There are many wonderful things about the cannabis industry – creation of new jobs, legal access to medicine, and reduction of drug war harms, to name a few. Every rose has its thorn though, and the cannabis industry is no exception. Like any industry pushed into the shadows, in this case by a misguided prohibitionist policy, unsavory individuals have found an opportunity to prey upon those without full access to the legal system or to legitimate sources of capital. All cannabis entrepreneurs need to be on the watch out for the tell-tale signs the person or business they are talking to is a scam artist. Below are ten common signs that something might not be legitimate in your business transaction. Not all these signs indicate something is foul, but they should be a red flag that the business dealings bear further investigation.
Extremely Tight Timeframe:
You’re given twenty-four hours to make a key business decision and you may have only just received the legal documentation formalizing the proposed deal.
There are many legitimate reasons why business decisions must often be made on short notice. And providing an opposing party with legal documents at the last moment is a time-honored negotiating tactic. However, the less scrupulous will often tell business owners (often in dire straits) that they need to decide in twenty-four hours, or in an even shorter time frame. This frequently means there’s no time for proper due diligence or legal review – exactly what someone with something to hide (e.g., they are trying to run a scam) wants.
Vague Website:
A website contains a lot of bold claims about a service or financing source, but is short on physical addresses, names of principals, or legal company names.
A lot of websites are vague. But scam artists like to leave out key information – which means it will be hard for you to report them to the investigators or sue them. Most legitimate companies will list a real street address that is associated with a business, not a residence. Why would a scam artist want to hide their real address? Well, think about trying to sue someone. You need to serve documents on them – not an easy feat when you have no idea as to their real name or address.
Pump and Dump:
Someone tells you they have a hot (marijuana) stock tip – it’s guaranteed to go up.
There are many problems with this scenario. If someone does have material insider information about a publicly traded company, they cannot legally trade on that knowledge. Nor can they tell someone else the information and have them buy or sell stock. Both persons are in violation of securities laws and subject to civil and criminal penalties. A common way this plays out is through a “pump and dump” scheme. This scam involves convincing the marketplace that an OTC stock (also known as a penny stock – a public stock that does not trade on a major exchange like the NYSE or NASDAQ) is a surefire win. As people buy into the hype, the stock price of the company soars (the pump part of the scam). Once the price climbs high enough, insiders of the company sell all their shares, making a tidy profit (the dump part of the scam). Everyone who bought shares of the company is then left with worthless penny stock as the share price tumbles after the major sell-off. Even people who don’t buy the stock can become accomplices to the scheme. Just by repeating rumors regarding the potential success of the company, they can help create the atmosphere necessary for the artificial inflation of the stock price. When it comes to OTC stocks, if it sounds too good to be true, it probably is.
Wire Money First:
An investor or other potential business partner has a great opportunity for you. The only catch is that you must first wire them money as a down payment for the process to get started.
This scam is a favorite of “Nigerian royalty” and now is making its way to the cannabis industry. Legitimate lenders do not require a prepayment prior to underwriting a loan. They will charge you fees for the work they do, and the work their lawyers do, but this is typically taken directly from the loan amount when funding occurs (this is called funding net). Except in exceptional circumstances that have been vetted by counsel, you should not wire money to someone on the promise they will help you raise money.
As a side note, many law firms and other businesses, will require a deposit before starting work. The difference is that these deposits are legitimate, and are refundable if no work is performed (always ask about refundability). Scam artists, on the other hand, are highly unlikely to return a deposit, even if a deal falls apart.
Refusal to Interact with Attorneys:
You’ve got a great source of financing lined up. The financier is telling you what you want to hear and you’re ready to sign on the dotted line. The only catch is she won’t speak to your attorneys (which may not necessarily take the form of outright refusal – it could also be a deliberate refusal to return or schedule calls), only directly with you.
Scam artists are understandably loathe to subject themselves to questioning from a skeptical lawyer. Sunlight is the best disinfectant and most scams will not stand up to a thorough vetting. Legitimate business professionals, however, while not always happy about it, accept that dealing with lawyers is the price to be paid to get deals done.
Multiple Company Names:
Every time you interact with a potential business partner you discover a new business name or web portal.
This is one of the harder red flags to interpret and on its own it may not mean there is something nefarious occurring. Almost every company of any size contains multiple legal entities. These legal entities often legitimately serve to contain liabilities (e.g., holding different real estate properties in separate LLCs so that a slip and fall claim on one property doesn’t result in a lawsuit against an entire portfolio of real estate assets). What most legitimate companies are not doing, however, is playing a shell game – setting up and shutting down companies to stay one step ahead of the law and angry creditors and customers. If you think this might be occurring, you should discuss your concerns with counsel before proceeding.
Unsubstantiated Claims:
You’re being told buying into a certain grow method will triple your yields, guaranteed, or someone claims they underwrite a tremendous dollar value of loans annually, but can’t give you names of past deals.
Beware unconditional guarantees. Sure, everyone knows the “best” grower and no one wins business by saying they are the worst in their field. When it comes to bold claims, trust but verify. Ask for concrete examples of a product’s or advisor’s success. Ask to speak directly to existing or previous customers. If they are offering payment processing solutions, ask which banks they work with and which credit card companies. Fate is fickle and the future is uncertain. No one can predict it with absolute certainty, especially not when it comes to the cannabis industry.
Ignorance of Basic Cannabis Laws:
When asked about the impact of certain laws or policies like the Cole memo priorities, the FinCen memo, or 280E on proposed business plans, someone responds these are not significant issues or, worse yet, they do not appear to have a strong grasp on what these items are.
