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You are here: Home / News & Insights / Cannabis Investments / Marijuana Fundraising In California: What’s In Your Private Placement Memorandums?

Marijuana Fundraising In California: What’s In Your Private Placement Memorandums?

November 15, 2017 by Hilary Bricken 1 Comment

Many of our California clients that are raising money ask us to draft or review private placement memorandums (“PPMs“) for private securities offerings in their cannabis companies and/or ancillary cannabis companies. As you would expect, investment in California cannabis businesses is at an all-time high thanks to the Medicinal and Adult Use Cannabis Regulation and Safety Act, (MAUCRSA) which will change the face of the industry in the Golden State.

The goal of a PPM is to describe the company raising the money, its management, how much money is being raised, how the money received will be used, and the risks involved in the investment. These things are important, but the description of the risk factors is the most important section for protection under federal and state securities laws.

This is when our clients often cringe because we always encourage full disclosure of all risk factors associated with the cannabis-related business seeking investment. As much as our clients may want to soften the blow for potential investors regarding their cannabis company’s potential volatility, they need to be as up-front and honest as possible about the criminal and business realities of cannabis investments. Should they fail to do so, they will face the consequences from state and federal regulators.

Though investor fraud investigations are (thankfully) beginning to pick up in various states (and I have no doubt California will eventually become very aggressive on this), investors still need to be wary of California cannabis PPMs as far too many are more unsubstantiated marketing pitches than legally viable securities disclosures. Here are the cannabis risk factors that should be present in every California PPM to avoid anti-fraud issues:

  1. Cannabis is federally illegal. This is a no-brainer. Though you can mention the various enforcement memoranda the Feds have issued on the subject, none of those memos have any real legal meaning or effect and — most importantly — they are not going to protect a cannabis company or any of its investors from criminal prosecution or asset forfeiture under the federal Controlled Substances Act (and, of course, notorious pot hater Jeff Sessions could change the Department of Justice’s current enforcement priorities). Even California ancillary companies should discuss cannabis illegality in their PPMs since these companies and their financial backers could be subject to charges of aiding and abetting or conspiring to violate the Controlled Substances Act for providing goods and services to cannabis businesses.
  2. Investors risk criminal liability and the cannabis business’s assets are subject to forfeiture. See point one above. Because cannabis is federally illegal, investing in cannabis businesses could be found to violate the federal Controlled Substances Act. Not only can investors and company directors and management be indicted under federal law, the assets they contribute to a cannabis business (and even to an ancillary cannabis business), including real property, cash, equipment and other goods, could be subject to asset forfeiture because cannabis is still federally illegal.
  3. California cannabis businesses may still not be able to secure bank accounts. Though more California banks are providing services to cannabis businesses, most banks and financial institutions will not because they worry about criminal liability under the federal Controlled Substances Act and under the Bank Secrecy Act for money laundering. Though FinCEN issued guidelines in 2014 that allow financial institutions to provide bank accounts to cannabis businesses, few banks have done so and many cannabis businesses still operate on an all-cash basis. This makes it tough for cannabis businesses to manage their businesses, pay their employees and taxes. Having so much cash on hand also creates significant public safety issues. Many ancillary businesses that service cannabis businesses must deal with the unpredictability of their clients and customers not having a bank account. California does not yet have robust enough regulations to provide security to financial institutions under the FinCEN guidelines, but this will likely change with full implementation of MAUCRSA.
  4. IRC 280E. Some securities attorneys omit IRC 280E from the list of cannabis industry risk factors, presumably because they don’t see taxation as a business risk. But it is. IRC 280E prohibits cannabis businesses from deducting their ordinary and necessary business expenses and it forces them to contend with higher effective federal tax rates than similar companies in other industries. The effective tax rate on a cannabis business depends on how large its ratio of nondeductible expenses is to its total revenues, but it can be as high as 90%. When trying to determine the future profitability of a cannabis business, a failure to mention 280E should be viewed as a red flag. This holds true even for an ancillary business PPM because having such an onerous tax burden significantly impacts the profitability of their cannabis clients.
  5. State cannabis laws and rules are not uniform from state to state and they can and do change constantly. The PPM should clarify how investors can legally participate in the cannabis company under California law and make clear that state (and local) cannabis laws and regulations can change so as to significantly diminish the cannabis company’s prospects. For ancillary businesses, the PPM should note how regulatory changes can negatively impact their cannabis clientele. Cannabis laws and regulations vary on investment and financing among the states where cannabis is legal. For example, Washington State once required lenders to cannabis businesses to be a Washington State resident for at least six months before lending funds to a cannabis business, but lenders are now exempt from this residency requirement (but it still applies to owning any portion of a cannabis business). Oregon freely allows out of state investors, but Alaska does not. California has no residency requirements for ownership or investment thus far, but new regulations could change that.

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Filed Under: Cannabis Investments, Compliance and Regulations Tagged With: Controlled Substances Act, FinCEN guidelines, full disclosure, Medicinal and Adult Use Cannabis Regulation and Safety Act, private placement memorandums, Washington state

About Hilary Bricken

Hilary Bricken is an attorney at Harris Bricken, PLLC in Los Angeles and she chairs the firm’s Canna Law Group. Her practice consists of representing marijuana businesses of all sizes in multiple states on matters relating to licensing, corporate formation and contracts, commercial litigation, and intellectual property. Named one of the 100 most influential people in the cannabis industry in 2014, Hilary is also lead editor of the Canna Law Blog. You can reach her by email at [email protected]

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