Cannabis investing

Cannabis and Crypto-Currency-The Blind Leading the Blind

Capital Markets, Investors, Issuers , , ,

A few weeks back I wrote a blog article where I stated that I was not interested in preparing the legal paperwork for any company that was raising funds for a cannabis related company. In the same article I said that I would also decline the opportunity to prepare the paperwork for an initial coin offering (ICO).  Either would be lucrative for me but in both cases I saw significant problems for the investors.

I might have predicted that people would start sending me the paperwork for ICOs that were looking to fund cannabis businesses seeking my thoughts and comments. Two stick out as examples of how not to raise money for your cannabis business.

In July, the US Securities and Exchange Commission (SEC) issued a report on ICOs. Crypto-currency is all the rage this year with some offerings raising millions of dollars in a matter of minutes and coins when issued quickly appreciating in price. Bitcoins for example have been appreciated significantly this year and some people think that Bitcoins are a legitimate investment, an assertion that is questionable at best.

The SEC correctly concluded that most crypto-currency offerings would fall within the definition of a security and thus its jurisdiction.  There was really no surprise as the SEC initiated about a dozen enforcement actions against crypto-currency issuers before it wrote its report.

Because an ICO is the offering of securities it is required by law to either 1) register with the SEC or 2) be exempt from registration assuming that an exemption is available. In either case, the issuer of the coins is required to give potential investors all the facts that would be material to making an investment decision.

If investors who purchased the coins got a discount on an ounce or two of marijuana the coins might not be securities. These two cannabis ICO offerings are clearly offering securities.  In both of these cases, investors profit if the underlying business profits which is more than enough for these to be securities and the SEC to have jurisdiction.

There are some facts which the SEC and any securities lawyer would consider to be material. This would include who is running the company; how much money is being raised and what will it be used for; the basic structure of the company’s ownership; how investors get paid and how much they might expect; an idea of the size of the market in which the company intends to compete and the names of the companies that are its major competitors.

Nothing really earth shattering,but the SEC has been reviewing offerings and ruling on how these facts are disclosed for decades. Making the disclosures correctly requires a fairly good idea of what the SEC expects and an equally good idea of the operation of the business offering the securities which is why securities lawyers who prepare offerings really have to know what we are doing.

The first cannabis ICO I looked at was for a company called Growers International.  Like all ICOs it uses a “White Paper” (which it prefers to call a “Green Paper”) instead of a traditional prospectus.  I doubt that it was prepared by a securities attorney. (I would suggest that you might add the words “Like, cool” or Yeah, man” between the sentences and it would read like the script of an old Cheech and Chong movie but I do not want to insult Cheech or Chong.)

From the Green Paper: “Q: Why should I trust the team? How do I know this isn’t a Pump & Dump situation?  A: We ask that all investors do their research on the people behind Growers International. Our lead developer has found success in both the cryptocurrency arena as well as in the cannabis industry. If there is any question regarding the legitimacy of the project, we encourage investors to reach out to Ryan (Lead Dev) personally on slack.”

It is always a good idea to research the people who are running any company into which you are making an investment.  In this case the “Green Paper” discloses the management to be: “Lead Developer: Ryan Wright (34, California / Taipei); Blockchain Programmer: Eddie E. (48, New Zealand); Web / API Developer: Michael J. (32, Maidenhead, England); Social Media Director: Devvie @Devnullius (40, Sweden); Community Coordinator: Jeremy Toman @MadHatt (37, Canada) who prefers the name ‘Tyler Dirden’ or ‘MadHatt’;Graphic Designer & Cryptocurrency Consultant: Chris S. @Elypse (26, Detroit); Community Manager: @DayVidd and Bitcointalk Manager & Financial Consultant: Dr. Charles @drcharles (26, USA).”

I suspect that if you contact Mr.Wright as suggested he will vouch for them all if he bothered to ask their last names. Do not bother to ask about Members of the Board of Directors as they have apparently not yet been appointed, so one Director might turn out to be Pablo@Escobar.

