Risky Business: Cannabis Security Interests and Secured Transactions
As a corporate and transactional attorney focused mostly on cannabis, I see my fair share of financing documents and transactions involving cannabis operators. It’s no secret many cannabis businesses can’t get bank accounts or loans or lines of credit from financial institutions because of the Bank Secrecy Act and federal anti-money laundering laws — despite current FinCEN guidance. It’s also no secret many cannabis businesses need significant start-up capital to even get to state licensure and operation in a multitude of states because of significant barriers for licensing, like liquidity requirements, wildly competitive and exclusive licensing regimes, build out costs, local permitting and licensing, need for city and county approvals, leasing and other real property costs, staff, inventory, and the list goes on and on.
The concept of starting a cannabis business on a shoestring budget has never really existed. As a result of this, I often see loan agreements and promissory notes between individuals/companies and cannabis operators of all sizes on loans secured by collateral belonging to the cannabis operator or cannabis business. In these sorts of loan deals, as is true in any secured lending situation, the value of the collateral is what matters most, and with cannabis businesses, secured parties typically want a few prized items included in the collateral description, such as the cannabis business ownership interests, its license, its inventory, its equipment, and its accounts receivable. However, unlike in more traditional secured transactions, foreclosing on a cannabis business and its secured assets depends very much on state law and it is often a very complicated process.
My clients that lend to cannabis businesses routinely ask me whether their security agreements will be enforced in the event of a dispute. My usual answer is, “Yes, if the security agreement will be/should be upheld pursuant to the state laws in which the loan was made or where the cannabis business operates.” In other words, this only occurs in a state with laws that recognize commercial cannabis conduct as legal. These states usually enforce cannabis contracts despite federal illegality. In cannabis legal states like California (where I’m located), the state usually has laws making commercial cannabis contracts enforceable. Smart lenders ensure their security agreements are enforceable based on the cannabis laws in the state in which any disputes will be handled.
Once a lender gets past the enforceability hurdles, its next legal hurdle is usually state-required disclosures. Depending on the state, if you’re a secured party dealing with a cannabis business, you almost certainly will need to disclose your financial interest in the cannabis business to state regulators in a timely and transparent manner (as required under the specific state’s law) or the state will not allow your loan to go through at all. It is important to mention that the Uniform Commercial Code (“UCC”) adopted in the relevant state still applies, and this means your security agreement should be drafted and authenticated in accordance with state UCC requirements.
In almost all cannabis states, state licenses are not transferable, and they therefore should not be listed as individual collateral in a security agreement. If a lender wants a cannabis license in a security agreement, it almost always should get the cannabis business to pledge its ownership interests in a separate pledge agreement. And if a cannabis business signs away its license and then seeks to transfer that license in the event of default, most cannabis states will just cancel the license due to an illegal transfer. In addition, if a lender wants the cash belonging to the cannabis company or its customer accounts or its inventory, the lender usually will first have to become an “owner” of the cannabis business, which creates its own complex and lengthy regulatory process outside the confines of the UCC.
Of course, certain other collateral belonging to the cannabis business, like its equipment, won’t trigger these ownership issues because foreclosing on equipment usually does not impact control of the business or its license.
In certain states, merely holding a security interest from a cannabis business does not trigger any disclosure requirement. But in some of these same states, the loan to the cannabis business triggers minimal disclosure requirements because the state considers the originating loan a minor financial interest in the business. If your collateral list includes ownership interests in the cannabis business or its inventory, most states require you first go through mandatory personal and financial disclosures to foreclose on that collateral. This is another reason why cannabis security agreements are not your run-of-the-mill secured transactions and why it is so critical for cannabis security agreements to properly account for these particular regulatory issues.
Bottom Line: Lenders should proceed with caution with cannabis secured transactions and not just trot out their boilerplate security agreements/pledge agreements because those do not sufficiently address the unique issues presented by cannabis companies.