It is not very common for banks and financial institutions to provide commercial loans to cannabis companies in Arizona. So why is that? The answer is not always as simple as it may seem.
The first thing to consider is what collateral the lender could secure if it wanted to make a loan to a cannabis enterprise in Arizona. In general, there are two classes collateral – real property and personal property. To perfect a security interest in real property in Arizona, a lender must record a deed of trust in the real property records in the county where the real property is located. In general, to perfect a security interest in personal property, among other things, a lender is required to file a Uniform Commercial Code (“UCC”) Financing Statement (commonly referred to as a UCC-1 Financing Statement) with the Arizona Secretary of State (the “SOS”).
All of this seems rather straightforward but there are several twists and turns. For a lender, to ensure it can recover if there is a default by a borrower, these issues are paramount. And even if some of these issues can be overcome, banks and financial institutions must nevertheless comply with the Treasury Departments Guidelines entitled BSA Expectations Regarding Marijuana-Related Businesses (FIN-2014-G001, issued on February 14, 2014) (the “Guidelines”) during the pendency of the loan.
Can A Cannabis License be Used as Collateral?
The primary asset for any cannabis company in Arizona is the license. In fact, just a license in Arizona has purportedly been valued in the $10,000,000 to $15,000,000 range. Can a lender take a security interest in the license of a nonprofit entity in Arizona? The short and long answers are – NO. A lender need look no further than the Arizona Administrative Code (“AAC”). AAC R9-17-306(A) states, “A dispensary may not transfer or assign the dispensary registration certificate.”
Thus, if a lender attempted to foreclose on the cannabis license of a nonprofit entity, it would be a fruitless exercise. The Arizona Department of Health Services (the “Department”), which is the regulatory agency for cannabis in Arizona, would not recognize the lender as a new license holder, and thus, the lender would not be able to run the operations or sell the license to another entity.
Would the result be any different for an adult use licensee or a dual licensee that is for profit entity? The answer remains the same – NO. AAC R9-18-305(A) states, “A marijuana establishment receiving a marijuana establishment license pursuant to R9-18-303(E) may not separately transfer or assign the dispensary registration certificate or the marijuana establishment license.” So, the most valuable asset of any cannabis operation in Arizona is not subject to foreclosure or enforcement by a lender.
Can a Lender take a Security Interest in the Cannabis Itself?
The second issue is whether a lender can take a security interest in the actual cannabis inventory or the raw flower produced by a cannabis company. Generally, as noted above, to perfect a security interest in product or inventory, a lender would need to file a UCC-1 Financing Statement with the Arizona SOS. Once the crops are converted into inventory, the lender’s security interest would need to attach to that product (or the “proceeds” of the inventory). Again, this is typically accomplished by a well-crafted UCC-1 Financing Statement (there are other requirements to take a security interest in the personal property, like the grant of the right from the borrower, etc. However, that is beyond the scope of this article).
The Uniform Commercial Code in Arizona has been codified under A.R.S. § 47-1101 et seq. Chapter 9 of the UCC in Arizona, which deals with the creation and enforcement of security interests can be found under A.R.S. § 47-9101 et seq. There is no express prohibit on granting or taking a security interest in cannabis collateral in Arizona. However, while that may seem like the end of the inquiry, there is more to consider. Mainly, as noted above, a lender who does not hold a license with the Department could never foreclose and sell the cannabis collateral.
However, there are other creative solutions for lending to nonprofit entities. For example, a cannabis company that has entered into a management agreement with another entity may have collateral that can be both secured and enforced under Arizona law. One simple example would be if the management company owned a building where it cultivated and produced cannabis products. Certainly, a lender could take a security interest in the building itself. Likewise, certain fixtures, furniture, and equipment could also be subject to a security interest where the lender could realize some value if the borrower defaults on the loan.
What are the Lending Implications under the Guidelines?
Most banks and financial institutions must also comply with the Guidelines as we’ve discussed extensively on this blog. Click here to view a copy of the FinCen Guidelines. For commercial lending purposes, one of the “red flags” identified in the FinCen Guidelines is – “A marijuana-related business purporting to be a ‘non-profit’ is engaged in commercial activity inconsistent with that classification, or is making excessive payments to its manager(s) or employee(s).”
Thus, in the management services agreement (“MSA”) structure discussed above, it is vitally important to ensure that a cannabis operation complies with the various Arizona nonprofit laws. MSAs can literally be a mine field for those unfamiliar with Arizona’s nonprofit laws and the Guidelines. Not only could a violation subject the nonprofit cannabis entity to various penalties and the loss of its nonprofit status, but a poorly crafted MSA will almost certainly dissuade a commercial lender from lending to that entity. No lender wants to be accused of aiding and abetting money laundering or the like.
The Guidelines also require a lender to continually monitor its commercial cannabis borrowers or customers. For example, the Guidelines require: “[(a)] ongoing monitoring of publicly available sources for adverse information about the business and related parties; [(b)] ongoing monitoring for suspicious activity, including for any of the red flags described in this guidance; and [(c)] refreshing information obtained as part of customer due diligence on a periodic basis and commensurate with the risk.” Thus, a nonprofit cannabis company that is shopping for a loan must ensure that it complies not only with Arizona’s various cannabis laws, but also Arizona’s nonprofit laws (and by implication, the Guidelines).
While commercial lending is not prohibited for cannabis companies in Arizona, there are many issues to consider for a lender interested in the Arizona market. We have only provided some of the more significant issues to consider. Contact our Phoenix office to learn more.