Regulated Cannabis Collateral Creates Challenges in Compressed Industry

Options exist, even with traditional methods like bankruptcy out of reach.

Benjamin Sobczak, Katherine VanderVeen, and Colin Ferguson, co-authors of this contributed article, are partners at Dickinson Wright PLLC. 

As a whole, the legalized cannabis industry is growing month-over-month and year-over-year. New jurisdictions continue to come online. Scientific advancements continue to turn out increasingly sophisticated and effective product lines. Funds continue to bet on, and expand upon, their investments.

Yet, thanks to lingering federal prohibition, restricted access to banking, biased taxation policies, a pandemic, “unlimited license” jurisdictions, a flourishing grey market, and continuing social and political stigmas, legalized cannabis has also produced many losses and is certain to produce many more.

The consortium of obstacles noted above has caused many well-intentioned but overcommitted cannabis businesses to fall short on contractual obligations, whether to one another or their respective creditors. Late payments, underpayments and missed payments have default letters flying in all directions, and court systems are seeing an influx of resultant litigation, including receiverships.

For instance, the Michigan market just witnessed a former industry leader, Green Peak Industries, which operates as Skymint, be placed in receivership by a senior-secured lender that claims to be owed more than $127 million in defaulted repayment obligations. That doesn’t include the untold additional millions Green Peak owes to secondary lenders, suppliers, and wholesalers, among others.

But, Green Peak is not the only one. Information obtained from Michigan’s cannabis regulator confirms that at least four other Michigan-based operators are also in active receiverships, with more failures expected in 2023.

Understandably agitated creditors are scrambling for solutions to stop the bleeding on their investments. Most specifically, those who took the “safer” course by investing in operationally entitled real estate are beginning to question the ease with which they can pivot operators if their current tenant/mortgagor goes upside down.

Traditional Options Out of Reach

In a traditional (read: non-federally illegal) market, these overleveraged cannabis businesses could elect – or be forced into – a civilized and merciful bankruptcy. But here, federal bankruptcy protections are largely unavailable to cannabis businesses.

Based upon current information, the orderly administration of affairs in a receivership can take years, leaving creditors without resolve (and their investors without returns) until finally settled, while racking up substantial professional fees and costs in the process.

So where does this leave secured creditors vis-à-vis their struggling cannabis debtors?

Depending on the facts and underlying documents, a creditor with a first-priority, perfected security interest or mortgage may be best served by efficiently executing on its own collateral. Generally speaking, cannabis operator collateral falls into the following three buckets:

  • Real estate, fixtures, and equipment
  • Inventory (specifically, marijuana products)
  • Permits and licenses.

For each bucket, enforcement of usual remedies is complicated by a patchwork of novel municipal and regulations which limit possession, restrict access, and encumber the transfer of cannabis products, permits/licenses, and the businesses at large. Neither the agencies in charge of enforcing those regulations nor the judiciary have sufficiently addressed creditors’ ability to enforce their liens outside of receivership but within the bounds of these unique restrictions, the UCC, and the common law generally.

Because the value of a cannabis company’s real estate and personal property is in great part intertwined with the company’s associated permits and licenses, it is imperative for both creditors and debtors to consider the impact of enforcement actions within the cannabis regulatory scheme, including the enabling ordinances of each municipality.

The line between taking and breaking regulated collateral is very thin.

For instance, if a landlord evicts a defaulting operator or a secured lender forecloses on its mortgaged property, the operator’s license may be jeopardized: no title or lease, no license. And, without a valid license attributable to the leased or mortgaged property, a landlord or lender’s ability to market the location at comparable rates is impaired.

Similarly, if an equipment financer seeks to recover its financed equipment, it must enter into restricted access areas of a cannabis business. Without the cooperation of the debtor-operator, an equipment financer’s exercise of remedies may trigger regulatory or even criminal violations, bringing about a wave of secondary consequences and potential liability.

Then there is the issue of the cannabis inventory. Under state regulatory schemes, these assets cannot be seized, possessed, or resold by anyone (including a creditor) without a license. Unless it can artfully navigate those restrictions, a creditor simply has to leave this otherwise easily liquidated collateral on the table.

With enforcement of many remedies requiring a valid cannabis license, it is ironic that those permits and licenses are unable to be directly collateralized or otherwise executed upon, as most jurisdictions expressly restrict or prohibit the transfer of (including granting a lien on) licenses and/or operator equity.

