Following years of explosive growth and regulatory change, the cannabis industry is at a turning point. Initial enthusiasm has fallen to harsh realities, and many cannabis businesses must address mounting financial pressure, operational inefficiency, and limited capital access. No longer sustained by early investor enthusiasm and aggressive expansion, the market has winnowed successful operators from overleveraged hopefuls, creating a new crop of distressed assets ready for harvest. From these ashes comes opportunity, and for savvy buyers and investors, this is a moment for growth and expansion.
Buyers in the distressed cannabis sphere should be prepared to navigate unique legal frameworks, regulatory environments, and non-traditional financing mechanisms when assessing opportunities. Despite many states legalizing or decriminalizing cannabis, it remains a Schedule I substance under the Controlled Substance Act (CSA), rendering it illegal federally, effectively barring bankruptcy trustees and federal courts from administering cannabis assets in violation of the CSA and preventing distressed cannabis companies from seeking bankruptcy protection. As a result, cannabis businesses turn to alternative methods for managing financial distress and facilitating the sale of their distressed assets. This article highlights some important considerations for evaluating distressed cannabis asset purchases.
Distressed Cannabis Asset Acquisitions
Traditionally, buyers have several avenues for purchasing distressed assets, including sales through (i) a bankruptcy case under section 363 of the Bankruptcy Code or chapter 11 plan; (ii) a state court insolvency proceeding; (iii) a receivership, whether federal or state; or (iv) an out-of-court acquisition process. However, the cannabis industry, which is unique and highly regulated, is without access to the federal bankruptcy system. As a result, receiverships, state court insolvency proceedings, and out-of-court sales emerge as critical alternatives to a traditional bankruptcy sale. Though the cannabis industry is highly regulated, some states and regulators are just beginning to encounter the first wave of distressed assets. As such, these regulators are working to update applicable laws and regulations to address these scenarios. As potential buyers explore options to purchase distressed assets, it is imperative that buyers understand the various applicable state laws as sales of cannabis assets will often cross state lines and require multiple regulatory approvals.
Sale Via an Asset Purchase Agreement and Common Issues
Unless a license cannot be assigned or assumed by a buyer under state law, cannabis assets may be sold and purchased through an asset purchase agreement without the need for court oversight. For example, cannabis licenses are nontransferable under California law (See Cal. Cod. Regs. Tit. 4, §15023(c)). As such, buyers purchasing a California cannabis business can acquire only the equity interests of the business. A cannabis acquisition that closes after regulatory approval may be treated similarly to most acquisitions in a regulated industry. After a letter of intent is entered into, the parties negotiate and finalize an asset purchase agreement and transfer the purchased assets to the buyer. Structuring an acquisition as an asset purchase offers a buyer greater flexibility and the ability to control specific assets to fit the buyer’s strategic needs. Asset purchases also allow a buyer to leave behind any potentially known and unknown liabilities in the target company. However, asset purchases can give rise to certain risks, including greater exposure to successor liability and fraudulent transfer claims. Issues surrounding license transferability and reliable banking are present in sale transactions.
While often present in transactions, the risk of successor liability claims increases when a purchaser acquires distressed assets, given the likelihood that the seller does not have the resources to satisfy its creditors. Buyers must consider potential successor liability claims when purchasing distressed cannabis assets and adopt strategies to mitigate successor liability risk from the transaction—usually through a well-drafted asset purchase agreement.
Moreover, buyers who do not strategically vet a seller and its assets could face claims of fraudulent transfer. These are claims which result from a seller using a sale to defraud its creditors, or by transferring assets for less than fair value while insolvent or leading to insolvency. While not as common an issue in purchasing assets through receiverships or a properly run Article 9 sale, buyers party to an asset purchase agreement should conduct thorough diligence, as detailed below, to avoid such pitfalls.
The non-transferability of cannabis licenses and regulatory restrictions on asset sales can complicate cannabis asset purchases. Regardless of whether the transaction is a traditional asset purchase—or if it is conducted via receivership, ABC, or Article 9 sale—the buyer must be licensed to grow, manufacture, and/or dispense cannabis products. More importantly, buyers (and often their owners) must possess state-issued licenses, thereby providing the company with the authority to operate.
