Succeeding in the cannabis industry is not easy, especially in California. Complex regulation, high taxes, expensive real estate, and competition with the black market are just a handful of factors that challenge cannabis businesses. The majority of players lack sufficient reserves and agility to stay in the game. Due to the substantial upfront costs required to obtain state and local licenses, many don’t even open their doors before cash flow problems lead to unpaid rent and defaulted loans. We are seeing an increasing number of distressed businesses in the cannabis space.
So, what happens when a cannabis business goes belly-up? A typical business can file for bankruptcy protection, and a court-appointed trustee may liquidate or reorganize the business to satisfy creditors and discharge the debt. Due to the federal prohibition against cannabis, however, cannabis businesses are not eligible for bankruptcy protection, and cannot discharge their debts the same way that other businesses can. Bankruptcy cases are handled exclusively in federal court, and the rationale is that it wouldn’t be possible for a United States Trustee to control and administer a debtor’s assets (cannabis) without violating the federal Controlled Substances Act. (See here for more on that).
What are the Options for a Distressed Cannabis Business?
One option, if all parties are in agreement, is to voluntarily work out a deal between creditors and the debtor outside of court. While this avenue carries risk due to the absence of any formal court order, and creditors will have to trust that the debtor will follow through with their promises, it could be the most cost-efficient means of resolving a creditor dispute if the arrangement works out.
Another option, which is growing in popularity, is the use of a court-appointed receiver.
What is a Receiver, How is one Appointed and What Does a Receiver Do?
In California, a receiver is an officer appointed by the court to take possession of and to protect assets for the benefit of all persons who may have an interest in those assets. The receiver is a neutral agent of the court and holds assets for the court, not for the plaintiff or the defendant. A receivership is only a provisional remedy in an action that seeks some other relief by final judgment. In other words, you cannot file a lawsuit for the sole purpose of having a receiver appointed.
The court will outline the powers of the receiver in an order, which typically include temporarily managing the business until it gets back into better financial standing, selling off assets, employing employees and professionals, and entering into contracts or leases, among other powers.
In the context of a cannabis business, a likely scenario would involve the business defaulting on a loan, the creditor suing to recover the money, and then the creditor seeking to have the court appoint a receiver to take over the business during the pendency of the action. As we have written about previously, receivership can be a helpful tool where there is a dispute between business owners, but it is not without risk.
Receivership can be expensive, and the costs are generally paid from the income stream generated by the receivership estate (AKA the cannabis business). However, when the receivership estate produces no income or produces income insufficient to compensate a receiver (or when equity requires), the appointing court has broad discretion in determining which party to the litigation should pay the expenses of a receivership. Ordinarily, a court will require the party that requested the receiver’s appointment to bear these costs. That means if you are a creditor who sues a cannabis business and asks to appoint a receiver, and the business does not generate enough income to pay the receiver’s fees, you could be on the hook to pay!
How Does Receivership Work in the Cannabis Industry?
The use of receivership in the cannabis industry can yield strong results (the assets of a cannabis business in receivership were recently sold at auction for $8.5 million), but it is a tricky and novel thing to navigate.
While there are California statutes specifically addressing the use of receiverships to transfer the interest of a debtor in an alcoholic beverage license, no such laws exist (yet) relating to receiverships for cannabis businesses. Combine that with the prohibition against transferring state licenses, the different regulations for ownership changes from the BCC, CDPH and the CDFA, the restrictions applicable to a person who engages in management and control of a cannabis business, and local jurisdiction requirements, and cannabis receivership becomes a very complicated endeavor. While the non-license business assets are less of an issue (e.g., the sale of real property and equipment is more straightforward), the management and sale of a business and license are a different story. We expect to see some legislation and/or regulation addressing receiverships for cannabis entities at some point in the future.
Opportunities for Investment in Distressed Cannabis Assets
The cannabis industry’s regulatory framework is extremely complicated to navigate. However, well-capitalized and savvy investors may be able to take advantage of distressed assets in receivership if they are prepared to deal with the uncertainty and risk.