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Receivership for Cannabis Business Investors

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April 08, 2020

The market downturn has, unfortunately, forced many cannabis operators out of business.  You’re even seeing bankruptcies roll in for cannabis businesses in Canada because it’s federally legal in that country.  Other cannabis operators are facing tough times as customers are forced to stay home and partners aren’t able to run their business as usual. 

As we covered in a previous post, Federal regulations outlawing cannabis mean that filing for bankruptcy protection is not an option for cannabis operators. The only option for cannabis businesses in trouble is something called receivership

Receivership is a financial process in which a trustee – a legally appointed custodian – steps in to restructure the company to avoid bankruptcy. Receivership allows a court-appointed person to either attempt to turn the business around or help liquidate assets and pay off obligations including debt owed to investors. 

Receivership is a good option for cannabis investors if the business took on a debt note versus if they’ve offered you an equity stake in the company. In an equity arrangement, there’s no obligation for the company to pay you back: as a result, you could leave the receivership arrangement of your cannabis business empty-handed. However, if you’re in a debt-relationship, receivership can help you recover some financial resources from the cannabis business. It’s also a good option if you entered into a Joint Venture deal with a cannabis company and are owed money from the deal. This is considered a debt that must be repaid.

Our team is seeing lots of movement among the early entrants to the cannabis market. Many cannabis businesses were founded when recreational cannabis was first legalized, and may have entered the industry for the wrong reasons. They wanted to cash in on the so-called “Green Rush” – and maybe you’re one of those people who believed the hype. We work with many cannabis operators who got in over their heads: the market hasn’t unfolded quite the way the media predicted it would. For many of those early adopters, working in the cannabis market has proven to be an uphill battle they’d rather not fight.

Receivership is a good option for those seeking to exit the cannabis market and still recoup some of the resources you’ve invested in this business. 

There is a nuance to receivership that makes it an appealing option for investors. If you have a debt note or loan out to a cannabis business, then you can ask a court to force that cannabis business into receivership. The business will have no choice but to be taken over by a court-appointed receiver and out of the current operator’s hands. 

One last thing to note before we dive into details is that you don’t have to be a third party investor to enter into receivership.  Many cannabis businesses were funded by the founders and on the books, that initial capital contribution may have been journaled as a loan to the company.  Yes, you may have equity in the business as well, but your loan to the company is debt that it owes you back, but surely that depends on the details of the agreement you signed.

Here’s what to expect when you trigger receivership for a cannabis business that you invested in.

Role of Receivership

When a court appoints a receiver, that person takes over the management of a cannabis business’s assets and properties. A receiver’s role is similar to that of a bankruptcy trustee. 

This person will serve as new management to manage, sell, or maintain assets with the ultimate goal of trying to pay creditors and stabilize the company toward recovery. “A receiver can provide quick, interim equitable relief, as well as long-term preservation and management of property,” one panel of experts described in Equity Receiverships: Forensic Strategy in Business Takeovers, a presentation from March 2020. 

While a receiver has a fair amount of discretion as to how they want to proceed to triage the business, their duties and responsibilities are set forth by the court. The judge has broad discretion in setting forth the receiver’s powers. If the receiver is unable to recover the business, the court may order the liquidation of all assets. This liquidation will be managed by a liquidator assigned by the court. 

Breadth of Receiverships

How much power does the receiver actually gain over the cannabis company? 

The breadth of a receivership depends on the circumstances and the court’s orders. A receivership can be for a limited purpose, such as to preserve property pending a lawsuit judgment or foreclosure sale. Or, a receivership can be used as a foreclosure alternative wherein investors and creditors can have someone manage assets instead of claiming them as collateral. It’s also a possible alternative to bankruptcy, in which a stakeholder who wishes to liquidate a property can ask the court to assign a receiver to do so responsibly. 

