The Interplay Between Control Issues and Loan Covenants in Cannabis

Regardless of the jurisdiction in which it conducts its business, licensed cannabis businesses (“Cannabis Operators”) are constantly grappling with what I’ll refer to as “control issues” while negotiating the documentation of a corporate transaction. Cannabis regulations in most states prohibit people from exercising a certain level of control (i.e., decision-making authority over operations, finances, strategic planning and/or marketing of a Cannabis Operator) without first being approved by the applicable regulatory authority, undergoing background checks, fingerprinting and submitting other application requirements. Conversely, people who contract with Cannabis Operators but are not afforded a material level of control over the Cannabis Operator according to the contract can avoid such rigorous requirements. Control issues arise when some third party (e.g., investor, lender, consultant, management services provider, each a “Contracting Third Party”) contracts with a Cannabis Operator to provide a service to the Cannabis Operator or funding in the form of an equity investment or a loan. For various reasons, Contracting Third Parties do not want to be considered persons with control over a Cannabis Operator or be subject to background checks or other reporting requirements to the applicable regulatory authority. It is the collective duty of counsel to the Cannabis Operator and the Contracting Third Party to negotiate the relevant transaction documents to balance, (x) on the one hand, the need for the Contracting Third Party to be granted certain rights over the Cannabis Operator to safeguard its investment or relationship, and, (y) on the other hand, the desire to avoid granting too much control to the Contracting Third Party, therefore, triggering regulatory approval or other reporting requirements. Control issues are especially poignant and common in loan transactions. In many states, there are limits on the number of Cannabis Operators that a single entity or person can exercise control over, and lenders, who want to deploy their capital to as many qualified Cannabis Operators as possible, would be hamstrung in their ability to maximize returns if they had to limit the number of Cannabis Operators they transact with.

The following components of a loan transaction have the potential to trigger control issues and require the attorneys involved to consider their drafting carefully. With respect to each component introduced below, we at Burns & Levinson LLP (“Burns”) have developed tactics for representing both lenders and borrowers to creatively avoid control issues while still ensuring the lender receives the protections it is reasonably entitled to in connection with its making of the loan to the Cannabis Operator.

Negative Covenants

Every loan agreement (regardless of the industry of the Borrower) has a section listing the activities or transactions a Cannabis Operator cannot engage in without (1) the prior written consent of the lender, and/or (2) satisfying certain conditions restricting such activity or transaction. Each such restriction is referred to as a “Negative Covenant”, which can be waived or consented to by the lender (typically in its sole discretion), but in each instance the Cannabis Operator must request such consent, thereby relinquishing some control over the Cannabis Operator’s operations to the lender.

Common Negative Covenants include, without limitation:

1. Prohibiting the incurrence of any indebtedness in excess of a certain dollar threshold;
2. Prohibiting the granting of liens in favor of any other person on any part of the Cannabis Operator’s assets that are included as collateral for the lender;
3. Restrict the appointing of any new managers or directors;
4. Prohibiting the sale of the Cannabis Operator’s stock or substantially all of its assets to a third party or the Cannabis Operator from undergoing a change of control;
5. Prohibiting the making of dividends or certain payments to third parties; and
6. Prohibiting the Cannabis Operator from changing its name, registering a DBA or changing the nature of its business.

Noticeably, Negative Covenants influence the operations of a Cannabis Operator, but without them in place the lender is unlikely to make the loan. The trick to ensuring these protections are in the loan agreement and that no control issues arise, is twofold. First, whether you are counsel to the Cannabis Operator or if you are counsel to the lender, you must be familiar with the applicable state’s regulations regarding what constitutes control of a Cannabis Operator and what, if anything, are lenders restricted from including in their loan agreement. Second, you need to work within the bounds of the regulations to draft each Negative Covenant in a manner that protects the lender to the maximum level but doesn’t trip the regulations regarding control.

Assignment of Cannabis Licenses, Permits and Agreements with the Municipality

Many lenders require the Cannabis Operator to assign its cannabis-related licenses and permits, including the licenses issued by the state regulators, the permits issued by the local regulators and any agreement between the Cannabis Operator and the local authorities in the municipality where cannabis operations are conducted. This is relatively common in non-cannabis loan transactions, but not possible in the same manner in a cannabis transaction because the cannabis licenses, permits and related agreements are non-assignable and no Contracting Third Party can have an interest therein without causing regulatory issues for the Cannabis Operators. However, it is critical from the lender’s perspective that, in the event the loan is foreclosed upon, the lender can step into the shoes of the Cannabis Operator and liquidate the cannabis-related collateral in satisfaction of the outstanding amounts under the loan.

To circumvent the foregoing issue, we’ve created a form agreement that grants the lender certain rights in the licenses, permits and related agreements without triggering any breach under such document or control issues. Rather than assigning the documents to the Lender, the form agreement requires the Cannabis Operator to, in the event of a default, cooperate with the lender in assigning the documents to the lender so it may efficiently foreclose on the cannabis-related collateral and pay down the outstanding loan. This issue exists in almost every loan transaction we see at Burns and it needs to be handled by practiced hands or else the Cannabis Operator risks suspension of its licenses and permits, or worse – ¬revocation – which doesn’t serve either party.

Board Observer

As a condition to extending a loan to a Cannabis Operator, many lenders require the Cannabis Operator to grant them a board observer seat where a representative of the lender is entitled to attend all meetings of the Cannabis Operator’s governing board in a non-voting observer capacity and is entitled to receive all information and communications that are sent to a voting board member. The provision granting this right to the lender needs to be drafted very carefully and make clear that the observer has no voting rights or authority to control. Once again, this is a balancing act of providing the board observer as many privileges and rights as possible without crossing the line and qualifying the observer as a person exercising control over the Cannabis Operator.

Conclusion

Avoiding control issues in a loan agreement requires limiting certain rights that a lender would expect to have in a non-cannabis debt transaction. This has a chilling effect on the volume of lenders available to Cannabis Operators. However, this problem is constantly being addressed by attorneys in the space and new creative ways to bolster the rights of lenders in cannabis loan deals are discovered daily. This is just further evidence that players in the cannabis industry are pioneers in both the development of corporate law and of business.