I spoke at GeraciCon 2016 last week on financing medical marijuana operators and ancillary businesses in California. More and more financiers are exploring lending to or investing in California’s medical marijuana industry, and certain themes for financing continue to emerge as California transitions to a heavily regulated cannabis industry as a result of the Medical Cannabis Regulation and Safety Act (MCRSA). With the likely passage of California’s Control, Regulate, and Tax Adult Use of Marijuana Act in November (i.e., Proposition 64), California will likely be facing a whole new world of marijuana financial opportunities.
The audience for my panel consisted mostly of banking lawyers, securities lawyers, hard money lenders, institutional lenders, landlords, fund managers, and those from all walks of life interested in investing in California’s soon to be booming cannabis industry. My panel mostly focused on the following issues likely to be encountered by anyone who puts money into California’s cannabis industry:
- Criminal liability for financiers. Any loan, investment, or cash infusion you make into a marijuana business can subject you to criminal prosecution and asset forfeiture under the federal Controlled Substances Act. Despite a high level federal court blocking the Feds from enforcing the federal Controlled Substances Act against California MMJ providers, it’s no slam dunk that either you or your investment will be safe in California. My panel spent the first fifteen minutes evaluating for the crowd which states were better than others at complying with the Cole Memo, figuring that financiers in the best states were at lower risk of federal criminal law problems. California’s current MMJ laws and lack of state oversight make California a risky financial prospect, but that is bound to change with implementation of the MCRSA, which definitely meets current federal enforcement priorities.
- Money laundering. Cannabis financiers are rightly worried about running afoul of federal anti-money laundering laws, especially in California where no bank or financial institution has yet emerged that’s willing to follow the 2014 FinCEN guidelines to bank MMJ entities.
- California MMJ “management company business models.” California’s shoddy laws and limited state governance drove many California MMJ operators to set up relatively unsavory business models, the most popular of which is the management company model. Given California’s non-profit restrictions on MMJ entities, managers and directors of “collectives” (i.e., non-profit entities) often will form a parallel, for-profit management company to assist the collective in its day-to-day operational activities. This management company is often just a vehicle for investors to garner profits from the MMJ industry and it can also serve to help the collective capture the costs of goods sold to better deal with the IRS under IRC 280e. These management companies can be extremely risky as they can actually increase liability if used improperly to dodge taxes or to lie to banks to secure a bank account for the collective. In “The Great Eight California Marijuana Industry Pitfalls,” I wrote about why financiers and collectives should use extreme caution when contemplating the management company model.
- Collateral (or lack thereof). The leading question for many of the financiers attending this event was whether and how they could collateralize their loans or extensions of credit to California MMJ entities. For example, can a creditor foreclose on the actual cannabis inventory or take as a security an equity position in a cannabis entity? Regarding inventory, the answer is likely no unless you are a qualified patient and an actual member of the collective, since only qualified patient members can legally possess the collective’s cannabis. Regarding equity in the cannabis entity, a non-profit model eliminates any possibility of taking “an equity stake” in an MMJ operator. The other issue with collateral in California is enforcement. Because there’s no state oversight or licensing of current MMJ operators, many of them are fly by night and cannot be found when the time comes to foreclose. The bright spot here that other MMJ assets, like equipment and real and personal property, are still subject to securitization.
- Fiduciary duties of fund managers. Fund managers have duties of care and loyalty to members of the funds they manage. Does a fund manager who exposes its members to criminal prosecution and asset forfeiture breach these duties? Fund managers should seek to keep their cannabis funds completely separate from other conventional funds so as to avoid commingling between lawful and technically unlawful income, and they should go overboard to ensure that their investors fully understand the legal and business risks involved with a cannabis fund. Of course, different cannabis funds will have different legal and business risks. For example a cannabis-related real estate fund will be riskier than a canna-tech fund.
- Due diligence. California can be a scary place when it comes to potential cannabis investments and financings because the industry abounds with scammers and distinguishing who is legitimate and who isn’t can be difficult. You also need to know applicable state and local laws to ensure that your financing target can actually operate in the city or county in which it plans to conduct its cannabis business and you need to ensure that your target has all applicable state and local permitting and registrations in place, including having registered with California’s Board of Equalization to pay its state taxes. It will also likely behoove you to ensure that your target has plans in place to comply with the MCRSA.
- Avoid the boilerplate. Whatever financing documents you typically use, whether loan agreements, promissory notes, or mortgages, will not work for any cannabis financing. If you want your cannabis financing agreements to be enforceable, you need to abandon the boilerplate to ensure that they address the conflict between state and federal marijuana laws and that their default, venue, and dispute resolution clauses, among other things, have all been crafted to reflect state and local laws as well as the federal conflict.
- The unpredictability of financing rules under the MCRSA and Proposition 64. No one can know what the rules will be under the MCRSA and Proposition 64. Though we have the statutory framework for both laws, designated California State agencies are going to be engaging in rule-making from now until at least the end of 2017 to fill in the blanks. And based on my law firm’s experience in multiple other states with robust marijuana regimes, financing is going to be a big part of that rule making. We should expect these rules to determine who will be allowed to finance marijuana businesses and even how much they’ll be allowed to spend or lend.
Stay tuned California financiers because California’s cannabis funding ride has just begun.