INSIGHT: Weathering a Downturn in the Cannabis Industry

How would the legal cannabis industry react to a downturn in the economy? Like everything else in the U.S. cannabis industry, the answer is complicated.

The legal cannabis market has enjoyed a wellspring of growth capital from investors in the U.S. and Canada over the past few years. Not only have U.S. companies tapped the Canadian public equity markets for cash; private placements of debt and equity continue to flow into the industry from specialized private equity funds, high net worth investors, and friends and family.

All of this has taken place during a period of sustained economic growth in the U.S. But what happens if the U.S. economy takes a turn for the worse?

Cannabis Capital Markets Today

Cannabis remains illegal under federal law as a Schedule I controlled substance under the Controlled Substances Act (and related regulations). Although 11 states and the District of Columbia have legalized adult-use cannabis, and 35 states and the District of Columbia have legalized medical-use cannabis (as of August 2019), for production, manufacturing, and sale, federal law takes precedence over state law. So, the U.S. cannabis market is currently both illegal (federally) and highly-regulated (by the states and locally) at the same time.

This dialectic of legality has not stopped investors from pouring money into the state–legal industry. Billions of dollars of equity and debt capital have been injected into companies serving all ends of the legal market, from vertically-integrated multi-state operators (MSOs) to picks-and-shovels ancillary businesses supporting that market.

That capital has mostly come from non-traditional sources of growth capital, such as high net worth individuals, private equity funds, and public listings on the Canadian Securities Exchange, since banks and institutional investors have mostly held off on participating in the cannabis industry.

If the U.S. economy experiences faces a downturn and investors seek to reduce risk and protect cash, investment activity into a high-growth, high-risk industry such as cannabis would likely drop. Further, as with many industries that grow very quickly, the growth in this industry could and likely will falter when a market glut occurs.

Yet, the legal cannabis industry is relying on a steady inflow of new risk capital to feed its growth and fund continuing losses that are exacerbated by the effects of IRS §280E, which prohibits cannabis businesses from deducting most business expenses (due to their being federally illegal), as well as specialized state and local tax burdens.

When new money dries up or becomes scarce, U.S. cannabis companies will be quickly tested with some undercapitalized companies likely resorting to ways in which to restructure their debt.

Distress and Restructuring

So what does that mean for the distressed cannabis company? One traditional path for distressed businesses—protection under the US federal bankruptcy laws—is not currently an option. U.S. federal bankruptcy courts have made it abundantly clear they will not allow any company that is directly or, even to a certain extent indirectly, participating in the cannabis industry to file for bankruptcy, until cannabis is legal under federal law.

The benefits of federal bankruptcy include the automatic stay (meaning that creditor actions are “stayed,” generally for resolution by the bankruptcy court) and an ability to restructure and possibly extinguish creditor claims. This powerful tool likely may not be available, so cannabis companies would be forced to resort to state-level bankruptcy, state-level laws regarding assignments for the benefit of creditors, receiverships, and workouts with creditors, none of which provide the same benefits as does the United States Bankruptcy Code.

And even though some states do provide for orderly receivership sales of cannabis licenses and assets (such as California, Washington, and Oregon), those processes have not yet been fully road-tested.

Distress and Opportunity

On the other hand, where there is risk, there is also opportunity. In a downturn, there could likely be a rise of distressed capital investors who will look to acquire assets and licenses at a significant discount, similar to what happens in other industries.

The MSOs and other large cannabis companies with significant asset bases may be able to borrow (particularly if interest rates fall in response to the downturn) and use that capital to acquire distressed companies, on top of continuing the current practice of acquiring companies with stock.

One sticking point, however, is that, due to the nature of the permitting laws in many states, ownership changes for business licensed for cannabis are complex and time-consuming (and, in some ways, prohibited).

Additionally, acquisitions in the cannabis industry tend to be on a stock basis (meaning the entire company is acquired), rather than an asset basis (meaning that just certain assets are acquired), buyers will be forced to assume existing liabilities (again, without the ability to extinguish those liabilities thru a pre-packaged bankruptcy process). If creditors are not being paid, other, creative routes to satisfying or restructuring those liabilities will need to be found.

Finally, there is the overhang of legalization. If there is a downturn, a severe pullback of capital, and still a lack of access to the bankruptcy courts to solve distress, does the call for legalization get louder? Or if the SAFE Banking Act gets passed, do lenders make an even stronger push for federal bankruptcy laws to apply to the businesses that are operating legally within their states?

With legalization, many of these problems would be alleviated, so does the industry finally make a coordinated and strong push for federal rescheduling of cannabis?

Preparing for the Worst

So, what can an industry that has enjoyed unfettered growth and a steady flow of capital do to prepare for a downturn?

• Model out whether and how you can sustain a downturn. What are your sources of capital and are there alternatives? How long could you last without clear access to capital, assuming the worst? Where costs may be cut? Do you have a cash cushion to weather a downturn? How could your growth plan be adjusted to weather the storm?
• Early strategy and planning is critical, since time is not on the side of either the distressed company. If you are seeing signs of stress, talking to a lawyer or advisor experienced with distressed situations and restructuring helps, particularly one who also understands the regulatory challenges of the cannabis industry as well as the restructuring process.
• Time is not on the side of the distressed investor, either. The opportunistic investor could be pulling together a fund or a club structure today to be ready to act. However, investing in cannabis takes specialized planning given its regulatory nature.
• Larger cannabis companies with access to cash could be planning their next moves and identifying targets to rescue at lower valuations.
• Smaller cannabis companies could be figuring out how they become more streamlined and focused in their niche, to better stand out in a sea of distress.
• Secured creditors could be reviewing their loan documents and making sure they have a practical and complaint strategy for seizing , whether a license, inventory, or real estate.
• The industry should continue making a coordinated push for legalization on the federal level, or, at a minimum, urge Congress to change the US Bankruptcy Code to allow cannabis business operating legally within states to take advantage of its protections.

Business cycles change quickly, and a high-growth, heavily-regulated industry like cannabis is just as vulnerable as any other.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Marc Hauser is counsel and vice-chair of the Cannabis Practice Team at Reed Smith LLP. Hauser has been a deal and capital markets lawyer for over 20 years, with extensive experience working with distressed companies and special situations. His current practice is entirely focused on the cannabis and industrial hemp industries, providing strategic advice to industry participants throughout the United States.

Contributing comments from Claudia Z. Springer, a bankruptcy and restructuring partner and chair of the Cannabis Practice Team at Reed Smith LLP.

The contents of this communication are for informational purposes only and do not constitute legal advice. Prior results do not guarantee a similar outcome in the future