Despite commodity prices and demand growth that are the envy of every other industry, cannabis companies still go out of business sometimes. Why? That’s another story. But despite a spate of high-profile failures, there is still no well-paved path to liquidating a corporation that sells cannabis.
This puts potential lenders at risk, which in turn tends to increase the interest rates the remaining funders can charge.
As previously reported in Cannabis Business Times, debt raised through private placement is surging as industry firms seek capital. Still, just because investors might have a document entitling them to be paid back from an asset sale upon default, that doesn’t mean they’ll be able to collect.
“There is no guarantee,” according to court-appointed receiver Ted Lanes, whose California-based company works to assist creditors and defaulting companies find solutions. “Licenses typically cannot be used as collateral, and inventory has its own issues. Lenders may be able to secure loans with direct ownership of the stock or partnership interests, but those values obviously decrease in a distressed situation. If there is value in the brand, or any [intellectual property], that may mitigate the risk.”
Cannabis & Bankruptcy
There are two kinds of investors: equity holders and debt holders.
Equity holders are willing to endure higher risk to get a higher reward; there is unlimited upside, but, if the business goes bust, equity holders get nothing.
Debt holders aren’t interested in the upside; they’re willing to lend the firm money, but demand that the note be paid back on time—in full and with interest. If the business goes bust, its assets get sold off and the lenders are first in line to get paid.
In the non-cannabis world, this is handled by bankruptcy, a court-ordered process that creates a protective legal shield around the debtor, allowing them to do any or all of a number of things to satisfy the lenders. Bankruptcy allows the company to liquidate its assets—essentially just sell off everything it owns. More often it allows the company to restructure its finances and operations, allowing the company to stay in business while its management strikes a deal with creditors. This often involves special dispensation to back out of leases or other contracts, and to pay back those creditors less than they’re owed.
Where this solution falls apart is that, like many other financial remedies, bankruptcy protection is not available to cannabis or even cannabis-adjacent firms. That’s because we are in a moment when the industry is sandwiched between its classification as a Drug Enforcement Agency Schedule 1 drug and the relief that would be brought by the SAFE Banking Act, which was once again stalled by the U.S. Senate in June.
The language provided by a memo from the Justice Department’s United States Trustee Program (USTP), which represents the federal government in bankruptcy courts, is illustrative.
“The USTP’s response to marijuana-related bankruptcy filings is guided by two straightforward and uncontroversial principles. First, the bankruptcy system may not be used as an instrument in the ongoing commission of a crime and reorganization plans that permit or require continued illegal activity may not be confirmed,” according to the 2017 memo. “Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets if doing so would cause them to violate federal criminal law.”
Meantime, cannabis operators’ need for some kind of relief from creditors is dire.
That’s not to say there’s no way for creditors to collect. These include:
- Out-of-court workout;
- Assignment for the benefit of creditors (ABC);
- State court receivership; and
- State-regulated remedies under the Uniform Commercial Code.
Dallas-based cannabis consultancy UnitedCMC provided Cannabis Business Times with a comparison grid (see above).
Out-of-court workout checks the most boxes and does so at a moderate price. It is predicated on there being some sense of good faith between the debtor and the creditors, as it does not involve hiring a third party to arbitrate.
“A workout is [a] non-judicial process through which a financially distressed company can negotiate with its creditors to restructure the amount or repayment terms of debt,” according to the website of U.S. law firm Fox Rothschild, which has a cannabis practice. “A successful workout can enable a company to continue to operate with the same management.”
Receivership can accomplish everything that a workout can, but is also the most expensive option, according to UnitedCMC, which acts as a receiver for distressed businesses. Typically, the court appoints a receiver at the request of the creditors.
“Receivership is an old, tested and proven legal tool to marshal, protect and preserve assets,” according to UnitedCMC President Dotan Y. Melech. “In today’s environment, this can include revocable privileged cannabis licenses as well as cannabis products.”
The greatest barrier, though, is that the rules governing receivers vary state by state, so courses of action that might be legal in one jurisdiction might be precluded in a neighboring one.
They might also change right in the middle of proceedings.
In the case of dispensary operator CWNevada, “The regulatory regime made a wholesale change in how marijuana would be regulated in Nevada. This took place in the middle of the receivership process,” according to Melech. “The Cannabis Compliance Board was created, replacing the Department of Tax as the regulating authority. Additionally, there were no laws governing cannabis receivership in Nevada until 2021, which led to the promulgation of regulations for receivership.”
An ABC is a voluntary alternative to bankruptcy that transfers the assets from the debtor to a trust for liquidation and distribution, according to Cornell Law School. The trustee will manage the assets to pay off debt to creditors, and if any assets are left over, they will be transferred back to the debtor. The advantages to the company are that management can choose the trustee and that the process is fairly rapid compared to that for bankruptcy. ABCs, however, are not without their critics.
“I am personally not a fan of ABCs,” Lanes says. “In a receivership, there is a court order both defining roles and protecting the receiver and their staff from litigation by parties. That does not exist in an ABC. The assignment of the assets is done under the purported default of the loan agreements, and creditors can, and do, bring litigation if they don’t think they will get any recovery of their funds. In short, it is certainly faster, and less expensive, but risky.”
If there is no suggestion of reorganization and liquidation is the only goal, there is some protection for creditors under the Uniform Commercial Code, which governs contracts. Specifically, they fall under Article 9, which focuses on debt. Creditors whose interests are secured by company assets can lay claim to those assets and sell them off, essentially doing what a bankruptcy court would do if it could. Without the court’s blessing, though, this course of action is fraught with risk.
“This is a limited option for security holders,” according to Melech. “However, revocable privileged licenses are not considered personal property, and cannabis inventory cannot be subject to foreclosure. Any sale or transfer of cannabis products requires a state-approved license.”