Overview

In a ground-breaking decision, the Ontario Securities Commission (OSC) overturned the decision of the acting director of the Investment Funds and Structured Products Branch of the OSC (IFSP) to refuse to issue a receipt for the establishment of the Bitcoin Fund (the Fund), which is a proposed investment fund based on the cryptocurrency bitcoin.

3iQ Corp. is the investment fund manager and had been working on the Fund for three years with the goal of allowing retail investors the benefits of investing in bitcoin through a regulated, listed fund. Following multiple discussions with the IFSP, the acting director of the IFSP refused to issue a receipt for the Fund’s prospectus. In declining to issue a receipt, the director questioned the suitability of cryptocurrency as an investment, citing the lack of regulation for cryptocurrencies and the various associated risks.

Original Refusal

By way of background, the proposed Fund is a nonredeemable investment fund (NRIF) established as a trust. The objectives of the Fund are to provide investors with exposure to bitcoin and the opportunity for long-term capital appreciation.

On February 15, 2019, the acting director for the IFSP refused to issue a receipt for the Fund’s prospectus because it was not in the public interest to do so (see Securities Act, RSO 1990, ch. S.5, § 61(1)) and the Fund’s prospectus did not comply in a substantial respect with a requirement of the Securities Act (see § 61(2)(a)(i)).

In arriving at this decision, the acting director put forward the Fund’s shortfalls:

1. The lack of the Fund’s ability to accurately value its assets due to the “fragmented and unregulated environment in which bitcoin generally trades”;
2. The risk associated with safeguarding the Fund’s assets and the ability of the subcustodian to provide Customary SOC Reports;
3. The risk of the Fund not being able to file audited annual financial statements in accordance with National Instrument (NI) 81-106;
4. The operational risks associated with the lack of established regulation in the bitcoin market; and
5. Bitcoin being an illiquid asset, and the Fund not complying in a substantial respect with the restriction NI 81-102 against the holding of illiquid assets.

OSC Panel Decision

In establishing and structuring the Fund, 3iQ engaged industry participants and the regulators. 3iQ requested to be heard before a panel of the OSC in which it submitted that a regulated Fund is a necessity given the recent collapses of various other platforms globally whereby individuals invest in crypto-assets without regulatory oversight.

Upon review, the OSC panel found that the Fund was structurally different in nature than certain Exchange Traded Funds (ETFs) related to cryptocurrencies that have been rejected by the U.S. Securities and Exchange Commission. This was due to the Fund placing restrictions by monthly reporting and only allowing redemptions annually by using the NRIF structure, which would significantly reduce the impact of market manipulation by daily trading. The Fund would also be using MVIBTC (as defined below) as the index and would only be purchasing bitcoin from dealers that hold a license or are otherwise regulated. All of these considerations distinguished the Fund from an ETF, which requires constant trading and is more vulnerable to market manipulation.

In arriving at its decision, the OSC panel also looked at the reasoning of the acting director as well as arguments put forth by staff:

1. Illiquidity. Staff argued that bitcoin is illiquid because it is not currently traded on market facilities comparable to the Toronto Stock Exchange, and there is no central source for trading data concerning bitcoin. The OSC panel found that there is sufficient evidence of real volume and real trading in bitcoin on registered exchanges in large dollar size. Furthermore, the regulation does not define the term “market facility” that is found in the definition of “illiquid asset,” and the term should not be narrowly construed to imply some form of established and mature trading facility or network.
2. Valuation and Market Manipulation. The OSC panel stated that under NI 81-106, the Fund would be required to calculate its net asset value using the fair value of its assets and liabilities. 3iQ proposed to value the Fund’s bitcoin by reference to an index called the MVIS CryptoCompare Institutional Bitcoin Index (MVIBTC), which is regulated by the German Federal Financial Supervisory Authority. MVIBTC uses transaction data from 22 trading platforms to calculate the value of bitcoin and complies with the European Union benchmark regulations and the International Organization of Securities Commissions regulations. As such, the OSC panel was not satisfied by the staff’s argument that valuation would not be possible. The OSC panel further noted that the issue with market manipulation having an impact would also be minimal because the fund (i) will only invest in bitcoin; (ii) would pursue a buy and hold strategy; and (iii) only buy and sell bitcoin on regulated exchanges.
3. Safeguarding of the Fund’s Assets. The Fund would use Cidel Trust Company, which is regulated by the federal Office of the Superintendent of Financial Institutions, as a custodian and use Gemini Trust Company, LLC as a subcustodian, which is regulated by New York State, as a qualified custodian under NI 81-102. Staff made two arguments: (1) risk of loss; and (2) lack of insurance. The OSC panel commented that bitcoin can be lost or stolen like any valuable commodity, but staff did not provide sufficient evidence that Gemini, a regulated crypto-asset custodian, has suffered losses of customer assets.
4. Auditability of the Fund’s Financial Statements. Staff submitted that it would be against the public interest to issue a receipt due to concerns over the Fund’s ability to file audited annual financial statements. In making this argument, staff pointed to the lack of Gemini’s SOC 2 type 2 report and the fact that Gemini may deny the auditor for the Fund access to test the operating effectiveness of Gemini’s controls. However, the OSC panel relied on the Fund’s submission that a qualified auditor can conduct the audit even without the report and still comply with generally accepted auditing standards.

