The Changing Face of Investing in Colorado Marijuana Businesses
November 18, 2019
By: Gil B. Selinger
Investing in the Colorado marijuana industry was once a difficult, if not impossible, endeavor for investors outside of Colorado due to onerous restrictions imposed by Colorado law. That all changed by the Colorado Legislature when Colorado House Bill 1090 (“HB 1090”) was signed into law. The law, which went into effect on November 1, 2019, fundamentally upends the existing marijuana regulations in Colorado.
HB 1090 permits Colorado marijuana companies to accept investments from more investors, including from investors located outside of Colorado and even outside the United States. The law also permits publically traded companies and certain qualified private investment funds to hold a state marijuana license, further enabling investors to invest in the Colorado marijuana industry. Additionally, investors who own less than 10% of a Colorado marijuana company will no longer be required to satisfy disclosure and licensing requirements.
In short, the changes HB 1090 introduces, which are discussed further below, are groundbreaking and have opened the flood gates to new investments and acquisitions by out-of-state investors of Colorado marijuana businesses. This is a great opportunity for investors and marijuana businesses alike, but it creates the need for careful navigation of the intersection of Colorado marijuana and securities laws.
Prior to soliciting new investments, Colorado marijuana companies should carefully review the new law and regulations.
The Marijuana Enforcement Division (“MED”) authorized emergency rules on August 1, 2019 implementing HB 1090. While the emergency rules likely will provide the framework for the final rules, there may be changes to the regulatory scheme before final rules are adopted. Marijuana license holders and investors should think carefully about the nature of any investment transactions they propose to undertake before final rules are adopted.
While in reality, the cap on the number of passive investors in a marijuana business has been lifted, the Emergency Rules have introduced the concept of an “Affirmation of Reasonable Care” where the licensed business must take steps to make sure that its beneficial owners aren’t people who are otherwise prohibited from owning interests in licensed marijuana businesses in Colorado. This saddles the license holder with an increased responsibility of due diligence that will even extend to “Indirect Financial Interest Holders” such as landlords, or other parties directly connected to cultivation, manufacture, or testing of marijuana but whose contractual compensation is not directly based on a percentage of revenue from the licensed marijuana business, a concept that was absent in the prior legislation.
Under the prior legislation, an ownership of Colorado marijuana businesses contains a complete prohibition on an equity interest being held by a publically traded company, even indirectly. The changes contained in HB 1090 now permit certain publicly traded companies and qualified private funds to own Colorado licensed marijuana businesses. The Emergency Rules define “Publically Traded Company” as any U.S. or foreign (where the country of domicile of the entity permits the sale of marijuana), which has a class of securities that is either registered pursuant to the Securities Exchange Act of 1934, or is listed on certain Canadian security exchanges. A “Qualified Private Fund” is defined by the Emergency Rules as a private fund that is exempt from registration under the Investment Advisors Act of 1940; better known to the lay person as a venture capital or private equity fund.
The prior legislation also contained one-year residency requirements: now only the individuals with day-to-day managerial control over the business must meet the residency requirements. Additionally, the new law opens the door to foreign investment in Colorado marijuana businesses by permitting non-U.S. citizens to own equity in a licensed marijuana business.
The passing of HB 1090 has changed the face of the economics and ownership of the Colorado marijuana industry as we know it.
Changing Terminology
Many of the old terms and categories of ownership have been modified by HB 1090. There are no longer any Direct or Indirect Beneficial Interest Owners or Qualified Passive Investors. The previous law relating to the ownership of licensed entities focused on any amount of control or ownership. HB 1090 generally requires more direct control or ownership to trigger legal obligations.
HB 1090 introduces three new types of ownership classifications, distinguishing between “Acquire” and “Control” more effectively. As defined in the new law, “Control” is the direct or indirect possession of the power to direct the management or policies of the licensed marijuana business, whether by contract, via ownership of voting securities, or in some other fashion. This is important because, unlike previous iterations of the laws and regulations governing the industry, the control requirement now specifically addresses management agreements within the industry. By means of an acquisition of ownership securities and 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, all now mean that a person has “Acquired” a marijuana business.
- A “Controlling Beneficial Owner” generally refers to persons, entities or their affiliates, or a Qualified Private Fund who own more than 10% of a marijuana business or a control person of the; or (b) a Qualified Institutional Investor with at least 30% ownership of a licensed marijuana business. A “Qualified Institutional Investor” refers to one of many specific entity types including banks, insurance companies, investment companies, and retirement accounts. All Controlling Beneficial Owners must submit disclosures and fingerprint-based criminal history checks as required by the regulations.
- A “Passive Beneficial Owner”, is any person holding any interest in a licensed marijuana business who is not a Controlling Beneficial Owner.
- As described above, an “Indirect Financial Interest Holder” is a person that is not an affiliate, a Controlling Beneficial Owner or Passive Beneficial Owner, does not receive compensation based on a percentage of the revenue or profits of the marijuana business and otherwise either: (a) holds a reasonable royalty in exchange for the marijuana business using its intellectual property; (b) holds a permitted economic interest or other convertible security prior to January 1, 2020 in a marijuana business that has not been converted into an ownership interest; or (c) is a party to a contract with a marijuana business involving a direct nexus to cultivating, manufacturing, or the sale of marijuana which will necessarily include parties leasing equipment or real property for use in marijuana operations or cultivation; secured and unsecured financing agreements (depending on collateral descriptions); security contracts; and management agreements. The key to this definition is that many more ancillary related parties who are receiving funds that relate to the licensed business will now be looked at under the regulatory umbrella in order to prevent prohibited parties from benefitting from the licensed business.
Additionally, certain definitions have been updated, including the definitions of “acquire” and “control.”
Requirements Related to Disclosure and Change of Ownership
Controlling Beneficial Owners and Passive Beneficial Owners each have specific disclosure requirements under Colorado law. All applicants for the issuance of a state license, which will necessarily come from any investment in a licensed entity by a public company or Publically Traded Company, will be required to provide a complete organizational chart reflecting the identity and ownership percentages of its Controlling Beneficial Owners. If the Controlling Beneficial Owner is a publicly traded company, the application must disclose the public companies’ managers/officer/directors and any beneficial owner that, directly or indirectly, owns at least 10% of the Controlling Beneficial Owner. If the Controlling Beneficial Owner is a Qualified Private Fund, then the disclosure will need to include the Fund’s managers, investment advisors, and anyone else that could control the manager or operations of the marijuana business (this means that, depending on the structure of the entity and its management, funds should be able to avoid disclosing their limited partners). An understanding of the securities concepts of control and beneficial ownership is paramount to avoid a misstep by incorrectly choosing who to disclose and who not to disclose.
Despite specific disclosure requirements listed in HB 1090 and the Emergency Rules, the MED has broad discretion to require additional reporting and disclosure, including piercing deep into the ownership structure of the controlling Beneficial Owner, Passive Beneficial Owner or Indirect Financial Interest Holders of the marijuana businesses. This could be problematic for large Publically Traded Companies, especially when they don’t know the identities of all of their equity holders to a degree to be certain that they will not run afoul of the Colorado regulations.
These significant changes and requirements implicate a necessity for both licensed marijuana businesses and investors in the industry to engage seasoned securities advisors. Our corporate and marijuana attorneys at Fairfield and Woods can help you navigate the complex intersection of securities laws and marijuana laws to ensure you avoid violating either.
Contact Gil Selinger at Fairfield and Woods, P.C. at 303.894.4478 or gselinger@fwlaw.com with questions, or to seek help with the issues implicated by this article.