As I started to write this article, the economy was still booming, despite the expectation of an impending adjustment in the market. Now, amidst the global COVID-19 pandemic, I still intend to share my thoughts surrounding bankruptcy and receivership in the cannabis industry, as I believe they are highly relevant in these uncertain times.
The outlook for the cannabis industry is still positive, however operators continue to face limited capital availability, especially as we see further effects of the present circumstances continue to unfold.
While the drivers of sales shift more heavily to location, product availability and quality as well as customer experience, the illicit market and the lack of regulation enforcement is still a threat. Operators and their investment partners may have more at risk than they can handle. Yet failure is not really an option; federal bankruptcy is not available to them. Due to federal marijuana prohibition, financially distressed cannabis companies face limited options when they need relief from creditors. Even most non-plant touching businesses may not be able to go through bankruptcy reorganization, although it may depend on their industry and generic overall business.
The good news is that there are other options are available, and they don’t require federal bankruptcy involvement. One of the most common paths operators can take is to seek assistance from professionals to initiate a process wherein a receiver or reorganization specialist manages the operations on a temporary basis and assists with the reorganization of the company until the business is back on track or the assets are sold or liquidated. This option is more widely known as “receivership”.
Before we discuss the details of the receivership option and how it can be implemented, let’s first cover what bankruptcy really means and what it could have brought to the table, were it an available option. Our team has worked on business insolvency cases in other industries. Although it may sound technical, I am trying to simplify the ideas here and I hope my lawyer friends will excuse me for it.
1. What is bankruptcy?
Through the process of bankruptcy and under the careful watch of the federal courts, individuals and businesses can restructure their financial situation without interference from creditors at the discretion of the bankruptcy courts.
All types of bankruptcies are governed by Title 11 of the United States Code.
The goal of bankruptcy is stated to be the rehabilitation of the debtor – in our case the business who is in debt to its vendors and/or investors – with a goal of to “start fresh” at the conclusion of the process and with a better business outlook, and fairness to creditors, all with respect to contractual priorities.
The economic efficiency of bankruptcy rests in the fact that the organization’s management can be retained intact (at least for a period of time) and the process seeks to preserve and maximize the going-concern value of the entity.
There are different types of federal bankruptcies, the most common for businesses being:
Chapter 11 is generally the first choice of debtors with no better out-of-court options, providing immediate refuge from creditor remedy actions (“automatic stay”) and allowing for continued financing of business operations through use of “cash collateral” or what is called “Debtor In Possession Financing”. It generally allows for management to continue to operate, but with limits and it imposes rules and timelines on restructuring negotiation. It also provides a framework for balance sheet restructurings as well as the tools for operational restructuring, including rejection of certain burdensome contracts (e.g., labor contracts, leases and supply obligations).
The ultimate goal of Chapter 11 is to preserve the “going-concern” value of business, through a plan of reorganization subject to creditor approval, although “reorganization” could later become a liquidation.
Bankruptcy proceedings can be initiated through a voluntary filing (where the insolvent debtor has immediate bankruptcy protections) or involuntary filing (initiated by entities other than the debtor).
As you probably imagine, some of the common warning signs ahead of a bankruptcy filing are:
- Covenant default(s) and/or poor financial results
- Late/poor financial reporting
- Cash shortage/payment default
- Debtor’s retention of financial/restructuring advisors
- Significant company- or industry-centered developments
- Significant lawsuits, or legal or regulatory changes
- New displacing technologies or products
Preparing for filing requires experts (usually lawyers and specialized consultants) who will assist with where and how to file and the proceeding will involve the participation of a United States Trustee as well as all the secured and unsecured creditor parties.
This process can be costly and can take time. If the bankruptcy option was available to the cannabis industry at large, another implication would be that the court does not have experience in the industry and the participating parties may not have been organized enough to be successful in what they aim to accomplish through the proceeding. Note that it might not be the case in Canada where a company like CannTrust Holdings Inc was able to file for creditor protection under CCAA, which is a different process.
In our nascent industry case, if the cannabis-related business and its major creditors are willing to work through an informal, yet efficient out-of-court restructuring process, state receivership seem to be a viable option for distressed operations and their stakeholders.
2. What is Receivership?
State court receivership is a strong alternative to bankruptcy. It is an equitable process that provides for the court appointment of a neutral and independent third party to act on behalf, and for the benefit, of all interested parties. The goals of receivership are similar to bankruptcy in that it is intended to preserve and maximize the value of an operating business for the benefit of its stakeholders.
