After intense growth through the period surrounding recreational legalization in 2018, market corrections have resulted in the cannabis market slowing significantly by the end of 2019. However, positive developments from some of the largest cannabis companies in January have left many cautiously optimistic that the market bottomed out in 2019 and will see renewed growth in 2020.

The fact that the Canadian cannabis market is highly regulated is a reality that infuses any transaction involving a cannabis business. There has been speculation that heavy regulatory requirements could be partially to blame for the recent market slow-down. As the industry re-groups for 2020 and beyond, it is important that businesses interested in cannabis-related M&As understand how to navigate the complex regulatory requirements, including security clearances for certain specified individuals.

As discussed in Cannabis Security Clearance Legal Requirements: Getting it Done Right, the security clearance process can be time-consuming and, if there are issues with an application, may be subject to frustrating delays. This is relevant to anyone involved in a cannabis M&A transaction. Acquirers, targets and underwriters alike will want to ensure the security clearances required on both the operational and ownership sides of the business are in place prior to an acquisition so as to avoid damaging regulatory delays.

Therefore, businesses should appreciate that regulatory due diligence must be a significant feature of any cannabis M&A transaction.

Look to the Business Structure to Determine Who Needs a Security Clearance

A cannabis business applying for a cannabis licence for cultivation, processing, and/or sale must ensure that all individuals holding key positions in the business obtain a security clearance from Health Canada. Once the business is licenced, an individual who assumes a key position for the licence holder is required to obtain a security clearance prior to assuming that position.

A cannabis business, as the licence holder, can be an individual or an organization, including a partnership, cooperative or corporation. The organizational structure of the business helps determine which individuals are in key positions:

Regardless of the licence holder's organizational structure, certain key individuals associated with the licence holder's operations must also hold security clearances. Depending on the type of licence, these may include the "Responsible Person", Head of Security, Master Grower, Quality Assurance Person, and alternates for these positions.

Effective Due Diligence Ensures Security Clearances Are in Place Prior to ClosingRegardless of the licence holder's organizational structure, certain key individuals associated with the licence holder's operations must also hold security clearances. Depending on the type of licence, these may include the "Responsible Person", Head of Security, Master Grower, Quality Assurance Person, and alternates for these positions.

As it is still a relatively new market space, cannabis is a time-sensitive, cost-sensitive, and competition-sensitive industry. It is critical that buyers and sellers conduct sufficient due diligence to minimize the risk of a missing security clearance becoming a roadblock to a transaction.

A cannabis M&A transaction will almost certainly result in changes to the list of those who need individual security clearances under the cannabis licence. Therefore, an acquirer should:

  1. ensure the required security clearances are obtained prior to closing; and
  2. be sure to provide the required notice of changes to Health Canada.
  3. be sure to provide the required notice of changes to Health Canada.

Where a transaction will result in changes to a licence holder's required individual security clearances, any new clearances must be in place by the time the transaction is completed. This applies to individuals in key positions of the business as set out above, as well as to new or additional individuals that are to be designated the licence holder's "Responsible Person", Head of Security, Master Grower, Quality Assurance Person, and alternates for any of these positions.

The Cannabis Regulations generally require that a licence holder notify Health Canada within five days of any addition to or replacement of the individuals required to hold a security clearance under its licence. A licence holder must obtain special approval from Health Canada prior to designating or replacing a Quality Assurance Person with anyone but their alternate, or designating or replacing the alternate. Notice is not required as this special approval is sufficient.

Understanding security clearance requirements is not only important to the acquirer. Everyone involved in a transaction has an interest in ensuring that all required security clearances are in place prior to closing.

If any key individual fails to obtain a security clearance, and the transaction closes, the cannabis company will be operating outside the scope of its licence, attracting considerable legal and financial risk. If such a deficiency is caught without sufficient time prior to closing, obtaining the required clearance could result in costly delays and be a deal breaker.

Takeaway

The requirements for individual security clearances run deep into the corporate structure and may surprise underwriters, acquirers and those looking to be acquired. It is important for all parties to examine which individuals require a security clearance to have confidence that such clearances will be in place prior to closing. As cannabis continues to be a volatile market where opportunities arise and vanish quickly, understanding the regulatory requirements and conducting the proper due diligence can help to minimize the risk of regulatory and transactional failure.