In reaching its decision, the OSC panel commented that denying the Fund a receipt would not promote fair and efficient capital markets and confidence because it would leave investors with no choice but to invest without the protections of a public fund. The OSC panel also found that there was no issue of unfair, improper, or fraudulent practices as far as the structure of the Fund was concerned or the operation of it.

In the end, the OSC panel decided that staff had not demonstrated that bitcoin is an illiquid asset and that the Fund will not be compliant with NI 81-102, or that it was not in the public interest to issue a receipt for the Fund’s prospectus. Accordingly, the panel ordered that the acting director’s decision be set aside, and directed the acting director to issue a receipt for the Fund’s prospectus.

Conclusion

Although the OSC’s findings in this decision are not an endorsement of investment funds based on a cryptocurrency model, they do provide guidelines for the regulation of these funds in Canada. This is an important step in that it will support innovative investment opportunities while also protect investors who will be able to invest in funds with regulatory oversight.

Highly regulated industries like the financial services industry have faced ever increasing regulatory compliance obligations. Technology, such as artificial intelligence (AI), that can be utilized to innovate the manner in which these organizations operate can lead to additional challenges for regulatory compliance, and the regulatory environment can drastically impact innovation in these sectors.

Regulatory compliance is a critical consideration for both start-ups and established organizations seeking to drive innovation in the financial services industry. Developing solutions and business strategies with compliance in mind will reduce the risk of potential fines and penalties and allow for the development of a viable solution.

To assist organizations in meeting these ever-growing compliance obligations, RegTech solutions are being developed that can be utilized to provide transparent, faster, and more efficient methods of reporting and ensuring compliance. This article will focus on the potential benefits of RegTech solutions for highly regulated industries, particularly the financial services industry.

What Is RegTech?

RegTech is a general term for new and innovative technologies designed to enable businesses to more easily meet their regulatory compliance obligations. Some of the benefits of the application of RegTech include: (1) the ability to efficiently navigate complex regulatory burdens and process enormous amounts of dense data, and (2) the reduction of risk flowing from human errors that could result in severe administrative fines.

RegTech has flourished due to a developing body of complex national and international regulations that often require the monitoring, evaluating, and reporting of vast amounts of information.

The Legal Landscape

Industries such as insurance, food and drug, oil and gas, mining, securities, telecommunications, energy, fisheries and forestry, and financial services (among many others) operate within a highly regulated environment that can be complex to navigate. Governments establish regulations with the intention of protecting the public from potential risk. This is particularly evident in the financial services industry where we have seen an increase in regulations impacting this industry in reaction to the 2008 financial crisis. However, overregulation can stifle innovation and create barriers to entry for emerging companies, such as FinTech organizations, due to the crippling expense required to comply with these regulations.

The adoption of disruptive technologies like AI in the financial services industry has led to the need for governments to develop new regulations to address the impact of these technologies.

Jurisdictions have diverged on how to address changes in the industry, including those driven by technology. This divergence creates significant obstacles for cross-border products and services or organizations that look to enter new markets. For example, organizations have differing compliance obligations with respect to data protection laws in Canada versus the European Union. Therefore, organizations must ensure that their compliance programs meet the relevant requirements of each jurisdiction in which they operate. RegTech solutions can be utilized to assist in the development of jurisdictional compliance frameworks.

Although some financial services companies have pre-emptively invested in technology to help keep up with the bourgeoning field of regulations, many don’t have the time or extra resources to focus on technology that would help them address the new regulatory burdens, so they have instead turned to using manual processes to address the frequency and volume of the new reporting requirements. This approach can be onerous and causes valuable human resources to be expended unnecessarily. Manual processing is also typically less accurate than RegTech processing.