It’s one thing to state that these obstacles can be overcome. Business are succeeding despite them every day. To cavalierly suggest they are not issues, or to somehow remain ignorant of their existence, however, is a major red flag. It may not always be a sign of fraud – it could also be the sign of rank amateurism. Either way, you should be hesitant to go into business with someone who does not fully appreciate the federal legal risks inherent in the cannabis industry, especially considering the current political environment.
Deliberately Opaque Documentation:
The definitive documentation for a deal is extremely poorly drafted and it’s not clear what business deal is being documented or the business deal you thought you had struck is not clearly reflected.
Legal documentation is, admittedly, frequently long, dense, and filled with antiquated terms. And for a non-lawyer, legal agreements can be hard to understand. Some of this is a consequence of the fact that complicated concepts are being addressed, and part of this is because lawyers adhere religiously to previously drafted documents, which results in the survival of Latin terms, clumsy turns of phrase, and other habits that make agreements hard to read for the layperson. With a scam, however, an agreement may be drafted to be deliberately obscure. Even unreadable documents could have a legitimate provenance – the cannabis industry is full of poorly trained transactional lawyers (or criminal lawyers moonlighting as transactional lawyers) and principals that don’t understand basic business concepts. What you need to be concerned about is a document that someone doesn’t want you to understand because they intend to fleece you.
Unclear Background of Principals:
The principal of a business claims he or she has 20 years of business experience and deep industry ties. However, when pressed, he or she cannot name an actual business they have worked for and no one in the industry has heard of them or their organization.
The cannabis industry certainly contains many successful people with eclectic backgrounds, but beware the individual with an unclear past. They may elude to successful enterprises, but never give specific names. They claim to be involved in other businesses, but never give enough information for you to track these down. The cannabis industry is still small and many of the pioneers of the industry have known each other for years. If someone claims to have been deeply involved in the industry, but can’t point to any specific businesses or individuals who they know, it’s a red flag.
If they come from the traditional business world, but don’t have a clear history (e.g., before they worked in cannabis, they were at X company for five years), be extra vigilant. There are often legitimate reasons not to name current or former employers (e.g., perhaps their employer doesn’t approve of the cannabis industry and it could put someone’s employment status at risk), but there are also many illegitimate reasons to obscure your past.
Final Thoughts
If you think you’re being scammed, step back and reevaluate the situation before proceeding. Do not sign anything or wire any money. Ask for items in writing and save relevant emails. Consider reaching out to an attorney. Better to spend time and money evaluating a deal upfront than to experience the heartache and headache that comes with trying to mitigate the damage of a scam. Remember, in the cannabis industry, the old expression caveat emptor remains as true as ever.
Charlie Alovisetti, Vicente Sederberg LLC
Charles Alovisetti is a senior associate and co-chair of the corporate department at Vicente Sederberg LLC. Prior to joining Vicente Sederberg, Mr. Alovisetti worked as an associate in the New York offices of Latham & Watkins and Goodwin where his practice focused on representing private equity sponsors and their portfolio companies, as well as public companies, in a range of corporate transactions, including mergers, stock and asset acquisitions and divestitures, growth equity investments, venture capital investments, and debt financings. In addition, Mr. Alovisetti has experience counseling portfolio and emerging growth companies with respect to general corporate and commercial matters and all aspects of compensation arrangements, including executive employment and consulting agreements, stock option plans, restricted stock plans, bonus plans, and other management incentive arrangements. Mr. Alovisetti has experience in both U.S. and cross-border transactions, and has advised clients across a range of industries including cannabis, technology, manufacturing, software, digital media, energy and clean tech, healthcare, and biotech. In addition to his corporate work, Mr. Alovisetti has worked with clients on multiple competitive licensing applications, including in Maryland, Hawaii, Pennsylvania, and Texas. He holds a Bachelor of Arts, with honors, from McGill University and a law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar. Mr. Alovisetti is admitted to practice in both Colorado and New York and is a Level One Interprener. He can be reached at charlie@vicentesederberg.com. Follow him on Twitter @CAlovisetti.
Jessica Scardina, Vicente Sederberg LLC
Jessica Scardina is an associate at Vicente Sederberg, LLC’s Denver office. Prior to joining Vicente Sederberg, Jessica worked at a small Denver law firm specializing in corporate law, business planning, and taxation. Jessica currently focuses her practice on corporate, licensing, and regulatory matters. Jessica is a graduate of the University of Denver Sturm College of Law, where she served as a staff editor for the University of Denver Law Review. Prior to moving to Denver in 2004, Jessica lived in Santa Cruz, California, where she received her Bachelor of Arts, cum laude, from the University of California at Santa Cruz.
Madeline Currie is a marketing professional working at Vicente Sederberg’s Denver office. Prior to joining the firm, she was a Senior Marketing Associate at Crystal & Company in their New York office. She has also worked with several other organizations to define and execute their brand strategy. Madeline has a Bachelor of Arts in Sociology & Policy Studies from Rice University.
Member Post: Raising Money 101 – Introduction to U.S. Public Cannabis Stocks
Most readers are familiar with the two major U.S. stock exchanges – the New York Stock Exchange (NYSE) and NASDAQ. But in the world of cannabis, almost all publicly traded companies are not listed on a stock exchange. Instead they trade over-the-counter (OTC). In fact, as of the date of publication, only a handful of cannabis companies (or at least cannabis-touching companies, as for most of these companies, cannabis is only a small part of their overall business) are traded on a U.S. stock exchange. There are publicly traded cannabis companies outside of the U.S., but those are beyond the scope of this article.
