Citrin Cooperman: Conversations about Legalization or Decriminalization—Cannabis Market Reactions

Authored By

MITZI KEATING

MITZI KEATING, CPA, CFE – Partner TEL 401.421.4800 | FAX 401.421.0643 | MOBILE 508.572.0264 500 EXCHANGE STREET SUITE 9-100, PROVIDENCE, RI 02903 Speculation abounds these days with regard to the impact of the political environment on cannabis in the United States. Whether the conversation centers around the potential SAFE Banking Act, or the MORE Act, or the general social media hype on cannabis legalization or decriminalization, this tidbit of unverified information appears to be influencing investors’ decisions to purchase stock in cannabis companies. As seen recently through the impact of social media like Reddit, and mainstream media jumping on the social media bandwagon, the influence of social media on investors’ buying habits can’t be discounted. However, as a Certified Public Accountant dedicated to the cannabis industry I can’t help but look to the actual financial results, tax revenue, and regulatory environments to discount much of what is being speculated as to where the industry will go in the next few years. While anyone can hypothesize as to what may happen in the future with a Democratic controlled government, one cannot discount the influence, regulatory environment, and the state tax revenue generated by a state-legal cannabis structure on the bigger impact on the industry. So as I look into my crystal ball which is full of actual cannabis company reported data, here are my short-term key predictions for the future of the cannabis industry: Decriminalization or Legalization Is Likely to Occur: Through the passage of both the SAFE Banking Act and the MORE Act which were both passed by the Democratic controlled house in the past, it is likely that there will be more traction with these bills in a Democratic controlled Senate, making them likely to appear for signature on the desk of President Biden. Related to both public and private cannabis company operations, these bills will assist cannabis companies in a few significant ways which will help ultimately with cash flow in the earlier stages of this industry:

Access to more traditional banking services, inclusive of potential bank-backed loans as opposed to investor funding, PE funding, or self-funding as the industry currently utilizes. This access will likely help professionalize and right-size the private operators in the industry with regard to typical bank requirements related to audited or reviewed financial statements. While publicly traded companies on the Canadian exchange are required to file audited financial statements, privately held companies do not have the same pressure to report earnings and operations in accordance with any accepted accounting framework. It is often surprising that investors in privately held cannabis companies do not require audited or reviewed financial statements as a condition of their investment. Buyer beware.
Potential access to bank loans at interest rates lower than the speculative rates charged by private lenders. Interest rates to cannabis companies from private lenders vary, but typically range in the 8%-16% rate block. With indoor cultivation occurring in states with unfavorable outdoor growing climates, a typical $10,000,000 indoor grow operation could see interest payments upwards of $1,600,000 per year, greatly impacting the company’s ability to generate profit to its investors. On top of the cash flow issue related to exorbitant interest rates, one must also realize that in this current environment, this interest expense is disallowed as a tax deduction under Code Section 280E, further impacting cash flow for investors.
Descheduling or rescheduling cannabis from Schedules I or II of the Controlled Substances Act (CSA). Cannabis is currently listed as a Schedule I drug under the CSA, which subjects it to IRC Section 280E which states that “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted”. What most investors or speculators do not understand is that cannabis businesses are subject to onerous tax requirements at the Federal level (some states have decoupled from Section 280E) where their effective tax rates can be upwards of 75% as they are taxed on gross margin, not on net income. Depending upon the entity type, the Company or its members/investors may be responsible for paying taxes on income that does not exist on a cash basis, further reducing cash returns to investors. If 280E is no longer applicable to the cannabis industry, the cash flow from these companies will greatly increase to investors.

Mass Interstate Commerce is NOT Likely to Occur: Speculators seem to believe that once there is some measure of Federal legality or decriminalization that floodgates for interstate commerce will open and that large corporate conglomerates are likely to emerge to dominate the industry. There is also belief that cannabis which can be grown in favorable outdoor climates in less expensive states (CA/OR) will make its way into markets less favorable for outdoor grow which will bring the prices down in the industry and set up some states as exporters and some as importers. Having worked within the regulatory frameworks of many states, I can’t believe that this is likely to happen. Reasons why I do not see interstate commerce as a mass viable disrupter to the industry is as follows:

States have created their own unique regulatory environments related to the sale of legal cannabis. Included in these environments are varying tax payments and structures relating to excise taxes, sales taxes, or other local taxes or payments tied directly into the sale or distribution of cannabis. Certain states earmark the use of some of these funds to drug education or economic empowerment investments, and it is likely that there would be a clear desire by state and local governments to not lose out on these important funds through allowing for interstate commerce.
The varying state regulatory environments often limit the number of licenses or limit control of these licenses to certain groups of individuals based upon the crafting of the state laws and regulations. These types of regulatory controls allow states to control for oversupply and to assist in regulating demand which have been carefully crafted and honed over the years of state-legal operations. Mass allowance of interstate commerce would completely disrupt state cannabis economies by flooding the market with inexpensively grown product, driving down prices, driving down tax revenues, and putting small businesses out of business. The crafting of the laws and regulations by each state and local government will not graciously be tossed aside for a country-wide commercial endeavor.

Lack of Investor Education: While all of these predictions are just that, speculative predictions, none of these concepts exist in reality today. Until a law is passed which changes the environment for domestic cannabis companies, there are significant challenges to investors based upon the cash flow generated by these companies. While many companies fare well, many do not. While reported financial results are issued by publicly traded companies, they are adjusted in many instances for the impacts of impairment charges on acquisitions (overpayment for companies), biological adjustments (for inventory valuation adjustments different between US Generally Accepted Accounting Principles (GAAP), and International Financial Reporting Standards (IFRS)) and tax adjustments and tax positions taken in a murky and unclear US tax environment. However, social media hype, media hype, and incomplete messages and information oftentimes fuel the rise of cannabis stocks, which can rise and fall based upon nothing to do with the underlying cash flow or investor return. If a Reddit thread can bolster and destroy the stock of various investments and mainstream companies through social media momentum, it would be a fool’s errand to think that the same isn’t happening with such a volatile, regulated, and unknown industry of cannabis stocks. As a long-term strategy, education is the best option of all.