Finally, maintaining reliable banking services post-closing may become a difficult hurdle when purchasing cannabis assets. When appropriate, buyers may want to continue a banking arrangement with the seller’s institution and use the seller’s cash transportation services post-closing. Buyers should examine all lending relationships as part of a thorough due diligence review.
Cannabis Receiverships
State court receiverships have become increasingly common within the distressed cannabis arena. Receivership is a legal process in which a third-party receiver is appointed by a court to take control of a company’s assets and operations. This process is often initiated at the request of a secured creditor when the company is in financial distress or facing insolvency and the secured creditor is concerned that its collateral will be dissipated or otherwise harmed. Some states allow for the appointment of a receiver upon the request of one or more unsecured creditors, or where the management of the company is deadlocked. Receivers could also be installed to resolve shareholder or management disputes, to wind down a company, or when there are allegations of fraud. A receiver is tasked with preserving the value of the business’ assets and determining the best course of action for the business and its stakeholders. Much like a bankruptcy trustee, receivers can shepherd a business’ restructuring or the liquidation of its assets, if necessary.
Placing a cannabis business into receivership involves special considerations to account for the industry’s unique regulatory framework. A receiver’s powers and responsibilities are governed by state law and vary greatly state by state. It is critical for cannabis businesses and prospective purchasers to understand the specific regulations in their state and for a receiver to have expertise in both insolvency and cannabis regulations. A receiver in this sphere must have expertise in managing cannabis inventory and other critical assets while complying with a state’s unique laws governing the use and distribution of cannabis. Many states require a receiver to obtain express authorization from a governing body before conducting any cannabis-licensed activities.
The typical result of cannabis receiverships to date has been the complete sale of the receivership debtor’s assets. If a receiver is authorized to sell cannabis assets, it will do so under the supervision of the court and in close coordination with regulators. Usually, the receiver will ask the court to approve a sale process and then advertise the sale for several weeks to maximize recovery. With the assistance of experienced counsel, prospective purchasers of distressed assets can monitor such sales to identify potential opportunities and submit offers to purchase.
Assignment for the Benefit of Creditors
Another option for financially troubled cannabis businesses is an assignment for the benefit of creditors (ABCs), which is an insolvency proceeding under state law and similar to a chapter 7 bankruptcy liquidation. Unlike a receivership, an ABC is generally a voluntary step taken by the distressed company itself to liquidate its assets. ABCs vary by state—some require a court proceeding while others do not. ABCs usually require the cooperation of the debtor and its senior secured creditors, as, in general, assets sold in an ABC are not sold free and clear of all underlying liens.
In an ABC, the distressed company assigns its assets to a third party, who is licensed to hold cannabis and cannabis-related assets, to hold such assets in the functional equivalent of a trust. Immediately after the assignment, the assignee takes possession of the assets, conducts due diligence, and creates a sale process. The assignee is responsible for selling the assets and distributing the proceeds to the seller’s creditors. This is particularly true in states where the ABC process is overseen by a court or where state law allows sales to be approved “free and clear” of such claims.
ABCs can create challenges for cannabis companies, third-party assignees, and purchasers, because a third-party assignee must be licensed by the relevant state regulatory agency to take possession of the assets. The pool of potential third-party assignees and purchasers is therefore limited to those already licensed, or those who are willing to undergo the process of becoming licensed.
UCC Article 9 Sales and Friendly Foreclosures
If a creditor has a security interest in the debtor’s assets, the creditor may seek to exercise its rights under Article 9 of the Uniform Commercial Code. Article 9 of the UCC governs the relationship between a debtor and its secured creditors. A secured party’s remedies upon a borrower’s default include the right to sell the collateral to a third party. Article 9 sales are typically cheaper and faster than ABCs or receiverships but provide less protection from successor liability or fraudulent transfer claims than court-supervised proceedings.
If licensing issues can be overcome, and if the seller is cooperative, a sale under UCC Article 9 can essentially be conducted as a “friendly foreclosure.” In a friendly foreclosure, the secured creditor and the seller agree the secured creditor will foreclose on the assets and transfer title to a buyer. The buyer should expect the secured creditor to sell the assets in “as-is” condition with few representations and warranties or indemnity. The structure of a friendly foreclosure may provide incremental protection against claims made by unsecured creditors and third parties asserting successor liability, because technically, the purchaser is acquiring the title from the foreclosing lender, and not the distressed debtor/borrower. Good faith transferees generally take free and clear of any interest subordinate to the foreclosing lender. Careful drafting of the sale documents and the value paid in the transaction (which is truly out-of-court) is critical to ensuring no later attacks by creditors asserting that the sale was not in good faith or commercially reasonable.