These companies primarily trade on NASDAQ: GW Pharmaceuticals (GWPH), a UK-based pharmaceutical company best known for its drug Sativex, a cannabinoid-based treatment for multiple sclerosis spasticity; Insys Therapeutics (INSY), an Arizona-based pharmaceutical company that has a number of cannabinoid-based drugs in development; Cara Therapeutics (CARA), a Connecticut-based pharmaceutical company that has a cannabinoid product in preclinical development; Zynerba Pharmaceuticals (ZYNE), a Pennsylvania-based pharmaceutical company that has synthetic cannabinoids for transdermal delivery under development; and Arena Pharmaceuticals (ARNA), a California-based pharmaceutical company that has a pain relief cannabinoid drug in development. There is also a largely non-cannabis company, 22nd Century Group, Inc. (XXII), with a cannabis-focused subsidiary called Botanical Genetics, LLC, that trades on NYSE MKT, the NYSE’s emerging company marketplace for smaller-cap companies. NYSE MKT has lower listing requirements than the NYSE.
MassRoots (MSRT), a Denver-based social networking company for cannabis users, made headlines when it was denied approval to be listed on NASDAQ. According to MassRoots, the stock exchange justified the decision by claiming that the company was aiding and abetting the distribution of an illegal substance. Some speculate, however, that the decision considered the company’s low share price, although MassRoots stated it did meet the listing requirements with a market capitalization in excess of $40 million and more than 300 shareholders. NASDAQ did not publicly provide the grounds for its rejection.
As of the date of publication, the New York Stock Exchange has approved the listing of Innovative Industrial Properties, Inc. (IIPR), a newly-formed real estate investment trust focusing on the cannabis industry, though the SEC has not yet approved the offering prospectus of the company and no shares of Innovative Industrial Properties currently trade publicly. This seems to indicate that NASDAQ’s rejection of MassRoots may not have been entirely based on its alleged aiding and abetting.
The language of publicly traded cannabis companies
If these companies aren’t on stock exchanges but still trade publicly, where and how do they trade? It’s best to start with an introduction to the vocabulary of publicly traded cannabis companies. Here are several terms you will see discussed frequently in this area:
OTC: An acronym for “over-the-counter” and refers to securities (both debt and equity) that are traded in a context other than a formal exchange. It may refer to stocks, debt securities, or other financial instruments such as derivatives. In general, the reason why a stock is traded over-the-counter as opposed to on a stock exchange is because the company is too small to meet exchange requirements. The overwhelming majority of publicly traded cannabis companies trade OTC.
Pink Sheets: The National Quotation Bureau (now the OTC Markets Group) formerly published price quotations for stocks on pink-colored paper called the Pink Sheets. The National Quotation Bureau renamed itself Pink Sheets LLC in 2000 and subsequently Pink OTC Markets in 2008. In 2010, the name was again changed to its current one, OTC Markets Group. Because of this historical background, people will often refer to OTC stocks generally as trading on the Pink Sheets. Another synonym is Penny Stocks, based on the low price of some OTC stocks. There remains an official reference to the color pink – the OTC Pink® Open Market.
SEC: Shorthand for the Securities Enforcement Commission, a government commission created by Congress to regulate the securities markets and protect investors. Any public offering of stock is subject to review by the SEC.
Stock Exchange: A marketplace (which could be a physical location or an electronic platform) in which securities are traded. The core function of a stock exchange is to ensure fair and orderly trading, as well as efficient dissemination of price information for any securities trading on that exchange. Exchanges give companies, governments, and other groups a platform to sell securities to the investing public. Each stock exchange will have certain listing requirements – such as regular financial reports and audited earnings reports. The New York Stock Exchange (NYSE) is an example of a stock exchange.
OTC Markets Group (formerly known as the National Quotation Bureau, Pink Sheets LLC, and Pink OTC Markets): Operates an electronic quotation system called OTC Link that displays pricing for many over-the-counter securities not listed on a national stock exchange. All transactions are carried out between dealers. The companies listed on the OTC Market are broken into three tiers based on the quality and quantity of information the companies have made available. These tiers, starting with the designation for the most established companies, are as follows: OTCQX® The Best Market, OTCQB® The Venture Market, and OTC Pink® The Open Market.
OTC Bulletin Board or OTCBB: A system run by FINRA (Financial Industry Regulatory Authority). Broker-dealers who subscribe to the non-electronic system can buy and sell OTC stocks. Companies on the OTCBB must make all required SEC filings, but there are no other size or corporate governance requirements. Most OTCBB companies are quoted on both the OTCBB and one of the OTC Markets Group marketplaces.
Gray Market: Refers to securities that are not listed on any stock exchange or on the OTCQX, OTCQB or OTC Pink marketplaces. There is likely little investor interest in or information available about such securities.
Liquidity: Refers to how easy it is to buy or sell a security. This is a function both of the market for the security and of the legal restrictions on resale.
Bid-Ask Spread: The difference between the highest price that a buyer is willing to pay for a share of stock or another asset (the highest bid price) and the lowest price that a seller is willing to accept to sell it (the lowest ask price).
Broker-Dealer: An individual or firm who is engaged in the business of buying and selling securities. When the individual or firm is executing orders on behalf of clients (i.e., acting as an agent), it is acting as a broker. And when the person or firm is acting as a principal (i.e., trading for its own account) it is acting as a dealer.
