Banking And Cannabis: Bank Lending, The Next Frontier – Finance and Banking

A fortuitous combination of developments and
circumstances present the banking and cannabis industries a large
opportunity to enhance each of their respective bottom lines:
conventional bank lending, payment processing, treasury management
and other services, and bank administered SBA and revenue bond
financing to cannabis businesses.

Loan numbers are difficult to come by, but knowledgeable sources
estimate that borrowing for “plant touching” cannabis,
businesses (e.g., growers, processors, retailers, testing labs and
delivery services) was at least in the low to mid-hundreds of
millions last year, numbers that appear certain to increase
dramatically. Whatever the number, it’s a significant, growing,
untapped line of new business for Banks (all federally insured
depository institutions, including credit unions). Even the few
Banks that take deposits don’t currently lend.

The timing for this surge in demand couldn’t be better, as
cannabis businesses across the spectrum are achieving operating
results that make them increasingly attractive customers for
Banks.

Also, the Banks that make the loans will largely own rights of
first refusal on the earning power on multiple billions of
low/no/negative cost deposits, not to mention tens of millions per
year in fees for services ranging from payment processing to the
spectrum of treasury management; combined with the likely future
prospect of an international component, increasing the
attractiveness of cannabis relationships to even the largest Banks.
In addition to those compelling bottom-line incentives, the offset
rights against deposits would provide important additional loan
security, perhaps sufficient to tip the balance as credit judgments
are made.

• State legal US cannabis industry revenues in 2020 are estimated
  at more than $15 billion (some estimates as high as $20 billion)
  and are expected to continue to grow at 30-40% With concomitant
  increases in the cannabis industry’s needs and appetite for
  funding, the demand for credit could match this growth rate for the
  foreseeable future.

• Not only is the future promising, but there is a substantial
  immediate opportunity. The cannabis industry currently has billions
  outstanding in high-rate, hard money loans. The refinancing of even
  a portion of these could offer Banks tens of millions in income at
  the same time adding tens of millions to cannabis business bottom
  lines.

• Parallel growth can be expected in ancillary, non-plant
  touching businesses that may fall under the “marijuana related
  business” (MRB) definition which triggers enhanced due
  diligence requirements for Banks.

Despite what appears to be a widespread misperception that it is
illegal for Banks to accept cannabis business customers, some banks
and credit unions are doing business with the cannabis industry,
although there is a lack of clarity about exactly how many. But
those that have been doing so for some time, all with the knowledge
and under the supervision of their federal and state Bank
Regulators, who have wisely and prudently faced the fact that the
cannabis industry is here and unlikely to disappear.

To mitigate the risk of running afoul of a myriad of federal
financial crimes laws, Banks doing business with the cannabis
industry, and their Bank Regulators, draw on guidance issued in
2014 by the Financial Crimes Enforcement Network
(“FinCEN”), a bureau of the US Department of
Treasury.

Despite discomfort with the federal illegality, as Banks tiptoe
into the cannabis industry, Bank Regulators are apparently going to
school- building on existing guidance and developing policies,
procedures, and protocols in connection with cannabis businesses
and other MRBs. Although they may have to be adapted to address
issues unique to lending, these will be the foundation for
regulation whenever new legislation emerges.

Limited federal guidance and oversight to date has been focused
on Banks providing deposit services, so although scaffolding is in
place, it will require thoughtful adaptation to address issues
unique to lending. Pending federal legislation, the Secure and Fair
Enforcement Act (the “SAFE Act”) and the Marijuana
Opportunity Reinvestment Act (the “MORE Act”), which
passed the House last year, appear to have improved prospects in
the Senate this year. These would provide expanded safe harbor
protections for Banks working with cannabis businesses and re- or
de-scheduling marijuana under federal criminal law that could
eliminate uncertainties such as the cannabis industry’s issues
under Section 280E of the Internal Revenue Code and the current
lack of access to the US Bankruptcy Courts.