Financing the Purchase of Distressed Cannabis Assets
Often, traditional debt financing is not available for the purchase of distressed assets. This is especially true for distressed cannabis assets. Although cannabis companies are increasingly able to use banking services offered by state-chartered banks and credit unions, cannabis’ Schedule I status under the CSA prohibits federally regulated institutions from dealing with cannabis companies. As such, traditional financing vehicles such as bank-originated loans and credit facilities from FDIC-insured institutions may not be available. Furthermore, some states require a purchaser to be vetted by the governing regulatory body before any funds change hands. Some states, like Washington, permit funding only from United States residents or impart other restrictions on the type of funding available.
Despite these challenges, there are a number of ways to finance the purchase of distressed assets in the cannabis arena, including: (i) utilizing cash flow from purchaser’s existing business; (ii) obtaining a secured loan from a lender with a security interest in the purchaser’s non-cannabis assets; (iii) using an asset-based lender to receive quick access to capital; (iv) assuming certainty of the seller’s liabilities or seeking a loan from the seller’s existing lender; and (v) seeking a private loan from cannabis-focused debt funds, family offices, or other interested private lenders and investors. Purchasers should note that cannabis license pledges are generally unenforceable unless approved by state regulators, but experienced counsel can help legally structure security alternatives.
What Makes a “Good” Purchase of Distressed Cannabis Assets?
Due diligence, due diligence, due diligence. Many cannabis operators conducted business in the budding quasi-legal industry before the enactment of state-law regulations. Accordingly, buyers of distressed cannabis assets and businesses should proceed with caution and consult counsel experienced in cannabis regulations to avoid stepping into regulatory and legal pitfalls. Conducting proper due diligence in any distressed sale is far preferable to discovering liabilities post-closing with limited recourse against a dissolved seller. A buyer should not assume that it will be able to recover any losses from the seller through breach or representation or warranty claims under the contract because the seller may have limited, if any, business operations or liquidity after the sale. The following is a non-exhaustive list of due diligence items to consider:
- Identify all assets to be acquired, including assets involved in growing, storing, and disbursing cannabis products, intellectual property, client contracts, applicable medical records, and other goods;
- Identify well-maintained cultivation facilities, proprietary technologies, and established brands;
- Ensure all licenses are in good standing and investigate any past compliance issues and target companies that have a history of compliance with state and local regulations;
- Understand the business operations, including production processes, inventory management, and distribution channels;
- Review client and vendor contracts scrupulously to determine whether they will be voided by insolvency or breached by nonperformance;
- Ensure the fair value for every asset being purchased and evaluate with accuracy the underlying performance of the asset;
- Determine the company’s supply chain risk and the availability of, and costs associated with, using alternative sources of supply;
- Analyze the company’s potential employment law issues and compliance with relevant government health guidelines;
- Assess the company’s market position, customer loyalty, and geographic footprint; and
- Be aware of potential environmental liabilities associated with cannabis cultivation and processing sites.
As with any distressed asset purchase, buyers should consider obtaining a third-party valuation of the assets being acquired and seek releases and waivers from third parties who might have claims against the seller.
Buyers of distressed cannabis assets must navigate complex regulatory frameworks and engage with regulatory bodies early in the transaction process to ensure compliance and avoid delays. Likewise, buyers should consider requesting a statement of valid licensure from the seller. Buyers who do not intimately know the regulatory framework of how a cannabis company’s major assets, regulatory licenses, equity, and inventory are managed can face serious problems.
Moreover, not all states have contemplated regulations to deal with distressed cannabis assets. As potential buyers consider their options, we recommend consulting with experienced attorneys in this unique arena to help buyers understand and navigate their legal options.
Conclusion
Purchasing distressed assets in the cannabis sphere provides a unique opportunity to acquire potentially valuable property, expand the purchaser’s existing business, reach new markets, or merely make a profit on the strategic purchase of a troubled asset that can be improved and sold for a profit—but steering clear of all the landmines and pitfalls associated with such transactions, and maximizing the protections that can be obtained by and through court-approved sales, requires the guidance of experienced insolvency professionals.