The other cannabis related ICO I reviewed is prepared more professionally but still, in my opinion, misses the mark by a good country mile. The company is called Paragon Coin, Inc. It is in the process of raising $100 million through the ICO. Just to be clear Paragon supports the cannabis industry, it does not appear that it intends to grow or distribute cannabis itself.

Paragon intends to bring block chain to the cannabis industry.  It intends to use a distributed ledger to bring order to this fragmented industry. According to the White Paper the company intends to “offer payment for industry related services and supplies through ParagonCoin; establish niche co-working spaces via ParagonSpace; organize and unite global legalization efforts through ParagonOnline; bring standardization of licensing, lab testing, transactions, supply chain and ID verification through apps built in ParagonAccelerator.”

All that is fair enough and the names and pictures of the operating personnel are included. Their education and work histories going back 10 years which I would have expected to see are not present.

The White Paper clearly notes that cannabis is not legal at the federal level and asserts that it will only operate in states where it is legal. This is the prime oxymoron of the cannabis industry.  Illegal at the federal level is illegal everywhere. Marijuana is a Schedule I drug and possession or sale is a felony in all 50 states. That is a fact about which that the cannabis industry does not want to think and largely ignores.

The Paragon White Paper describes one of the Risks of investing in its coin offering as follows:

CERTAIN ACTIVITIES INVOLVING MARIJUANA REMAIN ILLEGAL UNDER US FEDERAL

LAWS. SUCH ACTIVITIES INCLUDE BUT ARE NOT LIMITED TO: (A) DISTRIBUTION OF MARIJUANA TO MINORS, (B) TRANSPORTING MARIJUANA FROM STATES WHERE IT IS LEGAL TO OTHER STATES, (C) DRUGGED DRIVING AND OTHER ADVERSE PUBLIC HEALTH CONSEQUENCES, (D) GROWING MARIJUANA ON PUBLIC LANDS, (E) MARIJUANA POSSESSION OR USE ON FEDERAL PROPERTY, AND

(F) OTHER CRIMINAL ACTIVITY OR VIOLENCE ASSOCIATED WITH THE SALE OF MARIJUANA. TO THE EXTENT THE COMPANY AND/OR PARAGON COIN, INC. MAY NOT PREVENT CERTAIN OF ITS USERS FROM USING PRG TOKENS IN VIOLATION OF US FEDERAL LAW, IT MAY SUBJECT THE COMPANY AND/OR PARAGON COIN, INC. TO CIVIL AND/OR CRIMINAL LIABILITY AND THE UTILITY, LIQUIDITY, AND/OR TRADING PRICE OF PRG TOKENS WILL BE ADVERSELY AFFECTED OR PRG TOKENS MAY CEASE TO BE TRADED.

This derives verbatim from the Cole Memorandum which was written in 2013 as a direction from the US Department of Justice to Federal prosecutors as to how they should allocate their resources when they decide who to prosecute and for what. It never made cannabis legal anywhere.

More importantly, the Cole Memo it is not an Act of Congress or Federal regulation and not binding on the current administration in any way. Any suggestion that it will continue to be followed under the current administration is wishful thinking given the Attorney General has repeatedly stated that it will not.

Medical marijuana has been legal in California for more than a decade. That did not stop the federal government from raiding and closing down a large medical dispensary in Oakland, CA in 2012. Parenthetically, Paragon’s initial co-working space is slated to open in Oakland, California.

Perhaps the most troubling aspect of this offering is that it intends to fund the use of block chain, a relatively unsecure distributed ledger to link the many growers and suppliers in the cannabis industry. If successful it may well deal a serious blow to the cannabis industry it is trying to support.

One of the leading ICO platforms, Coinbase, has been engaged in a two year battle with the Internal Revenue Service which wants a list of all the people who use its platform to trade Bitcoins. The IRS alleges that people are trading the coins profitably and not reporting the gains and paying the taxes. The US government has also alleged that drug cartels and other bad actors use crypto-currency to launder money.

If you are in the cannabis industry you have certainly heard stories of how the DEA would obtain the customer lists of hardware stores that sold supplies for hydroponic growing. Everyone who was a customer did not use these supplies to grow cannabis but the government used those lists to identify and prosecute people who did.

