By Robert T. Hoban, Esq.
Tremendous entrepreneurial investment opportunities are unfolding as more and more states (and countries) legalize medical and recreational marijuana along with the (re)development of the industrial hemp sector in the United States. The regulated cannabis industry presents an interesting and dynamic forum for a variety of business and investor issues. With the industry generating ~$5.7 billion in sales in 2015 and with more than 300 public companies operating in the space, the cannabusiness industry is truly a business and financial revolution. That said, the risks are many and especially unique to this industry. The Top 10 issues one must consider are as follows:
- The Controlled Substances Act (CSA) - While an obvious issue to consider when examining investment in the cannabusiness industry, the ‘elephant in the room’ is the CSA. The CSA is the federal law that identifies marijuana as a Schedule I controlled substance and makes it unlawful to produce, process and possess accordingly. Despite the CSA, the cannabusiness industry operates largely free from wholesale federal interference as a result of various federal U.S. Department of Justice (DOJ) policy memoranda known as the Ogden, Cole and Wilkinson memos. The net effect of these memoranda, among other things, is that cannabis businesses are free to operate intra-state so long as they comply with their particular state’s robust regulatory framework, and the cannabis products are kept away from youth and not subject to diversion into the black market. Furthermore, the federal budget expressly prohibits the U.S. DOJ from spending budgeted monies on CSA-based law enforcement against cannabusinesses so long as they are compliant with state law.
Another “elephant in the room” surrounds civil forfeiture laws. While the foregoing items provide some comfort, investors should recognize that in the event of a federal civil forfeiture proceeding, there is a substantial risk of losing the value of the investment.
- Banking/Cash - Much has been written about the so-called cannabusiness banking crisis. In short, countless banks around the country have declined to bank any portion of the cannabis industry (marijuana, hemp and/or ancillary/support business). Others have banked the industry, and then swiftly reversed course. Some (mostly state-chartered banks) continue to bank the industry, but do so by charging punitive monthly fees ($750-$5,000). The lack of adequate banking alternatives also presents problems in accounting and diversion of funds as a result of regularly having large sums of cash on hand. And of course, the banking problem generally precludes institutional lending of any sort, which sends cannabusinesses into the private lending sector and where they pay the corresponding high interest rates, fees and finance charges.
- State/Local Regulation - The regulation of the cannabis industry occurs at the state and local level; this is known as a dual regulatory structure, much like the alcohol industry in most states. These dual regulatory structures vary, but are very strict and compliance is onerous. Compliance is of course the key to the viability of the industry as a whole, but is also essential for any individual cannabusiness to succeed.
But more importantly, investors need to understand that any sort of interest in a cannabis business is also very strictly regulated. There are serious barriers to entry (as both a debt and an equity investor) for those seeking to have a financial interest in a licensed business that ‘touches the plant’ (generally limited to cultivators, processors, retail outlets, and testing companies). Ancillary businesses present fewer ownership impediments, but are far from free of regulation. Thus, it is essential to ensure that any investment complies with the applicable regulations, both state and local government (cities, towns, counties), as many so-called cannabusiness investment advisors unwisely provide and encourage investment opportunities without adequate consideration of the state/local regulations governing the same.
- Publicly Traded Companies - Publicly traded cannabis companies are the subjects of much discussion. Generally speaking, no cannabusiness that ‘touches the plant’ can or should be a publicly traded entity based on limitations set forth under most state/local laws; however, for the time being, there are a number of exceptions to the rule. Absent a change in law at the federal level and/or an express authorization under state/local law, it is ill advised to establish a publicly traded company or to consider investment in one that seeks to cultivate, process, or distribute cannabis.
However, we have seen many ancillary businesses do so, and we have also seen national cannabis branding efforts (akin to holding companies) do so. The successes of these offerings have been a mixed bag. And more often than not they are the subject of penny stock trading, which has drawn a great deal of scrutiny in this industry for a variety of reasons; not the least of which is irregular trading behavior. There is a laundry list of concerns that must be addressed by experienced canna-business counsel before an investor can or should even consider this sort of investment.
- Due Diligence - Due diligence is commonplace in nearly all business transactions. However, the due diligence surrounding a cannabusiness investment is extraordinarily unique and specialized. It is something that is costly, time consuming and which most often yields a great deal of adverse information to consider. There are a number of companies and law firms that specialize in cannabusiness due diligence and the unique aspect of this practice as it relates to cannabusiness cannot be ignored. Simply put, due diligence cannot be properly completed without the use of professionals who specialize in the cannabis industry; far too many mistakes have been made by traditional due diligence professionals who do not specialize in the cannabis space. And this has cost investors millions.
