that Canntrust would tell on themselves like that. A look through Canntrust’s filings shows that – from the perspective of Health Canada, who know what they’ve licensed and what they haven’t – Canntrust has been telling on themselves for quite some time.

A January 22, 2019 press release about the beginning of construction on Phase 3 the company’s “Perpetual Harvest” facility in Pelham describes Phase 2 as “fully permitted,” and “on course,” for a first harvest in the first quarter of 2019.

The company’s MD&A for the period ending in December 2018, released March 27, 2019, contains a table labeled “operational overview” that lists both Phase 1 and Phase 2 as an “in production” grow facility, licensed for cultivation and sale.

By the March MD&A, Canntrust was describing the Phase 2 facility as “fully licensed by Health Canada as of the date of this MD&A (May 27, 2019),” which only begs the question about why they never mentioned before that it was only partially licensed.

When things like this happen, class action lawyers put together claims in less time than it takes to watch an episode of Matlock. Firms infest news feeds with press releases trying to get investors to sign on as a member of the class, and they’re often worth ignoring; the securities law equivalent of ambulance chasing.

In this instance, we’re not so sure. Rosen had their class action presser out within hours and, between yesterday’s blubbering admission, and public statements that quite clearly tell investors that the company was growing in a licensed facility at a time they clearly weren’t, it would take Lionel Hutz to fail to convert on that one (RIP Phil Hartman).

Having now shipped some of the illicit product internationally, the company could conceivably be facing international trafficking charges, which might mean the end of their US listing.

At the end of March, Canntrust had CAD$3 million $20.7 million in the bank, and $10 million in debt. This mess showed up just as they were in the process of finalizing had just closed a US$200 million raise at US$5.50/share that the underwriters are most likely going to be looking to get out from under until things settle down a bit.

We have a bearish outlook on TRST.

CORRECTION: Canntrust showed a  CAD$20.7 million cash balance at the end of March, NOT the CAD$3 million previously reported in this post. $3 million was TRST’s cash balance at the end of December. Fundamental Hype regrets the error. We’ve also updated the post to include Canntrust’s $10M in debt. Canntrust’s financials for the period ending March 2019 can be found here.

FURTHER CORRECTION: Turns out that Canntrust DID close that $200 million raise, which only further complicates things. Subscribers surely have a case that it was conducted under false pretenses. This could get ugly.