RegTech Applications

Although there are numerous opportunities for RegTech to assist with compliance, five of the most promising applications of RegTech include the following:

• Compliance. RegTech that can be used to review all relevant regulations and report on the potential impact of such regulations to the user, including jurisdictional data privacy laws.
• Risk Management. RegTech solutions that conduct scenario analysis and risk monitoring on internal business operations through the use of big data analytics to identify and evaluate these risks.
• Identity Management and Control. RegTech that has been developed in response to Anti-Money Laundering (AML) and the Know Your Customer (KYC) obligations regarding client identity authentication. The Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) has also established various other obligations requiring regulated entities to conduct analysis and provide seamless reporting. RegTech can be used to efficiently conduct customer onboarding and monitoring activities and will allow for greater transparency.
• Regulatory Reporting. RegTech that is utilized to assist in the generation and distribution of reports and information required by regulators. RegTech solutions can assist in data sharing between regulated entities and regulators and enable faster processing of vast amounts of data required to prepare these reports.
• Transaction Monitoring. RegTech that monitors financial transactions for suspicious activity quickly and with a high degree of accuracy by leveraging the benefits of distributed ledger through blockchain technology and cryptocurrency. This type of RegTech also aids with much of the required FINTRAC compliance obligations.

The operational benefits gained from RegTech will depend on the specific solution. RegTech that creates reports through automation of the processes required to generate these reports (e.g., data collection, aggregation, and report generation) could lead to a significant reduction in expenses and time required to prepare these reports. In addition, if this information is available in real time, organizations can react to any issues sooner than if the reports were to be generated at a later stage.

Barriers to RegTech Adoption

Despite the promise, certain RegTech solutions are in their infancy; thus, issues related to its adoption still exist. One such issue is pricing. For certain applications, it is unclear what the true cost savings are or what value is generated by the RegTech solution. Therefore, developers may have difficulty in communicating the value of the solution or selecting the appropriate pricing model (e.g., a fee per record generated versus a monthly subscription fee). In addition, the cost of developing a tool to meet the ever-changing regulatory landscape may mean that developers will have difficulty in recouping the ongoing maintenance fees associated with building and maintaining the RegTech solution.

Another concern is the potential for large-scale errors caused by minor issues with RegTech solutions, especially a solution that is one-size-fits-all and used widely in the marketplace. For example, if a RegTech solution fails to address a change in reporting requirements, this could lead to its customers failing to meet their regulatory requirements. If this same problem is replicated multiple times in the same customer, or widespread across multiple customers, then the losses could be significant. RegTech providers and customers must consider these risks when negotiating the terms of the agreement and ensure that these risks are addressed through the apportionment of liability between the parties, indemnities, and requirements for insurance.

Due to the potential sensitivity of the data collected and processed, it is critical to ensure the adequate protection of the data. The potential risk of a data breach can be significant for both the customer and RegTech provider. Customers should therefore conduct the appropriate due diligence on both the solution and provider to ensure that this risk is mitigated. RegTech providers should also ensure that they have the appropriate cybersecurity policies and procedures in place to protect themselves from both financial and reputational risk.

Conclusion

RegTech offers many benefits to organizations operating in regulated industries. Although we have addressed some barriers to adoption, the opportunities offered by adoption of innovative technologies that can assist in meeting an organization’s regulatory requirements are significant.

The manner in which RegTech is supported and integrated into the current regulatory structure will play an important role in navigating both the developmental and implementation stages.

Developers of RegTech solutions should look to engage regulators directly and take advantage of regulatory sandboxes to assist in ensuring compliance. With cautious and thoughtful integration into the current regulatory environment, RegTech shows major promise in reshaping the way that companies interact with the growing body of regulatory oversight.

On February 13, 2020, the Canadian Competition Bureau struck another blow against so-called “drip-pricing” ticket selling tactics when it slammed the deceptive online advertising, marketing, and selling practices of StubHub Canada Ltd. and StubHub Inc. (collectively “StubHub”) for failing to display the real price of the entertainment and sporting events tickets they sold upfront, instead augmenting prices through the addition of quasi-hidden mandatory fees.

The companies ultimately agreed to pay a $1.3 million administrative monetary penalty to the Canadian Commissioner of Competition as part of a Consent Agreement (“Agreement”) following the Bureau’s investigation and the determination by the Commissioner of Competition/Competition Tribunal that the companies had made representations to the public that were false and misleading in a material respect and that they had engaged in conduct reviewable under the Competition Act (Canada).

As described in The Commissioner of Competition v. StubHub Inc., Stubhub Canada Ltd. (CT-2020-002) (decided February 13, 2020), the Commissioner reviewed StubHub’s pricing for tickets advertised on its public websites and mobile applications, as well as in promotional emails. The Commissioner concluded that StubHub promoted prices for tickets that were not actually attainable and that consumers could not actually buy tickets at the advertised prices because StubHub charged consumers so-called “non-optional” fees in addition to the prices advertised. These fees included so-called “service fees,” “transactional fees,” “fulfillment fees,” “delivery fees,” “additional fees,” and just plain “fees” that were added to the prices described on checkout pages before the consumers actually purchased tickets. In fact, the prices shown on the checkout pages were often 28% higher than the advertised price because of these fees.