If you have a “decentralized” list of a large group of people who are on the list only because they are affirmatively in the cannabis business as Paragon wants to create, how long do you think it will take for the US Government to obtain it? Think that will be difficult because Paragon never touches any marijuana or sells it?

The CEO of Paragon, Jessica VerSteeg, is also CEO of AuBox which the White Paper describes as “an upscale marijuana delivery service in the SF Bay area”. That is more than enough “probable cause”for the DOJ to get its hands on Paragon’s distributed ledger and the names of every company that uses it. The icing on the cake will be when they tell the judge that the cannabis industry is full of drug cartels and money launders which, of course, it is.

When you write the risk factors for a securities offering, it is important to disclose all of the things that might reasonably occur.  Assuming that this ICO raises the $100 million that it seeks, it is certainly within the realm of possibility that the Attorney General might just seize that money under the federal asset forfeiture provisions. The people behind this offering somehow refuse to accept that there was an election last November and that there is a new sheriff in town.

What I took away from these two offerings was a sense that they were prepared by amateurs who were attempting to do something that was way over their head. In this current administration, raising money for a cannabis company waves a red flag in front of the US government. Compounding that fact by raising money through an ICO just increases the size of that red flag, exponentially.

I personally do not think that there is any hope for Green International but Paragon did not demonstrate that it needed $100 million and could have certainly raised a lesser, more reasonable amount in a more traditional fashion which is what I would have advised them to do if they had asked me.

 

 

Investing in a Cannabis Business

Investors, Issuers, Law

I am not a marijuana prude. I was in college in the 1960s.  I enjoyed it at the time but that is not a reason to invest in cannabis… or not to.

When I was in my 20’s and 30’s my closest friend was a major player in the drug paraphernalia business.  He sold high-end pipes, lighters, incense and stash boxes, wholesale, to boutiques and head shops around the US. I did a little bit of legal work for him and he, in turn, introduced me to many of the people who were active in the paraphernalia industry.

Today I can get all the marijuana that I might want. I am a cancer patient living in California where medicinal pot is readily available. I can get a card and order from a dispensary. They will deliver it to my home if I wish.

I asked my doctors about marijuana after my last round of chemo thinking that it might help me to regain some of the weight I had lost.  They offered to give me Marinol, a pharmaceutical that is a synthetic form of THC, the active ingredient in cannabis. It improves the appetite but provides no euphoria.  They offered me three  reasons:

First, they told me that the pot that I might get from a dispensary would vary greatly in terms of its THC content.  If doctors prescribe a drug, they want to be able to regulate the dosage. They told me that I could not trust the THC content on the label, as their experience showed it was not often accurate.

They also told me that much of the pot I might acquire at any licensed dispensary was likely to have been treated with pesticides.  A local TV station in San Francisco did a report where they picked up a few samples from several dispensaries and found pesticides in almost all of them.

Finally, there was the unassailable logic: “You just had cancer, why would you want to put smoke in your lungs?”  Yes, I could have ordered pot-infused brownies, but brownies are what I used to eat to come down from the high, so what was the point?

Investing in cannabis and cannabis-related businesses is a very hot item right now. There are dozens of small micro-cap companies that grow marijuana or sell it in states where pot is legal.  There are real estate funds renting agricultural land, warehouses and retail space to growers and dispensaries.  There is also a plethora of hemp and cannabis related oils, creams, dietary supplements and other products available. A hemp based toilet paper is a personal favorite of mine.

Because of my interest in investments and crowdfunding, in particular, I get a lot of questions about investing in cannabis-related businesses.  I generally tell people to invest in something else. I believe that the risks associated with a cannabis company are just too high.

Forgive me for stating the obvious but cannabis is illegal in the US both to possess and to sell.  Just because 28 states have allowed the use of marijuana for medicinal purposes, it is still illegal in those states.  State and federal penitentiaries are full of people who were convicted of selling marijuana.  Arrests are made every day.

The federal government is not currently enforcing existing federal law against small growers and dispensaries opting instead to focus US Justice Department resources on large dealers and drug cartels.  But that policy only started during the last 30 months of the Obama administration.

