Cannabis Musings - October 12, 2022

Friends – as promised in the last Cannabis Musings, this is The One about MedMen’s Illegality Claim. In case you missed it, multi-state operator MedMen is arguing in Federal court that a lease it signed, and then stopped paying rent on, should not be enforced because cannabis is illegal, which is funny.

Now, you might be thinking that this gambit is the height of chutzpah, but these Cannabis Musings serve to explain, not to judge. I won’t get into the details of the case filed by Thor Equities, MedMen’s landlord, to collect on unpaid rent, because they’re boring, but what you need to know is that Thor Equities sued MedMen in Federal court.

MedMen filed a motion on September 28th, 2022, asking the court to dismiss Thor Equities’ case, saying the lease is unenforceable because both MedMen (by selling cannabis) and Thor Equities (by leasing the property to MedMen to sell said cannabis) are breaking Federal law. (I’m paraphrasing from MedMen’s Memorandum of Law, but I can’t link to it because, although it’s publicly-available on the Federal courts’ docketing system, you have to register and pay for access, much to the annoyance of everyone.) Despite what you may think, it’s not a novel or frivolous argument - the motion cites a number of cases where a Federal court refused to enforce an agreement because it involved cannabis.

Indeed, the policy that courts should not be enforcing contracts to do illegal things (e.g., trafficking in raw milk or Mogwai) has been a fear for the cannabis bar for a while now. Although many states’ cannabis laws include a section affirming that cannabis contracts don’t violate public policy (effectively squelching the illegality defense in those states’ courts), there’s no such thing at the Federal level because, well, that wouldn’t make sense.

In response to this concern, diligent lawyers include a provision in cannabis industry contracts saying that the agreement doesn’t violate public policy and that the parties won’t try to argue illegality as a reason to cancel it. Funny enough, however, according to Thor Equities’ lawyer, the lease actually included this magic language. Nonetheless, there remains the paradox of whether that contract language is enforceable if the contract itself is unenforceable. Another example of how cannabis law is weird.

It’s part of a lawyer’s job to come up with arguments that make you go “hmmm” – indeed, lawyers are ethically bound to act “with zeal in advocacy upon the client’s behalf.” MedMen’s curious position has a real basis in law, and it’ll be interesting to see how it plays out. And if other cannabis tenants take a similar tack on their defaulted leases. (None of this is legal advice, by the way.)

Separately, TerrAscend announced today that it borrowed $45 million from Pelorus Equity Group. The press release doesn’t have a lot of detail, and the loan agreement isn’t filed publicly yet, but it does note that it’s a 5-year loan, with 36 months of interest-only payments and no warrant coverage (meaning no equity was issued to Pelorus as a kicker). The interesting datum is that the current interest rate is 12.77%, and the rate adjusts based on the changes in the one-month SOFR (the secured overnight financing rate that replaced LIBOR, for various reasons that only bankers and their lawyers care about). The press release doesn’t say this outright, but one-month SOFR is currently 2.77%, so the loan’s interest rate is one-month SOFR plus 10%.

Why is this interesting to me? Two reasons. First, many of the loans to MSOs that we saw over the past two years were made at fixed rates of interest. Now that the Federal Reserve is raising interest rates generally (something that didn’t happen for many years), lenders foresee that trend continuing (indeed, the Fed has said as much), so by making a term loan with a rate that adjusts based on prevailing rates of interest (SOFR is a widely-used metric for adjustable-rate loans), the lender is protected if rates continue to rise (it’s bad for the borrower though, which will have to pay more interest as rates go up). That Pelorus made this loan using an adjustable rate not only suggests that Pelorus is concerned about rising rates, but also suggests that cannabis borrowers have less leverage to demand a fixed rate in a rising rate environment.

Second, one-month SOFR + 10% is a higher interest rate than many of the loans we saw made in the past two years to cannabis MSOs. For example, about this same time last year, Trulieve borrowed $350 million at 8% fixed, and Jushi borrowed $100 million at 9.5% fixed. Credit is tightening, as it’s said, but particularly so in cannabis.

Be seeing you.

© 2022 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.