Cannabis Musings - November 3, 2022

Friends – I got into a friendly Twitter debate earlier this week, and just as one should never go in against a Sicilian when death is on the line, one shouldn’t go in against an ex-lawyer from New Jersey (born and raised!) on Twitter. The topic was one that’s interested me for a long time –how cannabis imports might change the US marketplace post-legalization. We’ve discussed this topic before in these Cannabis Musings (apologies that I don’t have a link), but I thought it was worth reexploring in more detail.

You may recall that, earlier this year, Democrats in the Senate introduced the Cannabis Administration and Opportunity Act (CAOA), which won’t pass, but if it did, it would legalize cannabis federally. Separately, Senator Nancy Mace (R-SC) introduced the States Reform Act (SRA), which also won’t pass, but likewise would legalize cannabis federally if it did, which it won’t. Curiously, neither of these bills (that won’t pass) included language banning the import of cannabis. Indeed, the CAOA even contemplates taxing imports.

What does it matter if neither of these bills are going to pass anyway? To me, it sends a signal that Congress isn’t too concerned about limiting the international cannabis trade, as compared to the states’ approach to the interstate cannabis trade. Longtime readers of these Cannabis Musings will know that I’ve been kvetching about how state laws are almost certainly violating the dormant commerce clause (not legal advice), the court-made doctrine based on the Commerce Clause of the Constitution that (very generally) says that states can’t impose an undue burden on interstate commerce. Like banning products from another state.

Let’s pretend the federal government legalizes cannabis and indeed allows for the import of products into the US. A handful of thoughts come to mind.

First, it would be really weird if Congress allowed for cannabis to come in from overseas, but also affirmatively allowed states to continue to limit interstate commerce, as has been proposed by some (such as Prof. Robert Mikos at Vanderbilt Law) based in policy/equity.

Second, even if Congress stayed silent on interstate commerce in legalization (neither the CAOA or SRA say anything about it), I’d expect the states to fight hard to keep their limitations in place. To be clear, legalization isn’t necessary for someone to challenge these state laws, but I think it would create a strong catalyst for it. So there could still be some weirdness post-legalization while that fight plays out.

Third, and here’s the part where I’m plagiarizing my old Cannabis Musings, the industry really needs to think about what all this would mean for domestic cultivation. I think the analog is the cut flower (the pretty kind, not the cannabis kind) trade. Cut flower production was huge in the US until the mid-20th century, when production took off in South America at a much lower cost. US cultivation of cut flowers never really recovered, other than for small producers.

Would the same thing happen to US cannabis cultivation? I have no idea, but it seems kinda plausible to me. There certainly are already licensed growers in South America such as Clever Leaves that are producing at scale and exporting globally. Now, whether it’s cost effective is another thing, and that’s where my Twitter counterpart took issue with my thesis. Fair point! (If you’re expecting me to have done any actual research into cost/pricing, you haven’t been reading these Cannabis Musings for long enough, but #Cannabis Twitter doesn’t know that.) However, I can’t imagine production and transportation getting more expensive over time as companies scale and global commerce increases.

The other counter to my thesis made by my sparring partner is that US cannabis customers are too discerning for mass-produced generic cannabis, so it simply won’t compete with the more specialized varieties of US cannabis. I think, however, that this is taking too narrow of a view of the future of US cannabis. His point may be somewhat correct regarding today’s average cannabis consumer, but I think it’s wrong going forward.

I’ve always speculated that this industry will eventually look like the beer industry – a handful of companies producing highly-branded, widely-distributed, mass-produced products with little typicity (to borrow a wine word); many regional, local, and hyperlocal producers of artisanal products for enthusiasts; and very little in-between. Beer isn’t the only CPG that has this kind of market structure, but it’s the best analogy I can think of. It’ll be an hourglass-shaped market.