Interestingly, while StubHub had given consumers an option to click or tap to “show prices with estimated fees” toggle on the pages containing the advertised price, the Commissioner found that even when consumers choose to see these fees by turning the toggle on, they sometimes were still required to pay more than the price represented as inclusive of all estimated fees.

Significantly, the Commissioner concluded that even if StubHub had disclosed the amount of the “non-optional” fees later in the purchasing process (i.e. on the checkout page), such action did not mitigate StubHub’s earlier practices nor prevent the sellers from engaging in “reviewable conduct” under the Competition Act.  Overall, StubHub’s practices were found to be in contravention of paragraph 74.01(1)(a) of the Act, which states that a person engages in reviewable conduct if they, for the purpose of promoting, directly or indirectly, the supply or use of a product or for the purpose of promoting, directly or indirectly, any business interest, by any means whatever, including making a representation to the public that is false or misleading in a material .

StubHub was also found to have used email to engage in reviewable conduct, contrary to Section 74.011 of the Act, as they sent misleading promotional email messages to consumers to promote their ticket sales, including (i) a false or misleading representation in the sender information or subject matter information of an electronic message; and (ii) a representation that is false or misleading in a material . It should be noted that the Act does not care whether the electronic address to which an electronic message is sent exists or whether an electronic message reaches its intended destination—it’s the fact that StubHub sent them that counted.

StubHub ultimately cooperated with the Commissioner and did not contest the Bureau’s findings (explicitly in exchange for more favorable terms). They agreed to execute a Consent Agreement which once registered has the same force and effect as an order of the Competition Tribunal. In the Consent Agreement, StubHub agreed to make all necessary changes with their Canadian websites, mobile applications, and emails to ensure that consumers were shown complete prices inclusive of all mandatory fees the first time that they were shown a price. StubHub was also required to intercept users identifiable as Canadians and require them at the outset to make an express choice to be redirected to Canadian stubhub.ca websites when searching for tickets on stubhub.com.

Additionally, StubHub was also required to establish a compliance program and implement new procedures to comply with the law and prevent advertising issues in the future within ninety (90) days of its execution of the Consent Agreement. Senior management of both companies, including the Chief Executive Officer, Chief Operating Officer, Chief Administrative Officer, Chief Financial Officer, Managing Directors, with responsibility for advertising and marketing tickets, must acknowledge a commitment to the compliance program by signing commitment letters. All current and future employees who are materially involved or responsible for developing, implementing, or overseeing ticket advertising or marketing will be given copies of this Agreement and are expected to sign statements acknowledging their compliance with its terms. StubHub has ten (10) days to notify the Commissioner of any breach or possible breach of any of the terms of the Consent Agreement, providing details sufficient to describe the nature, date, and effect (actual and anticipated) of the breach or possible breach, and the steps StubHub has taken to correct the breach or possible breach. The Consent Agreement is binding on StubHub for a period of 10 years following its registration.

This investigation and decision are consistent with recent Competition Bureau activity to resolve consumer concerns relating to the advertisement of unattainable online prices. As the Bureau’s website noted, various Canadian companies, including Ticketmaster and several car rental agencies, have paid a total of $11.25 million in penalties since 2016 in connection with hidden fees. On July 4, 2017 the Bureau expressly issued a warning to all ticket vendors to be upfront about the true cost of tickets available for purchase and make all necessary corrections to their existing business practices to be frank regarding any mandatory fees.

This decision serves as a costly reminder to all U.S. vendors that conduct business with Canadians online that not only is pricing transparency the hallmark of good business practice, it is also a legal requirement for doing business with Canadian consumers regardless of the media channel.  Deceptive marketing practices, including false or misleading drip pricing, will not be tolerated. As evidenced in the StubHub Consent Agreement, it also appears that the Bureau expects pricing transparency to exist throughout the purchasing experience; as discussed above, StubHub was not saved from findings of false or misleading practices or reviewable conduct by disclosing the non-optional fees at later stages of the purchasing process, including on the check-out page. U.S. vendors selling goods and services to Canadian consumers online would do well to review their marketing practices in light of this decision and take all necessary steps to bring themselves in compliance lest they risk significant penalties.

