By Jay Purcell, Senior Associate, Clark Neubert LLP
As California’s legal cannabis market matures, we are seeing increasing investor interest in licensed companies positioned for growth and profit. Many potential investors are emerging from outside the industry, meaning their familiarity with cannabis law is often limited. And even investors with longtime cannabis experience, many of whom have acted as de facto banks for companies, are struggling to stay abreast with the state’s constantly evolving laws. Regardless of their background, investors financing cannabis companies naturally bring expectations for customary terms—but translating commonly-used deal provisions into cannabis investments can prove challenging. This is the first of a two-part series focused on investor protections in cannabis companies. In this article, we look at mandatory disclosures under California law and how these impact investors.
Privacy is a thing of the past.
In California, every cannabis company is required to publicly report all investors to the Bureau of Cannabis Control (BCC). Investors fall into two categories: large investors are known as “Owners” and small investors are known as individuals with a “Financial Interest.”
- Owners must be disclosed if they meet a three-part criteria based on: (i) size(they hold an aggregate of 20 percent or more of a licensee); (ii) authority(they manage, direct or control a licensee); or, (iii) position(they are the CEO, LLC’s manager, partnership’s general partner or corporation’s director).
- Financial interest investors must also be disclosed if they have (i) contracts (an agreement to receive a licensee’s profits, or a loan from a non-bank); (ii) securities (any equity interest, or investment in, a licensee); or both.
Cannabis companies must report both Owners and Financial Interest investors on annual and renewal state applications. In addition, mandatory reporting on investors can also follow certain events (see below, Ongoing Obligations). In sum, while the kind of details required between Owners and Financial Interest investors vary, California law demands complete transparency by cannabis companies as to the identity of every investor.
Disclosure requirements are detailed, and personal.
Cannabis company disclosures focus on operations and operators, rather than results. Owners must submit to fingerprinting and a nationwide background check. In addition, they must provide their address, social security number, date of birth, mailing address, phone number, employer, investment size and its details, any criminal conviction or no contest pleas (including statements of rehabilitation and descriptions of criminal punishments, parole, or probation), existence of other CA cannabis investments and, finally, description of any cannabis license sanction, punishment or other suspension applicable.Finally, most owners are required to make an in-person visit to the jurisdiction where their investment is located. For investors who do not want their cannabis investments publicized, or for those who cannot travel to California, the requirements placed on Owners are a brick wall. Minor investors, on the other hand, are not required to submit any information about their histories or other investments; instead, they are merely required to provide their name and basic identification information. Current California regulations require no information about the beneficial owners of an entity that holds a Financial Interest.
Companies must disclose early and often.
Owner disclosure obligations are continuous and reach far beyond initial disclosures. First, any changes to information about Owners and Financial Interest holders must be reported to the BCC within ten days. Second, reporting obligations also include any newinformation about investors. For Owners, civil penalties and judgments must be reported within 48-hours, no matter the venue or the underlying claim. Owner criminal convictions must be reported within 48-hours, again without regard to the location or severity of offense. For cultivation companies, even Owner bankruptcies must be reported within 10 – 16 days.
All owner disclosures are public records.
Information supplied to BCC is subject to the California Public Records Act and the entire contents of an application can be disclosed to the public. Except for patient information from medical cannabis operations, everything disclosed to the BCC can become public knowledge, including but not limited to cap tables, criminal histories, and investments in other cannabis ventures.Major and minor cannabis investors should not expect any privacy concerning their investments. Because of the requirement to update BCC with newinformation, it may be impossible for a cannabis company to operate in stealth mode.
Loopholes are closing.
Lawyers on both sides of a deal must ensure these requirements are socialized early; late notice of necessary publicity may cause alarm. In addition, company counsel must confirm pre-closing that any Owner is qualified under California cannabis law and regulations. Selling securities to an ineligible Owner is self-destructive to a cannabis company.Company counsel should consider a suitability questionnaire and representations modeled on accreditation and Bad Actor rules. For non-Owners, currently the least visible route is holding a Financial Interest through a non-identifying entity. But recent BCC regulations have pushed even greater Owner disclosure requirements, and this trend towards greater transparency is likely to continue.The state’s latest regulations require disclosure of the entity’s CEO and directors, but this language appears limited to corporations, thus excluding partnerships and LLCs. We expect this loophole to close eventually.
There’s no confidentiality in cannabis.
The BCC considers a licensee’s ‘Owner’ anyone who: Holds at least 20 percent of its equity; exercises management, direction or control; sits on its board of directors or board of managers; or is its CEO or general partner. Holding a Financial Interest means owning equity, making an investment, making a loan, or being owed profits from a cannabis licensee. Between these two definitions, every investor in a cannabis company is disclosed to Sacramento, both annually and after certain events. Beyond identity, Owners also provide fingerprints, criminal histories, and agree to immediately report new criminal events, unrelated civil judgments and even bankruptcies. Because all reported information is a “public record,” a company’s cap table may become public knowledge, an outcome that will surprise many investors. Cannabis company disclosures are uniquely personal; unlike other businesses, regulators dig very deeply into operators and owners. Investors accustomed to minimal disclosures under Regulation D or Corps. Code§25102(f) are forewarned: In California, there is no confidential or private investing in cannabis.(Bus Prof§26001(al); 16 CCR§ 5003).
(Id. at § 5002(c)(20)).
(16 CCR§ 5035; 3 CCR § 8204).
(Bus Prof 26162; Gov’t Code§6250).
 (Cal Bus Prof §26057(4), (6)-(7))).
(16 CCR 5003((c)), Emergency Readoption Release, May 18, 2018).