It’s going to take a long time to get to that point (though it’s starting to shape up that way), but it will be driven in part by the need for the industry to attract customers who are new to cannabis. Growth in legacy states continues to flatten out in part because that base of legacy users is finally being satisfied. The newer uses who will drive future growth and expansion aren’t going to be as interested in high-end cannabis by their very nature – new wine drinkers don’t demand Domaine de la Romanée-Conti (very high-end Burgundy), they drink inexpensive, mass-produced wines, and there’s nothing wrong with that. Form factors (insider term!) such as beverages and edibles continue to improve in technology and provide the convenience and accessibility necessary for broad consumption. Nationally-recognized branding is still in its infancy.

In short, I think that there will eventually be demand for both high-end, locally-produced, artisanal domestic cannabis, and lower-quality, mass-produced, generic cannabis, whether it’s produced domestically or outside of the US. There’s room for both the expensive stuff and the cheap stuff.

What does it mean then for US cultivators if my thesis is correct? Whatever happens, it’ll be fartoost. As far as I can tell, the industry isn’t really talking about this, but I think it should be.

Be seeing you.

© 2022 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.

Cannabis Musings - October 27, 2022

Friends – I’ve been reading the Canopy Growth filings so you don’t have to. In case you missed it, Canadian licensed producer Canopy Growth Corporation, filed a dense press release on Tuesday announcing its plans to finally close on the acquisition of US-based Acreage, Jetty, and Wana, consolidating those assets into a single US holding company, buy back some debt at a discount, and adjust its relationship with Constellation Brands. There’s a lot going on, but I’m going to focus on trying to answer the question that I got from numerous Musings readers over the past two days – is this a way for MSOs to list on the Nasdaq? The short answer is “probably not”. The long answer is sort of explained below.

For some background, Canopy is a Canadian cannabis company whose common stock trades both on the Toronto Stock Exchange and the Nasdaq (so investors in both the US and Canada have direct access to those shares). Canopy, like other Canadian licensed producers, differs from US-based cannabis companies in that, as you most likely know, cannabis is legal in Canada. So, the TSX and Nasdaq are happy to take Canopy’s fees and list its stock. The TSX and Nasdaq don’t want to list the stock of US operators because, well, you know, so those companies list their stock on the Canadian Stock Exchange and Canada’s NEO Exchange, which have a higher tolerance for lawbreaking.

Canopy’s access to the TSX and Nasdaq is critical to its capital markets strategy, because those exchanges attract much more volume and liquidity, and therefore capital, relative to the CSE and NEO. It’s the reason why US companies are so eager to “uplist”, meaning shift their exchange listing to the TSX, Nasdaq, and, maybe, someday, the NYSE (interestingly, Canopy was listed on the NYSE, but moved to the Nasdaq in November 2020). So, Canopy wants to be careful to not doing anything that would jeopardize its TSX and Nasdaq listings.

You may recall that Canopy made headlines in April 2019 by acquiring an option to purchase US-based MSO Acreage Holdings, Inc., funded in part by Constellation Brands’ $4 billion investment into Canopy Growth eight months prior. In short, Canopy paid Acreage’s shareholders for the option (or “right”) to purchase all of the stock Acreage when (effectively) cannabis is legalized in the US, although they later changed that to also allow the option to be exercised (or “done” (kinda)) when the exchanges would allow it without delisting. The key was that they didn’t actually own Acreage – they only owned the right to purchase Acreage at a certain price in the future. Canopy then effectively did the same thing with US-based Wana Brands and Jetty Extracts.

Fast forward to this week, Canopy announced that it’s actually going to acquire Acreage, Wana, and Jetty by exercising those options into a US-based holding company subsidiary, Canopy USA. How, pray tell, are they going to do that without the TSX and Nasdaq, and the various state licensing authorities, thinking that Canopy will outright own US plant-touching assets? Well, it depends upon what the definition of “own” is.

In short, Canopy will reportedly only own non-voting stock of Canopy USA, and that non-voting stock may be exchanged, at Canopy’s option, into common stock of Canopy USA (which it presumably wouldn’t do until the US legalizes cannabis, or the TSX and Nasdaq tell Canopy that they won’t delist Canopy’s stock). This is sort of like “tracking stock”, which is stock of a company, or, more usually a division of a company, that’s issued to the public, but only has economic rights by contract, without any voting or liquidation rights.

