Financing The Marijuana Industry Revisited: What a Long, Strange Trip It’s Been!
Steven N. Kurtz, Esq., of Levinson Arshonsky Kurtz & Komsky LLP provides an updated look at factoring in the cannabis industry, including overcoming funding issues, complying with state and federal regulations, and maintaining collateral and liens.
BY STEVEN N. KURTZ
I’m not sure what it is about Dead & Company concerts that inspire me to write about financing the marijuana industry. After a catching several shows from their final tour this summer, it came to me during the drone performance encore at the closing show in San Francisco that my 2016 article on this topic should be updated.
When I wrote the last article, I thought that marijuana would soon lose its classification by the U.S. Drug Enforcement Administration as a Schedule 1 drug. This federal classification categorized marijuana as a highly dangerous narcotic, resulting in, among other things, the prohibition from most banks accepting money from the cannabis industry, which has inhibited many lenders and factors from getting into the business and prevented businesses and individuals in the industry from seeking bankruptcy relief, which is a necessary remedy for entrepreneurs.
Despite its present classification as a dangerous narcotic, there are banks and federal credit unions who now provide banking services to the cannabis industry. Hopefully, U.S. Congress will enact bipartisan legislation which addresses the reality of this large industry. Setting aside one’s views on weed, it’s a legitimate business that still has many opportunities.
Except for the regulatory issues that are now at the state level, there’s really nothing magical or super complex abut financing the cannabis industry. At its core, it’s dealing with inventory, accounts, general intangibles and taxing authorities while requiring participants to be aware of a possible fore into proposed UCC Article 12 and know the borrower/factor client and exit strategy. In other words, it’s just commercial finance.
Money Issues
First thing one must be aware of when financing the cannabis industry are the money issues. As discussed, there are banks and credit unions accepting deposits and transferring money for businesses in this industry. My focus in this article will be on money issues for those getting into the industry, particularly factors like you.
For bank-owned factors and asset-based lenders to break into and succeed in the cannabis industry, they will have to bump heads with compliance people and lobby to have top management support the move. Meanwhile, non-bank-owned factors and ABL firms need to address their lenders. If the lender is a bank, then the factor or ABL firm will need to have a frank discussion. If the lender have is a non-bank provider, factors and ABL firms still need to have the discussion because most re-discount or re-factoring documents will have language one can hang their hat on to find a default if factor finances the marijuana industry. Also, since most factors have discretionary financing facilities with factor clients/borrowers, meaning that factors can refuse to fund for any reason, factors may have facilities with their lenders that have the same language, further necessitating the need to get their lenders on board.
For companies that want to finance the cannabis deals using their own equity, whether in an existing company or a newco, they’ll need to address this course of action with their lenders (and investors, possibly) because when a firm moves money out of an existing company into a new group, or does something that radically changes the capital structure, it will draw attention and raise questions.
Since banks are reluctant to finance the cannabis industry, and commerce most go on, many in the cannabis sector deal in cryptocurrencies. From a factoring/lending perspective, there are many concerns with virtual currencies, such as their negotiability and the ability to lock in electronic payment rights, address lending rights and securing collateral against such digital currency rights. This will be codified in proposed UCC Article 12, which will govern digital currencies.
While proposed Article 12 will be discussed more fully in a separate article, here are some highlights: The world where the digital currency will be stored will be known as a controllable electronic record. One party can perfect its rights in the controllable electronic record using a control agreement. A controllable electronic record would be a general intangible, and an account that can be controlled will still be an account, meaning a factor or lender’s redirection rights to collect from account debtors will be addressed. For those financing in the cannabis industry via the digital currency world now, you will need do digging into the business in order to lock in your rights using the current Article 9 in the UCC, but these deals are doable.