Moreover, a creditor may not be prepared or able to directly hold a cannabis license or operator equity, especially when it has multiple investments within the same locale, is subject to governance restrictions, maintains traditional banking relationships, or simply does not want to be responsible for the liabilities of a failing cannabis company.

The Options

So how can creditors maximize their recovery against defaulting cannabis businesses? And how can struggling operators utilize these issues to negotiate a tolerable end to their troubles?

Awareness of these issues is a good start. When the market was humming and money was flowing just a few years ago, bullish operators and financiers were not reviewing local and state regulations with an eye toward these issues. Yet, that is absolutely the first step; you must understand the rules of the game board with regard to regulated collateral at issue.

The most critical of those devilish details will live in the municipal ordinances governing the local operational entitlements which serve as keys to the cannabis arena.

Each municipality is its own kingdom, with its own rules, processes, vernacular and policies. Without working through those ordinances and gaining signoff from those host-municipalities, transitioning a business to a new operator is impossible, and landlords/mortgagees risk killing the location’s future ability to operate in the process. Some factors include:

  • Buffer restrictions
  • Grandfathered special uses
  • The next in line in a competitive application process

For failed operators with multiple locations, any en masse sale to a new suitor requires the synchronization of these individualized processes and/or a multi-closing deal structure. Consider the job presently faced by the Green Peak receiver, who is now tasked with trying to portfolio or individually sell at least 26 licensed locations in different municipalities, each of which will impose its own process and opinions as to the operations within its borders. The phrase “herding cats” comes to mind.

As daunting as all that may seem, understanding the applicable rules of a given locality is only the beginning. One must also take into account the annual license renewal cycle and the customary obligation that any material changes to a license or its ownership/control structure be preapproved by the state regulator.

Any incongruence here, or renewal lapse, or excessive delay in closing due to regulatory red tape can kill the deal and/or the licenses and permits themselves. In the meantime, who is paying for insurance, utilities and taxes? And who is clearing off junior liens on the property which will likely be filed by disgruntled subordinate creditors and contractors?

New operators are not interested in buying into old problems. As mortgagees and landlords spend more money to salvage the “cannabis premium” on their properties, the size of the deficiency judgments which they will ultimately seek against their operator borrowers and tenants (and their founders who gave personal guarantees) grows larger. Clearly, this logjam is not going to be good for either side of the equation.

Once a theoretical course has been plotted, the plan must be executed. It is here that the defunct operator/debtor/mortgagor/tenant will make their stand and try to bargain for reprieve. In the absence of a receivership, the operator will still control the permits and licenses, so how does one force a failed operator to cooperate?

Executing against the equity of the defunct operator is not a great option, as no one wants to inherit its accounts payable and the fiduciary duties owed to its members. A multitude of contractual obligations intended to address this issue have been imposed in certain deals, but the regulators and judiciary lack experience with these issues, so there is no telling how a secured creditor will fare when attempting to employ those mechanisms (assuming they are at its disposal in the first place).

Too much unilateral control to dictate the actions of the operator may trigger a regulatory violation, as forcing an operator to give up “control” can itself be “control” for which preapproval would have been needed via assistance from the operator, creating a regulatory violation infinity loop of sorts.

Moreover, given the current economic factors in many jurisdictions, the proverbial “What makes you think the new guy can do any better?” quandary hangs heavy in the air. Savvy operators will leverage this conundrum in the course of the ultimate workout and, in the meantime, super smart cannabis attorneys will be thinking very hard about how to untie this Gordian knot.

Bottom Line

Cannabis permits and licenses are regulated as though they are authorizations to manufacture plutonium, but the industry was financed and funded as though those permits and licenses are fungible business assets. As the industry enters this new chapter of business Darwinism, lenders, landlords, operators, judges, lawyers, and regulators will be forced to grapple with that incongruence; much value will be lost, and many legal fees will be amassed in the process.

Whether you are a concerned creditor looking for the greatest recovery in an existing deal, an optimistic investor seeking to ensure downside protections while leveraging the depressed market or a scrappy operator trying to make it to the other side of this downturn, legal counsel with an astute knowledge of industry regulations, marijuana business operations, and insolvency law should be engaged to guide you, both offensively and defensively.

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