Lenders, Commercial Real Estate Owners, and Investors and the California Cannabis Business

March 12, 2019 by Kevin S. Kim, Esq. Tae Kim, Esq.

The recreational cannabis industry is becoming more regulated in California. On January 16, 2019, three state cannabis licensing agencies — the California Department of Food and Agriculture (“CDFA”), the California Department of Public Health (“CDPH”), and the Bureau of Cannabis Control (“CBCC”) — enacted state regulations to govern the California recreational cannabis industry as part of the Medicinal and Adult-Use Cannabis Regulation and Safety Act (the “Cannabis Act”). These new regulations will substantially impact the non-conventional cannabis lenders, investors, and commercial real estate owners (landlords) when doing business with commercial cannabis businesses (“CCBs”). Specifically, the regulations place more stringent disclosure requirements for CCBs seeking to obtain licensing, which can impact those counterparties.

Commercial Cannabis Business — Ownership vs. Financial Interest

According to the regulations, an owner is a person that (1) holds 20% or more ownership interest in a CCB, (2) is a CEO or board member of a nonprofit CCB, or (3) general partner, manager, or officers/directors of CCB. Generally, owners must be included in the CCB license application and will be required to disclose various personal background information including, but not limited to, criminal convictions, civil proceedings, administrative penalties, sanctions, fines, ownership or financial interest in any other licensed cannabis business, as well as detailed business information. Any changes in ownership must be disclosed to the CBCC and the CDPH within in ten days.

A financial interest holder is a person with a financial interest of less than 20% in a CCB, which includes loans and/or equity interest to the CCB. Financial interest holders must be disclosed on an owner’s application for licensure but has a less stringent disclosure requirement. Individual financial interest holders must accordingly disclose their name and provide government identification. Entity financial interest holders must disclose the legal business name and federal taxpayer identification number.  New financial interest holders must be disclosed when the annual license renewal is submitted.

There are certain parties who are exempt from the disclosure requirements: banks or financial institutions whose interest is a loan; persons who own a CCB through a diversified mutual fund, blind trust, or similar instrument; persons whose only financial interest is a security interest, lien, or encumbrance on property that will be used by the CCB; and individuals who hold a share of stock that is less than 5% of the total shares in a publicly traded company. Finally, lenders who make real estate loans on which a CCB occupies the property will also be excepted from disclosure as a “financial interest holder.”

Impact on Lenders  

Cannabis lenders should be aware how these regulations will impact them. First, as noted above, the regulations will require such lenders to disclose the identities to the regulators during the CCB application process and annual reporting, unless exempt. Second, the cannabis lenders must ensure that certain covenants and/or provisions be included in the loan documents to protect themselves from unnecessary liabilities. At minimum, there must be provisions in the loan documents that CCBs are reporting (and will continue to report) to state agencies and that they are (and will continue to be) fully compliant with California’s regulations.

Lenders who will engage in equity participation, option to receive equity, or any profit-sharing into the CCB must be much more cognizant when engaging in such deals.  The lender can become an “owner” through these equity related deals and will be impacted in the disclosure reporting requirement with the state agencies and be subject to a variety of California cannabis regulations. Considering that a vast majority of financing in the cannabis space is provided by non-conventional lenders, this poses a significant impact because it will raise the license reporting requirement for the CCB borrower to the California regulator beyond identification as a lender.

Impact on Commercial Real Estate Owners

The new regulations also implicate the relationships between real estate and landlords whose tenants may be engaged in a CCB. Like the old regulations, the new regulations require CCBs to provide the CBCC with evidence that a landlord knows and accepts that their property will be used for commercial cannabis activity, as well as a copy of the rental agreement. Similarly, the CDFA and the CDPH’s regulations require a license applicant to provide the property owner’s mailing address and phone number. A new feature of the regulations may impact how commercial real estate owners structure lease agreements with CCBs. The old regulations described “an agreement to receive a portion of the profits of a commercial cannabis business” as a form of financial interest. Now, the new regulations specifically state that a lease agreement that entitles a landlord to a share of a tenant CCB’s profits creates a financial interest. This will impact the decision making of many commercial real estate owners who may be interested in receiving profits from CCBs as part of rent.

Impact on Investors

The regulations will have the most significant impact on investors. An owner (i.e.: investor) or financial interest holder must disclose certain identifying information to CBCC, unless exempt.

Notably, the 20% carveouts and exemptions can create an avenue for investments to be made with limited or without disclosure of personal information. However, the California cannabis regulators will likely follow the methodology of the other regulators that are offering different licenses in the state. Indirect investments to bring the investment down below 20% or certain investment vehicles like a private diversified fund may be shut down based on certain internal policies determined by the applicable regulators. In other words, the California regulators may close the loopholes of disclosure requirements and prevent any circumvention of such requirement, which may be attempted by creative investors.

Ultimately, the cannabis investor should consider balancing between disclosure and ownership of the CCBs. Those who feel comfortable with extensive disclosures should be owners of the CCBs to maximize their returns. On the other hand, those who wish to safeguard his or her identity should limit the ownership interest to less than 20%.

Conclusion

The new regulations enacted to regulate the Cannabis industry in California will have a widespread impact with respect to lenders, investors and real estate owners that transact with CCBs. To ensure that their investments are not subject to risk of violating California law and the risk of federal action, it is essential that investors, lenders, and commercial real estate owners reach out to their borrowers, investment managers, and tenants to ensure full compliance with the new regulations.

Lenders, it may be time to amend your borrower’s licensure reporting requirements to ensure they are operating in full compliance with these new regulations. The same goes for investors and landlords.

Contact Kevin Kim at Geraci LLP about how your businesses can be protected from the new California cannabis regulations.