Reverse Merger: In the OTC context, this refers to a transaction whereby the stockholders of a private company acquire the majority of the shares of a public shell company, which is then merged into the purchasing entity. As a result of the merger, the private company exchanges shares with the public entity, making the purchaser a public company. Reverse mergers allow the private company to become public without raising capital, as opposed to a traditional initial public offering (or IPO) which combines going public via an S-1 and undertaking fundraising. A reverse merger is also quicker than a full-blown IPO or an S-1 filing. The full legal ramifications of a reverse merger versus an IPO or direct S-1 filing are beyond the scope of this article.
S-1: The traditional method for taking a company public is by filing an S-1, which is an offering prospectus for the shares to be listed publicly. This can be accomplished as part of an IPO, which also involves a fundraising process typically run by an investment bank, or it can be done by a company directly without the involvement of a bank. A company wishing to become publicly traded will file an S-1 with the SEC. Once filed, the company and the SEC will then go through a process of comments and revisions. When the SEC is satisfied with the revised S-1, it will declare the offering prospectus effective and the company can sell shares to the public.
Why cannabis companies trade OTC
Why would a company want to trade OTC? The simple fact is that it’s very difficult to trade on the NYSE or NASDAQ. In addition to limitations that apply specifically to cannabis companies, as may have been the case with MassRoots, though not with Innovative Industrial Properties, both NASDAQ and NYSE have high financial standards that most cannabis companies are too small or too unprofitable to meet. It’s also not free to list on these exchanges; while both exchanges have multiple revenue streams, one way they make money is by charging fees to the listed companies. There are other, smaller stock exchanges (note that NASDAQ, for example, has three different tiers domestically: The Nasdaq Global Select Market®, The Nasdaq Global Market®, and The Nasdaq Capital Market®, with different standards for each tier, and has other international markets beyond the scope of this article), but each will have requirements that companies need to meet to be listed. That leaves the OTC markets as the main alternative to a company that wants to be publicly listed, but has not yet achieved the size necessary to be listed on a stock exchange.
But why would a company want to be publicly listed in the first place? There are several reasons, most of which only apply to a company that is listed on a major stock exchange (e.g., the prestige of being a public company or additional liquidity), but the primary reason offered for becoming an OTC-traded company is that it allows the company a way to increase the amount of capital it can raise and offers existing equity-holders greater liquidity. With limited exceptions, a private company can only freely sell its securities to accredited investors (i.e., institutions or people who meet certain income or asset thresholds). And, prior to the JOBS Act, private companies were prevented from any kind of widespread public advertising (which they can now engage in, but only if they take steps to ensure only accredited investors purchase the equity for sale). A publicly registered company, in contrast, is largely free to offer and sell its stock to all interested parties, regardless of whether they are accredited. It is also far less restricted in its ability to advertise the fact that its stock is for sale.
Buying publicly traded stock is also far easier – investors don’t need to know anyone at the company in question. If a potential investor has access to a computer or phone, buying OTC stock is straightforward. In theory, this opens a far larger marketplace for a company’s stock, providing liquidity and allowing it to sell additional equity to finance growth and operations.
The risks of OTC cannabis stocks
There are other, less honorable reasons why a company might want to trade OTC. When a public stock is widely traded, it’s difficult to influence the price of the stock. Imagine trying to materially change the price of Google’s stock – it would require a vast sum of money. But when a company’s stock is infrequently traded and information about that stock is limited, it’s much easier for an individual or group to influence a stock’s price. And information does tend to be quite limited when it comes to OTC stocks. In contrast to stocks listed on the major exchanges, not all stocks that trade on the OTC Link are required to be registered with the SEC. As a result, the overall level of information available for OTC stocks is both less detailed and less up-to-date than that of stocks traded on the NYSE or NASDAQ. It is also not uncommon for an OTC stock to be deficient in providing the limited information that is required.
Several government agencies have sought to warn the public about the risks inherent in cannabis OTC stocks. On May 16, 2014, the SEC’s Office of Investor Education and Advocacy published a press release that specifically warned investors about the risks of cannabis-related stocks. The SEC highlighted the fact that five cannabis OTC stocks had recently been suspended from trading due to concerns about the accuracy of publicly available information about their operations. Two of these companies were also implicated in potentially illegal activity involving the sale of securities and market manipulation. And on November 12, 2015, the Colorado Division of Securities issued a warning to investors to be cautious when considering investments in marijuana-related companies, binary options, and digital currency. The Colorado Division of Securities noted that marijuana-related investments “could be particularly susceptible to scams, such as ‘pump-and-dump.’” A “pump-and-dump” scheme is an illegal scam where people holding equity in a company convince the market that the shares are worth far more than they are by spreading false or misleading information, a process made easier by the thinly traded nature of OTC stocks and the lack of good information about them. Before the public catches on, they sell all or a portion of their shares for a significant profit.
With some exceptions, most cannabis OTC stocks have minimal analyst coverage, if any coverage at all. Most major companies that are publicly traded, in contrast, are studied regularly by analysts, who frequently publish reports about the status and direction of the companies they cover. Academic literature has shown that analyst coverage can decrease informational gaps between investors and management of companies. But if no one is covering an OTC stock, then shareholders must either study the company themselves or risk being left in the dark about the condition of the company. In addition, many institutional investors do not invest in OTC stocks, so the investor base of an OTC company will have far fewer, if any, institutional investors, and more retail (i.e., ordinary individual) investors. This means that holders of OTC stocks, absent the benefits of analyst coverage, cannot count on their fellow shareholders to be sophisticated or committed to monitoring the company either. OTC investors must often do their own due diligence on the companies in question.
