Attorney Advertising www.kramerlevin.com © 2015 Kramer Levin Naftalis & Frankel LLP Alternative Assets ARTICLE OF INTEREST April 2015 Key Considerations for Investing in Marijuana Companies As the state-by-state legalization of marijuana continues to spread with little federal intervention, and in the wake of high-profile investments, increasing numbers of sophisticated investors are taking a closer look at opportunities in the marijuana industry. However, the continuously evolving legal landscape is complicated and contradictory, and investments require a heightened level of due diligence. This article provides a brief summary of the current market, both tailwinds and headwinds, and identifies key considerations for asset managers and other investors to bear in mind when analyzing potential investment opportunities. State of the Market The trend toward liberalization is uneven, but all signs indicate that the legalization of both medical and recreational marijuana will continue to gain ground: At the state level, 23 states have legalized the growth and sale of marijuana for medical purposes, and since 2012, Colorado, Washington, Alaska and Oregon have all legalized it for recreational purposes. Serious ballot and legislative actions are currently being planned for legalization in 2015 and 2016 in numerous additional states.1 At the federal level, recent official positions on criminal prosecution and banking reflect the Obama administration’s permissive approach to state reform.2 The most recent broad guidance issued by the Department of Justice to federal prosecutors, referred to as the “Cole Memo,” identifies eight enforcement priorities — such as preventing the distribution of marijuana to minors, preventing revenues generated from marijuana sales going to gangs and cartels, etc. — and otherwise accords a measure of respect for state legalization regimes, even with respect to large-scale, for-profit enterprises.3 The Department of the Treasury Financial Crimes Enforcement Network (“FinCEN”) subsequently issued its own guidance to clarify how financial institutions can provide services to marijuana-related businesses, and satisfy federal reporting requirements under the Bank Secrecy Act, consistent with those priorities.4 Although estimates vary widely, the market is robust. One industry research group has calculated the state-legal marijuana market at $2.7 billion for 2014,5 an increase of more than $1.0 billion from 2013. A recent Forbes article identifies the total U.S. marijuana market, including the black market, at $50 billion.6 In January, the SEC allowed the registration statement of a company with a business line dedicated to the growth and sale of marijuana to go effective,7 and several registration statements for other companies are currently on file with the SEC.8 Indeed, one index www.kramerlevin.com Alternative Assets ARTICLE OF INTEREST specializing in marijuana companies reports nearly 150 publicly traded companies with varying ties to the marijuana industry.9 The spending bill passed by Congress in December 2014 prohibits federal funds from interfering with the medical marijuana regimes of D.C. and 32 listed states.10 A Department of Justice spokesperson recently voiced the view that this spending bill does not preclude proceedings against individual, state-legal marijuana companies, and that the spending bill instead only stops the Department from “impeding the ability of states to carry out their medical marijuana laws.”11 Representative Sam Farr, co-sponsor of the amendment to the spending bill, responded to this interpretation strongly: “The Justice Department’s interpretation of the amendment defies logic. . . . No reasonable person thinks prosecuting patients doesn’t interfere with a state’s medical marijuana laws. Lawyers can try to mince words but Congress was clear: Stop going after patients and dispensaries.”12 While it remains to be seen how broadly the preclusion on impeding state-legal medical marijuana will be interpreted in the future, the spending bill is the strongest sign yet that Congress is acting to clarify the legal framework for state-legal marijuana, as further indicated by recent bipartisan legislation introduced in the U.S. Senate relating to medical marijuana.13 The investment opportunity is not to be taken lightly, however, as many serious issues remain unresolved: At the federal level, marijuana is still classified as a Schedule I drug, along with heroin, LSD and ecstasy, by the Controlled Substances Act (the “CSA”).14 As such, the CSA makes it illegal to manufacture, distribute or dispense marijuana. Although infrequent, federal enforcement activities have targeted state-legal marijuana operations.15 And while the Cole Memo makes clear that state-regulated industry participants are not an enforcement priority, it is not an absolute preclusion on prosecutions and it explicitly preserves an ability to challenge state regulatory structures that are “not sufficiently robust.” Similarly, while the FinCen guidance provides clarity to financial institutions on how