With legalization on the horizon, discussion among industry observers is increasingly concerned with how cannabis-related businesses, particularly licensed producers (LPs), will access the funds they need to succeed in a rapidly evolving and highly competitive recreational market.
To date, this has manifest for LPs largely in the form of equity financing. Indeed, since the 2015 federal election, over $1.8 billion has been raised through equity offerings and the industry market cap now exceeds $24 billion.
But what about debt financing?
A mainstay of any successful industry, debt financing is attracting increasing interest as a non-dilutive source of capital, but the existing regulatory regime under the Access to Cannabis for Medical Purposes Regulations (ACMPR) and its impact on the ability of lenders to take adequate security has largely hampered LP access. This is compounded by a general reluctance by institutional lenders to associate with the industry on account of reputational concerns.
While all of this has historically left LPs with limited borrowing opportunities, as we move closer to July, large institutional lenders, most notably banks and funds, are gradually demonstrating an increasing willingness to engage with industry stakeholders and more opportunities for debt financing may soon follow.
Devising effective debt financing strategies will be hugely beneficial for both financiers and the Canadian cannabis industry as a whole.
Many factors have contributed to the underuse of loans in the cannabis sector, but none more significant than the challenge in taking adequate security. Central to this challenge are the regulatory restrictions placed on an LP’s most valuable asset: its licence.
Currently, any cultivation or sales licence issued by Health Canada under the ACMPR is tied to the specific licensee and to the address of the licensee’s facility. It cannot be transferred to another entity nor is it effective for any other location.
Coupled with the requirement that all directors and officers of an LP and any “senior person in charge” or “responsible person in charge” of an LP’s facility must have security clearance from the RCMP, a licence is ineffective collateral to any would-be lender. Even if a lender were to forego a security interest in the licence, if a lender does not already have access to a licence in its own name, it will be unable to take possession of or sell any cannabis inventory in which it may also have a security interest.
Worse yet, uncertainty remains as to whether a cultivation licence is the proper subject of a security interest in the first place.
Pursuant to the Supreme Court’s decision in Saulnier v. Royal Bank of Canada, one could reasonably argue that since a licensee acquires both a right to do that which is otherwise unlawful (i.e., cultivate cannabis) coupled with a proprietary interest in the cannabis crop that is produced and the earnings of its sale, a cultivation licence may be considered “property” for the purposes of the Personal Property Security Act and Bankruptcy and Insolvency Act and may therefore be collateralized.
However, even if a valid security interest were created, the current regulatory regime does not provide for the transfer or assignment of a licence, without which a secured party is severely curtailed from exercising remedies to realize on its collateral.
The foregoing has resulted in equal parts trepidation and opportunity.
Whereas institutional lenders have been slow to provide debt financing to LPs, alternative lenders have enjoyed considerable success in their absence. While some of these lenders have used conventional strategies to avoid the regulatory minefield altogether (e.g., mortgages over real property), others have used more innovative strategies to take security in higher value assets.
Streaming, for example, has long been associated with the exploration-stage mining industry, but has enjoyed a renaissance among alternative lenders in the cannabis sector.
Under a basic cannabis stream, an upfront loan is provided to an LP borrower in exchange for and secured against a portion of the LP’s production. Stream financiers, in turn, may avoid potential illegality by either being an LP themselves or by establishing or acquiring a separate vehicle that holds a licence. In the latter scenario, security would be assigned to the benefit of the separate vehicle, avoiding regulatory issues in the event the lender must realize on its security.
Future of debt financing in cannabis
As a starting point, there has been exceedingly little to no guidance from federal or provincial regulators on the subject of debt financing in the cannabis industry.
For instance, while the proposed federal regulations released in November more or less confirmed that the current security clearance requirements and restrictions on transferability will persist after legalization, they are silent on whether specific provisions to facilitate financings or bankruptcy and restructuring proceedings will be included.
By comparison, federal and provincial legislation pertaining to other regulated industries have explicitly addressed lenders’ concerns about enforcing security over regulated assets.