Canopy also will not control the board of directors of Canopy USA. In other words, Canopy will have an economic stake in Canopy USA, but no right to direct Canopy USA’s actions. Instead, Canopy USA is agreeing to certain “negative covenants”, which means it won’t do certain things like sell itself or borrow too much money – this gives Canopy a level of assurance that its investment won’t be thwarted.

So, I presume Canopy’s argument to the exchanges and the state licensing authorities will be “See, we don’t own Canopy USA and its plant-touching assets because we have no control over it”. And, usually, the way these things go, the lawyers call the Nasdaq ahead of time and tell them about what’s going to happen, but the Nasdaq never says “oh, sure, go right ahead”. Instead, they either say “well, we’ll make a final decision when you’ve filed all of the documents, but we’re not yet going to tell you what we think,” or they laugh so hard that the lawyers hang up the phone and get their final invoice prepared.

I’m presuming the former happened here, but, apparently the Nasdaq isn’t totally in agreement yet. One of the reasons Canopy stated for closing the acquisitions of the US companies is to be able to consolidate those companies on its financial statements under US GAAP. Well, according to Canopy’s proxy statement it filed earlier today, Nasdaq doesn’t necessarily agree with that:

Nasdaq has objected to Canopy consolidating the financial results of Canopy USA in the event that Canopy USA closes on the acquisition of Wana, Jetty or the Fixed Shares of Acreage. Nasdaq has proposed that such consolidation is impermissible under Nasdaq’s general policies. The Company intends to comply with the SEC’s guidance on the application of U.S. GAAP for financial reporting purposes. The Company disagrees with Nasdaq’s potential application of its general policies as the basis for its objection since it contradicts the Company’s financial reporting requirements under U.S. GAAP including its application to THC plant touching businesses. While we are in regular dialogue with our auditors, regulatory bodies and the stock exchanges, there is no assurance that Nasdaq will harmonize their general policies with the SEC accounting guidance.

We’ll see how that plays out. The press has also picked up on this unexpected nugget in the proxy. In the meantime, back to the question of what this means for everyone else. Could a US-based MSO replicate this structure and somehow list its stock on the Nasdaq?

One way to think about this is whether Canopy could list Canopy USA’s non-voting stock separately on the Nasdaq (Canopy said publicly on a conference call that it hadn’t really thought about trying to list Canopy USA on the Canadian Securities Exchange). I suppose that, if the Nasdaq allows Canopy to remain listed while it owns non-voting stock of Canopy USA, because that non-voting stock isn’t “ownership”, then that same non-voting stock in the hands of a public shareholder would similarly not be “ownership” and should therefore be kosher (utilizing the “goose-gander principle”, to quote an old friend).

What then would prevent an MSO from restructuring so that it becomes a holding company with Nasdaq-listed stock that’s sold to the public, and that owns only non-voting stock of the US plant-touching assets, which may be flipped into common stock upon legalization? Well, I’m no longer a practicing lawyer, and none of these Cannabis Musings were ever legal advice anyway, but I think that, in theory, it could maybe work. In theory.

We’ll have to see whether the Nasdaq blesses this approach. It would also require a very large lift to shift around an entire corporate structure, likely including approvals of every state and local licensing authority. It would require public investors to be willing to purchase stock in a company that only owns non-control interests in US assets, which is weird. Tracking stocks offer something of a precedent for that, but tracking stock tends to be used for, say, divisions of a larger public company, not the entire thing. I’m certain that I’m missing other issues, but I’m also highly confident that many smart lawyers and bankers are right now burning hours trying to figure out whether this same needle can be threaded twice.

To me, what I love about this transaction is that it showcases the boundless creativity of the cannabis industry, working within massive constraints to continue to move forward. It’s crazy, but it just might work.

Be seeing you.

© 2022 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.

