What happens when you’re an investor in a marijuana business and there’s a short-term glut of marijuana on the market, making it harder to stand out and to make sales? The reality is that your asset isn’t competitive on price or quality and likely gets left behind. At that point, you’re probably looking for a way out of that marijuana business deal you now fear will never pay off. When you’re looking to bail on or navigate a marijuana investment that’s gone south, the road to financial redemption ain’t easy.
Mark Cuban once said that only a moron would start a business on a loan, but various state-law limitations on equity ownership of marijuana businesses (whether it’s residency or the sheer amount of red tape it takes to be vetted by state regulators) leave many newish cannabis businesses cash-strapped, so they have little choice but to turn to debt. I have also seen that many of the creditors involved in the marijuana industry are not seasoned small-business investors — they are people looking to take advantage of an industry that seems to be printing money. Debt feels less risky than equity, so they throw some money into a cannabis business or two, believing they will be able to get 10%-20% interest annually.
Because so many of these investors are new to small business investing, many don’t protect themselves adequately. Lenders ordinarily have many tools to make sure they get paid. Security interests in real, personal, and intangible property provide avenues for seizing assets. Marijuana inventory or the marijuana business license or permit itself are complicated to secure, but most marijuana businesses have at least some high-dollar capital equipment. Personal guarantees from major players put personal assets on the hook as well, and signed confessions of judgment make the process of obtaining a judgment on the debt significantly easier. Most loans do not involve all these protections, but most smart lenders are not willing to provide completely unsecured capital to brand new businesses (let alone federally illegal ones) without a clear path to get a return if the business folds.
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If you are an unsecured lender and the cannabis company to whom you loaned money defaults on your loan, what can you do? If you want any chance of recouping your investment, you really have only two options. First, you can renegotiate the debt. In most well-drafted promissory notes, an uncured event of default causes the debt to accelerate and mature. This means if your cannabis borrower misses a payment and doesn’t make a late payment by the cure date, its entire debt becomes due. Once this happens, it is a matter of negotiating an extension on the note. During that extension, you as the creditor have significant leverage to extract concessions from your cannabis borrower, such as personal guarantees, security interests, or even pledges of ownership interest in the cannabis company. The reason you as the creditor have leverage is because your only other viable option would be to obtain a judgment against the borrowing company and that judgment will likely be a nightmare for your borrower. If you are wiling to brave the legal fees and get a judgment against your borrower, you can then use that judgment to begin levying on the cannabis business’s assets as though you had a security interest in the property to begin with. In most states, once you get the judgment, at least some of what you spend collecting on it, including your attorneys’ fees, will be collectable as well. If you were smart, your loan contract provides for this.
Companies that owe debts to third parties and realize they are about to go under sometimes look for ways to avoid paying their debt. This is a good time to mention fraudulent transfers. As defined in most states, a fraudulent transfer occurs in a few different ways, the most common of which is when an insolvent debtor transfers property without receiving a reasonably equivalent value in exchange. If an “insider” — someone connected to the company like a director or a director’s spouse — is involved in the transaction, showing fraudulent transfer becomes far easier. For example, if a debtor company has a bunch of equipment and transfers it to the company owner’s brother, that is potentially a fraudulent transfer, and the equipment can be clawed back for creditors.
The stickiest situations come when there are multiple debts. A company is not necessarily breaking any laws if it chooses to pay one creditor before it pays other creditors. Unless the creditor is an “insider,” the company can generally choose which of its debts to pay unless it is in a formal bankruptcy (which is probably not available to marijuana businesses because of the federal law conflict) or a state receivership proceeding. In certain circumstances, multiple debt investors have signed promissory notes in which the company promises not to pay the notes proportionally and not to provide any payment preference. If the debtor company does pay one holder disproportionately and to the detriment of others, the left-behind creditor may be entitled to a claw-back of the payment.
These collection matters don’t usually end with either side truly happy. Attorneys make some money, and investors can often recoup a portion of their investments, but debt litigation against a business is an unpleasant affair. If you are looking to lend to a cannabis company, make sure you have a plan of action in place before you lend for when things go south. It’s better to have a security interest up front than it is to fight the company and other creditors in court to get the right to levy, especially given marijuana’s illegality under federal law.
Hilary Bricken is an attorney at Harris Bricken, PLLC in Seattle, and she chairs the firm’s Canna Law Group. Her practice consists of representing marijuana businesses of all sizes in multiple states on matters relating to licensing, corporate formation and contracts, commercial litigation, and intellectual property. Named one of the 100 most influential people in the cannabis industry in 2014, Hilary is also lead editor of the Canna Law Blog. You can reach her by email at [email protected].