Lisa R. Lifshitz

Background

On March 4, 2020, the Securities and Exchange Commission (“SEC”) issued an order (the “Order”) providing conditional relief to reporting companies affected by the novel coronavirus disease, or COVID-19. In recognition of the potential disruptions to transportation and limitations on access to facilities, support staff and professional advisors caused by COVID-19, the Order provides reporting companies with an additional 45 days to file certain disclosure reports that would otherwise have been due between March 1 and April 30, 2020, subject to certain conditions.

Highlights of SEC Order

Relief Provided: Extension of Deadlines to File or Furnish Certain SEC Reports

The Order provides that any registrant (as defined in Rule 12b-2 of the Securities Exchange Act of 1934 (the “Exchange Act”)), and any person required to make any filings with respect to a registrant, may take an additional 45 days to file or furnish certain materials with the SEC that are otherwise due between March 1 and April 30, 2020.

Exchange Act reports due during this time period include: (i) Form 10-K filings for registrants with a calendar fiscal year, (ii) Form 20-F filings for foreign private issuers with a calendar fiscal year, (iii) Form 10-Q filings for registrants with a non-calendar fiscal year, (iv) definitive proxy statements if Part III of a registrant’s Form 10-K incorporates information from its proxy statement by reference, and (v) Current Reports on Form 8-K that become due during such time. The Order also applies to any Schedule 13G (or amendment thereto) that is due between March 1 and April 30, 2020, but notably excludes from relief requirements to file any Schedule 13D (or amendment thereto). Additionally, the Order does not apply to beneficial ownership reports required under Section 16 of the Exchange Act, such as Forms 3 and Forms 4.

The Order also provides relief relating to the obligations of a registrant or other person under Exchange Act Sections 14(a) and (c) and Regulations 14A and 14C to furnish soliciting materials to any security holder where the security holder has a mailing address located in an area where, as a result of COVID-19, the common carrier has suspended the delivery service customarily used and the registrant or other person has made a good faith effort to furnish the soliciting materials to the security holder as otherwise required by the applicable rules.

The press release announcing the Order adds that, for Form S-3 eligibility purposes, a registrant relying on the Order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of March 1, 2020 and files any report due during the relief period within 45 days of the filing deadline of such report. Similarly, for purposes of Form S-8 eligibility and the current public information requirements of Rule 144(c) of the Securities Act of 1933, a registrant relying on the Order will be considered compliant in its Exchange Act reporting requirements if it was compliant as of March 1, 2020 and files any report due during the relief period within 45 days of the filing deadline of such report. Additionally, registrants will be able to rely on Exchange Act Rule 12b-25 to obtain extensions for filing deadlines for reports that were previously delayed in reliance on the Order.

Conditions to Relief

Any registrant relying on the Order must furnish to the SEC a Form 8-K or Form 6-K, as applicable, by the original filing deadline of the subject report stating (i) that it is relying on the Order, (ii) a brief description of the reasons why it could not file such report on a timely basis, (iii) the estimated date by which the report is expected to be filed, and, (iv) if material, a risk factor explaining the impact of COVID-19 on its business. Additionally, if the reason that the subject report cannot be filed timely relates to the inability of any person, other than the registrant, to furnish any required opinion, report or certification (e.g., an auditor’s opinion on audited financial statements), the Form 8-K or Form 6-K must attach as an exhibit a statement signed by such person stating the specific reasons why such person is unable to furnish the required opinion, report, or certification in time. The registrant then must file the subject report no later than 45 days after the original filing deadline. The subject report, when filed, must disclose that the registrant is relying on the Order and state the reasons why the registrant could not file such report on a timely basis.

In the SEC’s press release announcing the Order, Chairman Clayton clarified that registrants providing forward-looking information in an effort to keep investors informed about trends or uncertainties regarding COVID-19 can avail themselves of the Exchange Act’s safe harbor for forward-looking statements.

Conclusion

The outbreak of COVID-19 is rapidly developing and has created much uncertainty in markets worldwide. The Order recognizes the fluidity of the situation by extending relief to registrants with operations in “affected areas” without adding any context as to where those areas are located. Just as the SEC has quickly acted to announce relief through the Order, it is possible that the Nasdaq Stock Market and New York Stock Market, as well as other self-regulatory agencies, may follow suit.

The SEC’s press release announcing the Order acknowledges the balancing act presented by the need to protect the health and safety of market participants while also serving investors’ need for timely information. Similarly, affected registrants should consider taking advantage of the Order’s relief to ensure accurate disclosure , even in the face of demanding investor expectations.

