A fortuitous combination of developments and circumstances present the banking and cannabis industries a large opportunity to enhance each of their respective bottom lines: conventional bank lending, payment processing, treasury management and other services, and bank administered SBA and revenue bond financing to cannabis businesses.
Loan numbers are difficult to come by, but knowledgeable sources estimate that borrowing for "plant touching" cannabis, businesses (e.g., growers, processors, retailers, testing labs and delivery services) was at least in the low to mid-hundreds of millions last year, numbers that appear certain to increase dramatically. Whatever the number, it's a significant, growing, untapped line of new business for Banks (all federally insured depository institutions, including credit unions). Even the few Banks that take deposits don't currently lend.
The timing for this surge in demand couldn't be better, as cannabis businesses across the spectrum are achieving operating results that make them increasingly attractive customers for Banks.
Also, the Banks that make the loans will largely own rights of first refusal on the earning power on multiple billions of low/no/negative cost deposits, not to mention tens of millions per year in fees for services ranging from payment processing to the spectrum of treasury management; combined with the likely future prospect of an international component, increasing the attractiveness of cannabis relationships to even the largest Banks. In addition to those compelling bottom-line incentives, the offset rights against deposits would provide important additional loan security, perhaps sufficient to tip the balance as credit judgments are made.
- State legal US cannabis industry revenues in 2020 are estimated at more than $15 billion (some estimates as high as $20 billion) and are expected to continue to grow at 30-40% With concomitant increases in the cannabis industry's needs and appetite for funding, the demand for credit could match this growth rate for the foreseeable future.
- Not only is the future promising, but there is a substantial immediate opportunity. The cannabis industry currently has billions outstanding in high-rate, hard money loans. The refinancing of even a portion of these could offer Banks tens of millions in income at the same time adding tens of millions to cannabis business bottom lines.
- Parallel growth can be expected in ancillary, non-plant touching businesses that may fall under the "marijuana related business" (MRB) definition which triggers enhanced due diligence requirements for Banks.
Despite what appears to be a widespread misperception that it is illegal for Banks to accept cannabis business customers, some banks and credit unions are doing business with the cannabis industry, although there is a lack of clarity about exactly how many. But those that have been doing so for some time, all with the knowledge and under the supervision of their federal and state Bank Regulators, who have wisely and prudently faced the fact that the cannabis industry is here and unlikely to disappear.
To mitigate the risk of running afoul of a myriad of federal financial crimes laws, Banks doing business with the cannabis industry, and their Bank Regulators, draw on guidance issued in 2014 by the Financial Crimes Enforcement Network ("FinCEN"), a bureau of the US Department of Treasury.
Despite discomfort with the federal illegality, as Banks tiptoe into the cannabis industry, Bank Regulators are apparently going to school- building on existing guidance and developing policies, procedures, and protocols in connection with cannabis businesses and other MRBs. Although they may have to be adapted to address issues unique to lending, these will be the foundation for regulation whenever new legislation emerges.
Limited federal guidance and oversight to date has been focused on Banks providing deposit services, so although scaffolding is in place, it will require thoughtful adaptation to address issues unique to lending. Pending federal legislation, the Secure and Fair Enforcement Act (the "SAFE Act") and the Marijuana Opportunity Reinvestment Act (the "MORE Act"), which passed the House last year, appear to have improved prospects in the Senate this year. These would provide expanded safe harbor protections for Banks working with cannabis businesses and re- or de-scheduling marijuana under federal criminal law that could eliminate uncertainties such as the cannabis industry's issues under Section 280E of the Internal Revenue Code and the current lack of access to the US Bankruptcy Courts.
Although there is still important work to be done, for practical purposes, the anticipated federal legislation is largely and effectively in the rearview mirror. The constituents of 70% of states have spoken, and this issue has become demonstrably and increasingly bipartisan.
Federal legislation will not, however, affect state law limits or outright prohibitions on Banks' ability to secure readily and expeditiously enforceable collateral interests in cannabis licenses. Based on our experience in several hundred million of cannabis debt transactions-representing institutional and high net worth lenders, underwriters, third party beneficiaries and borrowers-collateral security interests have been among the toughest issues largely due to that inhibition.
Possible solutions include pre-approved receivership regimes to enable lenders to quickly get control in the event of a default, thereby mitigating further asset deterioration. Templates may be drawn from the manner in which security interests in liquor and FCC licenses are dealt with.
Unless cannabis licensing becomes federal and preempts state regimes, which is not currently on the active radar, the anticipated federal legislation cannot remediate this challenge. Doing so will require a collaborative effort by the two industries to effect necessary changes at the state level, the fruits of which benefit both.
