March 13, 2020

Marijuana M&A: Special Due Diligence Considerations

James J. Black

The wave of marijuana legalization that has washed over North America in recent years, with Canada and most U.S. states legalizing the substance for medical and/or recreational uses (although it remains illegal under U.S. federal law), has spurred an increasing number of mergers and acquisitions involving marijuana-related businesses (MRBs).  Despite the surge in deal-making, cannabis remains an emerging industry that presents unique challenges, even for experienced M&A practitioners who have advised on deals in a wide range of industries.  This article will discuss a few of the unique challenges for deal lawyers in marijuana M&A, including industry-specific due diligence issues and risks that may be hard to quantify and (through appropriate representations, warranties, and indemnities) limit for buy-side clients. 

Broadly speaking, marijuana deals entail advising companies engaged in the cultivation, processing, sale, or distribution of marijuana and products derived from marijuana, as well as some ancillary businesses that, while they do not “touch the plant,” primarily or exclusively serve businesses that do.  It is important to note that, while both marijuana and hemp are forms of cannabis, the laws and regulations applicable to the two substances vary dramatically, as hemp was legalized under U.S. federal law in 2018.  

Because of the unique legal status of marijuana as a federally prohibited controlled substance but a legal and highly sought-after commodity under the laws of most U.S. states, due diligence in marijuana M&A must encompass both the extent to which a target’s business is likely to become the subject of federal enforcement actions and its compliance with state and local laws.  The risk of federal enforcement itself is in part dependent upon the target’s compliance with applicable state laws, but it behooves buyers and their counsel to go beyond a pure state-law analysis to include an assessment of the target’s compliance with the factors enumerated by the U.S. Department of Justice in 2013 in the guidance that is commonly referred to as the Cole Memorandum. That document (the effectiveness of which is currently unclear, as it was rescinded by former Attorney General Jeff Sessions in 2018 but subsequently unofficially endorsed by current Attorney General William Barr) established enforcement priorities for federal prosecutors when choosing whether to bringing criminal charges for marijuana-related violations of federal law. 

Those priorities focused on such issues as preventing the distribution of marijuana to minors and ensuring that revenues from the sale of marijuana would not flow to criminal enterprises and that state-legal marijuana activity would not be used as a cover for trafficking other illegal drugs.  In order to get some degree of comfort that federal prosecution is at least a limited risk (although there is no legal protection from federal prosecution as long as marijuana remains illegal under federal law), buyers and their counsel should review the extent to which the target presents identifiable risks of implicating one of the enumerated federal enforcement priorities.  In addition, since a typical “compliance with law” representation and warranty is not feasible in the marijuana industry with respect to U.S. federal law, this provision of the purchase agreement should be tailored to address not only the target’s compliance with applicable state and local law but ideally also the non-implication of the federal enforcement priorities set forth in the Cole Memorandum (although the specific wording of such a provision will likely be heavily negotiated). 

While due diligence relating to a marijuana-industry target’s compliance with federal law is by nature a limited and highly bespoke exercise, diligence relating to state and local law compliance should be tailored to address the specific legal and regulatory requirements of the state(s) and localities in which the target operates.  The marijuana laws that have been adopted in recent years vary widely from state to state and are by nature complex, as they seek to create comprehensive regulatory schemes for the creation of an entirely new (legal) industry in their respective states.  As an example, the law adopted by the most recent state to legalize adult-use marijuana, Illinois (where adult-use marijuana became legal as of January 1, 2020), comprises over 600 pages of detailed provisions addressing licensing, ownership, and operational and marketing requirements, as well as change of control provisions if a licensee changes hands.  The parts of the relevant state laws that are applicable to a target will depend on where along the value chain the target operates (i.e., different rules may apply to a grower as opposed to a dispensary operator).  

