Investors closely watch U.S. Presidential elections because potential political changes could bring new policy and legislative changes. This is especially true in sectors wherein the two political parties have wide ideological differences. Presumptive Democratic nominee Joe Biden’s recent announcement about “legalization of medical marijuana” and “rescheduling it (cannabis)”1 has garnered wide attention. Rather than critique these proposals or dwell into who could win the elections, it is important to objectively analyze the impact of such changes on cannabis companies and investors.
Cannabis: A Schedule I Controlled Substance
Under the U.S. Controlled Substances Act (CSA) of 1970, cannabis is placed in the most restrictive category (“Schedule 1” controlled substances2) along with harmful drugs, such as heroin. Since then, there has been at least five petitions and three bills to reschedule cannabis, and all of them failed.
Over time, the perspective and acceptance of cannabis evolved. Currently, 11 U.S. states have approved cannabis for recreational use and 33 states have approved it for medical purposes, resulting in a multi-billion-dollar economy centered around cannabis. Rescheduling cannabis from Schedule 1 to lower categories and legalizing medical cannabis would address several issues the industry currently faces.
No More 280E Taxation
U.S. companies that fall under Schedule I or Schedule II of the CSA are subject to taxation under an amendment called Section 280E3. Given cannabis is a Schedule I substance, cannabis companies fall into this category. 280E effectively mandates that cannabis companies are taxed on Gross Profits and not on Earnings Before Taxes (which is the standard for every other industry). As a result, operating expenses (such as, sales, marketing, rent and administrative expenses), depreciation & amortization and interest expense are not tax-deductible. These result in even loss-making cannabis companies to have tax expenses.
Based on the current policy statement, we can expect one of two outcomes. First, cannabis could move from Schedule I to Schedule II. This would be a notional change with no real relief to cannabis companies. On the other hand, if cannabis is rescheduled to Schedule III or lower, they will not be subject to 280E taxes. This would reduce cannabis companies’ tax payments, increase their net income and free cash flows. Ceteris paribus, this should push valuations for U.S. cannabis companies higher. We expect the Horizons US Marijuana Index ETF (HMUS) to climb up once the legislative changes are announced or as the market sees the potential changes as more likely.
Access to Federal Bankruptcy
In every industry, a small portion of businesses are forced to restructure and the cannabis industry is no different. In fact, given the excess taxation, limited access to capital and lack of federal subsidies, they face relatively more financial pain. Unfortunately, given cannabis is federally illegal4, distressed cannabis and cannabis-related businesses are denied access to Chapter 7 and Chapter 11 bankruptcy protection. Bankruptcy protection are critical both for financially distressed companies to restructure and emerge financially more viable, and for creditors to protect their investments in case of a default. Without this protection, creditors will not get Section 363(F)’s free and clear order that only federal bankruptcy courts can issue. This added risk has kept some debt lenders away from this space.
If cannabis is rescheduled to Schedule II (or lower) and medicinal cannabis is legalized, there is enough precedent that might allow medical cannabis companies to access federal bankruptcy protection. For instance, in September ’19, Purdue Pharmaceuticals, the owner of OxyContin (a Schedule II controlled substance5), was able to file for Chapter 11 protection6. By extension, we believe Scheduled II medicinal grade cannabis companies might get access to bankruptcy protection as well. Such access should give debt investors more comfort, increasing the number of active lenders in the cannabis market. In the long term, this should drive down the cost of debt in this space.
The policy statement mentions that medical cannabis is likely to be federally legalized and recreational cannabis will be decided at the state level. Unfortunately, with this limited information, it is hard to foresee if recreational cannabis would also get access to federal bankruptcy protection. Given that the recreational cannabis market is much larger than the medicinal market, we can only hope that legislation would include the recreational segment as well.
Vendors & Partners
Compared to other sectors, cannabis has several shortcomings when it comes to its choice of financial and capital market partners. U.S. cannabis companies are still unable to access Tier 1 U.S. banks, list on major U.S. stock exchanges or work with the Big Four audit firms. Rescheduling per se may not remove these roadblocks. If rescheduling is combined with complimentary legislation, like the proposed STATES or HEROES Act, this would help cannabis companies access top-shelf banks, insurance companies, stock exchanges and audit firms.
Crossing State Lines
In addition to the above, they also face unique operational challenges. For instance, carrying cannabis across states (irrespective of whether cannabis is legal or illegal in those states) is a federal offense. Reclassification of cannabis will not solve or overcome this issue. Even with potential legalization of medicinal cannabis, crossing state lines could still be an issue because certain states, such as California, Oregon and Washington7, expressly prohibit import or export of cannabis.
Such restrictions defeat the need for large scale cannabis facilities. In the absence of economies of scale that come with large facilities, cannabis companies need to be vertically integrated at each state level to be successful. This is unlikely to change in the short term, despite the proposed changes.
A Step Forward
The cannabis industry, which generated $1.9 billion in 2019 taxes from just seven states8, is long overdue for policy overhaul. The proposed changes, irrespective of which party implements them, is a good starting point for the industry and would provide some relief by streamlining taxation, enabling some of them to access bankruptcy protection and help them catch up to the rest of the economy. On the same token, it is important to realize that the proposed policy is not a cannabis equivalent of the Farm Bill, which legalized hemp. Until cannabis is fully legalized, there will always be some outstanding issues and uncertainties. Whatever the final legislative changes are, the cannabis industry desires clarity and a path forward.
1 Source
2 To be classified under Schedule I, the substance should have high potential for abuse, have no accepted medical use, and not be safe to use without medical supervision.
3 Source: 26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs
4 Source: Another risk for marijuana biz: no bankruptcy protection, even for tangential players
5 Source: Drug Scheduling
6 Source: “Purdue Pharmaceuticals Files for Bankruptcy Protection” – Addiction Center
7 Source: “Can You Travel With Weed Between Legal States?” – Weed News
8 Source: State and Local Cannabis Tax Revenue Jumps 33%, Surpassing $1.9 Billion in 2019
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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