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When Investing In Cannabis Stocks, Think Like A Banker: 5 Tips To Avoid Fraud

Benzinga Cannabis

By David Olsky, Managing Partner at Fortis Law Partners.

Use the industry concept of the 5 C’s to better analyze the risks you might face, as well as the possibility of fraud.

Promises of outsize returns lure investors, big and small. And what better prospect for an outsize return, some have come to believe, than an investment in cannabis?

After all, 33 states now have legalized cannabis markets in some form, and at least three more states[1] could possibly legalize adult-use cannabis in 2020. This comes at a time of genuine momentum for landmark cannabis legislation, including passage of hemp-legalization provisions in the 2018 Farm Bill, as well as U.S. House approval of the SAFE Banking Act — the first time a standalone piece of cannabis legislation has been approved in Congress. As the political winds have changed, the industry itself has grown to an estimated $16 billion[2] in U.S. sales this year and forecast to be worth $66 billion[3] globally by 2025. Several marijuana-related investment companies are even publicly traded in Canada.

Investors have placed an estimated $10 billion into cannabis-related investments[4] last year, even though the cannabis marketplace still remains detached from most, if not all, banking institutions due to cannabis’ Schedule 1 classification under the Controlled Substances Act of 1970.

Investment in cannabis poses many risks. I have heard numerous stories from clients and potential clients about how they came to invest substantial sums in marijuana-related businesses. They learn of marijuana investments from friends, friends of friends, from personal trainers, or perhaps from a broker who is making a referral on the down low. If they actually receive offering documents and subscription agreements, those documents typically are poorly drafted and provide investors with few rights. The one thing the stories share: The investors never buy their investments from the platform of a nationally recognized broker dealer.

This is the type of investment that lends itself to a high degree of loss, if not outright fraud. If investors want to better protect their investments and avoid becoming victims, they need to think like bankers. Investors are extending credit to marijuana businesses, and they should take at least the same precautions as a bank that is extending credit to a borrower.

Related Story: Acreage CEO Kevin Murphy: Drop In Cannabis Stocks Isn't The End Of The Run

Although banks make individual decisions when considering investment proposals, they consider accepted types of criteria to determine levels of risk. By rationally analyzing these key criteria and removing the emotion from the decision, banks are better able to use their heads over their hearts and make informed investment decisions that can result in better returns and protect against fraud.

The 5 C’s To Consider

When considering an investment opportunity, bankers employ a common concept in the industry known as the 5 C’s, which is a framework to group risks and responses when considering investment proposals. These topics sometimes differ according to industries, but for investing and considering credit risks, the 5 C’s consist of Character, Capacity (or Cash Flow), Capital, Collateral and Conditions.

Character. Even if you think you are participating in a safe business arrangement with trusted friends, it is critical to verify the backgrounds of the individuals and entities managing your investment. Indeed, marijuana is still illegal at the federal level, and many individuals in the business have questionable intentions. 

A basic internet search such as Google can sometimes uncover important and revealing background information that you need to consider before making an investment. You should consider additional websites, such as sites that compile information on arrest records and liens.  You may also consider using the website run by the Financial Industry Regulatory Authority (FINRA) to determine if individuals behind the investment plans have previously acted as broker-dealers or have been sanctioned. If the investment has any relationship with a public company, you should check their registrations, such as the EDGAR search on the U.S. Securities and Exchange website or the company’s SEDAR filings. You may also seek out an attorney to assist you with additional computer research.

Capacity/Cash Flow. Will the entity you are investing in have the cash flow to repay the debt? Any business deal or investment requires due diligence. Request bank statements, P&Ls and any other financial records that will give you a better idea of the debt-to-income ratio of the companies requesting your investment dollars. 

Keep in mind that many small companies are not audited and, thus, will not be able to provide you with audited financials. Do not be shy about checking representations in the financials if this is the case. Get the assurance you need before you provide them your money.

Capital. How much money does the borrower have? Check any representations that they make against documents that they have provided to you. Take a closer look to confirm those statements are true.

Collateral. Sometimes, companies requesting investment dollars will offer collateral to assure repayment of the investment. But if that collateral already has a lien on it, you may need to wait in line and receive nothing in the event that the investment goes south. Check property records through Uniform Commercial Code (UCC) filings to reveal liens for any assets put up as collateral for your investments. UCC filings are legal forms that a creditor files to give notice that it has an interest in a debtor’s property. UCC financing statement forms must be filed in the state where the borrower is located, and this information typically can be found at websites for individual states’ secretary of state services.

And one other aspect of collateral: It’s up to you to secure the documentation on it, such as a deed of trust on a house being offered as collateral. Don’t expect the other parties to offer it up unsolicited.

Conditions: Finally, look at the governing documents closely to determine how you will be paid. Do the terms of the investments allow the borrowers to pay you whatever they want to pay you? Is there a specific percentage that you are supposed to get? And what does the resolution clause say about arbitration? The words that might be spoken among the best of friends in an investment deal may be disregarded by a court reviewing the words actually written in the investment contracts. So understand the written conditions well.

Related Story: A Complete List Of NYSE And NASDAQ-Listed Cannabis Companies

No investment is completely risk-free, just as no investment is completely immune to the possibility of fraud. But when thinking about investment in today’s cannabis marketplace, the 5 C’s of credit topics offer a solid framework to group risks and better view them objectively.

David Olsky is an experienced litigator who is particularly proficient at complex commercial cases on contingency, with clients reaping millions of dollars from his efforts. In addition to his civil practice, David has substantial experience representing individuals and companies in responding to government investigations.  He has represented clients before the Securities Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), Office of the Comptroller of the Currency (OCC), Department of Justice Antitrust Division, and various US Attorneys, state attorneys general, and state securities regulators. He has also conducted numerous internal investigations for corporate clients.  

Prior to joining Fortis in 2019, David was counsel at WilmerHale in its Washington D.C. and New York offices, and a senior counsel at Perkins Coie LLP in its Denver office.

[1] Arizona, Florida, Ohio

[2] https://www.fool.com/investing/2019/03/03/how-big-could-the-marijuana-industry-grow.aspx

[3] https://www.grandviewresearch.com/press-release/global-legal-marijuana-market

[4] https://www.apnews.com/0bd3cdbae26c4f99be359d6fe32f0d49

The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Photo by Javier Hasse.

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