Finally, it is important to understand the liquidity issues of OTC stocks. To return to the example of Google mentioned earlier, it is very easy to dispose of Google stock (or to be more accurate, Alphabet Inc. Class A stock) since there is a very active trading market for those securities. It would not be difficult to sell all the Google stock you hold at, or very close to, the current publicly listed price – unless the stock was currently reacting to major news or you were trying to sell a material number of shares. For an OTC stock, however, an investor should not take any of these advantages for granted. OTC stocks typically have significant bid-ask spreads since they are typically far less liquid than stocks traded on public exchanges – meaning that they are not as actively traded. That means in the event you decide to sell your stock there may not be a buyer readily available. And even if you could find a buyer for your stock, there is also the risk that your sale of stock could impact the quoted price, forcing you to sell at a lower price. This is why, unless there is an active market for an OTC stock, the quoted price may not be the price at which you can liquidate your position.
This is not to suggest that all OTC stocks are scams or even poor investments. But investors need to be particularly careful when evaluating these types of stocks and should be aware that not all publicly traded stocks are the same.
Key takeaways
In short, when it comes to OTC stocks:
A publicly traded stock by any other name: Any investment in an OTC stock is inherently riskier than an investment in a blue-chip stock trading on a public stock exchange. If you want to sell an OTC stock, it may not be possible to find a buyer. And OTC stocks can be subject to high volatility and at greater risk of fraud. This doesn’t mean that buying stock in a cannabis company trading OTC is necessarily a bad idea. But these kinds of investments demand an understanding of the risks involved.
OTC company beware: Any company considering listing as an OTC stock, whether by way of a reverse merger or otherwise, should carefully evaluate the costs and benefits of being publicly registered. Consider drawing on the private equity markets instead of the public markets. Please bear in mind that as a cannabis company, you will likely face heighten scrutiny by the SEC.
Know your terms: Not all OTC stocks are alike. The OTC Link has three marketplaces which are tiered based on the quantity and quality of information provided by the companies:
OTCQX® The Best Market: This is the marketplace with the most stringent requirements. To qualify, companies must meet financial standards, demonstrate compliance with US securities laws, be current in their disclosure, and be sponsored by a third-party professional advisor.
OTCQB® The Venture Market: Entrepreneurial and development-stage companies that are unable to qualify for OTCQX trade on this marketplace. Companies must undergo an annual verification and management certification process and be current in their reporting to be eligible.
OTC Pink® The Open Market: Defaulting or distressed companies trade on this marketplace, although some companies trade on The Open Market by design. Companies are further sub-categorized into one of three tiers by the level of information they provide: Current Information, Limited Information, and No Information.
Other Designations: Caveat Emptor: A concern exists about the stock, company, or person(s) controlling the company. The quotes will be blocked on OTCBB while a stock is labeled Caveat Emptor. OTC, Other OTC or Grey Market: Securities not traded on the three OTC Link exchanges. Public quotes are not provided by Broker-Dealers.
This information is educational only and shall not be construed as legal advice. Please consult your attorney prior to relying on any information in this article.
Charlie Alovisetti, Vicente Sederberg LLC
Charles Alovisetti is a senior associate and co-chair of the corporate department at Vicente Sederberg LLC. Prior to joining Vicente Sederberg, Mr. Alovisetti worked as an associate in the New York offices of Latham & Watkins and Goodwin where his practice focused on representing private equity sponsors and their portfolio companies, as well as public companies, in a range of corporate transactions, including mergers, stock and asset acquisitions and divestitures, growth equity investments, venture capital investments, and debt financings. In addition, Mr. Alovisetti has experience counseling portfolio and emerging growth companies with respect to general corporate and commercial matters and all aspects of compensation arrangements, including executive employment and consulting agreements, stock option plans, restricted stock plans, bonus plans, and other management incentive arrangements. Mr. Alovisetti has experience in both U.S. and cross-border transactions, and has advised clients across a range of industries including cannabis, technology, manufacturing, software, digital media, energy and clean tech, healthcare, and biotech. He holds a Bachelor of Arts, with honors, from McGill University and a law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar. Mr. Alovisetti is admitted to practice in both Colorado and New York and is a Level One Interprener.
Guest Post: Changes to Colorado Residency Requirements
By Charles Alovisetti, Senior Associate at Vicente Sederberg, LLC.
This is article is the second in a series, which will provide a general overview of the laws that impact raising money in the cannabis industry.
Introduction
Colorado currently has the strictest residency requirements for ownership of marijuana establishments in the United States, imposing a two-year residency requirement for any owner of a licensed business. In addition to the constraints imposed by such a lengthy residency requirement, the Colorado Marijuana Enforcement Division (the “MED”), which is the regulatory body concerned with the marijuana industry, takes a broad view of what constitutes ownership (e.g., guarantying the debt of a licensed entity can constitute ownership). Earlier this year, on May 11, 2016, in order to address the funding difficulties created by the strict residency requirements (note that because the changes to the residency requirements apply to both medical and retail marijuana businesses, this article will not distinguish between the two when discussing the legislative changes and will simply refer to licensed entities, which shall mean both medical and retail licensed entities), the Colorado Senate passed Senate Bill 16-040, as amended by the House, commonly referred to as the “Residency Bill” (the “Bill”). The Bill was subsequently signed into law by Governor Hickenlooper on June 10, 2016. The Bill, which goes into effect on January 1, 2017, will radically change the residency requirements imposed on licensed businesses. These changes are addressed in detail below. This article, with limited exceptions, only addresses the changes explicitly described in the Bill and does not address the further complexities raised by draft rules promulgated by the MED regarding the Bill since these rules are not yet final.
