With legalization on the horizon in Canada, industry observers are increasingly concerned with how cannabis-related businesses, particularly licensed producers, will access the funds they need to succeed in a rapidly evolving and highly competitive recreational market.
To date, this has come largely in the form of equity financing. Since the 2015 federal election, more than $1.8 billion dollars 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 interest as a non-dilutive source of capital, but the existing regulations under the Access to Cannabis for Medical Purposes Regulations (ACMPR) and its impact on the ability of lenders to take adequate security — an asset pledged to guarantee the repayment of a loan — has largely hampered access for licensed producers. This is compounded by a general reluctance by institutional lenders to associate with the industry because of reputational concerns.
This has historically left licensed producers with limited borrowing opportunities, but institutional lenders are gradually becoming more willing 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 of taking adequate security. Central to this challenge are the regulatory restrictions placed on a licensed producer’s most valuable asset — its license. Currently, any cannabis license 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 a licensed producer and any person “in charge” of a producer’s facility must have security clearance from the Royal Canadian Mounted Police, a license is ineffective collateral to any would-be lender.
Even if a lender were to forego a security interest in the license, if a lender does not already have access to a license 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 license 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 (2008), 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 and the earnings of its sale, a cultivation license 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 with a valid security interest, the current regulations do not provide for the transfer or assignment of a license, without which a secured party is severely curtailed from converting the collateral into cash for debts.
This has resulted in equal parts trepidation and opportunity. While institutional lenders have been slow to provide debt financing to licensed producers, alternative lenders have enjoyed considerable success in their absence. Some of these lenders have used conventional strategies to avoid the regulatory minefield altogether (such as mortgages over real property), while 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 a licensed producer (the borrower) in exchange for, and secured against, a portion of the company’s production. Stream financiers may avoid potential illegality by either being a licensed producer themselves or by establishing or acquiring a separate vehicle that holds a license. In the latter scenario, security would be assigned to the benefit of the separate vehicle, avoiding regulatory issues in the event the lender must collect its security or collateral.
Future of Debt Financing
There has been little to no guidance on debt financing in the cannabis industry from federal or provincial regulators in Canada. For instance, while the proposed federal regulations released in November 2017 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. In the absence of such guidance, lenders to the cannabis industry cannot be certain of whether they will be able to enforce their security.
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 licensed producer. The upside of this strategy is that issues concerning transferability and possession are avoided since the license and the inventory remain with the licensed producer. The potential downside to relying on a pledge of the shares of a licensed producer is that, due to security clearance requirements, there will be inherent difficulties in securing a qualified purchaser of the pledged shares. Moreover, under the proposed regulations, shareholders owning 25% or more of a licensed producer will also be subject to security clearance.
As an alternative, institutional lenders may wish to embrace the unconventional. As discussed, streaming is one possibility, but necessitates access to a license to be truly effective. Another option is factoring, which involves the sale of accounts receivable to a financier at a discount. The main risk here 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 licensed producers 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 the context of a properly constituted security agreement between a lender and a licensed producer, significant challenges remain in the event that a borrower goes under. The regulatory restrictions regarding license 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 licensed producer as a going concern.
A lender may instead request that the insolvent producer 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 licensed producer 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.
With Canada on the doorstep of a multibillion-dollar industry, there is tremendous opportunity for debt financiers. Lenders that adopt strategies that 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.
Cheryl Reicin, Amanda Balasubramanian and Scott Bomhof are attorneys at the law firm Torys LLP.
Reicin is a partner whose practice focuses on biotechnology, medical devices, health information and other technology-based companies, as well as representing private equity/venture capital funds and investment banks that fund such companies.
Balasubramanian is a partner whose practice focuses on commercial banking and debt financing. She represents both lenders and borrowers in complex domestic, cross-border and international transactions.
Bomhof specializes in all aspects of corporate restructuring and insolvency, including court proceedings under the CCAA and the Bankruptcy and Insolvency Act, plans of arrangement under the Canada Business Corporations Act, sales proceedings, debtor-in-possession/interim financing loans and receiverships.
Stephen Dalby, an articling student with the firm, also contributed to this column.