The wave of marijuana legalization that has washed over North America in recent years, with Canada and most U.S. states legalizing the substance for medical and/or recreational uses (although it remains illegal under U.S. federal law), has spurred an increasing number of mergers and acquisitions involving marijuana-related businesses (MRBs).  Despite the surge in deal-making, cannabis remains an emerging industry that presents unique challenges, even for experienced M&A practitioners who have advised on deals in a wide range of industries.  This article will discuss a few of the unique challenges for deal lawyers in marijuana M&A, including industry-specific due diligence issues and risks that may be hard to quantify and (through appropriate representations, warranties, and indemnities) limit for buy-side clients. 

Broadly speaking, marijuana deals entail advising companies engaged in the cultivation, processing, sale, or distribution of marijuana and products derived from marijuana, as well as some ancillary businesses that, while they do not “touch the plant,” primarily or exclusively serve businesses that do.  It is important to note that, while both marijuana and hemp are forms of cannabis, the laws and regulations applicable to the two substances vary dramatically, as hemp was legalized under U.S. federal law in 2018.  

Because of the unique legal status of marijuana as a federally prohibited controlled substance but a legal and highly sought-after commodity under the laws of most U.S. states, due diligence in marijuana M&A must encompass both the extent to which a target’s business is likely to become the subject of federal enforcement actions and its compliance with state and local laws.  The risk of federal enforcement itself is in part dependent upon the target’s compliance with applicable state laws, but it behooves buyers and their counsel to go beyond a pure state-law analysis to include an assessment of the target’s compliance with the factors enumerated by the U.S. Department of Justice in 2013 in the guidance that is commonly referred to as the Cole Memorandum. That document (the effectiveness of which is currently unclear, as it was rescinded by former Attorney General Jeff Sessions in 2018 but subsequently unofficially endorsed by current Attorney General William Barr) established enforcement priorities for federal prosecutors when choosing whether to bringing criminal charges for marijuana-related violations of federal law. 

Those priorities focused on such issues as preventing the distribution of marijuana to minors and ensuring that revenues from the sale of marijuana would not flow to criminal enterprises and that state-legal marijuana activity would not be used as a cover for trafficking other illegal drugs.  In order to get some degree of comfort that federal prosecution is at least a limited risk (although there is no legal protection from federal prosecution as long as marijuana remains illegal under federal law), buyers and their counsel should review the extent to which the target presents identifiable risks of implicating one of the enumerated federal enforcement priorities.  In addition, since a typical “compliance with law” representation and warranty is not feasible in the marijuana industry with respect to U.S. federal law, this provision of the purchase agreement should be tailored to address not only the target’s compliance with applicable state and local law but ideally also the non-implication of the federal enforcement priorities set forth in the Cole Memorandum (although the specific wording of such a provision will likely be heavily negotiated). 

While due diligence relating to a marijuana-industry target’s compliance with federal law is by nature a limited and highly bespoke exercise, diligence relating to state and local law compliance should be tailored to address the specific legal and regulatory requirements of the state(s) and localities in which the target operates.  The marijuana laws that have been adopted in recent years vary widely from state to state and are by nature complex, as they seek to create comprehensive regulatory schemes for the creation of an entirely new (legal) industry in their respective states.  As an example, the law adopted by the most recent state to legalize adult-use marijuana, Illinois (where adult-use marijuana became legal as of January 1, 2020), comprises over 600 pages of detailed provisions addressing licensing, ownership, and operational and marketing requirements, as well as change of control provisions if a licensee changes hands.  The parts of the relevant state laws that are applicable to a target will depend on where along the value chain the target operates (i.e., different rules may apply to a grower as opposed to a dispensary operator).  

Since state marijuana laws generally seek to closely control the issuance and ownership of licenses for cultivation, processing, transport, sale, and distribution of marijuana, a critical issue to be analyzed early in a transaction is whether applicable state laws limit the seller’s ability to assign its license(s), and, if a share deal is contemplated, what impact statutory change of control provisions will have.  Additionally, state law may include ownership limitations that prohibit a single person or entity from owning an interest in more than a fixed number of licenses, and some forms of cross-ownership of licenses may be restricted.  The Illinois law, for example, forbids the ownership by any person or entity of any legal, equitable, or beneficial interest in more than three cultivation centers, more than ten dispensing organizations, or more than three craft grower licenses (and cross-ownership of certain types of licenses is also restricted).  In deals in which a simultaneous signing and closing is not possible, it is also important to analyze whether a provision that grants the buyer extensive pre-closing control rights is consistent with legal prohibitions on license transfers without prior state approval. 