Current State of Colorado Law
As noted above, in addition to requiring that all owners of a licensed business be at least two-year Colorado residents (and must also meet certain background requirements), Colorado takes the view that a person or entity that has a beneficial interest in a marijuana business and/or substantial control over a marijuana business is considered an “owner.” A beneficial interest has been informally defined as being paid based on profits (whether gross or net). In determining if a person or entity has an ownership interest in a marijuana business, the state considers a non-exhaustive list of factors, including whether a person or entity 1) bears risk of loss and opportunity for profit; 2) is entitled to possession of the licensed premises; 3) has final operational decision-making authority over business; 4) guarantees the businesses’ debts or production levels; 5) is a beneficiary of the business’s insurance policies; 6) acknowledges tax liability for the business; 7) acts as an officer or director of the business; 8) is contracted to manage the overall operation of the business; 9) has a licensing agreement with the business (note that it is possible to structure licensing agreements so as to avoid triggering the determination of ownership, but this can be complicated); 10) has ownership of shares or other equity interests of the licensed business; 11) has a secured interest in furniture or fixtures directly used in the manufacture or cultivation of marijuana; or 12) has a secured loan with the business. In addition, any security interest in the furniture, equipment, or fixtures used directly in the manufacture or cultivation of marijuana or marijuana product may be considered ownership depending on the circumstances. Given the thoroughness of the foregoing list, it’s not difficult to understand why licensed entities have had difficulty raising capital from out-of-state investors.
However, Colorado laws do allow for out-of-state residents to invest in marijuana businesses through a permitted economic interest (“PEI”). A PEI is a financial interest in the form of an unsecured debt instrument, option agreement, warrant, or any other right to obtain ownership interest in a marijuana business, provided the conversion or transfer right is contingent on the holder qualifying as an owner and obtaining licensure as an owner by the MED – this could be upon the occurrence of either the holder meeting the two-year residency requirement or a change in law (which the Bill represents). A PEI may only be held by a natural person who is a U.S. resident. Holders of PEIs are subject to fingerprinting and criminal history background checks and must disclose financial and personal information with the MED in their applications. As of today, PEIs remain useful to licensed businesses since they allow them to accept out-of-state investment in advance of the Bill going into effect. On January 1, 2017, PEI holders will become eligible to have their interests converted into equity holdings in licensed businesses. After the Bill goes into effect, any kind of option, warrant, or similar convertible instrument will still be required to take the form of a PEI.
New Residency Bill
Before delving into the specifics of the Bill, it is worth noting that the summary attached to the Bill contradicts the actual law, as it was written prior to the passage of the final version of the Bill, and it should be ignored.
The Bill adds a number of new defined terms. Understanding these new terms is the key to understanding the Bill:
Direct Beneficial Interest Owner: Prior to the Bill, there was only a defined term for “Owner”; that concept has now been split in two – Direct Beneficial Interest Owner and Indirect Beneficial Interest Owner. Under the existing system, any level of control that the MED, using the 12-factor test outlined above, determined rose to the level of ownership resulted in the entity or individual being listed as a zero percent Owner (e.g., an individual who guaranteed the debts of a licensed entity might be considered as a zero percent Owner of that business, despite owning no equity in that entity). The term Direct Beneficial Interest Owner is meant to cover existing Owners who directly hold equity in a licensed entity. Direct Beneficial Interest Owners are subject to residency requirements and full background checks (except for Qualified Limited Passive Investors, a type of Direct Beneficial Interest Owner described in detail below). A Direct Beneficial Interest Owner must be either a resident of Colorado for at least one year or a US citizen. Publicly traded companies are explicitly barred from holding licenses.
Indirect Beneficial Interest Owner: The second new category that was previously included in Owner is Indirect Beneficial Interest Owner. No residency requirement exists for an Indirect Beneficial Owner. An Indirect Beneficial Interest Owner includes the following individuals and entities: (a) a holder of a PEI, (b) a recipient of a commercially reasonable royalty associated with the use of intellectual property by a licensee, (c) a licensed employee who receives a share of the profits from an employee benefit plan, (d) a qualified Institutional Investor (defined below), or another similarly situated person or entity as determined by the state licensing authority. The Bill does not explicitly state what kind of background check will be required for an Indirect Beneficial Interest Owner. Currently, the draft rules set forth an identical set of criteria to determine suitability to those for Direct Beneficial Interest Owners, but this may change in the final rules.
Institutional Investor: Up to 30% of a licensed business can be held by an Institutional Investor, and the Bill does not contemplate any residency requirement for an Institutional Investor since an Institutional Investor will be considered an Indirect Beneficial Interest Owner and residency requirements only apply to Direct Beneficial Interest Owners. The Bill sets out a list of entities that meet the definition: banks, registered investment companies, ERISA funds, and any other entities to be identified during the rule-making process. The current draft rules do not list any types of entities not specifically identified in the Bill. While not discussed in the Bill, the draft rules and legislative history make it clear that an Institutional Investor must be passive and may not have any control over a licensed company beyond voting its shares (meaning that the minority protections present in a typical non-control transaction cannot be present).
Qualified Limited Passive Investor: This is defined as a natural person who is a U.S. citizen and is a passive investor owning five percent or less of the equity of a licensed business.
New Residency Rule
In place of the existing rule that requires all Owners to be at least two-year residents of Colorado, the Bill now allows an entity to be either (i) held by an unlimited number of Direct Beneficial Interest Owners, each of whom must meet the one-year Colorado residency requirement, or (ii) if one or more Direct Beneficial Interest Owners do not meet the one-year residency, then the following conditions must be observed: (a) At least one officer of the licensed entity must be a Colorado resident of at least one year, (b) all officers with day-to-day operational control over the business must be Colorado residents of at least one year, and (c) there must be no more than 15 Direct Beneficial Interest Owners (this limitation is measured by natural persons on a look-through basis). A licensed business, whether wholly held by Coloradoans meeting the residency requirement or held by one or more Direct Beneficial Interest Owners who do not meet the residency requirement, may also have up to 30% of its equity held by qualified Institutional Investors.
