Cannabis Musings - January 17, 2023

Friends – the fact that US cannabis companies can’t file for bankruptcy has created a really interesting dynamic over the past few years. For background, the US federal courts made it clear in 2019 that plant-touching companies may not file and take advantage of the bankruptcy code’s protections such as staying litigation, a process to restructure and resolve claims, and the ability to wipe out debt. State laws (remedies) such as receivership and assignment for the benefit of creditors don’t offer much in the way of relief – they’re at heart just mechanisms to pay off creditors. Bankruptcy is a luxury that cannabis can’t enjoy right now.

When the industry fell into distress in 2019, after the salad days of 2017 and 2018 during which you couldn’t swing a dead cat without hitting an investor willing to throw millions at a pre-revenue cannabis business (I wrote a brief history of this history back in 2020), companies that were out of money and deeply in debt couldn’t take the usual route of filing for bankruptcy to deal with their debts. Instead, companies either cut costs dramatically, negotiated terms with creditors, and hoped for the best; or shut down and hoped to not get sued by creditors. They were stuck.

Let’s then turn our attention then to Flower One Holdings, a Nevada-based cultivator. Although the operating company is a US entity, its publicly-traded parent company is a Canadian entity that filed for the Canadian equivalent of bankruptcy in October 2022. Its restructuring plan, approved in late December, entirely wiped out the public equity and effectively handed over ownership of the company to creditors (note that I’m skipping over a lot of detail). You may be wondering how Flower One could do what other US-based operators that have publicly-traded Canadian parent companies (which is how all of the Canadian exchange-listed US companies are structured). That’s a great question!

Crucially, Flower One had a Canadian parent company, which only US operators with stock trading on Canadian exchanges also have. Second, Flower One appears to have had a significant amount of debt owed by the Canadian parent entity to actually restructure. Debts owed only by the US operating subsidiaries appear to have been unaffected, which makes sense because the Canadian process can’t affect any debts in the US. Third, as best I can tell from the docket, before they filed, they came to agreement with key lenders to the Canadian parent company on the outcome of the restructuring. This is known as a “prepack,” - the primary senior lender with claims against Flower One’s Canadian parent agreed to swap that debt for the equity of the company.

Even with all of that, Flower One still needs to deal with its US creditors (again, because those debts weren’t affected by the Canadian bankruptcy). In order for this to work, Flower One’s management team and new owner (that senior lender) will need to have a plan to manage those remaining US debts. This, I think, is what makes Canadian bankruptcy likely useless for most other US operators with Canadian parents – in general, they tend to have the bulk of their debts at the US subsidiaries, not at the Canadian parent. Again, I’m skipping a lot of detail, and also none of this is legal advice, but Flower One pulled off something that few thought was possible – a Canadian bankruptcy to restructure a US-based operator.

Another interesting example of restructuring is playing out in the California flower market. Aaron Edelheit of Mindset Value just posted an excellent analysis of the decline in cultivation in the state in 2022, resulting in a current inventory shortage and increase in prices after a fairly long-term decline due to overproduction. He notes that canopy has dropped by a meshuggah 14 million square feet, or 17%, since March 31, 2022, about nine months, due to licenses being abandoned and not renewed. Although there are a number of reasons for nonrenewal, I don’t think it’s unreasonable to assume that much of that may be attributed to the fact that flower prices were uneconomically low for so long. That cutback has apparently made a difference – Aaron notes the resulting meaningful uptick in flower prices. It will be interesting to see if this happens in other states with an overabundance of cannabis flower (e.g., Michigan), and whether we also see a similar retraction in other parts of the supply chain.

The typical rules of the workout game don’t fully apply in the cannabis industry (a maxim that may fairly be said of nearly everything in the industry). It requires a dose of pain that’s unexpected by everyone. It also forces lenders and investors to rethink their strategies and underwriting. I suspect we’re going to see a lot more workout activity this year – already we’ve seen Lowell Farms announce that its pursuing “strategic alternatives” and TerrAscend converted into stock C$125 million of its debt owing to Canopy.

I’ve advised countless operators and lenders on the dynamics of workout and restructuring. The usual leverage points and negotiating tactics among creditors and owners simply don’t apply when the threat (or relief) of bankruptcy doesn’t really exist. Nothing in cannabis is easy.

Be seeing you!

© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form. Subscribe to Cannabis Musings at hauseradvisory.com.