In addition, the Illinois marijuana law contains social equity provisions that offer preferential treatment in the issuance of licenses to applicants that are controlled by or employ a majority of people who have disproportionately suffered the consequences of enforcement of marijuana laws.  These include people who have been arrested or incarcerated for marijuana-related offenses that are eligible for expungement under the law, as well as their family members, and people who reside in high-poverty areas and other areas that have been disproportionately affected by the enforcement of drug laws.  If a target’s license was granted in part based on the participation of such a “social equity applicant,” transfer of that license is subject to additional conditions that the buyer must comply with.  As a result, it is critical that a buyer understand the basis on which the target’s license was issued and how that might impact the buyer’s operation of the business following the acquisition.  

Beyond licensing issues, while marijuana deals present many of the same due diligence topics as targets in other industries, some of these topics have special significance in marijuana M&A.  Two issues that are of particular importance are the target’s access to banking services and insurance, as both areas have proven very challenging for many MRBs.  In connection with the target’s banking relationships (to the extent that it has been able to obtain banking services), the buyer should ascertain whether the target’s bank is fully aware of the nature of the target’s business, as some banks have reportedly terminated banking relationships with customers because of their involvement in the marijuana industry.  Due diligence should also encompass payment processing and money-handling, as many MRBs operate largely on a cash basis due to the lack of available service providers.  MRBs that operate largely or fully on a cash basis present particular safety and security challenges, and due diligence on such targets is complicated by the fact that cash transactions may not generate electronic records that can be used for fraud control and to verify a target’s financial records. 

On the insurance front, due diligence should include an examination of the sufficiency of the target’s coverage, including director and officer insurance, as many MRBs have struggled to obtain adequate coverage.  In this regard, the target’s policies should be reviewed to ensure that there are no exclusions that would effectively prevent it from making a claim in the event of a product liability, recall, or other loss event. 

Finally, federal tax compliance is a critical issue for a buyer’s due diligence, as the Internal Revenue Code prohibits MRBs from deducting many expenses that other businesses can deduct as a matter of course.  As a result, buyers should carefully review the target’s past tax filings to assess the risk that the target has claimed impermissible expense deductions and, therefore underpaid its federal taxes.  It is also essential to review the target’s bookkeeping practices to ensure that expenses of different types (e.g., costs of goods sold vs. other types of business expenses) are appropriately recorded, as some expenses are deductible while others are not. 

These are only a few of the unique aspects of advising clients on marijuana M&A.  The industry continues to develop at a dizzying pace, and law and regulation are struggling to keep up with the market.  This creates an exciting environment for deal lawyers who are prepared to help their clients navigate an emerging industry with many challenges and even more opportunities. 

DISCLAIMER: Morrison & Foerster LLP makes available the information in this article for informational purposes only, and it does not constitute legal advice and should not be relied on as such. Morrison & Foerster LLP renders legal advice only after compliance with certain procedures for accepting clients and when it is legally permissible to do so. Readers seeking to act upon any of the information contained in this article are urged to seek their own legal advice.

Access to capital is critical for start-ups and emerging growth companies to fund operations, finance working capital, and develop and scale products and technology. These companies typically rely on invested capital to raise funds; however, equity financing may not be available and can be dilutive to founders equity. Venture debt can complement equity financing and offers a source of capital to bridge the gap until the company’s next equity round, to cover expenses, or to support growth.

What Is Venture Debt?

Venture debt is nondilutive financing in the form of term loans or lines of credit available to venture-backed growth companies. These organizations typically have limited assets and are not cash-flow positive. Thus, traditional loans are typically unavailable. There are three primary kinds of venture debt:

• Equipment financing. This kind of financing is meant to fund the purchase of equipment, such as network infrastructure, hardware, or research and development.
• Accounts receivable. A start-up borrows against their accounts receivable, thereby smoothing out their spikes in revenue.
• Growth capital. A catch-all category meant for loans that can be used to fund growth, such as M&A, a new round of hiring, or working capital.

Benefits of Venture Debt

Venture debt offers benefits over other forms of financing. Unlike equity financing, venture debt is nondilutive. It allows shareholders to create greater value by providing the necessary capital for the organization to achieve critical milestones and support growth prior to its next round of funding. Venture debt also allows founders and shareholders of the company to maintain control of the business, given that lenders do not generally require board seats or observation rights as a condition.

Venture debt can usually also be arranged much more quickly than raising capital through equity financing. Thus, growth companies can gain access to funds faster and with fewer requirements. In addition, organizations can structure their debt, including venture debt, to lower their overall cost of debt capital.

Is Venture Debt Appropriate for the Business?

Although venture debt does offer certain benefits, it is not ideal for every organization.

Venture debt is typically ideal for start-ups that lack sufficient tangible assets to be eligible for more traditional financing. As such, many venture lenders prefer start-ups with monthly recurring revenue. Venture debt is typically for fast-growing companies with low operating expenses for which revenue growth can ultimately exceed the cost of capital. These kinds of start-ups are frequently found in the technology space, where very little initial capital is needed before a steady stream of revenue is generated.