Reasonable Royalties Now Allowed
One additional major change in the Bill is the allowance for commercially reasonable royalties to be paid to Indirect Beneficial Interest Owners. As the law currently stands, a royalty would be considered a form of ownership by the MED (as the royalty would likely be based on the profit of the licensed entity) and would thus make the recipient of the royalty subject to residency and other ownership requirements. In addition, the current system requires all of the Owners to be present at MED meetings—which presents a major obstacle to the operator of a licensed business who wants to enter into multiple licensing agreements since any licensor could potentially put a license at risk by refusing to attend a meeting or by committing a bad act. However, Indirect Beneficial Interest Owners, while still subject to background checks, are not subject to residency requirements or the limitation of 15 natural persons (as is the case for Direct Beneficial Interest Owners when one or more equity holders does not meet the one-year Colorado residency requirement). It may also be the case, though we will need to wait for the final rules, that removing an Indirect Beneficial Interest Owner is easier than removing a Direct Beneficial Interest Owner from a license.
Conclusion
As noted above, the MED is granted authority to promulgate rules pursuant to the Bill, and final analysis of the Bill will require careful study of these new rules. The MED is currently accepting written comments to the draft-proposed rules in advance of a formal, public hearing regarding the permanent rules on Friday, September 2, 2016. In addition, as with any other change in a regulatory regime, we will need to pay close attention to how the Bill plays out when actually put into practice.
This information is educational only and shall not be construed as legal advice. Please consult your attorney prior to relying on any information in this article.
Charlie Alovisetti, Vicente Sederberg LLC
Charlie Alovisetti is a senior associate and co-chair of the corporate department at Vicente Sederberg LLC. Prior to joining Vicente Sederberg, Charlie worked as an associate in the New York offices of Latham & Watkins and Goodwin where his practice focused on representing private equity sponsors and their portfolio companies, as well as public companies, in a range of corporate transactions, including mergers, stock and asset acquisitions and divestitures, growth equity investments, venture capital investments, and debt financings. In addition, Charlie has experience counseling portfolio and emerging growth companies with respect to general corporate and commercial matters and all aspects of compensation arrangements, including executive employment and consulting agreements, stock option plans, restricted stock plans, bonus plans, and other management incentive arrangements. Charlie has experience in both U.S. and cross-border transactions, and has advised clients across a range of industries including cannabis, technology, manufacturing, software, digital media, energy and clean tech, healthcare, and biotech. He holds a Bachelor of Arts, with honors, from McGill University and a law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar. Charlie is admitted to practice in both Colorado and New York.
Guest Post: Raising Money 101 – What’s an Offer and Why Does it Matter?
This is article is the first in a series, which will provide a general overview of the laws that impact raising money in the cannabis industry.
Any business owner planning to raise capital should consider the federal Securities Act of 1933, commonly referred to as the “Securities Act.” In addition to federal law, each state has its own set of laws that regulate securities sales, commonly referred to as the “Blue Sky Laws.” Both the Securities Act and any applicable Blue Sky Laws must be complied with in connection with the sale of securities – a security being proof of ownership or debt that has been assigned a value and may be sold (stocks and bonds are examples). Both the Securities Act and the Blue Sky Laws regulate the sale of securities by prohibiting the offer and sale of unregistered securities (other than pursuant to specified exceptions) and requiring companies to provide investors disclosure of all material facts concerning the securities for sale.
Crucially for business owners, it’s not only the actual documents to raise money that are governed by the Securities Act: so are those initial business plans and executive summaries that might be circulated to gauge interest. Ensuring that your business plans are not violating any securities laws is the focus of this article.
In analyzing whether a transaction or communication is in compliance with the Securities Act and Blue Sky Laws, it’s helpful to think through the following questions:
Does the transaction or communication constitute an offer or sale?
Is the offer or sale of a security (as defined in the Securities Act and the Blue Sky Laws)?
If there is an offer or sale of a security, is the security properly registered with federal and state authorities?
If there is an offer or sale of a security and the security is not registered, does the transaction fall within one or more of the specified exemptions to registration?
As you assess your materials for compliance, begin by asking whether an offer has been made. If a transaction or communication does not constitute an offer, then compliance with state and federal securities law is not a concern. However, if an offer is unintentionally made – a common mistake – it may trigger a violation of securities law since it is unlikely that the unintentional issuer will have taken into account the necessary disclosure items and determined the relevant exemption to registration. Note that in the context of securities law, “issuer” means any company that issues or proposes to issue a security.
What, then, is an offer, from the federal standpoint and from that of the state of Colorado? Section 2(a)(3) of the federal Securities Act defines “offer” as “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” Under the Colorado Securities Act, “offer to sell” includes any attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security for value and “offer” means an offer to sell or an offer to purchase. What constitutes an offer, furthermore, may be a matter of perceived intent rather than explicit proposal: the SEC has noted that “[t]he publication of information and statements, and publicity efforts, generally, made in advance of a proposed financing, although not couched in terms of an express offer, may in fact contribute to conditioning the public mind or arousing public interest in the issuer or in the securities of an issuer in a manner which raises a serious question whether the publicity is not in fact part of the selling effort.” As a practical matter, these definitions, as well as the SEC’s guidance, mean that many communications that would not be considered offers under contract law may well be considered offers for purposes of state and federal securities law.