State & Federal Regulations
Since the cannabis industry is regulated at the state level, factors must understand the rules in the state in which their factor client/borrowers are managed as well as the states in which the factor client/borrowers do business while closing their eyes to transporting marijuana across state lines. For example, California has the Bureau of Cannabis Control, which handles regulation, licensing and discipline at the retail level. The California Department of Food and Agriculture handles the same for cultivation, while the California Department of Public Health handles licenses and oversees manufacturing. Similar to the disclosure and state lending licensing rules on a national basis, some states are looking at California’s models and rules for regulating the marijuana industry.
Because marijuana is still classified federally as Schedule 1 drug, the state regulatory scheme is detailed, contains a lot of compliance-based rules and has strict consequences for non-compliance. Factors should audit their factor clients/borrowers for compliance using a specialist and should be able to charge it into the deal. In addition, there are food, packaging, drug and similar regulations for which to be on the lookout, so factors need to make sure they trust their factor client/borrower to be able to manage this process.
When there are heavy regulations, there must also be tax compliance, especially to pay for said regulations. Although marijuana is illegal at the federal level, there are still federal, state and local taxes that must be paid and monitored for compliance in the cannabis sector, meaning now is as good a time as any to review the federal tax lien rules.
A federal tax lien will be junior in time to existing collateral in place at the time the federal tax lien is filed. Federal tax liens must be filed according to the rules in place for filing liens in the state where the lien arose, which generally calls for the UCC filing system to encumber personal property. While that typically means filing the tax lien against the entity in the state in which the factor client/borrower is organized using the name as referenced in the state of organization’s official filings, it does not always have to be the case. For example, if the factor client/borrower is a Nevada corporation but headquartered in Los Angeles and uses its Los Angeles business address in its tax returns, the IRS tax lien filing will likely be in California and not Nevada where the UCC-1 must be filed.
Current priority rules dictate the factor would be ahead of the federal tax lien on existing collateral. The factor would then have the earlier of 45 days after the tax lien is filed or its knowledge of the tax lien to make more advances and still be ahead. The instant a factor knows about the tax lien in under 45 days, or should have known, the tax lien will be ahead of the factor on new collateral. If factor never learns about the federal tax lien and continues to fund, the federal tax lien will prime the factor on new collateral acquired on day 46 after the federal tax lien was filed. Meanwhile, state tax liens and their priority against a factor’s collateral depend upon the individual state. Many states track the IRS rules but not always. The general rule is to immediately stop funding the instant you learn about a tax lien. Also, it’s best to employ a service that monitors for tax compliance and tax liens.
Collateral Considerations
Collateral in a cannabis deal will generally be inventory (whatever product is sold), equipment (to make product), accounts (the customers who buy product on terms), general intangibles and, of course, deposit accounts if using a bank.
For deposit accounts the factor/lender will perfect a lien against the funds therein through a control agreement. For crypto deals, they will need a form of a control agreement with the entity where the funds are kept. Therefore, access codes and 24/7 ability to monitor the money is critical. Special attention must also be paid to the intellectual property that falls under general intangible collateral.
The folks creating cannabis products are scientists, so there also will be trade secrets and trademarks involved and its possible there will be patents as well. The general rule for perfecting security interest in all types of intellectual property is to have general intangibles, which are always perfected with a UCC-1. Trade secrets are perfected with the UCC-1 and nothing more is needed. Patents and trademarks are perfected with a UCC-1 financing statement. However, in order to prevent a factor client/borrower from selling the patents and trademarks out from under you, you can file your lien against patents and trademarks at the U.S. Patent and Trademark Office, but failure do this does not disqualify perfection via a UCC-1; it just means the purchaser of the patent or trademark buys it free and clear of the lien. For registered copyrights, which are not highly likely in the cannabis industry, you perfect your lien only by filing at the U.S. Copyright Office.
We are in a limbo stage for cannabis deals until the federal issue is fixed. Even without federal legislation, the state legal marijuana business is a real and viable industry that can be financed. Hopefully, U.S. Congress will be able to put together a bipartisan effort to legalize it at the federal level, but it’s not high on the list of priorities and may not be for a while.
For those who are curious or care about the Dead & Company shows, please feel free to reach out.