to provide financial services to marijuana-related businesses, the detailed due diligence and reporting requirements described in the guidance constitute significant and untested undertakings. At the state level, a patchwork of varying models makes a one-size-fits-all approach to investment decisions impossible. For medical marijuana, differences across the state models include the amount of marijuana that patients may possess and the number of plants they may grow, whether dispensaries are allowed, the types of medical conditions legally treatable with marijuana, and whether other states’ medical cards are recognized.16 States also vary on the form of medical marijuana they allow. Many states — such as Alabama, Tennessee and Utah — restrict THC concentrations, while New York’s recent reform prohibits smoking marijuana.17 Notwithstanding the large number of companies with SEC-registered securities, the market segment has been the subject of investor warnings from both the SEC and FINRA.18 Both organizations have identified concerns about the accuracy of publicly available information of marijuana companies and pump-and-dump schemes, and the SEC’s warning was accompanied by trading suspensions of a number of marijuana companies. To date, we are unaware of any marijuana companies that have been listed on a major exchange. In spite of these challenges, however, entrepreneurs across the country are seeking capital to take advantage of state and federal liberalization, and investors who are willing to accept the inherent risks will have numerous investment opportunities. www.kramerlevin.com Alternative Assets ARTICLE OF INTEREST Key Investment Considerations While any investment in a marijuana enterprise requires sophisticated legal advice and extensive due diligence, below are certain high-level considerations relevant to investors: Stay abreast of changing priorities and developments in the regulatory landscape. While the overall trend has been toward liberalization in recent years, federal and state policies may change with elections, appointments or other factors. For instance, at a Senate confirmation hearing, recently confirmed Attorney General Loretta Lynch voiced her disagreement with President Obama’s ambivalence toward state efforts to legalize marijuana,19 while, as noted above, some federal authorities continue attempts to close state-legal marijuana businesses.20 In addition, while the Cole Memo provides substantive guidance on the Department of Justice’s key enforcement priorities and Treasury Department guidance offers some clarity to banking institutions, it is clear that additional guidance will be necessary at the federal level, which may supersede some or all of the prior guidance. Understand the impact of regulation on the specific investment opportunity. While federal and state regulation and enforcement focus on the possession, growth and distribution of marijuana, investors need to understand the impact of regulation even on businesses that do not “touch the bud.” In addition to the ancillary economic risks to businesses that serve those that do grow and/or distribute marijuana, each business should be evaluated from a legal risk perspective in its own right. For instance, it is illegal to sell “drug paraphernalia,” which is broadly defined by statute to mean “any equipment, product or material of any kind which is primarily intended or designed for use in manufacturing, compounding, converting, . . . producing, processing, preparing . . . a controlled substance, possession of which is unlawful.”21 This could be read to include any number of products not conventionally understood to fall within this terminology. Furthermore, even if investment is limited to medical marijuana companies, investors should ensure that the companies in which they invest are enforcing compliance with state-based prescription guidelines and prevent diversion to recreational use. As noted, state regimes vary widely, and each state in which an investee company operates must be closely examined, including with respect to planned initiatives. Review investment guidelines. In addition to weighing potential reputational risks associated with investing in marijuana companies, asset managers should be familiar with their institutional investor and fund guidelines. As well as general compliance with law restrictions and “vice industry” limitations, there may be other, less-obvious guidelines that an investor seeking to exit a fund prematurely may attempt to rely on to facilitate an early redemption. Identify banking and cash security risks. Nationally chartered banks have thus far been unwilling to make financial services available to growers and sellers, notwithstanding federal guidance designed to allay some of the concerns. As discussed above, FinCEN has issued guidance to banks offering financial services to marijuana companies providing that, while banks generally must file a “Suspected Activity Report” (“SAR”) to report suspected illegal activity, a new “Marijuana Limited” category of SAR may be filed where banking