Although there is still important work to be done, for practical
purposes, the anticipated federal legislation is largely and
effectively in the rearview mirror. The constituents of 70% of
states have spoken, and this issue has become demonstrably and
increasingly bipartisan.

Federal legislation will not, however, affect state law limits
or outright prohibitions on Banks’ ability to secure readily
and expeditiously enforceable collateral interests in cannabis
licenses. Based on our experience in several hundred million of
cannabis debt transactions-representing institutional and high net
worth lenders, underwriters, third party beneficiaries and
borrowers-collateral security interests have been among the
toughest issues largely due to that inhibition.

Possible solutions include pre-approved receivership regimes to
enable lenders to quickly get control in the event of a default,
thereby mitigating further asset deterioration. Templates may be
drawn from the manner in which security interests in liquor and FCC
licenses are dealt with.

Unless cannabis licensing becomes federal and preempts state
regimes, which is not currently on the active radar, the
anticipated federal legislation cannot remediate this challenge.
Doing so will require a collaborative effort by the two industries
to effect necessary changes at the state level, the fruits of which
benefit both.

SIDEBAR; SPOILER ALERT

Please see the following link to a blog discussing the potential
that the SAFE and MORE Acts will precipitate a new wave of
investment or acquisition activity by non-cannabis companies that
previously shunned the cannabis industry due to the unknown
implications of owning businesses whose activities are illegal
under federal law.

https://www.bmdllc.com/resources/blog/will-federal-legislation-open-cannabis-acquisition-floodgate/

Executive Summary

To put the size, scope, and momentum of the opportunity in
perspective, 35 states and DC have legalized marijuana, including
recreational or “adult-use” in 15 of those states. That
means approximately 225 million, or 70% of Americans, currently
have access to state legal medical marijuana, and approximately 111
million, or more than a third, of the US population to
recreational. Coincidently, or perhaps not, these percentages
closely track public opinion polls. A November 2020 Gallup Poll
indicates the most recent approval rate at 68%, an all-time
high.

Given the pace of decriminalization and legalization, and
organized, well-funded campaigns underway, it seems inevitable that
most holdout states will join the list over the next several years.
Additionally, almost all states with medical have, or soon will
have, active movements to decriminalize or legalize recreational.
New York and Florida, and perhaps Ohio, with total populations of
almost 53 million, seem poised to do so in the next year or
two.

Current state laws either preclude encumbrances against licenses
held by marijuana businesses, subject lenders to approvals under
transfer of control regulations and processes, or are unhelpfully
silent.

Banks, unlike private lenders, are subject to regulation and
examination, and are held to an overarching requirement of safety
and soundness. In order to assure that Banks and Bank Regulators
take license collateral fully into account in evaluating loans to
cannabis businesses, Banks need a degree of collateral certainty by
way of timely and effective control of underlying assets, so that
they can protect against further dissipation in value of the
underlying assets and business. This will be difficult to achieve
if they must go through some process of uncertain time or success
to gain asset control from the defaulting borrower.

Possible solutions

1. Either a blanket carve-out, or an efficient, rational one-time
   preapproval process, for federally insured Banks lending to
   cannabis businesses, with some or all of the following
   characteristics: (i) defined capital or bonding requirements,
   combined with (ii) limited and reasonable time frames for
   dispositions upon default to buyers that pass regulatory
   muster.

2. Using as a template existing processes already designed for
   comparable licensed businesses, such as liquor and broadcast
   licenses, which would provide time-tested and predictable




3. Creating processes for timely and effective execution of
   security interests in the cannabis industry, which could take
   several different paths or chart new territory:

(i) a list of preapproved receivers
that could be immediately interposed and operate under existing
state receivership laws, which is the most prevalent and familiar
process currently used by lenders as an alternative to the US
Bankruptcy Courts, but perhaps lacking sufficient certainty as to
timing and result to meet the likely higher standards of safety and
soundness, or

(ii) a regulatory receivership
process administered by state cannabis regulators, which would
require more state resources and legislative or regulatory action,
but perhaps result in a speedier process that is more attuned to
the unique aspects of the cannabis industry.