SIDEBAR; SPOILER ALERT
Please see the following link to a blog discussing the potential that the SAFE and MORE Acts will precipitate a new wave of investment or acquisition activity by non-cannabis companies that previously shunned the cannabis industry due to the unknown implications of owning businesses whose activities are illegal under federal law.
To put the size, scope, and momentum of the opportunity in perspective, 35 states and DC have legalized marijuana, including recreational or "adult-use" in 15 of those states. That means approximately 225 million, or 70% of Americans, currently have access to state legal medical marijuana, and approximately 111 million, or more than a third, of the US population to recreational. Coincidently, or perhaps not, these percentages closely track public opinion polls. A November 2020 Gallup Poll indicates the most recent approval rate at 68%, an all-time high.
Given the pace of decriminalization and legalization, and organized, well-funded campaigns underway, it seems inevitable that most holdout states will join the list over the next several years. Additionally, almost all states with medical have, or soon will have, active movements to decriminalize or legalize recreational. New York and Florida, and perhaps Ohio, with total populations of almost 53 million, seem poised to do so in the next year or two.
Current state laws either preclude encumbrances against licenses held by marijuana businesses, subject lenders to approvals under transfer of control regulations and processes, or are unhelpfully silent.
Banks, unlike private lenders, are subject to regulation and examination, and are held to an overarching requirement of safety and soundness. In order to assure that Banks and Bank Regulators take license collateral fully into account in evaluating loans to cannabis businesses, Banks need a degree of collateral certainty by way of timely and effective control of underlying assets, so that they can protect against further dissipation in value of the underlying assets and business. This will be difficult to achieve if they must go through some process of uncertain time or success to gain asset control from the defaulting borrower.
- Either a blanket carve-out, or an efficient, rational one-time preapproval process, for federally insured Banks lending to cannabis businesses, with some or all of the following characteristics: (i) defined capital or bonding requirements, combined with (ii) limited and reasonable time frames for dispositions upon default to buyers that pass regulatory muster.
- Using as a template existing processes already designed for comparable licensed businesses, such as liquor and broadcast licenses, which would provide time-tested and predictable
- Creating processes for timely and effective execution of security interests in the cannabis industry, which could take several different paths or chart new territory:
(i) a list of preapproved receivers that could be immediately interposed and operate under existing state receivership laws, which is the most prevalent and familiar process currently used by lenders as an alternative to the US Bankruptcy Courts, but perhaps lacking sufficient certainty as to timing and result to meet the likely higher standards of safety and soundness, or
(ii) a regulatory receivership process administered by state cannabis regulators, which would require more state resources and legislative or regulatory action, but perhaps result in a speedier process that is more attuned to the unique aspects of the cannabis industry.
Comments regarding alternatives are welcome and encouraged at email@example.com.
Momentum driving the SAFE and MORE Acts (or some variation) toward enactment, will further legitimize and move the cannabis industry another significant step out of the shadows and into the mainstream. This, together with rising revenue, profitability, and cash flow in the cannabis industry, will almost certainly provide a springboard:
For Banks, this will open an entirely new lending market. A market that is already large and rapidly growing, and increasingly populated by strong, stable and profitable businesses - in other words, highly desirable customers; and, at least for some period of time, lending to this market will offer the Banks pricing at the premium end of their conventional commercial lending rates while still saving borrowers between 3% or 4% at the low end, and significantly more at the high end.
For cannabis businesses, particularly those that become more desirable customers for Banks as they develop a solid financial platform and profitability, this offers a new financing option that can dramatically reduce interest costs, enhance earnings, and offer an attractive borrowing alternative to expensive equity to fund growth.
Although there is still important work to be done, for practical purposes the anticipated federal legislation is largely and effectively in the rearview mirror. Whatever shortcomings our Senators and Representatives may have, most eventually tend to be pretty good at electoral math. The constituents of 70% of the Senators and Representatives have spoken, with the voters having clearly expressed their views.
Moreover, this issue has become demonstrably bipartisan, with any red, blue, purple or puce state divides rapidly disappearing, as traditionally conservative states increasingly get on board with legalization (e.g., Arizona, Oklahoma, Louisiana, Mississippi, Arkansas, North and South Dakota, Montana) with more almost certain to follow.
The Current Banking Environment
Despite what appears to be a widespread misperception that it is illegal for Banks to accept cannabis business customers, there are hundreds of banking institutions that are and have been doing so for some time, all with the knowledge and under the supervision of their federal and state Bank Regulators.