services are provided to legal marijuana businesses not implicating any of the eight Cole Memo priorities.22 Compliance with such filing is costly, however, and banking access remains difficult, prompting many marijuana businesses to operate as all-cash ventures. This raises unique risks — for instance, what physical security measures is the business taking to protect its cash, and how will a lender perfect its lien on cash of an operating business via possession? Operating all-cash ventures also raises anti-money-laundering concerns, particularly in light of the federal investigation of a Colorado medical marijuana business with alleged connections to www.kramerlevin.com Alternative Assets ARTICLE OF INTEREST a Columbian drug cartel.23 Accordingly, investors need to thoroughly review potential investees’ cash accounting and security measures. Ensure appropriate insurance coverage. Setting aside the question of how general insurance providers will address loss exposures connected with marijuana,24 the marijuana industry is increasingly looking to specialty insurance providers for coverage. States that have legalized medical or recreational marijuana have therefore seen insurance companies create wideranging specialty coverage products, including insurance for “physicians who recommend [marijuana], dispensaries, growers, crops, landlords and even special events like medical marijuana conventions.”25 The president of the Insurance Information Institute acknowledged that the industry will face a learning curve, but noted that “[i]n the greater scheme of things, this is probably not the riskiest or most difficult of businesses for insurers to break into.”26 Given the novelty of this business, as well as the largely untested conflicts of law issues between state and federal authorities, a person or company seeking insurance for marijuanarelated activities should pay careful attention to policy exclusions relating to violations of law. The fact that a particularly activity is permitted under state law but criminalized under federal law should be considered in analyzing the insurer’s ability to invoke such an exclusion. Perform a heightened level of due diligence. In addition to understanding the banking, security and insurance issues raised above, investors should perform a thoughtful and creative due diligence process in general. While the precise steps will depend on the business being analyzed, due diligence should include among other things a real understanding of exactly who owns and runs the business, beyond customary background checks; a careful review of license applications and accompanying materials, rather than just confirmation that the proper licenses are held; a review of the intangible assets the business may own including formulae, growing techniques, trade secrets, trademarks, logos and packaging, as well as the availability of any federal or state registration of such intellectual property rights in light of the status of marijuana under federal law; and a thorough understanding of the nature of any loan collateral and how downside scenarios may play out in practice. Realistically assess exit opportunities. Although one can imagine that a cash-flowing business with a history of strong compliance will be attractive to private equity or other acquirers once the industry has matured, the IPO route is less certain. To date the SEC has allowed a registration statement to become effective, but that process requires the passage of 20 days following completion of the SEC’s review rather than a customary acceleration of effectiveness. As such, pricing an offering presents challenges, in addition to the challenge of generating interest from institutional investors in an IPO in the first place. In addition, even for companies with SEC registration that meet the quantitative criteria of the exchanges, the NYSE and NASDAQ have broad discretion to deny listing based on qualitative criteria.27 Accordingly, investors may want or need to stay in even an attractively performing business for a longer time horizon than is customary. Upcoming Developments The legal landscape is constantly evolving at both the federal and state level. Below are a few developments investors should monitor: Ongoing state legalization efforts. Oregon and Alaska currently have recreational marijuana regimes coming into effect this year. Washington, D.C. voters also passed a statute legalizing recreational marijuana, although in its December federal budget compromise, Congress exercised its constitutional power over D.C. to attempt to block the implementation of the NEW YORK 1177 Avenue of the Americas New York, NY 10036 212.715.9100 SILICON VALLEY 990 Marsh Road Menlo Park, CA 94025 650.752.1700 PARIS 47 Avenue Hoche 75008 Paris +33 (0)1 44 09 46 00 www.kramerlevin.com Alternative Assets ARTICLE OF INTEREST statute.28 Meanwhile, additional legalization efforts are being made in states across the nation,29 including Vermont, California and Nevada. Inter-state disputes. Nebraska and Oklahoma have filed an original action with the