Comments regarding
alternatives are welcome and encouraged at cannabislaw@bmdllc.com.

Analysis

Momentum driving the SAFE and MORE Acts (or some variation)
toward enactment, will further legitimize and move the cannabis
industry another significant step out of the shadows and into the
mainstream. This, together with rising revenue, profitability, and
cash flow in the cannabis industry, will almost certainly provide a
springboard:

For Banks, this will open an
entirely new lending market. A market that is already large and
rapidly growing, and increasingly populated by strong, stable and
profitable businesses – in other words, highly desirable customers;
and, at least for some period of time, lending to this market will
offer the Banks pricing at the premium end of their conventional
commercial lending rates while still saving borrowers between 3% or
4% at the low end, and significantly more at the high end.

For cannabis businesses,
particularly those that become more desirable customers for Banks
as they develop a solid financial platform and profitability, this
offers a new financing option that can dramatically reduce interest
costs, enhance earnings, and offer an attractive borrowing
alternative to expensive equity to fund growth.

Although there is still important work to be done, for practical
purposes the anticipated federal legislation is largely and
effectively in the rearview mirror. Whatever shortcomings our
Senators and Representatives may have, most eventually tend to be
pretty good at electoral math. The constituents of 70% of the
Senators and Representatives have spoken, with the voters having
clearly expressed their views.

Moreover, this issue has become demonstrably bipartisan, with
any red, blue, purple or puce state divides rapidly disappearing,
as traditionally conservative states increasingly get on board with
legalization (e.g., Arizona, Oklahoma, Louisiana, Mississippi,
Arkansas, North and South Dakota, Montana) with more almost certain
to follow.

The Current Banking Environment

Despite what appears to be a widespread misperception that it is
illegal for Banks to accept cannabis business customers, there are
hundreds of banking institutions that are and have been doing so
for some time, all with the knowledge and under the supervision of
their federal and state Bank Regulators.

In a Marijuana Banking Update as of June 30, 2020, FinCEN, the
mission of which is to safeguard the financial system from illicit
use and combat money laundering and promote national security,
reported that 510 banks and 185 credit unions were doing business
with the cannabis industry. Cannabis businesses seeking depository
relationships will find that number hard to believe based on the
difficulty they have in finding willing Banks. Most states have
only a relative handful (e.g., Arizona only has four and Ohio only
has only a few). That disconnect appears to exist because
FinCEN’s numbers are derived based on institutions filing
Suspicious Activity Reports (SARs) related to marijuana, and not
all institutions that file marijuana related SARs take deposit
accounts for marijuana businesses.

To mitigate the risk of running afoul of a myriad of federal
financial crimes laws, Banks doing business with the cannabis
industry, and their Bank Regulators, draw on guidance issued by
FinCEN in 2014 (the “FinCEN Guidance”). In fact,
reflecting the acceptance of the FinCEN Guidance as the current
lodestar, the SAFE Act would call for FinCEN to issue new guidance
for the submission of SARs for transactions with state legal
cannabis-related businesses in order to avoid significantly
inhibiting the provision of financial services to such
businesses.

Despite discomfort with the federal illegality, Bank Regulators
have wisely and prudently faced the fact that the cannabis industry
is here and unlikely to disappear.

FDIC Chairwoman Jelena McWilliams neatly explained why things
are still so complicated¹:

It has been one of the perhaps-I
would say-more challenging issues that I have encountered at the
FDIC. And here’s why: At a federal level it is still an illegal
substance. And at many state levels, it’s now legal, and
it’s legal to frankly bank it at a state level. And so banks
find themselves caught between the federal regulatory regime and
the state…so what I’ve been telling banks: There’s so
much uncertainty in this space that as a federal regulator, I still
have to say, it’s illegal to bank marijuana.

But to the extent that you’re
doing it because it’s legal in your state, please follow FinCEN
guidance.

We know we have banks that are
banking marijuana businesses, and you know, we can’t bless them
and say “go ahead and do it.” But to the extent
you’re doing it because it’s legal in your state, follow
FinCEN guidance.