In a Marijuana Banking Update as of June 30, 2020, FinCEN, the mission of which is to safeguard the financial system from illicit use and combat money laundering and promote national security, reported that 510 banks and 185 credit unions were doing business with the cannabis industry. Cannabis businesses seeking depository relationships will find that number hard to believe based on the difficulty they have in finding willing Banks. Most states have only a relative handful (e.g., Arizona only has four and Ohio only has only a few). That disconnect appears to exist because FinCEN's numbers are derived based on institutions filing Suspicious Activity Reports (SARs) related to marijuana, and not all institutions that file marijuana related SARs take deposit accounts for marijuana businesses.
To mitigate the risk of running afoul of a myriad of federal financial crimes laws, Banks doing business with the cannabis industry, and their Bank Regulators, draw on guidance issued by FinCEN in 2014 (the "FinCEN Guidance"). In fact, reflecting the acceptance of the FinCEN Guidance as the current lodestar, the SAFE Act would call for FinCEN to issue new guidance for the submission of SARs for transactions with state legal cannabis-related businesses in order to avoid significantly inhibiting the provision of financial services to such businesses.
Despite discomfort with the federal illegality, Bank Regulators have wisely and prudently faced the fact that the cannabis industry is here and unlikely to disappear.
FDIC Chairwoman Jelena McWilliams neatly explained why things are still so complicated1:
It has been one of the perhaps-I would say-more challenging issues that I have encountered at the FDIC. And here's why: At a federal level it is still an illegal substance. And at many state levels, it's now legal, and it's legal to frankly bank it at a state level. And so banks find themselves caught between the federal regulatory regime and the state...so what I've been telling banks: There's so much uncertainty in this space that as a federal regulator, I still have to say, it's illegal to bank marijuana.
But to the extent that you're doing it because it's legal in your state, please follow FinCEN guidance.
We know we have banks that are banking marijuana businesses, and you know, we can't bless them and say "go ahead and do it." But to the extent you're doing it because it's legal in your state, follow FinCEN guidance.
Credit Unions and their regulators have taken a somewhat more progressive approach, demonstrated when Rodney Hood, Chairman of the National Credit Union Administration stated
that credit unions will not be sanctioned for conducting business with marijuana-related firms. He said that it is a business decision for credit unions and that the NCUA would not micromanage financial institutions the agency supervises. He said that credit unions still have to follow Financial Crimes Enforcement Network rules, which require credit unions and other financial institutions to file Suspicious Activity Reports.
The FinCEN Guidance sought to clarify "how financial institutions can provide services to marijuana-related businesses consistent with their BSA obligations" with the goal of enhancing "the availability of services for, and the financial transparency of, marijuana related businesses."
The FinCEN Guidance specifically incorporated content from a memorandum issued by the U.S. Department of Justice in 2013 by Deputy Attorney General James Cole (the "Cole Memo"), that essentially deprioritized prosecution of marijuana-related federal offenses so long as the actors were complying with state law. Among other things, the Cole Memo identified continuing priorities such as preventing distribution to minors, money flowing to criminal enterprises, and diversion of marijuana to states where it was still illegal. Drawing on the Cole Memo, FinCEN's Guidance provides a laundry list of red flags and dictates that financial institutions must tailor their relationships with MRBs to reflect its priorities. Unfortunately, the FinCEN Guidance does not define MRB, other than indicating that it includes more than just plant touching enterprises, for example covering landlords with MRB tenants. This expansive reading is supported by a non-binding Small Business Administration Policy Notice from April 2018, which offered the following definitions:
"Direct Marijuana Business" - a business that grows, produces, processes, distributes, or sells marijuana or marijuana products, edibles, or derivatives, regardless of the amount of such activity.
"Indirect Marijuana Business" - a business that derived any of its gross revenue for the previous year (or, if a start-up, projects to derive any of its gross revenue for the next year) from sales to Direct Marijuana Businesses of products or services that could reasonably be determined to support the use, growth, enhancement or other development of marijuana. Examples include businesses that provide testing services, or sell grow lights or hydroponic equipment, to one or more Direct Marijuana Businesses."
The SAFE and MORE Acts; The Past as a Prologue for the Future
The SAFE Act has been rattling around Congress for a couple of years, passed the House in 2019, and now has meaningful support in the Senate. Briefly, it aims to provide a "safe harbor" for depository institutions that want to do business with state-licensed cannabis companies and their service providers. Banks need a safe harbor because marijuana is currently a Schedule I drug under the Controlled Substances Act, banned for all purposes and illegal under federal law even in states that have legalized it. Although the SAFE Act doesn't address the legality or scheduling of marijuana, it would provide a huge step towards resolving uncertainty, reducing risk, and providing a framework for expanded Bank participation in the industry, removing many of the concerns that prevent most Banks from doing so.