Supreme Court seeking invalidation of Colorado’s recreational marijuana legislation.30 It remains to be seen whether the Supreme Court will agree to hear the case. In any event, states favoring prohibition will certainly continue to call for strong measures to limit the interstate travel of marijuana, in line with the Justice Department’s priority of preventing the diversion of marijuana from states where it is legal under state law in some form to other states. Increasing banking access. Because of the difficulty in securing banking services under current law, notwithstanding the FinCEN guidance apparently aimed to facilitate the provision of banking services, some states are acting to develop additional measures for ensuring that marijuana companies have access to financial services31 and credit unions are also beginning to offer banking services to marijuana companies.32 Schedule I classification. The ultimate regulatory clarification would be the reclassification of marijuana under the CSA. Given that nearly half the states have legalized medical marijuana and additional ballot initiatives are under way, there is increasing pressure for the federal government to reconsider its classification of marijuana under the CSA. Schedule I drugs, including marijuana, are defined to have “no currently accepted medical use and a high potential for abuse,” but the U.S. Surgeon General recently stated that “we have some preliminary data showing that for certain medical conditions and symptoms, that marijuana can be helpful,” further stating that such data should “drive policy-making.”33 When — and whether—that pressure will be significant enough to lead to Congressional action such as adoption of the recently introduced bipartisan legislation34 is an open question. * * * The array of legal issues in the marijuana industry is unique in both breadth and depth. However, as serious investment firms enter the marijuana industry, those that manage to successfully navigate the numerous hurdles stand to gain an early foothold in this emerging multibillion-dollar industry. If you have any questions about this article, please contact the authors or any of your Kramer Levin contacts. John Bessonette firstname.lastname@example.org Jeffrey Taylor email@example.com Tai Aliya firstname.lastname@example.org * * * This memorandum provides general information on legal issues and developments of interest to our clients and friends. It is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters we discuss here. Should you have any questions or wish to discuss any of the issues raised in this memorandum, please call your Kramer Levin contact. Alternative Assets ARTICLE OF INTEREST 1 See, e.g., Niraj Chokshi, What’s next for the marijuana movement, The Washington Post (Nov. 6, 2014), http://www.washingtonpost.com/blogs/govbeat/wp/2014/ 11/06/whats-next-for-the-marijuana-movement/. 2 President Obama on legalization: “The position of my administration has been that we still have federal laws that classify marijuana as an illegal substance, but we’re not going to spend a lot of resources trying to turn back decisions that have been made at the state level on this issue.” Niraj Chokshi, Obama on marijuana legalization: ‘My suspicion is that you’re gonna see other states start looking at this,’ The Washington Post (Jan. 22, 2015), http://www.washingtonpost.com/blogs/govbeat/wp/2015/ 01/22/obama-on-marijuana-legalization-my-suspicion-isthat-youre-gonna-see-other-states-start-looking-at-this/. 3 James M. Cole, Guidance Regarding Marijuana Enforcement, Memorandum for All United States Attorneys, U.S. Department of Justice (Aug. 29, 2013), http://www.justice.gov/iso/opa/resources/305201382913 2756857467.pdf. 4 BSA Expectations Regarding Marijuana-Related Businesses, Department of the Treasury Financial Crimes Enforcement Network (Feb. 14, 2014), http://www.fincen.gov/statutes_regs/guidance/pdf/FIN- 2014-G001.pdf. 5 The State of Legal Marijuana Markets, 3d Ed., The ArcView Group (Jan. 26, 2015), http://www.arcviewmarketresearch.com/executivesummary/. 6 Mark Fidelman, Why Legalizing Medical Marijuana Will Make Investors Extremely Wealthy, Forbes (Nov. 4, 2014), http://www.forbes.com/sites/markfidelman/2014/11/04/w hy-legalizing-medical-marijuana-will-make-investorsextremely-wealthy/. 7 Gregory J. Millman, SEC Allows Pot Dealer to Register Stock Shares, The Wall Street Journal (Jan. 28, 2015), http://blogs.wsj.com/riskandcompliance/2015/01/28/secallows-pot-dealer-to-register-stock/. 8 Bill Meagher, S-1s no longer pipe dreams for dope companies, The Deal Pipeline (Jan. 23, 2015), http://pipeline.thedeal.com/tdd/ViewArticle.dl?id=100071 064040. 9 MJIC Marijuana Index Series, http://marijuanaindex.com/index-global/ (last visited Feb. 18, 2015); see also Bill Meagher, S-1s no longer pipe dreams for dope companies, The Deal Pipeline (Jan. 23, 2015), http://pipeline.thedeal.com/tdd/ViewArticle.dl?id=100071 064040 (estimating the total number of public marijuana companies to be around 250). 