SEC guidance says that receivers are generally given lots of leeway in managing a business in trouble: “Courts typically grant broad powers to receivers, including the authority to sue on behalf of the receivership and to gather, manage and liquidate receivership assets on behalf of potential creditors and harmed investors.” 

Why should you consider receivership? 

There are a few reasons why a receivership might be right for your cannabis business. 

First, receivership can rescue deteriorating collateral. This person can quickly safeguard and preserve your assets or stop fraud if you fear embezzlement is destroying your business. Maybe a loan was backed by a building or some type of equipment that could be damaged, misused or stolen.  In this instance, a court-appointed receiver can take over accountability for that asset. 

Receivership helps eliminate mismanagement and intentional misconduct. If you’re worried that a few bad actors within the cannabis business are purposely committing fraud, diverting cash or intentionally running the business into the ground, then a receiver may be your best ally. “The SEC typically recommends the appointment of a receiver in cases in which the SEC fears a company or an individual may dissipate or waste corporate property and assets,” reads SEC guidance.

Another good reason to consider receivership is that the arrangement insulates a secured creditor from lender liability. Lender liability means that lenders must treat their borrowers fairly; when they don’t, the lender is liable for litigation from the borrower. By having someone else take control of how the borrower (which is the cannabis business) is treated and directed, you are then separated from the situation and must follow the Court’s orders.

As a creditor, receivership benefits you by freezing and ceasing all other creditor actions. Bringing in a receiver essentially moves you to the front of the line; your claim will be honored before others who may have a personal relationship with the cannabis operator or try to take advantage of the business some other way. Receiverships convey property free and clear of liens – meaning when you, the creditor, receive an asset, you can sell it without any lingering liability. 

Lastly, you can potentially buy the business outright with your initial investment.  Our team has already witnessed cases where the cannabis business wants to stay in business. The receiver comes in to try to triage existing assets and structures, thereby setting the company up to recover (rather than liquidate). But, maybe the recovery plan doesn’t work out and now it is time to liquidate.  When the receiver goes to sell off the assets, the creditor’s initial investment (your initial investment) can be used as an opening bid to buy the entire business. This is a good option for investors who believe they have the business know-how to actually run a company profitably in the cannabis industry – and remove those managers who made bad choices. If no one else outbids you for the business, then you can take it over or take on the assets yourself.

If you’re interested in this route, make sure to do a deep dive into the company’s main assets: the accounts receivable, inventory, licenses, and equipment. Inventory is the least valuable unless it can be sold quickly, given that it will have a shelf life.

What does the process of receivership look like? 

Each case of receivership is different depending on the company. That said, there are four key phases you can expect during the receivership process. 

First, the receiver will seek to stabilize the business. The goal at this stage is to try to make the company as profitable as possible. This may include lowering expenses (through layoffs, terminating leases, or selling assets) and may also include negotiating with creditors. 

Next, the receiver will dive into the reasons leading to the need for receivership in the first place. This person will try to understand what went wrong either to initiate litigation (for instance, if cases of fraud are found) or to convince insurers to adhere to the original policy terms and conditions. 

If litigation is needed, the receiver will file a lawsuit if there is an economic benefit to do so. “The receiver files lawsuits that he believes will benefit all of the investors in the entity in receivership, but he does not file claims that only benefit some investors,” describes one law expert. If you’re an investor, you may need to consider pursuing an individual claim if your case doesn’t match the goal of the receivership. 

Finally, the receivership ends in the distribution phase. A receiver distributes assets to investors. This can take months if not years to establish who has claim to what parts of the business. “The amount receivers distribute varies widely and depends on the facts of each case. Some receiverships return less than 5% of investors’ losses, while others recover close to 100% of investment losses,” writes the law expert

In the next article, we will discuss the benefits or receivership, the powers granted to receivers and additional considerations you may wish to discuss with one of our team members. 

If you are thinking about entering into receivership, then please reach out to us today.

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Post Tags: Business, Finance, Accounting

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