On May 29, 2019, Governor Jared Polis signed HB19-1090 (“HB-1090”) into law. HB-1090 repeals regulations that prohibit publicly traded companies from holding ownership interests in Colorado marijuana businesses. HB-1090 dramatically alters the regulatory landscape surrounding ownership of licensed cannabis businesses, opening the door for significant outside investment. However, while the framework for public company ownership is outlined in HB-1090, the bill does not go into effect on November 1, 2019, and the rules, regulations, and application processes relevant to HB-1090 have yet to be drafted.
So, what do we know?
100% Out of State Ownership
While the old rules required at least one owner of a licensed business to have one year or more of Colorado residency, HB-1090 only requires that individuals with day-to-day operational control of the business be Colorado residents. The new law also allows non-US citizens to own equity in a licensed business.
The door for out of state ownership has been cracked since 2017, but this change will knock the door off its hinges. HB-1090 will allow non-residents of Colorado to own 100% of a licensed business, provided that the individuals in control of day-to-day operations of the business are Colorado residents. Prior to HB-1090, a non-resident of Colorado had to partner with at least one resident of Colorado, who had to hold at least some small percentage of equity in a business. Often, those partners had no prior relationship. Non-residents will no longer have to rely on in-state residents to hold equity in a business.
While the rules to implement HB-1090 are still being promulgated, this change poses some challenges and questions that have yet to be answered. For example: we believe that a non-resident manager of a LLC (not to be confused with a key employee or day-to-day manager of the business) or director of a corporation who has authority to bind the company to leases, promissory notes, etc., will have to go through the pre-suitability application process even if he or she does not have daily operational control. In addition, some banks do not allow a non-resident manager of a LLC or director of a corporation to have signing authority on a bank account. While this shift is a big step in the right direction, expect more changes in the next 18 months to iron out details.
New Classes of Ownership Interests
HB-1090 repeals the current concepts of “Direct Beneficial Interest Owners,” “Indirect Beneficial Interest Owners,” and “Qualified Passive Investors,” and their associated requirements, and instead creates three new ownership concepts: (1) “Controlling Beneficial Owners;” (2) “Passive Beneficial Owners;” and (3) “Indirect Financial Interest Holders.
First, a Controlling Beneficial Owner refers to (i) a natural person, entity, publicly traded corporation, or Qualified Private Fund that is not a qualified institutional investor (i.e. a typical venture capital or private equity fund), that, in each case, owns 10% or more of a cannabis business, or a person who is otherwise in control of the cannabis business (including managers); or (ii) A qualified institutional investor acting alone or acting in concert that owns or acquires beneficial ownership of more than 30% of the owner’s interest of a marijuana business.
Second, a Passive Beneficial Owner is any person holding any interest in a marijuana business who is not otherwise a Controlling Beneficial Owner or in control.
Third, an Indirect Financial Interest Holder is a person or entity, as applicable, that: (i) holds a commercially reasonable royalty interest in exchange for a business’s use of the person’s intellectual property; (ii) holds a permitted economic interest that was issued prior to January 1, 2020, and that has not been converted into an ownership interest; (iii) is a contract counterparty with a marijuana business, other than a customary employment agreement, that has a direct nexus to the cultivation, manufacture, or sale of medical marijuana, including, but not limited to, a lease of real property on which the medical marijuana business operates, a lease of equipment used in the cultivation of medical marijuana, a secured or unsecured financing agreement with the medical marijuana business, a security contract with the medical marijuana business, or a management agreement with the medical marijuana business, provided that no such contract compensates the contract counterparty with a percentage of revenue for profits of the medical marijuana business; or (iv) is identified by rule by the state licensing authority as an indirect financial interest holder. An Indirect Financial Interest Holder includes a person leasing equipment or real property for use in cannabis operations or cultivation, secured and unsecured financing agreements, security contracts, and management agreements. This broad definition may prove to be quite detrimental to established ancillary companies.
