Cannabis Investors and Producers Face Want for Due Diligence

September 1, 2020 | Benjamin P. Malerba | Stella Lellos | Cannabis

The cannabis market is increasing in leaps and bounds, but entrepreneurs interested in creating cannabis firms – as nicely as enterprise people today interested in investing in them – should make specific that they know what they are receiving themselves into. That is exactly where “due diligence,” like understanding how the bankruptcy law applies to cannabis firms, becomes vital.

Just after years of unrealized expectations, it appears as if the cannabis market is in an unstoppable development spurt, or at least poised to do so. Extra than half of the states in the United States currently have legalized health-related or recreational marijuana, or each. Even though cannabis remains a Schedule I drug below 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 exceptionally low concentrations of the psychoactive compound delta-9-tetrahydrocannabinol (THC) – that is, no extra than .three % THC on a dry weight basis.

These developments, and no doubt other societal and financial elements, have led to an improved demand for cannabis goods. At the identical time, extra and extra men and women are interested in beginning, functioning in or investing in a cannabis enterprise, driven probably by the lure of higher rewards.

There are measures that participants in each market normally take ahead of dipping their toes in the water – otherwise identified as “due diligence.” These variety from appraising the dangers and evaluating assets, liabilities and possible profit to understanding the essence of a company’s operations.

The have to have for due diligence is no much less critical for investors looking for to get involved in a cannabis business and these looking for to build 1 – and may perhaps, in reality, be even extra vital – than when examining a extra conventional entity for investment purposes.

Federal Law

The main complicating element for the cannabis market nowadays is the hodgepodge of laws governing cannabis in its many types.

Particularly, though cannabis remains illegal below federal law, marijuana is lawful in some states for recreational or medicinal purposes. In addition, specific types of hemp and goods derived from hemp, such as cannabidiol (CBD) oil, are no longer illegal below federal law though they stay topic to strict federal regulation, like by the U.S. Meals and Drug Administration (FDA).

These inconsistent and conflicting guidelines have substantial sensible implications that everybody involved in the cannabis market should recognize and realize.

For 1 issue, since cannabis continues to stay illegal below federal law, cannabis firms normally are unable to open bank accounts, borrow funds or retain banking relationships with federally chartered banks. Legislation has been introduced in Congress that would, if passed, ameliorate this issue, but irrespective of whether such legislation will be passed and in what timeframe remains unclear.

Some state banks, notably in Colorado, offer you specific banking solutions to cannabis companies that operate lawfully in their state, but cannabis firms face greater costs than other companies, the bank accounts they are capable to acquire may perhaps be extra restricted than these offered to other companies, and they also have to face concerns about the sustainability of their banking partnership – specially if federal authorities make a decision to challenge their validity below federal law, probably seizing or looking for 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 firms are not eligible for relief below 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 firms getting into bankruptcy also limits the capacity of investors to potentially recover at least some portion of their investment. It also tends to make it all the extra critical that investors know the other entities that conceivably may perhaps have a claim on the cannabis company’s assets.

One more federal situation relates to the availability of intellectual house (IP) protection – patents, trademarks and copyrights – for cannabis goods. For instance, edibles are regarded as to be formulas and recipes and, as a result, are not patentable.

The IP danger is pretty clear. Think about that the U.S. Patent and Trademark Workplace (PTO) rejected an application by Stanley Brothers Social Enterprises, LLC, to register a trademark for its CBD goods, which it indicated it intended to sell as meals supplements. The PTO identified that Stanley Brothers’ goods have been unlawful below the CSA as nicely as below the Federal Meals Drug &amp Cosmetic Act (FD&ampC Act). This obtaining was supported by a panel of administrative judges sitting on the Trademark Trial and Appeal Board who subsequently agreed with that choice.

The bottom line is that it is critical for all parties to take into consideration the extent to which IP protection is offered for a cannabis company’s goods and item names, amongst other assets, and how the unavailability (or questionability) of that protection impacts the underlying enterprise strategy.

State Law

Prior to enterprise people today engage in, or invest in, these firms, they should completely realize the applicable state laws, numerous of which are pretty strict. Also, in numerous situations, 1 state’s law differs pretty drastically from that of a further.

For 1 issue, nearby zoning laws could possibly have an effect on the capacity of a cannabis business to operate in a distinct constructing or location. In Colorado, specific locations are zoned for marijuana purposes, and marijuana firms should operate in only these zones. Other state laws prohibit dispensaries or other cannabis-connected retailers from becoming close to schools, playgrounds or homes of worship. In California, marijuana dispensaries are permitted by state law to sell weed and edibles. By contrast, New York severely limits the quantity of health-related marijuana dispensaries in the state, and the type in which the item may perhaps be sold.

