Cannabis Investors and Producers Face Need for Due DiligenceSeptember 1, 2020 | Stella Lellos | Benjamin P. Malerba |
The cannabis industry is growing in leaps and bounds, but entrepreneurs interested in developing cannabis companies – as well as business people interested in investing in them – must make certain that they know what they are getting themselves into. That is where “due diligence,” including understanding how the bankruptcy law applies to cannabis companies, becomes crucial.
After years of unrealized expectations, it looks as if the cannabis industry is in an unstoppable growth spurt, or at least poised to do so. More than half of the states in the United States already have legalized medical or recreational marijuana, or both. Although cannabis remains a Schedule I drug under the federal Controlled Substances Act (CSA), the 2018 Farm Bill removed hemp from the definition of marijuana in the CSA. Hemp is defined as cannabis and derivatives of cannabis with extremely low concentrations of the psychoactive compound delta-9-tetrahydrocannabinol (THC) – that is, no more than 0.3 percent THC on a dry weight basis.
These developments, and no doubt other societal and economic factors, have led to an increased demand for cannabis products. At the same time, more and more individuals are interested in starting, working in or investing in a cannabis business, driven perhaps by the lure of high rewards.
There are steps that participants in every industry typically take before dipping their toes in the water – otherwise known as “due diligence.” These range from appraising the risks and evaluating assets, liabilities and potential profit to understanding the essence of a company’s operations.
The need for due diligence is no less important for investors seeking to get involved in a cannabis company and those seeking to create one – and may, in fact, be even more necessary – than when examining a more traditional entity for investment purposes.
The primary complicating factor for the cannabis industry today is the hodgepodge of laws governing cannabis in its various forms.
Specifically, although cannabis remains illegal under federal law, marijuana is lawful in some states for recreational or medicinal purposes. Moreover, certain forms of hemp and products derived from hemp, such as cannabidiol (CBD) oil, are no longer illegal under federal law although they remain subject to strict federal regulation, including by the U.S. Food and Drug Administration (FDA).
These inconsistent and conflicting rules have significant practical implications that everyone involved in the cannabis industry must recognize and understand.
For one thing, because cannabis continues to remain illegal under federal law, cannabis companies generally are unable to open bank accounts, borrow funds or maintain banking relationships with federally chartered banks. Legislation has been introduced in Congress that would, if passed, ameliorate this problem, but whether such legislation will be passed and in what timeframe remains unclear.
Some state banks, notably in Colorado, offer certain banking services to cannabis businesses that operate lawfully in their state, but cannabis companies face higher fees than other businesses, the bank accounts they are able to obtain may be more restricted than those available to other businesses, and they also have to face questions about the sustainability of their banking relationship – especially if federal authorities decide to challenge their validity under federal law, perhaps seizing or seeking the forfeiture of the cannabis companies’ accounts.
A second concern stems from the federal Controlled Substances Act’s (CSA’s) classification of cannabis as a Schedule I drug: Cannabis companies are not eligible for relief under the federal bankruptcy laws, rendering them unable to hold off creditors temporarily so that they can either undergo an orderly liquidation or so they can restructure. The prohibition on cannabis companies entering bankruptcy also limits the ability of investors to potentially recover at least some portion of their investment. It also makes it all the more important that investors know the other entities that conceivably may have a claim on the cannabis company’s assets.
Another federal issue relates to the availability of intellectual property (IP) protection – patents, trademarks and copyrights – for cannabis products. For example, edibles are considered to be formulas and recipes and, therefore, are not patentable.
The IP risk is quite clear. Consider that the U.S. Patent and Trademark Office (PTO) rejected an application by Stanley Brothers Social Enterprises, LLC, to register a trademark for its CBD products, which it indicated it intended to sell as food supplements. The PTO found that Stanley Brothers’ products were unlawful under the CSA as well as under the Federal Food Drug & Cosmetic Act (FD&C Act). This finding was supported by a panel of administrative judges sitting on the Trademark Trial and Appeal Board who subsequently agreed with that decision.
The bottom line is that it is important for all parties to consider the extent to which IP protection is available for a cannabis company’s products and product names, among other assets, and how the unavailability (or questionability) of that protection affects the underlying business plan.
Before business people engage in, or invest in, these companies, they must fully understand the applicable state laws, many of which are quite strict. Additionally, in many instances, one state’s law differs quite significantly from that of another.
For one thing, local zoning laws might affect the ability of a cannabis company to operate in a particular building or area. In Colorado, certain areas are zoned for marijuana purposes, and marijuana companies must operate in only those zones. Other state laws prohibit dispensaries or other cannabis-related retailers from being near schools, playgrounds or houses of worship. In California, marijuana dispensaries are permitted by state law to sell weed and edibles. By contrast, New York severely limits the number of medical marijuana dispensaries in the state, and the form in which the product may be sold.