10 Consolidated and Further Continuing Appropriations Act, 2015, § 538 (Dec. 9, 2015), http://www.gpo.gov/fdsys/pkg/CPRT- 113HPRT91668/pdf/CPRT-113HPRT91668.pdf. 11 Timothy M. Phelps, Justice Department says it can still prosecute medical marijuana cases, Los Angeles Times (Apr. 2, 2015), http://www.latimes.com/nation/nationnow/la-na-nnmedical-marijuana-abusers-20150401-story.html. 12 Matt Ferner, Congressmen Say DOJ's Interpretation Of Their Medical Marijuana Amendment Is ‘Emphatically Wrong’, Huffington Post (Apr. 3, 2015), http://www.huffingtonpost.com/2015/04/03/doj-medicalmarijuana_n_6997016.html. 13 David Kroll, Senators Introduce Bill To End Federal Curbs On Medical Marijuana, Forbes (Mar. 11, 2015), http://www.forbes.com/sites/davidkroll/2015/03/11/iscongress-planning-to-legalize-marijuana/. 14 The Controlled Substances Act, 21 U.S. Code § 812(b). 15 See e.g. Matt Ferner, DEA Raids 2 Los Angeles Medical Marijuana Dispensaries, The Huffington Post (Oct. 24, 2014), http://www.huffingtonpost.com/2014/10/24/dea-raidmedical-marijuana-los-angeles_n_6038926.html; (but see also Matt Ferner, Carly Schwartz, Members Of Congress Stand Up For California Medical Marijuana Dispensary, The Huffington Post (Feb. 17, 2015), http://www.huffingtonpost.com/2015/02/17/congressmedical-marijuana_n_6702128.html). 16 For a discussion of the various differences among state regimes, see, e.g., State Medical Marijuana Laws, Alternative Assets ARTICLE OF INTEREST The National Conference of State Legislators (Jan. 1, 2015), http://www.ncsl.org/research/health/statemedical-marijuana-laws.aspx. 17 Philip M. Boffey, New York’s Not-So-Perfect Medical Marijuana Law, The New York Times (June 20, 2014), http://takingnote.blogs.nytimes.com/2014/06/20/newyorks-not-so-perfect-medical-marijuana-law/?_r=0. 18 Investor Alert: Marijuana-Related Investments, U.S. Securities and Exchange Commission (May 16, 2014), http://www.finra.org/Investors/ProtectYourself/InvestorAl erts/FraudsAndScams/P325352; Marijuana Stock Scams, Financial Industry Regulatory Authority (May 29, 2014), http://www.finra.org/Investors/ProtectYourself/InvestorAl erts/FraudsAndScams/P325352. 19 Matt Ferner, Loretta Lynch Says She Doesn't Support Marijuana Legalization Or Obama's Views On Pot, The Huffington Post (Jan. 28, 2015), http://www.huffingtonpost.com/2015/01/28/loretta-lynchmarijuana_n_6565962.html. 20 Carly Schwartz, Justice Department Continues To Crack Down On Medical Marijuana In California, The Huffington Post (Feb. 3, 2015), http://www.huffingtonpost.com/2015/02/03/harborsidemelinda-haag-appeal_n_6608768.html. 21 The Controlled Substances Act, 21 U.S. Code § 863. 22 BSA Expectations Regarding Marijuana-Related Businesses, Department of the Treasury Financial Crimes Enforcement Network (Feb. 14, 2014), http://www.fincen.gov/statutes_regs/guidance/pdf/FIN- 2014-G001.pdf. 23 See, e.g., John Ingold, Figure in Colorado medical marijuana raids likely to plead guilty, The Denver Post (Feb. 3, 2015), http://www.denverpost.com/news/ci_27444362/figurecolorado-medical-marijuana-raids-likely-plead-guilty. 24 The Marijuana Quandary, The American Association of Insurance Services (2014), http://www.aaisonline.com/Portals/0/AAISDocuments/Vi ewpoint/Online%20Articles/Summer%202014/2014_Su mmer.pdf. 25 Lori Widmer, Marijuana: The Implications of Legalization, Risk Management (Apr. 1, 2014), http://www.rmmagazine.com/2014/04/01/marijuana-the- implications-of-legalization-for-insurance-and-theworkplace/. 26 Id. 27 Overview of NYSE Quantitative Initial Listing Standards, The New York Stock Exchange, https://www.nyse.com/publicdocs/nyse/listing/NYSE%20 _Initial_Listing_Standards_Summary.pdf; Initial Listing Guide, The NASDAQ Stock Market, https://listingcenter.nasdaqomx.com/assets/initialguide.p df. 28 Consolidated and Further Continuing Appropriations Act, 2015, § 809(a) (Dec. 9, 2015), http://www.gpo.gov/fdsys/pkg/CPRT- 113HPRT91668/pdf/CPRT-113HPRT91668.pdf. 29 See, e.g., Niraj Chokshi, What’s next for the marijuana movement, The Washington Post (Nov. 6, 2014), http://www.washingtonpost.com/blogs/govbeat/wp/2014/ 11/06/whats-next-for-the-marijuana-movement/. 30 Lyle Denniston, SCOTUSblog (Dec. 19, 2014), http://www.scotusblog.com/2014/12/two-states-sue-toblock-colorado-marijuana-markets/. 31 See, e.g., Keith Coffman, Colorado lawmakers OK coop banking option for marijuana sellers, Reuters (May 8, 2014), http://www.reuters.com/article/2014/05/08/ususa-marijuana-colorado-idUSBREA3M27X20140508. 32 Marguerite Arnold, Marijuana Banking Blossoms: O Bee Credit Union Goes "Green" By Targeting Pot Customers, MainStreet (Feb. 4, 2015), http://www.mainstreet.com/article/marijuana-bankingblossoms-o-bee-credit-union-goes-green-by-targetingpot-customers. 33 Juliet Lapidos, ‘Marijuana Can Be Helpful,’ Admits Surgeon General, The New York Times (Feb. 5, 2015), http://takingnote.blogs.nytimes.com/2015/02/05/marijua na-can-be-helpful-admits-surgeon-general/?_r=0. 34 David Kroll, Senators Introduce Bill To End Federal Curbs On Medical Marijuana, Forbes (Mar. 11, 2015), http://www.forbes.com/sites/davidkroll/2015/03/11/iscongress-planning-to-legalize-marijuana/.