Cannabis Security Interests: Dos and Don’ts

I previously wrote about how the cannabis industry should prepare itself for tough financial times. Capital is increasingly hard to come by unless you find yourself in a newly launched state like New York, perhaps. But once a state cannabis program is relatively mature, it’s only a matter of time before it’s a race to the bottom: operators are trying competing with the illegal market on incredibly thin margins. If you’re in a place like California, you’re also facing high taxes and a lack of consistent enforcement.

Cannabis companies aren’t the only industry actors that must be mindful of lean financial times. Investors and financiers, too, must be cautious. Lately, as industry capital requirements increase while profits plummet, we have tackled more and more financing deals that involve a variety of collateral to secure the cash lent. Specifically, lenders are trying to collateralize the most valuable cannabis business assets of all: cannabis licenses, inventory and accounts receivable.

A critical fact to understand is that cannabis security interests don’t operate like other collateral under the Uniform Commercial Code (“UCC”). Below is my lists of dos and don’ts.

Do: follow the UCC

To have a valid security interest, you still need to follow the UCC, and pay attention to any state variances under state UCC laws. Article 9 of the UCC covers secured transactions. In a secured transaction, the parties are typically the debtor and the creditor.

The creditor’s goal with a cannabis company security interest is to attach and then perfect its interest in the collateral so that the creditor can later take possession of that collateral in the event of a default (without having to go to court). Under the UCC, a creditor cannot attach unless three conditions are met:

  1. something of legal value is given in exchange for the security interest
  2. the debtor has a right or interest in the collateral (i.e., they own it), and
  3. the parties (or, at minimum, the debtor) “authenticate” (i.e., execute) a security agreement.

Do: have a valid security agreement

Security agreements are not standard contracts: they must have certain elements in order to comply with the UCC. First, the security agreement needs to simply and clearly articulate that the debtor is granting the creditor a security interest in the collateral.

Second, security agreements must contain an adequate description of that collateral. That description is kosher if it “reasonably identifies what is described”. Per the UCC, some examples of reasonable identification are things like category or quantity. If you think you’re covered by just describing the collateral as “all” of a debtor’s personal or real property, that’s not enforceable under the UCC. And some kinds of collateral, like commercial tort claims, can’t be described only by “type”.

Lastly, the debtor must authenticate the security agreement. That’s not terribly contemplated, but overlooking the step is fatal.

Don’t: screw up perfection

Once you’ve attached your security interest in the collateral via the security agreement, it’s time to perfect. Perfection is key because it establishes priority for creditors to take over the collateral. How creditors perfect will vary from state to state under state UCC laws and it will also vary by collateral type (see Part 3 of the UCC). For most collateral, just filing a financing statement (oftentimes called a UCC-1) with the state will amount to valid perfection (because it puts the public on notice). But not always. Depending on collateral type, in order to perfect, the creditor may actually have to possess or control it first.

Don’t: ignore state laws around the transfer of cannabis licenses, inventory, and accounts receivable

Of course, neither the UCC nor any state UCC dictates anything specific about cannabis security interests. Cannabis licenses, inventory, and accounts receivable amount to personal property of the business. Creditors and debtors need to look carefully at state and even local cannabis laws to determine the process for changes of ownership, inventory control, and license transfers, as well as the ability to be paid by cannabis companies (with profits from trafficking), without having a license.

Don’t: use boilerplate security agreements for cannabis security interests

The UCC and state UCC laws do not contemplate the fact that any change in control over a cannabis business or a license transfer must always be run by state cannabis regulators first regardless of the method of transfer. These oftentimes have hardcore deadlines attached to such disclosures. Such a change up could even trigger local change of control laws that require a city or county’s approval, too.

Your boilerplate security agreement isn’t going to cut it then when it comes to cannabis security interests. The kicker too is that, in some states, licenses are not even transferable in the first place. And taking possession of any cannabis inventory is going to be illegal without having a license first.

Do: keep in mind that liquidation will not be easy

The whole point of the security interest is for the creditor to take control of valuable collateral, liquidate it, and recover their outstanding balance. Even if a creditor properly handles cannabis security interests, liquidating those interests will not be at all straightforward. Mainly, selling a cannabis business or a license or cannabis inventory is a major headache because of all of the regulations around transfer and eligibility. In Washington State, for example, a creditor could only sell the license or the business to an individual that had at least six months of residency in the state. Creditors should keep such red tape in mind when initially examining collateral, all the way through structuring a cannabis company security interest.