Venture debt is not suitable as a last resort for companies that already have a low cash balance and high operating expenses. If the debt payment ends up being more than 20 percent of the company’s operating expenses, it is probably too costly for the company. It is also not suggested for companies that have a variable revenue stream or any company that does not have a clear use for the funds.

What Are Typical Terms for Venture Debt Loans?

The terms of venture debt facility will vary depending on a number of factors, including: (1) the company’s current stage of growth; (2) its current cash position; and (3) the industry and market in which the company operates. Some key terms of which emerging companies should be aware include the following:

• Interest rate: Interest rates tend to be higher than a normal commercial loan. Organizations can expect venture debt interest rates to be upwards of 10 percent.
• Term: Given that the purpose of venture debt is to assist the start-up in reaching the next round of equity financing, the terms of the loans are typically short. Thus, the terms of these loans are typically 12 to 48 months.
• Security: The loan will typically be secured by the company’s assets, such that the lenders have priority over the assets in case of insolvency.
• Warrants: The lender will typically receive warrants allowing the lender to purchase shares in the emerging company at a future date.
• Covenants: A loan will normally include both positive covenants and negative covenants. Common covenants include limits on raising additional debt and restrictions on the use of the loaned amount.

Conclusion

Emerging companies exploring venture debt should ensure that it is right for their organization. For mature organizations with assets that a loan can be secured against and a healthy stream of revenue, traditional commercial loans may be more attractive because the interest rates for loans will likely be much lower. However, venture debt offers an attractive source of financing for venture-backed organizations that are in a certain stage of growth.

Due to the significant variability between the terms of venture debt facilities made available, it is advisable that emerging companies seek expert advice for guidance on this form of financing.

The year 2019 was active in the legal space. Legal operations continued to be adopted by major enterprises and mid-market businesses alike. Facebook, British Airways, and Marriott Hotel faced millions in GDPR penalties, and litigation over clickwrap and other online contracts continued to skyrocket. In 2020, we can expect a continuation of these trends and more. Here are three predictions for what you can expect in the legal/litigation space in 2020.

(1) Data privacy legislation will increase, as will the need for third-party solutions like consent tracking. Data privacy regulations are becoming more of a pain point to legal teams. With the California Consumer Privacy Act (CCPA) now in effect, and the GDPR continuing to be fleshed out, we may see more of a push for easy third-party solutions to things like consent tracking. We will also see a surge of privacy policy-related litigation as the courts are called in to resolve ambiguity surrounding CCPA requirements. Depending on what happens in the aftermath, we may see (and in fact have already seen) a push for federal regulation over privacy. With all of these privacy regulations giving the express mandate to produce a privacy policy that outlines to consumers how their data will be used, companies will need third-party solutions to track consent. Especially as scrutiny of back-end records increases and becomes more sophisticated, third-party solutions will be needed to effectively convince the court of compliance with the new privacy regulations. 

(2) eSignature and contract lifecycle management tools won’t be enough. Businesses should want to leverage any technology that gives them more control over legal and/or compliance-driven aspects of the business, especially business models that operate at a massive scale online. Given that businesses must move at breakneck speed to keep up with consumer demand, legacy technologies like eSignature and contract lifecycle management tend to break, particularly with these newer business models. Technology and tools like these cannot scale with fast-paced business while remaining compliant with the increase in data privacy regulations. As compliance grows in focus in the new year, so will the necessity for technology that governs that aspect of the business. 

(3) Tech adoption will increase because of the drive for efficiency. The constant drive toward efficiency will manifest itself in two ways. First, legal teams will take a more data-driven approach to managing outside counsel and the related spend. Technology within legal has proliferated to such an extent that there are now multiple tools that can be used to provide the data necessary to complete this function. As this technology improves and its adoption increases, it will become one of the most important drivers of change, not just for inhouse legal, but for private law firms as well. Second, legal’s adoption of a more holistic approach to enabling their departments using tech will drive not only major increases in efficiency, but in the type of tech solutions offered by vendors. This holistic approach will begin from a fundamentally different foundation—one that focuses on business velocity versus plodding risk management—and for the first time ever, technology will allow for increases in business velocity to occur simultaneously to a decreased risk profile.

Be Prepared to Defend Your Agreements in 2020

With the CCPA in effect as of January 1, there will be even more compliance-related litigation, which will inevitably change the way companies function. Courts will become even more sophisticated in their evaluation of online agreements, and consumers will become more concerned about their data privacy. Businesses must be more prepared than ever to defend the enforceability of their agreements and prove compliance to the new (and old) privacy laws.