Credit Unions and their regulators have taken a somewhat more
progressive approach, demonstrated when Rodney Hood, Chairman of
the National Credit Union Administration stated

that credit unions will not be
sanctioned for conducting business with marijuana-related firms. He
said that it is a business decision for credit unions and that the
NCUA would not micromanage financial institutions the agency
supervises. He said that credit unions still have to follow
Financial Crimes Enforcement Network rules, which require credit
unions and other financial institutions to file Suspicious Activity
Reports.

The FinCEN Guidance sought to clarify “how financial
institutions can provide services to marijuana-related businesses
consistent with their BSA obligations” with the goal of
enhancing “the availability of services for, and the financial
transparency of, marijuana related businesses.”

The FinCEN Guidance specifically incorporated content from a
memorandum issued by the U.S. Department of Justice in 2013 by
Deputy Attorney General James Cole (the “Cole Memo”),
that essentially deprioritized prosecution of marijuana-related
federal offenses so long as the actors were complying with state
law. Among other things, the Cole Memo identified continuing
priorities such as preventing distribution to minors, money flowing
to criminal enterprises, and diversion of marijuana to states where
it was still illegal. Drawing on the Cole Memo, FinCEN’s
Guidance provides a laundry list of red flags and dictates that
financial institutions must tailor their relationships with MRBs to
reflect its priorities. Unfortunately, the FinCEN Guidance does not
define MRB, other than indicating that it includes more than just
plant touching enterprises, for example covering landlords with MRB
tenants. This expansive reading is supported by a non-binding Small
Business Administration Policy Notice from April 2018, which
offered the following definitions:

“Direct Marijuana
Business” – a business that grows, produces, processes,
distributes, or sells marijuana or marijuana products, edibles, or
derivatives, regardless of the amount of such activity.

“Indirect Marijuana
Business” – a business that derived any of its gross revenue
for the previous year (or, if a start-up, projects to derive any of
its gross revenue for the next year) from sales to Direct Marijuana
Businesses of products or services that could reasonably be
determined to support the use, growth, enhancement or other
development of marijuana. Examples include businesses that provide
testing services, or sell grow lights or hydroponic equipment, to
one or more Direct Marijuana Businesses.”

The SAFE and MORE Acts; The Past as a Prologue for the
Future

The SAFE Act has been rattling around Congress for a couple of
years, passed the House in 2019, and now has meaningful support in
the Senate. Briefly, it aims to provide a “safe harbor”
for depository institutions that want to do business with
state-licensed cannabis companies and their service providers.
Banks need a safe harbor because marijuana is currently a Schedule
I drug under the Controlled Substances Act, banned for all purposes
and illegal under federal law even in states that have legalized
it. Although the SAFE Act doesn’t address the legality or
scheduling of marijuana, it would provide a huge step towards
resolving uncertainty, reducing risk, and providing a framework for
expanded Bank participation in the industry, removing many of the
concerns that prevent most Banks from doing so.

It would prevent federal Banking Regulators from punishing banks
just because they provide services to cannabis businesses and free
up federally insured Banks to both take deposits and lend. Among
other things, it would clarify that, for purposes of federal anti-
money laundering statutes, the proceeds of transactions involving
activities of state legal cannabis businesses would not be
considered proceeds of an unlawful activity. It would also provide
that Banks that have a legal interest in the collateral for a loan
or other financial service to state-legal cannabis businesses, or
to an owner or operator of real estate or equipment leased or sold
to such a business, would not be subject to criminal, civil, or
administrative forfeiture of that legal interest pursuant to any
federal law for providing that loan or service.

The MORE Act would significantly advance the progress
represented by the SAFE Act. The MORE Act also passed the House (in
December 2020) and several prominent Democratic senators have
indicated that they intend to bring the MORE Act or something
substantially similar to the Senate in 2021. The MORE Act would
entirely remove marijuana-more specifically, THC, the psychoactive
element in the plant-from the schedules of controlled substances
under federal law, essentially legalizing the drug at the federal
level. This would remove the many complications caused by current
federal law for the cannabis industry and banks, including access
to bankruptcy courts, tax deduction issues for cannabis businesses
related to Section 280E of the tax code, impediments to obtaining
insurance, etc.

