By William Gay, Wilson Elser Moskowitz Edelman & Dicker LLP

Conflict between state and federal law gives rise to unique risk factors in private placement memoranda for cannabis businesses. Equity interests in private businesses are frequently offered to investors by means of private placements. The standard disclosure document for private placements is the private placement memorandum, or PPM. One section of the PPM is “Risk Factors,” which discusses various possible sources and areas of risk in the private placement. This paper examines whether risk factors that are conventionally included in a PPM for a cannabis business that touches product are sufficient to address this tension between federal and state law.

Disclosure to Investors

Federal securities laws and regulations, as well as the securities laws of many states, are based on the “blue sky” concept of disclosure, rather than value. For publicly traded securities, this disclosure takes the form of initial and ongoing public filings with the Securities and Exchange Commission (SEC); private companies often employ a less rigorous form of disclosure – the PPM.

The exemption from filing for a private placement is set forth in section 4(a)(2) of the Securities Act. Most private placements are made pursuant to Rule 506 of Regulation D to this section, which is the safe harbor rule for private offerings. Rule 506 permits an unlimited amount of money to be raised from an unlimited number of accredited investors in addition to up to 35 unaccredited investors.

Use of a PPM is optional if all investors are accredited and sophisticated, and given an opportunity to make inquiries about the offering. However, use of a PPM is highly advisable, if only to estop the investor from claiming reliance on information outside of its four corners.

The structure of a PPM is set forth in Regulation S-K, 17 C.F.R. Part 229. For our purposes, the most significant part of the document is the discussion of “Risk Factors,” which is required under a concept with the ungainly name of the “Bespeaks Caution Doctrine.” Risk factors are described as follows in 17 C.F.R. §229.503(c):

Risk factors. Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make the offering speculative or risky. This discussion must be concise and organized logically. Do not present risks that could apply to any issuer or any offering. Explain how the risk affects the issuer or the securities being offered. Set forth each risk factor under a subcaption that adequately describes the risk. The risk factor discussion must immediately follow the summary section. If you do not include a summary section, the risk factor section must immediately follow the cover page of the prospectus or the pricing information section that immediately follows the cover page. Pricing information means price and price-related information that you may omit from the prospectus in an effective registration statement based on §230.430A(a) of this chapter. The risk factors may include, among other things:

• Your lack of an operating history
• Your lack of profitable operations in recent periods
• Your financial position
• Your business or proposed business
• The lack of a market for your common equity securities or securities convertible into or exercisable for common equity securities.” 17 C.F.R. §229.503(c)

By way of example, a risk factor addressing a lack of an operating history might read as follows:

The Company Has No Operating History

The Company was established on [DATE]. It remains a development stage business with limited operating history. There can be no assurance that the Company will be successful in building its business or that its business model will prove to be successful.

This, in fact, would be an appropriate risk factor for many of the California cannabis startups that focus on recreational use. By contrast, many of the entities that were set up to serve the medicinal use market have been structured as mutual benefit associations. As such, they would not in general be engaged in securities offerings.

How should cannabis business PPM risk factors address the federal-state tension?

The cannabis industry is broad, and “cannabis businesses” can include the following:

• Cannabis grow facilities
• Grow facility support businesses, such as potting soil and soil amendments, fertilizers, grow lights, irrigation and hydroponic systems
• Extraction services and extraction equipment
• Laboratory testing services and testing equipment
• Transportation of cannabis products
• Sale of cannabis products to consumers
• Leasing of real estate to any of these business lines.

All of these businesses are subject to some level of economic risk if the sale of cannabis products is interrupted by enforcement of federal law; however, this article will focus on those businesses that “touch product” and on private placements by those businesses. The discussion of this issue will be organized according to suggested risk factor headings.

An example of a risk factor recently used in a PPM for a debt offering by a medicinal cannabis dispensary reads as follows:

Cannabis is a DEA Schedule 1 Substance and risk exists related to its status as an illegal drug under federal law.

The current regulatory climate for the marijuana industry is inherently risky. The substance is illegal under the Controlled Substances Act and its current DEA Scheduling. Even in those states in which the use of marijuana has been legalized, its use remains a violation of federal law. Since federal law criminalizing the use of marijuana preempts state laws that legalize its use, strict enforcement of federal law regarding marijuana would likely result in our inability to proceed with our business plan. Noteholders may be exposed to legal prosecution under federal law and assume any and all risk associated with prosecution including incarceration and asset seizure.

On the face of it, this risk factor appears to be ample: It states that marijuana is illegal under federal law, that there are inherent risks even in states where it is legal under state law, and that strict enforcement of federal law could be fatal to the business plan. In terms of sanctions, it lays out the worst-case scenario: incarceration and asset seizure.

Clearly, this is sufficient to apprise the prospective investor that the investment is risky. But does it adequately warn of the full range of potential hazards?

A careful reading of Regulation S-K would suggest that it does not. It is true that the words “most significant factors” in the phrase “the most significant factors that make the offering speculative or risky” could be taken to mean the maximum penalty that might be incurred. However, it also could be read to refer to the likelihood that an event will occur, rather than the severity of its consequences. And in the cannabis business, lots of things can happen.

What risk factors are more likely to affect cannabis companies?

Securities

The company could be precluded from debt or equity fundraising, whether by means of a public offering or a private placement. Securities are regulated at both the federal and state levels. Engaging in criminal activity at the corporate level can result in sanctions, including suspension of trading. At the federal level, the SEC has given no clear indication whether it intends to pursue sanctions against cannabis companies that touch product.