State law also determines the ability of creditors holding security interests to foreclose on those security interests. Suppose a creditor claims a lien on a marijuana company’s inventory and has properly and timely filed a UCC-1 financing statement. If the debtor defaults, will the creditor be able to foreclose on the debtor’s marijuana? In other words, is the marijuana inventory? Does it matter if the debtor is a grower, is supplying seeds to retailers or is selling directly to consumers?
Cannabis companies also are subject to state licensing laws. These laws may require applications from business owners, criminal background checks and financial disclosures. In some instances, investors also may be required to provide similar information and undergo similar background checks, all of which can be quite invasive and which investors may be unwilling to provide.
A Cash Business
In part due to the limited ability of cannabis companies to develop banking relationships, and in part due to the historical nature of the cannabis industry, a substantial portion of the payment stream is conducted in cash.
There are numerous issues raised by a cash cannabis business:
- Who holds the cash?
- How can the risk of theft be diminished, which is especially important since cash generally is not an insurable asset?
- Will employees, local suppliers and creditors accept payments in cash?
- How can payments be made to creditors and others located across state lines, or across the country?
- How can investors physically make large investments of, say, $500,000 or more if the company operates only on a cash basis?
- What will financial statements look like?
- How can accountants and auditors reasonably be assured that financial statements prepared by a cannabis company are fair and accurate and that they meet generally accepted accounting principles?
It certainly may be possible to resolve some of these questions – for example, producers can install a safe and alarm system, and perhaps other security, at each location where cash is on hand. Others may not be as easily worked out. In those circumstances, business owners and investors may have to understand the risks and weigh their significance before deciding whether to proceed.
Payments to Cannabis Companies
A corollary to the cash problem is the question of how the cannabis company itself gets paid. It likely will be in cash, but it also might be in bitcoin, through Venmo or other mobile payment services, or electronically.
Suppose a dispensary reaches an agreement with a gift card company to put one of its gift card machines in the dispensary. Then, a customer can come in to the dispensary, put cash in the machine, buy a gift card, and use the gift card to purchase marijuana. But what does the dispensary then do with the gift cards? Does the gift card company pay cash to the dispensary for the gift cards in its possession? If so, are the payments at face value or at some discount?
Put differently, how can the cannabis company or investors in the cannabis company access the payments the company receives through these methods?
This is an important subject for investors, and for business owners, to think about.
Investors in particular should be aware that many cannabis businesses rely on “creative” corporate structures when forming their business. Thus, an investor that seeks to invest in a company that grows marijuana should make sure that the company it wants to invest in actually is the company that is growing marijuana. It is very important for investors to know the structure of what they are investing in.
Suppose that a business owner forms a company to make and bake edibles and a second company to grow marijuana. An investor should clearly understand if its investment is in the bakery or in the grower.
Even if an investor is confident at the initial stage of its investment that the cannabis company’s structure is what it understands it to be, the cannabis company may not continue to operate properly as time passes. This could lead to a situation where the “corporate veil” is breached, and assets from two or more corporations are combined to pay some creditors, leaving other creditors facing a shortfall.
Yet another issue that both business owners and investors should focus on is the company’s business plan.
Are the cannabis company’s prospective customers exclusively within the cannabis company’s state of incorporation? Do its projections rely on interstate sales, which may not be permissible or lawful? How does a state’s regulatory scheme affect the business plan?
On a more basic level, does the business owner understand what applicable laws permit and forbid? If the proposed business is to sell a CBD product, does the business owner know the 0.3 percent THC limit under federal law (and the lesser rule under applicable state law, if any), the legitimate suppliers from which it can purchase its product and the limits on the representations it can make in its advertising and promotional materials?
The future of the cannabis industry looks quite bright for business owners and investors – and for state coffers. At some point, Congress may amend the CSA to legalize marijuana or at the least authorize federally chartered banks to work with cannabis companies, the federal government may announce that it is not going to interfere with state marijuana laws, the FDA may finally issue a set of CBD regulations and even more states may legalize marijuana and clarify (or be forced by courts to clarify) how they handle cannabis-related businesses. We may be on the cusp of some or all of that occurring, which would likely diminish the risks identified in this article for owners and investors alike. Until there is more certainty however, an owner or investor would be best-served by using all existing resources to conduct thorough due diligence to understand the risks and benefits of a cannabis-related business.
- Stella Lellos
- Benjamin P. Malerba