A receivership may offer secured lenders some of the same safeguards and protections available in a Federal Bankruptcy Chapter 11 filing, but with more flexibility in terms of cost, timing, and procedural requirements.
Typically initiated by a secured lender or the business shareholders, the receivership order places the business and its assets under the control of the receiver and delegates its duties and responsibilities. The appointed receiver typically operates the business and examines the options for reorganization in accordance with the court. As an officer of the court with a fiduciary duty to all the interested parties, the receiver offers secured lenders a bit more control, experience, and security of professionalism through the process. The receiver is essentially in place to take over operations of the business with the goal of protecting and preserving the assets.
In the receivership process, creditors may seek additional collateral such as personal guarantees from the operator and business owners. This should be taken into consideration at the time of accepting a loan or investment and when the first signs of distress appear.
We recommend our clients and partners hire an attorney who specializes in this type of transaction so that all parties clearly understand the process and their interests are well represented. Although we often hear that clients in this circumstance would prefer to save costs and forego legal counsel, hiring a lawyer from the outset almost always works out to be a cost saving measure in the end.
It is important for business operators to understand the consequences of a receivership transaction and to ensure that it is a realistic, cost effective, and positive measure for them to take. Just like lenders and investors need to protect their interest and understand their rights, it is equally essential for the borrowers or business operators to do the same so they can continue to operate, employ their staff and satisfy their customers and vendors.
Receiverships are usually less expensive than a Chapter 11 proceeding due to less-stringent procedural requirements. However, this still doesn’t mean that it is cheap. The cost of the legal and operational proceedings surrounding receivership has to be factored in from the start. As I mentioned above, these costs can seem high, but they are almost always worth it when compared to the alternative. Professional counsel also assists with communication and in creating understanding for creditors, investors, and key stakeholders.
Although some states have enacted comprehensive receivership regulations, they are not all that comprehensive, and it can result in some uncertainties for businesses considering this option.
And while most think that receivership leads to liquidation of the business, it is not necessarily the case as the process can be flexible enough to allow the business to continue to operate. While the company is reorganized, it continues to operate. And if viable, it can continue on its path to success, as long as goals and liabilities are met.
This option is starting to be adopted already as we see this month with Green Growth Brands announcing the conclusion of a strategic review process and determining that the appointment of a receiver is in the best interest of the company and the creditors of Seventh Sense, their CBD business while they continue to expand their cannabis business as a multi-state operator (MSO), currently in Florida, Massachusetts, and Nevada.
3. Other options for Cannabis businesses
Let’s keep in mind that a lot of cannabis business may not want to deal with any court at all, State or Federal. The simplest option for all parties might be to agree on a path to restructuring or to deal with their corporate issues all together, with the involvement of a specialist. This option typically involves a mutual decision between the creditor and the business operators to formally engage a reorganization specialist with knowledge of the cannabis industry and its particularities, outside of the court.
We discussed the precursor signs of bankruptcy earlier. As soon as financial difficulties or operational issues arise in cannabis-related businesses, the operators should work with stakeholders to immediately tackle the issues and create strategy around addressing future problems to prevent a domino effect. Whether it is an investor wondering about reporting or lack of returns, cashflow issues or lack of capital or market changes leading to decreasing revenue or greater cost uncertainties, the management team (comprised of a president or a chief financial officer or controller) should prepare its plan and communicate with all stakeholders and creditors to change its course, restructure the business and its components, reduce payments, or forgive debt.
No creditors, lenders, or investors want to see a company slip into bankruptcy or insolvency. All parties involved in a business want to see success (usually, for those who have a good business sense) and this can be achieved as long as the business manager has a realistic, strategic plan that will make money, pay back its debt, and create value and opportunities while adapting quickly to the ever-changing cannabis industry.
All together, like any other businesses, the key in such matters is whether the business will be able to put together a viable and realistic reorganization plan, a compliant business and financial plan, which are achievable and agreeable by all parties involved.
The receiver or reorganization specialist can assist with preparing and communicating the plan, create reporting and communication channels with the creditors and other involved parties, and manage the operation on a temporary basis until the situation improves, either financially and operationally or by liquidating the assets.
The coming weeks will likely bring greater uncertainty and growing concern for our personal and financial health. As I’ve been quarantined in my house, I’ve been pondering the many options for businesses in our industry that may begin to struggle, and will continue to share my thoughts and findings with you all in an effort to provide resources and assistance to those who are interested.
Stay safe all.