Banking

The company is not permitted to open a bank account or to engage in banking transactions. Banks are regulated by federal statutes and regulations, and do not currently permit cannabis businesses that touch product to open accounts or engage in banking transactions. This creates a number of risks for the company, including lack of verifiable financial records and accumulation of cash.

Real Estate

The company’s access to real estate could be limited, its rights to such real estate could be voidable, and it could be forced to incur substantial extraordinary costs. In the view of many landlords and neighboring tenants, cannabis businesses contribute to an undesirable environment for a variety of alleged reasons: cash accumulations and the presence of cannabis create a target for theft; some customers are loud and unruly; and some processes, such as extraction, can create unpleasant odors. Therefore, many landlords will refuse to rent to cannabis businesses, or will do so only on condition that the tenant installs substantial and costly security devices.

Under the terms of many standard commercial leases, a cannabis business could be subject to cancellation on the grounds that illegal activity was being conducted on the premises. If a landlord’s real property were to be seized in the course of a raid by federal drug enforcement authorities, the company could become liable to the landlord for the value of that property.

Management

The company could experience difficulty in attracting qualified senior management and directors. Negotiated settlements in SEC actions often involve an agreement by a sanctioned executive not to act as an officer or director of a publicly traded company for some period of years. This prospect, should the SEC adopt a negative posture toward the cannabis industry, could discourage experienced executives from serving in such capacities in cannabis businesses.

Transportation

The company’s ability to transport its products is limited. Interstate commerce in cannabis products is a felony. Transportation of cannabis products from one state to another, even if cannabis is legal in both states, is prohibited. Within a state, transportation via air or sea is subject to federal regulation, and therefore illegal. Whether transportation intrastate on federal highways also is felonious is an open question.

Intellectual Property

The company’s proprietary intellectual property may not be protectable under patent, copyright or federal trademark law. Inventions, logos or other intellectual property that the company develops or acquires may not be afforded protection under federal law. Trade secret or state level trademark protections may be available.

Bankruptcy

The company may not be accorded the protection of federal bankruptcy laws. Most bankruptcy law is federal law. A cannabis company that wishes to obtain temporary protection from creditors may seek protection under common law or state laws relating to creditors’ rights, but may not be able to use the protections afforded under Chapter 11 or other provisions of the Bankruptcy Code.

Immigration

Involvement in the company’s business could jeopardize the visa status of non-citizens.

Visas may be denied or cancelled upon conviction of a crime. Investment in, or management of a cannabis company could result in deportation or cancellation of an existing visa.

Insurance

The company may not be able to obtain insurance of any kind. Insurance companies generally do not insure illegal activity. While a small number of companies are venturing into the cannabis space, companies in this industry may have difficulty obtaining insurance for loss, liability, business interruption, director and officer liability, errors and omissions, and other matters.

Firearms

Involvement in the company’s business could prevent a person from legally acquiring a firearm. All firearms transfers in the United States must include the filing of ATF Form 4473, the “Firearms Transaction Record.” This form is filled out by the buyer and seller of the firearm and forms the basis for the buyer’s background check. Statements are made under penalty of perjury, and false statements are grounds for disqualification. Sections 11 and 12 of the form consist of a series of yes or no questions.

For example, Question 11e. asks: “Are you an unlawful user of, or addicted to, marijuana or any depressant, stimulant, narcotic drug, or any other controlled substance?” And lest there be any confusion as to the meaning of the word “unlawful,” the following appears in boldface:

Warning: The use or possession of marijuana remains unlawful under federal law regardless of whether it has been legalized or decriminalized for medicinal or recreational purposes in the state where you reside.

While this question would appear to indicate that the Bureau of Alcohol, Tobacco, Firearms and Explosives comes down squarely on the side of the prohibitionists, it is noteworthy that the warning contains the words “use or possession,” but the question only asks about use. This is one of only two questions in Sections 11 and 12 (the other refers to straw-man purchases) that contain a warning.

Conclusion

This should not be treated as an exhaustive catalog of industry-specific risk factors, nor should it be imported wholesale into every PPM for a cannabis offering. The PPM should be tailored carefully to the specific business, and an important part of the job of a securities lawyer is to select those risks that are most noteworthy without so heavily padding the Risk Factors section as to render it unreadable and therefore ineffective.

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William Tolin Gay is an attorney in the Business Services Group in the Los Angeles office of Wilson Elser Moskowitz Edelman & Dicker.  He graduated from the University of Washington, where he also received his J.D. in 1982, his MBA in 1983 and his LL.M. in Japanese law in 1984.  

From 1984 to 1988, he practiced law in Tokyo, where he represented U.S. companies in their Japanese operations, and Japanese issuers and underwriters in Eurobond securities issues.  He speaks and reads Japanese.

Since 1988, he has worked in Southern California, where his practice focuses on corporate finance, mergers and acquisitions, real estate and technology transfers.  He is a certified mediator. In 2001, he was named one of “The Hot 25 People of Orange County” by OC Metro magazine.

He is currently a member and Chief Financial Officer of the Executive Committee of the International Law Section of the California Lawyers Association, and is the former Chief Financial Officer of the Business Law Section of the State Bar of California, and former Chair of its Committee on Cyberspace Law, and past President and Board Member of the Corporate and Business Law Section of the Orange County Bar Association.