The bill gives the state licensing authority rule-making authority related to the parameters of, qualifications of, disclosure of, requirements for, and suitability for the new ownership concepts. Accordingly, we would urge caution to would-be market participants and to current businesses looking for an exit, businesses that rush to execute transactions before the law takes effect run the risk of incurring significant fines, or worse.
The bill requires a person intending to apply to become a Controlling Beneficial Owner or Passive Beneficial Owner to receive a finding of suitability or an exemption from the state licensing authority prior to submitting a marijuana business application. This may include a review of an applicant’s financial statements, as well as a criminal background check. The MED’s current process for a finding of suitability is lengthy and burdensome, often taking in excess of six months, and requires an applicant to have a complete understanding of his or her financial position. The MED may ask invasive personal and financial questions and require spouses and joint account holders to submit additional applications or application materials. There is no indication that HB-1090 will loosen this process. To the contrary, we believe that the MED will heighten its scrutiny on non-residents applying for ownership, individually or through an entity (particularly public companies).
The bill also requires a marijuana business or Controlling Beneficial Owner that is a publicly traded corporation to comply with various notification, disclosure, notice, and suitability requirements. The bill limits the types of publicly traded corporations that can be marijuana businesses or Controlling Beneficial Owners.
Applicants for ownership of a state license must disclose a complete organizational chart reflecting the identity and ownership percentages of its Controlling Beneficial Owners. There are varying levels of disclosure requirements depending on whether a Controlling Beneficial Owner is a publicly traded company, a Qualified Private Fund, or something else. All applicants (including individuals) must take reasonable care to confirm that its Controlling Beneficial Owners, Passive Beneficial Owners, Indirect Financial Interest Holders, and Qualified Institutional Investors are not prohibited under the law, and failure to do such due diligence can lead to denial of an application or other significant penalties. The MED has recently ramped up criminal investigations into applicants who have falsified application materials, including negligent (not only intentional) misstatements.
Despite specific disclosure requirements listed in HB-1090, the MED has the discretion to mandate additional reporting. The disclosure requirements primarily focus on individuals with ten percent or more interest in a cannabis business and those persons in control of a business, but HB-1090 also includes a strict prohibition on structuring any transaction with the intent to evade disclosure, reporting, recordkeeping or suitability requirements, and any such action can lead to denial of an application or revocation of a license.
Control and Management
Finally, HB-1090 defines “Acquire” and “Control” more effectively. Control is the possession, direct or indirect, of the power to direct the management or policies of the cannabis business, whether through ownership of voting securities, by contract, or otherwise. The concept of “Control” now specifically addresses management agreements within the industry. A person “Acquires” a cannabis business not only through the acquisition of ownership interest, but also through the acquisition of direct or indirect control, voting power, or through the sole power to dispose of the owner’s interest through transactions, subsidiaries, purchases, assignments, transfers, exchanges, successions, or other means.
These definitions are important because the MED has often relied on a broad definition of “control” to penalize businesses who straddle the line between compliance and non-compliance. With a clearer definition, the MED has put all businesses on notice that it will continue to closely monitor who owns and exercises control over a business, and who receives revenues from such business. The definition poses some concerns, though. Hidden ownership has long been a hot ticket item for the MED, one which the MED routinely monitors and initiates investigations over. With the new definition of “Control,” the MED may be able to extend its reach by more closely monitoring consulting agreements. Businesses should be very careful how they tailor consulting agreements and management agreements moving forward.
Processes for changes of ownership are still unknown and will be clarified during the rulemaking process over the next months. HB-1090 is promising legislation, but it is important to know the law before you act. The Rodman Law Group will be monitoring the new law as the MED promulgates rules consistent with HB-1090’s intent. While we encourage public companies with interest in the Colorado marijuana business to wait until November 1, 2019, before initiating any transactions, we are available to provide updates on the bill and to assist businesses in structuring transactions compliant with HB-1090.