From a practical point of view, then, how should an entrepreneur approach an action that might be considered an offer – distributing information about a new company, for example? To mitigate risk of a securities violation, consider the following factors before circulating information about your business:
Include Appropriate Disclaimers: If you do proceed with distribution, any documentation provided to potential investors should contain disclaimers that clearly indicate that the provided information is not an offer or a solicitation of an offer to buy securities. Note that such disclaimers do not necessarily mean the document will not be considered an offer.
Require Further Information: Any documentation should also state explicitly that further information about a purchaser will be required before an offer can be made.
Minimize Details: Generally speaking, the fewer details provided about a potential security, the better. Even high-level details can result in a document being considered an offer.
Ensure Accuracy: Make absolutely sure that any information provided is correct and not misleading (i.e., do not claim that cannabis is legal in the United States, note that it remains illegal at the federal level). Avoid selective disclosure and be prepared to stand behind any claims made.
Follow Best Practices: Every communication should adhere to best practices regarding offerings in general (e.g., avoiding general solicitations, keeping track of distributed documents, etc.)
Seek Legal Counsel: When in doubt, speak to a qualified securities attorney. It’s always easier to do things right the first time, whereas it may not be possible to fix certain mistakes.
This information is educational only and shall not be construed as legal advice. Please consult your attorney prior to relying on any information in this article.
Charlie Alovisetti, Vicente Sederberg LLC
Charlie Alovisetti is a senior associate at Vicente Sederberg LLC. Prior to joining Vicente Sederberg, Charlie worked as an associate in the New York offices of Latham & Watkins and Goodwin Procter where his practice focused on representing private equity sponsors and their portfolio companies, as well as public companies, in a range of corporate transactions, including mergers, stock and asset acquisitions and divestitures, growth equity investments, venture capital investments, and debt financings. In addition, Charlie has experience counseling portfolio and emerging growth companies with respect to general corporate and commercial matters and all aspects of compensation arrangements, including executive employment and consulting agreements, stock option plans, restricted stock plans, bonus plans, and other management incentive arrangements. Charlie has experience in both U.S. and cross-border transactions, and has advised clients across a range of industries including technology, manufacturing, software, digital media, energy and clean tech, healthcare, and biotech. He holds a Bachelor of Arts, with honors, from McGill University and a law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar.
*Currently only admitted in New York
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There are many wonderful things about the cannabis industry – creation of new jobs, legal access to medicine, and reduction of drug war harms, to name a few. Every rose has its thorn though, and the cannabis industry is no exception. Like any industry pushed into the shadows, in this case by a misguided prohibitionist policy, unsavory individuals have found an opportunity to prey upon those without full access to the legal system or to legitimate sources of capital. All cannabis entrepreneurs need to be on the watch out for the tell-tale signs the person or business they are talking to is a scam artist. Below are ten common signs that something might not be legitimate in your business transaction. Not all these signs indicate something is foul, but they should be a red flag that the business dealings bear further investigation. 
Scam artists are understandably loathe to subject themselves to questioning from a skeptical lawyer. Sunlight is the best disinfectant and most scams will not stand up to a thorough vetting. Legitimate business professionals, however, while not always happy about it, accept that dealing with lawyers is the price to be paid to get deals done.
MassRoots (MSRT), a Denver-based social networking company for cannabis users, made headlines when it was denied approval to be listed on NASDAQ. According to MassRoots, the stock exchange justified the decision by claiming that the company was aiding and abetting the distribution of an illegal substance. Some speculate, however, that the decision considered the company’s low share price, although MassRoots stated it did meet the listing requirements with a market capitalization in excess of $40 million and more than 300 shareholders. NASDAQ did not publicly provide the grounds for its rejection. 
There are other, less honorable reasons why a company might want to trade OTC. When a public stock is widely traded, it’s difficult to influence the price of the stock. Imagine trying to materially change the price of Google’s stock – it would require a vast sum of money. But when a company’s stock is infrequently traded and information about that stock is limited, it’s much easier for an individual or group to influence a stock’s price. And information does tend to be quite limited when it comes to OTC stocks. In contrast to stocks listed on the major exchanges, not all stocks that trade on the OTC Link are required to be registered with the SEC. As a result, the overall level of information available for OTC stocks is both less detailed and less up-to-date than that of stocks traded on the NYSE or NASDAQ. It is also not uncommon for an OTC stock to be deficient in providing the limited information that is required. 
Colorado currently has the strictest residency requirements for ownership of marijuana establishments in the United States, imposing a two-year residency requirement for any owner of a licensed business. In addition to the constraints imposed by such a lengthy residency requirement, the Colorado Marijuana Enforcement Division (the “
One additional major change in the Bill is the allowance for commercially reasonable royalties to be paid to Indirect Beneficial Interest Owners. As the law currently stands, a royalty would be considered a form of ownership by the MED (as the royalty would likely be based on the profit of the licensed entity) and would thus make the recipient of the royalty subject to residency and other ownership requirements. In addition, the current system requires all of the Owners to be present at MED meetings—which presents a major obstacle to the operator of a licensed business who wants to enter into multiple licensing agreements since any licensor could potentially put a license at risk by refusing to attend a meeting or by committing a bad act. However, Indirect Beneficial Interest Owners, while still subject to background checks, are not subject to residency requirements or the limitation of 15 natural persons (as is the case for Direct Beneficial Interest Owners when one or more equity holders does not meet the one-year Colorado residency requirement). It may also be the case, though we will need to wait for the final rules, that removing an Indirect Beneficial Interest Owner is easier than removing a Direct Beneficial Interest Owner from a license. 