It is illegal for banks and federally chartered financial institutions to handle the proceeds of marijuana sales. In 2011, the federal government raided two credit unions in Sacramento, California clamping down on financial institutions that ignored that fact.

Several states in which cannabis is legal have attempted to remedy this in a number of ways.  In Colorado, state regulators permitted the creation of a state chartered credit union specifically to handle cannabis related businesses. A federal judge refused to allow the credit union to join the Federal Reserve System so transactions could not be processed.

As a practical matter, dispensaries cannot take checks or credit cards meaning that they accumulate a large amount of cash. They pay their rent in cash and their suppliers, employees, insurance and even their taxes.

Dispensaries and dispensary owners are obvious targets for thieves.  Some dispensary owners apply for concealed carry permits. Many use armored cars, private security and private depositories for the cash that they cannot store elsewhere. Customers, who must carry cash when they visit a dispensary, are also potential targets.

Some growers and dispensary owners establish holding companies or companion businesses to disguise where the cash comes from. You can imagine a dispensary supplying cash to a check-cashing business. But hiding the cash can lead to other problems.

In any business handling a lot of cash, there is always the presumption that some will get skimmed off along the way.  Most states that permit retail cannabis sales are careful to have stringent controls to make certain that they collect their sales taxes. Given that the federal government would still want all dispensaries closed, all that cash opens the door for more scrutiny by the IRS. The IRS is, after all, the way the government closed down Al Capone.

I remember the first Reagan administration when the Attorney General, Ed Meese, wanted to drug test every employee in the country. Test positive for pot and you would be out of a job and likely unemployable.

You cannot listen to the current Attorney General, Jeff Sessions, and honestly believe that he is going to look the other way while America gets high. He has been consistently on the record as being anti-marijuana.  People who believe otherwise have no basis for that belief. Anyone who thinks that the US Justice Department will continue to look the other way has not been listening.

Enforcing marijuana laws also furthers the Attorney General’s policy of rounding up undocumented immigrants. If the police kick down your door without a warrant because they “smelled marijuana as they approached” found no drugs but a cache of stolen property, there is a fair chance that the search might be quashed because you would get your day in court.  If they do the same and find an undocumented immigrant in the home, that immigrant will likely be deported without a day in court or any due process.

There is also the fact that the cannabis business has some nasty competition. Just north of where I live in California, in Humboldt and Mendocino counties there are a large number of pot farms. Some are run by Californians; some are run by drug cartels.  At some point the cartels are going to burn out their more legitimate competitors, or worse.

Finally, there is that fact that many of the cannabis products, oils, creams, etc. are making claims that would make the patent medicine salesmen of the 1880s blush. Cannabis does not cure cancers, autism or hemorrhoids. Call me when a peer reviewed study by a major medical school says otherwise.

One thing that might change the federal government’s thinking about legalization is the amount of tax revenue it might generate.  In states like Colorado, if the sales tax is only 7%, the state gets $70,000 on every $1 million of pot that is sold.  That is roughly the equivalent of the salary of one grade school teacher or one highway patrol officer for a year. Most states that have legalized cannabis charge a higher than 7% sales tax on purchases.

If and when Congress gets around to “fixing” the cannabis market, it is reasonable to assume that high priced lobbyists from the alcohol, tobacco and pharmaceutical industries will cut up the market between themselves.  If Congress approves marijuana sales and production it is likely to do so in a way that large companies will produce packs of 10 or 20 uniform marijuana cigarettes with a US excise tax stamp affixed to every pack in the same way alcohol and tobacco products are sold and taxed.

None of this, not the continued illegality of marijuana, the continued competition from the cartels or the legalization to the large corporations bodes well for the small micro-cap companies that are in the industry now or that are likely to get into the industry in the foreseeable future.  That is why I don’t think investing in one of these small companies is a good idea.

If you really believe that marijuana use will grow substantially in the next few years with 10 or 20 million new users entering the market, I suggest that you consider investing in Pizza Hut, Nabisco or Frito-Lay or perhaps Weight Watchers.  That way no matter which way the cannabis industry grows, your investment portfolio is likely to grow with it.