The Ontario Drug and Pharmacies Regulation Act, for example, permits the transfer of a pharmacy licence on notification to the Registrar of the Ontario College of Pharmacists. And whereas the federal Radiocommunication Regulations provides for the transfer or assignment of a licence with the authorization of the applicable Minister, the Ontario Liquor Licence Act contemplates the issuance of a temporary licence to, among others, a trustee-in-bankruptcy or court-appointed receiver in order to facilitate disposition of the underlying business.
It should be stressed that in the absence of such guidance, lenders to the cannabis industry cannot be certain of whether they will be able to enforce their security, which limits LP access to credit markets.
It is against this backdrop that strategies currently available to prospective lenders in the cannabis space may be contemplated. As noted above, certain conventional methods of taking security, such as mortgages, do not engage the regulations and should be adopted as a basic minimum standard moving forward.
Another conventional strategy would be to take a pledge of shares over the LP. The upside of this strategy is that issues concerning transferability and possession are avoided since the licence and the inventory remain with the LP.
The potential downside to relying on a pledge of the shares of an LP is that due to security clearance requirements, there will be inherent difficulties in securing a qualified purchaser of the pledged shares. The pool of potential buyers with the necessary personnel that have security clearance may be limited and there may be significant risk and delay involved in the review process for those interested buyers that do not. Moreover, under the proposed regulations, significant shareholders owning 25 percent or more of an LP will also be subject to security clearance, further compounding the problem.
In the alternative, institutional lenders may wish to embrace the unconventional. As discussed, streaming is one possibility, but necessitates access to a licence to be truly effective.
Another option is factoring, which involves the sale of accounts receivable to a financier at a discount.
The main risk in factoring accounts receivable is that certain accounts will not be paid by delinquent customers. That said, the risk will be quite low in jurisdictions like Ontario where the principal purchaser of recreational cannabis from LPs will be the provincial government. With medical cannabis, early indications are that large blue chip companies such as Shoppers Drug Mart will be major players. In any event, lenders considering factoring as an option should ensure that proper due diligence is conducted on any accounts receivable under consideration.
In the context of a properly constituted security agreement between a lender and an LP, there remain significant challenges ahead in the event that an LP borrower becomes insolvent.
For starters, the regulatory restrictions regarding licence and cannabis inventory apply equally to a receiver or trustee-in-bankruptcy, preventing them from assuming control over these assets or continuing the business of the LP as a going concern. These restrictions mirror those that were experienced historically in connection with liquor licences before the Ontario Liquor Licence Act and associated regulations were amended to allow for the temporary grant of a liquor licence to a court-appointed receiver, trustee-in-bankruptcy or mortgagee.
To avoid this problem, a lender may instead request that the insolvent LP make an application under the Companies’ Creditors Arrangement Act (CCAA) and, in turn, continue its operations as a debtor-in-possession under court direction. Notably, this is an entirely voluntary exercise on the part of the borrower and cannot be contractually mandated. If the LP refuses to make a CCAA application or otherwise does not qualify for CCAA protection then the only recourse available to the lender would be to have a receiver or trustee-in-bankruptcy step in.
To this end, legislators are strongly encouraged to consider specific transfer exemptions to facilitate the orderly disposition of an insolvent LP’s assets.
With the country on the doorstep of a multi-billion dollar industry, there is tremendous opportunity for debt financiers to capitalize on the many early market participants seeking non-dilutive alternatives to facilitate their expansion.
Lenders that adopt strategies that both minimize risk by maximizing security and are consistent with the future regulatory framework will be poised to be dominant players in the Canadian cannabis sector.
Amanda Balasubramanian is a partner at Torys LLP whose practice focuses on commercial banking and debt financings. She wrote this article in collaboration with Scott Bomhof, a partner specializing in all aspects of corporate restructuring and insolvency, Cheryl Reicin, a partner who focuses on life science and other technology companies and their funding sources, and Stephen Dalby, an Osgoode Hall Law School graduate working with the firm.
Photo of cannabis montage courtesy of Nastasic/E+/Getty Images
Photos of Amanda Balasubramanian and Scott Bomhof courtesy of Torys LLP
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