As we inch closer to a cannabis recession, businesses are desperately looking for new ways to stay afloat. A few years ago, our cannabis attorneys saw equity investments left and right. It seemed like everyone wanted to own a piece of a cannabis business. But as things grow more precarious for the industry as a whole, cannabis loans have been on the rise. Cannabis lending allows the person with the money to still interact with a cannabis business without the same risk of loss that they’d have in an equity investment scenario.
You could write an entire post on the difference between equity and debt investments (and I have!), but the purpose of this post is only to look at debt financing (i.e., cannabis loans). In this post, I go through five of the main factors that set cannabis loans apart from your average commercial loan.
#1 Cannabis loans almost always have high interest rates
Many states cap the permitted interest on commercial loans, though they often have numerous exceptions. If an interest rate exceeds the permitted cap and there is no exception, the interest rate is deemed usurious, which can lead to claims against the lender and even a loss of entitlement to a return of interest (depending on the state).
California’s interest cap is 10 percent, for example, yet we often see interest rates that are much higher in cannabis lending. In many cases, this is because there is an exception to the usury cap, such as California’s exception for loans arranged by licensed real estate brokers that are secured by real property. In some cases, lenders just roll the dice without any exceptions. Either way, it is pretty rare in our experience to see interest rates on cannabis loans that come in at less than the 10 percent cap.
Lenders often justify higher interest rates based on the same old issues that have always plagued the industry: uncertainty in market conditions, federal law enforcement, and other types of issues. Borrowers often have little recourse too, as traditional financial institutions still refuse to provide standard financial services to cannabis businesses. Until federal law changes, we can expect to see interest rates in excess of what we’d see with non-cannabis loans.
#2 Not all cannabis assets can be collateralized
The prospect of an unsecured loan with nothing tangible to seize on default is too much for most cannabis lenders. Lenders love security. So they usually ask for the borrower or one of its affiliates or owners to provide some kind of tangible or intangible asset as security. This can take the form of security interests in equipment, intellectual property, real estate, accounts receivable, stock or other equity interests, and so on – we’ve seen it all.
However, there are some things that cannabis lenders cannot collateralize. The list of these things will range from state to state. In California, for example, lenders cannot collateralize cannabis licenses. They generally also cannot take a security interest in cannabis inventory itself– generally because they wouldn’t have a license to sell it off. (Note, there are a lot of different schools of thought on this latter point, and many lenders will try to take a security interest in cannabis inventory with certain caveats. I won’t address that here, but have used the word “generally” to point this out.)
Lenders making cannabis loans need to understand what they can and cannot collateralize, because they wouldn’t want a security interest in something that they cannot legally take, and because there could be ramifications for them even trying to take a security interest in prohibited or restricted cannabis assets.
#3 Lender disclosure requirements
In my experience, this is the issue that almost every cannabis lender overlooks: required regulatory disclosures. Most jurisdictions require disclosures of a cannabis business’s lender. They often call lenders financial interest holders, true parties in interest, owners, finance lenders, or some other term. The disclosure timelines and types vary greatly from state to state. Some states may have minimal notice requirements. Others may require background checks and pre-cannabis loan vetting. Other states may have different thresholds that can apply, which requires lenders to evaluate their proposed loan before committing to a deal.
In all of these cases, the lender would be disclosed to a government agency. This is something many lenders don’t want to have to deal with and should be aware of up front. It is something that borrowers also need to be aware of, because if a lender refuses to comply with the borrower’s demand to provide disclosure info, it will be the borrower who bears the brunt of the regulatory penalties.
Yet as I mentioned, this is an issue that many cannabis loan agreements don’t even address, as they are often cribbed from templates from different industries. For lenders and borrowers alike, consideration of disclosure requirements up front is key.
#4 Default traps are everywhere
Related to the last paragraph, forms from non-cannabis deals are a bad idea. They usually fail to address the distinctions of law inherent to the industry and can have so-called default traps for borrowers. For example, a loan agreement may require that the borrower not use funds in any way that violates “applicable law.” Even state-legal cannabis activity definitionally violates the Controlled Substances Act. So without proper carveouts, the borrower could be in default upon its first drawdown of loan principal. Nobody wants this, yet it’s something that can happen if the parties use a non-adjusted form.
#5 Stock pledges are difficult for lenders
Circling back to point 2 above, one thing that lenders frequently ask for a security interest in is the stock or membership interest of the borrower. In other words, the owners of the borrower will grant the lender a security interest in their equity in the borrower. If the borrower defaults, the lender can simply take the stock/membership interest from the owners and continue on as the new owner of the business… at least in theory.
Cannabis law adds a major twist to this concept because virtually every state requires some level of approval of an incoming owner of a cannabis business. If State X does not allow changes of ownership without pre-approval, the lender in this example would have to notify the borrower of the default, ask the borrower to give the state notice of a change of ownership, and then (after receiving full approval) could take over the business. This strips pledges of “teeth” and can lead to bad outcomes if the parties granting the pledge, or the borrower entity, refuse to comply.
Cannabis loans are different from general commercial loans in many ways. They difference can vary significantly across state lines and even based on municipal law. Consultation with competent cannabis counsel is key. Stay tuned to the Canna Law Blog for more cannabis finance updates and analysis.