Cannabis Musings - October 12, 2022

Friends – as promised in the last Cannabis Musings, this is The One about MedMen’s Illegality Claim. In case you missed it, multi-state operator MedMen is arguing in Federal court that a lease it signed, and then stopped paying rent on, should not be enforced because cannabis is illegal, which is funny.

Now, you might be thinking that this gambit is the height of chutzpah, but these Cannabis Musings serve to explain, not to judge. I won’t get into the details of the case filed by Thor Equities, MedMen’s landlord, to collect on unpaid rent, because they’re boring, but what you need to know is that Thor Equities sued MedMen in Federal court.

MedMen filed a motion on September 28th, 2022, asking the court to dismiss Thor Equities’ case, saying the lease is unenforceable because both MedMen (by selling cannabis) and Thor Equities (by leasing the property to MedMen to sell said cannabis) are breaking Federal law. (I’m paraphrasing from MedMen’s Memorandum of Law, but I can’t link to it because, although it’s publicly-available on the Federal courts’ docketing system, you have to register and pay for access, much to the annoyance of everyone.) Despite what you may think, it’s not a novel or frivolous argument - the motion cites a number of cases where a Federal court refused to enforce an agreement because it involved cannabis.

Indeed, the policy that courts should not be enforcing contracts to do illegal things (e.g., trafficking in raw milk or Mogwai) has been a fear for the cannabis bar for a while now. Although many states’ cannabis laws include a section affirming that cannabis contracts don’t violate public policy (effectively squelching the illegality defense in those states’ courts), there’s no such thing at the Federal level because, well, that wouldn’t make sense.

In response to this concern, diligent lawyers include a provision in cannabis industry contracts saying that the agreement doesn’t violate public policy and that the parties won’t try to argue illegality as a reason to cancel it. Funny enough, however, according to Thor Equities’ lawyer, the lease actually included this magic language. Nonetheless, there remains the paradox of whether that contract language is enforceable if the contract itself is unenforceable. Another example of how cannabis law is weird.

It’s part of a lawyer’s job to come up with arguments that make you go “hmmm” – indeed, lawyers are ethically bound to act “with zeal in advocacy upon the client’s behalf.” MedMen’s curious position has a real basis in law, and it’ll be interesting to see how it plays out. And if other cannabis tenants take a similar tack on their defaulted leases. (None of this is legal advice, by the way.)

Separately, TerrAscend announced today that it borrowed $45 million from Pelorus Equity Group. The press release doesn’t have a lot of detail, and the loan agreement isn’t filed publicly yet, but it does note that it’s a 5-year loan, with 36 months of interest-only payments and no warrant coverage (meaning no equity was issued to Pelorus as a kicker). The interesting datum is that the current interest rate is 12.77%, and the rate adjusts based on the changes in the one-month SOFR (the secured overnight financing rate that replaced LIBOR, for various reasons that only bankers and their lawyers care about). The press release doesn’t say this outright, but one-month SOFR is currently 2.77%, so the loan’s interest rate is one-month SOFR plus 10%.

Why is this interesting to me? Two reasons. First, many of the loans to MSOs that we saw over the past two years were made at fixed rates of interest. Now that the Federal Reserve is raising interest rates generally (something that didn’t happen for many years), lenders foresee that trend continuing (indeed, the Fed has said as much), so by making a term loan with a rate that adjusts based on prevailing rates of interest (SOFR is a widely-used metric for adjustable-rate loans), the lender is protected if rates continue to rise (it’s bad for the borrower though, which will have to pay more interest as rates go up). That Pelorus made this loan using an adjustable rate not only suggests that Pelorus is concerned about rising rates, but also suggests that cannabis borrowers have less leverage to demand a fixed rate in a rising rate environment.

Second, one-month SOFR + 10% is a higher interest rate than many of the loans we saw made in the past two years to cannabis MSOs. For example, about this same time last year, Trulieve borrowed $350 million at 8% fixed, and Jushi borrowed $100 million at 9.5% fixed. Credit is tightening, as it’s said, but particularly so in cannabis.

Be seeing you.

© 2022 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.