As a cannabis company, secured debt may be your only option for a line of credit or for funding the evolution of your business.
Secured debt is where the lender takes a lien against either all assets or a particular set assets of a borrower as collateral for a loan. As can be imagined, trudging blindly into this type of debt can sink your business. Moreover, there are particular concerns when cannabis companies incur secured debt.
Increasingly, experienced secured debt lenders are entering this space, but a significant portion of those potential partners remain prohibited by federal law from participating in cannabis company debt. In the meantime, it falls disproportionately on cannabis companies to educate and steward and carefully consider potential debt partners. Unless you have been active in the space before, it is going to be hard for you to judge what is right, wrong or weird without trusted advisors.
The responsibilities between a borrower and the lender are commonly misunderstood. It is not an equal (or close to equal) partnership, which is the universal issue of this article. If you incur secured debt, it is your responsibility to understand that your lender has a right to your collateral—a right that is superior to rights of all others.
The consequence of misunderstanding this relationship can be the lender calling default on your loan.
Grasping this responsibility involves two important concepts under Article 9 of the Uniform Commercial Code (UCC):
(1) Attachment: This pertains to how a security interest grant is enforceable against the borrower, requiring the occurrence of each of the following events: (i) the borrower receives value for the grant; (ii) the borrower has rights in the collateral; and (iii) the secured lender receives a grant in the collateral, usually pursuant to a written security agreement; and
(2) Perfection: This pertains to how a secured lender’s security interest has priority to all other creditors.
With respect to secured debt, it is easier to ensure attachment when working with a trusted attorney. Following the elements above, here’s what happens: (i) You receive value in a secured debt transaction through a loan of funds or the promise to access to a loan of funds, (ii) you typically have rights in the collateral, but an attorney will help investigate potential issues, and (iii) the transaction documents should contain a specific grant of collateral as required under the UCC, but there are other methods to receive a grant.
Here is where you will run into your initial problem as a cannabis company.
Except in limited instances, including in Oregon and Maryland, legal regimes prohibit cannabis companies from granting a security interest in the applicable license and/or cannabis. Poof, your two most valuable assets–the right to engage in the cannabis industry and your inventory–are eliminated from the collateral package offered to lenders.
So, what else might a business have to offer? You will need to frame discussions with your lender to highlight the values on your balance sheet in equipment, land or other assets, and your attorney needs to make it clear that the license and inventory is excluded from the collateral package.
You can alleviate lender’ concerns on losing the value in the license and inventory if you pledge the equity of the entities holding licenses and consequently inventory. A pledge of equity is a security interest but is a reference to equity (membership interests, shares, etc.) that has value only to the extent the obligations of the direct creditors of the issuing entity are paid and has particular rules.
Naturally, a secured lender’s attempts to enforce a pledge cause other issues involving ownership change under applicable regulatory regimes. Depending on the regulatory regime, a lender taking ownership of equity of a licensed cannabis entity upon foreclosure is likely reportable and subject to consent of the applicable regulatory body, which will likely include burdensome and time-consuming compliance requirements such as extensive background checks on the lender and its affiliates. Thusly, this avenue may not be desirable for or a convincing point to your lender. Your lender is not in the cannabis business–they are in the money business.
Consequently, a secured lender may involve a trustee or an agent to act on their behalf such that the secured lender would not hold the equity or other assets of a cannabis company. But, you will more than likely pay the fees of these trustees and agents as a condition to the debt transaction. In addition, some of our clients are having difficulties securing a trustee or agent due to a lack of available options. So, timing can be a concern here if you are targeting a quick closing.
Next, perfection of a security interest is specific to the type of assets subject to the security interest.
Generally, a security interest is perfected by one of the following methods:
filing a financing statement (sometimes referred to as a UCC-1) in the applicable public filing office;possession;control; orautomatically upon attachment (specific circumstances).
Filing a financing statement covers most typical business assets, such as inventory, equipment and general intangibles. The failure to file a financing statement or failure to do so correctly is one of the common ways other creditors (but because of federal limitations, probably not a bankruptcy trustee) poke through the priority of a secured lender. Therefore, it’s important to have a trained eye who will ensure that a financing statement adequately and correctly names the debtor, the secured party and the collateral and a responsible party to file them. In this regard, you should consider how collateral is described in financing statements. As these financing statements are of public record, it is suggested that the collateral description explicitly exclude cannabis licenses and inventory.
Lastly, you should consider what financing statements have been filed by others on your UCC record. This is typically done as a part of due diligence by the lender, and you may be required to clean up certain filings as a condition to the debt transaction.
Another wrinkle with respect to your efforts toward perfection comes up with respect deposit accounts (i.e., bank accounts). A security interest in deposit accounts is perfected by control, and the means to do that is by the secured party, the debtor and the applicable financial institution entering into a deposit account control agreement. It is a typical condition to a secured debt transaction that the borrower and the applicable bank enter into a deposit account control agreement in favor of the lender prior to closing the debt transaction or within a period of time post-closing.
Large banks typically have a department that handles these requests and the process is relatively smooth. But because of the current federal banking regulatory stance, you do not have access to those banks. Instead, you are likely relying on smaller credit unions or community banks willing to provide banking services to cannabis companies that have no experience with deposit account control agreements.
In more than one instance, such institutions have refused to execute a deposit account control agreement. This puts you at risk for not complying with your loan agreement and would likely require moving all funds to a new, willing financial institution. Depending on the loan agreement’s contents, failure to execute a deposit account control agreement typically may put you in default. Confirming your bank’s position on this issue well in advance of a loan transaction would help manage this issue. Some of our clients have had extreme difficulty finding alternative banking partners because of the outright refusal to enter into a deposit account control agreement by some of their prior banking partners.
Not all cannabis companies are alike, but nearly all desire more access to capital. Secured debt presents its advantages and disadvantages, which can be enhanced or avoided based upon careful review, consideration and negotiation. As the above may have shown, it takes effort from a you, your trusted advisers and experienced debt partners for debt to elevate your business rather than dragging it into the murk.
JT Schuweiler is an attorney at Fox Rothschild, where he advises clients on complex financial transactions. He frequently works with early stage companies especially in the cannabis sector.