Since state marijuana laws generally seek to closely control the issuance and ownership of licenses for cultivation, processing, transport, sale, and distribution of marijuana, a critical issue to be analyzed early in a transaction is whether applicable state laws limit the seller’s ability to assign its license(s), and, if a share deal is contemplated, what impact statutory change of control provisions will have.  Additionally, state law may include ownership limitations that prohibit a single person or entity from owning an interest in more than a fixed number of licenses, and some forms of cross-ownership of licenses may be restricted.  The Illinois law, for example, forbids the ownership by any person or entity of any legal, equitable, or beneficial interest in more than three cultivation centers, more than ten dispensing organizations, or more than three craft grower licenses (and cross-ownership of certain types of licenses is also restricted).  In deals in which a simultaneous signing and closing is not possible, it is also important to analyze whether a provision that grants the buyer extensive pre-closing control rights is consistent with legal prohibitions on license transfers without prior state approval. 

In addition, the Illinois marijuana law contains social equity provisions that offer preferential treatment in the issuance of licenses to applicants that are controlled by or employ a majority of people who have disproportionately suffered the consequences of enforcement of marijuana laws.  These include people who have been arrested or incarcerated for marijuana-related offenses that are eligible for expungement under the law, as well as their family members, and people who reside in high-poverty areas and other areas that have been disproportionately affected by the enforcement of drug laws.  If a target’s license was granted in part based on the participation of such a “social equity applicant,” transfer of that license is subject to additional conditions that the buyer must comply with.  As a result, it is critical that a buyer understand the basis on which the target’s license was issued and how that might impact the buyer’s operation of the business following the acquisition.  

Beyond licensing issues, while marijuana deals present many of the same due diligence topics as targets in other industries, some of these topics have special significance in marijuana M&A.  Two issues that are of particular importance are the target’s access to banking services and insurance, as both areas have proven very challenging for many MRBs.  In connection with the target’s banking relationships (to the extent that it has been able to obtain banking services), the buyer should ascertain whether the target’s bank is fully aware of the nature of the target’s business, as some banks have reportedly terminated banking relationships with customers because of their involvement in the marijuana industry.  Due diligence should also encompass payment processing and money-handling, as many MRBs operate largely on a cash basis due to the lack of available service providers.  MRBs that operate largely or fully on a cash basis present particular safety and security challenges, and due diligence on such targets is complicated by the fact that cash transactions may not generate electronic records that can be used for fraud control and to verify a target’s financial records. 

On the insurance front, due diligence should include an examination of the sufficiency of the target’s coverage, including director and officer insurance, as many MRBs have struggled to obtain adequate coverage.  In this regard, the target’s policies should be reviewed to ensure that there are no exclusions that would effectively prevent it from making a claim in the event of a product liability, recall, or other loss event. 

Finally, federal tax compliance is a critical issue for a buyer’s due diligence, as the Internal Revenue Code prohibits MRBs from deducting many expenses that other businesses can deduct as a matter of course.  As a result, buyers should carefully review the target’s past tax filings to assess the risk that the target has claimed impermissible expense deductions and, therefore underpaid its federal taxes.  It is also essential to review the target’s bookkeeping practices to ensure that expenses of different types (e.g., costs of goods sold vs. other types of business expenses) are appropriately recorded, as some expenses are deductible while others are not. 

These are only a few of the unique aspects of advising clients on marijuana M&A.  The industry continues to develop at a dizzying pace, and law and regulation are struggling to keep up with the market.  This creates an exciting environment for deal lawyers who are prepared to help their clients navigate an emerging industry with many challenges and even more opportunities. 

DISCLAIMER: Morrison & Foerster LLP makes available the information in this article for informational purposes only, and it does not constitute legal advice and should not be relied on as such. Morrison & Foerster LLP renders legal advice only after compliance with certain procedures for accepting clients and when it is legally permissible to do so. Readers seeking to act upon any of the information contained in this article are urged to seek their own legal advice.

James J. Black

Of Counsel, Morrison & Foerster

James J. Black is Of Counsel in Morrison & Foerster’s Business Restructuring & Insolvency Group and has more than 20 years of experience advising companies on mergers and acquisitions, financings and corporate and compliance advisory work.  He has led numerous major cross-border transactions, including initial public offerings of shares by European issuers and complex M&A deals and regularly advises privately held businesses on transactional and other matters.

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