It would prevent federal Banking Regulators from punishing banks just because they provide services to cannabis businesses and free up federally insured Banks to both take deposits and lend. Among other things, it would clarify that, for purposes of federal anti- money laundering statutes, the proceeds of transactions involving activities of state legal cannabis businesses would not be considered proceeds of an unlawful activity. It would also provide that Banks that have a legal interest in the collateral for a loan or other financial service to state-legal cannabis businesses, or to an owner or operator of real estate or equipment leased or sold to such a business, would not be subject to criminal, civil, or administrative forfeiture of that legal interest pursuant to any federal law for providing that loan or service.
The MORE Act would significantly advance the progress represented by the SAFE Act. The MORE Act also passed the House (in December 2020) and several prominent Democratic senators have indicated that they intend to bring the MORE Act or something substantially similar to the Senate in 2021. The MORE Act would entirely remove marijuana-more specifically, THC, the psychoactive element in the plant-from the schedules of controlled substances under federal law, essentially legalizing the drug at the federal level. This would remove the many complications caused by current federal law for the cannabis industry and banks, including access to bankruptcy courts, tax deduction issues for cannabis businesses related to Section 280E of the tax code, impediments to obtaining insurance, etc.
Given this fraught environment, even Banks that already provide deposit accounts and a limited range of other services to MRBs don't make loans. Consequently, although some larger and more financially successful public companies have fared better, most cannabis companies needing debt finance have had to accept hard money terms from private lenders- much higher rates (ranging into the high teens and likely averaging 12-15%) and often highly dilutive equity conversion rights.
Impressive Financial Improvements; The Lure of Attractive Customers
If the mythological analogy of the cannabis industry from the second half of 2019 until mid-2020 is Icarus plummeting to earth after flying too close to the sun, it now is much more aptly the Phoenix rising from the ashes. Across the spectrum-small, single license operators, larger single state operators, small to large private multi-state operators ("MSOs"), and public companies-have achieved improvements in their financial condition and performance ranging from steady and solid to very, very impressive.
As a result, as the cannabis industry's already substantial appetite for credit continues to grow, at the same time, by gosh, cannabis businesses are becoming increasingly attractive customers for the Banks.
Even as they do, it is likely, at least for some time, that Banks extending credit to the industry, even its best performers, will be able to price loan products at the premium end of the range for conventional commercial loans; providing highly attractive net interest margins.
Since even those premium rates will be far, far less than the rates the industry has been paying, the entry of Banks into the cannabis lending market will not only have meaningful, direct, and force multiplier effect, improving bottom lines, but should also accelerate the growth of the cannabis industry by providing an attractive incremental alternative to high priced debt or dilutive equity.
The Rocky Road to Encumbrances; Transfers of Control
Particularly in light of the inability to access the U.S. Bankruptcy Courts, creditors of cannabis businesses must look to current state laws and regulations. These provide a patchwork of uncertainty regarding security interests in licenses that will almost certainly inhibit Bank lending to cannabis companies even if the SAFE and MORE Acts are enacted. Existing state laws either preclude encumbrances against licenses and/or would subject lenders to post- default approvals under often complex, time consuming and inherently uncertain transfer of control regulations and processes. This is a major hurdle for lenders seeking to enforce their rights to take control before the value of an asset or business can be dissipated by a defaulting borrower that, presumably, wouldn't be in default unless the business was already in trouble.
Receiverships as an Alternative to Bankruptcy
Lessons may be drawn from two of the most mature cannabis states-Washington and Oregon.
Washington regulations allow a receiver for purposes of foreclosure and liquidation within the recreational cannabis industry. The Washington State Liquor and Cannabis Board maintains a list of preapproved receivers and allows for appointment of a receiver who is not preapproved upon receipt of the standard receiver application. Similarly, Oregon regulations allow for appointment of an authority to temporarily operate a cannabis licensed business as a trustee, receiver, or secured party.
Evaluating the Silence
When a state's laws, regulations, and cannabis regulators are silent on whether a license may be encumbered, the next logical step is to evaluate a state's position on transfers of ownership or control generally. Whether a license or control of a licensed business may be transferred, the steps involved in transferring a license or ownership, and whether there are carveouts for a license's transferability in connection with the exercise of a collateral interest, are all factors in the evaluation of whether a lender has a path to an enforceable security interest adequate to satisfy a Bank's and Bank Regulators' safety and soundness criteria.
As a general proposition, states typically impose onerous and time-consuming transfer requirements, and there are no guarantees that approval will ultimately be granted, circumstances which must be addressed at the state level as part of an overall resolution to enable and facilitate Bank lending to cannabis businesses.
1 Crain's Detroit Business, June 3, 2020
2 The Credit Union Times, August 5, 2019
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.