State law also determines the capacity of creditors holding safety interests to foreclose on these safety interests. Suppose a creditor claims a lien on a marijuana company’s inventory and has correctly and timely filed a UCC-1 financing statement. If the debtor defaults, will the creditor be capable 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 promoting straight to customers?

Cannabis firms also are topic to state licensing laws. These laws may perhaps demand applications from enterprise owners, criminal background checks and economic disclosures. In some situations, investors also may perhaps be necessary to supply related info and undergo related background checks, all of which can be pretty invasive and which investors may perhaps be unwilling to supply.

A Money Organization

In portion due to the restricted capacity of cannabis firms to create banking relationships, and in portion due to the historical nature of the cannabis market, a substantial portion of the payment stream is carried out in money.

There are several troubles raised by a money cannabis enterprise:

  • Who holds the money?
  • How can the danger of theft be diminished, which is specially critical considering the fact that money normally is not an insurable asset?
  • Will personnel, nearby suppliers and creditors accept payments in money?
  • How can payments be created to creditors and other people situated across state lines, or across the nation?
  • How can investors physically make significant investments of, say, $500,000 or extra if the business operates only on a money basis?
  • What will economic statements appear like?
  • How can accountants and auditors reasonably be assured that economic statements ready by a cannabis business are fair and correct and that they meet normally accepted accounting principles?

It absolutely may perhaps be attainable to resolve some of these concerns – for instance, producers can set up a secure and alarm method, and probably other safety, at every place exactly where money is on hand. Other folks may perhaps not be as quickly worked out. In these situations, enterprise owners and investors may perhaps have to realize the dangers and weigh their significance ahead of deciding irrespective of whether to proceed.

Payments to Cannabis Providers

A corollary to the money issue is the query of how the cannabis business itself gets paid. It most likely will be in money, but it also could possibly be in bitcoin, by means of Venmo or other mobile payment solutions, or electronically.

Suppose a dispensary reaches an agreement with a present card business to place 1 of its present card machines in the dispensary. Then, a client can come in to the dispensary, place money in the machine, obtain a present card, and use the present card to buy marijuana. But what does the dispensary then do with the present cards? Does the present card business spend money to the dispensary for the present cards in its possession? If so, are the payments at face worth or at some discount?

Place differently, how can the cannabis business or investors in the cannabis business access the payments the business receives by means of these techniques?

This is an critical topic for investors, and for enterprise owners, to assume about.

Corporate Issues

Investors in distinct need to be conscious that numerous cannabis companies rely on “creative” corporate structures when forming their enterprise. Therefore, an investor that seeks to invest in a business that grows marijuana need to make certain that the business it desires to invest in truly is the business that is increasing marijuana. It is pretty critical for investors to know the structure of what they are investing in.

Suppose that a enterprise owner types a business to make and bake edibles and a second business to develop marijuana. An investor need to clearly realize 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 business may perhaps not continue to operate correctly as time passes. This could lead to a circumstance exactly where the “corporate veil” is breached, and assets from two or extra corporations are combined to spend some creditors, leaving other creditors facing a shortfall.

But a further situation that each enterprise owners and investors need to concentrate on is the company’s enterprise strategy.

Are the cannabis company’s potential prospects exclusively inside the cannabis company’s state of incorporation? Do its projections rely on interstate sales, which may perhaps not be permissible or lawful? How does a state’s regulatory scheme have an effect on the enterprise strategy?

On a extra fundamental level, does the enterprise owner realize what applicable laws permit and forbid? If the proposed enterprise is to sell a CBD item, does the enterprise owner know the .three % THC limit below federal law (and the lesser rule below applicable state law, if any), the reputable suppliers from which it can buy its item and the limits on the representations it can make in its marketing and promotional components?

Conclusion

The future of the cannabis market appears pretty vibrant for enterprise owners and investors – and for state coffers. At some point, Congress may perhaps amend the CSA to legalize marijuana or at the least authorize federally chartered banks to perform with cannabis firms, the federal government may perhaps announce that it is not going to interfere with state marijuana laws, the FDA may perhaps ultimately situation a set of CBD regulations and even extra states may perhaps legalize marijuana and clarify (or be forced by courts to clarify) how they deal with cannabis-connected companies. We may perhaps be on the cusp of some or all of that occurring, which would most likely diminish the dangers identified in this short article for owners and investors alike. Till there is extra certainty nevertheless, an owner or investor would be very best-served by utilizing all current sources to conduct thorough due diligence to realize the dangers and positive aspects of a cannabis-connected enterprise.

Share this short article:

Latest posts