We’re in that time of year when at least some of the licensed cannabis producers in Washington tend struggle. A short-term glut of marijuana on the market makes it harder to stand out and make sales, and businesses that aren’t competitive on price or quality get left behind. I bring this up because it is also the time of year when financiers come to my firm’s cannabis business lawyers looking for a way out of deals they fear will never pay off.
“Financiers” in the Washington marijuana system generally refers to debt investors that get a set interest rate of return rather than a profit-interest in a business. Mark Cuban once said that only a moron would start a business on a loan, but the limitations on out-of-state equity ownership leave many newish cannabis businesses cash-strapped, so they turn to debt. We have also seen that many of the creditors involved in the local marijuana industry are not seasoned small-business investors. They are people looking to take advantage of an industry that seems to be printing money. Debt feels less risky than equity, so they throw some money into a cannabis business or two, believing they will be able to get 10%-20% interest annually.
Because so many of these investors are new to small business investing, many don’t protect themselves. Lenders have a lot of tools to make sure they get paid. Security interests in real, personal, and intangible property provide avenues for seizing assets. Marijuana inventory is complicated to secure, but most marijuana businesses have at least some high dollar capital equipment. Personal guarantees from major players put personal assets on the hook as well, and signed confessions of judgment make the process of obtaining a judgment on the debt significantly easier. Most loans do not involve all of these protections, but most smart lenders are not willing to provide completely unsecured capital to brand new businesses without any way to get a return if the business folds.
If you are one of those unsecured investors and the cannabis company to whom you loaned money defaults on your loan, what can you do? If you want any chance of recouping your investment, you really only have two options. First, you can renegotiate the debt. In most well-drafted promissory notes, an uncured event of default causes the debt to accelerate and mature. This means that if your cannabis borrower misses a payment and doesn’t make a late payment by the cure date, its entire debt becomes due. Once this happens, it is just a matter of negotiating an extension on the note. During that extension, you as the creditor have significant leverage to extract concessions from your cannabis borrower, such as personal guarantees, security interests, or even pledges of ownership interest in the cannabis company. The reason you as the creditor have leverage is because your only other viable option would be to obtain a judgment against the borrowing company and that judgment will likely be a nightmare for your borrower. If you are wiling to brave the legal fees and get a judgment against your borrower, you can then use that judgment to begin levying on the cannabis business’s assets as though you had a security interest in the property to begin with. In most states, once you get the judgment, at least some of what you spend collecting on it, including your attorneys’ fees, will be collectable as well.
Companies that owe debts to third parties and realize that they are about to go under sometimes look for ways to avoid paying the debt. This is a good time to bring up fraudulent transfers. As defined in most states, a fraudulent transfer occurs in a few different ways, the most common of which is when an insolvent debtor transfers property without receiving a reasonably equivalent value in the exchange. If an “insider” — someone connected to the company like a director or a director’s spouse — is involved in the transaction, showing fraudulent transfers becomes far easier. For example, if a debtor company has a bunch of equipment and transfers it to the company owner’s brother, that is potentially a fraudulent transfer, and the property can be clawed back for creditors.
The stickiest situations come when there are multiple debts. A company is not necessarily breaking any laws if it chooses to pay one creditor before it pays other creditors. Unless the creditor is an “insider,” the company can generally choose which of its debts to pay unless it is in a formal bankruptcy (probably not available to marijuana businesses) or a state receivership proceeding. In certain circumstances, multiple debt investors have signed promissory notes in which the company promises not to pay the notes proportionally and not to provide any payment preference. If the debtor company does pay one holder disproportionately to the others in that circumstance, the creditor left-behind may be entitled to a clawback of the payment.
These collections matters don’t usually end with either side truly happy. Attorneys make some money, and investors can often recoup a portion of their investments, but debt litigation against a business is an unpleasant affair. If you are looking to lend to a cannabis company, make sure you know what your plan is if things turn south. It’s better to have a security interest up front than it is to fight the company and other creditors in court to get the right to levy.