Given this fraught environment, even Banks that already provide
deposit accounts and a limited range of other services to MRBs
don’t make loans. Consequently, although some larger and more
financially successful public companies have fared better, most
cannabis companies needing debt finance have had to accept hard
money terms from private lenders- much higher rates (ranging into
the high teens and likely averaging 12-15%) and often highly
dilutive equity conversion rights.

Impressive Financial Improvements; The Lure of Attractive
Customers

If the mythological analogy of the cannabis industry from the
second half of 2019 until mid-2020 is Icarus plummeting to earth
after flying too close to the sun, it now is much more aptly the
Phoenix rising from the ashes. Across the spectrum-small, single
license operators, larger single state operators, small to large
private multi-state operators (“MSOs”), and public
companies-have achieved improvements in their financial condition
and performance ranging from steady and solid to very, very
impressive.

As a result, as the cannabis industry’s already substantial
appetite for credit continues to grow, at the same time, by gosh,
cannabis businesses are becoming increasingly attractive customers
for the Banks.

Even as they do, it is likely, at least for some time, that
Banks extending credit to the industry, even its best performers,
will be able to price loan products at the premium end of the range
for conventional commercial loans; providing highly attractive net
interest margins.

Since even those premium rates will be far, far less than the
rates the industry has been paying, the entry of Banks into the
cannabis lending market will not only have meaningful, direct, and
force multiplier effect, improving bottom lines, but should also
accelerate the growth of the cannabis industry by providing an
attractive incremental alternative to high priced debt or dilutive
equity.

The Rocky Road to Encumbrances; Transfers of
Control

Particularly in light of the inability to access the U.S.
Bankruptcy Courts, creditors of cannabis businesses must look to
current state laws and regulations. These provide a patchwork of
uncertainty regarding security interests in licenses that will
almost certainly inhibit Bank lending to cannabis companies even if
the SAFE and MORE Acts are enacted. Existing state laws either
preclude encumbrances against licenses and/or would subject lenders
to post- default approvals under often complex, time consuming and
inherently uncertain transfer of control regulations and processes.
This is a major hurdle for lenders seeking to enforce their rights
to take control before the value of an asset or business can be
dissipated by a defaulting borrower that, presumably, wouldn’t
be in default unless the business was already in trouble.

Receiverships as an Alternative to Bankruptcy

Lessons may be drawn from two of the most mature cannabis
states-Washington and Oregon.

Washington regulations allow a receiver for purposes of
foreclosure and liquidation within the recreational cannabis
industry. The Washington State Liquor and Cannabis Board maintains
a list of preapproved receivers and allows for appointment of a
receiver who is not preapproved upon receipt of the standard
receiver application. Similarly, Oregon regulations allow for
appointment of an authority to temporarily operate a cannabis
licensed business as a trustee, receiver, or secured party.

Evaluating the Silence

When a state’s laws, regulations, and cannabis regulators
are silent on whether a license may be encumbered, the next logical
step is to evaluate a state’s position on transfers of
ownership or control generally. Whether a license or control of a
licensed business may be transferred, the steps involved in
transferring a license or ownership, and whether there are
carveouts for a license’s transferability in connection with
the exercise of a collateral interest, are all factors in the
evaluation of whether a lender has a path to an enforceable
security interest adequate to satisfy a Bank’s and Bank
Regulators’ safety and soundness criteria.

As a general proposition, states typically impose onerous and
time-consuming transfer requirements, and there are no guarantees
that approval will ultimately be granted, circumstances which must
be addressed at the state level as part of an overall resolution to
enable and facilitate Bank lending to cannabis businesses.

Footnotes

1 Crain’s Detroit Business, June 3, 2020

2 The Credit Union Times, August 5, 2019