- Real Estate - Real estate is an excellent place for investment in the cannabusiness industry. As an ancillary aspect of the industry, it is either unregulated or lightly regulated depending on the cannabis regulatory framework in each jurisdiction. Purchasing, leasing, and/or improving real estate for use as a cultivation, processing, or retail facility has created staggering financial gains for numerous early movers. This sort of investment presents the opportunity to obtain and improve a tangible asset that can be utilized for other purposes in the event of a reversal in federal or state cannabis policy. But it is not entirely free from risk, as various state regulations may prohibit the future use of the real estate in the event of regulatory violations by licensed operators. And the possibility of civil forfeiture is something that one must get a clear understanding of prior to investing in the same. Last, traditional lending is generally not available for such commercial property acquisition, and foreclosure laws and mortgage provisions are not entirely friendly to lessees and owners in such an event.
- Security Interest - Most states with a thriving regulated cannabusiness industry have enacted regulations that directly or indirectly prohibit affecting a security interest in the wares of the cannabusiness licensee and/or the membership/ownership interest of the business at issue. In effect, this renders most non-equity investment unsecured and unprotected. Thus, it is essential to work with qualified and experienced cannabusiness counsel to devise other lawful means to protect one’s investment.
- Taxes/Audits - The vast majority of cannabusinesses are well run and compliant. However, the industry has yet to attract top-level accounting and bookkeeping talent across the board. This is rapidly changing, but cannot necessarily impact and cleanup what has already been done. And because the industry’s continued place in society is largely tied to reliable and consistent tax revenue and financial transparency, accounting is critical. This is especially true as we have seen both income tax and sales tax audits at a tremendous rate in most cannabis-friendly states. More importantly, there has been a trend of cannabusiness owners being audited simply because of their individual involvement with a cannabis business. Ensure that your taxes and related documents are in order before considering such an investment.
- The FDA/FTC - While states with commercial cannabusiness industries have generally enacted extensive labeling and testing regulations, we have yet to see the FDA and/or the FTC enter into the realm of regulating marijuana. These agencies have willingly and openly regulated the industrial hemp side of the industry to date, but not without much confusion, inconsistent interpretation and uncertainty. To date, the FDA has only briefly commented on the marijuana side of the industry through a Q&A issued online in May, 2015 and updated in July, 2015. These agencies maintain that marijuana is unlawful and there is also the implicit notion that these businesses operate intra-state (versus inter-state); thus the federal government is not going to intervene at this level at this time. But there is tremendous uncertainty going forward as to the applicability of the FDA and FTC regulations on cannabis products in the marketplace. With the recent enactment of stringent FDA regulations concerning vaporizable products and the widespread popularity of vape technology in the cannabis industry, the FDA’s power looms large. Any regulatory enforcement by these agencies can have devastating financial consequences for cannabusiness.
- Crowd-Funding - Not a day goes by without some mention of crowd funding in the media. This is especially true as it pertains to the cannabis space. A new federal law/regulation known as Regulation A+ was passed in 2015 and it provides a tremendous opportunity for the cannabusiness industry to seek investment on a large scale from unaccredited investors, and generally provides a capital-raise mechanism for the industry to access the investors interested in the cannabis industry. In order to do this, however, it is essential to find a cannabis friendly financial institution, and many have been resistant to working with cannabusiness on Regulation A+ offerings. There are some banks, however, that will cooperate with these sorts of opportunities and a few cannabis-centric law firms have devised strategies to utilize Regulation A+ for the marijuana industry. It is something to keep a close eye on.
With all of that said, this article has focused largely on marijuana investment. The industrial hemp aspect of the cannabusiness industry presents unlimited promise. It will dwarf the marijuana side of the business by a long shot within five years. Moreover, international cannabis investment presents numerous opportunities free from many of the foregoing legal pitfalls. Look for forthcoming materials related specifically to these issues.
For regular updates on cannabusiness (the marijuana and hemp industries) in the United States and beyond, you can visit Hoban and Feola at: www.hobanandfeola.com
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Hoban & Feola is the nation's premier cannabusiness law firm (since 2008). Bob Hoban is an AV® Preeminent™ rated attorney and seasoned full-service commercial practitioner who has closed over 500 transactions across the country/around the globe in the cannabis space. Bob is recognized as a leading commercial cannabis practitioner nationwide, representing private and publicly held clients in numerous states and around the globe. He was identified as one of the “Five Pot Lawyers to Watch in 2015” by MarijuanaStocks.com. Mr. Hoban is a member of the Advisory Board for New Frontier Financials.